REAL ESTATE FINANCING: MORTGAGES

Introduction
– A mortgage is a loan secured by real estate. It is a pledge of property to secure payment
of debt. Real estate is usually in form of a house, land or such like property.
– There two parties to a mortgage:
o Mortgagor: borrower
o Mortgagee: lender
– The borrower also called a mortgagor must possess some real estate to obtain a loan from
a lender also called a mortgagee.
– A conventional mortgage arises when the loan is based purely on the credit of the
borrower and on the collateral for the mortgage.
– Mortgagees may however take additional steps to guarantee that the loan conditions are
fulfilled by the borrower. One such step would be to take on mortgage insurance.
– There are two markets in the mortgage industry:
 o Primary market: market of origination
o Secondary market: any subsequent trade
– Mortgages are traded in the mortgage market. The markets comprise a primary segment
which is the market of origin and the secondary market where the mortgages are traded.
– Real estate properties can be categorized as:
o Family residential properties- this category of real estate properties could be
owned by one or few families for residential purposes. Examples are houses,
apartments, etc
o Commercial properties- these are income generating properties. They include
multi-family apartment buildings, office buildings, industrial properties, shopping
centres, sporting facilities, entertainment facilities, warehouses, hotels and health
care facilities.
Mortgage Origination
– Mortgage origination is the process of initial mortgage lending. Mortgage banking is the
activity of originating mortgages. As a result, the original mortgage lender is called the
mortgage originator.
– Hence the mortgage origination market is the market where the initial mortgage lending
takes place. It comprises the mortgage originators.
– The most common originators include commercial banks, mortgage bankers, life
assurance companies and pension funds (companies that deal with long term funds)

Sources of Income for Mortgage Originators

– Mortgage originators generate income in the following ways
o Application fees: is payable on application for consideration of the mortgage loan
o Commitment fees: paid by those who qualify for the loan following evaluation. The
fee obligates the mortgagee to set aside the funds for the loan.
o Penalties: in case of infringements and defaults in the course of origination.
o Origination fees- the fee is usually expressed in points with each point taken as a
percentage of the funds borrowed.
o Secondary market profit - the mortgage secondary market is where subsequent
trading of mortgages originated in the primary market is done. The originator may
sell the mortgage in the secondary market at a higher price than the original cost.
The margin is called the secondary market profit.
o Servicing fees- applies when the originators are involved in the facilitation of the
mortgage they originate. Such facilitation could entail periodic collections from the
mortgagors and remissions of proceeds to owners of the loan; providing
notifications to mortgagors; maintaining mortgage records and due balances;
providing tax information to mortgagors etc. Such procedures incorporate mortgage
servicing and for such services, originators may demand servicing fee.
o Mortgage interest: if the loan is carried to the full term. The overriding objective
of mortgage origination.
 The Mortgage Origination Process
– Mortgage origination process takes the following 3 steps:
i. Mortgage application: the applicant furnishes pertinent information to facilitate
credit evaluation by the mortgage originator. The information sought include:
• The loan amount
• The real estate value and other credentials- location, size, form of ownership,
charges, legal interests, level of development, etc
• Past credit record
• Capital
• Business
• Capacity to pay
• Periodic income
• The assets outside of the real estate
• Age
• Income commitments
 • Type of job
• Existing legal contracts
• The purpose for the mortgage
• Existing financial obligations
• Existing primary or floating charges
• etc
ii. Credit evaluation: the mortgage originator considers a number of factors before
granting the loan. The main ones include:
a) The 5 Cs of credit: the lender makes an evaluation of the ability of the borrower
to make the repayments. The evaluation is based on the following:
o Character of the borrower- based on past experience, referrals from credit
rating agencies, etc. In Kenya history is mostly derived from CRB ratings. The
better the character, the higher the credit rating
o Collateral offered for the mortgage loan- the value of the real estate for which
the mortgage is borrowed. The higher the value of the collateral, the better the
chance of securing the mortgage.
o Conditions prevailing in the economy- depressed conditions may affect the
ability of the borrower to repay. Credit scores are highest during economic
boom and decline during economic recession and subsequent depression.
o Capacity of the borrower to repay- based income and periodic cash flows.
Evaluate the cash flow streams more critically than the income streams. The
earning power and cash flow patterns determine the ability to pay.
o Capital of the borrower- based on the financial base of the borrower. It is
looked at from two perspectives:
▪ The asset base: the higher the value of assets the greater the chance of
scoring highly on the mortgage evaluation score.
▪ The equity base: Owner’s equity increases the credit rating of a business
and the higher the level of leverage, the greater the mortgage risk.
b)Loan to value ratio (LTV): the ratio of the amount of the loan to the value of
the property. The lower the ratio, the more the lender is covered from the risk of
default by the borrower.
𝐿𝑜𝑎𝑛 𝑉𝑎𝑙𝑢𝑒
𝐿𝑇𝑉 =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦
c) Payment to income ratio (PTI): the ratio of monthly payments to the monthly
income. It indicates the ability of the borrower to meet monthly mortgage
obligations from the regular income. The ease of repayments increases with
decline in the ratio.
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑃𝑇𝐼 = =
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐼𝑛𝑐𝑜𝑚𝑒 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐸𝐵𝐼𝑇

