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Commercial Real Estate Loans - Categorization of an Investment Segment

August 2021
European Journal of Business Science and Technology 7(1):5-26

DOI:10.11118/ejobsat.2021.001

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Volume 7 Issue 1

ISSN 2694-7161

www.ejobsat.com

COMMERCIAL REAL ESTATE

LOANS – CATEGORIZATION OF

AN INVESTMENT SEGMENT

Beate Monika Philipps1

1Mendel University in Brno, Czech Republic

PHILIPPS, Beate Monika. 2021. Commercial Real Estate Loans – Categorization of an Investment Segment.

European Journal of Business Science and Technology, 7 (1): 5–26. ISSN 2694-7161,

DOI 10.11118/ejobsat.2021.001.

ABSTRACT

Commercial real estate loans (CREL) are a modern essential business segment and of major

relevance to the nancial stability of an economy as they interconnect the nancial markets and

the real economy. Consequently, CREL are of specic interest to regulatory authorities. As far as

the author knows, there exists no universal denition of CREL in the global nancial industry

and the regulatory environment. This has been subject to criticism due to resulting gaps and

bias in data generated by regulatory ling. This study contributes to academia and applied

sciences by providing the missing link. It develops a comprehensive categorization of CREL on

a foundation of 34 sources predominately provided by regulatory authorities in the US and the

EU. The categorization is based on a qualitative synthesis of main CREL characteristics of this

particular heterogeneous asset class outlined in the detected sources. The objective of this work is

to support the development of a common understanding of this investment segment among banks,

institutional investors and regulatory authorities in order to allow an accurate and prompt ling.

KEY WORDS

nancial economics, commercial real estate loans, investment decision, risk management

JEL CODES

G21, G32, G110, R33

1 INTRODUCTION

Commercial real estate (CRE) lending is in-

tertwined with the nancial economy through

nancial intermediaries like banks, insurance

companies or CMBS lenders (Glancy et al.,

2019). A downturn of the CRE markets might

aect the nancial industry through losses from

CRE lending and spread into the real economy.

As evidenced from existing empirical research,

CRE markets tend to be volatile and are

correlated to the economic cycle. In addition, a

6 Beate Monika Philipps

decline of CRE values might lead to a decrease

of CREL funds provided by lenders (ECB

Review, 2007) and shorten the loan supply

necessary for new real estate investments. In

this context, CRE nance is of specic interest

to the regulatory authorities. One of the main

features that separates CREL from other loan

types like consumer loans, commercial and

industrial loans (C&I loans), or residential

real estate loans (RREL) is the linkage to

the CRE that may serve as security for the

loan (OCC Handbook, 2013; Glancy et al.,

2019; Phillips, 2009). The commercial property

represents simultaneously the collateral and

the primary source of repayment of the loan

which is generated by rental income or sale

proceeds (Federal Register, 2006). Corporate

loans in contrary, even if they are secured by a

mortgage on a property, do not qualify as CREL

because their repayment source is funded by the

borrower’s operational business (OCC, BOG,

FDIC Sound RM Practices, 2006). According

to FDIC’s homepage1, CRE lending includes

the “acquisition, development, and construction

(ADC) nancing and the nancing of income-

producing real estate” that is leased to third

parties. The investment segment CREL is

noticeably heterogeneous and its characteristics

are multidimensional. There is, to this author’s

knowledge, per se no common denition for

this investment segment in place despite the

CREL market being globally linked. Bassett

and Marsh (2017) outline the necessity for a

joint understanding of CRE between regulators

and banks in order to generate an accurate data

base, for instance to identify concentrations

of CREL. The global nancial crises of 2008

that was triggered by a downturn of the US

real estate market is a perfect example that

an accurate data base and prompt reporting

is essential. The FDIC Financial Institution

Letter (2008) that was issued on March 17,

2008, only 6 months prior to Lehman Brothers

Holding Inc.’s ling for bankruptcy protection,

illustrates that the FDIC had identied a dete-

rioration of the CRE market that threatened

banks with high CREL concentrations. The

FDIC’s recommendation to combat the risk

had been too late for some of the institutions

to encounter the hazard. This reveals that a

common categorization of CREL is of utmost

importance for regulatory authorities, banks,

and the real estate industry.

The missing comprehensive denition is the

identied white spot and the key motivation for

this study. This work contributes to academia

and applied sciences by establishing a catego-

rization of CREL with the goal of supporting

the supervisory authorities’ ability to analyze

and evaluate their member institutions’ CREL

risk patterns. Their assessment may then be

based on accurate and prompt data processing

and regulatory ling provided by the lenders.

In addition, this study shall support to develop

a common understanding of this asset class for

the nancial industry and regulatory authori-

ties.

First, this paper identies the main charac-

teristics of CREL. Second, it outlines the risks

that are involved in this asset class in order

to develop a universal understanding of CREL.

Third, it establishes a categorization of CREL

based on the predominant loan characteristics

and the inherent credit risk which is closely

linked to the CRE market. Recommended

classications within the categorization reect

the various CREL types subdivided upon their

risk hierarchy. According to Jacob (2004), a

categorization is a composition of groupings

that display similarities based on context or

perception. A classication, in contrast, out-

lines the relation and hierarchy within the

grouping. The borders of a categorization are

permeable and leave room for further perceived

similarities (Jacob, 2004).

The remainder of this paper is organized as

follows. Section 2 covers the various information

sources that were utilized. Section 3 is dedicated

to the identication of the main characteristics

of CREL and outlines the various risks that are

involved in CRE lending. Section 4 contributes

by way of qualitative synthesis in order to

categorize CREL. Section 5 concludes with a

nal recapitulation.

1FDIC Banker Resource Center. For details, please visit https://www.fdic.gov/resources/bankers/credit/

commercial-real- estate-lending/.

Commercial Real Estate Loans – Categorization of an Investment Segment 7

2 INFORMATION SOURCES

According to Pana (2010), supervisory author-

ities have a strong impact on the lending

policies and the risk management of nancial

institutions. Signicant CREL providers are

banks and insurance companies, both regulated

institutions. For this reason, records of super-

visory authorities with the main focus on the

US and the EU were employed for the review.

The US and the EU represent major CRE

and nancial markets. In addition to regulatory

sources, scientic articles from electronic data

providers were employed to complement the

review.

Essential US depository regulators include

the Federal Reserve (Fed), represented by the

Board of Governors (BoG) and 12 regional re-

serve banks, the Oce of the Comptroller of the

Currency (OCC), the Federal Deposit Insurance

Corporation (FDIC) and the National Credit

Union Administration (NCUA). Astonishingly,

US insurance companies are regulated on a

state level and not by federal agencies. The Na-

tional Association of Insurance Commissioners

(NAIC) serves as unifying and coordination en-

tity (Labonte, 2020). The nancial supervision

on EU level is represented through the Euro-

pean Banking Authority (EBA), the European

Securities and Market Authorities (ESMA),

and the European Insurance and Occupational

Pensions Authority (EIOPA). The European

Systemic Risk Board (ESRB) is aliated to the

ECB and is supplementing the three author-

ities. The Federal Financial Supervisory Au-

thority (BaFin) is supervising German nancial

institutions on the national level.

Systematically all homepages of the afore-

mentioned supervisory authorities have been

assessed by using the keywords “commercial

real estate lending” and “commercial mort-

gages”. Throughout the initial screening process

33 relevant sources were detected, 23 sources

thereof were assigned to the US regulation.

The remaining ten sources belong to the EU

regulation. If identical records by dierent reg-

ulatory providers of one country were identied,

only one source was assigned to the review

set. 11 sources were found in the electronic

data providers Google Scholar, Science Direct,

Scopus, Springer, and Core. Ten papers thereof

were published in scientic journals, one source

represents a white paper by the sta of BoG.

The majority of documents have been published

between the years 2003 and 2020. Ten docu-

ments of the original set of 44 identied sources

have been excluded as they either provided

no additional insight or were irrelevant in the

context of CREL. The review was therefore

based on 34 records.

Utilizing the method of coding based on the

Grounded Theory (Schreier, 2012), diverse com-

ponents were detected, grouped and through

qualitative synthesis re-arranged with the aim

to categorize the asset segment CREL. A prole

matrix was established for the coding process

following Kuckartz (2014). The horizontal lines

of the matrix pick up on the research questions

and outline the essential headlines. Special

attention has been paid to add adequate sub-

components during the second screening of the

records. The dierent literature sources were

stringed in vertical columns. The design of

the prole matrix enables a subject-related

overview of the thematic extracts (Kuckartz,

2014). The review of records included a ranking

of the sources which connects to Okoli and

Schabram’s guidelines (2010). The records were

divided into four classes. Laws and regulation

were assigned to the premier quality class 1,

supervisory sources to level 2. Level 3 includes

journals published in renowned journals. Fur-

ther sources were labelled level 4. 23 identied

sources, representing more than two-thirds of

the records, were grouped into the category

level 1 and 2 (legal sources), ten records were

assigned to level 3 (excellent quality) and one

source to level 4 (other).

This examination shall capture the main

characterizing elements of CREL detected in

literature and further data. It is beyond the

scope of work to summarize all and each detail

provided by the reviewed sources. This would

diminish the purpose to give an overview of the

major attributes of CREL. This review includes

a critical evaluation of the researched literature

as well as a qualitative synthesis with the aim

to categorize CREL.

