The slump at present occurring in property values has been described as the low point in the current property cycle. What is meant by the property cycle in this context?
Interest in the concept of a property cycle has been revitalised by the recent boom and collapse in the market. The RICS recently commissioned a study of “Economic Cycles and Property Cycles”, undertaken jointly by Investment Property Databank and the University of Aberdeen.
It was interesting that the authors dedicate the report to “all those who saw their jobs destroyed, or their livelihoods blighted, by the property crash of the early 1990s”[1] – clearly highlighting the drastic effect of property cycles on the industry – but it should not be forgotten that the property cycle can have wider implications for the economy as a whole. This most recent downturn has emphasised the relationship between the property cycle and the financial stability of the national economy.
J Coakley, writing on the integration of the property market with the financial sector, concludes that:
the threat posed by the current property crisis to the financial system is relatively more serious than it was in the 1970s, as the main players are the larger banks rather than small secondary banks. This reflects the increased integration of the property and financial markets. One of the worrying aspects of the current crisis is that a recovery in real-estate values seems remote even in mid-1993, and this seems likely to prolong the recession as consumer expenditure remains in a depressed state. The possibility of the property crisis spilling over to the financial system more generally – the so-called contagion effect – is thereby sustained.[2]
And it is not just a phenomenon being seen in the UK. All developed countries have a property cycle. Steven Grenadier, writing in Journal of Real Estate Finance and Economics, notes:
the currently distressed state of the US real market is deservedly a matter of great concern. However, the appearance of abnormally high vacancy rates combined with plummeting market values is by no means a new phenomenon.[3]
What may, however, be a more recent de velopment is the emergence of a global cycle. Professor Mervyn Lewis, of the University of Nottingham, [4] shows a very close correlation between changes in nominal rental values for offices in Boston, London, Madrid, Melbourne, Milan, Paris, Stockholm and Zurich.
This suggests that global forces are at work influencing the property cycle, the probability being that this is in some way related to the globalisation of finance in recent years.
Definitions
The discussion so far has concentrated on the importance of property cycles to the property industry, the national economy and the global economy. However, it is clearly necessary to define what is meant by the property cycle and to consider whether there is one cycle or a number of cycles.
However, the RICS brief for the research project on property cycles left the definition of the cycle open; indeed, the report defined the property cycle in a new and unique way.
A useful starting point is to consider the traditional economic cycles, the classic treatment of these 9being by Schumpeter (1939)[5] . Students may find a more recent review by Sherman (1991)[6] useful.
Essentially a business cycle describes fluctuations in economic activity which, historical analysis will show, proceeds in an irregular path with upward spurts followed by pauses and even relapses. The word cycle suggests that there is some regular pattern to these oscillations of good and bad times. Figure 1 shows a simplified version of the traditional business cycle.
Depression…….A depression is characterised by heavy unemployment, a low level of consumer demand and surplus productive capacity plus low business confidence.
Recovery…….Employment, income and consumer spending all begin to in crease; investment also increases and business expectation become more favourable.
Boom……..As the recovery continues, in dustries become fully utilised and bottlenecks begin to appear – leading to price increases.
Recession…….Once a recession sets in it tends to gather its own momentum; consumption, employment and investment all begin to fall and business expectations become negative.
More than one cycle?
It is important to appreciate that no two cycles are the same. The extent and depth vary considerably; in some the recession phase is short and therefore the resulting effect on the economy is mild, whereas in others a full-scale period of depression sets in, as in the 1930s. The upturns show a similar range, some having a minimal outcome on inflation, others leading to severe inflation. Students will find it a useful exercise to apply each stage of the business cycle to recent events in the property market.
Richard Barras [7] has taken the four cycles identified in economic literature and linked them to the property cycle.
These are:
- The classical business cycle of four to five years’ duration acting on all aspects of economic activity and operating on the property market through occupier demand.
- Long cycles of nine to 10 years’ duration which are generated by the exceptionally long production lags involved in property development, creating a tendency for supply to outstrip demand in every other business cycle.
- Long swings with a period of up to 20 years are associated with major building booms; these may occur in every other long cycle of development; they are typically speculative in nature and of a scale sufficient to generate distinctive new phases of urban development.
