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The Paradox of Commercial Real Estate Debt

Working paper #641
Georgette Chapman Phillips

With the economic crisis devouring the US financial landscape, debt, specifically real estate debt, emerges as a culprit in the debacle. Reliance on debt financing for real estate has been the lynchpin of the property market for decades. Furthermore, US investors have looked to replicate debt financing as a foundation for real estate transactions when investing in other countries. But true, first lien mortgage debt is not at the heart of the US financial crisis. Rather, the effects of structured finance and derivative securitizations far removed from “plain vanilla” mortgage financing are the contributing forces to the calamity. An aspect of the securitized market that is not involved in the crisis is the equity-like investments in commercial transactions that offer credit support to the debt market—a crucial difference between the residential mortgage market and the commercial mortgage market. This paper examines these offshoots of the commercial securitized market that shares more economic characteristics with equity than with debt. The question presented is whether emerging markets can circumvent the traditional debt route and rely more on these equity-like forms of investment. Pardoxically this equity investment may provide a requisite risk cushion for investors while at the same time avoid the limitations imposed by reliance on debt financing.

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