Dynamic Residential Housing Cycles Analysis - Term Paper Example

Rent and Urban Economics To answer our question, we need considerable knowledge in economic theories, specifically concerning rents and location. Some of the economic theories related to our discussion are economic rents and location theory. The location theory was developed by Johann Heinrich von Thnen in the first volume of his Der Isolierte Staat in 1826. He is indeed called the "father of location theorists". LOCATION THEORY It is composed of group of theories which seeks to explain the sitings of economic activities and is based on the microeconomic premise that individuals choose to maximize their utilities (Answers.com). According to this theory, there are factors which constitute the differences in locations and it includes localized materials, amenities and transport cost (Answers.com). Von Thnen posits that transportation costs constitutes or consumes Ricardo's economic rent that's why "because these transportation costs and, of course, economic rents, vary across goods, different land uses and use intensities will result with distance from the marketplace". In the table we observed differences in rates across the different locations. The theory suggests that part of this difference is accrued to the transportation cost. Real Estates including residential areas near the industrial and commercial districts are priced higher than those which are farther. This is explained by the differences in transportation cost as the former requiring minimal time, effort and financial costs in travelling. We expect that the commercial districts house the necessaries that consumers usually go to such as the office, schools, groceries, malls, shops and others. In this theory, the West End is obviously in the advantage against the City, making its rent prices higher. The difference in prices is necessary as can be explained by the simple law of supply and demand. If the rent prices are the same with the West End and the City, there will be shortage of space in the West End resulting to overcrowding while none will stay in the City. In the presence of excess demand, the owners of land will be able to increase the price, thereby creating a disparity between the West End and the City price. Simply put, the law of demand will work for the land owners, maintaining the price differences between the two locations. Amenities are also better in the West End than the City. Being the centre of industry and commerce, amenities will be located in the cities making it more attractive and nearer to residence in the West End. This adds convenience to those who are in this place, thus it has to be compensated by a higher price. Von Thnen also mentioned the difference in land use and intensity causing differences in prices (Wikimedia Foundation, Inc.). Since the land in the West end is mainly used for commercial purposes, where tenants expect a higher return than in the City, land prices can be increased. Von Thnen also mentioned the importance of centrality in pricing, saying that "it was density of population increasing the profitability of commerce and providing for the division and specialization of labour that commanded higher municipal rents" (Wikimedia Foundation, Inc.) FLUCTUATING RENTAL RATES The simple law of supply and demand can be used to explain cyclical pattern in rents. Both locations, the City and the West End show fluctuation in rental rates. Some empirical studies have identified reasons for this. We are going to study each factor and relate it to existing economic theories. It has been found that employment growth account for the fluctuations in rental rate (Robert H. Edelstein). Accordingly, employment growth affects per capita income in a positive direction. With income being a determinant of demand, high employment growth will cause high demand for housing and land. With the increased capacity to purchase, over-all demand for space will be increased thereby increasing the prices of houses, offices and lands. This is observed at the time in 1973 and 1974, in 1987-1990, 2000-20001, and 2007-2008 in the City and similarly in the West End. Theory suggests that employment growth must be one of the reasons why the demand for housing and lands increased thereby pushing the prices upward. It is observed that with employment, people can opt to leave the parent's house and look for a house to rent or to buy. This adds to the over-all demand for housing. Another factor which shows as affecting the fluctuation of rental price is interest rate. There are theories linking interest rates to rental rates. Owning a house or land is an investment. And because it is so, it requires capital. The role of interest rate in investment is that it serves as the cost of capital. The worthiness of investment indirectly depends on the cost of capital or the interest rates. Although there are numerous financial institutions that lend for investments, the payment plus the interest is something that the investor should be considering. Since a house or a lot is an investment, ventures on such kinds are affected by the prevailing interest rate, in the opposite direction. The higher the interest rates are, the less are housing and land investments. This then results to greater demand for rental houses and properties. Since people would want to evade higher interest charges for mortgage, they would resort to rents and lease where they do not have to pay to banks and other financial institutions. This