8 Beate Monika Philipps

3 RESULTS

3.1 Predominant CREL

Characteristics

One of the main features that distinguishes

CREL from other loan types is the underlying

commercial real estate that serves as collateral

for the loan. The Comptroller’s Handbook

(2013) and further sources of the Federal

Deposit Insurance Corporation (FDIC), for

example the Federal Register (1992), refer

to CREL as a loan that is secured by a

lien on or interest in real estate. Glancy et

al. (2019) mention the security instrument

commercial mortgage. Phillips (2009, p. 337)

refers to real estate nance that is “almost

universally secured by a mortgage”. Blanket

mortgages may cover multiple properties in

cross-collateralization for one or multiple loans

(Bardzik, 2019). The ESRB as well connects

to CRE as collateral for a loan and refers

in this context to corporate lending (ESRB

Report, 2018). According to the Regulation

(EU) 575/2013 (CRR) (2013) art 14, CREL

is fully secured by the commercial property if

the loan does not exceed the market value or,

depending on the member state, the mortgage

lending value. Robins et al. (2012) dig deeper

in the fundamentals of the US mortgage law

and outline that through a mortgage the lender

receives an interest in the CRE as security

for debt service and repayment of the loan.

The Regulation (EU) 575/2013 (CRR) (2013)

art 208 requires the mortgage or land charge

to be enforceable at loan closing. In case the

mortgagor, which in the vast majority – but not

necessarily – is the borrower, does not perform

according to its duty, the mortgagee has the

right to foreclose on its lien on the property. The

performance of borrower includes its payment

duty as evidenced by the promissory note

(Bardzik, 2019) or due to the loan agreement.

This predominately includes the payment of

debt service and the repayment of loan at ma-

turity. Prior to a foreclosure an event of default

remains uncured (Bardzik, 2019). Depending

on the jurisdiction, the foreclosure includes a

judicial or non-judicial sale of the property

as remedy for the mortgagee’s claims (Robins

et al., 2012). Consequently, the value of the

property is essential for the ultimate repayment

of the loan. This aspect might be captured in

the FDIC Financial Institution Letter (2009)

recommending lenders to appraise the value of

the underlying collateral if the decision of a

loan workout shall be made. The Regulation

(EU) 575/2013 (CRR) (2013) art 208 refers to

commercial immovable property and requires

banks to monitor the value of the CRE once a

year. Depending on the country, the expression

market value is legally dened. The Regulation

(EU) 575/2013 (CRR) (2013) art 4 No 76 refers

to the market value as the sales price on the

evaluation date at which a willing purchaser

buys an at arm’s-length transaction from a

willing seller. In the EU jurisdiction, Regulation

(EU) 575/2013 (CRR) (2013) art 4 No 74,

there exists another property value, the so-

called mortgage lending value, which is dened

as the future value of the property under the

consideration of long-term sustainable rents

under ordinary market conditions. As environ-

mental hazard may cause huge damage to the

commercial property which might result in a

decrease of value, the FDIC has established its

Guidelines for an Environmental Risk Program

for its member institutions (FDIC Financial

Institution Letter, 2006). The security of CREL

does not necessarily depend solely on the CRE.

Also, additional collateral may serve as loan

protection. Federal Register (1992) depicts fur-

ther real estate and unconditional, irrevocable

standby letters of credit as additional security

for CREL.

According to the Federal Register (2015),

the institutions should take the nature of the

underlying collateral into account. This term

might refer to the property type of CRE which

is an outstanding characteristic of the collateral

of CREL. The type of property includes several

dimensions of CRE and it seems quite demand-

ing to categorize this parameter. Supervisory

authorities might consequently face challenges

in their aim to select data from a common data

base provided by banks or nancial institutions.

Commercial Real Estate Loans – Categorization of an Investment Segment 9

Predominantly, the property type refers to

the use of the real estate. The Comptroller’s

Handbook (2013) identies ve primary real

estate types that can also be identied in

further sources: oce buildings, retail prop-

erties, industrial properties, hospitality and

multifamily residential real estate. These main

CRE types might be sub-segmented. Retail

properties have several specications, among

them shopping centers, strip malls, and depart-

ment houses. Industrial properties, for instance,

include manufacturing plants, warehouses or

distribution facilities. Hospitality might in-

clude hotels and motels. The Regulation (EU)

575/2013 (CRR) (2013) art 126 (1) (a) includes

oces or other commercial premises and art

128 (2) (d) hints at speculative immovable

property that is according to (EU) 575/2013

(CRR) (2013) art 4 No 79 bought with the

predominant aim to generate prot due to

resale. The spectrum of CRE usage is broad

and the Comptroller’s Handbook (2013) serves

as a detailed source that refers to assisted-

living facilities, dormitories, residential health

care and religious organization facilities as well.

Case (2003) refers to single-purpose properties

like assisted living or nursing homes. Mixed-

use properties like retail, on the contrary, might

be used for several purposes. This might be an

advantage for the marketability of the premises.

Within the second dimension of property type,

income-producing property is segregated from

real estate under construction or under devel-

opment. Income-producing properties generate

rent that primarily serves for the payment of

debt service. This fact is even narrowed in

the Federal Register (2006) as the guidance

relates to properties where 50% or more rental

income is generated from third parties that

are non-aliated with the borrowing entity.

The OCC Handbook (2013) refers to non-

owner-occupied property in this context and

considers hospitals, golf-courses, car washes,

and recreational facilities as owner-occupied if

not rent to unaliated third parties. BoG,

FDIC and OCC (2016) separate real estate-

secured business loans when the real estate does

not generate the repayment or debt coverage.

The Regulation (EU) 575/2013 (CRR) (2013)

art 402 (2) (d) also distinguishes between

commercial immovable properties under con-

struction and fully constructed. Johnston Ross

and Shibut (2020) refer to a specic feature of

CREL that is essential when segregating the

property types into income-producing property

and construction and development. They point

out that the underlying CRE has not only

the function to secure the loan. Rental income

from the collateralized CRE is partially used for

the payment of debt service. Properties under

construction, however, do not generate rent.

Their sale proceeds are used to repay the loan.

This is the predominant pivotal point where

the nancial markets and the real economy are

interconnected as the commercial property is

the primary source of CREL repayment (Fed-

eral Register, 2006; Regulation (EU) 575/2013

(CRR), 2013). The interrelation between the

CRE sector and the nancial sector is derived

from debt service payment and repayment of

the CREL generated by rents and ultimately

by sale proceeds of the CRE. In their risk

management guidelines, the Board of Governors

of the Federal Reserve System, Federal Deposit

Insurance Corporation, and the Oce of the

Comptroller (Federal Register, 2006) point out

that the cash ow of the property is the primary

source of debt service coverage, whereas the

loan exposure is covered by the value of

property as the secondary source of repayment.

Consequently, corporate loans, even if they are

secured by a mortgage on a property, do not

qualify as CREL as their repayment source is

based on the borrower’s operational business.

The dimension property quality refers to specic

quality metrics of CRE that might belong to

the building substance, the tenant base, as

well as the micro location of the property. In

order to attract tenants, property owners have

to increase their capital expenditures in the

property or make rent concessions (Johnston

Ross and Shibut, 2020). The OCC Handbook

(2013) outlines three classications of oce

buildings, varying from class A (high-quality) to

class C (functional), depending on the quality of

used construction material and quality of design

and xtures and their status of maintenance.

The real estate industry often refers to land-

10 Beate Monika Philipps

mark buildings and trophy buildings as quality

classication. Bardzik (2019) refers to quality

with regard to the overall construction status

of the building, the location, the occupancy

rate, and the demand for the property in

the market. BaFin refers to core real estate

as fully leased properties with creditworthy

tenancy base and tenancy structure in prime

locations (BaFin Fachartikel, 2012). The cash

ow of the property is as well determining

the classication. Further risk classications

for real estate investments are core, core plus,

value add, and opportunistic, depending on the

degree of involved risk. During the recent years,

building certications in context with environ-

mental social and governance (ESG) require-

ments of supervisory authorities have become

more signicant. Eichholtz et al. (2019) refer to

LEED and Energy Star property certication

systems in their examination. They show that

the building certication has a positive impact

on the cash ow of the building. Some countries

in the EU, like the Netherlands, have already

started to require a minimum environmental

label in order to reserve the right to operate a

building. Remarkably, CRE markets might be

dened by property type. The various property

types include corresponding risk intensities in

response to economic downturns.

The Regulation (EU) 575/2013 (CRR) (2013)

art 126 uses the term commercial immovable

property for CRE which relates to an ele-

mental feature of real estate. It is bound to

its location and has to respond to changes

of the environment. The evaluation of the

property should include an extensive analysis

of the location. The micro location describes

the immediate surroundings of the property and

its position within the immediate competitors.

