The nature of real estate (RE) and RE markets

Chapter 1 of Real Estate Principles: A Value Approach by Ling and Archer, 5th Ed.
Chapter 1 of Commercial Real Estate: Analysis & Investments by Geltner, Miller,
Clayton 7 & Eichholtz, 2nd Ed.
TEXT
 OUTLINE

The nature of real estate (RE)

Supply, demand and rent in space market

RE markets and participants

Characteristics of RE markets

RE: Importance
 REAL ESTATE (RE): BASIC DEFINITIONS

• RE is property.
• Property refers to anything that can be owned or possessed.
• Property can be:
• a tangible asset, e.g., land/building, automobile, clothing
• an intangible asset, e.g., a lease/mortgage agreement.

• Real property is defined as rights in land

and its permanent structures. Personal
property is the rest; that is, it is simply
rights in any other kind of object, including
intellectual property.
 REAL ESTATE (RE):
BASIC DEFINITIONS

• We use the term “real estate” to refer

three things:
(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 gives the owner 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-
(1) the surface of the earth,
(2) rights to air space above the land up to a certain height,
(3) rights to the subsurface down to the center of the earth and
to the minerals contained therein, and
(4) the improvements to the land, e.g., walkways and water
drainage systems, fences.
 RE AS
TANGIBLE
ASSETS
 RE AS A BUNDLE OF RIGHTS

The bundle of rights is the services/benefits that RE provides to

its users. For example, RE provides owners with the rights to
shelter, security, privacy, doing business, etc.

The bundle of property rights is subject to different limitations.

For example, an apartment owner divides his/her full interest
in the property when he or she leases an apartment.

The value of a bundle of rights is a function of the property’s

physical, locational, and legal characteristics.
 The physical characteristics include the age,
size, shape, design, and construction quality of
the structure.

RE AS A For residential property, the locational

BUNDLE OF characteristics include convenience and access
to places of employment, schools, shopping,
RIGHTS… health care facilities.

Bundle of rights often is reduced by state and

local land use restrictions.
• The industry has a variety of
professions:
(1) brokerage, RE AS AN
INDUSTRY AND
(2) leasing and property management, PROFESSION
(3) appraisal,
(4) consulting and advising,
(5) property development and
construction,
(7) financing, mortgage, and
securitization, investment, and
(9) governmental planning, taxation,
and regulation.
 TYPES OF COMMERCIAL PROPERTY MARKETS

• Two types of markets relevant to commercial property:

1. The Space Market . . .
– For the usage (or right to use) “real property”.
– AKA “usage market”, or “rental market”.
– (e.g., tenants & landlords exchange money for
rents/leases.)
2. The Asset Market…
– For the ownership of “real property”.
– AKA “property market”.
– (e.g., you buy a house to live there or an office space for
renting out)
 SUPPLY, DEMAND, AND RENT IN THE SPACE MARKET

• Basic concepts of supply and demand and market

equilibrium can help us to understand what goes
on in a typical space market.
• We will consider the space demand in a typical
CBD (central business district) or downtown. The
same mechanism can be extended to explain the
demand-supply of suburban areas.
• The underlying source of the space demand was
the need of office workers for space in which to
work. As the number of office workers increased,
this need grew.
• The need for office space also grew because
technological change, such as the rise in the office
use of personal computers and fax machines, made
more space necessary per worker.
 SUPPLY, DEMAND, AND RENT IN THE SPACE MARKET…

𝐷𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑂𝑓𝑓𝑖𝑐𝑒 𝑠𝑝𝑎𝑐𝑒 = 𝑓(𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡)

The growth in office space

demand is represented in the
Exhibit by the movement to
the right of the demand
function, for example, from a
previous time when there were
24,000 workers to the time
when there were 30,000
workers and to 36,000
workers.
 SUPPLY, DEMAND, AND RENT IN THE SPACE MARKET…

𝐷𝑒𝑚𝑎𝑛𝑑 𝑓𝑜𝑟 𝑂𝑓𝑓𝑖𝑐𝑒 𝑠𝑝𝑎𝑐𝑒 = 𝑓(𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡)

