Towers of Capital

Offi ce Markets & International Financial Services

Colin Lizieri

Professor of Real Estate FinanceSchool of Real Estate & PlanningHenley Business SchoolThe University of Reading

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Towers of Capital

Offi ce Markets & International Financial Services

Colin Lizieri

Professor of Real Estate FinanceSchool of Real Estate & PlanningHenley Business SchoolThe University of Reading

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This edition fi rst published 2009© 2009 Colin Lizieri

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Library of Congress Cataloging-in-Publication Data

Lizieri, Colin. Towers of capital : offi ce markets & international fi nancial services / Colin Lizieri. – 1st ed. p. cm. – (Real estate issues) Includes bibliographical references and index. ISBN 978-1-4051-5672-1 (alk. paper) 1. Offi ces. 2. Offi ce buildings. 3. Commercial real estate. 4. Financial institutions, International. 5. International fi nance. I. Title.

HD1393.55.L59 2009 332′.042–dc22 2008053120

A catalogue record for this book is available from the British Library.

Set in 10/13pt TrumpMediaeval by Newgen Imaging Systems (P) Ltd, ChennaiPrinted in Singapore

1 2009

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Books in the seriesGreenfi elds, Brownfi elds & Housing DevelopmentAdams & Watkins9780632063871

Planning, Public Policy & Property MarketsEdited by Adams, Watkins & White9781405124300

Housing & Welfare in Southern EuropeAllen, Barlow, Léal, Maloutas & Padovani9781405103077

Markets and Institutions in Real Estate & ConstructionBall9781405110990

Neighbourhood Renewal and Housing MarketsEdited by Beider9781405134101

Mortgage Markets WorldwideBen-Shahar, Leung & Ong9781405132107

The Cost of Land Use DecisionsBuitelaar9781405151238

Urban Regeneration in EuropeCouch, Fraser & Percy9780632058412

Urban SprawlCouch, Leontidou & Petschel-Held9781405151238

Real Estate & the New EconomyDixon, McAllister, Marston & Snow9781405117784

Economics & Land Use PlanningEvans9781405118613

Economics, Real Estate & the Supply of LandEvans9781405118620

Development & DevelopersGuy & Henneberry9780632058426

The Right to BuyJones & Murie9781405131971

Economics of the Mortgage MarketLeece9781405114615

Housing Economics & Public PolicyO’Sullivan & Gibb9780632064618

International Real EstateSeabrooke, Kent & How9781405103084

British HousebuildersWellings9781405149181

Mass Appraisal MethodsKauko & d’Amato9781405180979

Forthcoming

Building Cycles & Urban DevelopmentBarras9781405130011

Transforming the Private LandlordCrook & Kemp9781405184151

Housing Markets & Planning PolicyJones & Watkins9781405175203

Management of Privatised HousingGruis, Tsenkova & Nieboer9781405181884

Affordable Housing & the Property MarketMonk & Whitehead9781405147149

Property Investment & FinanceNewell & Sieracki9781405151283

Housing Stock TransferTaylor9781405170321

Real Estate Finance in the New Economic WorldTiwari & White9781405158718

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Acknowledgements

The ideas presented in Towers of Capital have evolved over a long period and have been shaped by so many conversations, debates and arguments over the years that to single out any individuals who have, wittingly or unwittingly, contributed would almost be unfair. I am very grateful to my colleagues in the School of Real Estate & Planning at Reading, for their ideas, suggestions, and for their patience – and for covering my work while I was on sabbatical completing the text. Particular thanks are due to those who read and commented on drafts of chapters: Phil Allmendinger, Michael Ball, Peter Byrne, Steve Devaney, Franz Fürst, Charles Ward, with apologies to anyone else I have omitted. The book has been shaped, improved and made possible by my many friends and colleagues in the international real estate research community. A number of individuals and fi rms have pro-vided data: many thanks to all of them both for the data and for tolerating the queries and questions about it which inevitably followed.

