Lecture 4 Land resources of Georgia, Landscape and Soil diversity . .... In practice, there is not a job or career that doesn't somehow involve a knowledge of real ... Working hours will often include nights and weekends, as these times ...... real estate will be demanded in terms of either square footage or number of units.
Marine Natsvaladze, Nino Beraia
Real Estate Economics Reader
Tbilisi, 2014 1
Lecture 1 Main concepts of real estate economics.............................................................................. 3 Lecture 2 Physical, legal, economic concepts of land; City Origins and urban development Patterns ............................................................................................................................................... 10 Lecture 3 Forms of Real Property Ownership; Property Encumbrances ....................................... 26 Lecture 4 Land resources of Georgia, Landscape and Soil diversity ............................................... 34 Lecture 5 Land Cadastre of Urban Areas in Georgia; GIS System .................................................. 44 Lecture 6 Basic real estate economics................................................................................................ 47 Lecture 7 The Property and Capital Markets .................................................................................... 84 Week 8 Intermediate exam ............................................................................................................. 99 Lecture 9 Operation of property markets: a micro and macro approach ...................................... 99 Lecture 10 Real estate market analysis ........................................................................................... 110 Lecture 11 Theory in practice: office market analysis .................................................................. 126 Lecture 12 Real Estate Investment ................................................................................................. 166 Lecture 13-14 General principles of Valuation of Real Property ................................................. 178
2
Lecture 1 Main concepts of real estate economics Economic, physical and legal features of real estate and real property; Careers in Real estate (Development, brokerage, valuation, urban planning, property management etc.) Land, Real Estate, and Ownership of Real Property 1 There is an important distinction is made between the terms real estate and real property. Real estate is an identified parcel or tract of land, including improvements, if any. Real property is the interests, benefits, and rights inherent in the ownership of real estate. Real estate is the physical land and appurtenances affixed to the land—e.g., structures. Real estate is immobile and tangible. The legal definition of real estate includes the following tangible components: •
Land
•
All things that are a natural part of land, such as trees and minerals
•
All things that are attached to land by people, such as buildings and site improvements
In addition, all permanent building attachments (for example, plumbing, electrical wiring, and heating systems) as well as built-in items (such as cabinets and elevators) are usually considered part of the real estate. Real property includes the interests, benefits, and rights inherent in the ownership of physical real estate. In an appraisal, a particular set of real property interests—not the real estate—is what is valued. Real estate in and of itself has no value; the rights, or interests, in real estate are what have value. Improvements -Any form of land development, such as buildings, roads, fences and pipelines. Personal property -A right or interest in things of a temporary or movable nature; anything not classified as real property. Fixture -An object that has been attached to land so as to become real estate. When an object that was once personal property is attached to land (or a building thereon) so as to become part of the real estate, it is called a fixture. As a rule, a fixture is the property of the landowner, and when the land is conveyed to a new owner, it is automatically included with the land.
1
The Appraisal of Real Estate , Appraisal Institute (US), Editor Michael McKinley, 2013. ISBN 978-1935328-38-4 p. 7-9
3
Career Opportunities in real estate 2 The contents and organization of this book are designed for people who are interested in real estate because they now own or plan to own real estate and for people who are interested in real estate as a career. It is to those who are considering real estate as a profession that the balance of this chapter is devoted. In practice, there is not a job or career that doesn't somehow involve a knowledge of real estate. Most people who are considering a career in real estate think of becoming a real estate agent who specializes in selling homes. This is quite natural because home selling is the most visible segment of the real estate industry. It is the area of the business most people enter, and the one in which most practicing real estate licensees make their living. Selling residential property is a good experience. Entry-level positions are more available, and it can help you to decide whether real estate sales appeals to you. RESIDENTIAL BROKERAGE Residential brokerage requires a broad knowledge of the community and its neighborhoods; an understanding of real estate principles, law, and practice; and an ability to work well with people. Working hours will often include nights and weekends, as these times are usually most convenient to buyers and sellers. A residential agent must also supply an automobile that is suitable for taking clients to see properties. Some real estate offices are now giving new residential salespersons a minimum guaranteed salary or a draw against future commissions. However, this is not always the case, so a newcomer should have enough capital to survive until the first commissions are earned— and that can take four to six months. Additionally, the salesperson must be capable of developing and handling a personal budget that will withstand the feast-and-famine cycles that can occur in real estate selling. A person who is adept at interpersonal relations, who can identify clients' motives, and who can find the property to fit will probably be quite successful in this business. COMMERCIAL BROKERAGE Commercial brokers specialize in income-producing properties such as apartment and office buildings, retail stores, and warehouses. In this specialty, the salesperson is primarily selling monetary benefits. These benefits are the income, appreciation, mortgage reduction, and tax shelter that a property can reasonably be expected to produce.
2
Real Estate Principles; Charles J. Jacobus; ISBN-13: 978-0324787498 ISBN10: 0324787499 Edition: 11 th; 2009
4
To be successful in income property brokerage, one must be very competent in mathematics, know how to finance transactions, and keep abreast of current tax laws. One must also have a sense for what makes a good investment, what makes an investment salable, and what the growth possibilities are in the neighborhood where a property is located. Commission income from commercial brokerage is likely to be less frequent, but in larger amounts than from residential brokerage. The time required to break into the business is longer, but once in the business, agent turnover is low. The working hours of a commercial broker are much closer to regular business hours than for those in residential selling, although appearances can be deceiving. Commercial brokers often spend nights and weekends "networking," as that is a primary source of their business. One almost always finds commercial brokers actively involved in charitable activities, fundraisers, golf tournaments, and similar activities, as it gives them a lot of time to work with community leaders and expand these networks. INDUSTRIAL BROKERAGE Similar to commercial brokers, industrial brokers specialize in finding suitable land and buildings for industrial concerns. This includes leasing and developing industrial property as well as listing and selling it. An industrial broker must be familiar with industry requirements such as proximity to raw materials, water and power, labor supplies, and transportation. An industrial broker must also know about local building, zoning, and tax laws as they pertain to possible sites, and about the schools, housing, cultural, and recreational facilities that would be used by future employees of the plant. Commissions are irregular, but usually substantial. Working hours are regular business hours and sales efforts are primarily aimed at locating facts and figures and presenting them to clients in an orderly fashion. Industrial clients are usually sophisticated businesspeople. Gaining entry to industial brokerage and acquiring a client list can be slow. FARM BROKERAGE With the rapid disappearance of the family farm, the farm broker's role is changing. Today a farm broker must be equally capable of handling the tho-acre spread of farmer Jones and the io,000-acre operation owned by an agribusiness corporation. College training in agriculture is an advantage and on-the-job training is a must. Knowledge of soils, seeds, plants, fertilizers, production methods, new machinery, government subsidies, and tax laws is vital to success. Farm brokerage offers as many opportunities to earn commissions and fees from leasing and property management as from listing and selling property. PROPERTY MANAGEMENT 5
For an investment property, the property manager's job is to supervise every aspect of a property's operation so as to produce the highest possible financial return over the longest period of time. The manager's tasks include renting, tenant relations, building repair and maintenance, accounting, advertising, and supervision of personnel and tradesmen. The expanding development of condominiums has resulted in a growing demand for property managers to maintain them. In addition, large businesses that own property for their own use hire property managers. Property managers are usually paid a salary and, if the property is a rental, a bonus for keeping the building fully occupied. To be successful, a property manager should be not only a public relations expert and a good bookkeeper, but also at ease with tenants, handy with tools, and knowledgeable about laws applicable to rental units. RENTAL LISTING SERVICES In some cities there are rental listing services that help tenants find rental units and landlords find tenants. Most compile lists of available rentals and sell this information to persons looking for rentals. A few also charge the landlord for listing the property. The objective is to save a person time and gasoline by providing pertinent information on a large number of rentals. Each property on the list is accompanied by information regarding location, size, rent, security deposit, pet policy, and so on. Especially popular in cities with substantial numbers of single persons are roommate listing services. These maintain files on persons with space to share (such as the second bedroom in a two-bedroom apartment) and those looking for space. The files contain such information as location, rent, gender, smoking preference, etc. Most roommate and rental listing services have been started by individual entrepreneurs and are not affiliated with real estate offices. A majority of states now require a real estate license for rental listing services. REAL ESTATE APPRAISING The job of the real estate appraiser is to gather and evaluate all available facts affecting a property's value. Appraisal is a real estate career opportunity that does not require property selling; however, it does demand a special set of skills of its own. The job requires practical experience, technical education, and good judgment. If you have an analytical mind and like to collect and interpret data, you might consider becoming a real estate appraiser. The job combines office work and field work, and the income of an expert appraiser can match that of a top real estate salesperson. One can be an independent appraiser, or there are numerous opportunities to work as a salaried appraiser for local tax authorities or lending institutions. The appraisal process is now becoming more complex, however. Most lenders and taxing authorities require that their appraisers have some advanced credential designation or 6
special state certification to ensure an independent appraiser, or there are numerous opportunities to work as a salaried appraiser for local tax authorities or lending institutions. The appraisal process is now becoming more complex, however. Most lenders and taxing authorities require that their appraisers have some advanced credential designation or special state certification to ensure an adequate level of competence.
GOVERNMENT SERVICE Approximately one-third of the land in the United States is government owned. This includes vacant and forested lands, office buildings, museums, parks, zoos, schools, hospitals, public housing, libraries, fire and police stations, roads and highways, subways, airports, and courthouses. All of these are real estate, and all of these require government employees who can negotiate purchases and sales, appraise, finance, manage, plan, and develop. Cities, counties, and state governments all have extensive real estate holdings. At the federal level, the Forest Service, Park Service, Department of Agriculture, Army Corps of Engineers, Bureau of Land Management, and General Services Administration are all major landholders. In addition to outright real estate ownership, government agencies such as the Federal Housing Administration, VA, and Federal Home Loan Bank employ thousands of real estate specialists to operate their real estate lending programs. LAND DEVELOPMENT Most new homes in the United States are built by developers who in turn sell them to homeowners and investors. Some homes are built by small-scale developers to homeowners and investors. Some homes are built by small-scale developers story condominiums that are developed and constructed by large corporations that have their own planning, appraising, financing, construction, and marketing personnel. There is equal opportunity for success in development whether you build 4 houses per year or work for a firm that builds 400 per year. URBAN PLANNING Urban planners work with local governments and civic groups for the purpose of anticipating future growth and land-use changes. The urban planner makes recommendations for new streets, highways, sewer and water lines, schools, parks, and libraries. Emphasis on environmental protection and controlled growth has made urban planning one of real estate's most rapidly expanding specialties. An urban planning job is usually a salaried position and does not emphasize sales ability. MORTGAGE FINANCING 7
Specialists in mortgage financing have a dual role: 0.) to find economically sound properties for lenders, and (2) to locate money for borrowers. A mortgage specialist can work independently, receiving a fee from the borrower for locating a lender, or as a salaried employee of a lending institution. The ease with which mortgages can be bought and sold has encouraged many individuals to open their own mortgage companies in competition with established lending institutions. Sonic mortgage specialists also offer real estate loan consulting for a fee. They will help a borrower choose from among the numerous mortgage loan formats available today, find the best loan for the client, and assist in filling out and processing the loan application.
