1

2

3

4

5

6

7

8

9

10 Market Equilibrium Analysis

11

12 Richard L. Parli, MAI 13 The Johns Hopkins University 14 Carey Business School 15 1625 Massachusetts Avenue, NW 16 Washington, DC 20036 17 Office Tel 703-273-6677 18

19

20 Norman G. Miller, Ph.D. 21 University of San Diego 22 Burnham-Moores Center for Real Estate 23 5998 Alcala Park 24 San Diego, CA. 92110-2492 25 Office Tel 619 260 7939 26 27

Page 1 28 Market Equilibrium Analysis 29 30 31 32 Abstract 33 34 Extending the work of authors like Mueller, Pyhrr, Smith, Rosen and others on real estate 35 cycles a definition of market equilibrium is explored. A and a new definition is offered 36 identifying that indentifies stable rental rates as the key indicator. Recent research on the 37 application of the new definition is presented and a second definition - equilibrium 38 vacancy - is proffered. Finally, possible applications for the new approach to market 39 equilibrium analysis are presented. 40 41

42 Keywords: Equilibrium vacancy rate, predicting rents, long-term vacancy rates, natural vacancy, normal vacancy, vacancy and rent adjustments.

Page 2 43 MARKET EQUILIBRIUM ANALYSIS

44 45 Introduction 46 47 "What's the vacancy rate?" That's often the first question a market analyst n appraiser will ask 48 about a particular market. The answer, of course, is expected to communicate the health of that 49 market. ; Such such is the power of the vacancy rate, when viewed in a historical context. To 50 market analysts, a A high vacancy rate is often considered bad; a low vacancy rate is often 51 considered good (if you are an owner/investor in real estate), all things equal. High and low, 52 however, are relative terms and must be put into context. The context for a market vacancy rate 53 is the equilibrium vacancy rate.

54 Vacant real estate space has often been viewed as a negative market characteristic. In fact, 55 much of the market operates with the goal of eliminating vacant space, thereby matching demand 56 perfectly with available supply. From the landlords' perspective, this may be a desirable goal. 57 From the market's (and prospective tenant's) perspective, however, zero vacancy is a highly 58 negative condition that prevents satisfying both tenant relocation and new demand. Given these 59 underlying conditions requirements, the question arises as to how much vacant space is needed 60 in a balanced, efficient market? 61 62 Since disequilibrium is manifested by rising or falling rents, it stands to reason that a balanced, 63 efficient market should be characterized by stable rents.1 Equilibrium is therefore characterized 64 by stable rents. Since vacancy is recognized as the greates influence on rental rates, it follows 65 that an The equilibrium vacancy rate is that rate which produces no upward or downward 66 pressure on rents. Therefore, Comparing comparing a market’s actual vacancy rate with its 67 particular equilibrium vacancy rate can provide insights into a market's current condition as well as 68 an indication of future rent movements. The context for a market vacancy rate is the equilibrium 69 vacancy rate. 70 71 The purpose of this paper is to: 1) explore the concept of market equilibrium by tracing its 72 evolution; 2) present a new definition for market equilibrium and equilibrium vacancy rate; and, 3) 73 offer possible applications of the new approach to market equilibrium.

1 1 Over a longer term, one might suggest stable real rents, inflation adjusted. On this basis, most markets 2 in equilibrium will have rather flat real rents over time, unless the elasticity of supply is changing which 3 could soften/tighten the market and cause real rent decreases/increases relative to a change in demand.

