Timothy J. Riddiough

The Role of Uncertainty in Investment: An Examination of Competing Investment Models Using Commercial Real Estate Data

Neoclassical investment decision criteria suggest that only the systematic component of total risk affects the rate of investment, as channeled through the built-asset price. Alternatively, option-based investment models suggest a direct role for total uncertainty in investment decisionmaking. To sort out uncertaintys role in investment, we specify and empirically estimate a structural model of asset-market equilibrium. Commercial real estate time-series data with two distinct measures of asset price and uncertainty are used to assess the competing investment models. Empirical results generally favor predictions of the option-based model and hence suggest that irreversibility and delay are important considerations to investors. Our findings also have implications for macroeconomic policy and for forecasts of cyclical investment activity. Copyright American Real Estate and Urban Economics Association.

Mixed Uses and the Redevelopment Option

This paper considers how the potential for mixing uses and redevelopment impact property value. Operating flexibility of this type is found to significantly increase property value when the correlation between payouts from different property types is low or when redevelopment costs are low. The ability to mix uses and redevelop over time is also shown to affect the timing of initial land development. The shape of the development boundary is shown to differ considerably depending on whether marginal revenue is constant or decreasing to scale. Both policy and empirical implications concerning the effects of multiple-use zoning are discussed.

The Pricing of Multiclass Commercial Mortgage-Backed Securities

This paper considers the pricing of multiclass commercial mortgage-backed securities. A contingent-claims pricing methodology that overcomes state variable dimensionality problems is developed to examine mortgage pools with many distinct underlying assets and whose loan cash flow values are subject to interest rate uncertainty. Security structure and the correlation structure of collateralizing assets within a pool are found to be important determinants of tranche price and required yield spread. By disentangling default loss risk from default-related call risk, we show it is possible that mezzanine investment classes may require lower yield spreads than higher priority investment classes. Of particular interest is the finding that reduced cash flow volatility obtained through pool diversification may actually decrease the value of the first-loss (junior) tranche. When examining the relationship of pool size and tranche value, we find that five to 10 distinct mortgages are required to realize most of the effects of asset diversification.

Strategic Default, Workout, and Commercial Mortgage Valuation

This paper extends existing equilibrium commercial mortgage pricing models by endogenizing negotiated workout into the usual noncooperative lending game. Workout is a feasible subgame strategy for the lender to play whenever foreclosure transaction costs exist for either party to a loan transaction. In particular, negotiated workout solutions Pareto dominate the foreclosure alternative when default occurs. To obtain our results, we embed a cooperative bargaining game within a noncooperative mortgage loan/default game. We also address the valuation “wedge” problem that occurs when foreclosure transaction costs are introduced. Through the notion of replacement game equilibrium, we find symmetric mortgage pricing solutions that eliminate the valuation wedge and thus suggest that lending will occur in commercial real estate mortgage markets even when foreclosure transaction costs exist.

Wimp or Tough Guy: Sequential Default Risk and Signaling with Mortgages

When analyzing what to do with a currently defaulted loan, the lender must consider the impact of his foreclosure versus workout decision on the expected payoff of subsequent loans as well as on the payoff of the current loan. This is because borrowers with future loan payoff dates can observe the lenders actions and update prior information regarding the lenders toughness or wimpiness when dealing with defaulted loans. In this paper we consider the strategic interaction between a lender and multiple borrowers, where borrowers have distinct, sequentially maturing mortgage loans and where the lender has private information regarding the magnitude of his foreclosure costs. We find that a variety of strategic outcomes can occur that explain the co-existence of workout and foreclosure in the mortgage marketplace. In general, the lenders workout/foreclosure response depends on the cost of bluffing (e.g., foreclosing when workout is cheaper) versus the value of reducing expected defaults and workout concession losses on future loans (e.g., imperfect foreclosure cost information leads future borrowers to payoff the mortgage when default would have been optimal under perfect information). Given recently revised expectations regarding the depth of the real estate recession, our results may explain the move by many lenders away from granting workout concessions and toward taking a harder line when dealing with defaulting borrowers.

The value of recourse and cross-default clauses in commercial mortgage contracting

Abstract The traditional commercial mortgage contract is written without recourse to any other borrower assets except the subject property. For credit enhancement purposes, many lenders/ investors are today seeking access to additional collateral through recourse or cross-default clauses. This paper considers the contracting value of such clauses. To measure these values and assess other related risk statistics, we apply a contingent-claims approach in which borrowers rationally default when the value of the mortgage meets or exceeds the value of the collateral, where collateral value includes additional assets provided through the mortgage contract. In the case of recourse to an unencumbered asset, default risk is reduced in part simply because additional collateral is available. In addition, when the subject property and additional collateral are less than perfectly correlated, diversification benefits are apparent. In the case of the cross-default clause — which means that default on one loan constitutes default on all loans covered by the clause — risk management benefits are also found to be substantial. For example, default risk resulting from a two-asset cross-default clause arrangement can be reduced by over 50 percent of non-recourse default risk when asset values are uncorrelated.

Bias in an Empirical Approach to Determining Bond and Mortgage Risk Premiums

Empirical studies of bond and commercial mortgage performance often quantify a required risk premium by examining the difference between the promised yield and the realized yield as adjusted for default occurrence. These studies omit the effects of various other sources of risk, however, including collateral asset market risk, interest rate risk, and possibly call risk. These omissions downwardly bias the empirical risk premium estimate on the debt. In this paper, we disentangle and quantify the sources of this bias by modeling secured coupon debt (the commercial mortgage) as used in the calculation of a realized investment return. We consider deterministic and stochastic interest rate economies with mortgage contracts that are either noncallable or subject to a temporary prepayment lockout period. Given realistic parameter values associated with the term structure, underlying asset dynamics, and debt contracting, we show that the magnitude of the bias can be significant.

Valuing Debt in a Complex Capital Structure

This article extends previous bond valuation models to account for more realistic assumptions regarding financial distress. Realized value of an individual bond under severe financial distress will reflect the expected outcome of credit-event negotiations and the relative priority listing of the security. We explicitly represent the probability rate of credit-event occurrence as a function of firm value relative to the fixed overall debt obligations of the firm. Risk premiums generated under reasonable parameter value choices fall within the range of observed bond risk premiums. Our model also provides an explanation as to why observed bond risk premia are positive after adjustment for default.