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Systematic Valuation Errors and Property Cycles: A Clinical Study of the Sydney Office Market

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Abstract

The cyclical variation in office construction, vacancies, rents and values over the last decade has been enormous throughout the world. Numerous hypotheses have been advanced for this enormity, including prolifigate lenders, egomaniacal developers, and even rational behavior in the face of uncertainly and long gestation periods. Our analysis of the Sydney office market suggests a major role for the failure of investors to understand the workings of property markets. Given the incentives of developers to build when value rises substantially above replacement cost and not to build when value is low relative to replacement cost, the property market has to be mean reverting. That is, when times are really good (low vacancy rates and high real rents), they can't continue, and the same is true when markets are really bad. Because Sydney investors did not incorporate this implied mean reversion into their forecasts of future cash flows, they over valued properties when values were already high, thereby triggering excessive construction and vacancies. Of course, valuations obtained by simply "capping" current cash flows are unlikely to incorporate full mean reversion.

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  • Patric H. Hendershott, "undated". "Systematic Valuation Errors and Property Cycles: A Clinical Study of the Sydney Office Market," Research in Financial Economics 9611, Ohio State University.
    • Handle: RePEc:wop:ohsrfe:9611
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    File URL: http://www.cob.ohio-state.edu/~fin/journal/dice/papers/1996/96-11.pdf
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    1. Grenadier, Steven R, 1995. "The Persistence of Real Estate Cycles," The Journal of Real Estate Finance and Economics, Springer, vol. 10(2), pages 95-119, March.
    2. Patric H. Hendershott & Edward J. Kane, 1995. "U.S. Office Market Values During the Past Decade: How Distorted Have Appraisals Been?," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 23(2), pages 101-116, June.
    3. Stiglitz, Joseph E, 1990. "Symposium on Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 13-18, Spring.
    4. Avinash Dixit, 1992. "Investment and Hysteresis," Journal of Economic Perspectives, American Economic Association, vol. 6(1), pages 107-132, Winter.
    5. Hendershott, Patric H., 1996. "Rental Adjustment and Valuation in Overbuilt Markets: Evidence from the Sydney Office Market," Journal of Urban Economics, Elsevier, vol. 39(1), pages 51-67, January.
    6. Geltner, David & Mei, Jianping, 1995. "The Present Value Model with Time-Varying Discount Rates: Implications for Commercial Property Valuation and Investment Decisions," The Journal of Real Estate Finance and Economics, Springer, vol. 11(2), pages 119-135, September.
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    Cited by:

    1. Davis, E. Philip & Zhu, Haibin, 2011. "Bank lending and commercial property cycles: Some cross-country evidence," Journal of International Money and Finance, Elsevier, vol. 30(1), pages 1-21, February.

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