Modeling Credit Spreads on Commercial Mortgage Loans

Abstract

The focus of the paper is to offer empirical evidence on the factors that influence the credit spread on commercial mortgage loans. We extend existing work on the pricing of commercial mortgage loans and examine the relative significance of a range of factors that are lender, asset and loan specific. Theory suggests that mortgages secured on property types that are perceived to be riskier should be priced higher. Empirically our model examines the impact of mortgage endogenous factors such as loan-to-value ratios, property types, loan size together with exogenous factors including lender and origination date on the commercial mortgage credit spreads. Furthermore, using an event study framework, we exploit the credit premium changes after global incidents including the 2008 financial crisis and the Brexit vote.The paper makes use of a unique database in the UK. The dataset contains UK loan pricing data on a semi-annual basis from 2002 – 2018. Following the practice in existing work, the paper attempts to identify both cross-sectional and intertemporal influences on credit spreads.Given the dearth of studies in this field in Europe this paper provides the basis for useful comparisons with the US literature. More importantly, it represents a valuable investigation for institutions engaging in commercial real estate lending in the search for yield. With regard to the latter, we take the analysis a step further. A comparison is made between observed mortgage credit spreads with corporate credit spreads of fixed income bonds with the same maturity and credit quality over the same time period. In this way, the paper defines a new industry-wide framework for setting underwriting and mortgage pricing terms.