Real Estate Markets

Chapter 5
Two Types of Real Estate Markets
A market is a mechanism for the voluntary exchange
of goods and services among owners.

There are two types of real estate markets for our

consideration in this course. They are:
Real Estate Space Market
Real Estate Asset Market

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Real Estate Space Market
The term “space market” is the market for the usage
of real property.

In this market, tenants exchange rent with landlords

for the right to use land and built space.

This market is often called “the rental market.”

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Real Estate Asset Market
The term “asset market” refers to the mechanism for
the voluntary exchange of ownership of real property.

In this market, buyers exchange money with sellers

for ownership rights to land and built space (real
estate).

This market is often called “the property market.”

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Let’s first consider several characteristics of “space markets.”
After that, we will look at the characteristics of “asset markets.”

Before that we have to look factors that affects the market

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Real Estate Market Environment
 Market research and anlysis

Market research & marketing consulting firms

Financial intermediaries
Customers
Competitors
General public
 Market anaysis

Market research & marketing consulting firms

* Market study
* Feasibility study
* Marketing

Financial intermediaries
* Loan margin
* Borrowing cost
* Lending policies
 Customers

Customers
* Which target (individual, group,
institution)?
* Type (e.g. first-time, non first-time)?
* Needs, wants, choices, preferences?
* Affordability?
* Behavioural aspects?
* Cultural aspects?
 Competitors
 Competitors
* Who are they?
* What are producing?
* How, how much, and where?
* What are they offering?
* What are their marketing strategies,

 Identify gaps in opportunities, secure a certain market position, fill

the gaps, and, subsequently, capture the market share.
 General public

General public
* Who are they?
* What are their roles and functions?
* How do these roles and functions affect
company’s business or project?
 Outer Environment

Demographic
Market/Economic
Cultural
Political
 Demography

Population
* size
* quality
* distribution
* growth prediction
Supply and demand
 Economy

People’s affordability
* income
* property price
* credit facilities
* interest rate
* amount of saving
Lack of affordability → discourages DD
Property Price, Consumer Income, and Buyers’
Affordability
 Social

 Culture: psycho-sociological and/or socio- psychological

 Psycho-sociology…
* Consumer behavior (e.g. preferences)
* Norms and values
* Belief
 Socio-psychology…
* Lifestyle
* Perception
 Political

Political
* Government policies
* Government regulations
Have “ripple” effects
Tend to raise developer’s costs
 Importance to Market Research

Researching STEP fundamentals

Market forecast
Continuous flow of information
 Summary

 Market environment: a milieu in which factors and forces that are

external to the management functions of a firm impinge upon the
company’s ability to develop and maintain successful business.

 Immediate market environment: various groups of customers and the

general public.

 Outer environment: demographic, economic environment; cultural

environment; and the political environment (STEP)
 Significant implications to market research:
 Researching the STEP fundamentals
 Market forecasting
 Continuous information
Characteristics of the Space Market: Demand and Supply

Demand side of this type of market includes individuals,

households, or firms who want to use space for consumption or
production purposes.

Supply side of this type of market includes real estate owners

who “rent” (used as a verb here) space to tenants.

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 Characteristics of the Space Market: Rent

 “Rent” as noun refers to the price of the right to use space for a period
of time.

 May be measured in $ per square foot per year (office space), $ per
month per unit (apartments) or various other methods.

 Determined by the interaction of supply and demand forces.

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 Characteristics of the Space Market: Equilibrium

When the quantity of space demanded equals the

quantity supplied, the market is in equilibrium.

The observed rent at equilibrium is called market rent.

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 Characteristics of the Space Market:
Market Rent Changes
The principle of supply and demand states that equilibrium price
in a market is directly related to changes in demand and
inversely related to changes in supply.

Market rent, therefore, is directly related to changes in demand

and inversely related to changes in supply.

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 Characteristics of the Space Market: Segmentation

 The real estate space market is highly segmented, meaning that it

tends to be local in nature and specialized by property usage.

 Within each segment, or submarket, the same good may have a

different equilibrium price.

 Market rent for office space may differ significantly between Bole and
Lideta.

 Market rent for retail space and warehouse space in the same city may
different dramatically.
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Why is the Real Estate Space Market Segmented?

