Explaining Real Commercial Rents Using an Error Correction Model with Panel Data

This paper presents rent models for retail and office property in the United Kingdom. Panel data are used covering eleven regions for 29 years, enabling us to overcome the limitations of a relatively short time series. We use an error correction model (ECM) framework to estimate long-run equilibrium relationships and short-term dynamic corrections. The combination of panel data and an ECM is an innovative approach that is still being developed in economics. We construct new supply series that combine infrequent stock data with more frequent construction data. Separate regional models are estimated for retail and office properties. The regions are then combined into a number of panels on the basis of the income and price elasticities in the long-run and short-run models. Unlike previous studies, we find no evidence of a board north–south divide between low growth and high growth regions. Like these studies we do find a London effect: in London, demand elasticities for space with respect to both price (rent) and income are much lower in magnitude. We conclude that, while the economic drivers may vary, there is no evidence of differences in the operation of the regional property markets outside London. Elasticities for retail and office are similar. Our final models are parsimonious with single measures of economic activity and of supply and always support the use of an ECM.     

Valuing and Pricing Retail Leases with Renewal and Overage Options

We consider retail leases with landlord overages options, with tenant renewal options, with both and with neither. We illustrate how the ratio of initial expected sales to the sales threshold can be manipulated to equate the value of the landlord overage options to that of the tenant renewal option at the same initial rent. Not only are the values equal, but the cumulative distributions of potential IRRs on the two leases are nearly identical, suggesting that these leases are equally attractive to risk-averse investors and thus that the same risky discount rate can be used in valuing the leases. In contrast, the appropriate risky discount rate for the overage lease is calculated to be 75–160 basis points greater than that for the renewal lease.     

An Anatomy of Price Dynamics in Illiquid Markets: Analysis and Evidence from Local Housing Markets

This research analyzes the dynamic properties of the difference equation that arises when markets exhibit serial correlation and mean reversion. We identify the correlation and reversion parameters for which prices will overshoot equilibrium ("cycles") and/or diverge permanently from equilibrium. We then estimate the serial correlation and mean reversion coefficients from a large panel data set of 62 metro areas from 1979 to 1995 conditional on a set of economic variables that proxy for information costs, supply costs and expectations. Serial correlation is higher in metro areas with higher real incomes, population growth and real construction costs. Mean reversion is greater in large metro areas and faster growing cities with lower construction costs. The average fitted values for mean reversion and serial correlation lie in the convergent oscillatory region, but specific observations fall in both the damped and oscillatory regions and in both the convergent and divergent regions. Thus, the dynamic properties of housing markets are specific to the given time and location being considered.     

Escrow accounts and the value of mortgage servicing contracts

This paper was funded by the Education Committee of the Mortgage Bankers Association. We thank Richard Peach and Sharon Caravan of the MBA, Mark Marple and John Wiseman of MGIC, and Edward Kane of Boston College for their helpful comments, and especially Susan Busch Analytics, Inc for her keen market insights and extensive computational assistance.     

Prospective Changes in Tax Law and the Value of Depreciable Real Estate

The Economic Recovery Tax Act of 1981 significantly reduced the taxation of income-producing properties by accelerating tax depreciation on both new and, especially, existing properties. A partial reversal of the 1981 legislation appears likely. To provide some insight into the possible effects of a decrease in tax depreciation of income-producing properties, two potential tax changes are analyzed: an increase from fifteen to twenty years in the tax service lives of both new and existing properties and an increase for existing properties only. Both residential and commercial/industrial properties are considered.     

Equilibrium Models in Real Estate Research: A Survey

Equilibrium analysis is a valuable tool in real estate investment research. In this survey, I show how equilibrium models have been used to estimate the required risk premium for different classes of real estate, to explain real house prices, and to determine investment rental market adjustment and valuation (as well as to predict future rent, price, and value developments). Equilibrium analysis has also increased our understanding of differences in coupon or rental rates on loans or leases with and without various optionlike features. Because the work on leases has lagged that on loans or mortgages, application of the mortgage research methodology to leases is an especially fertile area for research.     

Mortgage Refinancing,Adverse Selection,and FHA's Streamline Program

When interest rates decline, borrowers whose houses have appreciated significantly refinance out of FHA, while those whose houses have not do not. We provide evidence of the negative impact of regular (nonstreamline) refinancing in the mid-1980s on the average quality of FHA's surviving business. We demonstrate this adverse selection both informally and econometrically. We also argue that the sharp reduction in the cost of streamline refinancing (limited documentation, no required appraisal, and so on) in FHA's streamline refinance program in 1992 likely reduced the level of adverse selection in the FHA portfolio during the 1993 to 1994 refinancing boom, and we provide quantitative estimates of the resultant reduction in claim rates. While this reduction in cost almost certainly increased the financial viability of FHA during the middle 1990s, it may not in the long run.     

Valuing ARM Rate Caps: Implications of 1970–84 Interest Rate Behavior

This paper computes how coupon rates on hypothetical default-free 1- 3- and 5-year adjustable rate mortgages with various caps and teaser rates issued during the 1970–76 period would have had to be set in order for the ARMs to have earned the market rate of return over a 7 1/2-year holding period. The 1970–84 period includes both a relatively stable interest rate experience (1970–77) and a "worse case" sharply rising rate environment (1977–84). Thus the calculations include the entire gamut of margins that lenders might need to charge for various caps in order to earn the market rate of return. What margins lenders should be charging at any point in time depends on the relative likelihood of future interest rate paths, e.g., the 1970–77 pattern versus the 1977–84 pattern. More formally, the appropriate charge depends on the slope of the yield curve and the perceived volatility of interest rates.