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Real Estate Markerts and Analysis 1 summary (6314M0293Y)
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Summary of all the compulsory chapters and articles for the course Real Estate Markets and Analysis 1.
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Real Estate Markets and Analysis 1Chapter 1. Real Estate Space and Asset Markets
The space market is the market for the usage of (or right to use) real property (land and
built space). This type of market is also often referred to as the real estate usage market or
the rental market. The price of the right to possess and use space for a specified temporary
period of time is commonly called the rent. It is usually quoted in annual terms, per square
foot (SF), though other methods are also used (such as monthly per apartment). Because
both supply and demand are location and type specific, real estate space markets are highly
segmented. MSA : metropolitan statistical areas. An MSA, encompassing a central city and
its surrounding suburbs, tend to be relatively integrated economically, culturally, and socially.
The demand in the space market is just like in any other market. However, the story is
different for the supply side. Economist often depict the typical real estate supply function as
being “kinked” – that is , it is not continuous, but has a corner or break in it. The supply
function starts out as a nearly vertical line at the current quantity of space supply in the
market. This reflects the fact that the supply of office space is almost completely inelastic: if
demand falls, office space cannot be reduced (at least in the short to medium term).
The kink in the supply function represents the fact that this situation is not symmetrical with
respect to an increase in demand. The kink in the supply function occurs at the current
quantity of built space at a rent level that equates to the long run marginal cost of supplying
additional space to the market. At this rent the addition of new supply into the market can be
quite elastic even over a relatively short to medium term. Recall that the supply function for
any competitively supplied product is simply the marginal cost function for producing
additional increments of the product. In the case of built space, the marginal cost is the cost
of developing new buildings, including the site acquisition costs as well as the construction
cost and necessary profit for developers. The level of rent that is just sufficient to stimulate
profitable new development in the market is called the replacement cost level of rent, and
this tends to be the long-run equilibrium rent in the market. After the kink the line will move to
the right. This part of the line will exhibit one of three possibilities – rising, level, or falling. A
rising supply function results when the development cost of new buildings is greater as more
total stock of rental space is added into the market. Roughly speaking, if it would cost more
to develop the next office building than it did to develop the last one.
Suppose investors were willing to pay $12.50 to purchase a class A Cincinnati office property
for each dollar of current annual net rent the property could produce. Then if a building could
charge $16/SF annual net rent for office space, and expect to keep that space rented, the
building would be worth $200/SF (as 16 x 12.5 = 200). Using typical real estate terminology,
we would say office buildings were selling at an 8 percent cap rate, as the annual net
income, $16/SF, divided by the building value of $200/SF, equals 8 percent.
The real estate asset market is the market for the ownership of real estate assets, often
being referred to as the property market. The ability of asset prices to respond quickly to
relevant news is known as asset market informational efficiency. Equity assets are those
that give their owners the “residual” claim on the cash flows generated by the underlying
asset. REIT: Real Estate Investment Trust.
,As individual properties and buildings differ greatly in size and magnitude, when speaking of
property prices and values in general it is common to think in terms of property value per
dollar of current net rent or income. This way, one can more easily compare prices across
properties of different sizes or values. In fact, in real estate, especially in commercial
property markets, a measure that is the inverse of this price/earnings multiple is most widely
used to describe property prices and values. We introduced this measure earlier, as the
capitalization rate (cap rate for short, also known as an overall rate or OAR), or sometime
as the “return on assets” ROA. The cap rate is simply the property operating earnings
divided by the property asset price or value, higher price > lower cap rate. The cap rate is
similar to a current yield (the amount of current income the investor receives per dollar of
current value of the investment)
The cap rate is determined by capital investment supply and demand in the asset market,
based on three major factors:
1. Opportunity cost of capital. The prevailing interest rates and opportunities for earning
returns in other forms of investments are a major determinant of how much investors
are willing to pay for any property per dollar of its current income.