SECURITIES AND SYNDICATIONS Limited partnerships and other forms of real estate syndications that combine the investment capital of a number of investors to buy large properties number in the thousands. The investment opportunities and professional management offered by syndications are eagerly sought after by people with money to invest in real estate. As a result, there are job opportunities in creating, promoting, and managing real estate syndications. CONSULTING Real estate consulting involves giving others advice about real estate for a fee. A consultant must have a very broad knowledge about real estate including financing, appraising, brokerage, management, development, construction, investing, leasing, zoning, taxes, title, economics, and law. To remain in business as a consultant, one must develop a good track record of successful suggestions and advice. RESEARCH AND EDUCATION A person interested in real estate research can concentrate on such matters as improved construction materials and management methods, or on finding answers to economic questions such as 'What is the demand for homes going to be next year in this community (state, country)?" Opportunities abound in real estate education. Nearly all states require the completion of specified real estate courses before a real estate license can be issued. All states require continued education for license renewal (mandatory continuing education, or "MCE"). As a result, persons with experience in the industry and an ability to effectively teach the subject are much sought after as instructors. Most states require a state approved instructor for teaching these classes. 8
FULL-TIME INVESTOR One of the advantages of the free enterprise system is that you can choose to become a full-time investor solely for yourself. A substantial number of people have quit their jobs to work full time with their investment properties, and have done quite well at it. A popular and successful route for many has been to purchase, inexpensively and with a low down payment, a small apartment building that has not been maintained but is in a good neighborhood. The property is then thoroughly reconditioned, and rents are raised. This process increases the value of the property. The increase is parlayed into a larger building—often through a tax deferred exchange—and the process is repeated. Alternatively, the investor can increase the mortgage loan on the building, and take the cash he receives as a "salary" for himself or use it as a down payment on another not-too-well-maintained apartment building in a good neighborhood. This can also be done with single family houses. It is not unusual for an investor to acquire several dozen rental houses over a period of years. Other individual investors have done well financially by searching newspaper ads and regularly visiting real estate brokerage offices looking for underpriced properties that can be sold at a markup. A variation of this is to write to out of town property owners in a given neighborhood to see if there is any wish to sell at a bargain price. Another approach is to become a small-scale developer and contractor. No license is needed if you work with your own proper.) Through your own personal efforts, you create value in your projects, and then hold them as investments. License Requirements As previously stated, property owners who deal only with their own propert3:, are not required to hold a real estate license. However, any person who, for compensation or the promise of compensation, lists or offers to list, sells or offers to sell, buys or offers to buy, negotiates or offers to negotiate, either directly or indirectly for the purpose of bringing about a sale, purchase, or option to purchase, exchange, auction, lease, or rental of real estate, or any interest in real estate. is required to hold a valid real estate license. Some states also require persons offering their services as real estate appraisers, property managers, syndicators, counselors, mortgage bankers, or rent collectors to hold real estate licenses.
9
Lecture 2 Physical, legal, economic concepts of land; City Origins and urban development Patterns Geographic, legal, social and economic aspects of land; Real property and urban development (economic- spatial development of cities; location as the main factor of real property value)
According to an old saying, “Under all is the land.” Land provides the foundation for the social and economic activities of people. It is both a tangible physical commodity and a source of wealth. Because land is essential to life and society, it is the subject of many disciplines, including law, economics, finance, sociology, and geography. Within the vast domain of the law, issues relating to the ownership and the use of land are considered. In economics, land is regarded as one of the four agents of production, along with labor, capital, and entrepreneurial coordination, and land provides the natural elements that contribute to a nation’s wealth. Finance applies the principles of economics within a market economy that furnishes capital for the exchange of property, and it helps market participants act knowledgeably and prudently. From a sociological perspective, land is a resource to be shared by all people, and that land is also a commodity that can be owned, traded, and used by individuals, corporations, partnerships, and other entities. Geography focuses on describing the physical elements of land and the activities of the people who use it. Lawyers, economists, sociologists, and geographers have a common understanding of the attributes of land: • Each parcel of land is unique in its location and composition. • Land is physically immobile. • Land is durable. • The supply of land is finite. • Land is often useful to people. Real estate appraisers recognize the attributes that form the basis for real property value. Contrasted with the physical character of land, value is an economic concept. Appraisers recognize the concepts of land used in other disciplines but are most concerned with how the market measures value. Markets reflect the attitudes and actions of people in response to social and economic forces and the constraints of law and legal encumbrances.
10
CONCEPTS OF LAND Although land and improvements on and to land can be viewed in a physical sense, there are other concepts of land that are less obvious. These concepts help to characterize the importance of land and provide the foundation for land value systems. GEOGRAPHIC AND ENVIRONMENTAL The study of land includes consideration of its diverse physical characteristics and how these characteristics combine in a particular area. Each land parcel is unique, and a fixed location is a prominent characteristic of all real estate. The utility of land and the highest and best use to which land can be put are significantly affected by the physical and locational characteristics of the land and other related considerations, broadly referred to as geography. Land is affected by a number of processes. Ongoing physical processes modify the land’s surface, biological processes determine the distribution of life forms, and socioeconomic processes affect human habitation and activity on the land. Together, these processes influence the characteristics of land use. Land can be used for many purposes such as • Agriculture • Commerce • Industry • Residence • Recreation And land use decisions may be influenced by many factors including • Climate • Topography • The distribution and density of natural resources, population centers, and industry • Trends in economics, population, technology, and culture The influence of each of these factors on a particular parcel of land varies. Geographic considerations are particularly significant to appraisers. The importance of physical characteristics such as topography, soils, water, and vegetation is obvious, but the distribution of population, facilities, and services and the movement of people and goods are important as well.
11
The geographic concept of land, which emphasizes natural resources, the location of industry, and actual and potential markets, provides much of the background knowledge required in real estate appraisal. LEGAL Land use reflects the needs and values of organized society. In countries where the ownership and marketability of land are not free, government often dictates the use of land. In free market economies, land use is regulated within a framework of laws. To understand how the various forces affecting land operate, the basic role of law must be recognized. The cultural, political, governmental, and economic attitudes of a society are reflected in its laws. The law does not focus on the physical characteristics of land but on the rights and obligations associated with various interests in land. In the United States, the right of individuals to own and use land for material gain is maintained, while the right of all people to use the land is protected. In other words, the law recognizes the possible conflict between private ownership and public use. “Whose is the land, his it is, to the sky and the depths.” This ancient maxim is the basis of the following legal definition: Land includes not only the ground, or soil, but everything that is attached to the earth, whether by course of nature, as are trees and herbage, or by the hand of man, as are houses and other buildings. It includes not only the surface of the earth but everything under it and over it. Thus in legal theory, the surface of the earth is just part of an inverted pyramid having its tip, or apex, at the center of the earth, extending outward through the surface of the earth at the boundary lines of the tract, and continuing on upward to the heavens.3 This definition suggests that land ownership includes complete possession of land from the center of the earth to the ends of the universe. In practice, however, the extent of rights available to private ownership is legally limited due to governmental controls. The US Congress has declared that the federal government has complete and exclusive sovereignty over the nation’s airspace and that every citizen has “a public right to freedom of transit in air commerce through the navigable air space of the United States.”4 Many states restrict ownership and use of subsurface areas such as underground aquifers and oil and gas reserves. Because land ownership can be limited, ownership rights are the subject of law. The value of these rights is the focus of real property appraisal. 3
Raymond J. Werner and Robert Kratovil, Real Estate Law, 10th ed. (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1993), 4.
4
The Air Commerce Act of 1926 (formerly 49 USC 171 et seq.), the Civil Aeronautics Act of 1938 (formerly 49 USC 401 et seq.), and the Federal Aviation Act of 1958 (see 49 USC 401). 12
The laws that govern the use and development of land in the United States give landowners great freedom in deciding how to use their land. However, this freedom is not without restrictions. The basic concept of private ownership calls for unrestricted use so long as that use does not unreasonably harm the rights of others. In the past, the test of harm focused on owners of adjacent properties. The concept of harm has been expanded to encompass broader social and geographic concerns.
The definition of reasonable use has been argued in many court cases. Legal matters of particular concern to appraisers include the following: • easements • access regulations • water and mineral rights • zoning and other use restrictions • the recording and conveyance of titles Also, appraisers must be familiar with local and state laws, which have primary jurisdiction over land. 13
ECONOMIC Land is a physical entity with inherent ownership rights that can be legally limited for the good of society. Land is also a major source of wealth, which, in economic terms, can be measured in money or exchange value. Land and its products have economic value only when they are converted into goods or services that are useful, desirable, paid for by consumers, and limited in supply. (A product with unlimited supply will have a low value.) The economic concept of land as a source of wealth and an object of value is central to appraisal theory. The economic concept of land reflects a long history of thought on the sources and bases of value, which is referred to as value theory.5 Value theory contributes to the value definitions used in appraisals and appraisal literature, and it is an important part of the philosophy on which professional appraisal practice is founded. SOCIAL Modern society has become increasingly concerned with how land is used and how rights are distributed. The supply of land is fixed, so increased demand for land exerts pressure for land to be used more intensively. Conflicts often arise between groups that hold different views on proper land use. Some believe that land is a resource to be shared by all. Some want to preserve the land’s scenic beauty and important ecological functions. Others view land primarily as a marketable commodity; they believe society is best served by private, unrestricted ownership. For example, the developer of a proposed shopping center or a business park may view a particular parcel of land as developable in a desirable and affordable location serving a definable market area. On the other hand, local residents may argue that, as the site of a significant Civil War battle, the parcel deserves government protection (if taxpayers could be persuaded to support such a public investment in historical preservation). These conflicting views do not alter the constitutional rights of ownership or market concepts of land. Rather, they reflect controversies that arise between the property rights of the individual and those of society. As a resource, land may be protected for the good of society. As a marketable commodity, the ownership, use, and disposal of land are regulated so that individual rights are not violated.6
5
Paul F. Wendt, Real Estate Appraisal: Review and Outlook (Athens, Ga.: University of Georgia Press, 1974), 17. 6 See also Charles E. Roe, “Land Use: The Second Battle of Gettysburg,” The Appraisal Journal (October 2000): 441-449.
14
In 1876 the US Supreme Court established the government’s right to regulate “the manner in which [a citizen] shall own his own property when such regulation becomes necessary for the public good.” The court quoted the words of England’s Lord Chief Justice Hale: “When private property is ‘affected with a public interest,’ it ceases to be juris privati only.”7 Throughout American history, land ownership has been recognized as a foundation of the country’s democratic institutions. John Adams wrote, “If the multitude is possessed of real estate, the multitude will take care of the liberty, virtue, and interest of the multitude in all acts of government.”8 All laws and operations of government are intended to serve the public. Thus, in the public interest, society may impose building restrictions, zoning and building ordinances, development and subdivision regulations, and other land use controls. These controls affect what may be developed, where development may occur, and what activities may be permitted subsequent to development. In recent decades, the US Government has increased its efforts to regulate the air and water emissions from manufacturing processes and to reduce pollution caused by dirt, chemicals, and noise. Protective controls over land use extend to wetlands, beaches, and navigable waters and to the preservation of the habitats of endangered species.9 As the nature and extent of land use controls change, so do the nature and extent of private land ownership. Such changes affect markets and ultimately real estate values. Consequently, real estate appraisers must be familiar with the regulations and restrictions that apply to land use and understand how these regulations affect a specific property.
City Origins and urban development Patterns10 The structure of land uses in an urban community usually reflects the settlement’s origin. This is known as the siting factor. Some cities were established at transportation centers such as seaports, river crossings, or the intersection of trade routes. Other cities were founded near power sources useful to manufacturing, and still others were located for defensive, commercial,
7
94 U.S. 113 (1896). Quoted in “Land as a Commodity Affected with a Public Interest” by Richard F. Babcock and Duane A. Feurer in Richard N. L. Andrews, Land in America (Lexington, Mass.: D.C. Heath and Company, 1979), 110. 8 Ibid., 31. 9 For more information on the government’s control of land use, see J. D. Eaton, Real Estate Valuation in Litigation, 2nd ed. (Chicago, Appraisal Institute, 1995). 10 Real Estate Principles; Charles J. Jacobus; ISBN-13: 978-0324787498 ISBN-10: 0324787499 Edition: 11th; 2009
15
or political reasons. As the national standard of living improved, climate and other natural advantages became siting factors responsible for the development of retirement areas, recreational resorts, and other specialized communities. From its initial site, a community grows outward in a pattern dictated by the nature and availability of developable land, the evolution of technology, and the government’s ability and willingness to provide essential public services. Where land is scarce, communities often experience an increase in land use density. New technology, building materials, and construction methods make it possible to construct high-rise buildings in cities without bedrock and those subject to earth tremors. Transportation improvements and the proliferation of automobiles have also shaped modern cities. Improved transportation allows urban settlements to expand and serve larger markets. The pattern of city growth is influenced by the local transportation network. Growth usually radiates from the central business district along major transportation routes. Major freeway systems can cause widespread migration from the city’s core. * Various conceptual models of urban growth are used to describe land use patterns. These “social ecology” models include the concentric zone theory, the sector (wedge) theory, the multiple nuclei theory, and the radial (axial) corridor theory. Elements of Urban Form11 This section seeks to dissect the arguments linking urban form and economic sustainability or, put more precisely, the relationships between urban form elements and sustainable economic outputs. In doing so the paper shifts from a normative outcome perspective to a positive one that stresses processes to actual/potential outcomes. To undertake this task the paper examines the intervening processes in the different sectors of the urban economy, focusing on the interaction of supply and demand and sectoral or intermediate outcomes. The approach taken is to focus on a city and to view it both in the urban macro context and as a potential combination of urban forms. There are four main elements that make up urban form. These are land use, density, position/transport infrastructure and characteristics of the built environment. An additional micro-element is layout. The dominant land use is residential but a functional urban area requires industrial, retail, offices etc. and some of these uses will be located together in one building, i.e. mixed land use (as distinct from an area with a mix of uses). Density has a number of sub-elements -gross population, net residential, commercial and industrial employment densities. Position/Transport infrastructure is closely linked to the idea of accessibility and is 11 Sustainable Urban Form and Real Estate Markets; Colin Jones and Charlotte MacDonald; Heriot-Watt University, Paper presented to the annual European Real Estate Conference, Milan, 2-5 June, 2004.
