What can commercial property performance reveal about bank valuations?

Summary

Focus

We ask whether commercial property markets affect bank equity prices. For this purpose, we use the prices of real estate investment trusts (REITs) as a proxy for the performance of commercial property markets. Our study is based on data from the euro area, Japan and the United States, focusing on the 2003-20 period. The study includes the effects of the Great Financial Crisis and the Covid-19 pandemic.

Contribution

We test the hypothesis that REIT prices affect bank equity prices, particularly during downturns. We have three reasons to consider this hypothesis valid. First, banks are exposed to commercial property. Second, REIT prices are likely to reflect commercial property valuations more promptly than publicly disclosed financial information. Third, as lenders, banks are more exposed to the downside than to the upside of real estate risk.

Findings

We find that, first, REIT prices can predict bank equity prices a month ahead. Second, we show that the "commercial property factor" adds value to standard bank equity pricing models. Third, the commercial property factor works particularly strongly during a crisis. This factor explains roughly half of the fall in average bank equity prices during the Great Financial Crisis and the Covid-19 pandemic. Our results suggest that REIT prices can usefully complement supervisory monitoring.

Abstract

We test whether commercial property performance, proxied by real estate investment trust (REIT) prices, can inform us about bank equity prices. Using data from the United States, the euro area and Japan, we show that REIT prices can predict bank equity prices. Furthermore, a "commercial property factor" adds significant explanatory power to both the CAPM and the 3-factor Fama-French model. At the same time, quantile regressions show that this factor becomes particularly prominent during downturns. It accounts for around half of the drop in average bank valuations during the great financial crisis and, again, during the Covid-19 pandemic.

JEL classification: E44, G12, G21

Key words: asset prices; banks; commercial property; financial stability; real estate.