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

Author

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  • John V. Duca
  • David C. Ling

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.

Suggested Citation

  • John V. Duca & David C. Ling, 2015. "The other (commercial) real estate boom and bust: the effects of risk premia and regulatory capital arbitrage," Working Papers 1504, Federal Reserve Bank of Dallas.
  • Handle: RePEc:fip:feddwp:1504
    DOI: 10.24149/wp1504
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    Cited by:

    1. Das, Prashant & Füss, Roland & Hanle, Benjamin & Russ, Isabel Nina, 2020. "The cross-over effect of irrational sentiments in housing, commercial property, and stock markets," Journal of Banking & Finance, Elsevier, vol. 114(C).
    2. Thomas L. Hogan, 2021. "A Review of the Regulatory Impact Analysis of Risk-Based Capital and Related Liquidity Rules," JRFM, MDPI, vol. 14(1), pages 1-29, January.
    3. Roland Füss & Daniel Ruf, 2018. "Office Market Interconnectedness and Systemic Risk Exposure," Working Papers on Finance 1830, University of St. Gallen, School of Finance.
    4. Martin Hoesli & Richard Malle, 2022. "Commercial real estate prices and COVID-19," Post-Print hal-03611776, HAL.
    5. Adonis Antoniades, 2015. "Commercial bank failures during The Great Recession: the real (estate) story," BIS Working Papers 530, Bank for International Settlements.
    6. John V. Duca & Lilit Popoyan & Susan M. Wachter, 2019. "Real Estate And The Great Crisis: Lessons For Macroprudential Policy," Contemporary Economic Policy, Western Economic Association International, vol. 37(1), pages 121-137, January.
    7. Michael D. Bordo & John V. Duca, 2020. "How New Fed Corporate Bond Programs Dampened the Financial Accelerator in the COVID-19 Recession," Working Papers 2029, Federal Reserve Bank of Dallas.
    8. Füss, Roland & Ruf, Daniel, 2021. "Bank systemic risk exposure and office market interconnectedness," Journal of Banking & Finance, Elsevier, vol. 133(C).
    9. John V. Duca & Patric H. Hendershott & David C. Ling, 2017. "How Taxes and Required Returns Drove Commercial Real Estate Valuations over the Past Four Decades," National Tax Journal, National Tax Association;National Tax Journal, vol. 70(3), pages 549-584, September.
    10. Duca, John V., 2017. "The Great Depression versus the Great Recession in the U.S.: How fiscal, monetary, and financial polices compare," Journal of Economic Dynamics and Control, Elsevier, vol. 81(C), pages 50-64.
    11. Jaccard, Ivan, 2021. "Leveraged property cycles," Working Paper Series 2539, European Central Bank.
    12. Martin Hoesli & Richard Malle, 2021. "Commercial Real Estate Prices and Covid-19," Working Papers hal-03186131, HAL.
    13. Nadia Balemi & Roland Füss & Alois Weigand, 2021. "COVID-19’s impact on real estate markets: review and outlook," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 35(4), pages 495-513, December.
    14. Lilit Popoyan, 2020. "Macroprudential Policy: a Blessing or a Curse?," Review of Economics and Institutions, Università di Perugia, vol. 11(1-2).
    15. Steffen Heinig & Anupam Nanda & Sotiris Tsolacos, 2016. "Which Sentiment Indicators Matter? An Analysis of the European Commercial Real Estate Market," ICMA Centre Discussion Papers in Finance icma-dp2016-04, Henley Business School, University of Reading.

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    More about this item

    Keywords

    Asset pricing; equity premiums; Bank deregulation; Institutional investors; Alternative asset classes; Commercial real estate;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • R33 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - Nonagricultural and Nonresidential Real Estate Markets

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