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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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    Cited by:

    1. 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.

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    JEL classification:

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

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