16
related to the ease at which buildings/ spaces/ places can be reached. Characteristics of the built environment, is a concept encompassing various features of an urban area such as building type, building height and intensity of land use. The fifth element of urban form is layout. This is an important social and environmental element, but is of less importance to the economic interest of this paper. Land Use Specific spatial distributions of land use are crucial to the arguments about potential 'sustainable' urban forms. There are two underlying substantive land use demand factors. The first of these is the spatial pattern of revenues/ costs (see Alonso, 1964; Dunse and Jones, 2005). The demand for different land uses will depend on the relevant cost of using certain locations, and the revenues it will provide. Land that is deemed to be more productive for one use may not be considered so for another. If a certain area is thought to be desirable because it will generate large revenues, it is likely to have a higher value. What is deemed to be desirable may vary from occupier to occupier. Residential location preferences are different to industrial demands, and these will be different to retail demands etc. Second, there are agglomeration factors. This is the impact of agglomeration economies on the demand for various land uses. The idea behind this is the potential propensity of office/ retail occupiers to choose locations that are close to other office/ retail occupiers undertaking similar or complementary activities (Henderson, 1974; Parr, 2002). Agglomeration economies result in potentially lower input costs and knowledge and skill transfers amongst other benefits (see later). There are three principal underlying influences linked to the (changing) supply of land use (ignoring the distinction between existing stock versus new supply). Development finance is an essential prerequisite but investment funds can be constrained by attitudes toward the risks associated with particular land uses and potential locations (Jones, 1996). For example investors in the UK have been traditionally reluctant to invest in mixed use development, although in recent years there has been an increase in the interest of developers in undertaking these mixed developments in regeneration schemes. Similarly public-sector investment can play a key role in the development of localities (Jones and Watkins, 1996). The decision to develop is ultimately based on profitability that in turn can be decomposed into a range of revenue and cost variables. These encompass construction costs, such as materials, land and labour. Finally, the scale of land availability offers opportunities/constraints to the adaptation of the land use pattern. This last factor can be seen to have a direct link with urban form but the others are more indirect with the exception of the revenue component of development appraisals. This is determined by prevailing rents and demand discussed above. In terms of intermediate outcomes the interaction of supply and demand determines simultaneously spatial land use patterns and land prices/ rents (ignoring planning). The pattern of 17
land uses influences travel patterns through for example commuting and shopping. Mixed use areas arguably encourage more travel by foot/ public transport and less travel by private car. Negative externalities (congestion/ health costs) may be caused by transport use over and above the socially optimal level. This is most likely to be caused where there are many single use areas and inadequate infrastructure or public transport provision. Position/ transport infrastructure This enables the ease by which people can reach buildings, spaces, and places. It provides a set of accessibility relationships within the urban area that can be seen in terms of the distances or travel costs. These relationships can be seen as a hierarchy with at one level travel from residential areas to city centre, major retail locations, work and other services and at the other extreme accessibility at the neighborhood level – i.e. looking at accessibility from one place to another within a certain area. (eg the accessibility to local schools, medical centres, shops within a neighborhood). Physical landscape shapes the infrastructure provision and can create physical barriers to accessibility. Infrastructure in the form of transport networks has a direct impact on the scale of local market areas. For example the spatial extent of retail and other services' catchment areas is partly a function of the costs of travel by customers. In fact a hierarchy of services provision/facilities exists determined by the transport network. This is most evident in retailing, e.g. large retail superstore, local supermarket, small corner shop. From a demand perspective the transport infrastructure primarily determines travel costs. If costs are high then travel trips may be short and some households could be excluded from access or refrain from using services/facilities. These costs take the form of both financial and time costs. Accessibility cost is a fundamental demand factor underlying the spatial location decisions. The tradeoff between accessibility to the central business district and space/land costs is the central relationship in seminal works in urban economics (Alonso, 1964; Muth, 1969). While these models are based on very restrictive simplifying assumptions the role of accessibility is an essential influence on the location decisions of firms and households. Transport infrastructure also impacts on modal choice by households. Where people have a greater modal choice their accessibility options can increase. If people have more available means of transport, they can potentially access more areas. Overall the range of travel modes and costs available influences the efficiency of the urban economy. Too much private car use can create congestion. Accessibility costs are therefore the key to the underlying spatial economic forces at work that creates the pattern of land use within urban areas. As a consequence accessibility also impacts on the spatial distribution of employment and residential preferences. In terms of location, there is likely to be a higher demand for land/ property that has good accessibility both 18
to it, and to other services/ facilities/ infrastructure etc. In as much as accessibility can influence profitability then this is reflected in land prices / rents.
Density Density can be seen as an outcome of the competition between land uses within a given urban transport infrastructure and its associated pattern of accessibility. In a competitive land market the higher the price the greater the density of utilisation. As noted earlier there are three main aspects to density; gross population density, net housing density, population density, and commercial and industrial employment density. The role of density has been at the heart of the sustainable urban form debate. Newman and Kenworthy (1989a, 1989b) found that for a range of cities across the world that population density is inversely related to fuel consumption. In contrast research in the USA finds that commuting distances remain constant despite continuing decentralisation because such trips are no longer necessarily only from suburbs to city centre (Gordon and Richardson, 1993). This effect may not be universal and Spence and Frost (1995) find the reverse in the UK. This issue is also confounded by the link between housing density and income. Access-space models of urban housing markets demonstrate that low income households live at high densities consuming small amounts of housing at a high price/rent per square unit. Similarly high income communities (countries) will tend to live at lower densities. Hence an analysis that focuses on density as a single variable can be misleading. High land use densities have a number of implications for demand for and cost of services provision. The greater concentration of demand, e.g. consumer spending, associated with high land use density, ceteris paribus, reduces the spatial extent of viable social and private services' catchment areas (including business services). This in turn suggests the potential for more consumer choice and diversity in high density areas. However, this conclusion must be tempered by the potential for concentrations of low income households in high density areas. For example Muth (1969) demonstrates (under a range of simplifying assumptions) that in cities where there is a high income elasticity of demand for housing low incomes households consume small amounts of housing at high unit costs in inner high density locations and high incomes households consume the converse. In high density residential and employment areas the spatial focus of travel demand is likely to lead to better public transport facilities although there is a greater propensity for congestion. Where areas are low density, single use, it is more likely that travel costs are higher in terms of both financial and time costs. Costs of public and private infrastructure provision therefore may be reduced where there are high densities. However, high densities are also associated with high land prices, particularly in the most accessible locations, 19
and this in turn may lead to higher unit costs for some services (controlling for quality). Empirical research in the USA finds that low density development has the highest infrastructure costs (Burchell, 2000). Higher employment densities are traditionally linked to potential agglomeration economies, thereby reducing production costs and promoting product development. In particular knowledge spillovers between firms in an industry, the Marshall-Arrow-Romer externalities promote urban economic growth. This view is supported by Porter (1990) who argues that competitive pressures brought about by the geographical concentration in an industry will stimulate innovation. However, Glaeser et al (1992) find no evidence to support these theories based on empirical research on American cities and instead their evidence supports Jacobs (1969) who argues that high employment densities increase economic growth but through knowledge spillovers between industries. Further, it has recently been argued that such effects are becoming more diffuse (Parr, 2002). Notwithstanding the precise mechanisms linking employment densities to economic growth a study of 47 cities in the USA finds that high employment density in urban areas (controlling for city size) contributes positively to economic performance as measured by high labour productivity (Cervero, 2001). Arguably the research is limited by its lack of full control for urban industrial structure but its finding is supported by Ciccone and Hall (1996) in a more limited empirical study, also in the USA.
Characteristics of the built environment This element encompasses building types, heights, and intensity of land use. Intensity is distinguished from density here because it refers just to the footprint of the building (s). For example, high rise flats would be considered high intensity even if they are surrounded by green space. There are three supply factors influencing the characteristics of the built environment. The types of buildings, heights etc may be influenced by the costs and/or the provision of infrastructure. For example, a low rise, low intensity estate of housing will require many separate water connections, electricity cables etc. making the provision of infrastructure more costly than a high intensity building. Construction costs are influenced by the type, height etc of buildings. A high rise development may provide a greater return to the investor if more housing spaces are created, leading to economies of scale. Higher quality buildings will almost inevitably cost more in materials, but may provide a significant return if they are deemed to be prestigious etc. Building costs are also influenced by the quality of buildings (physical, functional, aesthetics) and maintenance costs, as well as the degree of homogeneity of buildings. Investment attitudes of financial institutions can influence the characteristics of the built 20
environment (the building itself and its environment). While such investors are market led and will invest their funds where they will receive the greatest return, they tend to be risk averse with regard to new types of building form or the introduction of a building form new to an area. For example, they have been ambivalent to green buildings. Further banks in the UK are reluctant to lend on flats above a certain storey height. Similarly, house builders have taken a cautious approach to innovation for example in energy conservation, because introducing such measures increases the sale price. Demand factors can also influence the built environment through building type preferences, such as the desire of families with young children to occupy housing with gardens. The level of building maintenance may also be important. High maintenance buildings, ceteris paribus, may not be desirable in terms of the costs they incur and so demand would be low. Choice of residential, commercial or industrial building form is likely to be determined simultaneously with location. The type of building people choose to live in may also influence their choice of transport mode, eg fewer people in high rise flats may choose to own a car, as may fewer people living in high density central areas etc. If there is limited parking at the workplace, people may choose or be forced to walk/ use public transport etc. Layout Layout is an integral element of urban form and includes such phenomena as street type, road layout, degree of sprawl, which are primarily concerned with function and adaptability. ODPM (20002b) split layout into two levels: urban structure and urban grain. Urban structure is more concerned with how routes, developments, areas etc relate to each other. Urban grain is more concerned with the layout of street patterns, housing patterns, and other building layout patterns. The layouts of today’s cities are largely artefacts of their historical development and planning and building regulations. However, certain types of layout will make infrastructure provision easier and cheaper. Local layout may influence transport infrastructure provision and modal choice, and vice versa, which affect the urban structure through affecting how areas, space, places, developments etc relate to one another. Layout can therefore impact on ease of access to services and employment. Economic Sustainability of Cities The paper so far has reviewed normative models of sustainable urban form, and discussed the elements of urban form, their determinants and their interaction with urban economies. The latter section emphasises the role of real estate markets and transport infrastructure in the determination of urban form but the proven links with urban economic performance and sustainability are limited. Not only is more research required but it is not clear that the present formulation of the sustainable urban form debate is progressing policy. In this section the starting 21
point is a macro view of the economic sustainability of cities and size. The issue of sustainability is then examined by reference to sub sectors of the economy. The very existence of cities depends on the existence of agglomeration economies that can be subdivided into economies of scale, scope and complexity (Parr, 2002). A further distinction can be made between internal and external economies to the firm. Only external economies result in concentrations of urban economic activity. These include localization economies such as the access to a pool of labor, availability of a range of auxiliary trades and specialized services plus knowledge spillovers noted earlier. Urbanization economies, i.e. economies of scope, result from the common location of firms belonging to different and unrelated industries. They include the availability of a range of municipal services, public utilities, transportation and communication facilities, the existence of a wide variety of business and commercial services and a complementary of labour supply. Households can also benefit from agglomeration economies in the form of a range of shops, amenities and cultural facilities and firms and households from public services/infrastructure (Henderson, 1974). These external agglomerations are a function of urban size. However, beyond a certain urban size further increases there may also bring negative agglomeration economies such as congestion and pollution. Some also argue agglomeration economies can be too big to be sustainable (Fujita & Thisse 2002). Such arguments suggest there may be an 'optimal' urban size and the concept spawned a number of papers in the early 1970s including Alonso (1971), Evans (1972) and Richardson (1973). These theories suggest there may be an 'optimal' urban size where the total benefits of size equate with the total costs (McCann, 2001, Capello and Camagni, 2000). The theory of optimal city size can be criticised on a number of counts. No distinction is drawn between cities with different economic structures as it uses only one production function for all cities. The theory therefore fails to account for that fact that since all cities are different their optimal sizes may be different as well. Spatial dimensions of an urban economy are ignored in what is an essentially macro urban perspective. Beneath this macro-urban view there are a range of sectoral perspectives from public administration, households and industries with different size optima (Button, 1976). In the context of sustainable urban size, it is necessary to identify a set of sustainable criteria that establishes an appropriate optimum city size, or more precisely urban settlement size distributions. Capello & Camagni (2000) for example argue that it is optimal efficient size that achieves economic sustainability. The efficient size depends on what is produced, how, and how the area in question operates within the urban economy. Although size influences location costs and benefits through creating greater potential for more mixed and higher level urban functions, specialisation and integration within the system also have an effect. 22