- Long waves lasting up to 50 years have been proposed to explain alternating phases of high and low growth in the industrialised world economy, with each new wave being initiated by the adoption of a universal new technology such as steam power or electronics.
It should be noted that there is considerable controversy about the existence of longer-period cycles.
To see how the property cycle might operate, it is useful to consider the major building booms of the early 1970s and late 1980s, noting the particular influence that they have had on the property market of the past 25 years.
A conceptual model of how the building cycle may work is proposed by Barras and is illustrated in Figure 2.
The model shows how a building boom is generated by the interaction of the business cycle in the real economy, the credit cycle in the money economy and the long cycle of development in the property market.
A strong business cycle upturn coinciding with a shortage of available property is the starting point. This causes rents and capital values to increase, which in turn encourages new development; if the economy accompanies this upturn a full-blown boom may occur, leading to further speculative developments financed by an expansion of bank credit. A major building boom results. However, because of the nature of the construction in dustry, supply is, initially, little affected and rents continue to rise. Invariably, when the new buildings come into the market, the business cycle has moved into its downswing, causing a falling demand for property. Thus, just at the point when supply is increased, demand is falling; consequently there is a dive in rents and hence values. The process tends to feed itself, leading to a property slump characterised by depressed values, high levels of vacancy and widespread bankruptcies in the property sector, a picture all too familiar to members of the property professions.
Barras suggests that the effects of such a slump may well last through the next business cycle; the surplus property means that there is no shortage of space in the next upturn. Furthermore, when the next long cycle of development does pick up, it will tend to be demand-driven with minimal speculative development because the banking system is still grappling with the debt problems of the latest boom. Thus, another long cycle will need to proceed before the necessary conditions will be in place for the onset of another speculative boom. Barras suggests that herein lies the tendency for major property booms to occur in every second long cycle of development, and in every fourth short cycle of business activity.
It is important to appreciate that Barras is suggesting no more than a tendency which could well be disrupted by a wide range of political and economic events.
In its report, the RICS, as already noted above, has developed its own and very specific definition of the property cycle, separating it from the more general business cycle which we have just considered:
Property cycles are recurrent but irregular fluctuations in the rate of all property total returns, which are also apparent in many other indicators of property activity, but with varying leads and lags against the all-property cycle.
The definition adopted follows from the definition of property used – which was commercial investment property with the adoption of the rate of return as the most comprehensive indicator of investment property performance.
Several distinct components of property industry occupier markets make up the cycle – the development industry and the investment markets.
The RICS report concludes:
- The UK property industry shows a recurrent cycle which meets the qualitative definition conventionally applied to economic cycles, but cannot be described definitively by statistical techniques.
- The property cycle is the compounded result of cyclical influences from the wider economy, which are coupled with cyclical tendencies inherent to property markets.
- The critical linkage between property and economic cycles can, in the main, be captured in simple models which are intuitively plausible and statistically sound.
As in economic cycles in general, the property cycle consists of recurrent upswings and downswings which vary in length, scale and composition.
This review of the literature would suggest that there is a range of property cycles depending on the particular aspects of property con sidered, and activity in the property sector does follow a recurrent pattern of boom and bust. A future article will look at the most recent boom and subsequent collapse in the property market and consider the implications for the industry.
References
[1] Royal Institution of Chartered Surveyors (1994) Economic Cycles and Property Cycles RlCS, London.
[2] Coakley J (1994) “The Integration of Property and Financial Markets” Environment and Planning 1994 Vol 26.
[3] Grenadier S (1995) “The Persistence of Real Estate Cycles” Journal of Real Estate Finance and Economics Vol 10.
[4] Lewis M K (1994) Banking on Real Estate Discussion Papers in Economics No 9416, University of Nottingham.
[5] Schumpeter J A (1939) Business Cycles McGraw-Hill, New York
[6] Sherman H J (1991) The Business Cycle Princeton University Press, Princeton NJ
[7] Barras R (1994) “Property and the Economic Cycle: Building Cycles Revisited” Journal of Property Research Vol 11.
