University | Massachusetts Institute of Technology (MIT) USA |

Subject | Real Estate Finance |

**QUESTION 1:**

You are considering the acquisition of an office property with 20 floors that can be leased, with 5,000 square feet (SF) of leasable space per floor. Currently, all of this space is leased, at the market rent of £50 per SF per year, payable at the end of the year (the first rent is received in one year’s time). Annual operating expenses are equal to £1 million, and they have to be paid regardless of whether the space is vacant or not (the expenses are also paid at the end of the year). The lease contracts specify that the tenants are required to reimburse the property owner for half of these expenses. The property price implies a yield of 6%, based on initial NOI.

You are planning to finance the acquisition of this property partly with debt, more precisely by taking out an interest-only loan with an interest rate of 5%. In spite of the property is fully occupied, in addition to a maximum LTV of 80%, the bank is insisting on a maximum loan amount such that the property cash-flow is sufficient to cover the interest expense in case occupancy drops to 70%. The bank is worried about the fact that space is leased to tenants who have the right to break the lease at short notice.

- What is the acquisition price?

Income = 20*5000*50 = 5000000

NOI = 5,000,000 – 1,000,000 = 4,000,000

Acquisition price = NOI/yield = 4000000/0.06

Acquisition price = £66,666,666.67

- What is the maximum amount that you will be able to borrow?

When occupancy is at 70%,

- You decide to borrow the maximum amount permitted and to finance the remaining amount with equity. But you soon realize that in case of occupancy drops, it is also likely that rental prices will drop. In order to evaluate such risk, please calculate the combination of rental values and occupancy rates so that the property cash-flow would allow you to meet the interest payment on the loan. Please briefly discuss possible ways to mitigate the risk (
**maximum 5 lines**). - One year has passed and the risks that you were concerned with did not materialize. The property has remained fully occupied and you have just received the NOI for the first year. You have also just signed long term triple net lease contracts with the tenants, with annual rent increases indexed to inflation (equal to 2% for the coming year). The yield for your building has decreased and it is equal to 4%. You decide to sell. What is the realized IRR on your equity investment? What might explain the decrease in yield? Who might be the investor interested in such an asset? Please explain briefly (
**maximum 10 lines**).

**QUESTION 2****:**

Appendix A.pdf. This file contains information on a mortgage product provided by Barclays, named Family Springboard (FSB) Mortgage. This information is from the Barclays website. Please read it as you will need it to answer this question.

The FSB mortgage allows homebuyers to borrow up to 100% of the purchase price of the house. A family member of the homebuyer provides 10% of the price as security for five years.

More precisely, the family member deposits 10% of the purchase price in a deposit account with the lender, entitled Helpful Starter account, which earns interest at an annual rate of 1.6% paid monthly, or an annual equivalent rate of 1.61%. The deposit is returned to the family member after five years if no mortgage payments are missed. Otherwise, the deposit may be at risk. All the cash-flows occur at the end of the month, except the initial amount borrowed and initial family member deposit.

- Why do you think that Barclays has come up with this product? What are the benefits of the different parties involved? Please explain having in mind the evolution of residential real estate prices, interest rates, and household incomes over the last decade (
**maximum 15 lines**). - A borrower decides to purchase a house of price £200,000 using an FSB mortgage with an LTV of 100% and a 10% deposit from a family member. The interest rate on the mortgage during the first five years is fixed at 2.95% and the following on the rate (i.e. after these five years) is variable and currently equal to 2.74% (as per the information in Appendix A). The maturity of the loan is 25 years. Please use a spreadsheet to calculate the monthly cash-flows for each of the parties involved (i.e. the homebuyer, the family member, and Barclays). You may assume that the family member withdraws the interest paid out of the account in each month, the deposit at the end of five years and that the mortgage is held to maturity.
- Please evaluate quantitatively the risk that Barclays faces, over the life of the loan, in the product in part (b) compared to a standard mortgage (i.e. a mortgage without the deposit of the family member), with zero fees, an LTV of 90%, an annual interest rate of 2.8% over the life of the loan, and a maturity of 25 years (for the purchase of the same house of price £200,000). Please explain briefly (
**maximum 5 lines**). - For all the mortgage products considered so far in this question, including the FSB mortgages and the standard mortgage in part (c), the initial product fees are zero. Please compare the following two standard mortgages (i.e. mortgages taken without the family member deposit) used for the purchase of a £200,000 house:

Mortgage d1: Product fees of £0, LTV of 90%, the annual interest rate of 2.8%, and maturity of 25 years. This is the standard mortgage in part (c).

Mortgage d2: Product fees of £500, LTV of 90%, the annual interest rate of 2.7%, and maturity of 25 years. (You may assume that the product fees are added to the loan balance at the initial date.)

Please compare the cost of each of these products for (i) borrower A, who expects to repay the loan in exactly 2 years; and (ii) borrower B, who expects to repay the loan in exactly 5 years. Please explain which of the mortgages each borrower would choose, and why it may be beneficial for lenders to offer products which differ in such a way (**maximum 5 lines**)