Determinants of Credit Spreads in Commercial Mortgages
Titman, Sheridan, Tompaidis, Stathis, Tsyplakov, Sergey, Real Estate Economics
This article examines the cross-sectional and time-series determinants of commercial mortgage credit spreads as well as the terms of the mortgages. Consistent with theory, our empirical evidence indicates that mortgages on property types that tend to be riskier and have greater investment flexibility exhibit higher spreads. The relationship between the loan-to-value (LTV) ratio and spreads is relatively weak, which is probably due to the endogeneity of the LTV choice. However, the average LTV ratio per lender has a strong positive relation with credit spreads, which is consistent with the idea that lenders specialize in mortgages with either high or low levels of risk, and that high LTV mortgages require substantially higher spreads. Finally, we observe that spreads widen and mortgage terms become stricter after periods of poor performance of the real estate markets and after periods of greater default rates of outstanding real estate loans.
Commercial mortgages provide perhaps the best setting for examining default spreads in the fixed income market. In most cases, commercial properties have only one outstanding loan, the loans generally are not prepayable without substantial penalties and assets that are relatively easy to evaluate collateralize the loans. There is currently more than a trillion dollars of commercial mortgages outstanding and the market is growing, both in the United States and around the world.
This article empirically examines the determinants of credit spreads for commercial mortgages, that is, differences between mortgage rates and Treasury bond rates with the same maturities. Using a data set of 26,000 individual commercial mortgages that were originated between 1992 and 2002, with the intent of being included in a commercial mortgage-backed security (CMBS), (1) we examine cross-sectional differences in mortgage spreads, as well as time-series fluctuations in average spreads.
Our cross-sectional tests are motivated by theoretical pricing models developed by Titman and Torous (1989), Kau et al. (1990) and Titman, Tompaidis and Tsyplakov (2004). The earlier articles present models that indicate that mortgages on properties that are more volatile and that have higher payouts tend to have higher spreads. The more recent Titman, Tompaidis and Tsyplakov (2004) model shows that mortgages on properties with more investment flexibility, that is, properties that can be expanded or renovated, should also have higher spreads. (2,3)
Our empirical results are largely consistent with these theoretical predictions. In particular, properties like hotels, which are likely to be both riskier and have the greatest investment flexibility, have significantly higher spreads than warehouses and multifamily housing, which are likely to be less risky and have less investment flexibility. In addition, credit spreads are positively related to the ratio of net operating income to property value (NOI/Value), which is also consistent with the models if we assume that a higher NOI/Value ratio is indicative of higher payouts.
The observed evidence on the relation between mortgage characteristics and spreads is somewhat less straightforward to interpret. Most notably, the loan-to-value (LTV) ratio of a mortgage is expected to be positively related to mortgage spreads, but our evidence on this is mixed. Similarly, we expect from theory that mortgage maturity should be positively related to mortgage spreads, but we empirically find the opposite. These violations of the theoretical predictions are likely to be due to the endogenous choice of mortgage characteristics. Specifically, lenders are likely to require mortgages with higher downpayments, that is, lower LTV ratios and shorter maturities on properties that are likely to be riskier. (4)
To learn more about the endogeneity of the mortgage contract we examine the choices of individual originators. Our results indicate that different originators have different risk preferences; some originators attract riskier clienteles, attracting mortgages with higher LTV ratios as well as mortgages on properties that are riskier. …