California Real Estate Economics 156 Foldvary

Chapter 12 The economics of r.e. investment

Why do people own their dwellings?

Pride of ownership, status, measure of importance

Personal control over space.

Financial gains: tax shelter, appreciation, inflation hedge


Disadvantage: not liquid, lack of mobility

Opportunity costs, what else one could have invested in and gained.

Expenses: insurance, maintenance, property and transfer taxes, broker fees, mortgage debt, risk

In a pure free market with LVT, renting vs. owning would not matter so much.

There would be no appreciation or tax shelters, so leverage would be irrelevant.


Pyramiding through sale: improve the property, sell it, buy a more and more property.

Pyramiding through refinancing: retain the older properties.

Tax Depreciation

is a legal fiction for taxes, but it is not entirely a free lunch.

When the property is sold, the past depreciation gets taken away.

When the property sold, the basis for the gain is not just the purchase price.

The adjusted basis adds in the cost of improvements such as a deck.

But then the adjusted basis subtracts the tax depreciation.

Past tax depreciation that reduced income taxes now is given back by being subtracted from the purchase basis.

One can avoid this subtraction by never selling the property.

On death, the depreciation becomes irrelevant.

Another way to avoid taking back the depreciation is to do an exchange.

Federal Internal Revenue Code section 1031 allows for the tax-free exchange of property.

A 1031 exchange lets the owner avoid the capital gains tax.

The tax liability is not cancelled, but deferred.

Except if one still owns the property when one dies, then the liability is cancelled.

When you die, you can’t take it with you, but on the other hand, your debts get cleared.

A simple exchange is between A and B.

But often, 1031 exchanges involve three parties.

A common type is a buy-sell exchange, also called three-corner exchange or three-legged exchange.

The three parties are the exchanger, the seller who does not want to retain the property,

and the buyer.

E ↔ B ← S

The buyer B offers to buy the property from exchanger E.

Buyer B has no property to exchange.

Exchanger needs to find another property, called the up-leg.

The exchanger E finds the up-leg owned by S,

and the buyer B buys this property from the seller S.

Now buyer B has a property to exchange with exchanger E.

So, S transfers property to B, B transfers it to E, and E transfers his property to B.

This is all done in escrow within a short time.

But the exchange may be delayed so long as the property is identified within 45 days and that the exchange is completed within 180 days after the transfer.

A statement that the client wants to make a 1031 tax-deferred exchange

should be expressed on the listing.

The buy-up rule says that to qualify, the exchanger must trade up in value and put all the equity money into the new property. To be tax deferred, the new property has to be equal or greater in value than the old property. Any cash withdrawn is taxable.

Property which is not like kind and does not qualify for an exchange is called boot, which is taxable.

Chapter 11 - Financing and Taxation

Allocation of loanable funds to real estate purchase and construction depends on:

1) safety. Collateral based on real estate is considered safe. But is it, long run?

Safety also comes from government guarantees.

It is artificial safety - risks are shifted to taxpayers and government bondholders.

Bonds have an inflation risk and ultimately a default risk.

2) Liquidity. Real estate is illiquid, but mortgages have become liquid in the secondary market.

Primary mortgage market

Lenders that originate mortgage loans.

Their income sources are finance charges and interest.

Many banks and other lenders now get most of their income from the finance charges,

because they sell the loans to the secondary market.

The original lender may continue to collect the payments, and pass them on.

Some lenders get fees from servicing loans for other institutions.

They collect the payments, do the accounting, and follow up on delinquencies.

Credit unions now make more mortgage loans than previously.

The are mortgage banking companies that originate loans with money from insurance companies, pension funds. They then sell the loans.

Mortgage brokers are intermediaries. The process loans and submit them to lenders.

The secondary market for mortgages

Federal National Mortgage Association, FNMA, Fannie Mae.

Deals in conventional and FHA and VA loans.

The Federal Housing Administration provides mortgage insurance;

the borrower is charged a premium.

The lender can also charge points.

A point is one percent of the loan amount.

Points are tax-deductible.

