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

Abstract

• Required returns mainly drive commercial real estate (CRE) capitalization rates. • CRE risk premia stem mainly from general risk premia and capital requirements. • Weakened capital requirements on CMBS mainly drove the mid-2000 s CRE price boom. • The ensuing bust was triggered by rising general risk premia in the financial crisis. • More recent rises in CRE prices mainly stem from unusually low real Treasury yields. In the 2000 s, U.S. commercial real estate (CRE) prices experienced a boom and bust as dramatic as the more widely analyzed swings in house prices and contributed significantly to bank failures. We model short-run and long-run movements in capitalization rates (rent-to-price-ratio) and risk premia for office building and apartments. In the mid-2000s’ boom, CRE prices were mainly driven by declines in required risk premia that stemmed from a weakening of capital requirements. In the bust, CRE price declines were initially driven by a jump in general risk premia and later by a tightening of effective capital requirements on commercial mortgage-backed securities (CMBS) from the Dodd-Frank Act. The subsequent recovery in CRE prices was induced and sustained by unusually low real Treasury yields. We conclude that macro-prudential regulation of leverage may help limit asset price booms by preventing sharp declines in risk premia.