Academic journal article Real Estate Economics

Implicit Forward Rents as Predictors of Future Rents

Academic journal article Real Estate Economics

Implicit Forward Rents as Predictors of Future Rents

Article excerpt

This paper investigates the relation between the term structure of rents and future spot rents. A rich database of office rental agreements for various maturities is used to estimate the term structure of rents, and from this structure implicit forward rents are extracted. The data pertain to commercial properties in the three largest Swedish cities for the period 1998-2002. A positive relation between forward and spot rents is found in some regions, but forward rents underestimate future rent levels. Another contribution of the paper lies in the area of rental index construction. We provide evidence that rental indices should not only be quality constant (i.e., control for characteristics), but should also be maturity constant.

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Commercial leases are signed for a variety of maturities (terms). If rent levels for different terms are observable, then it should be possible to construct the term structure of rents in analogy with the term structure of interest rates. In most instances, one would expect very short leases to have high rent levels due to the transaction costs associated with such leases for the owner, while the longer end of the term structure curve can be either upward-or downward-sloping. Consideration of the term structure of existing rental contracts is obviously important when valuing individual properties. It should also matter for our picture of overall market movements. Rental indices that are constructed without controlling for the term structure may be biased if the composition of leases over different terms changes through time. Further, and this is the main focus of the paper, just like the term structure of interest rates is hypothesized to contain information that is useful in predicting future spot interest rates, the term structure of rents may offer important insights about market expectations of future rent levels.

In analogy with fixed-income securities, one may formulate an "expectations hypothesis" of the term structure of rents stating that forward rents are unbiased estimates of future spot rents. It is well known that such a hypothesis holds for interest rates under very restrictive conditions only. It can be shown that similar assumptions as in interest rate theory regarding risk aversion and the stochastic nature of interest rates (and of rents) are required in the case of rental contracts as well (see Clapham and Gunnelin 2003). The expectations hypothesis is conveniently formulated in terms of forward rates. There is no explicit forward market for leases, but it is possible to extract implicit forward rents from the spot rents at different maturities. For instance, the 1-year forward rent for a 1-year lease is implied by current spot rents on 1-year and 2-year contracts. These implicit forward rents may not be directly relevant for trading, since it is not possible to construct synthetic forward contracts, but it is still relevant to investigate if they are able to predict future spot rents. The mechanism that would bring about such a relation operates even in the absence of explicit or implicit forward contracts--in signing a lease, tenants could be expected to weigh the cost of a long contract against the expected costs (and uncertainty) of a sequence of shorter contracts. In other words, implicit forward rents should reflect market expectations of future spot rates. Under idealized conditions, they may even be unbiased predictors of future spot rates.

Despite the importance for actors on real estate markets of considering the term structure of rents, research in this area is limited. Grenadier (1995, 2002) puts forth equilibrium models of lease valuation that account for the term structure. Gunnelin and Soderberg (2003) report that differences in lease terms have a statistically significant impact on commercial rents in the Stockholm CBD for 7 out of 15 years between 1977 and 1991, with an upward-sloping structure in the bullish real estate markets of the 1980s shifting to a downward slope in 1990 at the start of the bearish years for real estate markets. …

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