Credit Restrictions and the Market for Commercial Real Estate Loans
Ambrose, Brent W., Benjamin, John, Chinloy, Peter, Real Estate Economics
This paper develops a model of the market for commercial real estate loans based on the income capitalization (cap) rate, debt-coverage ratio and loan-to-value ratio, variables used by investors and lenders in their decision-making. The model has separately identifiable loan demand and loan supply functions. The demand for loans comes from profit-maximizing decisions made by real estate investors. These investors include owners of existing properties who seek financing and refinancing, and developers of construction projects. The supply of loans originates from profit-maximizing decisions made by depository financial institutions and nondepository lenders. An investor unable to obtain credit from a depository lender has alternative channels of borrowing from nondepository lenders including pension funds and insurance companies, as Muth (1986) notes.(1)
The loan demand function comes from borrowers, who use the cap rate as the effective investing price. The cap rate sets a value for the property by discounting the future net operating income stream. This cap rate applies to existing cash income statements for properties being financed or refinanced, and to pro forma projections for new construction. Consequently, the cap rate is the demand price of loans. Also determining the investor loan demand are building permits, call options to construct. In their loan demand, investors may seek to maximize leverage.(2)
Lenders maximize profits by using underwriting standards and interest rates. Lenders are limited in their ability to use interest rates to ration loans because of an adverse selection toward risky borrowers and projects as rates rise.(3) In allocating credit, lenders determine the loan-to-value ratio and debt-coverage ratio. These underwriting standards limit the investor's demand for leverage and become the supply prices of loans. Since the cap rate is the demand price used by investors, and underwriting standards are the supply price for lenders, only coincidentally will loan supply and demand be equal at a given interest rate. Hence the model contains the characteristic of excess demand or supply of loans at a prevailing interest rate.
The model is tested on the aggregate market for commercial loan originations and commitments in the United States, based on a survey of eleven lender categories. The data set is from the U.S. Department of Housing and Urban Development's Survey of Mortgage Lending Activity. Two characteristics of the model and data are emphasized. First, the demand and supply functions are separately identified, even in the restrictive case where investors do not use cap rates and lenders do not use underwriting standards. Because the structure of the model is itself a testable hypothesis, the demand and supply functions are fully identified regardless of the restrictions supported by the data. Second, the data set covers depository lenders, as well as nondepository institutions, such as insurers and pension funds; dominant sources of credit for commercial real estate.(4) The coverage of the aggregate U.S. real estate loan market has implications for stabilization, monetary policy and credit markets.
Empirical results are for quarterly observations on commercial loan originations and commitments between the first quarter of 1970 and the first quarter of 1993. The results indicate that the loan demand function is well behaved. Higher cap rates depress loan demand. Lenders are shown to view the debt-coverage ratio, not the loan-to-value ratio as the binding constraint in originating a loan to a borrower. The implication is that in underwriting and originating loans lenders are looking to cash solvency as opposed to the property balance sheet.
Returns, Underwriting Standards and Lending
During the sample period, changes in regulatory and financial policy may have influenced the market for commercial real estate loans. On the lending side, these policy shifts include the thrift deregulation of 1980 in the Depository Institutions Deregulation and Monetary Control Act and deregulated interest rate ceilings in the Garn-St. …