Movements in market rents are the primary determinant of the return of an income producing property because they drive movements in property values.
Typically, double-digit returns in property investments cannot be achieved without significant increases of property values during the holding period. For this reason, the understanding of the mechanism by which property rents are determined and the main forces that drive their movements is fundamental knowledge that any individual involved in property investing must have.
To better understand how market rents are determined, and how rent/price increases may occur, assume for a moment that the amount of space demanded by companies is greater than the amount of space offered for leasing in the office market. In such a case, landlords with vacant space experiencing high demand will raise asking rents. This increase in asking rents will trigger changes, in both demand and supply. On one hand, some additional landlords will enter the market, offering additional space for lease as market rents move above the minimum (floor) rent they require in order to lease space. On the other hand, some renters will “drop out” of the market, as asking rents move above the maximum (ceiling) rent they are willing to pay. These adjustments will continue until the amount of space available for lease equals the amount of space demanded by renters. At that point, no renter will have any incentive to further bid up rents.
In case the amount of space demanded is smaller than the amount of space supplied, landlords will start reducing asking prices in order to attract renters, and eventually, rents will fall enough so that the amount of space demanded becomes equal to the amount of space supplied. Is there any evidence that the property market operates in such a way? The answer is yes. Rosen and Smith (1986) and Wheaton (1988) presented evidence from the housing market and the office market, respectively, which demonstrates that rents/prices have been decreasing in response to excess supply. Therefore, the basic force that drives market rents is the balance between demand and supply for the specific property type and typology considered.
In evaluating the balance between these two forces we need to take into account and a percentage of stock that needs to be vacant in order to accommodate normal search process of tenants looking for space and landlords looking for tenants. This percentage is referred to as structural, or natural or normal vacancy rate and it differs by property type (lower for apartments/housing and higher for office).
Therefore, the difference between demand and supply is calculated as:
Demand – Existing functional stock + Normal Vacant Stock