Real Estate Economics Lecture Notes PDF

INTRODUCTION – LECTURE 1  ASSESSMENT To pass – See learning outcomes  GOALS OF THE COURSE How real estate markets function at the macroeconomic/metropolitan level and at the more narrow/microeconomic/site level How to go about analysing in a meaningful way differen...

INTRODUCTION – LECTURE 1  ASSESSMENT To pass – See learning outcomes  GOALS OF THE COURSE How real estate markets function at the macroeconomic/metropolitan level and at the more narrow/microeconomic/site level How to go about analysing in a meaningful way different real estate markets for development, investment and/or valuation purposes.  LEARNING OUTCOMES Describe the market analysis process and explain the reasons for it Use metro growth analysis to identify the real estate asset classes that would benefit from the type of growth happening in a metro area Use macro analysis for the different asset classes to estimate demand and supply gaps for the different real estate types Use micro-level analysis of the different asset classes to forecast real estate prices,  QUESTION Why invest in Real Estate?  Think about what real estate is. When we discuss real estate or consider owning or leasing real estate, what things should be included under this term? What do you actually own or what can you own when you own real estate? Identify different asset classes which you are familiar or would like to learn more about.  Real estate RE is property. Property refers to anything that can be owned or possessed. Property can be (1) a tangible asset, e.g., a building, or (2) an intangible asset, e.g., a lease agreement.  Real Estate We use the term “real estate” in 3 ways: (1) we use it to refer to tangible assets, e.g., lands and buildings, (2) we use it to denote the bundle of rights that give the owner of the rights to use tangible assets, and (3) we use it to refer to the real estate industry or business activities.  RE as tangible assets RE can be defined as the land and its permanent improvements. Land may include (a) the surface of the earth, (b) rights to air space above the land up to a certain height, (c) rights to the subsurface down to the center of the earth and to the minerals contained therein, and (d) the improvements to the land, e.g., walkways and water drainage systems. The improvements on the land, e.g., buildings, fences, and decks, are also parts of real estate.  RE as a bundle of rights The bundle of rights is the services (benefits) that RE provides its users. For example, RE provides owners with the rights to shelter, security, privacy, doing business, etc.  RE as an industry: career The industry has a variety of professions: (1) brokerage, (2) leasing and property management, (3) appraisal, (4) consulting and advising, (5) property development, (6) construction, (7) financing, mortgage, and securitization, (8) investment, and (9) governmental planning, taxation, and regulation.  Some key business areas… Property Management Asset Management Facilities Management Corporate RE Valuation Development Finance  Property management Manage property on behalf of owners – Market the property – Locate tenants – Negotiate leases – Collect and manage rental income – Manage maintenance – Manage landlord requirements Asset managers – acquire, manage, dispose of and finance portfolios of different buildings  Facilitiesmanagement Manage services that support building functioning – Procurement and contract management – Building and grounds maintenance – Cleaning – Catering and vending – Health and safety – Security – Utilities and communications – Infrastructure and space management  Corporate real estate management Manage the building as – A place to do business Trend: aligning real – A way to brand the firm estate strategy to – A significant financial investment business strategy Responsible for – Site analysis – Leasing versus owning decisions – Building acquisition and disposal – Property and facilities management  Property valuation Estimate and offer value opinions for – Residential property The cornerstone of – Non-residential property real estate market Retail property Offices Industrial property Hotels Restaurants Farms and vineyards Golf courses, gas stations etc Site analysis, leasing/owning decisions, property tax appeals, investment analysis and portfolio valuation  Development More entrepreneurial than the others – Acquire land and old buildings (that could be renovated) – Build homes, offices, hotels, factories, shopping centres – Sell directly or through agents  Finance Residential Finance Commercial Property Finance  Types of Real Estate Residential – Used as homes – Zoned vacant land – Dwelling: free standing permanent building on single identifiable piece of land – Cluster housing: high density group housing Each house on a separate sub-division of land Both house and land owned by same person Owner has separate title for the property  Types of Real Estate Residential – Sectional title Complex divided into sections Each section owned by different owners Different rights to owner – Exclusive usage rights – Access to common areas – Share block Owned/leased by company Share owner gets right to occupy unit within building Shares are not recognised as immovable property Shareholder only has usage rights  Types of Real Estate Residential – Time share A number of people have right to occupy e.g. apartment over recurring short periods of time (e.g. 1-4 weeks/year) Mainly used for holiday accommodation Not immovable property and cannot be mortgaged  Types of Real Estate Commercial – Suitable for trading purposes retail wholesale service – Vacant commercial land zoned for commercial use – Buildings and developments – offices, shopping centres and hotels – leased for rental incomes and value appreciation – offices owned as corporate real estate Main Components of Real Estate Investing Market Relationships Reframing Research Assess the Your network is Negotiations underlying your networth – determinants of a project’s income- Robert Kiyosaki earning capacity at a macro and micro economic level Real Estate Economics The basic economic principles that govern the functioning of urban real estate markets.  