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

44 Pages Posted: 29 Sep 2015

See all articles by John V. Duca

John V. Duca

Federal Reserve Banks - Federal Reserve Bank of Dallas; Oberlin College

David C. Ling

University of Florida - Hough Graduate School of Business Administration

Multiple version iconThere are 2 versions of this paper

Date Written: September 20, 2015

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 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 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.

Keywords: Asset Pricing, Equity Premiums, Bank Deregulation, Institutional Investors, Alternative Asset Classes, Commercial Real Estate

JEL Classification: G12, G18, G21, G23, R33

Suggested Citation

Duca, John V. and Ling, David C., The Other (Commercial) Real Estate Boom and Bust: The Effects of Risk Premia and Regulatory Capital Arbitrage (September 20, 2015). Available at SSRN: https://ssrn.com/abstract=2663194 or http://dx.doi.org/10.2139/ssrn.2663194

John V. Duca (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Oberlin College

Oberlin, OH 44074
United States

David C. Ling

University of Florida - Hough Graduate School of Business Administration ( email )

PO Box 117165, 201 Stuzin Hall
Gainesville, FL 32610-0496
United States
(352) 392-0153 (Phone)
(352) 392-0301 (Fax)

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