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Capitalization effects of creative mortgage financing

University of British Columbia

This thesis studies the impact of creative financing on single family house prices, focussing on instruments such as Agreements-for-Sale, assumed mortgages and vendor-financed loans. Benefits from financing at below-market interest rates are expected to be capitalized into higher sale prices of houses, however, the literature is not clear on the appropriate adjustment. If the purchase price of houses increased by an amount equal to the present value of the payment savings, there would be no direct benefit for purchasers and they would effectively be using a financing scheme similar to a graduated payment mortgage. A Canadian sample of housing transactions has been used, specifically in the Lower Mainland area of British Columbia between 1980 and 1982. The sample was selected to include home sales at different price levels and during different periods of market activity. In this way, the capitalization effect of creative financing instruments could be tested at different house price levels and market conditions, as well as for alternative types of creative funds. Creative financing arrangements can be classified as institutional or non-institutional depending on the loan origination source, and it was hypothesized that assumption loans (institutional origination) would be properly capitalized in the price while vendor-financed loans (non-institutional origination) would be overcapitalized in house prices. The reason for the dual pricing response hinges on the discount rate used to calculate the benefit of below-market financing; it should be higher for vendor-financed loans due to the higher costs in loan origination and servicing for the seller as compared to a financial intermediary. The results indicated that assumption loans were properly capitalized in the price of single family homes as the coefficient of the creative financing variable assumed a value of approximately 1. The vendor-financed sample revealed that the benefit for below-market financing was overcapitalized in the price as the coefficient was generally in excess of 3. The research suggests that the market interest rate is not the appropriate discount rate to use in deriving the benefit from vendor-financed loans and possibly a higher rate should be used. This is an area which requires further study. A sample of house sales which includes information on the secondary yields of vendor-financing from sellers to other mortgage market participants should help to identify the true market rate for these non-institutional loans and provide for a more precise calculation of the present value of the payment savings in the case of vendor-financed loans.

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2010-05-03

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http://hdl.handle.net/2429/24397

Business Administration - Urban Land Economics

University of British Columbia

Graduate