Asymmetric adjustments in commercial properties under information asymmetry

Abstract

The commercial property rental market is characterized by high transaction costs. This results in sluggish adjustment of rent to external shocks. The demand gap due to short- term partial adjustment in rent will appear as deviation of the observed vacancy rate from the long- term natural vacancy rate. With transaction cost is low, such that rent is fully and quickly adjusted to external shocks, vacancy rate will stay at the long- term natural vacancy rate (insensitive to shocks). When rent is sticky due to high transaction costs, vacancy rate will deviate from the long-term natural vacancy rate (sensitive to shocks). However, despite the high transaction cost in the commercial property rental market, their role in the rent and vacancy rate dynamics has largely been ignored. This study conjecture that one of the main causes of high transaction cost is information asymmetry. The aim of this study is to examine how information asymmetry affects the rent and vacancy rate adjustment process in the commercial property rental markets. This study proposes that there are two types of information asymmetry in the commercial property rental market: structure information asymmetry and tenant information asymmetry. The former refers to asymmetric information about the quality of the property whereby the landlord knows more about the quality of the building structure than the tenant. The latter refers to asymmetric information about the quality of the tenant, of which the tenant has more information than the landlord. The general proposition of this thesis is that structure information asymmetry affects the speed of rent and vacancy rate adjustments while tenant information asymmetry leads to asymmetric rent and vacancy rate responses to external shocks. The value of a property can be conceived as comprising land value and building value. Attributes of the land can be easily observed by both the landlord and tenant. The value of the building structure can be proxied by the building construction cost after allowing capital depreciation due to ageing. Construction cost is about the same for buildings in different locations in Hong Kong. The empirical implication is that rent adjusts faster (slower) to external shocks in more expensive (cheaper) locations. Correspondingly, vacancy rate is less (more) sensitive to external shocks in expensive (cheap) locations. The effect of tenant information asymmetry depends on whether signaling or screening is the primary means of solving the adverse selection problem. Since reputable tenants are more likely to rent properties in expensive locations and financially less capable tenants are likely to be located in cheaper locations. We expect signalling and screening are respectively the major means of solving adverse selection problems in expensive and cheap locations. That is, we expect rent will adjust downward faster (slower) than upward in more expensive (cheaper) locations. Furthermore, in expensive (cheap) locations, vacancy rate adjustment is also asymmetric with downward adjustment less (more) sensitive to external shocks than upward adjustment. Empirical results are largely consistent with these predictions with the exceptions of a few anomalies.