Page 3 74 75

Page 4 76 Market Equilibrium as Defined in the Literature 77 78 Considering its importance to real estate market analysis and valuation, the specific concept of 79 market equilibrium is given relatively little attention in the literature. Typically, the concept is 80 treated as if the meaning were self-evident (Hagen and Hansen, 2010). Often, the concept of 81 disequilibrium is what is addressed (Voith & Crone 1988, Clapp 1993). In any event, when 82 addressed at all, it is identified as simply the point where demand and supply are equal. For 83 example, the most recent edition of The Appraisal of Real Estate (14th ed., 2013)) defines market 84 equilibrium as follows: 85 86 The theoretical balance where demand and supply for a property, good, or service 87 are equal. Over the long run, most markets move toward equilibrium, but a balance 88 is seldom achieved for any period of time.2 89 90 This is also the definition that is in the 5th edition of The Dictionary of Real Estate Appraisal 91 (2010) and that is referenced by Jorgensen and Fanning (2013).3 However, if reading this 92 definition in the literal sense, one might conclude that market equilibrium is only achieved at 100% 93 occupancy. This unreasonable implication was tempered with the 6th edition of The Dictionary of 94 Real Estate Appraisal (2013) which modified the definition to include vacant space: 95 96 The theoretical balance where demand and supply for a property, good, or service 97 are equal with the only vacant space being space needed to service the market 98 friction of normal tenant movements and space needed to accommodate new 99 demand coming into the market. Over the long run, most markets move toward 100 equilibrium, but a balance is seldom achieved for any period of time.4 (emphasis 101 added) 102 103 While continuing to assert that the concept is "theoretical", it is nonetheless encouraging that the 104 new definition includes an allowance for vacant space".5 According to the definition, the vacant 105 space associated with market equilibrium is allocated between the "space needed to service the 106 market friction of normal tenant movements" and "space needed to accommodate new demand 107 coming into the market." We will address each qualifier separately. 108

4 2 The Appraisal of Real Estate, Appraisal Institute, 14th ed., 2013, p. 306. 5 3 Jorgensen, Kerry M. & Fanning, Stephen F., "One Step Further - Implementing the Recommendations of Guide Note 6 12", The Appraisal Journal, Summer, 2013, p. 215. 7 4 Dictionary of Real Estate Appraisal, Appraisal Institute, 6th ed., p. 139. 8 5 We find it troublesome that the definition also relates a "good, or service" as needing vacant space.

Page 5 109 The space needed to service market friction is generally referred to as frictional vacancy. The 110 theory of frictional vacancy may first have been identified by Hauser & Jaffe (1947) when they 111 observed pointed out that the “continuous turnover in housing occupancy necessitates a minimum 112 number of vacant units which may be described as frictionally vacant units.”6 Hauser & Jaffe, who 113 had built upon the work of Homer Hoyt (1933), were concerned with a housing shortage following 114 the end of World War II. The presence of frictional vacancy has been accepted by analysts as 115 being a necessary ingredient to an efficient market. Aside from this recognition, there is little else 116 known about this vacancy - it cannot be measured and therefore cannot be proven to exist. It is 117 simply a theoretical construct that justifies a certain level of vacant space as present in every real 118 estate market and implies that an efficient market is always going to have an excess of supply 119 over demand (i.e., a certain degree of inefficiency). 120 121 The space needed to accommodate new demand has been referred to as lag vacancy (Fanning, 122 2014). This relatively recent theory states that the market needs an "inventory reserve for 123 forecasted new growth."7 This component of equilibrium is based on the demand characteristics 124 of a market - the greater the anticipated demand, the greater the required future supply, and the 125 greater the current equilibrium vacancy rate. Fanning demonstrates that when all else is equal, a 126 high growth market will have a higher equilibrium vacancy rate (lower equilibrium occupancy rate). 127 Regardless of a market's growth rate, if future supply increases match in the exact same amount 128 as demand (and after allowing for frictional vacancy), a vacancy rate that considers near-term 129 future demand and supply will represent market equilibrium. Sample calculations are shown in 130 table 1:8

131 Table 1 High Growth/Low Growth Sample Calculations

132 High Growth Market Slow Growth Market Current Year Year 1 Year 2 Current Year Year 1 Year 2 Demand (sf) 1,400,000 1,480,000 1,560,000 Demand (sf) 1,400,000 1,410,000 1,420,000 Forecasted Increase per year in Forecasted Increase per year in 80,000 80,000 10,000 10,000 Demand (sf) Demand (sf)

Frictional Vacancy @ 5% 73,684 + 8,889 + 8,889 = 91,462 Frictional Vacancy @ 5% 73,684 + 1,111 + 1,111 = 75,906 Lag Vacancy (sf) needed for new Lag Vacancy (sf) needed for new demand 80,000 + 80,000 = 160,000 demand 10,000 + 10,000 = 20,000

Total Needed Current Vacant Space (sf) 251,462 251,462 Total Needed Current Vacant Space (sf) 95,906 95,906

Total 3-year Supply 1,651,462 Total 3-year Supply 1,495,906 Market in Equilibrium Vacancy Rate 15% Market in Equilibrium Vacancy Rate 6%

9 6 Hauser, P.M. & Jaffe, A.J., “The Extent of the Housing Shortage”, Law & Contemporary Problems; Winter1947, Vol. 10 12, Issue 1, p. 3. 11 7 Fanning, Stephen F., Market Analysis for Real Estate, Appraisal Institute, 2nd Ed., 2014, p. 198. 12 8 These calculations replicate those by Fanning, 2014, p. 199.

