Heriot-Watt University Dubai Campus

Real Estate Economics (D41RE)

Coursework submission

REPORT ON RENTAL VOLATILITY OF COMMERCIAL PROPERTY MARKET IN UNITED KINGDOM

Name: Dhruv Jyotindra Jani Reg. No: 101673475 (MSc Real Estate Management and Development)

Table of Contents

Introduction ......................................................................................................................................................... 3 Property Cycles .................................................................................................................................................... 4 Sub-Sector Analysis and Investments ................................................................................................................... 7 Conclusion ......................................................................................................................................................... 10 References ......................................................................................................................................................... 11

Table of figures

Figure 1: How the property cycle works ............................................................................................................... 5 Figure 2: Changes in real rents ............................................................................................................................. 7 Figure 3: Changes in GDP & property rents .......................................................................................................... 8 Figure 4: Simple model of Property Market .......................................................................................................... 9

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Introduction
This report is intended to create an understanding and analyse the rental volatility observed in the property market. Rental volatility is the degree/frequency of change in the rental values of property. Generally a certain amount of volatility is observed in every market; however the volatility in the property market (worldwide) is typically large and very sudden. This volatility is observed to vary within the sub-sectors of the market and reacts differently to various external factors within any economy. The UK property market like any matured market displays higher rental volatility in the non-residential (commercial) property sector. This is largely due to the nature of the activities within the property sector in relation to the activities of the Macro economy. In simple terms, the demand & supply within the commercial property market is subject to the external influences from the real economy of the country. The degree of volatility in the property market can be corresponded to the economic condition (boom/recession) of the country. Thus the transactions within the corporate sector can be closely linked to the transactions in the property market. So if the businesses (economy) in a country are booming, this will trigger the rental values of the commercial property to also boom and vice versa. These highs and lows in the rental values in the property market being cyclic in occurrence lead to the theory of Property Cycles. We shall be discussing these property cycles, the factors of influence and their relationship between the other economic cycles. We shall also analyze the rental volatility within the sub-sectors of the commercial property market. To conclude we shall try to understand how this rental volatility in the commercial property market affects the investments in the property market.

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Property Cycles
Like all business markets, the property market is also demand driven. However as the property market is not as elastic to the change in demand as some other markets, it is considered an imperfect market. The factors which define the imperfections in the property market are mainly: y y y y Property being immobile, cannot have an organized central market center which lead to imperfect knowledge Lack of available information. It is difficult and expensive to acquire market information The transactions in property are costly when compared to other investment assets The investment in property is large and lumpy

From an economic perspective, property cycle is mainly concerned with cyclical movement of the levels of demand and supply of property over a given timeframe. Barras (1994) explained that the property market is not subjected to one but several cyclical influences, it is subjected to several different cycles at different periods but these cycles sometimes cancel each other and sometimes reinforce each other. These cycles are not restricted to property market they could be external. Barras (1994) also explained that there are at least four different cycles recorded in economic literature. They include: 1) Short cycles: This cycle ranges from four to five years. This is a result of the activities of the classic business cycle. Long cycles: This cycle ranges from nine to ten years generated by the long years involved in property development. Long swings: This is recorded in a period of twenty years upward and it is associated with major buildings booms. Long waves: This lasts up to fifty years and has been proposed to explain alternating phases of high and low growth in the industrialized world economy. This wave is triggered by introduction of a new technology (usually global) like steam power, electronics, computers, etc

2)

3)

4)

Real estate economics shows that the property market does not operate in isolation; it reacts to changes from external sources. Barras (1983) explained that the property market is knotted with both the real and money economy. A positive change in the operations of one of the elements will result in a positive change in the operations of the others. Barras and Ferguson (1987) illustrated this by the use of a conceptual model that shows how the building cycle works. This model incorporates both the real and

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money economy, the model illustrates how a building boom is generated by the interaction of the business cycle in the real economy, the credit cycle in the money economy and the long cycle of development in the property market, the below diagram is an attempt to explain how the building cycle works.

Real economy Economic upturn

Property market

Money economy credit expansion

Increased property demand Supply shortages Rising rents/falling yields Economic boom building boom Increased supply Economic downturn slackening demand Falling rents/rising yields Recession property slum
Figure 1: How the property cycle works (Extracted from the journal of property research)

credit boom

rising interest rents

credit squeeze

The diagram above explains how the property market relates with the real and money economy. The entire activities of the property market are summed up in the illustration above. Beginning with an economic upturn, coinciding with a shortage in available property supply, there will be an increase in demand in the market. This increase in demand shall push the rental and capital values to increase sharply thus triggering the first wave of new developments. Considering that credit expansion accompanies the business upturn the credit rates will tend to decrease. The fall in credit rates will encourage an increased lending by banks/financial institutions which will fund the second wave of development. The second wave is usually speculative in nature. At this stage, more investors are likely to capitalize the opportunity to maximize profits because cheap credit is available for development and the high rental values. However, due to the inherent nature of the new supply of property, it will take a while for new supply to come into the market. This will further boost the rental values. By the time new

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development nears completion, the shorter business cycle moves into the downward slide thus resulting in a drop in demand in property market. With the business cycle in the downturn, the credit rates will rise in order to combat the increasing inflation, thus lessening the demand further. As more supply enters the market overlapping with the drop in demand there will be steep fall in the rental and capital values. During the boom times, if the amount of supply is not regulated, it might lead to an oversupply of property which will result in a further fall in the rental values and a rise in investment yields. The oversupply of property will weaken the demand and the price of the property available in the market. This ultimately will lead to flattened rents and hence a property slump. The description above is only for illustration. In the real world, the situation barely goes unchecked. The diagram above is designed to illustrate a situation where the market is perfect and free from government intervention. Governments play a key role in the activities outlined in the diagram. Governments are responsible to an extent for the status of both the real and money economy. This control manifests through fiscal/monetary policies, inflation, taxes, subsidies etc. Governments devise laws/policies to regulate the usage of land and property which also controls the activities of the market.