Points in refinancing must be amortized over the life of the loan.

Home-equity loan points can be deducted in the year of the loan.

The FHA has maximum loan amounts, depending on the county and living units (p. 277).

Most real estate in Santa Clara County is above the limit, $362,790 for one unit.

In a conventional loan, the borrower makes a down payment of at least 20 percent.

Fannie Mae creates and sells mortgage-backed securities as a bundle of mortgages.

Fannie guarntees payment of the interest and principal.

The Department of Veterans Affairs (VA) guarantees loans to eligible veterans.

California also has a Cal-Vet program,

administered by the California Department of Veterans Affairs.

It provides subsidized loans up to $250,000 for single family homes,

to qualified veterans who are California residents.

Federal Home Loan Mortgage Corporation, FHLMC, Freddie Mac

It makes conventional loans that carry private mortgage insurance if the equity is less than 20%.

It does not guarantee the mortgages.

Fannie and Freddie have mortgage guidelines that have created standardized forms.

Government National Mortgage Association, GNMA, Ginnie Mae.

A government agency in the Dept. of Housing and Urban Development.

It assists low-income house buying and works with Fannie Mae in the secondary market.

A bank can originate a below-market loan to a low-income borrower,

and then sell it to GinnieMae at full market value.

The difference is paid from the budget of the Dept. of Housing and Urban Development.

In 1970, Ginnie Mae introduced a payment guarantee program backed by the US government.

Ginnie Mae guarantees the payments on mortgages insured by other agencies such as FHA.

The Farm Service Agency is part of the federal Dept. of Agriculture.

It offers assistance to buy a farm or a house in a rural area.

Financing techniques

FICO is short for Fair Isaac Corporation,

the company whose software is used by major credit bureaus

to calculate the financial scores of borrowers.

So one’s credit worthiness is called the FICO score.

The score ranges from 300 to 850.

A score over 740 is considered good. 680 is average.

You can get a free credit report every year from the credit bureaus.

FICO scores have become more important now that real estate prices are no longer escalating.

A person with a low FICO score will have to pay a higher interest rate, or risk premium.

Late payments on loans lower one’s score, as do unpaid bills.

If your parents add your name to their credit card, you get ten years of credit history.

Straight loans - interest only. That’s how bonds are financed.

The principal is paid at the end of the term.

The borrower can then obtain another loan.

Amortized loans. The principal is paid off during the term of the loan.

Payments are applied first to interest on the balance, and the remainder to the principal.

The principal payments increase at an increasing rate.

In the level-payment fully amortized loan, the mortgagor pays a constant amount.

Often the borrower can pay extra amounts to amortize the loan more quickly.

But, why amortize?

Adjustable-rate mortgages, ARM

The rate of interest is set to some indicator such as the U.S. treasury bond rate plus a premium.

Rate caps limit the amount that the interest rate can change per year.

There can also be aggregate rate caps limiting the change for the term of the loan.

If interests rates plus the premium rise above the cap, there could be negative amortization,

a higher loan balance.

Balloon payments - a large final payment of principal.

The lender may extend the loan for another term.

Growing-equity or rapid-payoff mortgage

Payments of principal are increased by some schedule.

This can be beneficial when the borrower’s income is expected to increase.

Reverse Mortgage

The owner gets an annuity, reducing the equity.

The institution is paid on the sale of the property, or from the estate.

To qualify, the homeowner must be 62 years of age.

A purchase-money mortgage is created by a seller, who loans to the buyer.

It cuts out the middleman and lets those with lower credit qualifications buy the property.

A package loan includes fund to purchase personal property, such as appliances or furnished dwellings.

A blanket loan finances more than one parcel.

A wraparound loan enables the borrower with an existing mortgage to obtain another loan from a different lender. The original loan gives permission to do this.

An open-end loan secures future advances of funds by the lender for some maximum amount.

A construction loan finances improvements.

The lender disburses the payments or draws to the owner or general contractor during the time involved.

In a sale and leaseback, the real estate is leased to the seller to continue the business as a renter.

It usually involves commercial or industrial real estate.

