We find that the real estate market is vulnerable to sustained deviations from long-run equilibrium prices, in part due to the role played by the banking system. The impact of the banking system in magnifying the real estate cycle occurs because high real estate prices increase the economic value of bank capital to the extent that banks own real estate. Such increases also drive up the value of loans collateralized by real estate, leading to a decline in the perceived risk of real estate lending. For these reasons, higher real estate prices increase the supply of credit to the real estate industry, which in turn leads to further increases in the price of real estate. We also observe that bank behavior plays an important role in exacerbating the collapse of real estate prices. In addition, we find that supervisors and regulators react to the resulting weakening of bank capital positions by increasing capital requirements and instituting stricter rules for classifying and provisioning against real estate assets. These measures further diminish the supply of credit to the real estate industry and place additional downward pressure on real estate prices. This conceptual framework of interactions between the real estate market and bank behavior is used to interpret recent examples of real estate crises linked to banking crises in Sweden, the United States, Australia, Japan and Thailand. We also provide a discussion of the policy implications of our analysis emphasizing measures to limit the amplitude of real estate cycles and ways to insulate the banking system from real estate cycles.
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Paper provided by Wharton School Samuel Zell and Robert Lurie Real Estate Center, University of Pennsylvania in its series Zell/Lurie Center Working Papers with number
298.