New Methods for the Construction of a Commercial Real Estate Rating

"The new capital standards for financial institutions issued by the Basel Committee on Banking Supervision (""Basel II"") caused a quantum leap in the risk measurement methodology. Especially the rating systems used for estimating the probability of default of the borrowers were greatly improved. Today the leading banks have instruments in place, which are superior to the ones even their most sophisticated customers use for themselves. This leads us to the question how external and internal real estate ratings can benefit from the advances in real estate lending. In this paper we use a large sample of properties from German open-ended funds to demonstrate which methods are suitable for building a commercial real estate rating. In the first part of the paper we give an overview of the most common procedures and statistical methods for ratings. Furthermore we define criteria for an adequate rating system. In the second section the process of constructing a rating is shown on the basis of the sample data. The emphasis here is on the real estate portfolio part of the rating. The results indicate that a combination of scorecards and cash-flow models--similar to, but markedly different from the ones used in banks--fulfils all requirements and is suitable for both external and external real estate ratings. The third section addresses the transfer of our findings to external ratings of commercial real estate."