Integrating Three Related Markets - Space, Capital And Physical Assets

Three distinct but related markets ñ the market for space, the capital market and the market for physical assets ñ contribute jointly to commercial property performance. Typically supply and demand in each of these markets is analyzed in isolation. A simple graphical analysis, similar in construction to the DiPasquale-Wheaton (DW) model that links real estate and real assets, is proposed that illustrates how the three markets inter-relate. Apparently contradictory trends, such as tightening yields at a time when vacancy rates are rising, or a boom in construction activity at a time when rents are falling, can be reconciled if the three markets are analyzed as an integrated whole. The analysis appeals to a production function for production, rather than short run supply constraints as in the DW model, to achieve equilibrium. The benefit of this approach is the new insights that are offered into the economic drivers of expansion and refurbishment for existing assets, which are a prominent feature of many property markets at present, as well as the key role of site-value ratios in determining equilibrium conditions and investment returns. With the increasing popularity of the Four Quadrant model for investment in real estate markets, a framework for describing how these markets are related has obvious expository applications to investment advisors and their customers. An integrated analysis is helpful at a time when commercial property in many countries is characterized by high levels of construction activity and refurbishment, falling yields and where the fundamental cost of capital, as measured by the long-term inflation-indexed bond yield, in several markets, such as the UK and Australia, has recently hit all-time lows. Firstly, the market for commercial space has been widely analyzed. The demand for commercial space is typically determined as a lagged response to economic variables such as employment, consumer spending or population growth. The supply of space can be regarded as fixed in the short run, though the lagged supply response to rental growth can display high elasticity. Secondly, and quite independently, the capital market determines the discount rate that the market will apply to the future rental stream of each asset. Typically the capital asset pricing model (CAPM) is employed to determine the cost of capital which sets the required rate of return on investment. Thirdly, the market for physical assets (hereafter, ìassetsî) is determined by construction costs and land values. Land value reflects the quasi-monopoly element in location. Land value is the adjusting factor that brings the construction cost of the asset (including developerís ìprofitî) into line with the discounted cash flow from the expected future rental stream. An exogenous shift in demand for space, or, quite independently, fluctuations in the cost of capital can each lead to disequilibrium in the market for assets, stimulating or deterring construction activity. For example, a reduction in the required rate of return, as defined by CAPM, can lead to a rise in property values and stimulate construction even though the demand for space is simultaneously declining. Property values can rise, and construction may be stimulated, even though rents are falling. The accuracy of prediction of future trends in each of the three markets, as well as overall investment returns for commercial property, is likely to be enhanced from analysis, or at least explicit acknowledgement, of the inter-relationships between the markets for space, capital and physical assets.