Working Paper No. 207
By John Whitley and Richard Windram
This paper develops a quantitative framework for analysis of the UK commercial property sector and the possible implications for the financial stability of this sector, and for the corporate sector as a whole. There is little previous empirical literature. But where there is, models have either studied particular markets or have developed single-equation approaches. Lack of suitable data has been a major impediment. In this paper a model of the real estate sector is constructed using econometric analysis of rental values and bank lending, supplemented by a calibrated model of the remainder of the financial accounts of real estate companies (using data for private and public real estate companies). Using related work on company-failure models, it is possible to extend the analysis to provide an equation for the probability of default of real estate companies. The empirical results fail to find a role for borrowing costs in the bank lending equation before 1999, but unless borrowing costs are included after this period, the equation breaks down and systematically underestimates the growth in lending to real estate from then on. Various potential explanations are examined for this breakdown, including the importance of sale and lease-backs. The estimated rental equation appears more stable. The historical tracking performance of the estimated real estate model fails to capture the full extent of the swings in capital values and bank lending in the early 1990s. This is attributed to shifts in the discount rate applied to property income, possibly reflecting a temporary shift in risk premia during this period. The property sector links to the rest of the private non-financial corporate sector through its role as collateral. Since the property model relies partly on macroeconomic influences it can be used in conjunction with macro models to provide forecasts of property values and the probability of default of property companies. Simulations that use this model with the Bank of England macroeconometric model show not only the sensitivity of the probability of default of real estate companies to selected macroeconomic shocks, but also the potential links between the commercial property sector and the financial health of the rest of the corporate sector.