A purely ecological approach to urban sustainability would suggest that that the goal of sustainability is not possible, since cities depend upon imports and exports of resources and waste. The nature of the urban environment is such that it has very little assimilative capacity. Most resources are imported into cities and waste exported, so cities what ever their size not only impact on their own environment, but on surrounding environments too. Beyond this narrow definition of sustainability in environmental terms as noted above it can also be seen to have social and economic dimensions. Camagni et al (1998) for example propose three types of 'environment' in the city -physical, economic and the social. The sustainability outcome from the social environment is equity and welfare. From the physical environment the outcome is pure ecological and aesthetic principles while from the economic environment comes profitability and economic growth. The authors identify three overlapping areas between the three environments contributing to sustainability. Between the social and economic environments arises distributive efficiency. Between the physical environment and the economic environment exists long-term allocative efficiency. Between the physical environment and social environment there is intra-and intergenerational equity. The economic environment is linked in particular to the existence of agglomerations and Camagni et al (1998) define a sustainable city as “a city where the three environments characterising an urban agglomeration interact in such
a way that the sum of all positive externalities stemming from the interaction of the three environments is larger than the sum of the negative external effects caused by the interaction” (p.108). This sustainability condition has a strong parallel with the original formulation of the original optimal size solution. Just like the original it does not appear to aid a practical solution. An alternative approach is to express the problem as maximising potential urban output or productivity subject to a series of sustainability constraints. These would encompass social, environmental and economic factors. From an economic perspective these constraints would include the viability of sectors of the local economy. These sectors are manufacturing, services, the labour market, transport, public administration and land use property markets (including viable catchment areas for public and private services). Linked social constraints are an adequate supply of housing for the workforce and their families and full employment. All constraints would need to be met to satisfy sustainability. Exogenous variables include industrial mix, incomes and national government taxation/ policies. The exact meaning of viability will vary with sector. Transport and public administration will at least be partially determined by social criteria. In the property market sustainable markets will be a necessary condition. Drawing on Jones and Watkins (1996) sustainable markets can be 23
defined as a combination of prices being achieved without public subsidy and the ability of the market to sustain itself through downturns in the property cycle. The adequate housing supply constraint implies also that there is sufficient choice and availability to meet demand. The sustainability of property markets has implications for the nature of urban form and its elements, and this in turn causes interaction with other sectors of the urban economy as noted above. But before this issue is addressed the paper now considers in more detail the operation of local markets. Role of Spatial Real Estate Markets The operation of local real estate markets, as noted above, is set within a framework of transport costs (that determines accessibility relationships) which in turn is dependent on the transport infrastructure (Alonso, 1964). Given that transport infrastructure is a key element of urban form then real estate markets can be shaped by transport policies. Thus for example Dunse and Jones (2005) show how the pattern of industrial rents in the Strathclyde sub-region of Scotland rise with closeness to the major road network (see Figure 1). On the other hand the operation of the property market in the absence of planning determines the spatial pattern of land use, the density of development, the characteristics of the built environment and layout. The real estate market is therefore a key determinant of urban form including its spatial dimension. Positive planning to achieve a specific/sustainable urban form therefore must centre on transport infrastructure and shaping the property market. Policies seeking to modify property market processes can attempt to determine land use patterns through zoning but sustainable land use markets remain a condition of viability. Given that planning controls can bring costs (Cheshire and Sheppard, 1989) in terms of higher prices and consequent equity issues to succeed in this task it is essential to understand the operation of these markets, not only within urban areas but also at the inter-urban level. Functional property (and labour markets) markets do not respect administrative boundaries or planning forms. Residential location theory implicitly defines a housing market area (HMA) as the surrounding travel to work area (TTWA) which may also be regarded as the urban labour market area. Jones (2002) argues that HMAs are created jointly by internal spatial arbitrage and by the lack of spatial arbitrage/ substitutability between them but are embedded in local labour market areas. They are hence estimated from a combination of self-containment and lack of interconnectedness measured by migration patterns. The results of his empirical research for west central Scotland show quite large differences in the sizes of HMAs but that they are dominated by one that embraces most of the Clydeside conurbation. There is, however, no clear link with urban form. Jones et al (2005) following a similar research approach also find that local industrial property markets (LIPMAs) are quite narrowly spatially defined and located within 24
TTWAs. The local shopping pitches of retail centres are very closely defined albeit their size is determined by their function or position within a retail hierarchy. This hierarchy reflects the nature of retail catchment areas that are a function of transport costs (see earlier). Similarly LIPMAs and HMAs are linked to transport costs via their relationship with TTWAs.
Figure 1: Simulated Industrial Rent Gradient
Source: Dunse and Jones (2005) The existence of housing submarkets has gained general acceptance in the academic literature even though there are considerable differences of views of the underlying causes (Watkins, 2001), and Jones et al (2003) demonstrates that submarkets are stable over time. Jones et al (2004) show that spatial submarkets in Glasgow are relatively self-contained in the sense that a majority of the households that move are likely to settle within the same submarket. This effect occurs partly as a consequence of households' self-imposed limits on search patterns. These limits are a logical outcome of the fact that the property market is associated with limited information and relatively high transaction costs. The limitation of household moves between submarkets reduces the effect of spatial arbitrage, or the process through which households trade constant-quality housing services between submarkets in order to gain from the price differentials. If these processes occur freely then logically submarket price differences will be arbitraged away and equilibrium restored across the urban housing market. The long term existence of submarkets implies that these processes do not occur and the housing characteristics in these submarkets tend to be stationary. Developers tend to build similar housing to that that already exists nearby and the planning system operates as an enabling mechanism. The consequence is that the existing urban form and submarket residential density tend to persist. Similar submarkets have been found in the office market (Dunse and Jones, 2002). 25
Conclusions There is much debate about the nature of sustainable urban form although most of the arguments are in normative terms. This paper has focused on the economic dimension of urban sustainability and addressed this issue from two perspectives. First, it examines the elements of urban form and this review shows that there are links with the economic performance of cities although there remain substantial imponderables. It is not clear that the framework of the current sustainable urban form debate is fruitful. However, the essential elements of urban form are shown to be outcomes of real estate markets. Transport infrastructure is also a key element of urban form because it creates the framework for real estate markets and their links to other sectors of the urban economy. The paper then starts from first principles to examine the economic sustainability of cities and considers its determinants. This leads to an approach that express the problem as maximising potential urban output or productivity subject to a series of sustainability constraints. These would encompass social, environmental and economic factors. From an economic perspective these constraints would include the viability of sectors of the local economy. Within the real estate sector this would require an adequate supply of housing for the workforce and their families and sustainable markets defined in terms of prices being achieved without public subsidy and the ability of the market to sustain itself through downturns in the property cycle. . Given the centrality of real estate markets to urban form it is essential not only to understand the operation of real estate markets and their interaction with transport but also to develop policies to change existing urban forms. Understanding real estate markets necessitates developing a policy analysis within a system of functional markets and submarkets and this in turn requires appropriate information systems. Research on submarkets suggests that the current planning system in the UK, at least, reinforces the existing spatial structure of property markets and hence urban form. To modify urban form planning systems will have to find an accommodation with the real estate market but first there needs to be a clearer understanding of a sustainable urban system .
Lecture 3 Forms of Real Property Ownership; Property Encumbrances Legal environment of land/real estate ownership in Georgia; Ownerships: public ownership, private ownership (fee simple); Encumbrances: easements, encroachments, deed restrictions, liens, leases, and air and subsurface rights
26
Protecting Ownership12 It cannot be overemphasized that, to have real estate there must be a system or means of protecting rightful claims to the use of land and the improvements thereon. In the United States the federal government is given the task or organizing a defense system to prevent confiscation of those rights by a foreign power. The federal government, in combination with state and local governments also establishes laws and courts within the country to protect the ownership rights of one citizen in relation to another citizen. Whereas the armed forces protect against a foreign takeover within a country, deeds, public records contracts and other documents have replaced the need for brute force to prove and protect ownership of real estate. Fee Simple The concept of real estate ownership can be more easily understood when viewed as a collection or bundle of rights. Under the allodial system, the rights of taxation, eminent domain, police power, and escheat are retained by the government. The remaining bundle of rights, called fee simple, is available for private ownership. The fee simple bundle of rights can be held by a person and his heirs forever, or until his government can no longer protect those rights. Figure 3.1 illustrates the fee simple bundle of rights concept.
The word estate is synonymous with bundle of rights. Stated another way, estate refers to one's legal interest or rights in land, not the physical quantity of land as shown on a map. A Fee simple is the largest estate one can hold in land, Most real estate sales are for the fee simple estate. Real Estate Principles; Charles J. Jacobus; ISBN-13: 978-0324787498 ISBN-10: 0324787499 Edition: 11th;
12
2009
27
When a person says he or she “owns” or has “title" to real estate, it is usually the fee simple estate that is being discussed_ The word title refers to the ownership of something. All other lesser estates in land, such as life estates and leaseholds, are created from the fee estate. Real estate is concerned with the "sticks" in the bundle: how many there are, how useful they are, and who possesses the sticks not in the bundle. With that in mind, let us describe what happens when sticks are removed from the bundle.
Encumbrances Whenever a stick is removed from the fee simple bundle, it creates an impediment to the free and clear ownership and use of that property. These impediments to title are called encumbrances. An encumbrance is defined as any claim, right, lien, estate, or liability that limits the fee simple title to property- An encumbrance is, in effect, a stick that has been removed from the bundle. Commonly found encumbrances are easements, encroachments, deed restrictions, liens, leases, and air and subsurface rights. In addition, qualified fee estates are encumbered estates, as are life estates. The party holding a stick from someone else's fee simple bundle is said to hold a claim to or a right or interest in that land. In other words, what is one person's encumbrance is another person's right or interest or claim. For example, a lease is an encumbrance from the standpoint of the fee simple owner. But from the tenant's standpoint, it is an interest in land that gives the tenant the right to the exclusive use of land and buildings. A mortgage is an encumbrance from the fee owner's viewpoint but a right to foreclose from the lender's viewpoint_ A property that is encumbered with a lease and a mortgage is called "a fee simple subject to a lease and a mortgage,— Figure 3.2 on the next page illustrates how a fee simple bundle shrinks as rights are removed from it. Meanwhile, let us turn our attention to a discussion of individual sticks found in the fee simple bundle. EASEMENTS An easement is a right or privilege one party has to the use of land of another for a special purpose consistent with the general use of the land. The landowner is not dispossessed from his land but rather coexists side by side with the holder of the easement. Examples of easements are those given to telephone and electric companies to erect poles and run lines over private property, easements given to people to drive or walk across someone else's land, and easements given to gas and water companies to run pipelines to serve their customers. Figure 3.3 on page 39 illustrates several examples of easements. There are several different ways an easement can come into being. One is for the landowner to use a written document to specifically grant an easement to another party. A second way is for an owner to reserve (withhold) an easement in the deed when granting the property to another party. For example, a land developer may reserve easements for 28
utility lines when selling the lots and then grant the easements to the utility companies that will service the lots. Another way for an easement to be created is by government condemnation, such as when a government flood control district purchases an easement to run a drainage pipe under someone's land. It is also possible for an easement to arise without a written document, For example, a parcel of land fronts on a road and the owner sells the back half of the parcel. if the only access to the back half is by crossing over the front half_ even if the seller did not expressly grant an easement, the law will generally protect the buyer's right to travel over the front half to get to his land. The buyer cannot be landlocked by the seller. This is known as an easement by necessity. Another method. of acquiring an easement without a written document is by constant use. or easement by prescription: if a person acts as though he owns an easement long enough, and the use is open, obvious, and without permission of the property owner, that person will have a legally recognized easement. One using a private road without permission for a long enough period of time can acquire a legally recognized easement by this method. EASEMENT APPURTENANT.
