1. The Capital Market
2. Interest Rates
3. The Mortgage Market

ROLE OF FINANCING IN REAL ESTATE TRANSACTIONS

Real estate transactions - the trading of ownership of interests in land- seldom occur without purchasers relying on borrowed funds, in addition to their own funds, to make up the full purchase price. Almost all house purchases involve debt financing. Most commercial, industrial and investment properties are bought with the aid of credit arrangements. The real estate development industry is dependent upon the availability of debt financing both to serve as production credit to finance construction operations (construction loans) and to facilitate the purchase of the finished product by buyers.

This heavy reliance on debt financing in the real estate market is a result of the high capital price, relative to income, of real estate. Long-term beneficial interests in land, such as fee-simple estates or long-term leases, generally have values as assets that are significantly larger than the annual income derived from the ownership of such interests and/or the annual income of prospective purchasers. The reason that the purchase price or capital value of interest in real estate is several times larger than the value of the annual benefits derived from the interest is that ownership of the interest provides a bundle of rights and benefits to the owner which continue for many years after the purchase. Thus, when an exchange of such an interest occurs, the vendor gives to the purchaser the right to the benefits that will occur for a long period of time in the future. In exchange, the purchaser pays the present value of future benefits, a large amount relative to the expected value of any one year's expected benefits.

Given the relationship between purchase price and annual income, many potential purchasers would have to wait for many years in order to save sufficient funds to make an outright (i.e., debt free) purchase of an interest in land. Similarly, many potential vendors would have to retain ownership for longer than they wished while waiting for a potential purchaser to accumulate the purchase price. In order to facilitate the acquisition of interests in land, most purchasers must borrow funds to add to their own resources, and thereby obtain enough capital to purchase the desired interest in land.

In the specific case of purchasers of housing for owner occupancy, the use of borrowed capital is usually a necessity because the price of the house is high in relation to their financial resources. Credit has the effect of multiplying purchasing power by combining a small down payment with a large debt. As a result, house purchasers can acquire a dwelling with a value much higher than their own capital would allow. Credit accelerates the time when purchasers can begin to enjoy the benefits of ownership; they would have a long wait until personal savings would permit an all-cash purchase. In effect, credit is an advance of future savings or purchasing power as it substitutes for capital yet to be accumulated: after the loan has been advanced, the borrower "saves" the required capital by repaying the loan (with interest).

The use of credit in the real estate market extends beyond the multiplying of the limited savings of purchasers of an interest in land. Many investors in income-producing properties (such as apartment buildings) find it financially advantageous to borrow a part of the required capital even though their own funds might be sufficient. There are several reasons which might lead to such borrowing.

First, in order to diversify investments and reduce the overall portfolio risk, it may be advisable to commit only a part of available funds to any one enterprise.

A second reason arises where it is possible to borrow at an interest rate lower than the expected debt free return from the property. Thus, the greater the debt, the higher will be the rate of return on invested equity capital: this is called leveraging or trading on the equity. For example, assume an investment in real property produces an income (before tax and debt financing) of $15,000 per year. The property costs $100,000. On this before tax basis, the property produces an annual yield (ignoring capital gains or losses) of 15%. If it is possible to borrow $70,000 at 12% per annum, compounded annually (interest only loan), the annual return on equity would be increased.

Third, debt financing may allow the purchase of real estate as a hedge against inflation. The investor may anticipate an inflationary rise in the general price level and in the returns on real estate. If the payments on the loan are fixed for the term of the loan, the investor could expect to pay off the debt in "cheaper" (inflated) dollars.

A fourth rationale for the use of debt financing is frequently to save (or release) equity for other activities. For example, a merchandising or manufacturing concern may prefer to use available funds in the business (for inventory or expansion) rather than to invest it in land and buildings. Note that many of these reasons for borrowing are equally applicable in the context of both acquisitions and use of financing by parties who already own interests in land.