d)Times interest coverage (TIC): applies where the mortgagor is a trading

business and the ratio indicates the number of times mortgage interest can be paid
from the normal trading profits before they are exhausted. The higher the ratio,
the better for the lender.
 𝐸𝐵𝐼𝑇
𝑇𝐼𝐶 =
𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

e) Times total mortgage coverage (TMC): indicates to what extend the mortgage
can be recovered from the normal trading activities of a trading mortgagor. The
ratio indicates the number of times mortgage loan plus its interest can be paid
from the normal trading profits before they are exhausted. The higher the ratio,
the better for the lender.

𝐸𝐵𝐼𝑇
𝑇𝑀𝐶 =
𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
f) Financial distress scores:
o Univariate scores based on liquidity ratios
o Multivariate scores like linear discriminant modes like the Altman 5-variale
linear discriminant financial distress model
𝑍 = 1.2𝑋1 + 1.4𝑋2 +3.3𝑋3 + 0.6𝑋4 + 1.0𝑋5 − − − 𝑐𝑜𝑚𝑝𝑎𝑟𝑒 𝑤𝑖𝑡ℎ 2.675
𝑊𝐶
𝑋1 = − − − −𝐴 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑓 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦
𝑇𝐴

𝑅𝐸
𝑋2 = − − − −𝐴 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑓 𝑟𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑇𝐴

𝐸𝐵𝐼𝑇
𝑋3 = − − − −𝐴 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑓 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦
𝑇𝐴

𝑀𝑉𝐸
𝑋4 = − − − −𝐴 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒
𝐵𝑉𝐷

𝑁𝐸𝑡 𝑆𝑎𝑙𝑒𝑠
𝑋5 = − − − −𝐴 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑓 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝑇𝐴
iii. Commitment letter- this is a letter send by the lender committing themselves to
provide the borrower with the money under loan consideration. A borrower often pays
commitment fee to the lender. For a fee, the applicant obtains the right but not the
obligation to require the lender to provide funds of a specified interest rate and on
specified borrowing terms.

NB: mortgage originators operate on two basic types of mortgages i.e. fixed rate mortgages
or adjustable rate mortgages.
▪ Mortgage originators have various options for options for dealing with mortgages
originated. These include:
– Holding the mortgage in their portfolio
– Selling the mortgage to an investor who could hold onto it or place it in a pool of
mortgages to be used as collateral for insurance of a security
– Use the mortgage as collateral for issuance of a security. Such a process is called
mortgage securitization.
Illustration
The following trial balance relates to the books of ABC Ltd as at 30th June 2023, the year end of the
firm.
Account DR (Sh.) CR(Sh.)
Purchases and sales 312,500 537,500
Bad debts and provisions for bad and doubtful debts 5,250 10,375
Sh.10 ordinary share capital 250,000
Ordinary share premium 53,750
10% Sh.12 Preferential share capital 112,500
Preferential share premium 8,750
Motor vehicle (cost Sh.107,000) 78,250
Machinery (cost Sh.200,000) 82,000
Land and Buildings 170,500
Inventory 101,250
Bank 25,514
Cash 74,769
Accounts receivables 88,768
Revaluation reserve 19,375
Income statement 1,875
Capital reserves 5,000
Revenue reserves 16,250
Accounts payables 11,875
 Commissions 25,044
Rent 12,500
County government rates 15,000
Electricity 12,835
Education Sponsorship expenses 17,819
Employees benefit costs 13,125
Discounts 8,000 5,750
Salaries and wages 48,825
Directors' fees 5,000
12% 5-year Mortgage 50,000
12% 5 year loan 62,500
Interest 7,500
Lease charges 12,000
Health social responsibility costs 15,316
Short term Investments 62,550
Excise duty costs 13,813
Miscellaneous expenses 41,438
Computers (cost Sh.37,500) 19,750
Returns 5,425 6,875
1,213,558 1,213,558

