Supply Adjustments to Demand Shocks in the Commercial Real Estate Market

Article excerpt

The commercial real estate market(1) is frequently observed to be in an extended state of disequilibrium. A partial explanation for the tendency towards disequilibrium is found in the asset attributes of real estate, especially fixity of location, asset heterogeneity, long production times, asset durability and the costliness of real estate development and acquisition. Further explanation is to be found in the characteristics of the commercial real estate market, especially long-term rental contracts and informational inefficiency.(2) Additionally, lending policies of financial institutions and governmental tax policies can exacerbate tendencies towards extended periods of disequilibrium by providing signals to space producers which may or may not be congruent with signals related to changes in space demand.(3)

An extensive body of literature examines the impact of exogenous shocks on prices and on supply and demand adjustments in the housing market. Of particular interest to this study, Poterba (1984) and DiPasquale and Wheaton (1994, 1996(4)) develop useful insights into how housing prices and housing supply adjust to exogenous shocks. DiPasquale and Wheaton (1996)(5) examine how rent and supply in office markets adjust to changes in demand, and provide a rich analysis of the complicated interrelations among demand forces, rent, lease terms, vacancy, supply adjustment parameters and new supply.

To this literature this paper contributes a theoretical investigation of real estate supply adjustments in the commercial real estate market. Simple theoretical linkages between the goods market (the demand side) and the space market (the supply side) are developed and then used to explain the optimal supply decisions of space producers in response to exogenous shocks in the goods market. Optimization models are used to derive propositions relating to how space production decisions are made under conditions of demand certainty, demand uncertainty, and free entry. For purposes of this paper, tax policy and financial variables are held constant, although the models of optimal supply decisions developed below provide a framework for the analysis of capital market influences on the supply of space. The focus of the analysis is on how supply decisions in the space market are linked to production decisions in the goods market, assuming the absence of tax policy and financial innovation. The intent is to lay a theoretical foundation for a more extensive analysis of the process by which the supply of space adjusts to demand shocks.

The analysis in this paper addresses four problems of commercial real estate market adjustment. First, how are supply decisions in the space market related over time to production and capital investment decisions in the goods market? Second, when there is an unanticipated exogenous shock to the goods market, what is the process of short- and long-run adjustment to this shock by the goods and space markets under demand certainty? Third, when faced with an uncertain demand for space, how do space producers determine the optimal supply of space to produce? Fourth, how does free entry affect space supply?

The following section develops a simple production model for the goods market that links the demand for space by the goods producer to its production decisions. The section after examines the process, path and speed of adjustment of the supply of space to changes in space demand resulting from exogenous shocks to the goods market under demand certainty. We then develop an optimal-supply model under demand uncertainty, and use this model to examine how demand uncertainty affects the optimal supply of space. Next we examine how free entry reduces the expected net present value of space, and show how free entry contributes to oversupply. Then we present a simulation of key results that illustrates applications of the demand uncertainty model. The final section presents conclusions. …