For these (and other) reasons, the capital to acquire or maintain ownership of an interest in land is usually provided in part by the owner and in part by lenders. Both owner and lender, as suppliers of capital, are investors. The owner's contribution is called "equity capital", while the lender's capital is in the form of an investment from his standpoint and a "debt" from the standpoint of the owner-borrower. The use of debt capital in real estate investments is generally referred to as "financing" or "leveraging" the investment.

The sources of capital and the factors that influence its flow into real estate are quite different as between equity funds and borrowed capital. The motivations and objectives of owner-investors are quite diverse, including various combinations of investment for use (owner-occupancy); expectation of a regular return (income property), and expectation of a capital gain. The primary objectives of the lender- investor are generally more limited and more specific: to receive a regular and predictable return on capital in accordance with the contract, and, to a return of capital through the scheduled repayment. Lenders of funds expect to receive compensation in the form of interest (or 'rent') on the funds advanced. As lenders are concerned not only with receiving interest, but also with the return of funds (the principal) advanced, they generally seek some form of risk protection. When such security or risk protection is the right, under certain circumstances, to take over ownership of the borrower's interest (subject to all previous claims on the interest), the loan is referred to as a mortgage.

Mortgage loans are the most common form of financing used in contemporary real estate practice. Of primary concern is the use of mortgages to facilitate trading of interests in real property, or the "primary mortgage market". However, the characteristics of a mortgage in the form of the borrower's contractual obligations to make payments results in a market for the purchase and sale of existing mortgages, or the "secondary mortgage market". It must be remembered that mortgages are only one form of real estate financing, albeit the most common one. Through experience in the industry, one will have the opportunity to become familiar with the use of alternative financing vehicles, such as agreements for sale, leases, sale/leasebacks, equity syndication and bonds.

The Basis of the Capital Market

Given the importance of financing in real estate transactions, the factors that determine the cost and availability of mortgage funds (the behavior of the mortgage market) have a direct impact on the level of activity in the real estate market. While the mortgage market is a distinct segment of the economy, it is not an isolated segment. Thus, before one can understand the factors that influence mortgage availability and cost, one must briefly consider the overall market for funds, the capital market which establishes the environment for the mortgage market.

The capital market exists because, in any one period of time, some segments of the economy do not spend all of the income received in that period while other segments desire to spend more than they received or have accumulated. Economic units, be they households, businesses, or governments, whose current income exceeds current expenses, are "savers". Borrowers, on the other hand, are economic units with expenses larger than income for the period under consideration. In this context, borrowing may be regarded as contractually committing oneself to save in the future through debt repayment in order to increase current consumption. Saving may be regarded as consuming less in the current period in order to increase future consumption, as future income will (hopefully) be increased by returns upon saved funds.

The discussion of the capital market, the mechanism by which savers and borrowers interact, is facilitated by consideration of the "wheel of the economy". If we start the analysis of the "wheel of the economy" with incomes, it is apparent that in any one time period, the principal segments of the economy (households or consumers, business or producers, and governments) must either spend or save their income. If they spend it, it goes to purchase products from business or government (taxes may be considered as payment for a "product"), which in turn forms incomes for other segments of the economy. Funds which are saved, on the other hand, go to segments of the economy wanting to expand their purchasing power beyond their periodic income.

The Capital Market

The savers supply their funds to borrowers through one or more avenues.

The first is direct contact with the borrower;

The second is contact with a borrower through a broker (who receives compensation for acting as an intermediary);

The third is to "lend" surplus funds to a financial institution or organization which re-lends these funds to borrowers (and which receives compensation by lending at a higher rate than it borrows).

Note that, in terms of the income they earn, financial brokers and lenders fall into the category of businesses or producers.

The capital market refers to the organization of economic units which facilitate the transfer of funds from savers to users. The existence of this market relies on the willingness of some segments of the economy to save (the supply of funds) and of other segments to borrow (the demand for funds). The supply of funds is a function of expectations of economic conditions, consumer demand (particularly changes in consumer demand), the relative productivity of capital goods, and, of course, the cost of borrowing. Thus, conditions in capital markets reflect (and are affected by) the expectations of both savers and users of capital with respect to short-run and long-run economic conditions.

