Rational expectations?

Purpose - Expectations of future market conditions are acknowledged to be crucial for the development decision and hence for shaping the built environment. The purpose of this paper is to study the central London office market from 1987 to 2009 and test for evidence of rational, adaptive and naive expectations. Design/methodology/approach - Two parallel approaches are applied to test for either rational or adaptive/naive expectations: vector auto‐regressive (VAR) approach with Granger causality tests and recursive OLS regression with one‐step forecasts. Findings - Applying VAR models and a recursive OLS regression with one‐step forecasts, the authors do not find evidence of adaptive and naïve expectations of developers. Although the magnitude of the errors and the length of time lags between market signal and construction starts vary over time and development cycles, the results confirm that developer decisions are explained, to a large extent, by contemporaneous and historic conditions in both the City and the West End, but this is more likely to stem from the lengthy design, financing and planning permission processes rather than adaptive or naive expectations. Research limitations/implications - More generally, the results of this study suggest that real estate cycles are largely generated endogenously rather than being the result of large demand shocks and/or irrational behaviour. Practical implications - Developers may be able to generate excess profits by exploiting market inefficiencies but this may be hindered in practice by the long periods necessary for planning and construction of the asset. Originality/value - This paper focuses the scholarly debate of real estate cycles on the role of expectations. It is also one of very few spatially disaggregate studies of the subject matter.