The following information is also available for Obama Ltd at 30th June, 2022:
i. Two respective invoices of Sh.37,500 and Sh.12,500 for sales and purchases made on the last
day of the year had remained unrecorded in the books of accounts of the company.
 ii. A debtor owing Sh.500 was declared bankrupt on 30.06.2023. This amount is to be written off
as unrecoverable. In addition, the provision for bad and doubtful debts is to be maintained at
4% of the remaining outstanding debtors at year end.
iii. The permanent appreciation of the value of land and buildings demanded that they be revalued
to Sh.180,000 at the end of the year.
iv. The company falls in the 30% tax bracket
v. A physical inventory count on 30.06.2023 showed that stock valued at a cost of Sh.150,000
remained unsold.
vi. Both motor vehicles and machinery are depreciated at the rate of 12.5% using the straight-line
approach. Computers are to be depreciated at 10% reducing balance
vii. Accruals at the end of the year are: Lease charges Sh.1,250 and health social responsibility
costs Sh.2,034
viii. Prepayments at the end of the year are: Salaries and wages Sh.1,325; Directors fees Sh.3,825
and excise duty costs Sh.1,313
ix. Once the preferential dividend and the proposed ordinary dividend of Sh.1 per share are
appropriated, a further Sh.37,500 should be transferred to capital and revenue reserves in the
ratio of 2:3 respectively.
x. A rental income of Sh.12,500 for the second half of the year is yet to be received or recorded.

Required:
i. LTV if the market value of land and buildings is 2.5 times the book value:
 𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝐿𝑜𝑎𝑛
𝐿𝑇𝑉 =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑅𝑒𝑎𝑙 𝑒𝑠𝑡𝑎𝑡𝑒

Sh.
Land and Buildings bf 170,500
Revaluation 9,500
Balance cf 180,000
Market Valuation Factor *2.5
Market value 450,000

𝑀𝑜𝑟𝑡𝑔𝑎𝑔𝑒 𝐿𝑜𝑎𝑛 50,000

𝐿𝑇𝑉 = = = 0.111: 1
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑅𝑒𝑎𝑙 𝑒𝑠𝑡𝑎𝑡𝑒 450,000

ii. Payment to Income ratio (PTI)

𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑃𝑇𝐼 =
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐸𝐵𝐼𝑇
12%
𝑟= = 0.01
12
 𝑡 = 5 𝑦𝑒𝑎𝑟𝑠 ∗ 12 = 60 𝑚𝑜𝑛𝑡ℎ𝑠

𝐿𝑜𝑎𝑛 50,000 50,000

𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = = =
𝑃𝑉𝐼𝐹𝐴𝑟,𝑡 (1 − (1 + 𝑟)−𝑛 (1 − (1 + 0.01)−60
[ ] [ ]
𝑟 0.01

𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 1,112.22

𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 1,112.22

𝑃𝑇𝐼 = = = 0.116: 1
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐸𝐵𝐼𝑇 9,604

WK 1: Provision for bad Debts

Debtors bf 88,768
Unrecorded Sales 37,500
Bad debt w/o (500)
Gross Debtors 125,768
Provision rate *0.04
Provision for bad debts cf 5,031
Provision bf (10375)
Provision Income 5,344
 WK2: Monthly EBIT
Sh. Sh Sh.
Sales (537,500+37,500) 575,000
Less Returns (5,425)
Net sales 569,575
Cost of Sales
Opening Stock 101,250
Purchases (312500+12500) 325,000
Returns (6,875) 318,125
For Sale 419,375
Closing Stock (150,000) (269,375)
Gross Profit 300,200
Provision Income 5,344
Commissions 25,044
Rent (12,500+12,500) 25,000
Discount received 5,750
Gross Income 361,338
Expenses
Bad Debts (5,250+500) 5,750
Vehicle depreciation 13,375
 Machinery depreciation 25,000
County Rates 15,000
Electricity 12,835
Education CSR 17,819
Employee costs 13,125
Discount allowed 8,000
Salaries (48825-1325) 47,500
Directors fees (5,000-3825) 1,175
Lease charge (12K+1,250) 13,250
Health CSR (15316+2034) 17,350
Excise duty(13813-1313) 12,500
Miscellaneous 41,438
Computer Depreciation 1,975 (246,092)
Annual EBIT 115,246
No. of months /12
Monthly EBIT 9,604

Account DR (Sh.) CR(Sh.)

