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Four lessons from London 1974 Cycle

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London 1970 - 1976: A case study into Real Estate Market Cycles

Four lessons from the London 1974 Cycle

1

Public policies that have the effect of stimulating the commercial real estate market should consider the lag between signals of user demand (a function of the business cycle) and new supply (a function of the development cycle). Legislation to promote new development only reaches maturity several years later, and in a potentially different economic climate. The Labour Party’s prohibitive building policies, subsequently reversed by the Conservatives, distorted the natural cycle of development. Indeed, the shifts in policy were, themselves, a shock to the system that exacerbated the natural market cycle.

2

Financial deregulation may lead to a race to the bottom for market share, resulting in a mispricing of risk. Without adequate regulatory oversight, a concentration of risk can develop through over-lending to a single sector and gearing above prudent levels. The Heath administration’s reaction to the over-buoyant property sector was too late and with insufficient force. While commercial rents were temporarily frozen in 1972, and the 1973 White Paper proposed a development tax on property profits, these measures were not adopted in the subsequent budget. A recurring theme in credit-induced boom-busts is that new lending channels appear, often outside the conventional regulated banking system. In the case of the London office market cycle, the banking - real estate crisis nexus emerged in the secondary banking market, with lending outside the formal regulated sector. The Bank of England had little visibility or control over the secondary banks’ lending practices, but these financial institutions still had links into the overall financial architecture, with systemic effects.

3

The effects of monetary policy on all important economic sectors should be considered. Most central banks have a dual mandate of ensuring price stability and promoting full employment. However, an expansionary monetary policy does not necessarily achieve these objectives and may even adversely disturb equilibrium asset prices. In this case, as in many similar events, a period of low interest rates encouraged over-leveraging and reliance on short-term financing, so that a subsequent rapid interest rate increase resulted in liquidity problems and defaults. The unprecedented jump in the Bank of England's MLR from 7.5% to 13% within five months shocked the credit markets, and led to defaults by overextended property developers reliant on revolving short-term loans.

4

The commercial real estate market is inherently linked to other important sectors of the economy – construction, business services, private and public sector tenants and, most importantly, banking. Each sector, with its distinct cycle, is susceptible to exogenous shocks that can spread contagion to other sectors via the real estate market (the common channel). Prudential supervision and regulation of the property market should be continuous and countercyclical, rather than discrete and pro-cyclical. Data and monitoring of debt markets – volume, tenor, pricing and expiry profiles – is essential if central bankers and regulators are not to be blind-sided when external shocks occur.