Dissecting the 2007-2009 real estate market bust: systematic pricing correction or just a housing fad?

We use Bayesian methods to estimate a multi-factor linear asset pricing model characterized by structural instability in factor loadings, idiosyncratic variances, and factor risk premia. We use such a framework to investigate the key differences in the pricing mechanism that applies to residential vs. non-residential (such as office space, industrial buildings, retail property) real estate investment trusts (REITs). Under the assumption that the subprime crisis has had its epicentre in the housing/residential sector, we interpret any differential dynamics as indicative of the propagation mechanism of the crisis towards business-oriented segments of the US real estate market. We find important differences in the structure as well as the dynamic evolution of risk factor exposures across residential vs. non-residential REITs. An analysis of cross-sectional mispricings reveals that only retail, residential, and mortgage-specialized REITs were over-priced over the initial part of our sample, i.e., 1999-2006. Moreover, residential-driven real estate has structural properties that make it different from non-residential assets.