The Pricing of Risky Debt: An Application to Commercial Real Estate

Joseph Pagliari, John Mazarakis and Chicago Atlantic Clinical Professor of Real Estate

As an extension of the option-pricing approach of Titman and Torous (1989), Jurek and Stafford (2015), Culp, Nozawa, and Veronesi (2018), and others who have examined the cost of debt (for real estate or otherwise), I propose ro empirically examine the cost of debt capital -- in the context of private, real estate mortgage-loan originations -- using a reduced-form equation which essentially provides an approximation of the Merton (1974) approach to pricing risky debt. The commercial mortgage-loan market is robust, originating such loans on a variety of prroperty types, leverage ratios, term, lender types, etc. In earlier work (Pagliari 2020), I have used a version of this reduced-form equation with a less-robust data set of mortgage loans -to examine the underperformance of high-volatility private-equity real-estate investment strategies (and they fared poorly). Here, I propose to examine a more-robust data set, in order to examind the cross-sectional and time-varying properties of pricing such risky debt.