I should properly acknowledge three individuals who have made major contributions to the development of my ideas. First, to Geoff Dobilas from GHK International in Toronto: Geoff helped with my early attempts to sketch out the links between international fi nance and offi ce markets nearly two decades ago and has been there ever since to insult me, distract me and prick pretensions. I owe a great debt, too, to Charles Ward (University of Reading) and to Steve Satchell (University of Cambridge). Both of them over the years, as friends and as co-authors, have forced me to tighten up my ideas and to wrestle with theories and techniques from economics and fi nance. My family and friends have borne the brunt of the writing of Towers of Capital: particular thanks to my son Neil and to Ruth Jordan for keeping me on track, I am truly grateful. Most of all, though, I must acknowledge my mother, Marjorie Lizieri, who taught me to ask why and how, not what, to search for explanations and to try to understand how the world is shaped. This book is dedicated to her memory.

Colin Lizieri, ReadingAugust 2008

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Contents

About the Author xIntroduction xi

PART I SYSTEMS OF CITIES AND CITIES OF FINANCE 1

Introduction 2

The Urban Hierarchy and Global Cities1 51.1 Introduction 51.2 Cities and the urban hierarchy 61.3 World cities, global cities 181.4 Cities, space and fi nance 31

International Financial Centres and Global Cities 32 32.1 Introduction 332.2 Concentration in fi nancial centres 342.3 Information technology and cities 442.4 Agglomeration and concentration 522.5 IFCs, concentration and offi ce markets 60

A Sense of History: Development and Inertia in the International 3 Financial Hierarchy 653.1 Introduction 653.2 A sense of history 673.3 ‘The age of catastrophe’ 743.4 Asian and Middle Eastern markets 763.5 Lessons of history: a tentative conclusion 81

PART II INSIDE THE OFFICE MARKET 87

Introduction 88

Occupational Demand, Offi ce Space and Rents 914 4.1 Introduction 914.2 Land value, land rent and fi nancial services 944.3 Rent models and rental adjustment 974.4 Empirical evidence of rental adjustment processes in major

offi ce markets 105

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viii Contents

4.5 Changing business practices and the demand for offi ce space 1094.6 Employment, volatility and the use of space 117

The Supply of Space 1255 5.1 Developers, development cycles and research 1255.2 Development, building costs and property value 1295.3 Economic models and developer behaviour 1355.4 Real options and developer strategies 144

Investment, Capital Flows and the Offi ce Market 1496 6.1 Introduction 1496.2 Real estate in the portfolio 1506.3 Investment patterns and investor behaviour 1616.4 Real estate vehicles and the portfolio 1636.5 International real estate investment 1656.6 Real estate capital fl ows 1706.7 Investment, capital fl ows and IFC offi ce markets 180

PART III INTERNATIONAL FINANCE, GLOBAL OFFICE MARKETS AND SYSTEMIC RISK 183

Introduction 184

Booms, Bubbles, Crises and Contagion 1877 7.1 Introduction 1877.2 Financial markets, co-movement and crises 1897.3 Booms and bubbles 2017.4 Real estate in booms and bubbles 2067.5 Bubbles, crashes and IFC offi ce markets 214

Globalisation, Ownership and Innovation in Real 8 Estate Markets 2178.1 Introduction: innovation in real estate investment and

ownership 2178.2 Innovation in property investment vehicles 2198.3 Global real estate investment 2468.4 Ownership patterns 2518.5 Conclusions: innovation, ownership and real estate

risk in IFCs 255

All Fall Down: Global Financial Centres, Real Estate 9 and Risk 2589.1 Introduction 2589.2 Retracing the threads 259

