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Option-Based Prediction of Commercial Mortgage Defaults

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Abstract

Underwriters set loan-to-value ratios and loan contract interest rates of uninsured commercial mortgages to anticipate the likelihood of subsequent default. The results of the use of a modified Black-Scholes option model suggest that loan-to-value ratios are bound from below by borrowers' desires to maximize project leverage in a limited liability setting and constrained from above by lenders' requirement to originate loans with institutional-grade (Baa) contract interest rates. Given the prevailing risk-free rate and the investment-grade rate, this model at the time of mortgage origination predicts the possibility of default for a new commercial mortgage. The model is empirically verified with ACLI data for 1968-89.

Suggested Citation

  • Leon G. Shilton & John Teall, 1994. "Option-Based Prediction of Commercial Mortgage Defaults," Journal of Real Estate Research, American Real Estate Society, vol. 9(2), pages 219-236.
  • Handle: RePEc:jre:issued:v:9:n:2:1994:p:219-236
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    References listed on IDEAS

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    1. James L. Kuhle & Carl H. Walther & Charles H. Wurtzebach, 1986. "The Financial Performance of Real Estate Investment Trusts," Journal of Real Estate Research, American Real Estate Society, vol. 1(1), pages 67-75.
    2. Kerry D. Vandell, 1992. "Predicting Commercial Mortgage Foreclosure Experience," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 20(1), pages 55-88.
    3. James R. Webb & Jack H. Rubens, 1986. "Portfolio Considerations in the Valuation of Real Estate," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 14(3), pages 465-495.
    4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    5. Michael J. Brennan & Eduardo S. Schwartz, 1985. "Determinants of GNMA Mortgage Prices," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 13(3), pages 209-228.
    6. Kaplan, Robert S & Urwitz, Gabriel, 1979. "Statistical Models of Bond Ratings: A Methodological Inquiry," The Journal of Business, University of Chicago Press, vol. 52(2), pages 231-261, April.
    7. Leon G. Shilton & James R. Webb, 1989. "Commercial Loan Underwriting and Option Valuation," Journal of Real Estate Research, American Real Estate Society, vol. 4(1), pages 1-12.
    8. Frydman, Halina & Altman, Edward I & Kao, Duen-Li, 1985. " Introducing Recursive Partitioning for Financial Classification: The Case of Financial Distress," Journal of Finance, American Finance Association, vol. 40(1), pages 269-291, March.
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    Cited by:

    1. Bradford Case, 2003. "Loss characteristics of commercial real estate loan portfolios," Basel II White Paper 1, Board of Governors of the Federal Reserve System (U.S.).
    2. Leon Shilton, 2000. "Random Walks and the Cointegration of the ACLI and NCREIF," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 28(3), pages 435-465.

    More about this item

    JEL classification:

    • L85 - Industrial Organization - - Industry Studies: Services - - - Real Estate Services

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