Is real estate riskier than you think? Don’t look for clues in corporate bonds.


Corporate bond spreads do not offer much insight into the relative risk levels of commercial real estate mortgages.

The table below shows credit rating criteria from Standard and Poors as of January 2015. In this chart, ratings are based on interest coverage levels of smaller non-financial service companies with market capitalizations less than $5 billion.

greater than ≤ to Rating is Spread is
12.5 100000 AAA 0.40%
9.5 12.499999 AA 0.70%
7.5 9.499999 A+ 0.90%
6 7.499999 A 1.00%
4.5 5.999999 A- 1.20%
4 4.499999 BBB 1.75%
3.5 3.9999999 BB+ 2.75%
3 3.499999 BB 3.25%
2.5 2.999999 B+ 4.00%
2 2.499999 B 5.00%
1.5 1.999999 B- 6.00%
1.25 1.499999 CCC 7.00%
0.8 1.249999 CC 8.00%
0.5 0.799999 C 10.00%
-100000 0.499999 D 12.00%

For many apartment development projects, lenders require a debt service coverage ratio of between 1.25 and 1.35. This means that for every $1.00 of debt service, your property has to generate $1.35 of net operating income. However, according to the S&P chart above, if real estate mortgages were priced like a corporate bond, they would be rated at C – “or junk”. Such a mortgage would trade at a whopping yield of over 10.3% with an 8% spread over current treasuries.

Thankfully, commercial real estate loans – much like home mortgages – are priced at a spread over treasuries somewhere between 185 basis points and 250 basis points depending on the lending environment. Today, a 4.35% is a widely available rate.

So why does this disparity exist between the interest coverage ratios of mortgages and corporate bonds?

The answer is found in the long run historical data for collateral recovery rates.

Surprisingly, the default risk of commercial mortgages is much higher than one might expect. Howard Esaki’s study of data from 1972 to 2002 showed that the average default rate of all commercial mortgages was 19.6% for loans in service over 10 years.

In the short term, the annual chance of default compounds by what is known as the “hazard function”. For example, if a loan has a 1% chance of default in year one, then it has a 2% chance of default in year two, and a 3% chance of default in year three, and so on. Esaki found that this level generally stabilizes at a 16% default rate after 15 years.

hazard rates

What mitigates lenders against this high default risk?

The recovery rate is the key factor in the data that have allowed insurance companies, government sponsored entities and commercial mortgage backed security firms to price mortgages at a spread in the range of 2% over treasury yields.

Loans are originated as a percentage of estimated values. Loan-to-value ratios do not exceed 80% at origination. Experience has shown that only in rare occurrences have lenders over-estimated values to the extent that their loan balances could not be recovered in the event of default.

So, even if the loan has a 5% chance of default in year 5, the lender will have collected 4 years of interest plus the principal balance recovered in a foreclosure process. In long run studies, even the distress sale of a commercial property has been sufficient to make the lender whole.

Mr. Esaki’s numbers may yet prove to be understated. Many wise observers have noted that the aggressive underwriting of the late 2000’s has not truly been revealed. In 2016 and 2017 the ten-year mortgages originated in the crazy pre-Lehman days begin to mature. This loan maturity problem may push the Federal Reserve into another quantitative easing program to lower long term rates and assure that mortgages can be “rolled over” without default.

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