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Underwriting Limits and Optimal Leverage in Commercial Real Estate

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  • Leo Cremer

    (RheinMain University of Applied Sciences)

Abstract

Risk-averse commercial mortgage lenders follow an underwriting policy with strict limits based on the property’s value and cash flow. A borrower then chooses the initial loan amount and amortization that fit into these requirements and maximizes the investment’s net present value. For an underwriting policy based on typical mortgage ratios, this optimization problem has a closed-form solution. Applying the formula to loan business data from life insurance companies, fluctuations in market parameters and cash flow-based policy limits can explain the major part of the observed variability in initial leverage. This analysis gives further support to observations that initial leverage is endogenous to the underwriting process, while cash flow-based and forward-looking measures are of primary importance in commercial loan risk management.

Suggested Citation

  • Leo Cremer, 2020. "Underwriting Limits and Optimal Leverage in Commercial Real Estate," The Journal of Real Estate Finance and Economics, Springer, vol. 60(3), pages 375-395, April.
    • Handle: RePEc:kap:jrefec:v:60:y:2020:i:3:d:10.1007_s11146-018-09695-4
    DOI: 10.1007/s11146-018-09695-4
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    References listed on IDEAS

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