Jones Lang LaSalle
Game Theory and Office Development
March 10, 2006 Volume 7, Number 9
Jim Costello, Senior Economist
jcostello@tortowheatonresearch.com
The first time I visited Toronto the physical layout made me feel like I was back in Chicago. Granted, the lake and the commuter train stations were in the wrong direction, but the physical structures and the weather seemed especially similar. A number of the economic structures are similar as well, with heavy concentrations of manufacturing activity and financial services. Chicago has its LaSalle Street, and Toronto has Bay Street. Still, one thing Chicago has that Toronto doesn't is a good deal of office tower construction in the CBD. Game theory is a tool that can be used to explain these differences in construction.
I know--if one hears "game theory," "Chicago," and "Toronto" all in the same breath, it's likely to lead one to brace for a Blackhawks vs. Maple Leaves analysis. Rather, game theory is a useful framework within which economists examine the behavior of firms as they both compete and co-operate with one another. In 2005, in fact, the Nobel Prize in economics was awarded to Thomas Schelling and Robert Aumann for work that helped expand the application of game theory to decision-making in the world of business and economics. Of interest to us, this work has a strong application to commercial real estate, with an interesting example tied to the game behind the development of new space.
Owners and managers of existing assets obviously compete with one another in that they are all chasing the same tenants. Sometimes, however, these same competitors need to co-operate with, say, the establishment of standard market benchmarks and, if they can help it, preventing new competitors from entering the market. When they do co-operate, it is because they know that there will be some gains down the road, from participating in the rules and conventions of the market.
If owners of existing assets could set up conventions that prevent new construction, then these same owners would stand to gain down the line. For existing property owners, the best performance environment over a medium horizon would be one in which no new construction occurred. In such a supply-constrained environment, all new tenant demand would be focused toward existing assets helping to push vacancy rates down as low as physically possible. Of course, in most markets, existing owners cannot control who has the right to develop new space.
In Chicago, for instance, there has been 10.3 million square feet of new construction in the Downtown major market over the last five years, with 6.7 million square feet of that space concentrated in the West Loop. Recent projects by Hines and the Buck Company came to the market in an environment where the space's leasing came largely at the expense of assets held by other investors. But what would happen if the existing owners did have some (presumably legal) mechanism with which to regulate the introduction of new space to the market?
In Toronto, there are a handful of development sites in the Central Core near the commuter rail that, if fully developed, could lead to 8 million square feet of office construction. Nothing has really happened there though, as the owners of these sites do not have the same incentive to develop as do their counterparts in Chicago. Most of these development sites in Toronto are, in fact, owned by investors that also have an interest in existing assets in the Central Core.
There is nothing illicit happening in Toronto with the limits on construction; individual firms realize that they would push themselves into a ruinous situation if they built new assets that would simply take tenants out of existing portions of their portfolio. This situation gives each of the investors an incentive to co-operate and not develop new space in Toronto.
What would happen though, if one of the existing owners decided to cheat? What if one investor decided to move a project forward on one of the prime development sites in Toronto, figuring that, yes, there would be some losses in other portions of their portfolio, but by poaching from other competitors in Toronto they will be better off in the long-run. This approach would work if an owner could be assured that they would be the only market participant able to get a project off the ground.
Instead though, if one owner moves forward in a way that allows others to get moving as well, the market is likely to face a mutually-assured-destruction situation with every investor developing their sites, too few tenants to go around, and a general increase in market vacancy. The way to cheat is to somehow telegraph that the delivery of a new asset is inevitable in such a short-time frame, that other investors do not have a chance to get going.
In Chicago and Toronto, there are similar market conditions and economic trends. (There's a reason that Second City grew out of both markets.) These similarities have generated a large concentration of office space in both markets, with a heavy weighting of the markets toward the downtown submarkets. Because of the different ownership structure in each market though, only in Chicago has downtown construction ramped up in recent years. In Toronto, the ownership structure is such that market participants have an incentive to co-operate and limit their development activity.