The balance between savers and borrowers in the economy is governed by interest rates, a reflection of the cost of borrowing and, concurrently, the reward for saving. The supply of savings in any period of time is a function of the amount people will save at each possible interest rate. The demand for funds is the amount that people will borrow at each level of interest. The point where the amount borrowed and the amount saved are the same determines the average interest rate for the particular time period. In this sense, the interest rate is the "price" of borrowed money.

An increase in demand for debt financing will have the effect of increasing the level of competition among borrowers for available funds: the predictable result being an increase in general interest rates. At the same time, potential returns associated with saving would also be on the rise. Some economic units would, therefore, be motivated to restrict current consumption as a result of the greater reward associated with saving, thereby increasing the amount saved. This expansion in the supply of funds will slow the increase in interest rates. Through this matching process, the economic units comprising the capital market, an ever-changing group of savers and borrowers, will work toward establishing a new balance between the demand and supply of funds.

By the same token, if the general level of demand for funds decreases, the capital market can be seen working in the opposite direction. As a consequence of lessened demand for debt financing, savers will find that they will have to lower their expectations with respect to earnings on "saved" (or "invested") funds. Thus interest rates on both the "borrowing" and the "saving" side of the capital market will decline. As these rates drop, a balance will again be approached as savers have less incentive to save and the costs associated with borrowing also becomes less onerous. Again the change in interest rates would be checked as the supply of savings was reduced (as the lower yields would not induce some individuals to continue to forego current consumption).

The preceding discussion merely outlines the basic elements and dynamics of the capital market. Of course, such a brief analysis does not consider the full complexity of this market. It does not examine the role of the federal government in determining the overall supply of money in the economy, and in determining the prime interest rate charged by the Bank of Canada. The brief discussion does not consider the impact of governments in the country in affecting the legal, taxation, and economic climate in which the capital market operates. Further, it does not present detailed discussion on the role of expectations, and changes in expectations, on both the demand and supply sides of the capital market. Finally, it treats the market as a single entity, when the market is, in reality, an aggregation of a large number of sub-markets, among which funds are highly mobile, but each of which has its own unique characteristics. In any in-depth analysis of the capital market, those topics must be considered.

Money and Capital Markets

Saving, the decision to restrict current consumption below current income, is simply another term for investment, the spending of capital today in order to receive benefits in the future. This differs from consumption, the spending of capital today in order to receive benefits today. Implicitly, whenever an investment decision is to be made, the investor must compare the benefits to be received in the future with the consumption foregone today.

This conceptual definition of investment does not indicate the wide range of competing investment alternatives open to investors/savers, both directly and indirectly through financial intermediaries. Some of these alternatives are saving accounts, term deposits, government securities, savings bonds, stocks, bonds, mortgages, foreign currencies, real estate equity investments, units in real estate syndicates, venture capital loans, personal loans, art and antiques, RRSPs, commodities and futures. Each of these investment alternatives represents "borrowers" competing for the funds of investors by offering different combinations of risk and reward potential. Prospective borrowers seeking mortgage funds must compete with all other borrowers, as listed above, plus consumption, in order to obtain the desired funds.

In order to comprehend the significance of the mortgage market in Canada and the role played by each lender, it is important to have some understanding of the total market for both money and capital. The financial markets in Canada are generally characterized as consisting of a "money market" and a "capital market".

The money market is described as a national market specializing in the buying and selling of short-term credit. As a general consideration, the money market is generally limited to the creation, purchase and sale of credit notes with less than a three year maturity. This market includes Government of Canada short-term bonds and treasury bills, day-to-day loans through banks, commercial paper (short- term negotiable notes issued by private corporations which call for the payment of a specific amount of money at some specified future date), banker's acceptances (short-term bank notes), and trust company guaranteed investment certificates (short-term credit notes issued by trust companies).

In contrast, the capital market includes the creation, buying and selling of long-term credit notes: bonds, debentures and mortgages, as well as equity issues, either common stock or preferred shares.