The seller gets funds that it can concentrate in its business.

Otherwise, the firm is in two enterprises, one for its products, and one for the real estate.

In a buydown, a lump sum is paid in cash to the lender at the closing.

It lowers the initial interest rate on a loan.

Home equity loans tap the increase in equity.

The funds can be used for consumption or investment, often to make repairs or additions.

It is junior to the original lien.

If the owner refinances, the original mortgage is replaced by a new one.


Regulation Z is based on the Truth-in-Lending Act.

It requires lenders to inform borrowers of the full cost of the credit.

That enables borrowers to better compare options.

For mortgages, the lender must disclose the annual percentage rate, APR.

This does not include closing expenses.

The borrower has three days in which to cancel the transaction.

The Community Reinvestment Act of 1977 requires financial institutions to invest in local community development projects.

Property taxes

Local property taxes that circumvent Proposition 13

Proposition 13, by limiting the tax increase to 2%, makes it not really ad valorem.

There has been a windfall benefit to the federal government of $1.6 billion as the property tax is deductible from federal income taxes, and a shift from property taxes to sales taxes and other non-deducted taxes increases California’s taxes paid to the federal government.

About 40 percent of the benefit from Proposition 13 went to Commercial and rental properties, with 24 percent going to homeowners and the rest to the state and federal governments in increased revenues from income taxes

California's local governments (1991):

58 counties, 466 cities, 1005 school districts,

81 transportation agencies,

381 community redevelopment agencies,

4995 special districts.

1) Developers' exactions or "impact fees"

Financing of new infrastructure by developers.

Can be money, land, infrastructure, or services.

Does not need voter approval.

A relationship between benefit and charge.

"Exactions are simply taxes on development."

Cannot be ad valorem.

Can be based on the square footage,

            or else lump-sum.

California has the greatest use of exactions.

$20,000 to $30,000 per dwelling.

Creates additional risk, can deter development.

2) Tax increment financing

Does not require approval of voters.

Government creates a redevelopment agency.

Agency declares some area to be "blighted"

Development increases site values.

The tax increment is shared

by the agency and local governments.

Shoup: parking increment finance district.

3) User and Property-related "Fees"

Levied as incidental to property ownership.

E.g. garbage collection, sewage.

New and increased fees require voter approval

if related to the property.

Fees based on usage are not restricted.

4) Civic partnerships

Governments partners with private enterprise.

To develop shopping centers, sports stadiums.

The city provides the infrastructure

and relaxation of zoning or tax abatements.

5) Certificates of Participation (COP)

Issued by nonprofit established by government. Bonds from nonprofits don't need approval.

Finances infrastructure or other capital goods.

Government rents facility from the organization. Holders of bonds receive shares of revenues.

6) Mello-Roos

The Mello-Roos Community Facilities Act

of 1982.

Gives local governments the authority to finance infrastructure or services in a designated "community facilities district."

Either two-thirds of the residents

or owners of two-thirds of the land area

can vote to levy special taxes

and issue tax-exempt bonds,

which become a lien against the real estate.

Homeowners are responsible for the payment of the debt.

Mello-Roos has been widely used

in areas of new and existing development

to provide services to communities.

7) Parcel taxes

Levied on the size of property,

either of the lot or

the square footage of improvements.

Revenue can be used for any purpose.

Many local parcel taxes have been levied.

8) Assessment districts

The purpose of a tax is for general revenue;

the purpose of an assessment

is to finance specific benefits,

the levy proportional to the assessment.

An assessment also differs from

an imposed "fee,"

which is charged for the use of a commodity such as water,

or to offset government burdens

such as in property development.

New benefit assessments

cannot be based on property value.

Each assessment district has a benefit formula

in which each parcel in the service area

is assessed according to the specific benefit

it receives from the services and improvements.

New assessments require approval

by the majority of the property owners

in proportion to the assessment liability.

Assessment districts finance benefits

such as landscape development,

street lighting, flood control, and sewage maintenance.

Special assessment districts are units of local government that manage specific resources within defined boundaries.

