Commercial mortgage prepayments under heterogeneous prepayment penalty structures

Journal of Real Estate Research, The, Jul-Sep 2003 by Fu, Qiang, LaCour-Little, Michael, Vandell, Kerry D

Abstract Much of the literature on pricing commercial mortgages and commercial mortgage-backed securities has assumed homogeneity in prepayment penalty structure. This study provides evidence that such an assumption is inappropriate and examines the effect of penalty structures observed in actual contracts. After conducting preliminary simulations, hazard models estimated from data on 1,165 multifamily mortgage loans are presented to show how empirical prepayment rates vary with alternative penalty structures. While yield maintenance and lockout provisions are relatively more effective than fixed or step down structures in reducing or postponing prepayment, none completely eliminates the risk. The empirical results generally confirm the theoretical findings of Kelly and Slawson (2001).

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Introduction

Much attention has been directed toward understanding the performance of commercial, especially multifamily, mortgages, given the dramatic increase in commercial mortgage-backed security (CMBS) issuance and recent pricing and liquidity problems.1 Most earlier research (e.g., Titman and Torous, 1989; Kau, Keenan, Muller and Epperson, 1990; Vandell, 1992; Vandell, Barnes, Hartzell, Kraft and Wendt, 1993; and Goldberg and Capone, 1997) focuses on default risk and assumes away prepayment risk, on the view that commercial mortgages contain prepayment penalties, lockouts or yield maintenance provisions that render prepayment unlikely, or fully compensate the lender.

However, a careful empirical look at prepayment exercise among commercial and multifamily mortgages reveals that prepayment does occur and cannot be ignored, especially since it may produce pricing fluctuations an order of magnitude greater than default risk. Prepayment occurs because (1) the assumed penalties do not exist, (2) they exist but are less effective than assumed, or (3) borrowers over-exercise prepayment irrationally, perhaps motivated by factors outside the standard model framework.

Accordingly, more recent research on commercial mortgages (e.g., Abraham and Theobold, 1997; Boyer, Follain, Ondrich and Piccirillo, 1997; Capone and Goldberg, 1998; Daingerfield, 1995; Elmer and Haifdorfer, 1997; Follain, Ondrich and Sinha, 1997; Follain, Huang and Ondrich, 1999; and Kelly and Slawson, 2001) has focused on prepayments. Among these, only Abraham and Theobald and Kelly and Slawson address alternative penalty structures, and the latter only through simulation. This study examines, both theoretically and empirically, using estimation as well as simulation, the extent to which alternative prepayment penalty structures can be expected to-and actually do-affect prepayment exercise among multifamily mortgage borrowers. Results can inform pricing models for both commercial mortgages and their mortgage-backed securities.

The paper is structured follows. First, related past research is reviewed. Next, a simplified option-theoretic model is developed that explicitly incorporates five observed prepayment penalty structures and simulates expected prepayments in a stochastic interest rate environment. Results of the simulation provide explanatory variables used in the subsequent empirical analysis are next presented. The empirical model, data and report results follow. Finally, general conclusions and implications of the results are presented.

Past Research

Empirical research using single-family data has shown that both default and prepayment options appear to be under-exercised, relative to the predictions of the option-theoretic approach (Quigley and Van Order, 1990, 1995). This has led to debate over the role of transaction costs and the degree of "ruthlessness" among option holders (Vandell, 1995). An alternative view holds that it is trigger events that often prompt default and prepayment and these decisions are only imperfectly related to underlying option values (Riddiough and Thompson, 1993). In the single family market, borrower mobility and institutional constraints that prevent refinancing may provide further explanation, for instance, insufficient equity or impaired credit may constrain prepayments (Peristiani, Bennett, Monsen, Peach and Raiff, 1997; and Green and LaCour-Little, 1999).

Some argue that irrational option exercise may be less an issue in the commercial mortgage market, since investors in income property do not relocate, triggering prepayments, in the way that single-family mortgagors do, though they may have heterogeneous or tax-induced holding period preferences. Moreover, financially sophisticated investors seem more likely to "ruthlessly" exercise their options. Default in commercial mortgages has been thoroughly explored in Vandell (1992) and Vandell, Barnes, Hartzell, Kraft and Wendt (1993), who still find under-exercise compared to theoretical model predictions, although at a lower level than Foster and Van Order (1985) find in the single-family market, using similar methodology.