Academic journal article Real Estate Economics

Profitability of Office Rental Market in Seoul: An Application of Simultaneous Structural Equations

Academic journal article Real Estate Economics

Profitability of Office Rental Market in Seoul: An Application of Simultaneous Structural Equations

Article excerpt

This article is concerned with the estimation of excess rates of return on the office rental market in Seoul using a simultaneous structural equation model. The office rental market in Seoul is spatially divided into CBD and non-CBD, and the model has three behavior equations of Chonsei price, monthly rent and key deposit, with two identity equations of conversion rate and excess rate of return. This article reveals that it would be rational for the owners to ask tenants for a higher deposit with a lower monthly rent under increasing interest rates because the interest rate has a positive effect on the Chonsei deposit and the key deposit, but a negative effect on the monthly rent. Although high nominal interest rate and low economic growth reduce the excess rate of return on both submarkets, the non-CBD office rental market would be more profitable than the CBD market despite lower levels of the monthly rent and key deposit.

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As office markets are spatially monopolized, the value of office buildings has been estimated with a general hedonic price model using locational accessibility and structural characteristics. However, this valuation approach does not take into account the interaction of property market with asset markets, upon which Dipasquale and Wheaton (1992) built a foundation. They attempted to illustrate how real estate markets depend on the national macro economy and financial markets, tracing out the impacts of rents, asset prices and construction on the real estate markets. Fisher and Webb (1992) also examined the determinants of returns on commercial properties in a consolidated framework of space and capital markets in the United States.

This study focuses on the estimation of excess rates of return on the office rental market using a simultaneous structural equation model of Seoul. The excess rate of return is defined as a difference between the returns on commercial properties and an interest rate. The model has three behavior equations: Chonsei deposit, monthly rent and key deposit, as well as two identity equations, conversion rate and excess rate of return. The key (money) deposit is the required down payment. The Chonsei price is a lump sum payment paid in advance to the landlord and returned at the end of the lease period without interest. Generally, the office rental market in Seoul consists of three submarkets, the CBD, Gangnam and Yoido. However, we assume two submarkets, the CBD and the non-CBD markets (Gangnam and Yoido), due to the limitation of data availability. The simultaneous equations are estimated with data from 85 office buildings between the third quarter of 1999 and the fourth quarter of 2000 using the Limited Information Maximum Likelihood.

Literature Review: Determination Process of Rent and Asset Price (1)

The value of office buildings is determined by rental values in the property market as well as the value of real estate assets in the asset market. The former is determined by the demands of tenants, building type and quality, while the latter is determined by transactions for the ownership of real estate. The variation in rent affects the supply of office buildings in the property market and ultimately the demand for ownership in the asset market. The relationship of the property market to the asset market is illustrated in the four-quadrant diagram in Figure 1. The two right-hand quadrants represent the property market for the use of space. The northeast quadrant has two axes of monthly rent and stock. The downward-sloping demand curve depicts how the demand for space determines the monthly rent in the property market. The southeast quadrant determines the annual flow of new construction to be converted into a long-run stock of real estate. The two left-hand quadrants capture the asset market for the owners of real estate. The northwest quadrant represents the ratio of monthly rent to the asset price. This is also known as the capitalization rate for or profitability index of real estate assets. …

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