Systematic Valuation Errors and Property Cycles: A Clinical Study of the Sydney Office Market

Abstract

The cyclical variation in office construction, vacancies, rents and values over the last decade has been enormous throughout the world. Numerous hypotheses have been advanced for this enormity, including prolifigate lenders, egomaniacal developers, and even rational behavior in the face of uncertainly and long gestation periods. Our analysis of the Sydney office market suggests a major role for the failure of investors to understand the workings of property markets. Given the incentives of developers to build when value rises substantially above replacement cost and not to build when value is low relative to replacement cost, the property market has to be mean reverting. That is, when times are really good (low vacancy rates and high real rents), they can't continue, and the same is true when markets are really bad. Because Sydney investors did not incorporate this implied mean reversion into their forecasts of future cash flows, they over valued properties when vacancy rates were low and rents were high, thereby triggering excessive construction and vacancies. Of course, valuations obtained by simply capping current cash flows with a normal cap rate will not incorporate full mean reversion.