Page 6 133 Interestingly, this approach rests on the initial theory that a 5% frictional vacancy rate exists in the 134 market, and that this 5% vacancy rate is the true current equilibrium vacancy rate. With That is, if 135 there were no forecasted new demand, the market equilibrium vacancy rate would be 5%. This is 136 shown in Table 2:

137 Table 2 No Growth Market Calculations

138 No Growth Market 139 Current Year Year 1 Year 2 Demand (sf) 1,400,000 1,400,000 1,400,000 140 Forecasted Increase per year in 0 0 Demand (sf) 141 Frictional Vacancy @ 5% 73,684 + 0 + 0 = 73,684 142 Lag Vacancy (sf) needed for new demand 0 + 0 = 0 143 Total Needed Current Vacant Space (sf) 73,684 73,684 144 Total 3-year Supply 1,473,684 145 Market in Equilibrium Vacancy Rate 5% 146 147 The fallacy is not with the formula, which correctly relates future demand to future supply. The 148 fallacy is with the theory that frictional vacancy is the basis for calculating equilibrium vacancy. 149 150 We present the following alternative definition of real estate market equilibrium: 151 152 The balance of space where supply of a property type exceeds demand by an 153 amount of space that produces stable rents. 154 155 or simply: 156 157 The relationship of demand and supply that results in real rent stability.9 158 159 This definition moves the concept of market equilibrium from a theoretical condition to one a 160 tangible, measurable condition with practical applications. 161 162

13 9 Real rents would be stable even though they move nominally with inflation; In a market with 1.5% inflation per year 14 the rents would rise by approximately 1.5% per year.

Page 7 163 Linking Equilibrium to Rents 164 165 There is an abundance of published research linking vacancy to equilibrium and equilibrium to 166 rents. Possibly the first to connect the three was Smith (1974) in concluding that there is some 167 level of vacancy that is associated with market equilibrium, “at which rents are in equilibrium”.10 168 169 Smith’s later collaboration with Rosen (1983) postulated that a real estate market in equilibrium 170 means a vacancy rate at which rent changes equal zero.11 Numerous subsequent studies 171 expressed the same conclusion but in different various ways: that rate of vacancy that provides 172 landlords with no incentive to adjust rents (Jud & Frew 1990), (Mueller 1999) and others; the 173 vacancy rate where effective demand is equal to effective supply (Clapp 1993); a market is in 174 equilibrium when there is no tendency toward changes in prices or quantities (McDonald & 175 McMillen 2011). 176 177 Classical economic theory supports the premise that if there is market disequilibrium due to 178 excess supply, there will be downward pressure on rental rates, which produces new effective 179 demand for the vacant space.12 If the disequilibrium is due to excess demand, there will be 180 upward pressure on rental rates until the relative demand is diminished (via higher rents or 181 additional delivered space). Consistent with this theory, there must be some level of vacancy - 182 equilibrium vacancy - that is associated with no upward or downward pressure on real rents. 183 184 The equilibrium vacancy rate hypothesis is, therefore, that there must be a market vacancy rate 185 where demand and supply are effectively equalized. As a corollary, the movement of rents in a 186 market is inversely related to the vacancy rate of that market and movement away from 187 equilibrium can produce either upward or downward pressure on rental rates. 188 189 190 191 192 193

15 10 Smith, Lawrence B., “A note on the Price Adjustment Mechanism for Rental Housing”, The American Economic 16 Review, June 1974, p. 481. 17 11 Rosen, Kenneth T. and Smith, Lawrence B., “The Price Adjustment Process for Rental Housing and the Natural 18 Vacancy Rate”, The American Economic Review, September 2983, pp. 779 – 786. 19 12 Since demand consists of not only desire but also affordability - the ability to act on the desire.