Purchases and sales 312,500+12,500 537,500+37,500
Bad debts and provisions for bad and doubtful debts 5,250+500 10,375-5,344
Sh.10 ordinary share capital 250,000
Ordinary share premium 53,750
10% Sh.12 Preferential share capital 112,500
Preferential share premium 8,750
M. Vehicle (cost Sh.107,000) Dep=0.125*107K=13375 78,250
Machinery (cost Sh.200,000) Dep=0.125*200K=25K 82,000
Land and Buildings 170,500+9,500
Inventory Closing stock =150,000 101,250
Bank 25,514
Cash 74,769
Accounts receivables 88,768+37500-500
Revaluation reserve 19,375+9,500
Income statement 1,875
Capital reserves 5,000
Revenue reserves 16,250
Accounts payables 11,875
Commissions 25,044
Rent 12,500+12,500
County government rates 15,000
Electricity 12,835
Education Sponsorship expenses 17,819
Employees benefit costs 13,125
Discounts 8,000 5,750
Salaries and wages -1,325 48,825
 Directors' fees -3,825 5,000
12% 5-year Mortgage 50,000
12% 5 year loan 62,500
Interest 7,500
Lease charges +1,250 12,000
Health social responsibility costs +2,034 15,316
Short term Investments 62,550
Excise duty costs -1,313 13,813
Miscellaneous expenses 41,438
Computers (cost Sh.37,500) Dep=0.1*19,750=1,975 19,750
Returns 5,425 6,875
Tax=30% 1,213,558 1,213,558

iii. Times Interest Coverage (TIC)

𝐸𝐵𝐼𝑇 115,246
𝑇𝐼𝐶 = = = 19.20 𝑡𝑖𝑚𝑒𝑠𝑓𝑜𝑟 𝑚𝑜𝑟𝑔𝑎𝑔𝑒 𝑜𝑛𝑙𝑦
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 0.12 ∗ 50,000

𝐸𝐵𝐼𝑇 115,246
𝑇𝐼𝐶 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑙𝑜𝑎𝑛𝑠 = = = 8.54 𝑡𝑖𝑚𝑒𝑠
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 0.12(50,000 + 62,500)

iv. Total Mortgage Coverage (TMC)

 𝐸𝐵𝐼𝑇 115,246
𝑇𝑀𝐶 = = = 2.061 𝑡𝑖𝑚𝑒𝑠
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑀𝑜𝑟𝑡𝑎𝑔𝑒 50,000 + 6,000

v. Altman Z-score

Risks Associated with Mortgage Origination

– The basic lending risk associated with mortgage origination is called pipeline risk. This
risk can be illustrated as:

Pipeline risk

Price risk Fallout risk

– Pipeline risk is hence composed of the fallout risk and the price risk.
– Fallout risk is the risk that the mortgage applicant or those issued with the commitment
letters by a mortgage originator will not complete the transaction by purchasing the
 property with funds borrowed from the mortgage originator. The applicant may decline
to close out the contract as a result of:
o Decline in mortgage rates that makes it economical to seek alternative finance
sources
o Unfavourable property inspection report
o Change in borrower circumstances e.g. loss of employment, etc
– Price risk defines the adverse effects on the value of the mortgage commitments as a
result of changes (rises) in mortgage rates. This occurs especially for fixed rate
mortgages such that when the mortgage rate rises, the originator is left with low rate
commitments.
– The originator faces the same risk if there are rate changes between commitment and
closeout time and he commits at a lower mortgage rate.
– A mortgage originator can hedge against a pipeline risk by agreeing on a forward-like
contract with the agent or investor he wishes to sell the mortgage to.
– To avoid the adverse impact of price changes in such agreement, the originator could
agree on an optional contract with the agency. This will give the originator the option to
sell out the option to the agency only while price movements are upward.

Mortgage Designs
– These include:
o Traditional mortgage designs
o Adjustable rate mortgages
o Inflation oriented mortgage designs
o Prepayment penalty mortgages
o Growing equity mortgages
o Reverse mortgages
o High LTV mortgages