9) Business Improvement Districts

BIDs establish a partnership among property owners and businesses in commercial areas to improve the business environment.

In some districts, tenants are responsible for paying the assessments.

Otherwise, landlords may pass the assessment to the tenants' rentals.

Assessments are levied on businesses on the basis of relative benefit from the improvements and activities to be funded.

They can be based on the amounts of license fees, gross revenues, or gross payrolls.

10) Real Estate Transfer Taxes

and documentary Transfer Tax

Also known as a real property transfer tax,

Local levy on the sale of real estate.

By California law, the tax is computed at

55 cents for each $500 of consideration

or fraction thereof, hence a rate of .11 percent.

A city may also adopt its own transfer tax ordinance with the tax amount fixed at one-half the rate charged by the county.

Proposition 13 prohibits new and additions to the transfer tax, but left the existing ones intact.

As an example, the City of Berkeley

has a city transfer tax of 1.5 percent,

in addition to the Alameda County

rate of .11 percent,

for a total rate of 1.61 percent

11) Hotel taxes (transient occupancy taxes)

The hotel or transient occupancy tax  

can be considered real-estate related,

as a tax on the rental of a hotel room,

the incidence falling mostly on nonresidents.

As examples, the hotel tax rate is

14 percent in San Francisco and Los Angeles,

11 percent in Oakland,

12 percent in Berkeley.

Case study, in the City of Berkeley

A typical house in Berkeley can serve as an example of the charges.

The property was purchased in 1979.

The land is valued by the country at $120,630;

the improvements at $26,975,

for a total of $147,605.

The homeowners exemption of $7000

is subtracted from the total

for a tax base of $140605.

The bill for 2006-2007 includes the following ad valorem charges:

Taxing agencyTax rate                      Tax amount

County                                    1.0000                         $1406.05

Berkeley debt             0.0525                         $ 73.81

School District            0.1352                         $ 190.10

College District          0.0272                         $ 38.24

Rapid Transit              0.0050                         $ 7.03

Regional Park             0.0085                         $ 11.95

EBMUD                     0.0068                         $ 9.56

            total                1.2352                         $ 1736.74

Landscaping & parks  $186.28           parcel tax

Library services          $257.18           parcel tax

Berkeley School Tax  $230.58           parcel tax

School maintenance   $ 92.34           parcel tax

School 2004                $176.64           parcel tax

AC Transit                  $ 48.00           parcel tax

Physically Disabled    $ 18.58           parcel tax

Paramedic                   $ 49.66            parcel tax

City Street Lighting    $ 19.28           assessment

City refuse collection $541.68           fee

Mosquito abatement   $ 1.74           unit tax 

CSA Paramedic          $ 24.96           assessment

CSA lead abatement   $ 10.00            assessment

CSA Vector control    $ 5.92

CFD1 Disaster Fire    $ 22.34           Mello Roos

EBMUD Wetweather $ 58.80           unit fee

EBRP Park Safety      $ 12.00            excise tax

Clean Storm Water     $ 31.26            lot footage

The total tax divided by the assessed tax value

is $3529.42/$140605 = 2.51 percent.

The market value of the property is about $750,000, thus $3529.42/$750000 = .47%.

The tax rate relative to market value

is about one-half percent.

The rolled-back base is $81,488 (1975-76).

($147605 divided by 1.02^30).

A new owner would pay the tax of

1.2352 percent of $750,000, or $9264

plus the fixed and special charges of $1792.68 for a total of $11056.68,

effectively 1.47 percent of market value.

Estimating the building value at $100,000 and the land at $650,000, the tax rate

based on site value would be about 1.7 percent.

Federal tax laws

Depreciation 27.5 years residence, Tax Reform Act of 1986.

Nonresidential 39 years, Revenue Reconciliation Act of 1993.

The 1997 tax act allows an exemption from capital gains taxes of $250,000 for a single person owner of a house, every two years; $500,000 if married,

used as a principal residence for two out of five years.

California has the same exclusion.

The Economic Growth and Tax Relief Act of 2001:

increased the estate tax exemption