Faculty Research Update: The Impact of Tenant Diversification on Spreads and Default Rates for Mortgages on Retail Properties

Yildiray Yildirim
Yildiray Yildirim

Editor’s Note: Yildiray Yildirim, Michael Falcone Chair in Real Estate and professor of finance, authored the below article regarding his recent research. Yildirim also was honored as a 2015 Fellow of the Weimer School of Advanced Studies in Real Estate and Land Economics.

Traditional portfolio theory dictates that a greater degree of diversification leads to a greater amount of safety for investors. Considering that a commercial property’s value is effectively reliant on cash flows that are generated by a portfolio of tenants, it is natural to assume that commercial properties with greater diversification in their tenant mix (e.g., a large rent roll) should have more stable cash flows than properties that are less diversified. If this is indeed the case, then mortgage lenders should recognize the benefits of tenant diversification by offering lower mortgage spreads to properties whose tenant base is more diverse than similar, less diverse properties. However, given the fixed physical size of commercial properties, there may also be benefits to limiting the degree of tenant diversification. For instance, tenants that lease larger amounts of space are likely to be more credit-worthy and to provide property owners with rental payments that are stable and predictable.

In this paper, we empirically investigate how the structure of a property’s rent roll influences the credit spreads charged and the mortgage default rates. We use the percent of square footage occupied by a property’s largest tenant as a proxy for the degree of tenant diversification. We find that mortgages on properties with a highly diversified tenant base do not receive lower spreads than single-tenant properties, but that mortgages on properties with low to moderate levels of tenant diversification have spreads that are up to 5.8 basis points lower than mortgages on single-tenant properties. The interest rate discount given to mortgages on properties with low to moderate levels of tenant diversification disappears when the largest tenant’s lease expires before the loan matures. Finally, we find that the likelihood with which a mortgage defaults increases as the degree of tenant diversification increases. This implies that properties with higher degrees of tenant diversification should have higher spreads.

This paper is co-authored with Brent Ambrose and Michael Shafer.