In Figure 3.3, the driveway from the road to the hack lot is called an easement appurtenant. This driveway is automatically buildings not compatible with the neighborhood. Where scenic views are important, deed restrictions may limit height of buildings and trees to 15 feet. A buyer would still obtain fee simple ownership, but, at the same lime, would voluntarily give up some of his rights to do as he pleases. As a buyer, he is said to receive a foe simple title subject to deed restrictions. The right to enforce the restrictions is usually given by the developer to the subdivision's homeowner association. Violation of a deed restriction can result in a civil court action brought by other property owners who are bound by the same deed restriction. LIENS 29
A hold or claim that one person has on the property of another to secure payment of a debt or other obligation is called lien. Common examples of lien are property tax liens, mechanic's liens, judgment liens and mortgage liens. From the standpoint of the property owner, a lien is an encumbrance on her title. Note that a lien does not transfer title to property. In most states, the debtor retains title unless the lien is foreclosed. When there is more than one lien against a property, the lien that was recorded rust usually has the highest priority in the evens of foreclosure. Property tax liens are, however, always superior to other liens. PROPERTY TAX LIEN. Property tax Hem result from the right of government to collect taxes from property owners. As the beginning of each Tax year, a tax lien is placed on taxable property. ft is removed when the property taxes are paid. IF they are not paid, the lien gives the government the right to force the sale of the property in order to collect the unpaid taxes. MECHANIC'S LIEN. Mechanic’s lien laws give anyone who has furnished labor or materials for the improvement of land the right to place a lien against those improvements and the land if' payment has not been received. A sale of the property can then be forced to recover the money owed. To be entitled to a mechanic's lien, the work or materials must have been provided pursuant to contract with the landowner or his representative. For example, if a landowner hires a contractor to build a house or add a room to his existing house and then fails to pay the contractor, the contractor may file a mechanic's lien against the land and its improvements. Furthermore, if the landowner pays the contractor but the contractor does not pay his subcontractors, the subcontractors are entitled to file mechanic’s lien against the property. In this Situation, the Owner may have to pay twice. The legal theory behind mechanic-s lien rights is that the labor and materials supplied enhance the value of the property. Therefore, the property should be security for payment, if the property owner does not pay voluntarily, the lien can be enforced with a court-supervised foreclosure sale. Mechanics (contractors), material men, architects, surveyors, and engineers arc among those who may be entitled to the protection of mechanic's lien laws. All mechanic's liens attach and take effect at the time the first item of labor or material is furnished, even though no document has been filled with the county recorder. To preserve the lien, a lien statement must be fled in the county where the property is located and within 20 to 120 days (depending on the state) after Labor or material has been furnished. This is called perfecting the lien. Whenever improvements are made to the land, all Persons (including sellers under a contract for deed and Landlords) may be held to have authorized the improvements. As protection, an owner can serve or post notice that the improvements are being made without the owners authority. A lender planning to finance a property will be particularly alert for the possibility mechanic's Liens. If work has commenced or material has been delivered before the mortgage is recorded, the mechanic's lien may be superior to the mortgage in the event of foreclosure. 30
JUDGMENT LIEN. Judgment liens arise from lawsuits for which money damages are awarded. The law permits a hold to be placed against the real and personal property of the debtor until the judgment is paid. Usually the lien created by the judgment covers only property in the county where the judgment was awarded. However, the creditor can extend the lien to property in other counties by filing a notice of lien in each of those counties. MORTGAGE LIEN. A mortgage lien is created when property is offered by its owner as security for the repayment of a debt. If the debt secured by the mortgage lien is not repaid, the creditor can foreclose and sell the property. IF this is insufficient to repay the debt, some states allow the creditor to petition the court for a judgment lien for the balance due. (Mortgage law is covered in more detail in Chapter 9.) VOLUNTARY AND INVOLUNTARY LIENS. A voluntary lien is a lien created by the property owner. A mortgage lien is an example of voluntary lien: the owner voluntarily creates a lien against his/her property in order to borrow money. An involuntary lien in created by operation of law. Examples are properly tax liens, judgment liens and mechanic's liens. SPECIAL AND GENERAL LIENS. A special lien is a lien on a specific property. A property tax Lion is a special hen because it is a lien against a specific property and no other. Thus, if a person owns five parcels of land scattered throughout a given county and fails to pay the taxes on one of those parcels, the county can force the sale of just that one parcel; the others cannot be touched. Mortgages and mechanic's liens are also special liens in that they apply to only the property receiving the materials or labor. In contrast, a general lien is a lien on all the property of a person in a given jurisdiction. For example, a judgment lien is a lien on all the debtor's property in the county or counties where the judgment has been filee. Federal and state liens for taxes are also general liens. LIENOR, LIENEE. The party holding the lien is called the Lienor. Examples of lienors are mortgage lenders, judgment holders, and tax authorities. The party whose property is subject to the lien is called a lienee. The terms lienor and lienee apply whether the lien is voluntary or involuntary, specific or general. Qualified Fee Estates A qualified fee estate is a fee estate that is subject to certain limitations imposed by the person creating the estate. Qualified fee estates fall into three categories; determinable, condition subsequent, and condition precedent. They will be discussed only briefly as they are rather uncommon. A fee simple determinable estate indicates that the duration o the estate can be determined from the Lim! For example, Mr. Smith donates a parcel of Lund to a church so long as the land is used for religious purposes. The key words arc so long as_ So long as the land is used for religious purposes, the church has all the rights or fee simple ownership. But if some other use is made of the land, it reverts back to the grantor (Mr. Smith). or someone else named by Mr. Smith (called a remainder man.). Note that the termination of the estate is automatic if the land is used contrary to the limitation stated in the deed.
31
A fee simple subject to condition subsequent gives the grantor the righi to terminate the estate. Continuing the above example, Mr. Smith would have the right to reenter the property and take it back if it was no longer being used for religious purposesWith a fee simple upon condition precedent, title will not take effect until a condition is performed. For example, Mr. Smith could deed his land to a church with the condition that the deed will not take effect until a religious sanctuary is built. Occasionally, qualified fees have been used by land developers in lieu of deed restrictions or zoning. For example, the buyer has fee title so long as he uses the land for a single-family residence. In another example, a land developer might use a condition precedent to encourage lot purchasers to build promptly. This would enhance the value of his unsold lots. From the standpoint of the property owner, a qualification is an encumbrance to his fide.
Life Estates A life estate conveys an estate for the duration of someone's life. The duration of the estate can be tied to the life of the life tenant (i he person holding the life estate) or to a third party. In addition, someone must be named to acquire the estate upon its termination. The following example will illustrate the life estate concept. Suppose you have an aunt who needs financial assistance and you have decided to grant her, for the rest of her life, a house to live in. When you create the life estate, she becomes the life tenant. Additionally, you must decide who gets the house upon her death. If you want it back, you would want a reversion for yourself. This way the house reverts back to you, or if you predecease her, to your heirs. If you want the house to go to someone else, your son or daughter for example, you could name him or her as the remainderman. Alternatively, you could name a friend, relative, or charity as the remainderman, Sometimes a life estate is used to avoid the time and expense of probating a will and to reduce estate taxes. For example, an aging father could deed his real estate to his children but retain a Lice estate for himself_ A life estate can also he created for the life of another. For example, I will dyed this property to Jim Bob for the life of his mother (anticipating that Jim Hob will maintain control over the property for the purpose of taking care of his mother—perhaps given the opportunity to live there at no cost}. Then, upon the death of his mom, the life estate would revert to the grantor or vest in thy remainderman, depending on the terms that created thy lily estate. In legal terms, this is ached a life estate pur autrie vie. PROHIBITION OF WASTE Since a life estate arrangement is temporary the life tenant must not commit waste by destroying or harming the property. Furthermore, the life tenant is required to keep the property in reasonable repair and to pay any property taxes, assessments, and interest on debt secured by the property. The life tenant is entitled to income generated by the property, and may sell, lease, rent, or mortgage his or her interest. Although the life estate concept offers intriguing gift and estate planning possibilities, uncertainty of the duration of the estate makes it rather unmarketable. Thus, you will rarely see a tire estate advertised for sale in a newspaper or listed for sale at a real estate brokerage office. 32
SURFACE RIGHT OF ENTRY In parcel a the fee simple landowner has leased or sold the right to extract oil and as from beneath her land. However, no 5 Lea= right for the purpose of entering and drilling has been leased or sold. Thus, the oil company must slant drill from a nearly" property where it does have a surface right of entry_ The remaining rights amount to a full lee estate in the surface and air space. However, use of those rights is subject to stoning laws and building codes that restrict what can he built. Deed restrictions may include additional limitations on the type of sinicture that can be built. Also, the government claims air space rights for passing aircraft, as it does over all land within its borders_ Just above and beneath the surface, easement rights have been gained to utility companies for electric, telephone, water, and as lines
33
Lecture 4 Land resources of Georgia, Landscape and Soil diversity Reliefs, soil, landscape, land resources and zoning in Georgia
Despite the fact that this homeowner's bundle of rights is not complete, what she does have is quite suitable for a home site Recognizing this, lenders will accept the owner's offer of this house and lot as collateral for a loan. This might ricii be the Cane if the oil company had a surface right or entry. The noise, odor, and fire hazard of a working oil well next to a house would considerably reduce its value as a residence. LAND LEASE In parcel C shown in Figure 3.7, the fee owner has created an estate for years by st long-terrn lease of his land to an investor, who has subsequently constructed an apartment building on the land. This estate gives the building owner/lessee the right to occupy and use the land for a fixed period of time, most often between 55 and 99 years_ In turn, the building owner rents out apartment units on a monthly or yearly basis. The rights to tiny mineral, oil. or gas deposits earl either be included in the lease or reserved by the landowner. At the end of the lease period, the reversion held by the owner of the fee estate entitles the owner to retake possession of the land, including the buildings and other improvements thereon.
Land and Land Resources13 Georgia is situated in the south-east part of Europe between Turkey, Armenia, Azerbaijan, Russia and the Black Sea. The length of costal zone is 310 km; the length of land border covers 1838 km that consists of the following according to the neighboring countries: length of land border to Russia is 894 km, length of land border to Azerbaijan is 445 km, length of land border to Armenia is 224 km, length of land border to Turkey is 275 km. The whole length of Georgian border is about 2148 km. Land area of the country is 6949, 4 thousand ha. In 2002, according to Georgian Law ‘About Water', the area of territorial water was counted and defined as 679,0 thousand ha. As a result, the whole area of the country has been determined as 7628,4 thousand ha since January 1, 2002 and 3025,8 thousand ha (39,7%) out of it is agricultural land. Intensive usage land - arable and perennial plantations, is 1065,3 thousand ha (35,2% of the whole agricultural land) and that consists of 802,1 thousand ha arable land (26,5%), 263,5 thousand ha perennial plantations (8,7%), 143,5 thousand ha mowing land (4,7%), 1796,6 thousand ha pastures (59,4%). 20,1 thousand ha (0,7%) of agricultural lands is covered by buildings and yards. 60,3% or 4602,6 thousand ha of territory of the country is shrubberies, water, roads, buildings and other unused areas (rocks, ravines, erosion land, cemeteries).
13
http://moe.gov.ge/index.php?lang_id=ENG&sec_id=43
34
2838,3 thousand ha (33,3%) of the whole territory of the country is covered by forest; 11,5 thousand ha (0,2%) is field protection wood zone; 154,7 thousand ha (2,1%) is wood shrubbery; 17,1 thousand ha (0,2%) is wetland; 876,5 thousand ha (11,5%); is covered by water: 91,3 thousand ha (1,2%) is rivers and streams, 17,9 thousand ha (0,2%) is reservoirs, 21,3 thousand ha (0,3%) is glaciers, 17,5 thousand ha (0,2%) is lakes, 1,0 thousand ha (0,01%) is puddles, 49,0 thousand ha (0,6%) is main line canals and its networks, 678,5 thousand ha (8,9%) is the Black Sea territorial water, 291,2 thousand ha (3,8%) is roads, 108,1 thousand ha (1,4%) is buildings, 6,3 thousand ha (0,1%) is damaged lands. 298,9 thousand ha (3,9%) is unused non-agricultural land that consists of 18,4 thousand ha (0,2%) is rocks, 2,4 thousand ha (0,3%) is sands, 171,3 thousand ha (2,2%) is ravines, 4,1 thousand ha (0,05%) is cemeteries, 102,7 thousand ha (1,3%) is erosion land.