Notice that if the underlying

need for office workers in the
downtown increased further, to
36,000 workers, for example,
then demand in the market
would support an additional 1
million SF of space if there is
enough supply (a total of 6
million SF, assuming it was 5
million initially would be
needed) at the $16/SF rent.
 SUPPLY, DEMAND, AND RENT IN THE SPACE MARKET…
• The typical real estate supply function does not look like classical
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(rise), office space cannot be
reduced (increased) (at least in the short to medium term, even for
several years).
• Compared to most other products, buildings last much longer. Rarely
is a building torn down within less than 20 or 30 years from the time
it is built. So at least for several years the market will maintain pretty
much the same quantity of supply it already has, in the case of a fall
in demand.
SUPPLY, DEMAND, AND Supply function for any competitively
RENT IN THE SPACE supplied product is simply the marginal
MARKET… cost function for producing additional units
of the product.

In the case of built space, the marginal

cost is the cost of developing new buildings
(site acquisition cost + construction cost +
profit for developers).

Rising LRMC (costs more to build next

than the last) Land scarcity, Location
demand increase. LRMC must be >Rent for attracting new
investment.

Falling LRMC (costs less to build next than

the last) Loss of centrality, Location
demand decline
 SUPPLY, DEMAND, AND RENT IN THE SPACE MARKET…
• Suppose that the office market in 2000 and in 2009. In the
late 2000s, developers in that market, apparently
anticipating further growth in office demand, built an
additional 1 million SF of new office space, expanding the
supply from 5 million to 6 million SF.
• This change in supply is indicated in the Exhibit (next slide)
by the movement of the supply function to the right, from 𝑆1
to 𝑆2 , assuming a flat long-run supply function.
• Had the demand continued to grow, from 𝐷1 to 𝐷2 for
example, this expansion of supply would have been justified,
and rent levels in the market would have remained at the
long-run equilibrium level of $16/SF.
SUPPLY, DEMAND, AND RENT IN THE SPACE MARKET…

•However, if the supply

overshot the demand. But
if the demand does not
change, the market
remained stuck essentially
with the same demand
function, 𝐷1 . Combined with
the new supply function of
𝑆2 , this caused market rents
to drop to levels around
$13/SF.
SUPPLY, DEMAND, AND RENT IN THE SPACE MARKET…

•During the general economic

recession in 2009 and the
subsequent corporate
downsizing, demand for office
space in the downtown fell, at
least temporarily, from its
previous level, perhaps to the
level indicated by 𝐷0 , resulting
in market rents temporarily in
the $10/SF range.
 • Real estate values derive from the
interaction of three different sectors, or
RE MARKETS AND markets, in the economy: local user
PARTICIPANTS: USER markets, capital markets, and property
MARKET markets.
• Real estate user markets are
characterized by competition among users
for physical location and space.
• This competition determines who gains
the use of each parcel of land and how
much they must bid for its use.
• The primary participants in user markets
are the potential occupants, both owner
occupants and or renters.
 RE MARKETS AND PARTICIPANTS: USER MARKET…

• Ultimately, the demand for real estate derives from the need
that individuals, firms, and institutions have for convenient
access to other locations, as well as for shelter to
accommodate their activities.
• Based on the financial positions of households and firms and
their wants and needs, they decide either to own and occupy
property, or to lease property from others.
 RE MARKETS AND PARTICIPANTS: CAPITAL MARKET
• The capital markets serve to allocate financial resources
among households and firms requiring funds.
• Participants in the capital markets invest in stocks, bonds,
mutual funds, mortgage contracts, real estate, and other
opportunities with the expectation of receiving a financial
return on their investment.
• Funds flow from investors to the investment opportunities
yielding the highest expected return (i.e., the greatest
benefit), considering risk. Thus, real estate competes for
scarce investment capital with a diverse menu of other
investment opportunities available in the capital market.
 RE MARKETS AND PARTICIPANTS: PROPERTY MARKET
• Finally, property markets determine the required property-
specific investment returns, property values, capitalization
rates, and construction feasibility.
• The capitalization rate, or the ratio of a property’s annual
net income from rental operations to its value, is a
fundamental pricing metric in commercial real estate
markets.
𝑁𝑂𝐼 𝑜𝑟 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑒𝑛𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒
𝐶𝑎𝑝. 𝑅𝑎𝑡𝑒 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦

• Q. What does 8% cap rate mean?