Page 8 194 Identification of the Equilibrium Vacancy Rate 195 196 There is no known way to forecast an equilibrium vacancy rate; it must be inferred or extracted 197 from the historical record. Over the years, the research has produced at least 16 published 198 studies that estimated the equilibrium vacancy rate for different property types in many different 199 communities and for many different time periods. The published research has emphasized two 200 main methods (1) regression analysis using rent as a dependent variable; and (2) simply using the 201 average vacancy rate over an extended time period. The results range from 4.4% to 22.3%. All 202 have relied upon historical vacancy rates linked to published rental rates. 203 204 Parli and Miller (2014) tested and compared the results of these methods in nine markets of study: 205 three cities on the west coast, three cities on the east coast, and three cities in the central part of 206 the United States. In all cases, the equilibrium vacancy rate of the city’s Class A office space was 207 the focus of analysis.13 Their conclusion is that consistent reliance on the mean vacancy rate 208 would produce a reliable indication of a market's equilibrium vacancy rate. In addition, the 209 equilibrium vacancy rate indicators indication for each city demonstrate enough difference that 210 variation is confirmed; localized analysis is essential. Geltner, Miller, et al (2007) concluded that 211 the regression process may not produce reliable results unless net effective rent is used, stating 212 that “real [net effective] rents reflect the actual physical balance between supply and demand in 213 the space market.”14 By using the mean vacancy rate, this problem is eliminated. 214 215 A major value of relying on the long run mean vacancy rate is that it implicitly recognizes the 216 cyclical nature of any real estate market and is consistent with the Rental Growth Theory.15 This 217 theory states that the long run average occupancy rate is the point of inflection, where the 218 growth rate of real rents change course. In the process of changing course, the rents inhabit 219 (however briefly) an area of stability. Since our definition of equilibrium is based not on growth 220 rates, but a change in direction of rents, by definition, this temporary stability signifies market 221 equilibrium. 222

20 13 Parli, Richard L. & Miller, Norman G. "Revisiting the Derivation of an Equilibrium Vacancy Rate," Journal of Real 21 Estate Portfolio Management, Vol. 20, Issue 3, 2014. 22 14 Geltner, David M., Miller, Norman G., Clayton, Jim, Eichholtz, Piet, Commercial Real Estate Analysis & 23 Investments, Thomson South-Western, 2007, p. 106. 24 15 Mueller, Glenn R., “Real Estate Rental Growth Rates in Physical Market Cycle”, Journal of Real Estate Research," 25 Volume 18, Number 1, 1999, p. 135.

Page 9 223 The long run average (or natural) vacancy rate can be a reliable indicator of the equilibrium rate 224 for any given market, as long as adequate fluctuation over an extended period has been 225 experienced by the market. Mueller (1999) observed that the market cycle was not symmetrical 226 and that the response of rents was different if the market was above or below the long term 227 average vacancy. This suggests that while the historic mean vacancy rate can be calculated, 228 forecasting rents may require an adjustment for current supply and demand characteristics. For 229 example, if the mean is calculated at a time of peak occupancy (or vacancy), this could skew the 230 average upward (or downward) and result in an equilibrium vacancy rate that maybe artificially 231 high (or low).16 This result is implied by the Fanning use of lag vacancy - a market that is 232 forecast to grow faster may have an artificially high vacancy rate if future delivery is taken into 233 account. It is understood that a market in equilibrium will remain in equilibrium as long as the 234 growth in supply matches the growth in demand (both in rate and timing). A mismatch will, of 235 course, move the market out of equilibrium because the market's actual vacancy rate will diverge 236 from its equilibrium vacancy rate. 237 238 Mueller (1999) correctly indicated that rental growth will be below inflation when the actual 239 vacancy rate for a market is above the long term average vacancy rate. ; Of of course, the inverse 240 is also true. Thus, in a stable market in equilibrium, the change in rent should be consistent with 241 the change in inflation.17 As an extension of this theory, it can be seen that new construction will 242 not take place unless rental rate change exceeds building cost inflation to the extent that market 243 rents are equal to or exceed new construction rent (i.e., feasibility rent). 244 245 While we know that the vacancy rate plays a significant role in rent changes, this role may 246 become more prominent as the vacancy rate distances itself from the equilibrium level. The 247 research could be skewed in this direction since the further away from equilibrium the vacancy 248 rate gets, the less likely concessions are to mask changes in face rent. 249 250 It is of interest that virtually all of the indicators of equilibrium vacancy rate exceed 5%, the 251 industry standard for frictional vacancy. In this context, if market demand drives vacancy rates to 252 as low as 5%, that market is likely experiencing strong upward pressure on rents - a characteristic 253 in conflict with market equilibrium.

