Dissecting the 2007-2009 Real Estate Market Bust: Systematic Pricing Correction or Just a Housing Fad?

Abstract

We use flexible Bayesian model averaging methods to estimate a simple parametric factor pricing model characterized by structural uncertainty and instability in factor loadings and idiosyncratic risks. We propose such a framework to investigate key differences in the pricing mechanism that applies to residential vs. non-residential (such as office space, industrial buildings, retail property) real estate investment trusts (REITs). Under the assumption that the sub-prime crisis has had its epicentre in the housing/residential sector, we interpret any differential dynamics as indicative of the propagation mechanism of the crisis towards business-oriented segments of the US real estate market. The empirical evidence shows important differences in the structure as well as the dynamic evolution of risk factor exposures across residential vs. non-residential REITs. An analysis of cross-sectional mispricings reveals no evidence of a pure housing/residential real estate bubble inflating between 1999 and 2007, to subsequently burst. In fact, all REITs sectors record a climb-up in alphas during this period.