Game Theory and Office Development
March 10, 2006 Volume 7, Number 9
Jim Costello, Senior Economist
jcostello@tortowheatonresearch.com
The first time I visited Toronto the physical layout made me feel like I was back in Chicago. Granted, the lake and the commuter train stations were in the wrong direction, but the physical structures and the weather seemed especially similar. A number of the economic structures are similar as well, with heavy concentrations of manufacturing activity and financial services. Chicago has its LaSalle Street, and Toronto has Bay Street. Still, one thing Chicago has that Toronto doesn't is a good deal of office tower construction in the CBD. Game theory is a tool that can be used to explain these differences in construction.
I know--if one hears "game theory," "Chicago," and "Toronto" all in the same breath, it's likely to lead one to brace for a Blackhawks vs. Maple Leaves analysis. Rather, game theory is a useful framework within which economists examine the behavior of firms as they both compete and co-operate with one another. In 2005, in fact, the Nobel Prize in economics was awarded to Thomas Schelling and Robert Aumann for work that helped expand the application of game theory to decision-making in the world of business and economics. Of interest to us, this work has a strong application to commercial real estate, with an interesting example tied to the game behind the development of new space.
Owners and managers of existing assets obviously compete with one another in that they are all chasing the same tenants. Sometimes, however, these same competitors need to co-operate with, say, the establishment of standard market benchmarks and, if they can help it, preventing new competitors from entering the market. When they do co-operate, it is because they know that there will be some gains down the road, from participating in the rules and conventions of the market.
If owners of existing assets could set up conventions that prevent new construction, then these same owners would stand to gain down the line. For existing property owners, the best performance environment over a medium horizon would be one in which no new construction occurred. In such a supply-constrained environment, all new tenant demand would be focused toward existing assets helping to push vacancy rates down as low as physically possible. Of course, in most markets, existing owners cannot control who has the right to develop new space.
In Chicago, for instance, there has been 10.3 million square feet of new construction in the Downtown major market over the last five years, with 6.7 million square feet of that space concentrated in the West Loop. Recent projects by Hines and the Buck Company came to the market in an environment where the space's leasing came largely at the expense of assets held by other investors. But what would happen if the existing owners did have some (presumably legal) mechanism with which to regulate the introduction of new space to the market?
In Toronto, there are a handful of development sites in the Central Core near the commuter rail that, if fully developed, could lead to 8 million square feet of office construction. Nothing has really happened there though, as the owners of these sites do not have the same incentive to develop as do their counterparts in Chicago. Most of these development sites in Toronto are, in fact, owned by investors that also have an interest in existing assets in the Central Core.
There is nothing illicit happening in Toronto with the limits on construction; individual firms realize that they would push themselves into a ruinous situation if they built new assets that would simply take tenants out of existing portions of their portfolio. This situation gives each of the investors an incentive to co-operate and not develop new space in Toronto.
What would happen though, if one of the existing owners decided to cheat? What if one investor decided to move a project forward on one of the prime development sites in Toronto, figuring that, yes, there would be some losses in other portions of their portfolio, but by poaching from other competitors in Toronto they will be better off in the long-run. This approach would work if an owner could be assured that they would be the only market participant able to get a project off the ground.
Instead though, if one owner moves forward in a way that allows others to get moving as well, the market is likely to face a mutually-assured-destruction situation with every investor developing their sites, too few tenants to go around, and a general increase in market vacancy. The way to cheat is to somehow telegraph that the delivery of a new asset is inevitable in such a short-time frame, that other investors do not have a chance to get going.
In Chicago and Toronto, there are similar market conditions and economic trends. (There's a reason that Second City grew out of both markets.) These similarities have generated a large concentration of office space in both markets, with a heavy weighting of the markets toward the downtown submarkets. Because of the different ownership structure in each market though, only in Chicago has downtown construction ramped up in recent years. In Toronto, the ownership structure is such that market participants have an incentive to co-operate and limit their development activity.
posted by Jones Lang LaSalle NJ News Blog at 12:05 PM
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