 CHARACTERISTICS OF RE MARKETS

• Real estate assets and markets are

unique when compared to other goods.
The two primary characteristics of
real estate assets are their
heterogeneity and immobility.
• Because of these two factors, the
market for buying, selling, and leasing
real estate tends to be localized and
highly segmented, with privately
negotiated transactions and high
transaction costs.
 CHARACTERISTICS OF RE MARKETS: HETEROGENEITY
• Real estate tends to be heterogeneous, meaning that each
property has unique features.
• Example of a relatively homogeneous product is gasoline.
Although it is possible to purchase different grades of gasoline
(e.g., octane levels), a gallon of gasoline received from a particular
pump cannot be distinguished from the next gallon.
• For real estate, however, age, building design (pool, bedroom,
garages), and location combine to give each property distinctive
characteristics. Even in residential neighborhoods with very
similar houses, the locations differ.
• Corner lots have different locational features than interior lots;
their access to parks and transportation routes may differ.
 CHARACTERISTICS OF RE MARKETS: IMMOBILITY
• Real estate is location, and it is immobile.
• Although it is sometimes physically possible to move a
building from one location to another, this is generally not
financially feasible.
• Most structures removed from the land are demolished
rather than moved.
• Another term for location is access. For households it is
access to school, shopping, entertainment, and places of
employment.
• For commercial properties it may be access to customers, the
labor force, or suppliers.
CHARACTERISTICS OF RE MARKETS: LOCALIZED MARKET

• Real estate markets tend to be localized. By this we mean

that the potential users of a property, and competing sites,
generally lie within a short distance of each other.
• For example, competing apartment properties may lie within
15 minutes, or less, in driving time from each other.
• While competing properties of single-family residences may
tend to be within a single elementary school district or even
within a small number of similar subdivisions.
 CHARACTERISTICS OF RE MARKETS: LOCALIZED MARKET…

• The market for a neighborhood shopping center is very localized.

• Such centers usually draw most of their customers from within a
five-mile radius, or less.
• For a parent looking for a gallon of milk, a convenience store 15
minutes away is not a good substitute for the convenience store
up the street.
• Users of other commercial property types do not depend so
heavily on access to a particular location. Thus, some commercial
property users may search a wide range of alternative markets
within a single metropolitan area or even among different
metropolitan areas.
 CHARACTERISTICS OF RE MARKETS: SEGMENTATION
• Segmented by building type : Households that search for
single-family detached units in the market will generally not
consider other residential product types such as an attached
townhouse unit or condominium.
• Segmented by region: A person who has a job in Rajshahi
may not want to consider a house in Dhaka. Competing
properties usually lie within a short distance of each other.
 CHARACTERISTICS OF RE MARKETS: SEGMENTATION…

• Segmented by price: In addition, real estate is segmented by

product price. The same holds true, although to a lesser
extent, in the commercial property market.
• Commercial property markets are segmented by both users
and investors. Larger, more valuable commercial properties,
referred to as investment-grade properties targeted by
institutional investors.
• Individual private investors typically do not compete directly
with institutional investors for properties.
 CHARACTERISTICS OF RE MARKETS: PRIVATELY NEGOTIATED
TRANSACTION AND HIGH TRANSACTION COST

• Transactions involving directly held real estate generally are

privately negotiated between the buyer and seller.
• The negotiation process can be lengthy, and the final
transaction price and other important details such as price
and other terms are not usually observable.
• The time and effort involved in searching, pricing, and
evaluating alternative properties is substantial. Transaction
costs include both search costs (e.g., time) and actual costs.
 CHARACTERISTICS OF RE MARKETS: PRIVATELY NEGOTIATED
TRANSACTION AND HIGH TRANSACTION COST

• Real estate agents, mortgage brokers, attorneys, and others

may be involved in the transaction due to the considerable
value of the investment.
• Thus, the transaction costs involved in the transfer of directly
owned real estate from one owner to another are high
compared to many other goods and investments.
 RE: IMPORTANCE
• Real estate is the single largest Symbol of strength, stability,
and independence
component of wealth in our society.
Because of its magnitude, it plays a
key role in shaping the economic
condition of individuals, families, and
firms.
• Changes in the value of real estate
can dramatically affect the wealth of
businesses and their capacity to grow.
• The adequacy of the housing stock, as
well as the public infrastructure,
including roads, bridges, dams,
airports, schools, and parks, all affect
the quality of life in a region.
• Real estate has been often become the
center of many regional disputes.