Asymmetric Properties of Office Rent Adjustment

Authors: Dirk Brounen Maarten Jennen

Publish Date: 2009/05/20

Volume: 39, Issue: 3, Pages: 336-

PDF Link

Abstract

In this paper we use an error correction model for understanding the changes in real office rents for a panel of 15 US MSA’s over the period 19902007 We find that office rents in all cities react positively to a rise in office employment and lagged rent changes while lagged deviations from equilibrium rent levels exhibit a slow and partial adjustment over time Given the nonnegativity constraint of vacancy rates we extend the basic model by examining whether rents react to positive changes in employment conditional on the vacancy rate level Our results show that office rents react significantly stronger to increases in employment when vacancy rates are below the longterm average We also repeat the analysis for clusters of cities based on similarities in rent and employment dynamics using multi dimensional scaling The cluster results confirm the overall conclusions and show that our results are not solely valid for the full panel of citiesIn this study we show that the impact of increases in demand for office space on changes in office rents depends on the disequilibrium in the demandsupply relationship If vacancy rates are below their long term average office rents react significantly stronger to positive changes in office employment when compared to periods of abundant supply Understanding rent dynamics is key to both users and investors in office markets markets that have developed into a significant proportion of the overall economy According to the US Bureau of Labor Statistics office employment accounts for over 19 of nonfarm employment This statistic represents a total of 26 million office based employees in the US by the end of 2007 For metropolitan areas like San Francisco Washington DC and New York the weight of office employment can reach peaks of close to 30Office rents are also a key input variable for construction decisions and to a large extent determine the profitability of new office investments Hence a vast strand of academic literature has developed over the years which aims at cracking the DNA code of office rents In these models rents are typically related to changes in employment office supply and vacancy levels However in almost all of these studies the authors assume that these relationships are symmetric and thus that changes in employment will have similar scale effects irrespective of the level of the vacancy rate Early studies by Wheaton 1987 already showed that vacancy rates evolve around a natural rate and that given the nonnegativity constraint vacancy rates tend to reach more distinctive peaks than troughs Therefore an increase in office employment when vacancy rates are low is likely to have a very different impact on rents than when rates are high Englund et al 2008a are the first to include these asymmetric properties into their model calibration They explicitly studied asymmetric rent adjustments depending on the level of vacancy rates when modeling Stockholm office rents for the period 1977–2002 and reported a significant increase in the explanatory power of their rent models due to this inclusionThis paper will add to the existing literature by applying an asymmetric rent adjustment model to a unique panel set of quarterly data that covers fifteen metropolitan areas MSA’s in the United States over the period 1990–2007 Measured by net rentable area of office floor space these MSA’s are the largest in the US and include Atlanta Boston Chicago Dallas Denver Detroit Houston Los Angeles Minneapolis New York Philadelphia Pittsburgh San Francisco and Washington DC Besides a panel that includes all MSA’s in one specification we also estimate the model based on different clusters We group MSA’s with multi dimensional scaling based on similarity in rent or employment dynamics and run panel data regressions based on these clusters The clustering methodology benefits from an increase in the number of observations when compared to analysis on a MSA level while keeping the ingroup homogeneity as large as possible Our results show that changes in office employment have a larger impact on office rents when vacancy rates are below their long term average This finding implies for office investments that new demand does not influence rent rates in a symmetric way but is most influential when prevailing vacancy rates are relatively low We also show that the coefficients are similar in sign and magnitude across clustersThe paper continues as follows After discussing the office market literature that is most relevant for our research we discuss the rent adjustment model that will be applied in the subsequent analysis Before discussing our results we first present our dataset and review the main attributes of the markets that are included in our sample In our results we explicitly compare results that were yielded from competitive model specifications models with and without asymmetric properties Besides discussing pooled panel results we also look at results for clusters of cities The main results will be summarized in our conclusionsWhere v t is the estimated natural vacancy rate and R t is the timevarying equilibrium real office rent This model offers a more general adjustment path for office rents with pleasing longrun properties as effective rents are specified as adjustments to gaps between both the natural and actual vacancy rates and equilibrium and actual gross rents With this equation vacancy rates do not have to overshoot following a supply shock After high vacancy rates have dragged rents significantly below equilibrium the known eventual return to equilibrium acts as a force causing real rents to rise even when the vacancy rate is still above the natural rate This model is estimated by Hendershott et al 1999 using data from the City of London for the period 19771996 and shows that the model tracks the market dynamicsInclusion of the dependent variable in Eq 5 in the rent adjustment model is possible if the variable is stationary which is equal to the independent variables being cointegrated Since we base our model on panel data we apply the Levin et al 2002 panel unit root test2According to Eq 6 office rents react to shortrun changes in causal variables and to lagged residuals of the longrun model as a reflection of market imbalances4 The immediate responses to employment shocks and changes in occupied space are given by the coefficients α1 and α2

Keywords: