Underwriting Limits and Optimal Leverage in Commercial Real Estate
Risk-averse commercial mortgage lenders follow an underwriting policy with strict limits based on the property’s value and cash flow. A borrower then chooses the initial loan amount and amortization that fit into these requirements and maximizes the investment’s net present value. For an underwriting policy based on typical mortgage ratios, this optimization problem has a closed-form solution. Applying the formula to loan business data from life insurance companies, fluctuations in market parameters and cash flow-based policy limits can explain the major part of the observed variability in initial leverage. This analysis gives further support to observations that initial leverage is endogenous to the underwriting process, while cash flow-based and forward-looking measures are of primary importance in commercial loan risk management.
KeywordsCommercial real estate Underwriting Leverage Amortization
I am grateful to Bernhard Funk and seminar participants of RheinMain University of Applied Sciences for helpful conversations, to the anonymous referees for their valuable suggestions and comments, and to the American Council of Life Insurers for providing data.
- Basel Committee on Banking Supervision. (2017). Basel III: Finalising post-crisis reforms. Bank for International Settlements publication.Google Scholar
- Modigliani, M., & Miller, M.H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48, 261–297.Google Scholar
- Modigliani, M., & Miller, M.H. (1963). Corporate income taxes and the cost of capital: a correction. The American Economic Review, 53, 433–443.Google Scholar
- Peng, L. (2014). How is leverage determined for commercial real estate? RERI working paper.Google Scholar