The Effect of Tenant Defaults on CRE Loans
Introduction
In lending to commercial real estate (CRE), it is clear that the credit-worthiness of the building's tenants influences the overall risk of the deal. But then the question arises, "To what extent is a tenant's credit-worthiness important?" This paper answers the question by taking a series of deals and assessing their risk for different levels of tenant credit-worthiness. We also look at examples of how the impact the tenant quality is different for different levels of loan-to-value, number of tenants, and rental rates.
Base Deal
The first step is to define a standard deal and then assess the risk of the deal given different probabilities of the tenant defaulting (PTD). The standard deal is chosen as follows:
Property: Office in NY valued at $10,000,000 with prevailing market rent of $700,000/year
Lease: One tenant, paying $700,000/year (i.e., currently at market rent), expiring in 8 years
Loan: Balance of $7,000,000, paying 5% fixed, maturing in 10 years with 25 year amortization
The lowest PTD is set to be 0.1% and is then repeatedly doubled to create a range up to 51.2%. The risk is then assessed using Risk Integrated's Specialized Finance System (SFS), which runs a Monte Carlo simulation of a detailed CRE cashflow model to capture all property and loan details. Chart 1 shows the profile of the annual probability of default (PD) of the loan until the loan's maturity. For this graph, the PTD is set to be 1.6% in the first year.
Chart 1: Probability of Default Profile for the Base-deal with PTD=1.60%
In Chart 1 we see the following:
In year 1 the PD of the deal is 0.44%, i.e., much lower than the tenant's PD of 1.6%. This is because it is often possible to replace [...]