The other (commercial) real estate boom and bust: The effects of risk premia and regulatory capital arbitrage

Abstract

The last decade's boom and bust in U.S. commercial real estate (CRE) prices was at least as large as that in the housing market and also had a large effect on bank failures. Nevertheless, the role of CRE in the Great Recession has received little attention. This study estimates cohesive models of short-run and long-run movements in capitalization rates (rent-to-price-ratio) and risk premiums across the four major types of commercial properties. Results indicate that CRE price movements were mainly driven by sharp declines in required risk premia during the boom years, followed by sharp increases during the bust phase. Using decompositions of estimated long-run equilibrium factors, our results imply that much of the decline in CRE risk premiums during the boom was associated with weaker regulatory capital requirements. The return to normal risk premia levels in 2009 and 2010 was first driven by a steep rise in general risk premia that occurred after the onset of the Great Recession and later by a tightening of effective capital requirements on commercial mortgage-backed securities (CMBS) resulting from the Dodd-Frank Act. In contrast to the mid-2000s boom, the recovery in CRE prices since 2010 has been mainly driven by declines in real Treasury yields to unusually low levels. Our findings have important implications for the channels through which macro-prudential regulation may or may not be effective in limiting unsustainable increases in asset prices.

How the New Fed Municipal Bond Facility Capped Muni-Treasury Yield Spreads in the Covid-19 Recession

“…As Bolton and Oehmke (2015) and Stout (2011) show, the CFMA exempts derivatives counterparties from the automatic stay in bankruptcy, enabling immediate collection from a defaulted counterparty, providing them a senior claim over most other bankruptcy claimants. The passage of CFMA was quickly followed by a surge in credit default swaps (Duca and Ling, 2020). By giving bankruptcy priority to derivatives (mainly credit default swaps), the CFMA lowered the priority of bonds and made bonds riskier (see Bolton and Oehmke 2015).…”

The cross-over effect of irrational sentiments in housing, commercial property, and stock markets

“…Although residential real estate markets are known to play a significant role in economic cycles, there is limited knowledge on how commercial and residential real estate sectors are inter-connected and related to the general stock market through return, and in particularly, sentiment channels. Barring some exceptions ( Ling and Naranjo, 1999 ;Duca and Ling, 2020 ), which consolidate real estate and capital markets within a single study, most studies examine residential 22 Hyndman and Koehler (2006) proposed to add the RMSE because the MAE underestimates the impact of large but infrequent errors. 23 Anecdotal evidence suggests that the transaction costs are in the range of 3-5% or more.…”

“…and commercial real estate, and equity markets in isolation. Moreover, Duca and Ling (2020) focus on direct spillover of returns across these markets rather than examining the role of cross-over effects in sentiments. Our study contributes to the literature by not only investigating how sentiment affects the private residential and commercial real estate market separately, but also treating them as one system with potential interdependence between their sentiment and return measures, as well as with investors' sentiment in stock markets.…”

“…Both housing and CRE markets are correlated with output growth and house prices exhibiting a strong correlation with lagged and contemporaneous CRE prices ( Kan et al, 2004 ). Duca and Ling (2020) show a strong correlation between CRE prices and the overall capital markets. Prices deviate from their intrinsic values in both distressed (low-sentiment) and booming (high-sentiment) market phases ( Yu and Yuan, 2011 ).…”

“…Within the residential sector, Ionnides and Rosenthal (1994) show that compared to consumption demand, the investment demand for housing is more sensitive to wealth and income. However, the demand for residential and commercial real estate (CRE) is directly exposed to common macroeconomic factors ( Ling and Naranjo, 1999 ;Hoesli and Reka, 2015 ;Duca and Ling, 2020 ). CRE markets, beyond the residential sector, have a significant impact on the business cycle ( Quigley, 1999 ), a phenomenon that is widely ignored in the literature ( Levitin and Wachter, 2013 ).…”