On the demand side:

Users require specific types of space
Users require specific locations

On the supply side:

Buildings are built for specific uses
Buildings are fixed in location

Thus, we often talk of “geographic” or “property usage”

submarkets.
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Characteristics of the Space Market: Demand Curve
The typical space market (or submarket) has a
“downward sloping” demand curve.

$25

$20
REAL RENT

Real Estate Demand Curve

$15

$10

$5
3.5 4 4.5 5 5.5 6 6.5
QUANTITY OF SPACE (Mil. SF)

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Characteristics of the Space Market: “Kinked” Supply

The typical space market (or submarket) has a

“kinked” supply curve.
$25
REAL ESTATE SUPPLY CURVE

$20
REAL RENT

KINK

$15

$10 EXISTING
QUANTITY

$5
3.5 4 4.5 5 5.5 6 6.5
QUANTITY OF SPACE (Mil SF) 27
Characteristics of the Space Market: Why these shapes ?

 The shape of the demand curve makes sense when we consider that
users will prefer more space when prices are low than they will not
when prices are high.

 The shape of the supply curve (kinked) makes sense when we

consider that the amount of built space is fixed in the short run
because it takes a long time to add new space and because existing
space lasts a long time.

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Characteristics of the Space Market: Where is the Kink?

 The kink occurs at the price equal to the marginal cost of adding
new space to the submarket.

 From basic economics, we know that the supply function for a

competitively produced product equals the marginal cost function.

 The marginal cost of built space includes site acquisition costs,

construction costs, and the developer’s necessary profits.

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Characteristics of the Space Market: Impact of the Kink

 Placing the supply and demand curves on the same graph, we can
see the impact of the kink on equilibrium prices in a submarket.

REAL RENT
$25 As demand increases from
D0 to D1, equilibrium price
$20 D2 increases from about $13 to
D1 about $16. If demand
LRMC continues to increase to D2,
16
$15 D0
13
the price remains at $16 as
new space is brought online
$10 by suppliers (S2).
S1 S2
$5
3.5 4 4.5 5 5.5 6 6.5
QUANTITY OF SPACE (Mil

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 Some Important Observations

 In submarkets with rising long-run marginal costs (rising land prices make the
next building more expensive than the prior one), the supply curve is
increasing beyond the existing supply quantity.

 In submarkets with falling long-run marginal costs (the next building is cheaper
to construct than the prior one), the supply curve is decreasing beyond the
existing supply quantity.

 the supply curve is flat beyond the existing supply quantity because the next
building probably costs the same as the previous one (in real terms).

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 Characteristics of the Asset Market:
 “Asset market” refers to the market for the ownership of real estate assets (land and
the buildings on it) rather than the use of space in real estate assets.

 Buyers in this market purchase real estate in expectation of receiving future cash
flows (rent paid by tenants).

 These buyers could buy other kinds of assets (stocks, bonds, etc.) that would also
produce future earnings.

 In this sense, the real estate asset market is really a part of the larger capital
market.

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 Overview of Capital Markets

Capital markets can be divided into four categories

Public equity markets
Private equity markets
Public debt markets
Private equity markets

Where do real estate assets fit?

In all four categories, in some fashion!

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Types of Capital Asset Markets and Investment Products

Public Markets Private Markets

Stocks Real Property
REITS Private firms
Equity Assets Mutual Funds Oil and gas partnerships
Bonds Bank loans
MBS Whole mortgages
Debt Assets Money Instruments Venture debt

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 Characteristics of Capital Markets

 Public markets are more liquid than private markets and thus are more
informationally efficient.

 Private markets are usually for transactions involving “whole” assets rather than
shares of assets (like stocks) as we typically see in public markets.

 Debt assets give their owners the rights to future cash flows to be paid by
borrowers on loans.

 Equity assets give their owners the rights to the residual cash flows generated by
an underlying asset after other claim holders (including debtors) have been paid.

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 Pricing Real Estate Assets

Commercial property prices are typically quoted in terms

of “Cap Rates” (short for “capitalization rates”)

Also known as overall rate (OAR)

Defined as:

current annual net income

Cap Rate 
property price

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 Characteristics of Cap Rates

 Cap Rate can be thought of as:

 Current yield on the investment
 Inverse of a “price/earnings” ratio

 Three major determinants of the cap rate are:

 Opportunity Cost of Capital - from the capital market. Considers how much investors
could earn on other types of capital assets. Higher OCC implies higher cap rate.

