Price Volatility in the UK Commercial Property Market - Essay Example

Property Economics: An Understanding of Price Volatility in the UK Commercial Property Market Executive summary This report is aimed at shedding light on the commercial property market in the United Kingdom. In concrete terms, it looks at the reasons why there has been rental volatility in this market. In doing so, the report draws attention to the fact that the market shows the characteristics of a free market economy such that rental volatility varies from one region to the other across the United Kingdom. Given the important differences that exist between the housing and commercial property markets; especially in relation to the separation of use and ownership and the role of developers, the scope of the report would be limited to the commercial property market. The report establishes that there a number of micro and macro economic factors strongly account for rental volatility in the non-residential property market. These factors ranged from changes in the demand and supply for commercial property, the level of industrialization, interest rates, and government policy on economic and regional development. Introduction This report about rental volatility in the commercial property market is divided into four sections. The first section would look at the cyclical movements in rental volatility, resulting from the interaction of the micro and macro economics factors, as well as government policy on economic and regional development. The second section would make an investigative view on why this rental volatility has witnessed marked variations on a regional basis. Then the third section would give an outline of the extent to which government planning has influenced rental volatility in the commercial property market. Subsequently, the role of government and council reforms in determining the frequency and extent of rental volatility would be examined in the fourth section. Finally, there would be a section for conclusion on the trend of rental volatility in the commercial property market. Rental Volatility Cycles Ball et al (2002) hold that the commercial property markets consist of thousands of parcels of land and buildings. They believe that individual properties have distinct attributes such that the concept of product differentiation associated with consumer products can be applied here. This makes it difficult for a property to be a perfect substitute of the other. In the context of property economics, Jackson and Watkins (2007) opine that rent refers to the price mechanism that balances the demand and supply property to achieve equilibrium in four interlinked markets: the user market, the development market, the financial asset market, and the land market. The volatility cycle would now be viewed in the above ways. They further argue that in the user market, the payments a firm makes in order to use a given amount of commercial property for a particular time period is called building rent. It acts as the key signal to agents active in the market, and, through its rises and falls, clears these markets by equating the quantity supplied with that demanded. According to Ball et al (2002), rent volatility in the property market can best be explained using the DiPasquale and Wheaton framework. The equation, according to Dobson and Goddard (1992), maintains that property rents are a function of industrial investment in leasing or buying or new property, the floor space and geographical location. This means that the higher the rate of industrial investment, the higher would be the demand for commercial property. This would certainly drive up the price of property without any certainty in the supply. A look at the demand and supply curve would help clarify this scenario. Market forces on the demand and supply of property Price D1 D2 S P2 P1 Q1 Q2 Property demanded/supplied For instance, the above diagram shows a typical situation in an increase in the demand for property. In the diagram, there is equilibrium in the demand/supply of property with the price, denoted by Q1 and P1. However when other micro/macro economic factors interplay to make companies to invest in property, the demand for property automatically shifts from D1 to D2. When this is not matched by an increase in supply by property developers, the price of property jumps from P1 to P2. However, the above is a stark irony to the fact that compared to the US, yields to property developers from rents have been decreasing, as shown in appendix 4. Perhaps, this is because of the continuously falling prices. In the financial asset market, the price of a commercial building is the current estimate of its value. Virtually all commercial properties are bought and sold on the basis of a professional valuer's estimate of their current worth, rather than simply on the basis of a direct trade between buyer and seller. This therefore means rental volatility is a function of time and the subjective valuation/appreciation of property by developers, while taking into consideration the net present value of money. For instance, an ABN Amro report1 maintains that The UK looks more vulnerable to a housing