Integrating Regional Economic Indicators with the Real Estate Cycle
Gordon, Jacques, Mosbaugh, Paige, Cantor, Todd, The Journal of Real Estate Research
Jacques Gordon* Paige Mosbaugh* Todd Canter*
Abstract. Previous literature has followed an evolutionary path in the examination of office market volatility. Where initial models were designed to show the close relationship between economic fundamentals and volatility at the national level, more recent models have focused on metro-level volatility. This study quantifies the volatility associated with metropolitan markets in terms of vacancy rates and identifies those economic factors that underlie this risk. The analysis suggests that movements in vacancy rates are likely to be affected by different factors at different stages of the cycle. In the long run, this analysis shows that the availability of capital had the strongest effect on the volatility of office vacancy rates. In periods that follow excess construction, market-specific, demand-side factors appear to be the dominant influence.
Reliable measures of real estate risk are notoriously hard to come by. Financial measures of real estate volatility suffer from either appraisal-based "smoothing," in the case of privately held assets, or stock market "noise," in the case of publicly traded companies. Yet, fluctuations in the underlying supply-demand dynamics of office markets are readily observable. Moreover, previous research suggests that these underlying fundamentals are key determinants of financial performance (Wheaton, 1987; Pyhrr, Webb and Born, 1990; Mueller and Laposa, 1994).
This paper attempts to enhance our understanding of movements in these underlying fundamentals and to build an explanatory model that identifies economic factors likely to be associated with fluctuations in the office market. For the last ninety years, office markets in the U.S. have moved through cycles in which periods of scarcity have been followed by over-supply. Our analysis suggests that measures of office market volatility, such as movements in vacancy rates, are likely to be affected by different factors at different stages of the cycle. An improved understanding of these factors should help practitioners reach a better understanding of the amplitude and duration of the office market cycle in American cities.
A review of previous literature shows a steady evolutionary path in the examination of office market volatility. Where initial studies modeled office market behavior based on a homogenous national market; more recent models explored intermarket distinctions. Analysis of market-level factors is important in order to identify the cause of volatility or risk levels associated with specific office markets.
Wheaton, in his early research (1987), examined the national office market and studied the causes of market movement that make the office market cyclical. He determined that both supply and demand variables respond directly to expected office employment changes, although noting that supply responds more quickly than demand.
Pollakowski, Wachter and Lynford (1992) thought it inappropriate to impose a single structure on all markets for demand and supply relationships; instead they tested for structural differences across metropolitan areas by office market size. Using data for twenty-one metropolitan areas for a period of ten years, they concluded that the stage of the real estate cycle is clearly not uniform across markets.
Voith and Crone (1988) evaluated office vacancy rates in seventeen metro areas for the period June 1980 to June 1987. They discovered significant differences in natural vacancy rates between the markets both in terms of cycle frequency and amplitude. They concluded that inter-market variation was significant and called for additional research on the relationship between the so-called natural vacancy rate and market conditions.
Downs (1993) addressed this call for additional research by showing that differences in market equilibrium vacancy rates exist due to fundamental differences in market conditions (supply and demand fundamentals). …