Chapter learning outcomes Describe the concepts of demand and supply of real estate Describe the price/rent adjustment process Explain disequilibrium and ways of assessing disequilibrium Information Classification: General  Real estate demand Nature and drivers Information Classification: General  Real estate demand How much of space/number of units of real estate users are willing and able to buy/rent at each possible price over a given time period, other things constant Planned rate of purchase per period at each possible price (entire curve); different from a point on the curve Different conceptions of demand Effective demand Ex ante demand Ex post demand Pent-up demand Information Classification: General  Change in quantity demanded (1) Change in quantity demanded in response to change in price Movement along the same demand curve Price elasticity of demand Responsiveness of quantity demand to price changes Ratio of proportionate change in quantity demanded to proportionate change in price Elasticity greater than, equal to, or less than 1 Information Classification: General  Change in quantity demanded (2) At the macro level, elasticity of demand allows assessment of impact of price/rent changes on demand At the micro level allows us to see the impact of price changes on revenue Information Classification: General  Actual and expected price changes Law of demand generally holds Rent rises can also be accompanied by increases in amount of housing demanded Same applies to rising office rents and increased absorption Violation of the law of demand? Increases not triggered by actual prices but expectations of future price increases (all things equal) Information Classification: General  Changes in demand Demand curve - relationship between price of a good and quantity demanded when other factors that could affect demand remain unchanged – the shift factors Market size (Population, Employment) Income/wealth Prices of substitutes Expectations Information Classification: General  Market size Relevant drivers include Population, employment or output (depending on property type) Housing and retail driven by # of households Office space is driven by office employment Industrial demand driven by industrial output and warehouse & distribution employment Information Classification: General  Income/wealth effects Positive direct effects on retail and residential units Indirect positive effects on office space through office employment Indirect positive effects on industrial space through growth in consumption Information Classification: General  Prices of substitutes Housing market Increases in town houses rents likely to increase demand for apartments When renting becomes more expensive relative to owning some renters may find home-ownership more attractive – increased demand for owner occupied housing Office market Rent increases in class A markets may force firms to seek offices in class B markets Information Classification: General  Consumer/firm expectations Housing market Expected price increases may motivate some households to accelerate their home buying plans Office market Expected rent increases may result in ‘banking of office space’ Lease more space than current needs Information Classification: General  Measuring changes in real estate demand Done using the concept of absorption Gross absorption Net absorption Normal/average absorption Information Classification: General  Gross absorption Total amount of space from all leases signed during a period A measure of market turnover Does not account for vacancies Gives no indication of changes in aggregate demand Information Classification: General  Net absorption Change in market’s occupied stock during a particular time period If and then Where S is total market stock and V the vacancy rate Information Classification: General  What factors drive net absorption? DETERMINANTS OF NET ABSORPTION Information Classification: General  Determinants of net absorption Prices/Rent (-) Income/wealth (+) Market size (Population, Employment) (+) Prices of substitutes (+) Expectations (+) Information Classification: General  Given the multiple determinants of net absorption, handle with care Is it due to changes in rents? Employment, population or income growth? Or simply due to expectations? Increasing absorption may be due to pent-up demand Information Classification: General  Real estate supply Nature and drivers Information Classification: General  Real estate supply Amounts of non-residential space/housing units offered for sale or available for rental at various prices per unit of time Supply curve typically upward sloping Three concepts of supply Long-run aggregate supply Short-run aggregate supply New construction Not equally useful in period-by-period forecasts of changes in market inventory Information Classification: General  Long-run aggregate supply Amounts of non-residential space/housing units offered for sale or available for rental at various prices over the long run Upward sloping Useful for analysing long-run behaviour of real estate markets Information Classification: General  Short-run aggregate supply A market’s total stock at a given point in time Very useful for analysing short-run adjustments in real estate markets Communicates important behavioural characteristics The fixity of real estate stock in the short-run Due to the lag in construction: time needed to plan and develop a building Information Classification: General  Short-run aggregate supply P S P2 b D2 P1 a D1 O Short-run aggregate Q1 Q Information Classification: General supply  Construction lag Construction lag 6 to 12 months for residential and industrial 18 to 24 months for office and retail Construction lag makes short-run supply of real estate insensitive to price/rent changes Supply perfectly price inelastic If office rents increase tomorrow by 20%, total office space stock will remain unchanged for some time Information Classification: General  New construction The most important supply concept in market analysis The total square footage in all new buildings that have been given a certificate