correction than the US. It argues that overvaluation (subjective) of property in the UK has jumped to a whooping 50%, compared with just 25% in the US. This suggests prices would remain volatile, in view of falling further and maintain equilibrium. As can be seen from the diagram in the appendix, a single property in Basildon advertised as a shop premises witnessed intense volatility in its price and saw the value plummeted by 38% from 215,000 to 132,000. As per the land and development market, price volatility in the commercial property market can be seen in the fluctuations in the price of acquiring land, as well as the extra cost of developing property. These are costs that are transferred from the developers to the users of property. This gives rise to the seeing of two scenarios here. Everything being constant and developers acting fairly, an increase in the price of acquiring land or the development of property would be reflected in an increase in the price of the commercial property delivered to users. In the same vein, a relatively lower land acquisition and property development cost should be translated into a lower property price delivered. The peculiarity of this property price volatility in the UK has been the region-to-region variation. Regional Variation The most intriguing factor that has accounted for price volatility in the commercial property market is the location of the property. The role of regional location in determining property price volatility was first developed as the first treatment of spatial economics, connecting it with the theory of rent. One of the most significant contribution to understanding this phenomenon is the work of Von Thunen, who developed the equation R= Y (p-c) - Yfm, where R is the land rent (or property rent), Y is the yield per unit of floor space of the property, c is the production expense per unit of commodity on the part of the user of the property, p is the price per unit of the commodity, F is the freight rate, and m is the distance from the property to the market. In view of the above equation, one can conveniently explain that price volatility in the UK commercial property market is a function of how close the property is to a company's market or source of raw materials. As an example, should a company be considering the opening of a warehouse for its final products, it would obviously want to do so close to its market. This makes the company in question constrained to bidding the highest possible to acquire the property. For a region like London that provides a market for both consumer products and financial services, it therefore means acquiring property there would come at a relatively higher price compared to a region like New Castle. This has therefore given rise to a sectoral and geographical distribution of the commercial property market across the UK as shown in appendix 2 (diagram adapted from Ball and Lizieri). On the other hand, regional variation in price volatility can be the result of the level of industrialization and business development in the various regions across the UK. As Ball and Lizieri (2002) observed, the general influences affecting the location of offices are similar to those of manufacturing industry, although the weightings differ. They include factor input costs (such as labour and rent), transport and communication costs, agglomeration economies and the quality of life in specific urban areas. The locational decision is a two-stage process. A firm must decide on its 'regional' location. Then, for most enterprises, urban areas offer advantages, so the firm has to think about the best urban location-taking into account supply constraints as well as the net benefits of specific urban districts. The cumulative effects of these are that companies would competitively bid for property in a region that provides the best positive attributes for industrial location. In effect, such scramble would drive up property prices in regions that have the best combination of industrial location factors, while prices would remain constant (or even drop) in regions that do not offer a good combination of industrial location attributes. While price volatility has been different between one region and the other, an external force has been playing to further impact on this volatility. This force is coming in the system of planning from the government, through its policies of land acquisition and the development of residential and commercial property. This report would now still maintain its focus on the commercial property market to see what state planning has to do with the price volatility in the UK commercial property market. Planning Planning, in the context of project management property economics, refers to the mapping out of a system of procedures to be followed by stakeholders in the market. Jackson and Watkins (2007) maintain that during the last decade retail geographers have provided compelling evidence that changes in government policy have influenced the performance of the property market. This influence has on the most part being on making the price volatile for the commercial property market. Moreso, Bramley (1998) observed that