Exploring the non-linear dynamics between Commercial Real Estate and systemic risk

• CRE market is significant for financial stability due to its size and cyclicality. • We use MSCI CRE capital values growth to capture market variation. • Adverse CRE market developments amplify systemic risk across financial sectors. • The relationship between CRE and systemic risk exhibits non-linearities. • The link between CRE and systemic risk weakens in CRE market misalignment periods. The commercial real estate (CRE) market significantly influences financial stability, given its size, use as collateral, and cyclicality. This study explores macro-financial vulnerabilities arising from the CRE market, revealing that adverse developments in CRE capital values amplify systemic risk across financial sub-sectors, namely, banks, insurance companies and investment trusts, consistent with the collateral channel hypothesis . The CRE and financial markets relationship, however, displays nonlinearities. We introduce a UK CRE Misalignment index which integrates various market indicators to assess deviations from fundamental values in the CRE sector. We find that during market misalignments, the link between systemic risk and CRE growth weakens, suggesting that further property price increases in an overheated market could lead to a bubble and heightened systemic risk, in line with the deviation hypothesis . Finally, we employ a quantile regression model that captures another aspect of this non-linear relationship. We find that positive (negative) developments in the CRE market decrease (increase) the right tail of the historical systemic risk distribution, but CRE variation has a weak impact on the left tail and cannot effectively reduce systemic risk in periods of growth.