What Can We Really Learn from Vacancy Behaviorin the Real Estate Market?A Theoretical Perspective

YongpingLiang[*] and KerryD.Vandell[†]

Department of Real Estate and Urban Land Economics

School of Business

University of Wisconsin-Madison

975 University Avenue

Madison, WI 53706-1323

Abstract

Vacancy rates in real estate markets traditionally serve as important indicators of market health. Yet the same vacancy rate across markets may have very different implications because the underlying forces that induce vacancies may be very different.In this paper we specify and solve a formal theoretical modelof vacancy behavior to analyze such differences. Our model is similar to other search models in the real estate market in that potential tenantssearch existinglandlords to find a match. But our model is different from traditional search models in two respects: First,we also considerpotential builders in the market monitoring conditions for opportunities for new development. Second, all market playersface an uncertaineconomic environment and may be subject to uncertain shocks. In our dynamic model, equilibrium vacancy ratesresult from the strategic interaction among the threetypes of players in the market (tenants, landlords, builders). The vacancy rate in the current period will affect the decisions of match and new development in the next period. The equilibrium rent level andnumber of new units are also determined over time. This model has the virtue of allowing us to “decompose” the vacancy rate into its constituent parts:(1) search - induced vacancies, due tosearch costsin a “thin” market;(2)uncertainty – induced vacancies, due to the option value of a match;(3) demand-side vacancies, the “excess demand” by tenants considering their future space needs;and (4) supply-side vacancies, the “over supply” resulting from competitive gaming among builders.The model will be used to explain some anecdotal facts, e.g.,the effects of lumpy supply (i.e., large building size relative to the market) on vacancy rates,recent high “phantom” vacancy rates, and the co-variation of vacancies with absorption. Simulations will evaluate alternative market dynamics under varying conditions.
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[*]YongpingLiang is a Ph.D. studentin the Department of Real Estate and Urban Land Economics, University of Wisconsin-Madison.

[†]KerryD.Vandell is Tiefenthaler Professor in the Department of Real Estate and Urban Land Economics, University of Wisconsin-Madison.