planning policy intervention has a more pronounced impact on the investor market than on the user market. This has made it such that in the scenario of state planning on the supply of commercial property, it is the developers of property who control the market and determine the price. For instance, recent government regulations on building environmental-friendly (green property) mean that property developers are tied to taking different investment procedures in making commercial property available to users in the market. And so, the issue of planning is basically to make the supply of commercial property inelastic for a period of time (Ellison, 1998), while property developers take alternative courses of action in making their investments. in view of this, Ellison further contends that the demand and supply diagram that follows can help shed light on how the process of planning can trigger changes and price volatility in the property market. Effect of planning on the supply of property Price D2 S2 S1 P2 P1 Q1 Property demanded/supplied As the diagram shows, without state planning and intervention equilibrium is maintained over the demand for and the supply of commercial property at a price labeled as P1. The demand and supply indicators at this point of equilibrium are denoted by D1 and S1 respectively. With the coming of planning and state intervention, and following an increase in demand from D1 to D2, the supply of property by developers is rendered inelastic and consequently shifts from S1 to S2. The result is a skip in price from P1 to P2. This means that property users are left with the same amount of property in the market before the advent of state planning, and forced to pay a higher price P2. On the other hand, as property developers grow conscious of the time value of money (DiPasquale and Wheaton, 1996), state planning in the UK may mean that property developers decide to invest abroad. This incentive to invest in property abroad is obviously fuelled by the fact that other countries my not have a planning system in place to drastically halt operations in the property market. Therefore, as planning and state intervention has been strong in the commercial property market, UK property developers have been increasing their investment abroad as shown in appendix 3. With a resultant decrease in the supply of commercial property, prices are bound to increase. Then as the self price mechanism steps it, prices would instead fall again, as previously seen in the case in appendix 1. Conclusion So far, the cycle of price volatility in the UK commercial market has been seen and a number of factors are seen to account for this. However, it should be noted that factors beyond the UK borders or in other European property markets (Wootton, 1996) too have a very strategic and invisible role in accounting for this price volatility. In the light of this, a report by the property investment arm of ABN Amro Bank suggests that any good study of the UK property market should be made side by side that of another country or economy such as shown in appendix 5. When such an analysis is made, then a report on price volatility in the commercial property market can be seen to be objective, given that no country or economy today operates in isolation. To buttress this point, it would be worthwhile noting the results of findings from estate agents and property developers2 that the Welsh property market is not experiencing the same property market downturn as the rest of the UK. According to Mark Jones, broker owner of Remax Wales, Cheshire & Merseyside, explained that while the UK as a whole is expected to see house price growth slow in the year 2007, Wales was yet to see any sign of a cool down. This, he further explained made the Welsh property market to be almost five years behind the London and England scene. In view of the above arguments therefore, price volatility in the commercial property market is the result of not only demand and supply factors in the home country under consideration. It also depends on government policies on planning as well as market forces and investment prospects in foreign property markets. Appendix 1 A rundown of the drop in the price of commercial property market3 30 Jul 2007 First day listed (price 215,000) 30 Jul 2007 Price changed from 174,995 to 180,000 30 Jul 2007 Price changed from 159,950 to 174,995 30 Jul 2007 Price changed from 136,500 to 144,995 30 Jul 2007 Price changed from 158,500 to 159,950 30 Jul 2007 Price changed from 144,995 to 158,500 01 Aug 2007 Price changed from 174,995 to 180,000 01 Aug 2007 Price changed from 159,950 to 174,995 01 Aug 2007 Price changed from 158,500 to 159,950 01 Aug 2007 Price changed from 144,995 to 158,500 01 Aug 2007 Price changed from 136,500 to 144,995 03 Aug 2007 Price changed from 174,995 to 180,000 03 Aug 2007 Price changed from 159,950 to 174,995 03 Aug 2007 Price changed from 144,995 to 158,500 03 Aug 2007 Price changed from 158,500 to 159,950 03 Aug 2007 Price changed from 136,500 to 144,995 06 Aug 2007 Price changed from 136,500 to 158,500 06 Aug 2007 Price changed from 159,950 to 174,995 06 Aug 2007 Price changed from 158,500 to 159,950 06 Aug 2007 