Commercial Real Estate: Underwriting, Mortgages, and Prices

Commercial real estate (CRE) has undergone enormous changes over the past two decades, even apart from the financial crisis. At the end of 2010, commercial mortgage balances totaled over $2 trillion. That was about twice as many at the end of 2000. At its peak in 2008, the ratio of balances to the size of the U.S. economy was one and a half times as large as it was in 2000. Historically, more than half of commercial mortgages were held by commercial banks and other depositories. Life insurers historically were the other major holders. Over the past dozen years, however, “nontraditional investors” have held increasingly important shares of total commercial mortgages. Thus, the relative size of the commercial mortgage market has fluctuated considerably and the percentages of total commercial mortgages that different groups of investors held have also shifted considerably over time. In addition, (inflation-adjusted) CRE prices dipped by more than 20 percent in the early 1990s, before rising about 50 percent during the 2000s and then dropping by about 50 percent since 2007. Since 2007, various indicators signaled that commercial mortgage underwriting, after apparently being lax, had tightened rapidly and severely.We combined information from several indicators of commercial mortgage underwriting to construct a single underwriting index (UW) for 1990-2011. We used information about commercial mortgage underwriting from banks and from government-employed bank examiners. We also used information about the commercial mortgages that were acquired by life insurance companies. These data series each directly measured an important aspect of underwriting. To construct UW, we then combined those data series with an indirect indicator of underwriting, the net flow of commercial mortgages acquired by “nontraditional” investors. We also explain why some well-known indicators were unlikely to accurately reflect underwriting during 1990-2011.We then used the UW in a vector auto-regression to estimate how CRE prices and commercial mortgages responded to changes in underwriting, and, in turn, how prices and mortgages affected underwriting itself. We found that underwriting had important, independent effects on the CRE market. The estimates suggested that both price and non-price components of underwriting affected commercial real estate.We also found that underwriting itself responded to developments in commercial real estate. In particular, we found that underwriting loosened when (the growth rates of) CRE prices were predicted to rise. One implication is that underwriting amplified movements in CRE markets: Predictions of faster price growth loosened underwriting, which raised CRE lending and prices, which in turn loosened underwriting further.