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Sub-Sector Analysis and Investments

The non-residential sectors in the UK show a higher degree of volatility because of the inherent interdependency of the property market with the activities of the real economy which are also volatile in nature. The non-residential sectors exist for commercial activities. This commercial interest makes the demand for office, retail and industry slightly higher than the demand of residential property. As a result, prices for commercial floor spaces are slightly higher than the residential sector. This situation makes the average investor more inclined to invest in commercial development of the office, retail and industrial floor space. As illustrated in the journal of property research (1994), the property booms closely follow the business cycles; an example is the 1973 and 1988 UK post war business cycles which provided the trigger for major speculative buildings booms (JPR 94).

Figure 2: Changes in real rents (Extracted from D41RE lecture notes)

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The chart above shows the annual fluctuations of property rents of the UK commercial sector from 1980 to 2006. The chart shows that the office market is slightly more prone to rental changes than the retail and industrial market. This means that the office market has the highest volatility rate compared to the retail and industrial sector. This is followed by the industrial market and lastly by the retail market. The chart below shows the rate of change in property rents combine with the rate of change in real GDP.
Rate of Change in Real GDP and Property Rents
25

20

15

10

D-Retail

19

19

19

19

19

19

19

19

19

19

19

19

19

19

-5

20

19

19

19

19

19

19

19

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19

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19

19

19

19

20

D-Office D-Indust DGDPR

72

73

74

77

80

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86

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92

93

94

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98

71

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82

84

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99

-10

-15

-20

-25

-30

70

Figure 3: Changes in GDP & property rents (Extracted from D41RE lecture notes)

Both charts suggest that the office market is more responsive to changes in rental values followed by the industrial market and lastly the retail market. The reasons for these fluctuations could be attributed to factors such as the level of demand and supply of property (commercial property), the nature and status of the real economy, property development activities, credit rates, inflation, rents and yields, institutional investment, government regulation/building policies and capital values. Generally speaking, if any of these variables fluctuate it will directly or indirectly reflect on the activities of the property market. The degree at which these variables affect the property market varies according to the sectors. For instance, the office sector is more responsive to price changes because it serves a larger and more important part of the property market. The demand for administrative workspace will always exist irrespective of the

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economic conditions. Both the retail and industrial sectors cannot function without the provision of space for administrative work. This means that the functions of the two markets are relatively dependent on the existence of the office space. The property market has always been a major investment market mainly due the high amount of returns and as a fixed asset. The investment decisions are subject to different market/economy influences and respond to different motives. The commercial property market can be broken into 3 functional components: use, investment and development (Frazer, 1993a; Keogh, 1991) Use & investment are clearly separable as the right to use property and the right to hold, purely for financial interest in property. In UK, it is this distinction in the property rights which forms the basis of the mature market which presently exists. The third element development is conceptually distinct and is important to explain the user and investment markets. The changes in these markets affect development and the development in turn supplies new user and investment rights in the property market. Below model (figure: 4) illustrates the relationships between the building blocks of the property market. Each component in the model represents the market arena in which trade occurs and the prices are determined by the interaction of the demand and supply.
USER MARKET RENTS EXPECTED RENTS New Supply (Long run) Repackage Property Interests (short run) Use Values Use Values

USER MARKET RENTS EXPECTED RENTS Capital values

USER MARKET RENTS EXPECTED RENTS

New Supply (Long run) Key:

Value Information Adjustment process

Required rate of return Figure 4: Simple model of Property Market (Extracted from Keogh (1994))

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Conclusion
The UK commercial property market appears to exhibit high rental volatility which presents a degree of uncertainty in the market. This situation tends to make investors uneasy. However, due to the nature of the UK property market (i.e. its maturity and reasonable stability as well as adequate flow of information) an investor can study the cyclical movements of all the relevant variables that influence rental values and consequently furnish him with the advantage of making informed investment decisions. The process of acquiring these pieces of information is not easy, straightforward or cheap. This is because the variables that influence rental volatility are many and they also have their cycles which must be studied independently and later combined to determine the current and future trend of rental prices. This report tried to summarize a number of macroeconomic factors that influence rental prices. They include (but are not limited to) inflation, yields, cost of borrowing, government policies and so on.

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References
1. Heriot Watt University. (2010). D41RE: Real Estate Economics Lecture Notes. 2. Barras. R (1994). Property and the economic cycle: building cycles revisited. Journal of property research 11. 183-197. 3. Barras. R & Ferguson (1985) 4. Keogh. G (1994) 'Use and Investment Markets in British Real Estate.' Journal of property valuation and investment 12, (4) 58 72 5. Wheaton. W, Torto. R, Evans. P (1997) 'The Cyclic Behavior of the Greater London Office Market.' Journal of Real Estate Finance & Economics 15, (1) 77 - 92

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