Optimal Mortgage Contract Choice Decision in the Presence of Pay Option Adjustable Rate Mortgage and the Balloon Mortgage

The unprecedented run-up in global house prices of the 2000s was preceded by a revolution in U.S. mortgage markets in which borrowers faced a plethora of mortgages to choose from collectively known as nontraditional mortgages (NTMs), whose poor performance helped ignite the global financial crisis in 2007. This paper studies the choice of mortgage contracts in an expanded framework where the menu of contracts includes the pay option adjustable rate mortgage (PO-ARM), and the balloon mortgage (BM), alongside the traditional long horizon fixed rate mortgage (FRM) and the short horizon regular ARM. The inclusion of the PO-ARM is based on the fact it is the most controversial and perhaps the riskiest of the NTMs, whereas the BM has not been analyzed in the literature despite its different risk-sharing arrangement and long vintage. Our inclusive model relates the structural differences of these contracts to the horizon risk management problems and affordability constraints faced by the households that differ in terms of expected mobility. The numerical solutions of the model generates a number of interesting results suggesting that households select mortgage contracts to match their horizon, manage horizon risk and mitigate liquidity or affordability constraints they face. From a risk management and welfare perspectives, we find that the optimal contract for households with shorter horizons, specifically households who expect to move house once every 1 to 2 years, is the PO-ARM. Beyond 2 years the welfare advantage of the PO-ARM diminishes and BM becomes the more optimal contract up to 5-year horizon. Overall, the results suggest that households are neither as risk averse as the selection of the FRM would suggest, nor are they as risk-seeking as the selection of PO-ARM or regular ARM would suggest. The results also suggest that the exuberance demonstrated for NTMs by borrowers, especially PO-ARMs, may be both rational and irrational.     

Resource Combination and Security Price Reactions: The Case of Real Estate Joint Ventures

Joint ventures are a commonplace occurrence in the U.S. economy. In particular, firms undertaking real estate projects frequently use the joint venture as a method of combining resources. This paper examines security price reactions around real estate joint venture announcements. The evidence indicates that significant increases in the values of the participating firms occur within a two-day announcement period. The changes in values appear to be due principally to the amount of information about the local real estate market possessed by the participating firms, and an information signal about the potential financial viability of the proposed project conveyed by the presence of anchor tenants. While the results are important in their own right, they are also significant in another respect. They seem to confirm the efficiency with which the capital market processes information about the markets for trading real estate claims.     

Rankings of Contributing Authors to the AREUEA Journal by Doctoral Origin and Employer: 1973–1987

This paper reports on the rankings of the contributing authors to the AREUEA Journal, the origins of their doctoral degrees, and their employers from 1973–1987. Articles in the Journal were identified as being either finance, investment, valuation, housing, and urban and regional. The rankings suggest that approximately 28% of the contributing authors have managed repeat appearances. The rankings also indicate that over 74 different institutions have awarded doctoral degrees to AREUEA Journal contributors and more than 180 different institutions have employed them.     

REIT Stock Price Volatility and the Effects of Leverage

This article sheds light on several puzzling empirical observations. We examine the volatility implications of equity Real Estate Investment Trust (REIT) stock returns over the sample period from January 1985 through October 2012. We find a negative “leverage effect” in the pre‐ and post‐Greenspan era, but not during the Greenspan era (circa 1994–2006). We argue that the positive elasticity of variance with respect to the value of equity during the Greenspan era can be explained by a decline in the spread between the yield on commercial mortgages and 10‐year Treasuries, which triggered a wealth transfer from REIT equity holders to REIT debt holders. We also argue that the declining commercial‐mortgage‐10‐year‐Treasury yield spread during the Greenspan era allowed REITs to take on far more risk than most people realized. We then document that average REIT stock return volatility increased significantly in the 2007–2010 period in the midst of a historic decline in REIT stock prices. The results have significant implications for the good deal of interest and debate in the media over the status of REITs and whether equity REITs have become excessively risky relative to the returns they generate.     

Is Real Estate Becoming Important Again? A Neo‐Ricardian Model of Land Rent

Classical economists believed that land rent as a share of total income would increase with economic growth. This belief was important to many 19th and 20th century critiques of capitalism. Land rents as a share of national income apparently declined for most of the 20th century, but increased during the 1990s. In this paper, we develop a model of the classical theory of land rent that allows rent to increase or decrease as a share of national income, depending on several parameters. It seems likely that the long decline in land rent is over and that land rent in the future will slowly increase as a share of national income.     

The Role of Real Estate in an Institutional Investor's Portfolio Revisited

Many papers have recently pointed out that institutional investors allocate only a very small fraction of their portfolio to real estate, much smaller than theory would dictate. This raises the question, are institutional investors underinvested in real estate equities? Or do we simply have the wrong priors? This paper is an attempt to provide some new insights into this asset allocation paradox. The key conclusions of the paper are several: First, unlike other assets, it would appear that real estate, and real estate diversification, pays off at the very time when the benefits are most needed, that is, when consumption growth opportunities are low. Second, real estate returns are predictable. In fact, the amount of predictability in real estate returns appears to be about the same as in stock returns. Third, real estate performs well in an asset-liability framework. Fourth, the chance of experiencing a large loss on real estate over a long horizon is quite small. We also report here that private sector commercial real estate investments represent between 6 and 12 percent of investable wealth in the United States. Thus, it follows (if one believes the capital asset pricing model) that if institutional investors were to invest more in real estate (up to 12 percent of their assets), they should be able to eliminate nonmarket or unique risk. All of this leaves us a bit dumbfounded as to why institutional investors hold only between 2 and 3 percent of their assets in real estate.     

Choosing between fixed-and adjustable-rate mortgages: The case of commercial mortgages

This article reports on the determinants of the ARM choice for commercial real estate projects. The theoretical literature suggests that commercial real estate projects are more likely to be financed with an adjustable-rate mortgage (ARM) if the project's income stream or value is expected to rise with inflation over time. The empirical model estimated is a structural probit probability model of the ARM choice. Our results demonstrate that commercial borrowers typically place great emphasis on relative interest-rate differentials when deciding which mortgage is best. We also find that commercial mortgage borrowers will ordinarily be reluctant to issue an ARM when the fixed interest rate is low.