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

Turning to recent studies of commercial mortgages, Abraham and Theobald (A&T) (1997) develop a simple prepayment model using a sample of 7,800 multifamily mortgages owned by Freddie Mac and originated over the period 1984-1990. Following Foster and Van Order's (1985) work in the single-family segment, A&T find that multifamily has lower prepayment risk at discount coupons and higher prepayment risk at premium coupons (i.e., that multifamily loans have greater interest rate sensitivity compared to single-family). Since their data set includes some variation in prepayment penalties (lockouts, yield maintenance and step down structures), the effect of the prepayment penalty over time may be observed. A&T describe the function as a "hockey stick" pattern, in which prepayments are close to zero during the lock-out period, then inflecting sharply (to roughly a 45[degrees] angle) once the prepayment penalty period has expired.

Follain, Ondrich and Singha (FO&S) (1997) consider whether prepayments in the commercial mortgage market are indeed more "ruthless" compared to the single-family market. FO&S use loan-level data on 1,083 multifamily loans originated during 1975-1986 and tracked through 1989 to estimate a mortgage prepayment function. Over the study period, 451 loans prepaid, 20 defaulted and the balance survived. All were subject to a single prepayment penalty, which FO&S treat as a prepayment-reducing transaction cost, consisting of six months interest if the loan is less than five years old and 1% of outstanding loan balance thereafter. While they find that their measure for the option value is positive and statistically significant across models, the implied hazard model predicts relatively low values (never exceeding 10% until loan age exceeds ten years), even when the prepayment option is deep in the money.

Elmer and Haidorfer (E&H) (1997) focus on prepayments of RTC commercial mortgage-backed securities issued during 1991-1992. E&H use cross-sectional time series methods to calculate 12-month conditional prepayment rates as of December 1995 in the range of 13%-18%, substantially higher than the hazard rate results of FO&S. These higher rates may be related to the absence of prepayment penalties on these loans or loan seasoning, although E&H are silent on the topic of prepayment penalties, if any exist.

Capone and Goldberg (1998) use data on Freddie Mac and Fannie Mae cash purchases of 13,338 multifamily mortgage loans originated during the period 1983-1995. They augment their data to create time-varying estimates of vacancy rate and property net operating income. Simulation results show relatively low conditional prepayment rates (never exceeding 10% annually) for 30-year fully amortized loans even when the option is significantly in the money; however, prepayment rates for 10-year balloons are very high (over 40%) in periods around the balloon date.

Maxam and Fisher (M&F) (1998) focus on pricing effects on CMBS issues backed by multiple property types in which lock-outs preclude rate-driven prepayments but in which defaults may produce early return of principal to senior security holders. Among innovations, M&F use kernel density regression to model security prices as a function of property indices and mortgage rates. M&F argue that although senior tranches are theoretically immune from prepayment risk, the transformation of default to prepayment risk is evident in the pricing relationships generated.