26 16 This problem could be eliminated by matching the study period to a full real estate cycle(s). 27 17 Mueller, Glenn R., "Real Estate Rental Growth Rates at Different Points in the Physical Market Cycle", Journal of 28 Real Estate Research, Vol. 18, No. 1, 1999, p. 135.

Page 10 254 Most research does not distinguish between frictional vacancy and equilibrium (natural) vacancy 255 (e.g., Clapp 1993, Sivitanides (1997), Krainer 2001, Thoma 2005). In fact, most recent articles do 256 not even acknowledge the existence of frictional vacancy. A main reason for this may be not the 257 denial of its presence, but it has little use in contemporary markets. The original utility of frictional 258 vacancy was to calculate the amount of space that excess supply could support.18 Although the 259 growth in certain cities has been robust over the past fifty years, it is nonetheless unusual for 260 aggregate demand to actually exceed aggregate supply. Consequently, market analysts rarely 261 need to calculate the amount of supply that excess demand can support. The challenge is to 262 determine the deficiency of aggregate demand relative to aggregate supply, recognizing that a 263 certain amount of vacant space is necessary to accommodate market dynamics. 264 265 The (theoretical) relationship of frictional vacancy and equilibrium vacancy to market vacancy is 266 demonstrated in Exhibit 1. 267

29 18 See for instance, Hauser & Jaffe, "The Extent of the Housing Shortage," Law and Contemporary Problems, Winter 30 1947, Vol. 12, Issue 1, pp. 3 - 15.

Page 11 268 269 270 Exhibit 1. Relationship of Equilibrium Vacancy to Frictional and Overall Vacancy Rates 271 272

Page 12 273 Equilibrium Vacancy Rate Applications 274 275 Now that it has been shown that the simple average of a market's long term vacancy rate can be 276 a reliable indication of that market's equilibrium vacancy rate, of what value is this knowledge to 277 the market analyst? 278  Knowing the distance that current vacancy is from equilibrium vacancy, and the The 279 expected direction of vacancy movement would be indispensible to developing a reliable 280 cash flow model on a property. Rental rates should not change direction until the market 281 passes through equilibrium. 282  Knowing the slope of the change in rental rates is should also be important. This can be 283 inferred from the slope of previous changes that occurred under similar circumstances. 284 Segmenting a change and regressing the data can provide the slope of the change, and 285 projecting thus the projected growth/decline in future rents. 286  There is good reason to associate equilibrium vacancy with development feasibility. That 287 is, until rents are ascending, development plans will naturally be postponed; rents will not 288 ascend until vacancy has dropped below equilibrium level. The commitment to develop is 289 based on many factors other than the movements of rent, but financial feasibility is a major 290 consideration. McDonald (2000) described the equilibrium vacancy rate as "being 291 consistent with a net rent that provides no incentive to change the size of the stock of 292 space."19

293

294 All three of these items are identified by Mueller (1999), and shown in Exhibit 2.20 295 296

31 19 McDonald, John F., “Rent, Vacancy and Equilibrium in Real Estate Markets," Journal of Real Estate Practice and 32 Education, Vol. 3, No. 1, 2000, p. 59. 33 20 Mueller, Glenn R., "Real Estate Rental Growth Rates at Different Points in the Physical Market Cycle", Journal of 34 Real Estate Research, Vol. 18, No. 1, 1999.

