Abstract/Summary

Expectations of future market conditions are generally acknowledged to be crucial for the development decision and hence for shaping the built environment. This empirical study of the Central London office market from 1987 to 2009 tests for evidence of adaptive and naive expectations. Applying VAR models and a recursive OLS regression with one-step forecasts, we find evidence of adaptive and naïve, rather than rational expectations of developers. Although the magnitude of the errors and the length of time lags vary over time and development cycles, the results confirm that developers’ decisions are explained to a large extent by contemporaneous and past conditions in both London submarkets. The corollary of this finding is that 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. More generally, the results of this study suggest that real estate cycles are largely generated endogenously rather than being the result of unexpected exogenous shocks.