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Contents ix

9.3 Market integration, globalisation and systemic risk 2709.4 Some preliminary evidence 2779.5 Global fi nancial centres and offi ce market risk: some policy

implications 287

Epilogue 297Bibliography 303Index 321

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About the Author

Colin is Professor of Real Estate Finance in the School of Real Estate & Planning at the University of Reading’s Henley Business School. He is Director of Research for Real Estate & Planning and served as Head of Department. Colin has worked in real estate for nearly 30 years. His princi-pal research covers modelling of real estate investment, offi ce markets and international real estate. He has carried out research and consultancy for the European Union, the Norwegian Government, Her Majesty’s Treasury, the Department of Communities and Local Government, the Home Offi ce and a wide range of public and private sector clients including PREA, the RICS and IPF. He led the Investment Property Forum research projects on commercial property market liquidity and on the pricing of property deriva-tives. He has published widely in academic and professional journals, with over 100 publications and is the co-author of The Economics of Commercial Property Markets and has been asked to present research and lecture in over 30 countries. In 2004, he was awarded the International Real Estate Society achievement award ‘for outstanding achievement in real estate research, education and practice at the international level’ and in 2005 was elected an honorary fellow of the Society of Property Researchers ‘in recognition of an outstanding contribution in the fi eld of property research’.

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Introduction

For all the many cultural and physical differences that distinguish the developed world’s great cities, a common feature of the majority is the existence of a dense core of offi ce space in or near the centre of each city. That offi ce space accommodates global fi rms, domestic and non-domestic, many of which are international fi nance fi rms – banks, insurance compa-nies, pension funds, hedge funds, private equity funds, wealth managers and real estate companies – or are business and professional service fi rms whose work is linked to global capital fl ows. From time to time, these offi ce mar-kets undergo a dramatic transformation – old buildings are demolished, new larger, higher specifi cation buildings, often designed by signature architects, are constructed; the core offi ce area spills out into surrounding neighbour-hoods, displacing other activities. From time to time, these offi ce markets undergo crises: overbuilding creates an oversupply of space, vacancy rates rise, rents and capital values fall, real estate fi rms fail. Such crises are often linked to fi nancial market crises – and, crucially, often occur simultane-ously in cities spread geographically across the regions of the world.

Towers of Capital explores the relationship between the evolution of major international fi nancial centres (IFCs) as part of the global capital mar-ket system, the development of offi ce markets in those cities, real estate investment in those offi ce markets and the patterns of risk and return that result from the interactions between fi nancial fl ows and offi ce markets. Each of these aspects has, individually, been the subject of considerable research from a variety of academic traditions. Here, rather than focusing on just one single aspect of the relationship and conducting micro-analysis, an attempt is made to set out the interconnections between the location of fi nancial activity, the processes operating in offi ce markets and the volatility of real estate returns. The intention is to create a schematic model of risk in IFC offi ce markets that can act as a springboard for subsequent empirical work.

The essential thesis examined here starts from the increasing spatial clus-tering of global fi nancial business. The concentration of fi nancial activity in a small number of major cities, acting as the coordinating centres for an interlinked international fi nancial system has been accompanied by a redevelopment of the core offi ce markets of those cities and a growing func-tional specialisation of activity in those offi ces as high-order fi nancial ser-vices and the business and professional service fi rms that supply them have tended to drive out other users. A consequence of this process has been an interlocking of occupation, ownership and fi nance: fi rms that occupy space are the same fi rms that acquire offi ces as an investment asset (directly and indirectly) and who provide fi nance and funding for the creation of new

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xii Introduction

offi ce space. This interlocking creates greater potential volatility in offi ce markets, increasing the amplitude of upswings and downswings. Shocks in international fi nancial markets are transmitted to occupier, investment and property debt markets and can reinforce any tendency to cyclical behav-iour. A number of more recent trends have tended to reinforce this potential volatility: notably the growing globalisation of ownership of real estate and innovation in real estate investment vehicles and debt markets which has fragmented ownership without necessarily diversifying away risk at the overall market level.