Each constellation is unique which supports the

heterogeneous character of real estate (OCC

Handbook, 2013; ESRB Report, 2018). The de-

termining factors of the site analysis according

to the OCC include the access of the property,

the availability of public utilities, adjacent

shopping utilities and further amenities, and

possible future land development (OCC Hand-

book, 2013). Closeness to public utilities like

schools or universities are positive aspects that

increase the property value. Also, the vacancy

rate of property compared to its competitors

is important. Certainly, the evaluation of micro

location should take the property type as well as

competing neighboring real estate into consider-

ation. The micro location requirements for large

shopping malls, for instance, are completely

dierent compared to multifamily estates. The

macro location analysis responds to the broader

economic environment of the property. Indica-

tors for the economic developments are, among

others, the employment rate and population

trends including demographical developments

(Federal Register, 1992). According to OCC,

the demographic analysis should answer the

question of household formation and household

income (OCC Handbook, 2013). The OCC

refers to the U.S. Census Bureau data provider

in this context. Glancy et al. (2019) collect

information on geography based on the zip

codes of the properties. Some sources refer

to location as geographic location, geographic

market or geographic region (Federal Register,

2015; Federal Register, 2006; ESRB Report,

2018). Those terms are not dened but may

be assigned to macro location. The Regulation

(EU) 575/2013 (CRR) (2013) art 126 (2) (a)

brings up macro-economic factors that may

impact the value of the real estate. Case (2003)

refers to the geographic region in terms of con-

centration risk. He illustrates that properties of

the same region are likely to be impacted by

similar economic factors. This seems to be co-

herent, but might depend on the property type.

A distribution center might not respond as

severely to negative regional economic changes,

compared to an oce building. Most sources

do not distinguish between micro and macro

location. Bardzik (2019) refers to location in

general. The CRE markets can be dened in

terms of micro and macro location as pri-

mary, secondary and tertiary markets (Bardzik,

2019). In relation to retail properties, the

micro location classication might vary from 1a

locations (most frequented micro location) to 2b

locations (mediocre frequented micro location,

mixed use location). They include favorable

site conditions, compared to B or even C

locations. This connects to the risk classication

Commercial Real Estate Loans – Categorization of an Investment Segment 11

core, core plus, value add, and opportunistic.

The classication of macro locations reects

the criteria metropolitan area, urban aria and

suburban area. Cities can be classied from A

cities to D cities, depending on their economic

signicance to the region.

The value of the property is essential as

it covers, in its function as collateral, the

loan exposure. Especially at loan maturity it

is an indicator for loan coverage (Bardzik,

2019). But as well throughout the loan term

the property value is considered in the de-

termination of the nancial covenant loan to

value (LTV). The property is usually evaluated

by an independent appraiser that has the

required knowledge (Federal Register, 1990).

The market value is dened as the most likely

property price in a regular market and at

fair sale conditions under which the purchaser

and seller maneuver in a far-sighted savvy

manner (Federal Register, 1990). The FDIC

Financial Institution Letter (2009) refers to

the market value in the context of collateral

valuation. The market value reects the value at

a certain point in time, it may change due to the

market conditions (FDIC Financial Institution

Letter, 2009). The FDIC refers to three basic

valuation methods known as cost approach,

direct sales comparison approach and income

approach (FDIC RMS Section 3.2 Loans, 2020).

For the evaluation of income-producing CRE

the income approach is essential. Basically, it

represents a discounted cash ow method to

determine the net present value of the property.

The value of income-producing real estate

depends on the vacancy rate of the property,

the lease renewal trends inclusive projected

rents, discount rates, and direct capitalization

rates (FDIC Financial Institution Letter, 2009).

With regard to developments, the OCC refers

to the market value on an as-is, as-completed

or as-stabilized basis (OCC Handbook, 2013).

The Regulation (EU) 575/2013 (CRR) (2013)

art 229 (1) refers to valuation rules and to an

independent appraiser to evaluate the market

value. Unforeseen events like environmental

hazard might negatively impact the property

value and shall be taken into consideration in

the assessment of the value (FDIC Financial

Institution Letter, 2006). Further explanation

of the approaches is beyond the scope of this

study. The BOG, FDIC and OCC (2015) refer

to low capitalization rates and rising property

values. The capitalization rate (cap rate) is

the ratio between rental income and the value

of the real estate. It reects the protability

of the investment and the risk pattern of the

CRE. The higher the cap rate, the higher the

investment risk in the real estate market. The

cap rate is an indicator of the CRE market

condition for a dened property type but also

a property value determinant. The Regulation

(EU) 575/2013 (CRR) (2013) art 229 (1) refers

to the mortgage lending value as a further

value to appraise the property. This value is

dened in Regulation (EU) 575/2013 (CRR)

(2013) art 4 No 74. It shall be determined by a

prudent assessment of the future marketability

of the real estate based on long-term sustainable

criteria of the property under regular market

conditions. In Germany, for example, the mort-

gage lending value is based on the Pfandbrief

Act and the Regulation on the Determination

of the Mortgage Lending value (BelWertV).

Usually, the mortgage lending value is a more

conservative value compared to the market

value.

Bardzik (2019) refers to the borrowers of

CREL as corporate entities or private indi-

viduals. Usually in this loan segment, ring

fenced special purpose vehicles (SPV) are the

borrowing entities. Frequently, the borrower

and the property owner are the same entity.

An SPV’s only function is to own and operate

the collateralized property and this is usually

of non-recourse to the sponsor. The sponsor

is the managing and controlling entity of the

borrower and the equity investor (Robins et al.,

2012). Fig. 1 illustrates the sponsor – borrower

relationship in connection with an SPV as

mortgage borrower. The capital from the share-

holders might be provided to the borrowing

entity through shareholder loans which should

be subordinated to the CREL by means of a

subordination agreement (FDIC RMS Section

3.2 Loans, 2020). The non-liability of the

sponsor is one reason according to the ESRB

Report (2018) why CREL is relatively volatile

12 Beate Monika Philipps

Fig. 1: Commercial Real Estate Ownership Structure with Senior Lender, Junior Lender, and Mezzanine Lender.

Following Robins et al. (2012).

in comparison to RREL where the private

individual’s home represents the collateral. The

sponsor, nonetheless, plays an important role

for the success of the undertaking and asset

management of the property. Special attention

shall be paid to its track record and market

standing. A sponsor might, depending on the

risk prole of the CREL, provide a guarantee

for the nancing as additional collateral. In

order to evaluate the guarantee, a lender shall

consider the nancial capacity of the guarantor

and its ability to cover and repay its total in-

debtedness (FDIC Financial Institution Letter,

2009). Especially with regard to developments

of CRE, the sponsor’s capabilities to complete

the project within the predetermined cost and

time budget is essential (OCC Handbook,

2013). The Regulation (EU) 575/2013 (CRR)

(2013) art 126 (2) ascribes to CREL a par-

ticular risk dimension, as the value of the

property depends upon the credit quality of

the borrower. The performance of the borrower

as the owning SPV and the performance of

the securing property to repay the CREL are

unconditionally linked. The motivation for a

borrower to engage in debt nancing rather

Commercial Real Estate Loans – Categorization of an Investment Segment 13

than to contribute in an equity investment, is

based on the desire for diversication (Phillips,

2009). The so-called leverage eect plays a

further dominant role. The return on equity

might be increased employing debt nancing.

In case of portfolio nancing, multiple bor-

rower might be engaged. In this context it

is important that each borrower is jointly

liable and that a defaulting borrower, due to

insolvency, is triggering a cross-default. Special

attention within the risk monitoring shall be

paid, if the borrower is an out-of-territory entity

(FDIC Financial Institution Letter, 2015). In

order to determine the utilization of borrower

limits, the lenders shall identify the borrower’s

respectively the sponsor’s aggregate exposure

including derivatives (Federal Register, 2006).

3.2 Broader CREL Characteristics

CREL comprise specic loan structures. The

maximum loan term should correspond with the

type of property (Federal Register, 1992; OCC

Handbook, 2013) and should not exceed the

remaining useful life of the real estate. The OCC

refers to CREL secured by income-producing

multifamily properties with a longer loan term

and hotel nancing with a shorter term (OCC

Handbook, 2013). Warehouse facilities repre-

sent a property type for an even compressed

loan term due to their relatively short useful

life span. The FDIC Financial Institution Letter

(2009) and the Federal Register (2006) refer

to the loan term and the structure of the

loan. The OCC outlines a maximum term of

30 years, even if the property might have a

longer useful life (OCC Handbook, 2013). The

amortization schedule shall be in line with the

loan term because the amortization protects

against any diminishing collateral value during

the loan term (OCC Handbook, 2013). Closely

associated with the appropriate loan term is the

tenancy structure. In case of a single tenant

property, the lease expiration date should sur-

vive loan maturity by a determined timeframe

in order to provide for a smooth loan exit. It

is benecial, if a part of the free cash ow is

swept into a re-leasing and capital expenditure

reserve to cover expenditures for refurbishment,

rent concession, and rent-free periods. With

regard to multi-tenant properties, the loan

term might be linked to the weighted average

lease term or the weighted average lease term

to break option. If leasehold properties are

involved, the loan term should expire at least

ten years prior to the ground-lease expiration

(OCC Handbook, 2013). Black et al. (2017) nd

that construction loans are short-term loans.

Glancy (2019) shows that banks usually provide

short-term loans whereas life insurers tend to

lend long-term with more than ten years until

maturity. Bardzik (2019) nds that commercial

banks may provide shorter term loans based

on underlying properties with less stable cash

ows in contrast to life insurance companies.

Ambrose et al. (2003) nd that nonbank lenders

that are not publicly traded or undergo a

separate tax regime, like insurance companies,

tend to be long-term lenders. Usually, the

CREL is not completely paid o at maturity

which requires a careful assessment of the

property value to ensure loan exposure coverage

at the end of the loan term (Bardzik, 2019).

Johnston Ross and Shibut (2020) nd that

only 20% of the loan proceeds were repaid

at maturity in their sample data of FDIC

loans. This may have resulted from the sample

date having included shorter-term bank loans.

