Fund Flows and Commercial Real Estate Investment: Evidence from the Commercial Mortgage Market
Donohue, Ron, Hendershott, Patric H., The Journal of Real Estate Research
Abstract This paper addresses the issue of the impact of fund flows on real investment. In the classical world, fund flows affect investment by changing the cost of funds or through the weighted average cost of capital. In a less perfect world, fund flows can directly alter investment though a rationing mechanism, where even presumably profitable investment is choked off.
This paper examines the commercial mortgage market over the last quarter century. The findings indicate an effect of constrained flows on investment in the early 1990s, but an independent impact of higher flows to the commercial mortgage market in the middle 1980s is not found.
Periodically concerns arise that commercial real estate activity is being choked off by a shortage of financial capital (Mejia, 1999). At other times, too much financial capital is alleged to cause overbuilding (Hendershott and Kane, 1992; and Giliberto, 1992). This paper analyzes the commercial mortgage market over the last quarter century to determine periods of credit crunches or credit gluts.
Commercial real estate is one of many real investments in the economy. And this investment is undertaken by a number of different types of business entities that are funded by a wide range of financial institutions, who themselves obtain funding from savers. Thus, understanding the funding of commercial real estate investment requires examination of the financial behaviors of many economic sectors. Presenting a broad framework for understanding the interactions of these behaviors and the funding of commercial real estate investment is the place to start. The U.S. flow of funds accounts constitutes the framework.
Under what circumstances do security flows determine (affect) the volume of commercial real estate investment? In general, the supply of funds can have an independent impact on commercial real estate investment only when "disturbances" emanate from the financial system or within the funds flows matrix. Such disturbances begin by affecting the distribution of saving and the portfolio decisions of financial institutions and then spill over onto real investment decisions. The different financial intermediaries |e.g., banks, thrifts, real estate investment trusts (REITs), insurance companies, etc.] have different proclivities to invest in commercial real estate either directly or indirectly; thus shocks that alter the distribution of funds among the intermediaries or the allocation of investments of the intermediaries will affect the financing of real estate unless the total supply of funds is completely elastic. Thus, the paper considers factors affecting the demands for commercial real estate equity and debt instruments.
The major debt vehicle for financing commercial real estate is commercial mortgages. clayton (2003) suggests that increases in net commercial mortgage issues lead to greater commercial property returns (as measured by the NCREIP Commercial Property Index), which presumably triggers greater commercial real estate investment. Thus, the paper analyzes sectoral issues and purchases of commercial mortgages over the last quarter century. The paper concludes with a brief summary and some thoughts on future work in this area.
The Flow of Funds Matrix and Commercial Real Estate Investment
The flow of funds in an economy can be viewed as a pipe system with water (saving) flowing in one end and out the other (as nonfmancial investment). Exhibit 1 pictures such a system, where the left inflow represents saving in the economy and the right outflow represents investment in real assets (nonfinancial capital). Because changes in inventories are defined as investment/disinvestment, the saving and investment flows are equal; an unanticipated increase/decrease in saving (decrease/increase in consumption) increases/decreases inventories equally.
Both investment and saving consist of a number of component parts. Total saving is portioned into household (or personal), business and government plus foreign (henceforth called "other"). …