Imperfect Substitutability in Real Estate Markets and the Effect of Housing Demand on the Macroeconomy

Abstract

Changes in housing demand can have a macroeconomic effect through the collateral channel, where the change in residential real estate prices is associated with a change in commercial real estate prices, affecting firm collateral and thus firm investment. We argue that this channel is weaker when residential and commercial real estate are poor substitutes. Using cross-state heterogeneity in the strength of zoning regulations as a proxy for heterogeneity in the substitutability of residential and commercial real estate, we first show with firm level data that the strength of local zoning regulations has a negative effect on the estimated increase in firm investment following an increase in local residential real estate prices. We then construct a DSGE model where land has both residential and commercial uses and estimate it using Bayesian techniques and U.S. macroeconomic data. We find the average elasticity of substitution between commercial and residential real estate in the U.S. to be around 0.35, but in states with strong zoning restrictions it can be as low as 0.16 and in states with weak zoning restrictions it can be as high as 0.66. Simulations of the model show how these differences in zoning restrictions can affect the transmission of a housing demand shock to the macroeconomy.