Is it possible to make the property cycle go away?

Definition: Property Cycle Property cycles are recurrent but irregular

fluctuations on the rate of all-property total return, which are also apparent in many other indicators of property activity, but with varying leads and lags against the all-property cycle (Investment Property Databank,1999)

The property cycle means the tendency for property demand, supply, prices and returns to fluctuate around their long term trends or averages.

Modern History of Property Cycle Importance:

Property accounts for around 44% of the non-financial assets of UK companies (McWilliams, 1992)

Property market boom-bust cycle creates destabilizing economic effects

Major Events: Early 1990s crashes: adaptive behaviour of lenders

& adaptive behaviour of investors (Beardsley,1995) Pattern between 2002-2004 Property market downturn starting from 2009

Historical Data & Global Comparison

UK and World Property Quarterly Fair Value Indices (Mar 1992 - Jun 2011)

0

20

40

60

80

100

120

MM/YY

UK

Inde

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0102030405060708090100

Glo

bal I

ndex

UK (All) Global (All)

* Data retrieved from DTZ Property Fair Value Index Database (Oct 11 2011)

How the building cycle works

How the building cycle works

Rent & Stock

Knowing the stock of real estate, what rents are people willing to pay?

Stock S (sq. ft)

Rent R (£)

R = 40 – (S/10E)

whereR = rents S = supply E = office workers

Price & Rent

Estimating user costs in relation to rent levels

where

ρ = yield

Price P (£)

Rent R (£)P = R / ρ

Prices & Construction

Construction costs

Why?Lower C excess

profitsHigher C

unprofitable

Price P (£)

Construction C (sq. ft.)

C = (P – 200)/5

Construction & Supply

Construction output has to be converted into the stock of real estate

Stock S (sq. ft.)

Construction C (sq. ft.)

S = 100 C

Four Quadrant Model The building cycle: Market shock leads

to increased demand

Rent rises Prices rise Construction

increases Stock increase

leads to oversupply Rents fall below the

initial equilibrium New equilibrium

with higher rents and prices

Stock S (sq. ft)

Rent R (£)

Price P (£)

Construction C (sq. ft.)

The determinants of property cycles

Market reaction to a 50% demand shock

Market reaction to a 50% demand shock

Source: Wheaton,1999 Source: Wheaton,1999

The determinants of property cycles

The volatility of the cycle is dependent upon the strength of the transmission process

How fast will the market react to changes in vancancy rate? How fast will builders translate price changes in

building output? How long is the construction lag?

Can you make the property cycle go away?

In theory „yes“but not in practice due to: Market imperfection such as:

Construction lag Uncertain market predictions about future prices Inelastic demand for buildings because of long

fixed leases and high transaction costs Demand for buildings is relatively price inelastic beacause of: long fixed leases, high transaction costs

Can you make the property cycle go away? Integration of real estate and capital markets

Accelerating innovation in occupier activity and growing investment demand for real estate assets

Integration of property cycle and the business cycle It results in rising volatility of bothInstability in wider economy changes in occupier activity

changes in building investment changes in interest rates affected profitability and investment returns

In reverse situation property booms reinforce economic cycles by boosting investment, consumption and borrowing and experience downturns during the property slump.

Globalisation of property cycles It may strengthen economic growth and urban

development but at the same time may result in increasing the risk of market instability

References Ball M, 1994, “The 1980s property boom”, Environment and

Planning A, Vol 26, pp 671-695 Baum, “Evidence of cycles in European comercial real estate

markets – and some hypothesis”, Henderson Investors, London and the University of Reading, Reading

Barras, R., 2005, A Building Cycle Model for an Imperfect World, Journal of Property Research. 22(2):63-96

Barras, R., 2009, Building Cycles. Growth and Instability, Wiley-Blackwell

Goodman A., 2000, Four quadrant model, available at: www.econ.wayne.edu/agoodman/7800/week3/re_dw1.ppt

Henneberry J and S Rowley, 2002, “Developers decisions and property market behaviour” , in S guy and J Henneberry (eds.),Development and Developers: Perspectives on Property, Oxford: Blackwell, pp 96-114

Scott and Judge, 2000, “Cycles and steps in British commercial property values”, Applied Economics, Issue 32, p. 1287-1297

Ratcliffe J., Stubbs M., Keeping M.,2009, Urban Planning and Real Estate Development, 3rd Edition, Routledge

Wheaton, W., 1999, Real Estate “Cycles”: Some Fundamental, Real Estate Economics. 27(2): 209-230