Black et al. (2017) nd out that CMBS lenders

provide in majority a loan term of ten years.

Case (2003) nds that the average loan term

for the nancing of fully constructed properties

amounts to ve years and to one year for

development and construction loans. The loan

agreement may provide for termination rights

or extension rights of the borrower. In case of

early termination, the lender should make sure

that a prepayment fee at-arms-length will be

due to compensate for the lost interest portion

respectively the reinvestment loss.

Loan term and amortization are closely

interlinked. Both inuence the loan structure

(OCC Handbook, 2013). According to the

Federal Register (2015), the borrower shall

repay the loan in a timely manner. This might

be done through graduate payments (Johnston

Ross and Shibut, 2020) or annuity payments.

As Bardzik (2019) states, each amortization

14 Beate Monika Philipps

reduces the loan exposure. The repayment of

CREL might be recorded in an amortization

schedule (Federal Register, 1992) which could

include interest-only payment periods (BOG,

FDIC and OCC, 2015). Ongoing amortization

for CREL is generated by the rental income of

the real estate securing the loan (FDIC Finan-

cial Institution Letter, 2015; Federal Register,

2006; Case, 2003). According to the Regulation

(EU) 575/2013 (CRR) (2013) art 126 (2) (b),

the repayment of CREL is derived from the

performance of the underlying property. Pana

(2010) describes this as main characterization

of CREL. According to the OCC Handbook

(2013), the amortization criteria is dependent

on the loan type. Construction loans usually do

not require ongoing amortization (OCC Hand-

book, 2013). They are usually repaid by sale

proceeds of the project. OCC Handbook (2013)

recommends to limit the interest-only periods

until the cash ow from property is stabilized.

Interest-only loan structures require a bal-

loon payment at maturity (Johnston Ross and

Shibut, 2010). Any re-amortization throughout

the loan term increases the risk potential of

the lender (OCC Handbook, 2013). The exit

scenario relates to the ultimate payo of the

loan which might be accomplished through the

renance of the current lender or an alternative

lender, through the sale of the property or, in

a worst-case scenario, by foreclosure proceeds.

The latter follows an event of default with accel-

eration of the loan (Bardzik, 2019). Mandatory

repayments of the loan prior to maturity might

be triggered through a sale of the property or

the sale of shares in the borrowing entity that

might be followed by a change of control. In case

of portfolio nancing, the loan documents might

allow for partial repayment by sale proceeds

from released units. The lender is advised to

specify the allocated loan amounts for the sold

units in order to maintain the quality of the

remaining portfolio. During an ongoing event of

default, proceeds from captured cash ow after

debt service might be used to repay the loan

amount. This usually follows an uncured cash

trap or cash sweep event.

Traditionally, CREL are high loan volume

transactions. The Federal Register, 2015 pushes

the responsibility to the bank and points out

that its loan procedure should take the loan

amount into consideration. The loan approval

process should consider the volume of the loan

in connection to the property type and to the

initial loan to value (LTV) as well as outlined

in the supervisory maximum LTV limits of the

Federal Register (1992). The Federal Register

(2006) and the OCC Handbook (2013) pick

up on these two determinants, too. In addition

to these features, the lender shall consider the

maximum loan amount per transaction and

the maximum loan exposure of the borrower

group in order to limited the maximum possible

underwriting volume. Construction facilities

usually include a budgeted interest reserve that

increases the loan amount (FDIC Financial

Institution Letter, 2009). This forces the bor-

rower at the time of loan origination to fund

the remaining necessary investment volume

via equity or mezzanine loan proceeds. The

loan documents should include cash trap or

cash sweep mechanism to force borrower to

partially repay the loan amount in case of

non-compliance with the LTV covenant during

the loan term. Glancy et al. (2019) nd that

CMBS transactions exceed portfolio lender loan

amounts by 200% on average. Black et al.

(2017) call up on this fact as well. Wong and

Kaminski (2019) nd that the loan volume

per transaction of life insurance companies

is usually higher compared to loan amounts

provided by property and casualty insurances.

It is common in the CREL industry, that a

club of lenders is providing a high-volume loan.

Club deals or participations are types of loan

syndication.

Basically, the CRE loan type may be classied

according to the usage of the loan proceeds,

the purpose of the loan, as well as the degree

of borrower’s liability. Following this rationale,

CREL can be classied as land development

loans (Federal Register, 2006; Pana, 2010),

commercial construction or development loans

(Federal Register, 2006; FDIC RMS Section 3.2

Loans, 2020; Johnston Ross and Shibut, 2010),

and acquisition loans. In the case where the

loan proceeds are allotted to the improvement

of the property (BOG, FDIC and OCC, 2015),

Commercial Real Estate Loans – Categorization of an Investment Segment 15

the classication includes refurbishment loans.

The acronym ADC includes acquisition, devel-

opment and construction loans (FDIC Finan-

cial Institution Letter, 1998; OCC Handbook,

2013). The OCC Handbook (2013) further

relates to bridge loans to cover the short-

term period of rental income stabilization of

the property and to bridge the time slot until

the renancing of the loan. The renance of

CRE is the replacement of an existing mortgage

with a new loan. Depending on the individual

circumstance, the total loan amount might

be divided into several tranches, such as an

acquisition tranche and a capital expenditure

tranche. The capital expenditure advances shall

be used to improve the property quality and

might increase the chance of successful re-

leasing in case of value-add properties. The

loan proceeds might not be necessarily invested

in the underlying property but may be used

for other purposes. Depending on the degree

of borrower’s liability, CREL are non-recourse

loans, recourse loans or partially recourse loans

(Federal Register, 1992). Frequently, CREL are

provided to non-recourse ring-fenced borrower

structures due to sponsor liability protection

but as well to shelter the lender from any cross-

default within the sponsor entity structure.

With regard to the loan risk evaluation of the

supervisory authorities, CREL may be classied

as substandard, doubtful, loss, and special

mention depending on borrower’s capability

of repayment (FDIC RMS Section 3.2 Loans,

2020; FDIC Financial Institution Letter, 2009).

Depending on the ability to repay the loan,

CREL may be assigned to performing loans and

non-performing loans.

An important feature of the CRE loan

structure is the lender’s contractual ranking

of security position. The ranking classies the

loss absorption in case of a foreclosure (Robins

et al., 2012). CREL might be structured with

regard to the risk prole of the lender (OCC

Handbook, 2013). There might be senior loans

and junior loans in place depending on the

ranking of the lien on the property, also

referred to as rst lien and second lien (OCC

Handbook, 2013). Bardzik (2019) refers to

subordinate ranking in connection with second

and third mortgages. Depending on the lender’s

risk appetite, the structuring of a senior and

a junior portion might be obsolete and the

lender might nance the so-called whole loan.

In case of a restructuring of a loan, the

inclusion of rst and subordinate liens might

be reasonable in order to distinguish between

performing and non-performing tranches (FDIC

Financial Institution Letter, 2009). Mezzanine

loans are often referred to in connection with

CREL. But in contrast to CREL they are

secured by a pledge of ownership interest in the

property owner and not by a mortgage on the

property (Bardzik, 2019). Upon foreclose in the

company shares, the mezzanine lender might

bid and ultimately become the indirect owner

of the property. Mezzanine loans include an

in place structural subordination to senior and

junior loans (Robins et al., 2012). Therefore,

they provide a higher risk component com-

pared to CREL but represent a lower risk in

comparison to equity (Phillips, 2009). Fig. 1

displays the specic loan relationships including

senior/junior nance and mezzanine nance in

an SPV structure.

Of utmost signicance are the loan documents

of CRE nance as the loan agreement and the

accompanying nance documents establish the

contractual frame for the relationship between

lender and borrower throughout the whole loan

term. As expressively pointed out in the Federal

that its legally valid loan claim is enforceable.

According to FDIC Financial Institution Letter

(2006), the loan agreement should as well

protect the lender against any environmental

liability in connection with the contamination

of the property. Also, loan purchase and partic-

ipation agreements that concern the relation of

lenders amongst each other are of high relevance

(FDIC Financial Institution Letter, 2015). It is

important that voting and enforcement rights

within the lender group should be addressed

as well. Additionally, the right to sell the

loan participation should be included (FDIC

Financial Institution Letter, 2015). Intercred-

itor agreements rule the relationship among

the lenders with diering ranking, especially

the relationship between mortgage lenders and

16 Beate Monika Philipps

mezzanine lenders (Robins et al., 2012). The

lender may mandate an external legal advisor

for the review of the participation agreement

and especially for high volume CRE nance

documents (FDIC Financial Institution Letter,

2015). A certain degree of standardization with

regard to the loan documentation is benecial

to maintain the fungibility of the CREL and

to keep the loan transaction costs low. The

standardization of loan documents is evidenced

by CMBS transactions that are usually less

complex than loan documents used in portfolio

transactions (Robins et al., 2012). The loan

market association standard (LMA) for loan

agreements is also well known in the industry.

One disadvantage of standardized nance docu-

ments is, that they do not provide space for ex-

ibility, for instance during times of special situa-

tions. This is where portfolio lenders generate a

comparative advantage using non-standardized

loan agreements (Black et al., 2017).

