Commercial property markets are one of the most difficult markets to fully understand, with high levels of volatility and regular property cycles. In spite of this volatility, and the cyclical nature of the market, there is generally accepted to be a relationship between property returns and various macroeconomic indicators. For example, Hoskins (2004, p. 163) analysis of correlation models in the property market reveals that "gross domestic product, unemployment, and inflation were identified as leading macroeconomic determinants affecting Australian, Canadian, U.K., and U.S. commercial property performance during 1985-1999". In addition to this, various institutional economic factors also have an impact on the commercial property market, including the willingness of major institutions to finance commercial property, and the policy of governments towards commercial property. As such, this piece will investigate these relationships, and the extent to which our understanding of commercial property markets can be enhanced by the application of neo-classical and institutional economic theories.
One of the main ways in which neoclassical economic theories can help us to understand commercial property markets is by helping to understand the nature of the property cycles that regularly occur in the market, and can cause problems for investors. Specifically, Key et al (1994) demonstrated that the market cycle is strongly dependent on the level of development lag that is encountered when attempting to build new properties, as well as the level of supply and demand elasticity in the market. Specifically, as levels of demand rise in the market, prices will rise. The responses of the market, and the nature of the cycle, are dependent on the extent to which demand falls as the price rises, and also the level of delay involved in bringing new property onto the market. If the demand elasticity is low, and delay is long, then the cycle is likely to continue, potentially leading to the formation of a large bubble.
However, at the same time Barras (1994) has extended this relatively basic economic model into a market cycle model that also includes the role of the capital market and the macro economy. This is because the cyclical movement of the commercial property market is not just dependent on the level of demand elasticity and lags in the development process, but is also dependent on changes in property yields and capital values. This is because the property yields are a function of expected rental growth and interest rates, and hence explain the value to investors of investing in the market. The higher the yields and the capital values grow, when compared with the risk free rate, the greater the market value of property will rise for a given scenario. In addition to this, more recent economic research on the role of lag in the commercial property market has demonstrated a link to the stock market. The stock market can also thus be used in an overall economic model to better explain and understand the movements in the commercial property market.
Further insight can also be obtained from the use of transaction cost economics. This is because, according to Hendershott and MacGregor (2005) the presence of transaction costs can cause prices to deviate from their long run equilibrium values, thus causing uncertainties and unpredictability in the market. By understanding the role of transaction costs in causing said uncertainty, it will be possible to estimate the difference between the actual and equilibrium prices, and hence also to understand the underlying market forces and how they will move to bring the market back to equilibrium. However, at the same time, it is important to understand how this general equilibrium is formed. Fortunately, this can also be explained through neo classical economies, by considering the trade off between consumption and investment in various types of assets, of which commercial property is one. By understanding the trade-offs made in the economy, and the resultant decisions made by investors, it is possible to understand where the equilibrium commercial property price and yields will be found, as well as how changes in productivity will affect the demand for property and other potential uses of money. This will thus help us understand how the market will clear in the event of any shifts in the equilibrium (Dunse et al, 2007). It also leads to the general conclusions that commercial property prices will tend to be positively correlated with both residential property prices and overall levels of output growth, and hence how the market will behave in different economic situations (Kan et al, 2004).
In addition to the insight that can be obtained from neoclassical economics, insight into the property market can also be obtained by considering institutional economic theories in particular the work of Galbraith (1973). As Galbraith noted, many businesses have now become so large that they are able to set their own terms in the marketplace, particularly when their overall size and scale is large compared to the market itself. This is the case in the commercial property market, where many of the large banks that finance the market are much larger than the size of the UK commercial property market, and hence can use their resources to influence the market for their own ends. In addition, the commercial property market is strongly vulnerable to the influence of the technostructure referred to by Galbraith, with this technostructure able to influence the core factors affecting the commercial property market (Galbraith, 1973).
Perhaps the clearest example of this effect in action is the influence of lenders on the construction and ownership of commercial properties. According to Mason and Leaffer (1976) the attitude of the major institutional lenders toward different types of properties has a major influence on what properties will be built, and in what volume. This is largely because the construction lending required to build new commercial properties comes with significant covenants and restrictions over what type of building can be made. Indeed, evidence shows that the commercial banks that finance commercial construction tend to protect themselves from risk to a much greater extent than permanent mortgage lenders, who also tend to protect themselves to a greater degree in the commercial market than they do in the residential market. Whilst there may be market and risk management reasons for this, the discrimination between commercial and residential property on the part of the major banks has a significant institutional impact on the behaviour of the market. As such, understanding the nature of this institutional impact will also help us to understand the nature of the market and how it moves over time.
In addition to this, local property cycles are distorted by the impact of local government policies, and the impact of important external investors on the nature of urban development cycles (Hendershott and MacGregor, 2005). Specifically, the government has a specific interest in maintaining economic growth and stability, but also in maximising their public perceptions. In the case of commercial property development, these two factors will often clash, with the government wanting to build more commercial property to allow businesses more land to grow, but also wanting to avoid building to much property for fear of annoying local voters. In addition to this, many of the main commercial developments are initiated by large building companies. These companies are also generally involved in other markets such as house building and government infrastructure projects. As such, new commercial developments may be a very small part of their business, and their decisions may thus be driven more by their technostructure and institutional properties rather than by the market factors.
Indeed, the impact that institutional factors can have can most clearly be seen in the case of local markets. For example, Sivitanides et al (2001) examined the various national and local influences on commercial property markets over a ten year period. They found that the markets were influenced by both a national and a local fixed component, which varied across different markets. Their analysis indicated that the national component was largely influenced by economic policies, whilst the local components were more institutional in nature, and in some cases were substantially stronger than the national influences. This can also be seen in the case of MacGregor and Schwann (2003) who demonstrated that the UK commercial property market, similar to the residential property market, was strongly dependent on institutional factors focused on London. This ultimately led to a London based property perspective being imposed on other regions by the major lending and building institutions, which saw London as the dominant, and hence most important, market in the UK. As a result, Henneberry's (1999) study demonstrated that regional property yields had a tendency to all change more or less at the same time, due to the impact of the strong institutional factors in London, which effectively spread across the whole country influencing all the other local markets. These results held even when there was a local recession or other economic crisis, further demonstrating the dominance of strong institutional factors. As such, understanding the institutional economic nature of the commercial property market is a key part of understanding the market itself.
In conclusion, our understanding of commercial property markets can be greatly enhanced by the application of neo-classical and institutional economic theories. The main ways in which these theories can enhance our understanding is that they can help us understand what data and what factors are most relevant to the movement of the market and the transactions within it. In addition to this, they can also tell us where the market is likely to find its equilibrium, what forces may be causing the market to deviate from its equilibrium position, and how the market is likely to try to return to equilibrium. They can also help indicate the length, magnitude and consequences of any major property boom, and the extent to which it could form an unsustainable bubble. Finally, a knowledge of the institutional factors affecting the property market can help us understand the extent to which they can override the fundamental economic factors, and the implications for the efficient, or inefficient, functioning of the market in a given region, or even nation.