Georgian forests14 Georgian forests are great national treasure. The constitution of Georgia urges all citizens to treat nature carefully with respect and accordingly the same attitude is expected to the forests an important strategic source of our country. The concept of stable management of forests in Georgia stems from understanding of ecological, economic and social importance of forests. Ecological, economic and political aspects of forest management are a part of national development strategy and stable development of the country. The purpose of stable forest management is to satisfy basic needs of the society in forest resources on the basis of scientific rational multipurpose non-depleting usage, protection and reproduction saving biologic variety of
the
forests.
Georgia is one of the most ancient countries in the world, a part of the Caucasus with 5.5 million populations. The territory is 6.5 million hectares. Georgia borders Russia in the north, Azerbaijan in the east, Armenia and Turkey in the south and the Black Sea in the west. Forest areas occupy 3005.3 thousand hectares while pure forestry accounts for 2772.4 hectares which is 40% of the country's territory. The total timber resources of the world are estimated at 360 billion cubic meters, in the Georgian mountains these resources are estimated at 451.7 million cubic meters i.e. 0.13% of the world resources. Average forest density in the world is 100 square meters per hectare, in Georgia it is 163 square meters. 97% (2915.8 hectares) of Georgian forestry are situated on mountain slopes, the rest 3% are low-lying and flood plain forest in Kolhida region and in the west of Georgia. On the slopes the forests density is following 010 .5. % (165 thousand square hectares, 1120 16.5% (496 thousand hectares), 2125 16.6% (499 thousand square 14 http://moe.gov.ge/index.php?lang_id=ENG&sec_id=44 35
hectares)), 2630 18.2% (547 thousand hectares), 3135 19.6% (589 thousands hectares) 36 and higher 23.6% (710.4 hectares) Georgia defines forests according to age which might be of special interest. Mature trees dominate, 33.4 % (852.3 thousand hectares), ripe and old age plants 35.4% (904.4 thousand hectares), which gives opportunity to test and carry out regenerating measures. The tree types are distributed as follows: the beech 1060 thousand hectares. 46.6 %, the fir 161.5 thousand hectares. 7.1 %, the pine 91.0 thousand hectares. 4.0 %, the oak 241 thousand hectares. 10.6 %, the alder 125.1 thousand hectares. 5.5 %, the Chestnut 72.8 thousand hectares. 3.2 %, the hornbeam 220.6 thousand hectares 8.8 %, the Fir-tree 102.0 thousand hectares 4.5 % and other types 220.6 thousand hectares. 9.7 %. Above sea level the areas of forests are distributed in the following order: 100 m. above sea level. 2 %, 101500 m. above sea level. 5 %, 5011000 m. above sea level. 20 %, 1001 1500 m. above sea level. 35 %, 15012000 m. above sea level. 31 %, 2001ј and the rest 7 %. Distribution of the areas according to the category is the following: Reserves 168.9 above sea level. National parks 61.4 above sea level, Protected reserves 12.4 above, Forests in green zones 276.5 thousand hectares, Resort woods 119.4 thousand hectares, Soil-protective and Water-protecting forests 2366.7 thousand hectares.
NATURAL RESOURCES, POLICY-MAKING FRAMEWORK FOR ENVIRONMENTAL PROTECTION AND SUSTAINABLE DEVELOPMENT15 Georgia has an area of 69,875 km2. It is situated in the Caucasus region at the juncture of Eastern Europe and Western Asia. The country is bounded to the west by the Black Sea coast (shoreline 310 km), to the north by Russian Federation (border length 815 km), to the south-east by Azerbaijan (460 km), to the south by Armenia (197 km) and to the south-west by Turkey (248 km). The Greater Caucasus Mountain Range forms the northern border of the country while the Lesser Caucasus Mountains occupy the country’s southern part. The Likhi Range connects these two mountain systems and divides the country from the northeast to the southwest. To the west of this divider is the Kolkheti Lowland area, which extends to the coast of the Black Sea. To the east of the Likhi range is the Kartalinia Plain, a high plateau along the Kura River up to the border with Azerbaijan. Georgia has thousands of rivers, most less than 25 km long, which either drain into the Black Sea to the west or flow through Azerbaijan to the Caspian Sea to the east. Two of the longest
UNITED NATIONS ECONOMIC COMMISSION FOR EUROPE, ENVIRONMENTAL PERFORMANCE REVIEWS GEORGIA, Second Review, UNITED NATIONS, New York and Geneva, 2010. 36 15
rivers, the Kura (or Mtkvari in Georgian, 1,364 km; of which 390 km within Georgia) and the Rioni (327 km), flow in opposite directions. Georgia has several distinctive climatic zones. The coastal area has a humid subtropical Mediterranean climate all year round. The Greater Caucasus Mountain Range forms a barrier against the cold air from the north, while warm, moist air from the Black Sea can move easily into the coastal lowlands from the west. The plains of eastern Georgia have a more continental climate than the west, with colder winters, hotter summers and lower humidity, while the Alpine and highland regions and the semi-arid region of the Iori Plateau to the south-east have distinct microclimates. Alpine climates begin at about 2,100 m, and above 3,600 m mountains are covered by snow and ice all year round. The long growing season allows for the cultivation of almost any crop, making Georgia’s agriculture very diverse. The main crops are corn and winter wheat. There is a long tradition of winemaking in the country, and wine is a major agricultural product. Other leading crops are citrus and non-citrus fruits. Animal husbandry—mainly the raising of cattle, pigs and sheep—is also important. Agriculture has considerably transformed the land at lower altitudes, and little of the country’s native wildlife remains. Dense forests and woodlands cover 40 per cent of the country, but forests are mostly concentrated in the western and mountainous regions, while in the sparsely wooded eastern uplands, underbrush and grasses predominate. Manganese, of which Georgia has some of the richest deposits of the world, is the country’s main mineral resource. The manganese reserves located in Chiatura and Sachkhere are estimated at 222 million tons. Manganese has not been a significant commodity since 1990; before that date, it played a key role in the country’s economy, not only in its own right but also by stimulating infrastructure development as well as other industrial sectors. In addition, the country has an estimated 341,700 tons of copper reserves and 37.6 tons of gold reserves. In Kazreti, an Australian–Georgian joint venture is extracting gold from the abandoned slag heaps of Soviet-era copper mines. Deposits of non-ferrous metals and polymetallic ores have also been found, along with arsenic, agate and obsidian. The Ministry of Economic Development began issuing mining licenses for several of these deposits in 2007. After the break-up of the Soviet Union, the level of mineral production declined sharply, and although the mineral industry began to pick up in 2005, Georgia has not produced any mineral products in quantities of more than regional significance.
37
Potential oil reserves are estimated at some 580 million tons, of which 200 million are located in offshore fields of the Black Sea. Proven gas reserves stand at 8.5 million m3 and estimated reserves at 125 million m3. Georgia also has around 1 billion tons of coal reserves, but the coal is not of good quality. Over 80 per cent of the country’s electricity is produced by hydropower, and while hydropower is plentiful its use is underdeveloped. There is an economically viable potential of 32 TWh hydropower production capacity, one of the largest in the world, of which only 18 per cent is currently being utilized. Potential per capita production is 7.27 MWh, 35 per cent more than the world’s biggest hydropower producer, Norway. Georgia became a net electricity exporter in 2007. With its massive unused capacity and its current per capitaelectricity consumption, one of the lowest in Europe, Georgia can easily increase its electricity exports while satisfying fast-growing domestic electricity consumption (8– 9 per cent annually). Georgia has substantial mineral water resources, with an estimated 2,300 springs. The bestknown sources are at Borjomi in central Georgia, where two plants bottle water for export and domestic use. The mineral water industry has struggled since 2006, however, and unlike in previous years, mineral water did not figure among the country’s top 10 export items in either 2006 or 2007. Georgia has a host of environmental problems, the most important of which relate to air and water quality, waste management, land use, coastal and marine pollution, chemical pollution and nature conservation. Air pollution is fast becoming a major environmental concern. At the moment, the annual national emissions inventory of air pollutants covers only the energy, industry and transport sectors. The impact of the transport sector, especially increasing road transport, is a cause for concern. The effect of the some 3,000 stationary sources on air pollution is mitigated by the fact that not all are working at full capacity. Georgia has considerable water resources, but water distribution is uneven due to the varying geographic conditions. A bigger problem, however, is maintaining water quality given the inadequate and outdated infrastructure. Defective water distribution infrastructure and contamination from wastewater are causing drinking water quality concerns. Data on surface and ground waters is limited Georgia does not have an overall government strategy on waste management. From prevention through collection, treatment and recovery to final disposal, the chain of waste management is seriously compromised and not well managed. The country’s waste management is also burdened with the problem of what to do with stocks of obsolete pesticides.
38
Land degradation and desertification are worsening. In general, nature conservation may encounter increased problems due to the State’s weakening environmental control. Diminishing living standards can also drive environment and environmental deterioration, as reflected by increasing illegal logging. Coastal and marine pollution is caused by a number of industrial hotspots, pipelines and oil spills from oil transport. With regard to land use, administrative structures to ensure effective spatial planning and management of the environment require particular attention. Industrial pollution is mainly caused by metallurgy, oil refining, coal mining and the chemical industry. The main environmental transboundary issues are related to the Kura-Araks River basin and the Black Sea. The Kura-Araks basin is an important regional source of freshwater and the problems in the Kura basin relate to both water quantity and quality. The most serious Black Sea problems are the discharge of wastewater, oil pollution in the coastal areas and the loss of biodiversity, including fish stocks . Georgia acceded to the Kyoto Protocol in 1999, and has undertaken to implement the relevant provisions and concrete policies and measures aimed at reducing greenhouse gas emissions, especially in the energy and heavy industry sectors. Since Georgia’s first Environmental Performance Review (EPR) in 2003, major political changes have come about, mostly in the aftermath of the Rose Revolution of November 2003. Following the presidential elections of 4 January 2004, a host of constitutional, institutional and legislative changes took place, reflecting the President’s main priority of drastically reforming the economy in order to achieve rapid economic growth, and accelerating the privatization of State property. The 1995 Constitution has undergone several amendments, most recently on 10 October 2008. The most farreaching amendments, however, were introduced earlier, on 6 February 2004. They have given rise to an entirely new “Chapter 41” entitled “The Government of Georgia”. The amendments provided, inter alia, for a new position, that of Prime Minster, and reduced the number of parliamentarians. Despite the amendments to the Constitution, Article 37 (in particular paragraphs 3-5), which embodies the main article on environment and the State’s responsibility for its protection, has not changed since 1995. Since 2004, the composition of the cabinet has undergone frequent changes: On occasion, ministries have been renamed, abolished or established; and ministers are very often being replaced, in a number of instances moving to another ministry. This includes the post of Prime Minister, who is appointed by the President (since 2006 there have been five Prime Ministers) and the post of the Minister of Environmental Protection and Natural Resources. At the time of 39
the review, there have been 8 Ministers of Environmental Protection and Natural Resources since 2004, and 19 deputy ministers, thus affecting continuity of operation in the Ministry and sometimes impeding its effective functioning. The 1999 Law on Legal Entities of Public Law introduced a new entity: the legal entity of public law (LEPL). According to the law, an LEPL is an organization separate from governmental bodies and established by corresponding law, presidential decree or administrative act adopted by Government bodies on the basis of the law, which independently implements political, state, social, educational, cultural and other public activities under State control. Under the Ministry of Environment Protection and Natural Resources, three such legal entities of public law have been established: the Forest Nursery, the Protected Areas Agency, and the National Environmental Agency. The 2008 amendment of the 1999 Law on LEPL introduced a new type of entity by defining LEPLs for an Autonomous Republic within the State of Georgia. The new entity is separate from Government bodies and established by a normative act of the supreme executive organ of an Autonomous Republic, that independently implements social, educational, cultural and other public activities under State control. The 2007 amendment to the main environmental framework law, the 1996 Law on Environmental Protection, provides among other changes that the State of the Environment Report must only be prepared once every three years instead of each year, and stipulates that statute on “Rules of Transportation, Preservation and Usage Norms of Chemical Substances within the Environment`` needs to be updated every five years, whereas previously no interval was specified. Through these amendments, the applicability of the Law on Environmental Protection has been diminished. Many of the sectoral laws, as described in the first EPR, also remain valid. Most of them have undergone modification and amendment, including the 1996 Law on the System of Protected Areas, the 1996 Law on Wildlife, the 1997 Law on Water, the 1998 Law on Nuclear and Radiation Protection, the 1999 Forest Code and the 1999 Law on Ambient Air Protection. Since 2003, a limited number of new laws have been adopted, as follows: • The 2004 Law on Fees for the Use of Natural Resources, which gives an overview and definition of the terms and fees relating to the rational exploitation of State-owned natural resources, such as mines, forests, water, and wildlife, indicating the amount of fees to be paid for their usage and extraction. Fees are based on the potential capacity of the resource and on the principle of sustainable development of the environment, by establishing the principle of paid resource exploitation. The Law entered into force in 2005.
