The goal of this report is to provide a deep understanding of how UK commercial property markets function overtime and why they present volatility issues. The purpose of this analysis is to familiarize yourself with aspects such as how, when and why these markets show signs of volatility, and by that way, reduce the risk of your investment. We will be examining empirical data on commercial property aspects in the which can be found from several UK property companies and databases.
Business and property cycles
A successful property investment relies, in a great degree, on the fluctuations of the economy. Generally, if the economy is in an upswing, then the demand for new space increases, and so the rents, while vacancy rates fall, while when on recession, property investment decreases for a number of reasons. These fluctuations, however, which are often referred as “business cycles” tend to be smooth, and their level of variance depends mostly on exogenous phenomena. In the contrary, property development markets tend to be more volatile and respond with higher sensitivity to the upturns and downturns of the economy. This is mostly due to the nature of the property, as a good. In addition, not all types of property respond with the same intensity (Ball, Lizieri, & MacGregor, 1998). We will examine this phenomenon later in this report.
Property cycles can be categorized regarding their time duration. The most common cycles are of 4-5 or 9-10 years. The first kind of cycles are mainly driven by the economic growth and business cycles we mentioned above, while the 9-10 year cycles are driven mostly by property development (Ball, Lizieri, & MacGregor, 1998).
Taking into consideration the UK commercial property market and its cycles and bubbles over time, we can extract several important conclusions. UK commercial property market doesn’t show that much volatility. With an exception of the 1990’s bust following the 1980’s boom, in a period from 1950 to 2000 we have small fluctuations and development cycles of mostly 10 years duration. In addition, it seems that small fluctuations in GDP growth don’t affect commercial property output in a great manner (Ball, Lizieri, & MacGregor, 1998).
Rental volatility in UK commercial property is another issue. Because of the nature of property as a good, being slow in production and requiring large capital funds, there is often a lag between demand
Figure 1 – Source: UK National Statistics, self constructed
and supply for property. This failure of adjustment leads to rent increase or decrease. So, if after a long period of property development no more space is absorbed by users, further development will stop. After a short time demand will increase but the property supply mechanism will fail to serve this demand, a fact that will eventually lead to rent increase (Ball, Lizieri, & MacGregor, 1998). With this in mind we can guess that rents are more sensitive in economy’s ups and downs. In fact there
Figure 2 – Source: GVA – Grimley: Rent Review Outlook 2009
is a strong relationship between real GDP and rent levels as shown in Figures 1 and 2. The massive increase in real GDP from 1985 to 1987 was followed by an increase in rents, while from 1987 to 1991, when GDP falled, UK rents were decreased to a percentage of about 20%. The same pattern continues until the end of data. As we can see from Figure 2, the degree of variance differs across property sectors. Office property shows the highest volatility while industrial and retail property exhibit volatility to a less extent.
In fact, the role of GDP as a determinant of rents has a different intensity in each of the three sectors. For example, the decline in industrial rents which happened between 1979 and 1985 in UK, has its roots in the restructuring of the British economy away from manufacturing activities (Keogh, 1994). In addition, the rents of industrial factories and warehouses are affected by economic depression in a greater extent than the properties in the other submarkets (Harvey, 1996). This may create questions regarding the low levels of volatility shown in Figure 2. On the other hand, industrial properties have their unique characteristics, such as, their rapid depreciation and their risk of obsolescence due to production technology improvements. Last, but not least, we have the production identity of each industrial unit, which is constructed for the production of a specific good, a fact which makes the finding of a similar tenant more difficult. So, one can understand that industrial properties are subject to a decreased – relatively to the other submarkets – demand, which explains the lower levels of volatility shown in Figure 2. In fact all these characteristics also make developers’ supply very limited because of the very high yields, reaching 16%. (Harvey, 1996) In addition, rents of industrial property are also affected by fixed factors such as the location. In the extent that industrial premises are decentralized, and, taking into consideration the assumption that these premises may operate in geographical proximity and they may be near a transportation network, creates a common advantage for all such premises (Dunse, Jones, Fraser, & Brown, 2000).
Another important variable regarding the demand factor of the rent determination process, is the employment structure of UK. As you can see on Figure 3, the percentage of workforce employed in manufacturing activities is continuously
Figure 3 – Employment by sector in UK
Source: UK National Statistics, self – constructed
decreasing. This implies a continuously shrinking secondary economic sector and a switch to service labour. This deindustrialization, in combination with international outsourcing activities, in which UK is the leader in Europe (Schoinakis, 2009), results in limited supply and demand for industrial properties. This results in low volatility levels in UK in general. In a regional level of analysis however, this volatility may differ, due to local concentration factors and agglomeration economies (Ball, Lizieri, & MacGregor, 1998).
On the other hand, employment in the service sector shows a very strong increasing trend, which implies an increased demand for office property. This fact has two sides. First, the user demand is continuously growing, and so would the rents, if it wasn’t for unexpected economic busts. Second, this demand growth adds to the already existing characteristic of property developers to over – supply. (Gallagher & Wood, 1999). Adding the slow process of new office development, we arrive at appoint of high rents, and potentially higher new office supply (Keogh, 1994). In fact, the higher the demand for new floorspace, the higher the rents. This, along with speculative development, explains why, particularly in London, where space is very limited, we observe higher volatility than the rest of UK (Ball, Lizieri, & MacGregor, 1998).
In addition, office rent volatility depends on the performance of the macroeconomic indicators, such as GDP and employment rates (Keogh, 1994). By comparing Figures 1 and 2, we can see a large bust of office rents when strong recessions occur. This shows a link between the overall economic performance and office rents. In addition, Figure 4 shows us the employment rates in UK from 1992 to 2009. As we can see, the lowest employment rates occurred in 1992, a fact which coincides with the lowest level of office rents. On the contrary, while on 2008 employment rates were at their peak, there was a rent decrease, but still smaller of the one on 1992. This is because of the high levels of employment which kept rents in an appropriate level, not repeating the bust of 1992 (Chin, 2003).
Ball, M., Lizieri, C., & MacGregor, D. (1998). The Economics of Commercial Property Markets. London: Routledge.
Chin, W. (2003). Macro – Economic factors affecting Office Rental Values in Southeast Asian Cities: The Case of Singapore, Hong – Kong, Taipei, Kuala Lumpur and Bangkok. PRRESS Conference. Brisbane, Australia.
Dunse, N., Jones, C., Fraser, W., & Brown, J. (2000). Cutting Edge 2000: The determinants of industrial rents. RICS Cutting Edge Research Conference.
Gallagher, M., & Wood, A. P. (1999). Fear of Overbuilding in the Office Sector: How Real is the Risk and can we predict it? Journal of Real Estate Research , ÏƒÏƒ. 3-32.
Harvey, J. (1996). Urban Land Economics. London: MACMILLAN PRESS LTD.
Keogh, G. (1994). Use and Investment Markets in British Real Estate. Journal of Property Valuation and Investment , ÏƒÏƒ. 58-72.
Schoinakis, E. (2009). Thesis: Global Spatial Distribution of Innovation and Production Networks: Empirical Evidence from 58 TNCs. Veria.