Page 13 297 Exhibit 2. Long Term Vacancy and Market Cycles 298 299 300 301 302 303 304 305 306 307 308 309 310 311 In describing real estate cycles, Mueller focuses on demand and supply growth rates and defines 312 demand/supply equilibrium as being when "demand and supply growth rates are equal (dg = sg) 313 at the peak and trough of the market cycle (thus existing space plus new construction exactly 314 matches new demand)." Mueller indicates agreement with Pyhrr, Webb and Born (1990) in 315 stating that "the only real demand/supply equilibrium point is at the peak of the real estate cycle 316 where supply growth finally catches up to demand growth." Mueller clarifies this equilibrium 317 condition in the real estate cycle as being the peak point, stating that at the peak "the space 318 market is usually at its tightest level (occupancy rates highest) and the rental growth rate should 319 also be at its highest level." Yet, Pyhrr, Webb and Born, indicated that "equilibrium occurs in this 320 apartment market when occupancy rates are in the range of 92 - 96 percent."21 We interpret this 321 to mean that the peak of the market is when actual vacancy meets frictional vacancy, producing 322 hyper-supply. As such, the "demand/supply equilibrium" identified in Exhibit 2 should not be 323 confused with a market equilibrium as defined in this article; our position is that market equilibrium 324 is actually represented by Long Term Average Occupancy shown in Exhibit 2.22 325 326

35 21 Pyhrr, Stephen A., Webb, James R. and Born, Waldo L., "Analyzing Real Estate Asset Performance During Periods 36 of Market Disequilibrium under Cyclical Economic Conditions," Research in Real Estate, Vol. 3, 1990, p. 84, p. 465. 37 22 Exhibit 2 also shows construction as being triggered/dampened by the cycles' relationship to the LTAO. 38 We agree, but testing this theory would be problematic due to the small sample size typically associated 39 with most markets.

Page 14 327 One final observation: it appears that equilibrium vacancy rates tend to be lower for residential 328 properties and higher for office properties. We uncovered no direct research comparing the 329 equilibrium vacancy rates, although there is anecdotal evidence to support this conclusion. For 330 example, Hagen and Hansen (2010) concluded that for the Seattle and surrounding King 331 County market, the equilibrium vacancy rate for residential rental properties was between 4.97% 332 and 5.25%.23 This is quite low in comparison with the results of Parli and Miller (2014) for Seattle 333 Class A office space of about 10%.24 We expect that this relationship is similar in kind 334 throughout the nation, if not in degree. One reason for such differences can be explained by 335 market friction. Residential has lower friction with less lumpy demand than office. There are 336 also structural differences - residential growth may be more predictable since it is a function of 337 household growth rates which seldom move radically while job growth may change faster, thus 338 needing more space in equilibrium for the office market to handle the more volatile demand 339 characteristics. 340 341 342 Conclusions 343 344 Research reviewed in this paper is convincing that vacancy influences rental rates. Market 345 observation, however, indicates that rental rates also influence vacancy. At a fundamental level, 346 both rents and vacancy are responsive to economic demand for space relative to supply. 347 Demand absorbs vacant space to the point that rents are driven up, which stimulates new 348 construction, which may drive average rents up (due to the premium charged for new space) or 349 down (due to an oversupply). This cyclical pattern produces variations in vacancy rates that tend 350 toward a central point, known as the market's natural vacancy rate. The analysis in this article 351 reveals that the natural vacancy rate is a reliable indicator of ion the market's equilibrium vacancy 352 rate, and a type of market trigger that can be used to forecast changes in future rental rates. 353 354 Given that vacancy can and does significantly influence rent changes, and that stable rents are a 355 characteristic of market equilibrium, it follows that there must be some level of vacancy - the 356 equilibrium vacancy rate - which produces stable rents. Vacancy in excess of this rate will 357 produce downward pressure on rents; vacancy of less than this rate will produce upward pressure 358 on rents. Although we agree that inflationary/deflationary pressure on rents can cause market-

40 23 The Hagen and Hansen study included apartment projects of 20 or more units over 35 biannual periods, beginning 41 in September 1988 and ending in September 2005. 42 24 The Parli and Miller study covered only Class A office space within City of Seattle over 56 quarters beginning 43 January 2000 and ending December 2013.