40
• The 2005 Law on Licenses and Permits, which regulates and legally organizes activities posing certain threats to human life and health and addresses specific State or public interests, including the usage of State resources. It also regulates activities requiring licenses or permits, determines types of licenses and permits, and defines the procedures for issuing, revising or cancelling licenses or permits. • The 2005 Law on State Control of Environmental Protection, which regulates legal relations between the Inspectorate of Environmental Protection and the “regulated objects” (private persons, legal entities of private or public law or executive bodies, to which the environment legislation requirements are applicable). • The 2007 Law on Environment Protection Service, which regulates the responsibilities of the Environment Protection Service, its legal status and basis of activities as well as the main operating principles; it also contains the procedures for the employment of persons in the Inspectorate, their social benefits and legal status. • The 2007 Law on Environmental Impact Permit , which determines the list of activities and projects subject to ecological examination and requiring an environmental assessment, as well as providing the legal basis for public participation in the process of environmental assessment, ecological examination and decision-making relating to the issuance of an environmental impact permit. • The 2007 Law on Ecological Expertise, which regulates the procedures for ecological expertise concerning the activities listed by the Law on Environmental Impact Permit. • The 2003 Law on the Establishment and Management of Tusheti, Batsara-Babaneuri, Lagodekhi and Vashlovani Protected Areas; • The 2003 Law on the Red List and Red Data Book; • The 2006 Law on Mtirala National Park; • The 2007 Law on the Establishment and Management of Borjomi Kharagauli Protected Areas; • The 2007 Law on Tbilisi National Park; • The 2007 Law on the Status of Protected Areas; • The 2007 Law on Establishment and Management of Protected Areas of Imereti Caves. Further, bylaws concerning environmental impact assessment (EIA) have been adopted, namely Order No.193 of the Minister of Environmental Protection and Natural Resources on Legalization of the Statute on Rules for Conducting State Ecological Expertise (06.03.2007), and the 2006 Orders on Approval of the Regulation for the Ministerial Council on Environmental 41
Impact Assessment and on Approval of Instruction for State Inspection and Related Workflow Administration. Other bylaws adopted since 2003 are the 2008 Technical Regulations for Environmental Protection and the 2009 Statute on Environmental Impact Assessment. Since the first EPR, normative acts on the environment were mainly enacted or modified through presidential decrees, governmental resolutions or ministerial orders, not through the amendment of existing laws or the development of new legislation, which would be the preferred and more correct procedure. According to the 1996 Law on Normative Acts, laws are ranked higher than regulations, resolutions, orders and decrees. Since 2006, the Regional Divisions (former authorities of the MEPNR coordinating the inspection activities) are no longer able to perform control functions. Their current duties are linked to participation in the procedure of changing land use, gathering statistical information on water and air emissions, as well as on pollution caused by industrial accidents. Despite this delegation of new responsibilities, some overlap and duplication of work with the tasks of the Environmental Protection Inspectorate is possible. Georgia fulfills its reporting obligation under UNCCD. The third national report on the implementation of UNCCD was submitted in 2006, with the support of the World Bank. The fourth report is to be prepared in 2010. The 2003 National Action Plan for Combating Desertification (NAPCD) identifies the priority regions facing the risk of desertification, defines the main factors resulting in desertification for these areas, and determines short- and medium-term (2003–2007) action measures for combating it, along with setting out an expected outcomes and implementation schedule. Specifically, the Plan proposes scientific research measures as well as biodiversity conservation, public environmental awareness-building, desertification monitoring, and agricultural and international cooperation measures. Irrigation The irrigation system is mainly located in eastern Georgia, whereas western Georgia is characterized by drainage. The country’s melioration potential is estimated at 700,000 ha, of which 500,000 ha can be irrigated with infrastructure built during the Soviet era. However, during the 1990s due to conflicts, problems associated by land reform, transition to market economy and loss of traditional trading partners, the irrigated area was reduced to 200,000 ha. The source for irrigation water is surface water and the main technology is surface irrigation. The total length of the main channels is about 3,500 km, but the bulk is heavily damaged. During the drought of 2000, only 160,000 ha were irrigated. Almost all pumping schemes have been out of order. The total volume for irrigation has decreased in recent years. In 2006, a total amount of 42
161 million m³ was used for irrigation (17 per cent of water use without hydropower) compared to 57 million m³ in 2008. The Unit for Melioration Policy, Department of Rural Development Management, under the Ministry of Agriculture, the body responsible for managing the State property schemes, started in recent years a rehabilitation programme to renew the infrastructure of existing irrigation and drainage schemes; meanwhile, 20 per cent of the main channels and the water intake facilities have been rehabilitated. Agriculture About 43 per cent of land is used for agriculture. Reliance on fertilizers and pesticides was very high during the Soviet period, but declined in the 1990s. However, it is estimated that with future higher demand for agricultural products, this percentage will increase, impacting water quality. In particular, for the citrus and tea plantations as well as for grapes, the use of pesticides is important. Without training and advice for farmers, proper selection and use is difficult. As many of these plantations are located in the coastal zone due to weather conditions, the pesticides reach the Black Sea immediately. A monitoring of these substances does not exist, and available data is very limited. As a whole, Georgia's water-related legislation is fragmented. The 1996 Law on Environmental Protection provides for the establishment of environmental quality (including water quality) norms. It considered groundwater as part of mineral resources, regulated all aspects of groundwater use, and contained certain provisions on groundwater protection. However, following the adoption of the 2005 Law on Licenses and Permits, many articles of the former Law were abolished. The 1996 Law on System of Protected Areas provides a legal background for establishing protected area categories (including marine protected areas and water bodies within terrestrial protected areas). The 1997 Law on Land Improvement regulates waters and water bodies used for melioration (agricultural) purposes. The 1997 Marine Code and 1998 Law on Marine Space provide pollution prevention and control measures of coastal territorial water. The 2000 Law on Regulation and Engineering Protection of the Sea Shores, Reservoir and River Banks regulates engineering protection for seashores and river/reservoir banks against abrasion, floods and others. The 2007 Law on Recognition of Ownership Rights on Land Plots under the Usage of Natural Persons and Legal Persons of Private Law regulates ownership rights to land plots, including water bodies and wetlands, which are being used by natural and legal persons in an unlawful way. The 2003 Law on Conservation of Soils and Reclamation and Improvement of Soil Fertility, the 2005 Law on State Control for Environment Protection, the 2005 Law on Licenses and 43
Permits, and the 2007 Law on Ecological Expertise provide the legal streamlining in a number of water-related aspects (as i.e. EIA). The 2005 Law on Self-Governance provides for the introduction of certain rights for local authorities in the water-related sphere, such as to own waters of local importance. The 2007 Law on Public Health provides for the establishment of sanitary and hygienic requirements, norms and rules with regard to water quality. Land information system16 A follow-up activity is that the Ministry of Agriculture started with the development of a concept for creation of land information system including information on land use, agricultural land categories and their status. The Ministry of Agriculture has requested the World Bank assistance with the implementation of land information systems. Primary registration of agricultural land: The experts participating in the LGAF reccomended the abolishment of fee for primary registration of agricultural land. In accordance with the Government Decree of June 28, 2012, National Agency of Public Registry started agricultural land survey and registration, in order to ensure compliance of cadastral information of systemic registration with existing legal requirements. The Decree allowed NAPR to outsource the activities to physical or legal persons and pay 3 Gel (1.8 USD) per parcel for the services. It should be noted that this does not apply to the land within administrative borders of selfgoverned cities and recreational areas - Bakuriani, Bakhmaro, Gudauri and Ureki. State owned land survey and registration: Under the iniatiative of the Ministry of Economy and Sustainable Development of Georgia, the National Agency of Public Registry started survey and registration of state owned land through private land surveyors.
Lecture 5 Land Cadastre of Urban Areas in Georgia; GIS System Geographic aspects of Real Estate; Interpretation of Cadastral and other physical features; Description of GIS; Land Cadaster of urban areas in Georgia17 Up to date development of cartography is characterized by changes in its structure. The new directions are now being emerged, which are connected to use of new technology. Consequently
16
http://web.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTRESEARCH/EXTPROGRAMS/EXTARDR/EXTLGA/0,, contentMDK:23284630~pagePK:64168445~piPK:64168309~theSitePK:7630425,00.html 17
Liparteliani D, Urban Land Cadastre in Georgia / D. Liparteliani // Caucasian geographical review/ Geographic Society of Georgia- Tbilisi, 2003.-#2.- p.33-37.-res. English and Russian.. – lit. p37[MFN: 113903 44
the following opportunities appeared: processing the arial photography materials using the new methods, bringing together the cartography and geo-information structures, the creation of dynamic cartographic and 3-D reflections. In 1990s twentieth century, the new direction of thematic cartography – land cadaster cartography, covering agricultural and urban areas has started to develop by the support of donor organizations. The existence of effective cadaster system makes it possible to achieve the following three goals, as confirmed by practice obtained in Georgia and international experience. The goals are as follows:
Land (immovable property) ownership security;
Implementation of wise and justified fiscal policy by the country and strengthening of
budget;
Planning and monitoring of ongoing and future developments.
The realization of each afore-mentioned task gives the bases for the development of market economy. The cadastral activities are ongoing in the cities of Tbilisi, Kutaisi, Batumi. Poti is already finalized. The final product – the Cadastral Map – proves that the activities have been accomplished on a high technological level, and the maps meet the scientific and practical requirements. It can be mentioned that Poti town – as object of cadastral cartography is well registered and researched on the bases of land parcels. After the completion of ongoing registration process Poti town may be considered as a complete sample of urban land cadaster in Georgia. Gis System18 A geographic information system, or GIS, is a computerized data management system used to capture, store, manage, retrieve, analyze, and display spatial information. Data captured and used in a GIS commonly are represented on paper or other hard-copy maps. A GIS differs from other graphics systems in several respects. First, data are georeferenced to the coordinates of a particular projection system. This allows precise placement of features on the earth’s surface and maintains the spatial relationships between mapped features. As a result, commonly referenced data can be overlaid to determine relationships between data elements. For example, soils and wetlands for an area can be overlaid and compared to determine the correspondence between hydric soils and wetlands. Similarly, land use data for multiple time periods can be overlaid to determine the nature of changes that may have occurred since the original mapping. This overlay function is the basis of change detection studies across landscapes. 18
http://www.nerrs.noaa.gov/doc/siteprofile/acebasin/html/gis_data/gisint2.htm
45
Second, GIS software use relational database management technologies to assign a series of attributes to each spatial feature. Common feature identification keys are used to link the spatial and attribute data between tables. A soil polygon, for example, can be linked to a series of database tables that define its mineral and chemical composition, crop yield, land use suitability, slope, and other characteristics. Third, GIS provide the capability to combine various data into a composite data layer that may become a base layer in a database. For example, slope, soils, hydrography, demography, wetlands, and land use can be combined to develop a single layer of suitable hazardous waste storage sites. These data, in turn, may be incorporated into the permanent database of a local government and used for regulatory and planning decisions. GIS software generally allow for two types of data. Some use raster data (i.e., discrete cells in a rigid row by column format), such as satellite imagery or aerial photography, while others use vectors (points, lines and polygons) to represent features on the earth’s surface. Most systems allow for full integration of both types of data. In either case, a fully functioning GIS allows the user to enter or digitize data that are georeferenced; link specific attributes to each feature using relational database management system technology; analyze relationship between various geographic features using a wide range of spatial operations and functions; and produce highresolution images or graphics on color monitors or plotters. A GIS can be used to answer basic locational questions such as: What is located at a given point on the earth; or where is a specific feature located? For example, using a mouse-driven cursor, a specific point on a map can be queried to determine its land use, vegetation, soil type, elevation, and land ownership characteristics. Similarly, soils data across an entire watershed can be queried to determine the distribution of areas with hydric soils of greater than 100 acres and are adjacent to a major river system. In the first case, a specific, known point was identified and queried to determine preselected attributes. In the second case, however, specific locations were not known. Rather, the database was searched by the GIS to determine where specific conditions were satisfied (hydric class, size restrictions, and neighboring or adjacent feature characteristics). One of the more powerful functions of a GIS is that it allows users to synthesize or combine different layers of information to identify resource distribution patterns that may otherwise not be obvious. For example, using various map overlay techniques, threatened and endangered species data may be combined with wetland information to determine if any of the freshwater tidal wetlands in an area provide habitat for sensitive or critical species. This information could be used to develop specialized resource management plans that protect critical wetlands or it could be used to identify areas where the reintroduction of a threatened or endangered species might be successful. This information also can be used in the design of survey strategies and methods to focus on areas of potential threatened and endangered species locations. 46
A GIS also can be used for complex modeling to answer a wide range of "what if" and ecosystem simulation questions. These may be cartographic models designed to document the cooccurrence or interrelationship of multiple data layers or they may be hypothetical research models designed to mimic natural ecological systems. Similarly, modeling with GIS can be used to predict the impacts that one set of parameters will have on another. For example, wetlands, soils, hydrography, climatology and elevation data can be combined to model flooding within a river system. Upstream changes in land use within the same system can be modeled to determine the potential impact of conversion of a forested floodplain to residential development or to agriculture. As a result, both natural system responses to storm events and the impact of human land use decisions can be assessed prior to the proposed action. Regardless of the application in which GIS technology is used, these systems provide rapid data access and multidimensional analysis and graphical output capabilities that can result in more effective resource management decisions.
