The Economics of Commercial Property Markets

Michael Ball,Colin Lizieri,Bryan MacGregor

• Publisher: Routledge
• Year: 2012
• ISBN:
  9781134749669
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

This new text provides a rigorous analysis of real estate markets. Three main sections cover:

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• microeconomics of property markets

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• the macroeconomics of commercial property

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• the financial economics of property

Global empirical examples illustrate the theories and issues. This often complex area is made accessible: each chapter contains a boxed summary and questions for self-testing or discussion.

1

INTRODUCTION

THE IMPORTANCE OF COMMERCIAL PROPERTY MARKET ECONOMICS

This book seeks to provide a rigorous analysis of the economics of commercial property markets. Conventional economics texts neglect property as a sector. By contrast the majority of the existing (UK) texts in the property field are rooted in an urban economics tradition or are little more than introductory economics texts with housing and property examples pasted on. A limited number of other texts concentrate on finance and investment, neglecting wider economic factors. There is, thus, a clear need for a book that examines the economics of commercial property markets in detail, drawing on the growing body of economic research in both space and financial markets, and which provides readers with a clear overview of developments in the field.

An understanding of the economics of commercial property markets is important since there are many property-related issues that affect everyone and shape the built environment. Some of these issues and themes are highlighted below. In the research literature, these issues have been examined from the perspectives of a variety of academic disciplines and professions. These include, economics, finance, geography, sociology, urban economics, law, planning, surveying and construction management. This book integrates those analyses within a formal economics framework.

Before setting out the approach adopted in the book and outlining the content, some of the key economic issues in commercial property are now considered. These are divided into microeconomic, macroeconomic and financial issues, following the three-part structure of the text.

Microeconomic issues in commercial property

In examining micro themes, the text focuses on the structure of demand for commercial property, changing locational needs and the response of land and property markets to those changing patterns. Relevant contemporary issues include:

• the large areas of vacant industrial properties and of vacant land in the centres of major urban areas in the early 1980s following closure of many manufacturing firms and factories;

• the pressures for the development of out-of-town shopping centres and retail warehouses and grocery superstores in the later 1980s; in some areas this led to major declines in city centre shopping and had environmental impacts;

• the expansion of high technology industrial activities along motorway corridors in the late 1970s and early 1980s; and

• decentralisation of many office-using activities from city centres to suburban, peripheral and satellite locations in the 1970s and 1980s and the development of call centres in the 1990s.

An understanding of market adjustment processes in commercial property markets is critical in analysing these events. Demographic and economic changes create new patterns of demand for property but the response of developers, investors and land owners determines the spatial outcomes and affects the competitiveness and profitability of sectors of industry in a city, a region or a country.

Macroeconomic issues in commercial property

The macro themes investigated in the book include the role of commercial property in the economy, the possibility of ‘crowding out’ or overinvestment in property, property cycles and the need to model property market behaviour. These are topics of great importance:

• in property booms capital switches from other parts of the economy; in busts, company asset values fall as property prices tumble;

• the property crash of the mid-1970s had a dramatic effect on the UK secondary banking sector with economic—and political—consequences;

• the property crash of the late 1980s led to many company failures and resulted in much high quality but vacant office space, particularly in the City of London; and

• the turmoil in South East Asian financial markets in the late 1990s is linked to the very large amounts of capital tied up in land and buildings and the contribution of property loans to debt in those countries.

The world-wide boom and bust property cycle of the late 1980s and early 1990s raised the awareness of the important links between the macroeconomy and commercial property markets. Generally, in the property literature these links are only tangentially incorporated into analysis and discussion. There are a number of widely held beliefs concerning property that need detailed examination. For example, the common beliefs that there is overinvestment in property and that the volume of property development is subject to marked cyclical fluctuations are not supported by the available UK data. Economic modelling of property market behaviour is of great importance in analysing the linkage between key economic and financial variables and the behaviour of commercial property.

Financial issues in commercial property

Commercial property has different (and difficult) financial features when compared to other asset classes. Nonetheless, there are increasing trends to integrate property asset management with that of other financial assets. Other key trends include the growth of cross-border investment and the development of indirect investment vehicles. Topics of importance and interest are listed below:

• The types and formats of financial analyses practised by property professionals are very different from those of other asset markets. This causes problems as property must compete with shares and bonds for a place in the investment portfolio.

• A number of well-publicised valuation ‘disasters’, particularly in the aftermath of the late 1980s and early 1990s property crash, reinforced suspicions about the adequacy of traditional valuation techniques and performance measures based on those techniques.

• Over the last two decades, the major pension funds and insurance companies have decreased the proportion of commercial property held in their investment portfolios.

• In many markets, notably in the United States with Real Estate Investment Trusts (REITs), there has been rapid growth in securitised or unitised property investment vehicles.

• Following financial liberalisation and deregulation in the mid-1980s, there have been large flows of overseas capital into commercial property; a substantial proportion of the office stock in the City of London is now owned by non-UK firms, while UK investors hold large portfolios of mainland European and North American property.

Insights drawn from financial economics help to explain these trends and provide a framework for analysis of investment issues. This is vital in breaking down the isolation of much existing property research.

THE PURPOSE

The purpose of the book, then, is to provide an economic framework within which to explain and understand these and related commercial property issues. The text should prove valuable for property researchers and practitioners in many ways. We hope that it will clarify and deepen understanding of:

• the likely behaviour of economic agents in the property markets;

• the implications for property of new business and social trends;

• the place of property and the development process in the wider economy;

• the causes and significance of property cycles;

• forecasting and modelling property markets;

• financial principles applied to property; and

• the role and consequences of valuation and other asset pricing models.

