The Other (Commercial) Real Estate Boom and Bust: The Effects of Risk Premia and Regulatory Capital Arbitrage

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The U.S. commercial real estate (CRE) price boom and bust during the last decade was at least as large as the one in the housing market and contributed significantly to 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 premia for two 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 premia 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.