Rational expectations?. Developer behaviour and development cycles in the central London office market

Date02 March 2012
Publication Date02 March 2012
AuthorFranz Fuerst,Anna‐Maija Grandy
SubjectProperty management & built environment
Rational expectations?
Developer behaviour and development cycles
in the central London office market
Franz Fuerst
Henley Business School, School of Real Estate and Planning,
University of Reading, Reading, UK, and
Anna-Maija Grandy
DTZ, London, UK
Purpose – Expectations of future market conditions are acknowledged to be crucial for the
development decision and hence for shaping the built environment. The purpose of this paper is to
study the central London office market from 1987 to 2009 and test for evidence of rational, adaptive
and naive expectations.
Design/methodology/approach – Two parallel approaches are applied to test for either rational or
adaptive/naive expectations: vector auto-regressive (VAR) approach with Granger causality tests and
recursive OLS regression with one-step forecasts.
Findings – Applying VAR models and a recursive OLS regression with one-step forecasts, the
authors do not find evidence of adaptive and naı
¨ve expectations of developers. Although the
magnitude of the errors and the length of time lags between market signal and construction starts vary
over time and development cycles, the results confirm that developer decisions are explained, to a large
extent, by contemporaneous and historic conditions in both the City and the West End, but this is more
likely to stem from the lengthy design, financing and planning permission processes rather than
adaptive or naive expectations.
Research limitations/implications – More generally, the results of this study suggest that real
estate cycles are largely generated endogenously rather than being the result of large demand shocks
and/or irrational behaviour.
Practical implications – Developers may be able to generate excess profits by exploiting market
inefficiencies but this may be hindered in practice by the long periods necessary for planning and
construction of the asset.
Originality/value – This paper focuses the scholarly debate of real estate cycles on the role of
expectations. It is also one of very few spatially disaggregate studies of the subject matter.
Keywords United Kingdom,Office buildings, Real estate, Expectation,Development,
Rational expectations, Developmentcycles, Developer behaviour, Vectorauto-regressive models,
Recursive OLS,Office markets
Paper type Research paper
Developers’ expectations of costs, future capital values, and hence profitability, play a
crucial role in influencing their decisions to develop. Much of the previous research
done on development cycles and on developers’ expectations supports the assertion
The current issue and full text archive of this journal is available at
This research would not have been possible without the generous assistance of DTZ who
provided the data for this study. Two anonymous referees have given valuable comments that
helped improve this paper.
The central
London office
Journal of Property Investment
& Finance
Vol. 30 No. 2, 2012
pp. 159-174
qEmerald Group Publishing Limited
DOI 10.1108/14635781211206904
that present and past trends remain the dominant influence on the formulation of
developers’ profit expectations.
This paper tests empirically whether developers active in London City and London
West End between 1986 and 2009 have responded to current or past trends, or whether
evidence of rational expectations can be found in their decision making. The main
hypothesis to be tested is that developers predominantly respond to past trends when
forming their profit expectations and hence exhibit adaptive rather than rational
expectations. This paper also seeks to uncover whether different patterns of developer
behaviour can be identified between the market cycles that occurred during the period
under review and whether developers have behaved differently in the two subma rkets.
In particular, we investigate whether there is a “memory effect” among developers,
which would be reflected in post-recession development activity staying below the
levels suggested by contemporaneous market conditions for prolonged periods.
This paper is structured as follows. After a discussion of the extant literature on
expectations in the real estate literature, we describe the analytical strategy used to
detect whether developers exhibit adaptive or rational expectations. Next, the results of
the empirical analysis of the London office market are presented and interpreted.
Finally, the wider implications of these findings are explored with a view towards
developing an agenda for future research.
Rational expectations and the development decision
The cyclicality of both the real estate rental market and construction activity is one of the
best researched phenomena in real estate research. Most empirical studies use an
equilibrium framework to analyse and predict cycles. The underlying assumption is
typically that a deviation from equilibrium prices as for example reflected in prices
above replacement value will trigger a development response (Hendershott et al., 1999,
2002) albeit with a time lag. The contribution of this paper is more narrowly defined in
that it explores developers’ expectations and their impact on construction activity.
To this end, we test for the presence of three types of expectations, rational, naı
¨ve and
In contrast to most previous studies, however, we do not follow a game theoretic or
option pricing approach but instead focus on empirical evidence from aggregate office
market statistics[1]. Both naive and adaptive expectations can lead to or exacerbate
disequilibria and, in turn, depress capital values and rents. Adaptive expectations in
particular have the potential to result in aggregate supply below the equilibrium level if
developers tend to be overly pessimistic and cautious in their outlook following a
Rational expectations – an elusive concept
The commonly accepted definition of rational expectations in the real estate context
appears to be that developers use the best currently available information to form their
expectations. The “best” information may involve forecasts that need to take into
account the actions of their competitors given the current market consensus.
Expectations are assumed not to be systematically biased and hence any errors
associated with pricing are random. As a result of rational expectations, changes in asset
prices over time should be unpredictable and follow a random walk. Naive expectations
(also called myopic expectations) imply that developers expect that future market prices

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