is currently observed in Sydney Australia where falling rental vacancies were observed, urging the banks to cut on interest rates. We therefore see that with high interest rates, there will be greater demand for rental houses and lands, therefore its prices will also increase. On the other hand, lower interest rates would boost investment including houses, industrial and commercial buildings and even lands, allowing people to own houses, thereby cutting the number of those who rent. This decline in demand for rental houses will inevitably reduce rental rates as more suppliers observe greater number of vacancies. DIFFERENCES IN RENTAL TRENDS Before we attempt to explain the differences in rental trend between the West End and the City, it is worthwhile to understand the situations between these two locations. "The City of London is a geographically small city within Greater London in England" and serves as the historic core of London (Wikimedia Foundation, Inc.). More importantly, "the City's boundaries have remained almost constant since the Middle Ages, and hence it is now only a tiny part of the much larger London metropolis" (Wikimedia Foundation, Inc.). On the other hand, the West End is in the centre of London, England housing the city's major tourist attractions, businesses, headquarters, and theatres. It is believed that the West End "was long favoured by the rich elite as a place of residence because it was usually upwind of the smoke drifting from the crowded City and because "it was also located close to the royal seat of power at Westminster, and is largely contained within the City of Westminster" (Wikimedia Foundation, Inc.). It is seen in the table that starting 1989, the rental price in West End has surpassed the rental prices in the City. It is because the West End has shown promise of more commercialization and business enterprises than the City itself. It is believed that if an investor would consider a place for his businesses, there are things that are necessarily important to consider, especially in the long-run. The expectation about the place, as to whether it will be prosperous in the future or not is a paramount consideration for long-run profitability. Obviously, if a place promises centralization as what David Ricardo considers as a determinant of trend, then its land price will be higher. In a book of Charles F. Floyd and Marcus T. Allen entitled Real Estate Principles, these considerations were listed. These considerations are as follows: a) What are the long-run prospects for the economy of the community b) What national or regional trends are likely to affect employment in the area c) Are new firms likely to locate in the area bringing additional employment 'Projecting and forecasting future employment trends is an interesting exercise that often involves sophisticated modelling techniques", however, "real estate investors must carefully evaluate the assumptions that lie behind population and employment projection" (Charles F. Floyd). At this point, we will be discussing the economic theories regarding expectation. Expectation has been such an important concept in economics so that it can alter the level of supply and demand and therefore change the market equilibrium. "Expectations' in economics refers to the forecasts or views that decision makers hold about future prices, sales, incomes, taxes, or other key variables" (G.W Evans). There is a forward looking decisions made by economic agents which actually shape some events in the future (G.W Evans). This is present in the differences in the long-run rental difference between the residences in the West End and the City. The rich elite have foreseen that the West End will be a better location in the future given the convenience of the place and the future developments to occur in the area. Thus, we see this developments since the population has grown in this place enough to sustain commercial business and other establishments. Rental Rate and the Rate of Inflation The City is obviously in a disadvantage compared to the West End in terms of consumer demand for housing. It is obviously reflected by the inability of its prices to increase. Since it is inevitable to suffer the consequence of inflation as it is a nationwide phenomena, even the investors in the City has to construct buildings and houses at a higher cost similar to the one in the West End. However, due to lesser demand for its houses compared to the West End, the investors do not have the capacity to increase its prices similar to that in the West End. This is simply explained by the law of demand, in which a greater demand pushes the prices upward. Inflation will obviously work against the place or the establishment who does not have the leeway to increase its price since the demand for its product is elastic or highly sensitive. This means that increasing the price will result to lower revenue, in contrast to what is desired. Works Cited Answers.com. http://www.answers.com. 14 May 2009 . Charles F. Floyd, Marcus T. Allen. Real Estate Principles. 7th. Dearborn Real Estate Education , n.d. G.W Evans, S. Honkapohja. "http://www.uoregon.edu." 13 May 2009 . Robert H. Edelstein, Desmond Tsang. "Dynamic Residential Housing Cycles Analysis." Research. 2007. Wikimedia Foundation, Inc. http://en.wikipedia.org. 18 April 2009. 14 May 2009 . -. http://en.wikipedia.org. 17 February 2009. 13 May 2009 . Wikimedia Foundation, Inc.,. http://en.wikipedia.org. 12 May 2009. 15 May 2009 . Read More