Aspects of the underlying idea here were sketched out more than 15 years ago in Lizieri (1991, 1992); developed in Lizieri and Finlay (1995) and, more fully, in Lizieri et al. (2000a). The idea of a linkage between real estate and shifts in global fi nancial markets and on the importance of real estate pro-cesses and real estate fi nance in understanding the transformation of world cities is also present to an extent in, for example, Leitner (1994), Fainstein (1993) and Haila (1997). However, over the last two decades, urban research seems to have veered away from a holistic focus on urban development, driven by the apparently increasing gulf between urban social science approaches and those of real estate and urban economics. In particular, the cultural turn in urban geography and urban social science has seen a drift away from criti-cal empirical work to a focus on the symbolic and political implications of urban form and a mode of analysis which often produces opaque, esoteric work that is inaccessible to outsiders. Much of the research in this tradition seems to have moved very far away from the policy-driven critical urban social science that underpinned the early development of the world cities literature and the analyses of urban development processes in the 1980s and early 1990s. From this perspective, traditional urban economic approaches are dismissed for economism and reductionism, generally using a caricature of economic research. In terms of method, the cultural turn has brought an emphasis on textual analysis and small scale interview work, and a focus on individuals – with a consequent rejection of aggregate level analysis.

Even where the urban social science focus has returned to economic pro-cesses in global cities, there seems a reluctance to deal with real estate pro-cesses at anything other than a superfi cial level. Commentators note the production of real estate in global cities, they note its symbolic importance, they discuss the politics of urban planning – but, with few exceptions, they do not address the production and exchange of that space in suffi cient depth as to suggest an understanding of actual processes and the implications of those processes. As an example, Doreen Massey’s recent World City1 pres-ents a powerful critique of much of the global city debate in relation to London, to social inequality and to the relationships between London and

1 Massey (2007).

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Introduction xiii

the UK regions. She does deal with real estate: ‘it is these land and property interests that have been the vital mechanism in the concentration of invest-ment in commercial building in the prime central areas of cities and into the central cities such as London’ (Massey, 2007, p. 48). But there is no further analysis – she talks of ‘fi nancial land ownership’ citing her own work from fully 30 years ago (Massey & Catalano, 1978), there are a handful of refer-ences to urban geography articles from the late 1980s or early 1990s and a brief discussion of real estate values and property taxes. As with Sassen (1991) she emphasises that a world city must produce the means by which ‘command and control’ of the world economy can take place – which must include offi ce space. Yet there is almost nothing about the mechanisms by which this takes place, no consideration that these might change over time with consequences for the development of a global urban system and risks within that system.

To a large extent, the motivation for this book comes from a frustration about this neglect of the key role played by real estate and by a superfi cial view of property that ignores change over time and the importance of mar-ket structures in determining spatial outcomes in the offi ce markets of cit-ies in different countries and regions. I wanted to try to explore the processes that operate in major offi ce markets and the dynamics of those markets in more depth – because it seems to me that we cannot truly understand the forces that shape the city unless we have that depth of understanding. That exercise requires a blending of the wider insights of urban social science, international economics and fi nance with the more detailed focus on micro-level processes found in real estate and urban economics research, for all the methodological differences that exist between these different literatures and disciplines.

There are similar frustrations in drawing on the real estate economics literature. Increasingly, the leading journals in the fi eld publish work that is highly quantitative, using theoretical micro-economic modelling and empir-ical econometric analysis. Wider explanatory frameworks can be squeezed out in the focus on technique. For example, the drive to more advanced quantitative techniques has led to a focus on analysis of public real estate company returns. A number of papers have examined global or regional inte-gration issues.2 Results typically show the existence of a global real estate factor, some convergence, but less integration than national equity indices. Investment in REITs and property companies is, in the long run, a real estate investment, but the results of such analyses tell us little about actual invest-ment in real estate and the extent to which building performance is affected

2 See, for example, papers by Eichholtz and co-workers (e.g. Eichholtz et al., 1998), Quan and Titman (1999), Ling and Naranjo (2002), Bond et al. (2003) and McAllister and Lizieri (2006).

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