FINANCIAL MARKETS

Money Market	Capital Market
Treasury Bills	Debentures
Commercial Paper	Long Term Bonds
Guaranteed Investment Certificates	Equity (common shares)
Banker's Acceptance	Preferred Shares
	Mortgages

Within these two markets the various users of money and capital are brought together with the various sources of credit. The users of credit, both short-term and long-term, include:

Public Users: Federal Government, Provincial Governments, Municipal Governments, Crown Corporations

Private Users: Individuals, Partnerships, Corporations

The suppliers of credit include the various financial institutions in Canada, industrial firms and private individuals. The largest pools of capital are directed through the financial institutions which include:

Chartered Banks

Life Insurance Companies

Trust Companies

Pension Funds

Mortgage and Loan Companies

Investment Mutuals

Fire and Casualty Companies

Credit Unions

Chartered banks are the largest financial institutions in terms of the size of their asset base.

INTEREST RATES

When persons invest capital, they allow someone else to make use of it on agreed conditions one of which relates to the borrower making periodic "rental" payments for the use of capital the lender has invested. These payments for the use of capital are known as interest payments, and are generally calculated as a percentage of the capital invested. While the overall level of interest rates is set by the supply and demand factors in the financial markets as discussed in section II, there is a structure of relative interest rates within the financial markets. Investigation of the rates of interest being paid at any given moment will show that the rates will vary between alternative types of investments. The major factors affecting the difference in interest rates between investment vehicles are the degree of risk involved in the investment and the terms of the loans. The higher the degree of risk on an investment (in terms of risk of losing some or all of the capital invested or of not receiving all of the anticipated benefits) the higher the interest rate required to attract investors' capital. At the same levels of capital and return risk, the longer the term of the investment, the higher the rate of interest that must be paid to "lock in" investment funds unless there is a general expectation of declines in interest rates in the future.

Risk, and therefore relative interest rates, may usefully be explained in relation to government bonds which are generally regarded as a particularly safe (i.e. risk free) security. A federal government bond represents a promise by the Canadian Government to pay the interest stated and to repay the capital at the stated date. The holder of the bond, therefore, has little to worry about in terms of income security as the government is not likely to default on either payment of interest or repayment of principal. The only risks are from general price fluctuations before the date of redemption and the possibility of a fall in the value of money. In these relatively riskless circumstances, the rate of interest is relatively low.

In contrast, a mortgage lender does not enjoy the same degree of security. The promise of an individual purchasing a house to pay the interest and principal cannot be compared with that of the Canadian Government, and the mortgagee may have more trouble in recovering his capital than a bondholder. Furthermore, a mortgage is a less liquid investment than a government bond and may require significantly greater management effort. Invested funds which can be easily and quickly converted to cash without loss in capital are considered "liquid ".

As a compensation for the extra risks and effort involved, the mortgage lender (mortgagee) requires a higher expected yield on the loan than is obtainable from a government bond. Generally, the rate on a well-secured first mortgage will be greater than the yield on government bonds redeemable at the end of a time period similar to that of the term of the mortgage. With less sound propositions, the difference in interest rates will increase.

The interest rate charged on a mortgage loan is, from the lender's viewpoint, comprised of three components:

The return on the invested capital, this portion being determined by prevailing rates in investment markets and by the supply of, and demand for, mortgage investment funds;

An inducement to accept risk on the capital resulting from an uncertain investment; prime investments will generally be granted a lower rate than investments involving greater risks, (e.g. junior mortgages); and

Payment to the lender of a proportion of the general capital and operating costs of mortgage lending activities.

The determination of the rate on a loan is often a difficult task, as the lender seeks a rate that will be acceptable to borrowers and still satisfy the lender's objectives. Generally, the elements which are considered in the setting of a rate include:

The credit rating of borrowers and the value of the (real property) security;

The amount of administrative attention required (higher rates are charged on loans involving extensive administrative work);

Type of property used for security (there will generally be a different rate charged on each type of property, such as unimproved land, owner-occupied residential, revenue residential, commercial, industrial, hotel, etc.);

Amount of equity, the rate being inversely related to the relative amount of equity.