Page 15 359 wide movement, this issue and others are avoided by relying on the mean vacancy rate for an 360 indication of the market’s equilibrium rate. In doing so, however, one must recognize the 361 limitations of using the historical mean vacancy rate given that the equilibrium rate is likely 362 dynamic and asymmetrical. It is dynamic in that it is a moving target, shifting with each new 363 vacancy rate. It is asymmetrical in that, even though it is an extension of the theory of real estate 364 cycles, rents would be expected to respond differently to changes in vacancy depending on the 365 relative relationship to the equilibrium rate. 366 367 The equilibrium vacancy rate hypothesis is not in conflict with the presence of frictional vacancy. 368 Accepting frictional vacancy as a necessary component only allocates the numbers and does not 369 change the relationship. For example, if frictional vacancy for a given office market is assumed to 370 be 5%, then the equilibrium vacancy rate almost certainly exceeds this amount. Because search, 371 contracting, and moving costs cause some vacancy in every market, a portion of the vacancy of 372 the equilibrium condition is most certainly associated with friction. 373 374 Knowledge of equilibrium vacancy is a valuable component of market analysis and valuation. It 375 can be used to forecast when a change in vacancy will actually produce a change in rent, 376 something critical to any cash flow prediction. We have demonstrated that just because the 377 vacancy rate is moving does not mean rental rates will move. Instead, movement in rents is 378 altered when the vacancy rate crosses the critically important equilibrium rate, and that this rate 379 may in fact be a range, and at the same time vary by property types and local market.

Page 16 380 REFERENCES 381 Amy K., Ming Y. S., Yuan L. L. (2000) The natural vacancy rate of the Singapore office market, 382 Journal of Property Research, 2000, Vol. 17, No, 4, pp. 329–338 . 383 Anari, M.A. & Hunt, Harold D., Natural Vacancy Rates in Major Texas Office Markets, Technical 384 Report, Real Estate Center, November 2002. 385 386 Blank, David M. & Winnick, Lois, “The Structure of the Housing Market,” Quarterly Journal of 387 Economics, May 1953, 67, pp. 181 – 203. 388 389 Born, Waldo L. & Pyhrr, Stephen A. "Real Estate Valuation: The Effect of Market and Property 390 Cycles", Journal of Real Estate Research, Vol 9: No. 4, 1994, pp. 455-485 391 392 Carn, Neil, Joseph Rabianski, Ronald Racster, and Maury Seldin, Real Estate Market Analysis, 393 Techniques and Applications, Prentice Hall, 1988. 394 395 Clapp, John M., Handbook for Real Estate Market Analysis, Prentice-Hall, Inc., 1987. 396 397 Clapp, John M., Dynamics of Office Markets, The Urban Institute Press, 1993. 398 399 Crone, Theodore M., “Office Vacancy Rates: How Should We Interpret Them?”, Business 400 Review, Federal Reserve Bank of Philadelphia, May/June 1989. 401 402 Downs, Anthony, ”Cycles in Office Space Markets,” The Office Building From Concept to 403 Investment Reality, Counselors of Real Estate, et al., 1993, pp. 153 – 169. 404 405 Eubank, Arthur A., Jr. & Sirmans, C.F., “The Price Adjustment Mechanism for Rental Housing in 406 the United States” Quarterly Journal of Economics, February, 1979, pp. 163 – 168. 407 408 Fanning, Stephen F., Market Analysis for Real Estate, Appraisal Institute, 2nd ed., 2104. 409 410 Fanning, Stephen F., Market Analysis for Real Estate, Appraisal Institute, 2005. 411 412 Fanning, Stephen F., MAI, Grissom, Terry V., MAI, PhD, Pearson, Thomas D., MAI, PhD., Market 413 Analysis for Valuation Appraisals, Appraisal Institute, 1994. 414 415 Friedman, Milton, “The Role of Monetary Policy, The American Economic Review, Volume LVIII, 416 Number 1, March 1968, pp. 1-17. 417 418 Gabriel, Stuart A. & Nothaft, Frank E., “Rental Housing Markets and the Natural Vacancy Rate”, 419 AREUEA Journal, Vol 16, No. 4, 1988, pp. 419 – 429. 420 421 Geltner, David M., Miller, Norman G., Clayton, Jim, Eichholtz, Piet, Commercial Real Estate 422 Analysis & Investments, Thomson South-Western, 2007. 423 424 Hagen, Daniel A. & Hansen, Julia L, “Rental Housing and the Natural Vacancy Rate,” Journal of 425 Real Estate Research, Vol. 32, No 4, 2010, pp. 413 - 433. 426 427 Hauser, P.M. & Jaffe, A.M., “The Extent of the Housing Shortage,” Law and Contemporary 428 Problems, Winter 1947, Vol. 12, Issue 1, pp. 3 - 15. 429

