Construction Cycles And Stock Markets: An International Empirical Investigation

In this paper we analyse the influence of expectations on the timing of office development in Amsterdam, Hong Kong and Singapore over a 25 year period. The forces that influence office development have been subject of a long history of empirical studies. Statistical work by Rosen (1984), Wheaton (1987), Kling and McCue (1987) and others identified factors such as gross national product, employment, vacancy rates and nominal interest rates to drive office development. These models are capable of explaining office development to a large extend, but despite the insights gained, overbuilding is still not a condition from the past. There are still undiscovered factors at work and as such overbuilding still remains somewhat of a mystery. The previously stated empirical work in the field of office construction to date has been confined to current or backward looking economic variables which influence the office development cycle. We test for the influence of forward looking expectations by decomposing stock returns by means of the Campbell-Shiller log-linear present value framework and hypothesise that expectations about future real demand (cash flow news) and future discount rates (financial news) influence the timing decision of developers. We use stock returns as a proxy for market expectations based on the theory that stock prices reflect the discounted value of all cash flows and the large number of investors and analysts congregating on the stock market making expectations expressed on stock markets a proxy for overall expectations. With the Campbell-Shiller vector autoregression (VAR) framework methodology we add forward looking variables to the existing models of office construction. The rationale for incorporating a forward looking variable into office construction models is formed by the fact that real estate is a long-lived asset and as such, expectations about the future should play a role in the construction decision. We propose that the rationale for constructing an asset, which lasts decades, is not solely based upon last yearís economic growth or this yearís demand and we use forward looking measures to test this hypothesis. After a discussion of existing office construction cycle models and the different office and stock markets incorporated in our international study we empirically test the link between cash flow and discount rate news on one hand and office construction timing on the other. Stock return and office market data over the period 1981-2004 allow us to incorporate several economic cycles and periods of vast stock market volatility in the analysis. With this analysis we introduce a new viewpoint to explain the flow of new office construction and as such expect to contribute to understanding office construction mechanics and add a piece to the overbuilding puzzle.