Generally, individual lenders will not directly adjust the interest rate in accordance with risk on a specific loan within classes of loan types, as they prefer to adhere to what they interpret as the market rate for funds. Other devices are used to provide such "fine tuning". For example, lenders may adjust the nonrate factors of individual loans to compensate for differing levels of risk on individual loans (i.e., by setting loan-to-value and debt-service ratios, contractual terms and amortization periods to suit individual circumstances). As well, front end charges (bonuses, commitment fees, points and the like) can be used as prepayment of "interest" beyond the interest charged in the contract. Further, in investment real estate, lenders may seek cash flow and/or equity participation in projects, either directly through joint ventures or indirectly through the mortgage contract. All of those devices can be used to tailor the "interest" rate to reflect risk on a specific loan.

THE MORTGAGE MARKET

The mortgage market is linked to the capital market through its competition with other investments for a share of the total supply of savings. Investment funds will flow to segments which promise the most attractive returns in light of the expected risks and returns. As the demand for funds in the mortgage market increases, the interest rate on mortgages will increase, thereby attracting investment funds away from other segments of the capital market and into the mortgage market. Conversely, increases in the demand for capital outside the mortgage market will draw funds away from the mortgage market, thereby resulting in an increase in mortgage interest rates in order to attract the funds back to the mortgage market. Funds will continue to leave the mortgage market until the interest rate has risen to a level that is equivalent to that offered on equivalent non-mortgage sectors of the capital market.

Changes in the level of savings will affect all sectors of the capital market (including the mortgage market), to the extent that the supply of investment funds changes with changes in the level of savings. Thus, the supply of mortgage funds depends on the total amount available in the form of savings and on the competitive position of mortgage investment among other available alternatives.

Finally, since the monetary and fiscal policies of governments and the Bank of Canada influence the state of the credit market and the supply of savings in the economy, changes in government policies are of utmost importance to the supply of mortgage funds.

The demand for mortgage credit is just as complex as the supply. The demand for mortgage funds is derived from the demand for ownership of real property. This derived demand for borrowing is very sensitive to the cost of borrowed funds (i.e., the interest rate). Small changes in interest rates, because of the long period over which most mortgage loans are repaid, have sizeable effects on monthly, as well as overall, carrying costs and, therefore, on the individual's ability to acquire a house or other interests in real property. Almost every individual will have a maximum price that can be paid for the use of credit to finance a real estate investment. Credit costs that exceed this maximum price will cause the individual to forego the investment. Thus, just as the supply of funds to the mortgage market was seen to depend on the general level of savings and the relative attractiveness of mortgage investment, demand for real estate credit depends on the level of activity in the real estate market and on the terms and, hence, the price of the mortgage loan.

In general, mortgage interest rates tend to move with fluctuations in the national economy; rates rise when the economy is expanding and decline during periods of recession. Mortgage rates are sluggish relative to rates in the other sectors of the capital market; they have tended to lag behind changes in bond yields in both upward and downward movements. This "stickiness" in mortgage rates is the result of a variety of factors including the wide use of advance commitments in placing mortgage loans, the long-term nature of the loan contract, and the absence of an active secondary mortgage market. Furthermore, mortgage rates have fluctuated within a narrower range than that of other security yields. These historical relationships, while still generally correct, are currently in a state of change as a result of long-term organizational changes in Canadian capital markets.

Mortgage investments lack the liquidity which favors those securities and investments which are traded in organized, established security markets (e.g., the stock market). In addition, the mortgage labors under the handicaps of a complicated lending process and relatively costly investment management (referred to as servicing). The greater expenses of acquisition and administration, the relative non-liquidity of the mortgage investment and the greater risk often involved explain the traditionally higher interest rates on mortgages compared with bonds. These characteristics of mortgage loans as potential investments have had an effect on how much capital is made available for real estate debt financing.

Compliments of The Real Estate Division of The University of British Columbia