The interest rate structure of CREL ranges

between xed and adjustable rates (FDIC

RMS Section 3.8 O-Balance Sheet Activities,

2019; Federal Register, 2006). Life insurers and

CMBS lenders tend to arrange xed rates with

the borrower, banks usually provide oating

rate loans (Glancy et al., 2019; Black et al.,

2017). Pricing components like commitment

fees, upfront fees, and agency fees impact

the price structure of CREL. The interest

rate shall bear the cost of loan funding, loan

administration and credit risk. The interest rate

should as well compensate illiquidity cost since

CREL are a rather illiquid asset class with only

a secondary market in place. The prot/risk

prole shall also take the type of the underlying

property into consideration (Federal Register,

1992). Compared to oce buildings, leisure

accommodation and hotels represent higher risk

as those property types quickly respond to

economic downturns. Therefore, they demand

a higher pricing (Glancy et al., 2019). The

recent changes in the perception of the nancial

industry of environmental sustainability and

ESG performance might have an impact on

future pricing of CREL. A rst approach in

this context has been included in the BaFin

Guidance (2020).

The cash ow generated by rental income or

sale proceeds deducted by operating costs of

the underlying property impacts the structure

of the loan. Johnston Ross and Shibut (2020)

point out that CREL are structured with regard

to lease payment schedules. The Regulation

(EU) 575/2013 (CRR) (2013) art 126 (2) ex-

plicitly relates to the cash ow generated by the

underlying property. Pana (2010) refers to the

cash ow as main source of repayment of CREL.

The cash ow shall grant the appropriate debt

service coverage at all times during the loan

term and the repayment of the loan (BOG,

FDIC and OCC, 2015). Certainly, a long-term

predictable cash ow is benecial for CMBS

transactions (Black et al., 2017). The cash ow

analysis is the pivotal element in the evaluation

of CREL and based, among others, on the lease

agreements. The cash ow projections should

account for appropriate vacancy rates and

adequate re-leasing periods (OCC Handbook,

2013). The analysis should as well take rent

increases (Bardzik, 2019) and indexed rents

into consideration. In the case of insucient

cash ow in combination with shortage of

reserves or equity, the borrower might take

third party capital providers into consideration

(Robins et al., 2012). Eichholtz et al. (2019) nd

that environmentally certied buildings might

account for a constant cash ow and reduce

consequently the risk of CREL.

CREL might include loan covenants in the

loan documentation that may impact the loan

quality. Financial covenants may bridge the

information gap between borrower and lender

and might reduce lenders’ risk. The LTV or

the modied version loan to mortgage lending

value (LTMLV) belong to the capital covenants.

The LTV represents a limit for the maximum

loan amount L. Tight senior loan LTV-limits

require higher borrower equity or third-party

contributions (Robins et al., 2012). According

to the Federal Regulation (1992), the maxi-

mum supervisory LTVs are connected to the

underlying property type. The loan amount

shall not excess a certain threshold of the

property market value V(Cremer, 2019), all

senior liens shall be taken into consideration

(OCC Handbook, 2013). Some German banks

Commercial Real Estate Loans – Categorization of an Investment Segment 17

prefer to focus on the LTMLV as dened in

the Regulation on the Determination of the

Mortgage Lending Value (BelWertV) instead of

the market value as it reects a conservative

sustainable property value. Glancy et al. (2019)

examine the LTV limits by lender type and

discover that banks even provide loans above

75% LTV, life insurers generally oer loans

within the range of 50% to 67% LTV and CMBS

lenders from 60% to 71% LTV. Equation (1)

reects the LTV ratio.

LTV =L

V(1)

The performance covenant yield on debt

(YoD) exposes the property cash ow Ctrel-

ative to the loan amount Ltat a dened point

in time. This reects the ability of property’s

cash ow to cover indebtedness. Equation (2)

outlines the YoD ratio.

YoDt=Ct

(2)

The debt service covenant (DSCR) or in-

terest service covenant (ICR), belong to the

performance covenants as well. The DSCR is

the key indicator to measure the debt cover-

age capability of the property’s net operating

income (NOI). DSCRtdepicts to what extend

the debt service for a loan amount Ltis covered

by cash ow Ctor by NOItof the property

(Cremer, 2019; OCC Handbook, 2013). Lenders

determine a DSCR covenant depending on the

risk grid of the underlying property. As an

example, the DSCR covenant for a loan secured

by an oce building might be lower compared

to a DSCR of a hotel nancing. Glancy et al.

(2019) detect the typical DSCR at 1.50, for

hotel nancing at 1.85. The DSCR covenant is

outlined in equation (3).

DSCRt=Ct

(3)

The ICR is an alteration of the DSCR

covenant and a “second line of defense” (Cre-

mer, 2019, p. 378) outlining coverage in case

of deferral of amortization or in case of bullet

loan structures. There exist further covenants

like guarantor nancial requirements or require-

ments of minimum borrower equity. LTV and

DSCR should not be a static reection at

loan origination but should be calculated on

an ongoing basis during loan term (Bardzik,

2019). Non-compliance with nancial covenants

might lead to an event of default and ultimately

to the acceleration of loan and the foreclo-

sure.

Typical CREL lenders are commercial banks,

life insurance companies and CMBS lenders

(Glancy et al., 2019; Bardzik, 2019). The ECB

Review (2007) further includes pension funds

as CRE debt investors but not as immediate

CREL lender. According to BaFin, banks might

withdraw from the CREL market due to high

capital charges in respect to Basel III and in-

surers might bridge the resulting nancing gap

(BaFin Fachartikel, 2012). Commercial banks

perform in their function as loan originator

and balance sheet lender and benet from the

immediate borrower relationship (Downs and

Xu, 2015). CMBS lenders, on contrary, have

almost no deeper relationship to the borrower

(Downs and Xu, 2015). The lender strategy

might focus on a loan sale right after origination

without recourse to the purchaser (Federal

loan sales experienced during the global nan-

cial crisis 2008, this type of business might

be currently rather limited. Some institutions,

especially those without direct relationships to

potential CRE customers, implement loan par-

ticipations in their business model. The main

drivers for this business strategy are fast CREL

exposure increase and the diversication of risk

and protability (FDIC Financial Institution

Letter, 2015). For the selling institutions risk

diversication is a benet as well. In addition,

exhausted borrower limits might get released

in order to provide leeway to originate new

business with the CREL borrower (FDIC RMS

Section 3.2 Loans, 2020).

3.3 CREL Inherent Risks

According to the OCC Handbook (2013), CRE

lending might be accompanied by seven risk

categories. These comprise the credit risk,

interest rate risk, liquidity risk, operational risk,

compliance risk, strategic risk, and reputation

18 Beate Monika Philipps

risk. The various risk types may be in place

simultaneously. They may as well interrelate

and interconnect.

The underlying CRE might serve as collateral

and debt service provider for the CREL and

in this respect could be considered as a two

lines of defense system (Kim, 2013; Johnston

Ross and Shibut, 2020). The CRE markets are

essential risk drivers of CREL as rents impact

the cash ow of a property and its value.

Prospering CRE markets depend on an intact

legal, economic and political system. These

attributes as well dene a performing debt

market (Phillips, 2009). The OCC refers to the

CRE markets as the “key elements of risk” of

CRE nance (OCC Handbook, 2013, p. 1). The

CRE markets are correlated to the real economy

(Black et al., 2017) and thus respond to local

and national economic developments (OCC

Handbook, 2013). As outlined in the Statement

on Prudent Risk Management for Commercial

Real Estate Lending rents, sale prices, and

operating expenses impact the repayment and

debt service coverage of the loans (BoG, FDIC

and OCC, 2015). According to the Federal

respective market of the underlying CRE. The

Federal Register (1992) recommends a market

condition monitoring in order to adequately

respond to market changes. According to the

Federal Register (1990) abnormal market de-

velopments shall be explicitly outlined in an

appraisal. Those market developments could be

caused due to excessive price increases of certain

CRE that follow the strong demand of investors

in a dened risk bucket (BaFin Fachartikel,

2012). The turning of CRE markets with asset

price deterioration or increasing vacancies could

cause non-compliance with contractual LTV

covenants or, in the worst case, unsecured

loan exposures and uncovered debt service.

The FDIC Financial Institution Letter (2008)

recommends to request from borrower current

cash ow statements and rent schedules. It

might be necessary for the lender to mandate a

revised appraisal in case of deteriorating CRE

market conditions in order to re-evaluate CREL

collateral (FDIC Financial Institution Letter,

2008). This emphasizes the linkage between the

CRE markets and the CREL inherent credit

risk. Once CREL defaults become systemic,

they may infect the nancial economy and

ultimately harm the real economy (ESRB Re-

port, 2018). A CRE market bubble might be

inated as a result of a long-term low yield

environment (ESRB Report, 2018) caused by

investor’s high demand of additional alpha.

Signs for a turning CRE market might be

the increase of rent concessions, substantial

amendments to construction and development

projects inclusive construction delay, prolonged

re-leasing of rental space and slow unit sale

(FDIC RMS Section 3.2 Loans, 2020). Exces-

sive property development activities with vast

increase of supply of CRE space might aect

the CRE markets negatively (FDIC Financial

Institution Letter, 1998). Cheap loan supply

and extensive lending could even boost CRE

market developments but also cause an im-

mediate market drop if the loan supply runs

dry (Bassett and Marsh, 2017). Property types

might respond to economic changes dierently

(OCC Handbook, 2013). The hotel sector may

be intensely linked to the development of wages

and the unemployment rate. The success of

construction projects depends on the accurate

timing within the economic cycle and the

demand of the market participants. According

to the OCC Handbook (2013), construction

projects respond extremely sensitive to the

economy. As Case (2003) points out, supervi-

sory authorities, as the Federal Reserve Board,

deem construction loans as highly sensitive to

downturns of the CRE markets. To mitigate

the risk, lenders should insist on adequate

pre-leasing or pre-sales. Important economic

indicators for CRE markets are demographic

changes, the development of income and of the

unemployment rate (OCC Handbook, 2013).

