The Pricing of Construction Loans

Abstract

In this study, we use a simple 2-period game theoretic model to determine a mutually acceptable interest rate for a construction loan. This mutually acceptable interest rate is the rate that makes a developer indifferent between using 100% equity financing and a construction loan. It is also the highest interest rate that a developer is willing to pay and a bank is willing to lend. The three risk factors identified in the model are the loss, leverage and first-phase loan ratios. Our analytical and numerical analyses indicate that the derived mutually acceptable interest rate has desirable properties as the rate increases with an increase in the three identified risk factors.
 

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Keywords

Construction Loan, Real Option, Risk Shifting, Interest Rate

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