Page 17 430 Hoyt, Homer, 100 Years of Land Values in Chicago: The Relationship of the Growth of Chicago to 431 the Rise in its Land Values, 1830–1933, Chicago, IL: University of Chicago Press, 1933. 432 433 Jorgensen, Kerry M. & Fanning, Stephen F., "One Step Further - Implementing the 434 Recommendations of Guide Note 12", The Appraisal Journal, Summer, 2013. 435 436 Jud, G. Donald & Frew, James, “Atypicality and the Natural Vacancy Rate Hypothesis”, AREUEA 437 Journal, Vol 18, No. 3, 1990, pp. 294 – 301. 438 439 Krainer, John, “Natural Vacancy Rates in Commercial Real Estate” FRBSF Economic Letter, 440 Federal Reserve Bank of San Francisco, No. 2001-27, October 5, 2001. 441 442 McDonald, John F., “Rent, Vacancy and Equilibrium in Real Estate Markets", Journal of Real 443 Estate Practice and Education, Volume 3, Number 1, 2000, pp. 55 – 69. 444 445 McDonald, John F. & McMillen, Daniel P. Urban Economics and Real Estate, John Wiley & Sons, 446 2nd ed., 2011 447 448 Miller, Norm G. “Downsizing and Workplace Trends in the Office Market” Real Estate Issues, 449 CRE, Vol. 38, No. 3, 2013. 450 451 Mueller, Glenn R., "Understanding Real Estate’s Physical and Financial Market Cycles," Real 452 Estate Finance, 1995, 12:1, 47–52. 453 454 Mueller, Glenn R., “Real Estate Rental Growth Rates at Different Points in the Physical Market 455 Cycle” Journal of Real Estate Research, Vol 18: No. 1, 1999, pp. 131-150 456 457 Parli, R.L. and N.G. Miller “Revisiting the Derivation of an Equilibrium Vacancy Rate”, Journal of 458 Real Estate Portfolio Management, Vol 20, No. 3, 2014, pp. 195-208 459 460 Pyhrr, S. A., J. R. Webb and W. L. Born, "Analyzing Real Estate Asset Performance During 461 Periods of Market Disequilibrium Under Cyclical Economic Conditions: A Framework for 462 Analysis", Research in Real Estate, Vol. 3, 1990, JAI Press. 463 464 Pyhrr, S. A., S.E. Roulac, and W. L. Born, "Real Estate Cycles and Their Strategic Implications for 465 Investors and Portfolio Managers in the Global Economy" Journal of Real Estate Research, Vol. 466 18, No. 1, 1999, pp.7 – 68. 467 468 Rabianski, Joseph F., “Vacancy in Market Analysis and Valuation”, The Appraisal Journal, April 469 2002, pp. 191 – 199. 470 471 Rosen, Kenneth T. & Smith, Lawrence B., “The Price-Adjustment Process for Rental Housing and 472 the Natural Vacancy Rate,” The American Economic Review, Vol. 73, No. 4, September 1983, 473 pp. 779 – 786. 474 475 Shilling, James D., Sirmans, C.F. & Corgel, John B., “Price Adjustment Process for Rental Office 476 Space”, Journal of Urban Economics, Vol. 22 (1), 1987, pp. 90 – 100. 477 478 Sivitanides, Petros S., “The Rent Adjustment Process and the Structural Vacancy Rate in the 479 Commercial Real Estate Market”, Journal of Real Estate Research, Vol. 13, No. 2, 1997, pp.195 480 – 209.

Page 18 481 482 Smith, Lawrence B., “A Note on the Price Adjustment Mechanism for Rental Housing”, American 483 Economic Review, Vol. 64, No. 3, 1974, pp. 478 - 481 484 485 Thoma, Mark, “The Natural Vacancy Rate for Housing,” Economist’s View, blog, November 29, 486 2005. 487 488 Sumichrast, Michael “Housing Market Analyses,” as reprinted in Readings in Market Research 489 for Real Estate, edited by James Vernor, Appraisal Institute, 1985, p. 69. 490 491 Voith, Richard & Crone, Theodore, “National Vacancy Rates and the Persistence of Shocks in the 492 U.S. Office Markets”, AREUEA Journal, Vol 16, No. 4, 1988, pp. 437 – 458. 493 494 Wheaton, William C. & Torto, Raymond G. “Vacancy Rates and the Future of Office Rents”, 495 AREUEA Journal, Vol 16, No. 4, 1988, pp. 430 – 436. 496 497

Page 19