CHAPTER SIX: INCOME-

PRODUCING PROPERTIES
Reference
Page 249 - 290
Chapter Outline
• Property Types
• Supply & Demand analysis
• Business of Real Estate
• Market for Income-producing real estate
[IPRE]
• Income potential real estate assets
• General contents of lease
• Developing operating cash flow statement
• Various case examples
 Overview
• This chapter focus on income property investments
or what we call “income-producing properties[IPP]”
• Examples on apartments, office buildings, shopping
centers, & warehouses.
• Many concepts may include other property types
like:
– understand leases, demonstrate how properties are
appraised, how to analyze the potential returns &
risks of an investment, & how taxes impact
investment returns
• We also discus as how to evaluate whether a
property should be sold or renovated.
 Overview …
• Also we’ll look at how corporations [although not
in the real estate business], must make real
estate decisions as part of their business. This
could include whether to own or lease the
property & other issues.
• Furthermore, we’ll see how leases impact the
income potential and riskiness of income
property investments.
• Generally, it focus on investing or financing
existing properties, & not discusses how to
analyze projects proposed for development
 Types of Property
• Classification of Real Estate Uses:
Two major Real Estate use types:
• Residential
• Nonresidential &
• Mixed use (combines both uses)
Residential properties :
• Single-family houses & Multifamily properties
• Examples: apartments, Condominiums and co-ops
Nonresidential properties :
• six major subcategories: office, retail, industrial,
hotel/motel, recreational, and institutional
Property Types: Classification of Real Estate Uses
 Supply and Demand Analysis
• Market rents for properties depend on the
economic base, and on the supply and
demand for space by tenants.
• In this section, we look more closely at market
forces that affect both the supply and demand
for space and how these factors affect real
estate investments.
 Equilibrium Market Rental Rate
• At any point in time, a fixed stock of space exists in the
market in previously constructed buildings.
• Some of this space will be leased. The remaining space
constitutes vacancies, or supply of space available for lease.
• The price at which an owner can lease the space depends
on the market rental rate on comparable properties.
• The amount of existing space that building owners are
willing to lease at different rental rates is expressed by a
supply curve [ see next slide].
• As the market rental rate rises, more space is supplied by
the building owners.
• The maximum amount of space that can be leased at any
given point in time is limited to the existing stock of space.
Figure 6.1 : Rental Market Equilibrium
Figure 6.2: Increase in Demand & Supply
 Change in Equilibrium: Implications for Risk
• In general, market rent depends on changes in the demand
for space & expected changes in the supply of space.
• Expected & unexpected changes in market rental rates over
the entire economic life of a property affect the return & risk
associated with investing in that property.
• Changes in the demand for space can result from a number of
factors that affect the economic base of the area where the
property is located.
• Changes in the supply of space can result from developers
reacting to anticipated increases in the demand for space or a
belief that they can attract a sufficient number of tenants
from existing buildings to make their building profitable.
• Local Market Studies of Supply and Demand analysis is key
for Real Estate Investment.
Question

What are the factors affecting supply and demand for real estate?
Determinants of Supply & Demand: Major Property
Types
Determinants of Supply & Demand: Major Property Types…
 Location and User-Tenants
• After identifying the determinants of SS & DD for REP,
we develop a conceptual framework for determining
how locations within a city are evaluated by
businesses.
• It goes without saying that location is an important
attribute in real estate.
• Successful real estate investors and developers must
also realize that location as viewed by user-tenants is
also important to recognize.
• Real estate investors & developers should understand
the business operations of potential tenant-users and
how certain locations will appeal to those users.
 Location and User-Tenants…

• Consequently, most real estate decisions made by

these users are considered in terms of how
leasing space in alternative locations will
generate more profit by:
1. Increasing sales revenue,
2. reducing the cost of operations, or
3. some combination of both.
• A very basic illustration of the relationship
between user profits and locations can be seen in
table 6.1.
Table 6.1:Relationship between User Revenue,
Expenses, and Profits per Square Foot by Location
 Maximizing profits from Real Estate Investment
• Certain general land-use results in real estate markets:
i. The process of firms competing for space will result in the
highest rents possible for the most profitable locations &,
ultimately, the highest land value & best development for a site
(e.g., office, retail, warehouse, apartment, or hotel).
ii. Locations will tend to be dominated by clusters of users with
revenue or operating expense structures that relate in similar
ways to a given location.
iii. Locations with the greatest appeal to users will tend to
produce higher rents and also to exhibit highest spatial
densities.
iv. Some locations are competed for by firms that are most cost-
sensitive. These firms tend to require large amounts of land
and large facilities on which to conduct larger scales of
operations at lower rents per square foot.
The Business of Real Estate
• Contrary to popular belief, the vast majority of real estate used by
business firms is leased and not owned.
• Why is this the case?
• There are many important reasons:
1.Most tenants find leasing to be more cost-effective than owning;
Because
i. Owning would require a large commitment of capital
ii. A purchase would “put the user in the real estate business”
• Example: assume that a user needs 20,000 square feet of space to
operate profitably, and it must have such space in a specific location.
However, only buildings with a minimum size of 100,000 square feet are
available for purchase in that location.
• In this case, the user will usually opt to lease the 20,000 square feet of
space as opposed to purchasing a 100,000-square-foot building.
• Leasing will usually be preferred b/se purchasing would include the
responsibility for leasing the remaining 80,000 square feet of excess
space to other users.
 The Business of Real Estate…