THE APPROACH

The book is divided into three broad parts covering microeconomics, macroeconomics and financial economics. The first two are standard divisions within economics. Microeconomic analysis investigates individual production and consumption decisions and their influence on the allocation of resources within an economy, while macroeconomic theory deals with interactions in the economy as a whole. The third area, financial economics, examines investment decision-making. This is an important but often neglected perspective from which to understand the economics of commercial property markets.

There has been a vast increase in the amount of research into commercial property over the last decade. Much of this research has drawn on applications from the more developed fields of financial and housing economics. This makes it difficult to write a definitive textbook. Rather, it has been necessary to order and survey the literature, to impose a structure and to set out the main themes of research. While property research related to financial economics has become more developed and complete in recent years, there are major gaps in the literature in other fields. These include the inadequate micro foundations for the modelling of property market supply and demand and the need to establish a formal theoretical link between the macroeconomy and the property market. The book attempts to develop these areas.

The approach adopted is based upon demand and supply interactions in four interlinked submarkets, using a simple competitive model with the assumption of rational economic agents. The remainder of the book is built upon this foundation. This perspective forms a valuable starting point for analysing the relationships and adjustment processes in property markets and has empirical backing. This does not mean that the model is expected to apply in all situations, rather, it is an ‘ideal form’ model. Property markets have specific characteristics, including heterogeneity, lumpiness, lack of information and externalities that make simplistic application of the competitive model problematic. The book explores these characteristics and examines modifications and extensions to, and critiques of, the competitive model.

The general principles outlined in the text apply to all commercial property markets. The perspective adopted is largely that of the UK and, to a lesser extent, of the US. European, Far Eastern and Australasian perspectives are used where appropriate. This reflects both the experience and knowledge of the authors and the importance of the UK and the US in the development of these subject areas.

Commercial property is generally divided into broad sectors: offices, shops and industrial property. This division underpins much commercial property research. The categories broadly relate to sectors of employment. Offices serve business and professional services, administrative and government activity; industrial space is utilised by manufacturing industry and warehousing; and shops are the retail outlets for consumption activity. The book does not consider residential property except in passing. Housing economics is the subject of other texts. While residential property is an important real estate investment sector in the US, it has yet to be established as such in the UK. Other classifications of commercial property are possible and new sectors, such as leisure property, are emerging.

In illustrating the economic principles discussed, offices are used more frequently than other sectors. This reflects three main factors. First, much of the published research literature deals with office markets. Second, offices are the most important investment sector by value. Finally, they offer the clearest illustration of many of the issues raised, including location, overbuilding, modelling and forecasting and internationalisation. Since offices remain strongly clustered in the centres of major cities, this leads to a strong urban focus in the text.

The academic development of different areas covered in the book varies. As a result, the form of the material in the book varies too, reflecting the current state of knowledge and the scope of the literature. In some areas, particularly in macroeconomics, a well-developed theoretical framework exists and, hence, discussion focuses on the role of property within existing models. In others, such as urban location, there are a variety of partial explanations drawn from different academic disciplines which must be set into some coherent framework. In areas such as property market forecasting, the field is still developing and material is best presented as a critical review of the research literature with identification of the broad themes. The need to interlink the themes and to cross-reference has led to long chapters. Practical examples and equations have been kept to a minimum to ensure that the focus is on the economic principles.

The book covers such diverse areas that it is unlikely that any one reader could be expected to have the same level of prior knowledge across all topics. However some assumptions have had to be made. It is assumed that readers will have studied micro- and macroeconomics to at least first year undergraduate level; that they will understand the basic principles of probability and statistical inference and that they understand the fundamentals of financial mathematics.

Some clarifications are required as to how certain key terms are used throughout the text. Different parts of the literature use the same terms in distinct ways, which can be confusing. Three that are worth highlighting are the concepts of efficiency, institutions and investment.

Economic efficiency in much of the economic literature refers to situations where resources are allocated optimally, so that the goods desired in the market place are produced in the cheapest possible way, given current technical knowledge. Consequently, efficiency in this sense is about making the best use of inputs to produce the maximum amount of output. In financial economics, the efficient market hypothesis defines price efficiency in terms of the amount of available information that is utilised. Weak form efficiency holds where an investor cannot profit from patterns in historic price series, strong form efficiency holds that prices reflect all available information at a particular time. This results in a more specific definition of price efficiency. This should be borne in mind in reading the financial economics sections.

Institutions in the financial economics literature generally refer to the major investor groups including pension funds, life insurance and general insurance companies. Institutional investors are highly significant in all investment markets including the commercial property markets. They hold a considerable proportion of investment property. In other areas of economics, institutional analysis refers to the behaviour of individuals and organisations as market agents and the role of market and social structures, rules and regulations in affecting market processes. This may entail relaxing some of the assumptions of economic rationality in the competitive model. The institutional framework determines how supply and demand adjustment processes take place. Although the particular usage of the term should be clear from the context an upper case I is used to refer to the investing Institutions and a lower case i to refer to institutional analysis and market structure.

In financial economics, investment means the acquisition of the title to some asset. Property investment, then, refers to the purchase of land or buildings and the right to receive rent as income and capital value growth. In macroeconomics, investment refers to investment in real goods as inventories or fixed capital. In the macroeconomic sense, property investment refers only to allocation of resources to create new structures—the development process. By co...