Price changed from 174,995 to 180,000 08 Aug 2007 Price changed from 158,500 to 159,950 08 Aug 2007 Price changed from 136,500 to 158,500 08 Aug 2007 Price changed from 174,995 to 180,000 08 Aug 2007 Price changed from 159,950 to 174,995 10 Aug 2007 Price changed from 174,995 to 180,000 10 Aug 2007 Price changed from 159,950 to 174,995 10 Aug 2007 Price changed from 136,500 to 158,500 10 Aug 2007 Price changed from 158,500 to 159,950 13 Aug 2007 Price changed from 174,995 to 180,000 13 Aug 2007 Price changed from 159,950 to 174,995 13 Aug 2007 Price changed from 136,500 to 158,500 13 Aug 2007 Price changed from 158,500 to 159,950 15 Aug 2007 Price changed from 136,500 to 158,500 15 Aug 2007 Price changed from 159,950 to 174,995 15 Aug 2007 Price changed from 158,500 to 159,950 15 Aug 2007 Price changed from 174,995 to 180,000 17 Aug 2007 Price changed from 158,500 to 159,950 17 Aug 2007 Price changed from 159,950 to 174,995 17 Aug 2007 Price changed from 136,500 to 158,500 20 Aug 2007 Price changed from 159,950 to 174,995 20 Aug 2007 Price changed from 158,500 to 159,950 20 Aug 2007 Price changed from 136,500 to 158,500 23 Aug 2007 Price changed from 136,500 to 158,500 23 Aug 2007 Price changed from 159,950 to 174,995 23 Aug 2007 Price changed from 158,500 to 159,950 24 Aug 2007 Price changed from 158,500 to 159,950 24 Aug 2007 Price changed from 159,950 to 174,995 24 Aug 2007 Price changed from 136,500 to 158,500 31 Aug 2007 Price changed from 159,950 to 174,995 31 Aug 2007 Price changed from 136,500 to 158,500 31 Aug 2007 Price changed from 158,500 to 159,950 04 Sep 2007 Price changed from 159,950 to 174,995 04 Sep 2007 Price changed from 158,500 to 159,950 04 Sep 2007 Price changed from 136,500 to 158,500 06 Sep 2007 Price changed from 159,950 to 174,995 06 Sep 2007 Price changed from 136,500 to 158,500 06 Sep 2007 Price changed from 158,500 to 159,950 07 Sep 2007 Price changed from 158,500 to 159,950 07 Sep 2007 Price changed from 159,950 to 174,995 10 Sep 2007 Price changed from 159,950 to 174,995 10 Sep 2007 Price changed from 158,500 to 159,950 12 Sep 2007 Price changed from 158,500 to 159,950 12 Sep 2007 Price changed from 159,950 to 174,995 14 Sep 2007 Price changed from 159,950 to 174,995 14 Sep 2007 Price changed from 158,500 to 159,950 17 Sep 2007 Price changed from 159,950 to 174,995 17 Sep 2007 Price changed from 158,500 to 159,950 20 Sep 2007 Price changed from 159,950 to 174,995 20 Sep 2007 Price changed from 158,500 to 159,950 22 Sep 2007 Price changed from 158,500 to 159,950 22 Sep 2007 Price changed from 159,950 to 174,995 25 Sep 2007 Price changed from 158,500 to 159,950 27 Sep 2007 Price changed from 158,500 to 159,950 29 Sep 2007 Price changed from 159,950 to 164,950 29 Sep 2007 Price changed from 158,500 to 159,950 01 Oct 2007 Price changed from 159,950 to 164,950 04 Oct 2007 Price changed from 159,950 to 164,950 06 Oct 2007 Price changed from 159,950 to 164,950 09 Oct 2007 Price changed from 159,950 to 164,950 11 Oct 2007 Price changed from 159,950 to 164,950 12 Oct 2007 Price changed from 159,950 to 164,950 16 Oct 2007 Price changed from 159,950 to 164,950 10 Nov 2007 Price changed from 224,995 to 239,995 15 Nov 2007 Price changed from 224,995 to 162,950 17 Nov 2007 Price changed from 224,995 to 162,950 20 Nov 2007 Price changed from 224,995 to 162,950 21 Nov 2007 Price changed from 224,995 to 162,950 29 Nov 2007 Price changed from 215,000 to 162,950 29 Nov 2007 Price changed from 215,000 to 162,950 04 Dec 2007 Price changed from 215,000 to 162,950 21 Jan 2008 Price changed from 162,950 to 132,000 Appendix 2 Breakdown of the sectoral and geographical distribution of the UK commercial property market4. Appendix 3 UK investment in overseas commercial property5 Source: ABN Amro Commercial Property Report Appendix 4 Rental Yields in the US and UK6 Source: ABN Amro Commercial Property Report Appendix 5 International property demand7 trend Source: ABN Amro Commercial Property Report References Ball, M., Lizieri, C., and McGregor, B.D. (2002). The Economics of Commercial Property Markets. Bramley, G. 1998, Measuring Planning: Indicators of Planning Restraint and its Impact on Housing Land Supply'' Environment and Planning Bulletin: Planning and Design. Vol. 25, pp. 31-57 Catherine Jackson, C. and Watkins, C. (2007). Supply-side policies and retail property market performance. DiPasquale, D. and Wheaton, W. C. (1996) Urban Economics and Real Estate Markets (Prentice-Hall, Englewood Cliffs, NJ). Dobson, S. and Goddard, J. (1992). The Determinants of Commercial Property Prices and Rents'' Bulletin of Economic Research. Vol.44, pp.301-321. Ellison, L. (1998), Supply-side Policies and the UK Commercial Property Markets: 1979 to1990''. Journal of Property Research. Vol.15, pp.15-33. Henneberry, J., McGough, T. and Mouzakis, F. (2005) Estimating the Impact of Planning on Commercial Property Markets'', in Planning, Public Policy and Property Markets. Eds Adams, D., Watkins, C., White, M. (Blackwell, Oxford) pp 105-126 Wootton, J. L. (1996). Retail Planning Policies: Their Impact on European Retail Property Markets JLW, London. www.abnamroresearch.com www.estateangels.co.uk www.propertysnake.com Read More