2. Growth expectations. Potential investors will be forward looking, considering the
likely amount of growth (or decline) in the net rent they can expect the property to
generate in the future.
3. Risk. If investors regard the future potential net income from the property as less
risky and more certain, then they will be willing to pay more per dollar of current
income for the property, also reducing the cap rate. Other things being equal,
investors do not like risk and will pay more for less risky assets.
Chapter 2. Real Estate System
It is important to know that within the real estate system there exist what
are called negative feedback loops. These are dampening mechanisms
that tend to make a system self-regulating, preventing it from spiraling
out of control. The principal negative feedback loop in the real estate
system is the ability of the asset market to regulate the flow of financial
capital to the development industry. If either supply or demand threatens
to get out of balance in the space market, the resulting expected effect on
assets’ operating cash flows will trigger a pricings response in the asset
market. As commercial property prices rise, investors effectively
begin to lose sight of the risk and the fundamental basis of asset values,
as rising asset prices tempt yet more money into the market. In effect,
asset prices rise simply because asset prices have been rising. This is a
type of positive feedback loop. Positive feedback loops are ‘explosive’
elements in a system, tending to cause spirals in one direction or another.
,2.3 Four-Quadrant Model
1. The northeast quadrant depicts the determination of rent in the
space market. The horizontal axis is the physical stock of space in
the market, and the vertical axis is the rent. The downward sloping
DD-line represents the space usage demand function.
2. The northwest quadrant depicts the asset market valuation process.
Relating the equilibrium property prices, on the horizontal axis, to
the level of current rent, on the vertical axis shared with the
northeast quadrant. The line represents the cap rate or OAR. The
steeper the line, the higher the cap rate.
The two top quadrants depict the short-run or immediate price
link between the asset and space markets.
3. The southwest quadrant depicts the operation of the development
industry – the physical asset production process. The relationship is
between property prices and the annual amount of construction
activity. The line relates a given level of property prices to a given
rate of construction. The vertical axis represents the physical rate of
construction in a year. And the horizontal axis represents the price.
4. The southeast quadrant completes the long-run integration of the
space and asset markets by linking the rate of construction to the
total stock of built space available in the usage market.
The two bottom quadrants depict the long-run effect of the real
estate development industry by showing the impact of
construction on the total stock of built space in the market.
, Chapter 3. Urban Economics and Real Estate Market
Analysis
The population of a city, and how that population changes over time, has
important impacts on the space markets. For example, larger, more
rapidly growing cities will generally be able to sustain higher real rents,
other things being equal. In fact, the sizes of cities tend to follow a rather
striking pattern. This pattern is known as the rank/size rule (also referred
to as Zipf’s Law)
Largest cit y ' s population
City Population=
Rank of city
With some exceptions, cities of similar size are not located near each
other geographically. This suggests a hierarchical structure of cities and a
division of territory into zones of influence. This in turn suggests two
points:
1. Centralizing city-causation (centripetal) forces are
counterbalanced by opposing decentralizing (centrifugal)
forces.
2. The relative strength of the centralizing and decentralizing forces
differs for different functions and activities.
The centralizing forces cause cities to form in the first place and to
tend to agglomerate into fewer and larger cities over time. The
decentralizing forces tend to limit the growth of city size and tend to
make more, smaller cities dispersed throughout the territory.
Three primary centralizing forces cause cities to coalesce:
1. Economies of scale
2. Economies of agglomeration
3. Positive locational externalities
Operating together, these three forces underlie an important
characteristic of urban growth dynamics known as cumulative
causation. Suggesting that there can be momentum in the growth (or
decline) of cities and regions. Growth breeds growth (and decline
breeds decline).
Central place theory (CPT) a body of geographic theory, including
an extension known as the theory of urban hierarchy. These two can be
summarized with the following statement: “In order to reduce “special
friction,” places of similar size, rank, or function will tend to be evenly
spaced across geographical space and/or population.”
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