2. Even if a tenant could occupy the entire 100,000 square feet

in a building, it might still choose to lease because:
i. Owning would reduce operating flexibility
ii. If it owns the property, the firm must operate, maintain, & repair
facility
iii. If the firm decided to size down from using 100,000 square feet, as
the owner of the building it would have to engage a broker to find
an additional user or buyer for the excess space.
• The real estate industry includes economic functions that are
specialized in nature & are separate and distinct from the
operations of the many different business activities conducted
by tenant-users.
• Business firm - users are best left to focus on their primary
activities
– E.g., lawyers, accountants, advertising companies serving clients, &
retailers serving their customers.
 The Business of Real Estate…
• The noncore[special] real estate business
activities include the risks of:
1. Selecting the “right tract” of land and developing the
“right amount” of space;
2. Leasing that space to many different tenants;
3. Hiring personnel, collecting rents, and maintaining
the facility;
4. Finding financing for the investment or development;
and
5. Doing continuous research about real estate markets
in order to decide when to sell, raise or lower rents,
renovate, and so on.
 The “Market” for Income-Producing Real Estate

• What is this?
• Given the preceding discussion about:
1. the general relationships between users seeking a location to
maximize profits,
2. the general desirability among users to lease rather than own
the space they need in their operations, and
3. The advantages in terms of cost effectiveness of depending up
on the real estate business/industry to perform the functions
and risks associated with developing, owning, leasing, &
maintaining land and buildings, clearly market for RE services
has emerged.
• When making real estate investments, one must understand
how this competitive market operates & the nature of the
negotiations between owners of RE and tenant-users.
 The “Market” for IPRE….
 Property expenses are usually allocated by owners to
users, and property owners do not pay expenses
associated with the operations of tenants.
 In order to estimate total occupancy costs for tenants and
profits for owners, there are many other areas of
negotiation between real estate owners and business-
users of real estate or tenants in addition to rent.
 These may include additional rights and responsibilities of
both parties that are usually contained in leases.
 Lease contents are important because they affect how
much income may be produced from an investment
property, the legal responsibilities, & any future options
negotiated between owners & tenants that may ultimately
affect the value of an investment.
 Income Potential—Real Estate Assets

 Here the goal is to familiarize the student with the

operating & lease characteristics for each & how
forecasts of cash flow may be developed.
 The term market rent refers to the price that must be
paid by a potential tenant to use (lease) a particular
type of space under then current market conditions.
The rent depends on factors, including ;
a) the outlook for the national economy,
b) the economic base of the area in which the property is
located,
c) the demand for the type of space provided by the
property in the location being analyzed, and
d) the supply of similar competitive space.
 Income Potential—Real Estate Assets…

• Example1: the market rent on office buildings

depends on:
– The number of firms doing business in the area,
– the likelihood of new firms locating in the area,
– The number of employees these firms currently
employ and are expected to employ in the near
future, and
– Amount of space that the firm needs for its
employees to do their job.
 Income Potential—Real Estate Assets…

 Similarly, the market rent on apartments depends on:

 the demographic makeup of the population

 The median income of families in the area in which

the property is located,
 the cost & availability of homes or condominiums
to purchase as an alternative to renting an
apartment, &
 other factors.
 Income Potential—Real Estate Assets…

 Market rents for retail space also depend on the demographic

make up of the population and the median income of families
as well as the percentage of income they typically spend on
various goods and services from retail establishments in a
particular area.
 Real estate investors must be very worried with the credit
quality of tenants.
 As a part of the leasing process, credit reports, bank
references, and references from suppliers and customers are
all important.
 Real estate is a durable asset that has a relatively long
economic life.
 The market rent at a given point in time is the price that users
must pay for the use of a particular unit of space, say, the
rent per square foot of leasable area in a building.
 Income Potential—Real Estate Assets…
• The value of a particular property at any point in
time depends on the present value of the rental
income expected from the building over its
remaining economic life.
• Therefore, real estate investors must consider
how changes in the supply and demand for
space might affect market rental rates over the
economic life of the property.
 Vacancy

 As indicated previously, all space available in a

building may not be lease data particular time.
 This is because tenants may leave after their lease
has expired or breach their lease agreement before it
expires, or it could be that the space has never been
rented, mainly if it is in a newly constructed building.
 It is more difficult to project vacancy for newly
constructed properties.
While some leases may be signed before a project is
completed, it is possible that less than full occupancy
will be achieved immediately after construction is
completed.
 Vacancy…

• At this point it is useful to make a few additional

observations.
• First, when dealing with an acquisition of a property
& developing a pro forma statement that will be used
in an investment analysis, it is important to stress that
such a forecast should contain a summary of cash
flow only.
– The focus on cash flow is stressed and should be
differentiated from statements that stress accounting
income determined in accordance with generally accepted
accounting principles (GAAP).
• Second, the term net operating income (NOI) is used
extensively in the real estate investment business.
Useful Data Sources for Income Property Research
 Remaining contents of the Chapter, PP: 266-296
• Underwriting Tenants
• General Contents of Leases [about 15]
• Leases and Rental Income
• Leases and Responsibility for Expenses
• Large users of lease space
• Comparing Leases: Effective Rent, effective net rent
• Other Financial Considerations
– concessions and/or tenant improvement allowances (Tis
• Developing Statements of Operating Cash Flow
 Text Book of this Chapter
• William B. Brueggeman, & Jeffrey D. Fisher.
[2022].Real Estate Finance and Investments,
Seventeenth Edition. McGraw-Hill Education,
USA, New York.
• Other reference books that were already
distributed can be used too.
Thank You!

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