Changes to existing laws like rent control or

condominium conversion rules, could strongly

impact the CRE market condition (OCC Hand-

book, 2013). Both, lender and borrower might

be hit by a CRE market downturn. However,

they might be aected with dierent severity.

Depending on the LTV of the nancing, the

lender might disproportionally participate in

the investment compared to the borrower’s

Commercial Real Estate Loans – Categorization of an Investment Segment 19

equity contribution. Notwithstanding this fact,

borrower’s equity can be deemed as the rst

loss piece if the property value drops. The

Directive 2009/138/EC (Solvency II) (2009) art

105 No 5 (c) refers to property risk in connection

with “market prices of real estate”. In addition,

the Commission Delegated Regulation 2015/35

(Solvency II) (2014) art 174 reects the CRE

risk within the risk sub-module property risk.

The ECB Review (2007) refers to the CRE

market risk in connection with the potential of

cross-border spreading of CRE price decreases.

The Federal Register (2015) refers to in-

creased credit risk as the outcome of extensive

lending. This risk is dened as the borrower’s

inability to repay its loan obligations. The

Directive 2009/138/EC (Solvency II) (2009) art

13 denes credit risk as “the risk of loss or

adverse change” of the counterparty’s nan-

cial condition. The Regulation (EU) 575/2013

(CRR) (2013) mentions the terminology credit

risk 263 times which emphasizes its signicance

to this regulation. A loss might occur if the

loan exposure is not suciently covered by

foreclosure proceeds of the underlying property

or if the cash ow generated by the CRE

does not cover the debt service during the

loan term. According to the Federal Register

(1990), the quality of a lender’s collateral is

inuenced by the physical condition of the

building. The lender shall pay special attention

to the triangle of loan exposure, potential sale

price of the property and the market demand

for the type of property (FDIC RMS Section

3.2 Loans, 2020). Black et al. (2017) outline

the property type as a predominant risk driver.

According to the FDIC RMS Section 3.2 Loans

(2020, p. 23), “adverse economic developments”

could cause the lender to re-evaluate the credit

risk. Construction delays might result in cost

overruns (FDIC RMS Section 3.2 Loans, 2020)

and threaten the completion of the project.

Excessive and especially speculative property

developments might negatively impact the ex-

isting properties in a sub-market, jeopardize

their long-term nancing, and ultimately lead

to a loan quality deterioration (Bassett and

Marsh, 2017). Usually, CREL are provided on a

non-recourse basis without liability of the spon-

sorship (ESRB Report, 2018). The Commission

Delegated Regulation 2015/35 (Solvency II)

(2014) art 42 (2) connects the credit risk to the

defaulting counterparty and art 42 (5) explicitly

states that the probability of Default (PD) of

a borrower is related to its assets. The ECB

refers to the credit risk as the main risk driver

in CMBS transactions (ECB Review, 2007).

Higher equity contributions of the sponsor,

result in a lower LTV at origination, which

might mitigate the credit risk. This shifts the

risk from lender to the borrower and improves

the risk sharing between lender and borrower

(ESRB Report, 2018). The credit risk of dis-

tressed loans might be increased by asymmetric

information distribution between lender and

borrower, agency conicts of securitized loans,

contracting frictions in case of multiple lenders,

and regulatory pressure (Downs and Xu, 2015).

According to FDIC Financial Institution Let-

ter (2009), distressed loans are classied as

substandard loans, doubtful loans, loss assets,

and special mention. Loss assets are dened

as loan exposures that are not covered by the

market value of the property (FDIC Financial

Institution Letter, 2009). If a loan is in distress,

it is crucial to accelerate the decision, if a

restructuring shall be processed or if the loan

shall be foreclosed upon. Downs and Xu (2015)

detect that portfolio lenders seem to resolve

a special loan situation quickly compared to

lenders of a securitization. They point out that

balance sheet lenders, in contrast to CMBS

lenders, are more likely to foreclose on a loan

than to restructure the loan. The lender should

not solely rely on the appraised value as the

actual sales price of the property could dier

(FDIC RMS Section 3.2 Loans, 2020). Inap-

propriate loan documentation might increase

the credit risk (FDIC RMS Section 3.2 Loans,

2020). The risk measure expected loss (EL)

might be used as a pricing component for CREL

to compensate for the credit risk (Bardzik,

2019). The EL includes the PD, the loss given

default (LGD) and exposure at default (EaD)

as outlined in equation (4).

EL =PD ·LDG ·EaD (4)

20 Beate Monika Philipps

According to Kim (2013), the property cash

ow has an impact on the PD whereas the

LGD depends on the property value. Environ-

mental property certication might positively

inuence the cash ow due to rent increases

or short re-leasing periods (Eichholtz et al.,

2019). Johnston Ross and Shibut (2020) are of

the opinion that defaulting non-seasoned CREL

are stronger impacted by economic turmoil

and reveal higher LGDs compared to seasoned

CREL. Increasing property values over time

due to successful re-leasing or indexed rents

might be the reason. The quality of a lender’s

loan portfolio might be classied by EL groups.

Another signal of portfolio quality might be the

extend of delinquencies (Pana, 2010).

The lender could be aected by the interest

rate risk on its portfolio level. This risk might

be hedged through derivatives like swaps (FDIC

RMS Section 3.2 Loans, 2020). On transac-

tion level, rising interest rates that are not

accompanied by an increase of the property

cash ow could cause a loan default (Phillips,

2009). The lender may push back this risk to

the borrower and require borrower to enter

into an interest rate hedging. Interest rate lock

commitments counter borrower’s interest rate

risk during the loan approval process (FDIC

RMS Section 3.2 Loans, 2020). The Regula-

tion (EU) 575/2013 (CRR) (2013) addresses

the terminology interest rate risk 21 times.

The Commission Delegated Regulation 2015/35

(Solvency II) (2014) art 165 requires insurance

undertakings to cover this risk with capital.

CREL are an illiquid asset class. The ECB

Review (2007) refers to the underlying commer-

cial property as illiquid. This emphasizes the

fact that the liquidity risk of CREL is linked

to the liquidity risk of the underlying asset.

The liquidity risk is inherent during the entire

loan term and especially at loan maturity as

most of the CREL are not amortized during

loan duration. The exit possibilities of CRE

lending include the renancing of the loan by a

dierent lender, the securitization or the sale of

the loan, and the full amortization throughout

the loan term (OCC Handbook, 2013). The lack

of fungibility of CREL represents the liquidity

risk for the lender (Directive 2009/138/EC

(Solvency II) (2009) art 13 No 34). The Reg-

ulation (EU) 575/2013 (CRR) (2013) refers to

the terminology liquidity risk nine times, much

less in comparison to the reference to credit

risk. The ESRB refers to this risk as lender’s

renancing risk caused by a lack of liquidity

to repay the loan at maturity (ESRB Report,

2018). Eichholtz et al. (2017) refer to the

benecial inuence of environmental certied

buildings as collateral on the cost of funds for

the CRE nancing. This mitigates the liquidity

risk and might be an indicator for the quality

of CREL. Environmental certication of the

asset may reduce the liquidity risk during loan

term and at maturity (Eichholtz et al., 2019).

The Commission Delegated Regulation 2015/35

(Solvency II) (2014) art 326 requires the value

of the asset of an SPV to be sucient to

cover the liquidity risk among others. The ECB

refers to this risk bucket with regard to indirect

investment products like speciality funds that

do not have a primary market in place and

therefore are less fungible (ECB Review, 2007).

BoG, FDIC and OCC (2015) refer to the

operational risk as the risk that is inherent

in a lender’s internal processes and connected

to lender’s risk management. The FDIC Fi-

nancial Institution Letter (2015) relates to

this risk in context with lenders’ activities in

unfamiliar business segments or new markets.

It is emphasized, that those segments and

markets shall be comprehensively monitored

and controlled. The OCC refers to strategic

risk as a lender’s risk of failure to eectively

oversee the CRE lending activities which could

lead to a non-compliance with the lender’s CRE

lending policy (OCC Handbook, 2013). This

risk per denition could also be assigned to the

operational risk bucket. A signicant amount

of defaulting loans might cause banks to adjust

their lending strategy which ultimately could

result in restrictive lending. In the worst case,

this might trigger a credit crunch and limit

the real economy’s new investments (ESRB

Report, 2018). Supervisory requirements could

as well aect the lender’s strategy. Pana

(2010) investigated changes in the strategies of

banks prior to the global nancial crisis. Pana

showed that banks adjusted their strategy and

Commercial Real Estate Loans – Categorization of an Investment Segment 21

shifted from CRE lending to RRE lending in

order to decrease supervisory capital charges.

The Regulation (EU) 575/2013 (CRR) (2013)

mentions the terminology operational risk 53

times. The Directive 2009/138/EC (Solvency

II) (2009) art 13 No 33 specically denes

this risk as risk resulting from internal pro-

cesses that could also be triggered by external

factors. The Commission Delegated Regulation

2015/35 (Solvency II) (2014) art 204 encloses

the calculation of capital requirements for the

operational risk. The ECB points out that this

risk may be inherent in transactions of private

equity funds and hedge funds (ECB Review,

2007). These investment groups usually are

not regulated. They might not have sucient

internal processes and control systems in place.