of occupancy or passed the final inspection under the building permit during the period under consideration. Information Classification: General  New construction Modelled using the stock-flow identity Stock at time t, equals the stock of the previous period, St-1, minus the depreciated stock, dSt-1, plus completions during period t, Ct. Information Classification: General  Pipeline effect 3 stages of the development process: a) building permit b) start of construction c) completion From conception to completion, leakages could occur Not all projects get a permit Not all permitted projects get started Not all started projects get completed Magnitude of leakages depend on market conditions Information Classification: General  New construction behavior Obeys the law of supply Higher property prices induce new space production Threshold asset price below which no space is produced Developers cannot cover costs and return a profit Information Classification: General  Elasticity of supply Responsiveness of new construction to asset price/rent changes is captured by elasticity of supply High cost and low availability of factors of production Less elastic supply New construction is, on average, very price elastic Especially in office markets Information Classification: General  Drivers of new construction Profit - major determinant of speculative commercial project/housing development Determinants of new construction Determinants of profitability and risk of new construction Availability and cost of inputs Expectations of future demand and prices Perceived market risk Information Classification: General  Types of expectations (1) Myopic expectations, where investor/developer assumes current demand/price levels/increases will continue into the future Adaptive expectations where investor/developer form current expectations by adjusting them based on past errors Rational expectations where developers/investors ca use relevant market information to correctly predict market response to exogenous shocks [DiPasquale & Wheaton,1996] Information Classification: General  Types of expectations (2) Studies show investors and developers form their expectations myopically expectations of growth in demand, rents, and/ or prices should have a positive effect on new construction New construction should also be affected by market risk or the perceived uncertainty of a market in supporting development of specific asset risk and uncertainty should have a negative effect on new construction Theory of irreversible investments a given asset price, an increase in risk should result in lower real estate construction Information Classification: General  Price determination Rental/price adjustments Information Classification: General  Equilibrium prices/rents Equilibrium prices/rents equate quantity demanded and quantity supplied of space Prices/rents above equilibrium result in surplus (excess supply) space that puts a downward pressure on prices/rents Prices/rents below equilibrium result in shortages (excess demand) space that puts an upward pressure on prices/rents Only in equilibrium are these forces absent Information Classification: General  Equilibrium and price determination S Surplus space P2 P1 a P3 Shortage of space D1 O Q1 Q Information Classification: General  Short run price adjustment S P2 b D2 P1 a D1 O Short-run supply Q1 Q Information Classification: General  Long run price adjustment S P2 P1 D2 D1 O Q1 Q Information Classification: General  The stock-flow model The short-run time paths of price, rent, and supply adjustments Information Classification: General  The simple stock-flow model Information Classification: General  The stock-flow model in a demand supply framework Information Classification: General  Assessment of the stock-flow model (1) Cycles can be generated by repeated positive/negative demand shocks Repeated positive demand shocks likely to increase rents and construction Stock increases create surpluses Surpluses depress prices and new construction Price elastic supply also creates cycles Excessive construction in response to price/rent increases Information Classification: General  Assessment of the stock-flow model (2) Initial demand shock triggers an increase in rents and prices developers and investors over- react, initiating an excessive amount of new space New completions push the real estate stock above its long- run equilibrium level which, in turn, causes rents/ prices to decline below their long- run level in order to equate the excessive stock with existing demand Rents, prices and construction decline below their long-run level long- run completion rate should equal the depreciation rate if there is excessive stock, the completion rate needs to decrease below the depreciation rate durability of real estate means that is the only way the existing stock can decrease Information Classification: General  Assessment of the stock-flow model (3) Simple stock-flow model views market adjustments as a series of short-run price equilibria Applicable only to markets with low, stable vacancy rates, absence of overly long construction lags, e.g. residential markets Less applicable to office markets characterised by near constant disequilibrium Stock-flow model has to be adjusted to explain office market behaviour Information Classification: General  Demand-supply imbalances Real estate market inefficiencies Information Classification: General  Market inefficiencies Scarcity, cost and timeliness of market information Construction lags prevent speedy adjustment of supply to demand and price changes Long term leases prevent speedy adjustment of existing leases and contract rents to changes in supply and demand Information Classification: General  Disequilibrium Excess demand or excess supply Excess demand characterised by rising rents and prices Excess supply characterised by falling rents and prices Two simplistic approaches Trends in [C-AB] Nominal vacancy rate trends [C-AB] reflects change in market’s vacant stock If [C-AB]>0, vacant stock is rising If [C-AB]0,prevailing rents are likely above equilibrium value and decreases are likely in the future R– R*