Thermodynamics and London office property cycles

Publication Date03 Apr 2018
AuthorMoshe Szweizer
SubjectProperty management & built environment,Real estate & property,Property valuation & finance
Thermodynamics and London
office property cycles
Moshe Szweizer
Department of Research, CBRE Group Inc., Auckland, New Zealand
Purpose The purpose of this paper is to extend the studies of commercial property cycles by providing a
cross-field approach to property markets modelling.
Design/methodology/approach The approach allows for the incorporation of market shocks into the
property cycle model as fundamental building blocks; assessment of overall market absorption generated
through cyclic activity; and timing estimation of major market events. An ideal model is first constructed,
which relies on an observation that a property cycle consists of four distinctive phases. These are
described formally through appropriate formulae. Subsequently, it is observed that an analogous cyclic
behaviour is described in physics as the Otto cycle. The formulae derived in physics for the Otto cycle are now
redefined so to be applicable to the property market.
Findings The model has been applied to the London office market, both to the historic and the current data sets.
This allowed for the comparison of model predicted absorption and vacancies with the historic records, providing
for assessment of the model accuracy. The model predicted that absorption was also compared with historic
space supply allowing for estimation of oversupply and resultant vacancies. London office submarkets were
analysed and compared to each other, allowing for estimation of their relative attractiveness as perceived by tenants
and developers.
Practical implications The model may be used to estimate cycle generated absorption; therefore, over
and under supply of space due to developersactivity may be assessed. It is also possible to use the model to
assess the timing of future market peaks and troughs.
Originality/value This is the first research directly applying the methodology developed in physics to
commercial property cycles.
Keywords Absorption, Property cycles, Commercial vacancy, Oversupply of space, Property cycle duration,
Property market modelling
Paper type Research paper
1. Introduction
The paper presents a top-down model of property cycles. When we construct the model,
we posit that the market expands when it is supplied with momentum from the financial
sector and general economic growth. This energy is turned into demand for space which in
turn reduces vacancy and increases rents. We also assume that the amount of energy
supplied is finite and becomes exhausted at some later stage. When this tipping point is
reached, the market cannot grow any longer and corrects.
The model allows for estimation of absorption based on the market conditions during the
initial stages of a cycle. Moreover, by comparing model predicted historic vacancies, with those
factually occurring, it is possible to find factors contributing to the changes in demand for space.
Area of study
Four main submarkets of London: The City, Midtown, Docklands and the West End are
analysed. For each of the submarkets, the current cycle and two historic cycles are studied.
For each of the cycle/precinct combinations supply as supported by general economic
growth is modelled and compared with the actual. Subsequently, the vacancies resulting
from oversupply of space are found.
The data
The space, vacancy, rents and yields analysis is based on a data series provided by CBRE.
The inflation data are from the Office for National Statistics.
Journal of Property Investment &
Vol. 36 No. 3, 2018
pp. 273-294
© Emerald PublishingLimited
DOI 10.1108/JPIF-09-2017-0061
Received 12 September 2017
Revised 22 November 2017
17 January 2018
Accepted 31 January 2018
The current issue and full text archive of this journal is available on Emerald Insight at:
London office
property cycles
In the following pages, a market model, based on the thermodynamic Otto cycle, is
presented. Readers who would like to follow the details of the calculations can refer to the
Appendix where they are laid out in full. In the body of the paper, we refer to Otto or just
the modelas the identifiers of predictions made by the model.
2. Literature review
When one looks at the structural models, an assumption is made that the real
effective rent is inversely proportional to the changes in vacancy. When a polynomial is
used to model rents, the vacancy is taken with a negative sign to account for this.
Otherwise, a product of rents and vacancies is assumed to be a function of other variables.
This again, provides for an inverse relationship between vacancy and rents. Smith (1974)
provided an empirical support for the inverse proportionality relationship between rents
and vacancy.
Hendershott et al. (1999) reiterate a commonly accepted reason for market peak as being
first due to, rapidly increasing rents and capital values, followed by an oversupply of space,
which in turn results in high vacancy and falling prices. The oversupply of pace is expected
to be concurrent with the onset of recession. Employment growth and changes in real
interest rates are listed as main exogenous variables and causes of market shocks.
The model is presented in two forms. The first excludes exogenous variables leading to
vacancies and rents asymptotically settling at their respective natural levels. The second
version includes employment and interest rates as exogenously influencing factors resulting
in the cyclic behaviour of the model.
The model provides seven equations linking occupational, development and
investment markets. Equations cover supply, demand, real effective rents in
equilibrium, rent change which depends on vacancy and rent distortions from their
respective equilibria, completions which also depend on vacancy and rental distortions
from equilibrium. Absorption is a function of employment and rent. Rents are expected to
have an inverse relationship to vacancy which is achieved through a polynomial with a
negative coefficient in front of vacancy. Furthermore, two exogenous variables, real
interest rates and employment growth are used to simulate their effect on the cyclic
behaviour of real rents and vacancy.
Hendershott et al. (2000) present an improved model with rental changes depending on
vacancy rate and rental deviation from natural or equilibrium levels. The equilibrium rent is
assumed to be time dependant, although it is expected that the equilibrium varies slowly,
and the change is associated with the long-term real default-free rate which is taken to be the
long-term treasury rate. Demand is modelled as rent and employment dependant, being a
product of the two, with each factor raised to an exponent corresponding to its elasticity.
Rent is expressed as a function of employment, occupancy and supply, all at logarithmic
level allowing for the application of respective elasticities to each. The rental equation is
modified through a standard error correction term, providing for a better performance when
compared to vacancy gap models.
Wheaton et al. (1997) build a structural model consisting of equations for demand, supply
and rental changes. Absorption is driven by rents, office space and space per office worker.
The rent equation depends on vacancy, absorption and occupied space. The construction
(supply) equation depends on rents, vacancy, interest rate and replacement costs. All of
them are linear polynomials. The endogenous variables are absorption, rent, construction
orders, vacancy, total stock and occupied stock. The exogenous variables are interest rates,
office employment and real construction costs. Market shocks are modelled through sudden
changes in the exogenous variables and the model, while being generally stable, generates
echoeffect in the form of mini-cycles following the main cyclic event.

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