Environmental issues like the contamination

of the property do not only impact a lender’s lia-

bility but may also account for a lender’s reputa-

tion risk. The FDIC Financial Institution Letter

(2006) require lenders to organize an adequate

environmental risk assessment during the entire

loan term. In general, the reputation of a lender

could be negatively aected by lender liability

lawsuit (OCC Handbook, 2013) or the negative

inuence of the borrowing entity or by a shady

tenancy base. The Regulation (EU) 575/2013

(CRR) (2013) uses the terminology reputation

damage only once. According to Directive

2009/138/EC (Solvency II) (2009) art 102 (4),

this risk is allotted to the operational risk.

The OCC Handbook (2013) refers to com-

pliance risk as the risk of non-compliance with

laws and regulation, including environmental

laws. The Regulation (EU) 575/2013 (CRR)

(2013) does not refer to the term compliance

risk at all. According to the Commission

Delegated Regulation 2015/35 (Solvency II)

(2014) art 270 (1), the undertaking shall set

up a compliance management to encounter the

compliance risk.

The Federal Register (1992) directly men-

tions the necessity for an institution to diversify

its loan portfolio with respect to loan type,

geographic market and loan quality in order to

face the concentration risk. It is important that

the lender takes the transaction loan amount

and lender’s entire CREL loan exposure into

consideration. The concentration risk refers to

a lender’s portfolio cash ow correlation. The

risk may be higher if the cash ows of a

portfolio are positively correlated, which could

be the case in connection with properties of

the same macro location and similar economical

exposure (Case, 2003). The Federal Register

(2006) forces the supervised institutions to

report in case their CREL exposure exceeds

a dened threshold, such as construction loan

threshold of 100% of the total capital of the

institution or other CREL threshold of 300% of

the total capital of the institution. The FDIC

RMS Section 3.2 Loans (2020) includes the

risk of the lender’s loan exposure to a single

entity or person. Some lenders have diculties

in diversifying their loan portfolio with regard

to location or business segment as they are

only active in limited local markets (FDIC RMS

Section 3.2 Loans, 2020). According to BoG,

FDIC and OCC (2015), the management board

shall approve concentration limits within its

risk management process. The Regulation (EU)

575/2013 (CRR) (2013) mentions the termi-

nology concentration risk ten times. According

to the Directive 2009/138/EC (Solvency II)

(2009) art 13 No 35, this risk could be severe

and threaten the undertaking’s going concern.

The Commission Delegated Regulation 2015/35

(Solvency II) (2014) recital (62) refers to

geographical or sector concentration of assets.

According to Bardzik (2019), lender’s CREL

portfolio concentration may include LTV, YoD,

DSCR, EL, PD, LGD segmentation in addition

to property type and to the geographic area of

the property. The diversication of asset classes

and geographical markets creates a possibility

to mitigate concentration risk. Pana (2010)

fears that smaller banks might not encounter

concentration risks fast enough to diversify

their loan portfolio if necessary. This could be

the case for local banks that provide CREL to

borrowers in a limited geographical area. The

ESRB also addresses the risk of concentration

of losses and recommends cross-border syndica-

tion of CREL in order to mitigate the nancing

risk (ESRB Report, 2018).

22 Beate Monika Philipps

4 DISCUSSION

CREL are an essential investment segment in

the economy which accounted in 2019 for 14%

of the US GDP (Glancy, 2019). Commercial

banks, life insurance companies, and CMBS

lenders are the main CREL providers (Glancy

et al., 2019; OCC Handbook, 2013). As in-

termediaries, they clearly inuence the capital

ow into the real estate sector. Supervisory

authorities extensively monitor the institutions’

CREL activities as any deterioration in the

nancial market could infect the real economy.

A synchronized and accurate database is essen-

tial for eective CREL supervisory monitoring,

mainly because the asset class is particularly

heterogeneous. Data gaps have been criticized

especially by regulatory authorities (ESRB,

2018). With regard to the ling of the banks’

CREL data base, time is of the essence. This

was clearly evidenced by the experience made

shortly prior to the global nancial crisis of

2008 which was triggered by the deterioration

of the US real estate market. Accordingly, the

supervised institutions themselves might have

an interest to ll this gap as their capital

charges correlate with their risk weighted assets.

Surprisingly, and as far to this author’s knowl-

edge, no universal denition of CREL exists

in the global nancial world. Only few articles

of the reviewed set explicitly dene this loan

type, among them the Federal Register (2006)

and Pana (2010). Although they provide a solid

guidance, in some respect their denition might

be misleading and ambiguous. The Federal

rental income generated by the underlying

property as primary source of repayment and

draws a second quantitative precondition. In

the case where the borrower or an entity of the

borrowing company group is providing 50% or

more of the rental income, the criteria for CREL

is not met. This is a notable approach to capture

loans that are correlated to the CRE market

risk. In this author’s opinion, the threshold of

50% is rather high as consequently up to 49%

of the rental income could be derived from the

borrowing company group. This represents a

risk sphere other than the CRE market. The

risk of distortion of the tenancy schedule would

shift from CRE market to the borrower’s nan-

cial ability. Pana (2010) interconnects CREL

to the cash ow from the property as well, but

her denition does not include any threshold for

third party rental income. She connects CREL

to the usage of the loan for construction, land

development, and other land loans. This list

could have been completed by the acquisition

of CRE, the refurbishment of the property,

and the renance of CREL. Pana (2010, p.

17) denes CRE among others as “multi-family

residential properties”. This gives room for in-

terpretation. It is unclear if the term is based on

the denition of multifamily property according

to 12 CFR §1266.1 which includes nursing

homes, dormitories and homes for elderly. The

Federal Register’s denition (2006) takes land

development loans, construction loans and land

loans into account and explicitly includes 1-to-4

family residential construction and commercial

construction. This would comprise one family

residential construction which rather should be

allotted to RREL. The denition includes as

well multi-family and nonfarm nonresidential

properties. It is benecial, that loans to REITs

and unsecured loans to developers are dened

as CREL (Federal Register, 2006) as they are

correlated to the CRE markets, too. Pana

(2010) does not refer to these borrower groups

at all.

In order to categorize CREL it is in this

author’s opinion important to focus on the main

risk drivers of CREL and to understand how

they impact the asset class. The general risk of

providing loans is the inability of borrower to

pay the debt service and ultimately, the risk

of non-repayment of the loan obligation. This

risk is dened by regulators as credit risk. The

generated cash ow that provides for the debt

service and the repayment of the loan is in

focus. The Regulation (EU) 575/2013 (CRR)

(2013) art 126 (2) (b) relates to exposures where

the risk of repayment of the CREL is derived

from the “performance” of the collateralized

commercial property and is not generated by

other sources. The Federal Register (2006)

Commercial Real Estate Loans – Categorization of an Investment Segment 23

Fig. 2: Commercial Real Estate Loan Categorization and Classication

refers to the cash ow that is produced by CRE

as a primary source of repayment. This excludes

loans that are secured by CRE but where the

primary source of repayment comes from the

business operations that owns the property.

It also excludes CRE where the borrowing

entity is a tenant who exceeds a threshold of

the tenancy base. The Federal Register (1992)

interlinks the requirement to appraise a prop-

erty by a State certied or licensed appraiser

to those loans whose repayment depends on

the sale or rental income as primary source.

The BOG, FDIC and OCC (2015) deem the

CRE cash ow analysis broken down to rents,

sale proceeds and operating costs of extreme

importance in order to evaluate the borrower’s

loan repayment ability. The OCC, in addition,

outlines the signicance to comprehend “the

income generating capacity of real estate”

(OCC Handbook, 2013, p. 36). Despite the

rental income, sale proceeds of the CRE are

essential for the repayment of the CREL, either

generated through open sale or upon foreclosure

on the loan. The value of the property is either

determined by future rents or sale prices. The

Federal Register (2015) requires institutions to

evaluate the value of collateralized properties.

The Federal Register (1992) refers to the value

of mortgaged CRE as main credit factor of

the loan decision. The determination of market

value is essential and for this reason it should be

perfected by an independent appraiser (Federal

Comparison Approach and Income Approach

are the main valuation concepts (FDIC RMS

Section 3.2 Loans, 2020; BOG, FDIC and OCC,

2016). Their approach to evaluate the property

interconnects with the evaluation of the CRE

markets (BOG, FDIC and OCC, 2015).

Credit risk seems to be closely linked to the

CRE markets. Following this rationale, CREL

might be categorized as loans whose primary

source of repayment and debt service is derived

from CRE, either from rents or sales proceeds

sourced mainly by non-borrower-aliated third

parties. The primary source of repayment might

be derived from CRE that serves as collateral

for the CREL. Secured or even unsecured loans

to SPVs or real estate companies that own and

manage CRE, like REITs, should be included

24 Beate Monika Philipps

as well in the categorization of CREL as their

repayment is dependent on the development

of the CRE markets. Classications beneath

the categorization might be established to

dierentiate among the various CREL risk

characteristics. First, CREL might be classied

as loans that are secured by liens or interest in

the property depending on their security rank-

ing. Second, CREL might be grouped in non-

mortgage-secured loans to SPVs like mezzanine

loans. Third, CREL might be clustered as non-

mortgage-secured CREL to corporations, as

REITs or other real estate companies. Fig. 2

exemplies this categorization of CREL.

