Understanding property market dynamics: insights from modelling the supply-side adjustment mechanism

The volatility of commercial property markets in the United Kingdom has sti mulated the development of explanatory models of 'price' determination. The se models have tended to focus on the demand-side as the driver of change., A corollary of this is that, despite the fact that construction lags are kn own to exacerbate cyclical fluctuations, the supply-side adjustment mechani sm has been subject to relatively little research effort. In this paper the authors develop a new model of commercial property markets in the United K ingdom. The model is adapted from Poterba's two-equation asset-market appro ach to modelling the housing market. The first equation is an arbitrage rel ationship where the return on property is made up of rent, as determined in the user market for property services, and the capital gain, which is depe ndent on the return on alternative assets. This can be interpreted as a 'st ock' demand equation. The second equation explains that 'flow' supply is de termined by real capital values. The long-run empirical generalisation of t he two-equation model allows the authors to estimate two key behavioural pa rameters required in explaining supply-side adjustment to market change. Fi rst, the authors interpret the coefficient on the capital value variable in the supply equation as an estimate of the long-run 'price' elasticity of s upply. Second, from the demand equation, they estimate the extent to which new supply can act as an 'automatic stabiliser' on property values. It is a rgued that although increases in demand drive up property values, new devel opment is also initiated and will, in turn, dampen down the growth in real capital values. The equations are estimated for the office, industrial, and retail sectors. Although there are no comparable estimates of supply elast icities in the real estate economics literature, the results are generally consistent with prior knowledge. Estimates of the stabiliser effect are als o plausible and, taken together, the supply-side parameters help provide in sights required in understanding property market dynamics in the last twent y-five years.