 Growth Expectations – from the space market. Considers how much investors think net
cash flows will increase in the future. Higher growth implies lower cap rate.

 Risk – from both the space and capital markets. Considers how risky a property is
relative to other properties and other asset types. Higher risk implies higher cap rate.

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 Is the Asset Market Segmented? No (not very)
 “Physical Capital” = Real physical assets that produce real goods or services over an
extended period of time.
 “Financial Capital” = Money. 
 Physical capital is specific and relatively immobile.
 Financial capital is fungible (homogeneous) and very mobile.
 In the real estate asset market, financial capital is used to purchase physical capital assets.
 The real estate space market deals with physical capital.
 The real estate asset market deals with financial capital.

 Financial capital can quickly and easily flow from a one office building in Bole to a other office
building in Lideta or apartment buildingin Piassa. Returns are all returns, because $$$ are $$$
are $$$, whether those $$$ come from Bole office rents, Lideta office rents, or Piassa
apartment rents. Therefore:

 THE REAL ESTATE ASSET MARKET IS NOT SEGMENTED LIKE THE SPACE MARKET
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What is the overall magnitude of real estate in the capital market?

Real Estate Assets account for:

50% of all Private Debt
15% of all Public Debt
85% of all Private Equity
15% of all Public Equity

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 Is Real Estate Market Efficient market?

Efficient market refers as:

Similar product,
ample knowledge about the market,
 no/little government intervention,
stable prices (relatively)
easy product supply and transport
Efficient market – perfect competition
Real estate market is far from perfect
 Factors that affects real estate market

1. Every parcel of real estate is unique – can not

be interchangeable to other parcel
2. Buyers and seller lack information
3. Buyers and sellers frequently moves away
from equilibrium
Create either seller or buyer market
Seller market = many more buyers than seller
Buyer market = many more seller than buyers
 Factors that affects real estate market

4. Real estate market is highly regulated

5. Real estate is immobile while price is volatile

Location factors – shipment cost – other goods
Location is most important single factor
The seller of real estate can build, improve the property,
advertise, make promotion but ……

Analyze the needs and requirement

Market analysis
 Demographic factors are important
 The overall market area further defined by
“segmentation”

 Segmentation categorization of consumers

preferences according to income, work, leisure
and other lifestyle patterns
 By knowing as much as possible people who
make up market area
Market analysis
a) possible to predict the probable demand
b) demand of various types
c) prices levels etc.
 Absorption analysis

It is a study of the number of units of residential or

nonresidential property that can be sold or leased over
a given period of time in a defined location

space inventory is required in light of demand

absorption is performed as part of feasibility study
Feasibility study – cost / benefit analysis
Political climate and government regulations
 Functions of the real estate market

1. To allocate existing real property resources and

interests
land is scarce resource – must be allocated b/n the
various uses – needs and requirement – arriving at
equilibrium price
the market reflects preferences and allocates the
available supply
different people prefer different types of interest
2. To indicate changes in demand for land recourses
and interest
 Functions of the real estate market
a) Expectations of future yields
b) Taxation
c) Income and tastes
d) Institutional factors

3. To induce supply to adjust to change in demand

e) Developing real property
f) Changing existing interest
 Functions of the real estate market
4. To indicate changes in the conditions upon which
land resources can be supplied
Improving the technique of construction
5. To induce demand to respond to changes in the
conditions supply
6. To “reward” the owners of land resources
6.1. return on capital – opportunity cost – profit
6.2 economic rent – depends on demand – “super-
normal profit” – risk attached to any fixed factor
 Conclusion
The function of real estate market is to establish
prices and rent mechanism – long run (sufficient time)
to allocate scarce resources to their most profitable
uses.
Competitive market – owners switch resources
Highest and best uses
Different interest and preferences
 Quiz
1. does real estate has the characteristics of Financial
Capital or Physical capital or both expain?

2. What do you understand the space market and asset

market ?

3. What are the factors that should be consiered in cap rate?

Please work only one question from the listed.

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