Valuing Commercial Mortgages: An Empirical Investigation of the Contingent-Claims Approach to Pricing Risky Debt

Authors

  • SHERIDAN TITMAN,

  • WALTER TOROUS

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    • Both authors from Anderson Graduate School of Management, University of California, Los Angeles. We wish to thank Jim Brandon, Bruno Gerard, and Geoff Renk for research assistance and Michael Brennan, Julian Franks, Pat Hendershott, Stephen Ross, Eduardo Schwartz, René Stulz, Robert Van Order, seminar participants at the University of Arizona, the University of British Columbia, the University of Colorado, Stanford University, and Vanderbilt University, and, in particular, an anonymous referee for helpful comments and suggestions. The paper also benefited from helpful discussions with William Kahane at Morgan Stanley and Stephen Bram at George Smith Financial, who provided the data for this study.


ABSTRACT

This paper empirically investigates a contingent-claims model of commercial mortgage pricing. We find that the magnitude of the observed default premia for a sample of nonprepayable fixed rate bullet mortgages can be explained by the contingent-claims model. In addition, the model explains a significant proportion of the period-to-period changes in the default premia. However, given an assumed negative correlation between building value changes and interest rate changes, the model's risk structure tends to increase less steeply with increasing maturity than the observed risk structure.

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