The developed categorization of CREL allows

a broad approach on the one hand, and on the

other hand captures dierent characteristics of

this asset class. It separates CREL from further

loan types like RREL where the risk is assigned

to the value of the real estate as well, but where

the cash ow is derived by other sources of

the borrower, such as wages. The categorization

separates CREL from corporate loans secured

by properties where the cash ow that covers

the debt service is generated by the operating

business of borrower.

5 CONCLUSION

The aim of this work is to establish a catego-

rization of CREL that is, to this author’s knowl-

edge, missing in the global nancial sector. The

developed categorization shall close the gap and

provide a consistent structure of an extremely

heterogeneous asset class. The classications

within the categorization of CREL shall set up

a risk hierarchy and could support supervisory

authorities’ ability to analyze and evaluate the

institutions’ CREL risk pattern. A compre-

hensive CREL categorization might support

lenders in their accurate and prompt data

processing and regulatory ling. Additionally,

this work shall assist in creating a common

global understanding of this asset class between

banks, institutional investors and regulatory

authorities.

6 ACKNOWLEDGEMENT

We acknowledge the nancial support of the Internal Grant Agency of the Mendel University in

Brno, Grant No. 121106. The usual disclaimer applies.

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AUTHOR’S ADDRESS

Beate Monika Philipps, Department of Economics, Faculty of Business and Economics, Mendel

University in Brno, Zemědělská 1, 613 00 Brno, Czech Republic, e-mail: xphilipp@mendelu.cz

ResearchGate has not been able to resolve any citations for this publication.

Loss Given Default, Loan Seasoning and Financial Fragility: Evidence from Commercial Real Estate Loans at Failed Banks

Article

Full-text available

Nov 2021
J R Estate Finance Econ

Commercial real estate (CRE) loan losses are a recurring contributor to bank failures and financial instability, yet they are not well understood. We examine a unique and proprietary data set of CRE loan defaults at banks that failed and were resolved by the FDIC after the 2008 financial crisis. We build upon an existing literature relating stochastic collateral values to loss given default (LGD). Consistent with model predictions, we show that CRE loans defaulting sooner after origination are more sensitive to declining economic conditions and exhibit LGDs that are more severe. These results are robust to a number of factors, including the declining balance of the loan over time. Our findings point to an inherent fragility associated with high CRE loan growth, even without necessarily a deterioration in lending standards, due to the changing composition of CRE loan seasoning in the industry. This reflects an unexplored risk in the literature concerning rapid and cyclical expansions in CRE credit.

Intermediary Segmentation in the Commercial Real Estate Market

Article

Full-text available

Nov 2019

Banks, life insurers, and commercial mortgage-backed securities (CMBS) lenders originate the vast majority of U.S. commercial real estate (CRE) loans. While these lenders compete in the same market, they differ in how they are funded and regulated, and therefore specialize in loans with different characteristics. We harmonize loan-level data across the lenders and review how their CRE portfolios differ. We then exploit cross-sectional differences in loan portfolios to estimate a simple model of frictional substitution across lender types. The substitution patterns in the model match well the observed shift of borrowers away from CMBS when CMBS spreads rose in 2016.

Underwriting Limits and Optimal Leverage in Commercial Real Estate

Article

Full-text available

Apr 2020
J R Estate Finance Econ

Leo Cremer

Risk-averse commercial mortgage lenders follow an underwriting policy with strict limits based on the property’s value and cash flow. A borrower then chooses the initial loan amount and amortization that fit into these requirements and maximizes the investment’s net present value. For an underwriting policy based on typical mortgage ratios, this optimization problem has a closed-form solution. Applying the formula to loan business data from life insurance companies, fluctuations in market parameters and cash flow-based policy limits can explain the major part of the observed variability in initial leverage. This analysis gives further support to observations that initial leverage is endogenous to the underwriting process, while cash flow-based and forward-looking measures are of primary importance in commercial loan risk management.

From Origination to Renegotiation: A Comparison of Portfolio and Securitized Commercial Real Estate Loans

Article

Full-text available

Jul 2017
J R Estate Finance Econ

We use a unique loan-level dataset to compare portfolio and securitized commercial real estate loans. The paper documents how the types of loans banks choose to hold in their portfolios differ substantially from the types of loans the same banks securitize. Banks tend to hold loans that are “non-standard” in some observable dimension. These loans are riskier and more likely to become delinquent or distressed. Conditional on default, we find that banks are significantly more likely to extend portfolio loans than is the case for securitized loans. Our results suggest that banks have a comparative advantage in funding risky assets with contracts that may require flexibility in the event of distress.

Mezzanine Finance and Preferred Equity Investment in Commercial Real Estate: Security, Collateral & Control

Article

Jan 2012

This article will review both the genesis and the rise in popularity of preferred equity and mezzanine debt, examine their legal and structural differences, and provide some exposition as to how these financing techniques work from security, collateral and control standpoints. We do not undertake in this article to address the differences in tax and accounting treatment between mezzanine loans and preferred equity investments both for either the mezzanine lender or preferred equity investor on the one hand, or for the mezzanine borrower or the common equity investor, on the other hand. In deciding upon which structure to use, transaction participants should consult with their independent tax and accounting advisors to ensure that the transaction is appropriately structured to best meet their individual needs, subject to such compromise as may be necessary to effect a desired transaction. We proceed as follows: Section II outlines the legal principles of, and the practical realities that have shaped, real estate finance from common law to modernity. Section III begins with an exposition of the preferred equity instruments and mezzanine debt that form the subject of this study. It will start by outlining their qualities and follow with a delineation of the organizational structures used in deals in which they form part of the capital structure. Lastly, it will proceed through theoretical and practical issues for legal counsel to consider. Section IV will address an open issue, never, to the authors’ knowledge, having been before a court: whether these funding mechanisms should be treated as equitable mortgages according to the common law equitable tradition to treat mortgage-like agreements as mortgages. This Section will argue that these funding mechanisms should not be treated as equitable mortgages. Finally, we will set forth our conclusion in Section V.

Banks, Non Banks, and Lending Standards

Article

Oct 2020

We study how competition between banks and non-banks affects lending standards. Banks have private information about some borrowers and are subject to capital requirements to mitigate risk-taking incentives from deposit insurance. Non-banks are uninformed and market forces determine their capital structure. We show that lending standards monotonically increase in bank capital requirements. Intuitively, higher capital requirements raise banks’ skin in the game and screening out bad projects assures positive expected lending returns. Non-banks enter the market when capital requirements are sufficiently high, but do not cause a deterioration in lending standards. Optimal capital requirements trade-off inefficient lending to bad projects under loose standards with inefficient collateral liquidation under tight standards.

Environmental Performance and the Cost of Debt: Evidence from Commercial Mortgages and REIT Bonds

Article

Mar 2019
J BANK FINANC

The increasing societal focus on environmental issues leads to important questions about the relationship between corporate environmental (ESG) performance and firms’ cost of capital, but research on this topic remains scant. The real estate sector offers an ideal testing ground to investigate the relationship in two distinct manners, while specifically addressing concerns about endogeneity. We first investigate the spreads on commercial mortgages collateralized by real assets, some of which are environmentally certified. We then study spreads on corporate debt of property companies (REITs), both at issuance and while trading in the secondary market. The results show that loans on environmentally certified buildings command lower spreads than conventional, but otherwise comparable buildings, varying between 24 and 29 basis points, depending on the specification. At the corporate level, REITs with a higher fraction of environmentally certified buildings have lower bond spreads in the secondary market. These results are robust to different estimation strategies, and signal that environmental risk is efficiently priced in the real estate debt market.

Assessing targeted macroprudential financial regulation: The case of the 2006 commercial real estate guidance for banks

Article

Jun 2016
J Financ Stabil

In January 2006, federal regulators issued guidance requiring banks with specific high concentrations of commercial real estate (CRE) loans to tighten managerial controls. This paper shows that banks with concentrations in excess of the thresholds set in the guidance subsequently experienced slower growth in their CRE portfolios than can be explained by changes in bank or economic conditions. Moreover, banks above the CRE thresholds tended to have slower commercial and industrial loan growth but faster household loan growth following issuance of the guidance. The results highlight the potentially broad influence that portfolio-based macroprudential regulation might have on bank behavior.

The Paradox of Commercial Real Estate Debt

Article

Sep 2009
CORNELL INT LAW J

Georgette Chapman Phillips

Commercial Real Estate, Distress and Financial Resolution: Portfolio Lending Versus Securitization

Article

Jul 2014

This paper examines the contrasting influence of portfolio lending and securitization in the resolution of distressed commercial real estate. The empirical analysis utilizes a large and unique data set of distressed commercial mortgages. The data set is constructed based on the recent financial crisis and includes portfolio and securitized loans. The main hypotheses address the marginal impact of portfolio versus securitized loans on the likelihood of resolution, resolution outcome, time to resolution and capital recovery rates. Conditional on a loan becoming troubled, we find that distressed commercial real estate loans held in a portfolio are more likely to be resolved and experience higher foreclosure rates compared to those that are securitized. Furthermore, portfolio loans experience shorter time to resolution and higher capital recovery rates when resolution is relatively swift. Our study is intended to contribute to the growing literature on distressed asset resolution and to provide new perspectives on how different lending options impact the financial resolution and workout process in a distressed commercial mortgage market.

Commercial Real Estate Loans - Categorization of an Investment Segment

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