ABOUT
The Commercial property market model
Models which purport to explain or represent economic reality may be mathematical, physical or diagrammatic. Each has its merits. Mathematical models receive the greatest attention from economists because of their ability to represent the relative importance of a multitude of variables.
Yet there is also a place for the diagrammatic model in providing a comprehensive portrayal and in explaining basic relationships and forces at work.
All models are wrong – some models are useful and the commercial property market model is no exception.
This is a schematic diagram that is intended to illustrate the operation of the property market and to reflect the difference forces that influence the market, the demand and supply and the prices of properties. This is what the model we use for this module represents.
The Schematic Model
The schematic model presented here is necessarily a simplification of the real world.
It is representative of a local market in investment quality property of one of the main commercial types (offices, shops, or industrials).
The model represents a market in which the ownership and occupation of property is separate, (as distinct from the market in owner occupied property).
The property market is not a single entity. The commercial property market is a ubiquitous conglomeration of inter-related sub-markets, subdivided according to function (letting, investment, development), use type, location, quality, etc.
While necessarily being a simplification of reality, it represents the principal internal dynamics of the property market and its relationship with the stock of property, and the external economic and regulatory context.
The diagram explained
The stock of property is represented by the inner core of the circle (pink).
The property market is represented by the outer segment of the inner core (in yellow).
The property market is surrounded by the overall economy and regulatory context, having local, national and international dimensions represented by concentric rings around the market.
The market is subdivided into the letting, investment and development sectors.
The arrow flows
Arrows represent the flow of properties between sectors within the market, and also the interflow of existing properties entering the market from stock (for re-let, re-sale or redevelopment), and both new and existing properties leaving the market to join stock (after letting or sale).
The inter-sectoral (intra-market) influence of property values on demand in the investment and development sectors is illustrated by the yellow-brown arrows linking the lettings sector through rental values and the development sectors through capital values and yields.
The external influences on each sector which derive from the economy or regulatory system are represented by curved force lines emanating from the local, national and international segments of the surrounding economy.
Market Forces and Flows
The interaction of the three market sectors is represented in the model by a clockwise rotational movement.
It is useful to distinguish between the dynamics of market forces in the yellow ring and the flow of properties within the yellow ring (the yellow arrows) and between the market ring and the inner core.
An analysis of market forces starts naturally in the letting sector where occupation demand emanating from the outside economy interacts with the supply of vacant property to let (new floorspace created in the development sector and existing floorspace entering the market from stock) to determine the level and growth of rental values.
Rental values and rental growth expectations influence investment demand from the outside economy which, interacting with the supply of investments for sale (new and existing), determine capital values and yields in the investment sector of the market.
In the development sector, the demand for sites and the level of development activity is internally (profit) driven by the relationship between capital values and development costs, the former deriving from the investment sector and the latter being primarily determined by conditions in the outside economy.
The supply of new property determined in the development sector influences rental values in the letting sector, and so on. Hence the clockwise rotation of forces shown.
Property Flows
The flow of properties also follows a clockwise rotation. The flow of new properties naturally starts in the development sector, moving clockwise to the letting sector followed by the investment sector and thence into stock. In reality, the sequence may differ.
Properties may be pre-sold or pre-let before development. Yet a sale is normally dependent on a letting and a letting is dependent on a decision to develop, so the clockwise sequence shown by the model is essentially valid.
The diagram also represents the (clockwise) flow of existing properties entering the letting or investment sectors of the market from stock, and leaving the market to rejoin stock after being re-let or re-sold.
Arcs representing sector boundaries emphasise that each sector operates with a substantial element of autonomy. For instance, activity in the letting sector will consist mostly of existing stock being re-let; neither entering from the development sector nor proceeding to the investment sector. Although inter-related, the volume of activity in each sector can vary independently of the others.
The model incorporates all three elements of supply, viz. new properties, existing investments and transfers to and from owner occupation. Transfers into or out of owner-occupation would tend to take place after redevelopment or refurbishment, and are therefore presented by the flow of properties into and out of the development sector. Transfers out of owner occupation by sale and leaseback are represented by the flow of property in and out of the investment sector.
While the market is influenced by its endogenous (internal) forces, the level of market activity is primarily driven by the external economy. Ultimately it is the ability to let property that is paramount, and in the long run property stock and the market will expand or contract according to the amount of floorspace demanded by occupiers. So, primarily, the market is driven by occupation demand, but also by investment demand from investing funds and companies, and by influence of the economy on development costs.
The diagram shows occupation demand, investment demand and development costs influencing the relevant market sectors, together with a selection of the principal variables which are responsible and their source (local, national or international segments). The relative importance of the local, regional, national or global economy will depend upon the sub-market being represented. Normally the local economy will be of dominant importance in determining occupation demand (e.g. for shops in a provincial town) but the national economy will be relatively more important in a capital city and, of course, trends in the international economy are particularly important to occupation demand for offices in the City of London.
Conditions in the national economy will tend to dominate investment demand and development costs, but the influence of the international economy is increasing with the spread of globalization.
Institutional filters
The white dotted line represents the influence of ‘institutional’ constraints on the free operation of the market is represented by dashes at the market’s interface with both property stock and the outside economy. At the interface between property stock and the development sector, this could represent the impact of planning controls.
At the occupation sector it could represent the ‘frictions’ caused by leases structures with infrequent breaks and the impact of rent review. For the investment sector, these constraints could represent high transactions costs. In each sector, these are constraints which reduce the free flow of market activity.
Summary of full model
The diagram represents a comprehensive circular flow model of the commercial property market operating with interfaces both to property stock and the outside economy. It provides both an overview and a framework for analysis. It does not articulate the full subtleties of the market’s operation nor to explicitly represent the influence of expectations on which decisions in all sectors of the market are based.