Interest Rate, Regulation, and Tax Effects on Commercial Real Estate: Lessons from the Past Half Century

Abstract

Collapses in commercial real estate (CRE) prices sharply reduced construction outlays and—via their accompanying loan losses—induced bank credit crunches, thereby playing a large role in the U.S. recessions of 1990 and 2007-09 and the sluggish recoveries from them. We develop a system of equations for commercial office valuations, rents, and construction that empirically incorporates some of the features of the DiPasquale and Wheaton (1992) four-quadrant model of CRE markets. Using quarterly data spanning a half century, we estimate how changes in taxes, interest rates, tax depreciation, credit conditions, and capital requirements have affected office valuations (capitalization rates), which, in turn, induce changes in rents and construction—the latter of which is analyzed using a Tobin’s q approach. Using data covering several decades is needed because CRE activity tends to experience long cycles. Our results indicate that while current high valuations of CRE are in line with a low real interest rate environment, office prices and valuations are vulnerable to mean-reversion in long-term interest rates. Nevertheless, the impact of valuation swings on office construction in recent years has been muted by less pronounced changes in existing property prices relative to replacement costs, implying that prices are more vulnerable than is the level of construction.