Lecture 6 Basic real estate economics Real estate demand; Supply of real estate; Real estate price adjustments; Assessing demand-supply imbalances19
Urban real estate markets may be peculiar and idiosyncratic in a number of respects, but they still obey some basic economic principles: the principles of demand and supply. In what follows, we are going to elaborate on some basic/generic demand and supply concepts and demonstrate how they determine market prices. The premise is that supply and demand frameworks provide basic analytical tools for conceptualizing the workings of urban real estate markets. As one of the readings by a down-to-earth practitioner suggests, these simple principles have been ignored by the real estate industry in favor of boilerplate analysis or simple hunch and intuition (Featherstone, 1986). Hunch and intuition may be useful when they are based on a solid understanding of how markets generate opportunities and constraints. However, such an approach may be very misleading when it is based on a myopic interpretation of market conditions. Within this context, this chapter covers the basic economic principles that govern the functioning of urban real estate markets. As such, it first reviews the fundamental concepts of demand, supply, prices, and price adjustments, then expands on how they apply to real estate, 19 Market Analysis for Real Estate by Rena Mourouzi‐Sivitanidou, edited by Petros‐Sivitanides, unpublished manuscript. Copyright 2011 by Petros Sivitanides (chapter 2) 47
and finally elaborates on their relevance to market analysis. REAL ESTATE DEMAND In this section, we first discuss the traditional economic definition of demand and distinguish between different demand concepts, such as, effective demand, ex ante vs ex post demand, and pent-up demand. Subsequently, we focus on the price elasticity of demand, and elaborate on the difference between actual price effects and expected price effects. After a discussion of the exogenous determinants of real estate demand, we conclude the section with a review of the various absorption concepts that are commonly used to measure marginal changes in real estate demand. REAL ESTATE DEMAND CONCEPTS
Following conventional economic theory, the demand for real estate space can be defined as the quantity of space or number of units demanded at various prices. In this sense, it is more appropriate to think of demand as a schedule as shown in Figure 2.1, rather than a single quantity. Figure 2.1 demonstrates the fundamental law of demand, which states that the quantity demanded declines with price or, in real estate terms, that a lower amount of space or number of units is demanded at higher prices. Figure 2.1 Fundamental Law of Demand
Embedded in the demand definition is the concept of effective market demand, that is, the demand that is backed up by purchasing power. In some cases, in real estate analysis we may need to focus on desired or ex-ante demand. This refers to the aggregate desired quantity of a good before consumers interact with the marketplace. After interacting with the marketplace, however, realized or ex-post demand may be different from the ex-ante demand for various reasons, such as supply constraints. The not-yet-realized demand is often referred to as pent-up demand. DEMAND SENSITIVITY TO PRICE/RENT CHANGES: PRICE ELASTICITY OF DEMAND
An important trait of the demand curve is the sensitivity of quantity demanded to price changes. This sensitivity is summarized by the concept of the price elasticity of demand εD. 48
This is calculated as the ratio of the percent change in quantity demanded over the percent change in prices. The price elasticity simply shows by what percent the quantity demanded will decrease in response to 1% increase in price. For example, a hypothetical estimate of the price elasticity of housing of –0.5 would suggest that the number of housing units demanded will decrease by 0.5% if the average price of housing increases by 1%. In general, if the price elasticity is less than one demand is considered to be inelastic. An inelastic demand schedule implies that demand is insensitive to price increases or, that large price increases induce relatively small decreases in the quantity demanded as in Figure 2.1 (a). On average, real estate demand is price inelastic. If the price elasticity is equal to one then demand is considered to be unit elastic, and refers to the case in which a percentage increase in price induces exactly the same percentage decrease in the quantity demanded. Finally, demand is considered to be elastic if its price elasticity is greater than one. An elastic demand schedule implies that small increases in price induce large decreases in the amount of space or number of units demanded as in Figure 2.1 (b). The price elasticity of demand is determined by the availability of substitutes. For example, a product with few substitutes, such as luxury housing, should have a less elastic demand than a product with plenty of substitutes, such as middle-income housing. Similarly, the demand schedule for a submarket must be more price elastic than the demand schedule for the whole metropolitan area since there are many substitutes for the former (other sub-markets) but hardly any substitutes for the latter. To better understand this argument considers that most of the companies housed in a metropolitan area serve the local population and businesses. Thus, while these firms can move from one submarket to another submarket and still be able to serve their local clientele, they cannot do so if they move to a different metropolitan area. Why is the concept of the price elasticity of demand relevant for real estate analysis at the macro or micro level? At the macro level, it can help gauge the impact of changes in market prices or rents on demand and more specifically, on the amount of space and/or number of units demanded. At the micro level, it can help investors and developers assess the impact of price increases on revenues.
Developers and investors would always prefer to face inelastic project demands because if prices/rents increase, revenues increase as well, as demand/absorption does not decrease enough 49
to eliminate the gains from rent increases. In other words, if the price of real estate, P, goes up, the quantity demanded, Q, goes down but, still revenue, P*Q, increases because Q decreases considerably less than P increases (Kau and Sirmans, 1985). Impact of Actual Price Changes vs Expected Price Changes In analyzing the effect of price changes, it is important to distinguish between actual price increases and expected price increases. As discussed earlier, if actual prices increase quantity demanded is impacted negatively to a lesser or a greater extent, depending on the price elasticity of demand. In graphic terms, this impact can be traced by moving along the demand curve since price, P, is an endogenous determinant of demand (see Figure 2.1). Are there any scenarios under which this fundamental law of demand may appear not to apply? For example, some market analysts observing increasing housing demand during periods of rising prices may be tempted to conclude that the law of demand is being violated. One could also make the same argument alluding to periods during which both office rents and absorption are increasing. Although these phenomena appear to violate the law of demand, they are perfectly consistent with economic theory. In the cases discussed above, increases in demand are not triggered by the actual price increases but by the expectation of further increases in the future (assuming that no other changes that would trigger an increase in demand are taking place in the marketplace). To further elaborate on this issue let’s consider a market in which housing prices rise initially due to massive immigration of households in the area and the resultant increase in the demand for housing. These initial increases in housing prices may ignite in the minds of housing buyers expectations of further price increases in the future. Such a scenario is quite likely since empirical studies have shown that real estate investors behave “myopically”, or in other words, tend to extrapolate recent market developments and price movements into the future (Sivitanidou and Sivitanides, 1999). If that is the case, what will be the likely impact of these expectations for higher housing prices on single-family housing demand? Would it be the same as the impact of actual price increases? The answer to the above question is no for the following reason. In the case of the single-family market, while actual price increases may discourage some households from realizing their plans to buy a house because they can no longer afford it, expectations of further price increases in the future may motivate some other households to accelerate their decision to enter the market before prices climb at even higher levels. Similarly, in the case of the office market, expected rent increases may motivate office firms to engage in the so-called “banking of office space”, that is, lease more space than they currently need for future use. Therefore, under the assumption of reasonably behaving households and firms, expected price or rent increases may result in an increase in demand for housing or office space, which is opposite of the effect actual price increases would have. Such a behavior explains the phenomenon of increasing demand during periods of increasing prices or rents. The effect of expectations for higher prices represents, therefore, a shift of (and not movement along) the demand curve. In this fashion, expected price changes are exogenous determinants of demand.
50
EXOGENOUS DETERMINANTS OF REAL ESTATE DEMAND
So far, we discussed the role of the endogenous determinants of real estate demand, that is, actual prices and rents. As the previous discussion has indicated, however, quantity demanded does not depend only on prices, but also on other non-price or exogenous (as they are typically referred to) factors, that can induce shifts of the demand schedule (see Figure 2.2). These exogenous determinants are of equal or even greater importance to real estate analysts. Competent forecasts of these factors can be very helpful in assessing real estate market prospects, evaluating project viability, and identifying real estate development and investment opportunities. The exogenous drivers of the demand for real estate can be classified into the following four categories: • Market Size (Population, Employment) • Income/Wealth • Prices of Substitutes • Expectations Market size variables that drive the demand for real estate include population, employment, or output, depending on the property type under consideration. For example, in the case of housing and retail the relevant exogenous determinant is the number of households, while in the case of office space the most relevant market-size variable is office employment. In the case of industrial space demand, the relevant size variables include output, as well as warehouse and distribution employment (Wheaton and Torto, 1990). The effect of market size on real estate demand is positive, that is, for the same price level and larger market size a greater quantity of real estate will be demanded in terms of either square footage or number of units. Figure 2.2 Demand Shift
Income/wealth affects directly the demand for retail and residential real estate in the sense that, keeping prices constant, as income increases more households can afford to buy a house and a greater dollar amount is available for retail spending. Therefore, increases in real income or wealth should be associated with increases in the number of housing units and the square 51
footage of retail space demanded. Demand for office and industrial space may also be indirectly affected by income movements. For example, as income increases the demand for office services may increase to the point that local office firms may need to hire more employees and expand their office space usage in order to accommodate this increased demand. So eventually, income increases may lead to shifts in demand for office space through their effect on office employment. Similarly, increased consumption of goods due to increases in income may motivate wholesalers and retailers to increase their storage/distribution space, thereby inducing shifts in the demand for warehouse/distribution space. The price of substitutes could also induce shifts in the demand for real estate. For example, for a given level of single-family housing prices, increases in apartment rents are likely to induce a shift of the demand curve for single family-housing to the right. Such a shift is likely to occur because as renting becomes more expensive relative to owning a house some renters may find home-ownership more attractive. Similarly, in the office market, as rents in the class A market rise some firms may be forced to seek space in the class B market where rents are more affordable. In such a case, the demand schedule for class B space will shift to the right in order to reflect the greater amount of office space demanded in response to rent increases in the class A market. Finally, consumer or firm expectations may induce shifts in demand for the different types of real estate. For example, as discussed earlier, expectations of higher prices or rents in the future may result in increases in the number of housing units demanded or the amount of office space demanded. Similarly, growth expectations on the part of firms may also induce shifts in the demand for commercial real estate. For example, an office firm in a market that is growing rapidly may require a greater amount of space in anticipation of future expansion than an identical firm would require in a stable market that does not foresee any expansion potential. MEASURING CHANGES IN REAL ESTATE DEMAND: ABSORPTION CONCEPTS
Given the durability of real estate, marginal shifts in demand are more important than aggregate demand from a real estate development point of view. Real estate analysts use several proxies/indicators of such changes in demand, most of which are absorption measures. Properly used or misused proxies of marginal changes in space demand include gross absorption, net absorption, and average or normal absorption. Gross absorption is defined as the total amount of space involved in all leases signed during a particular period. Notice that physical occupancy of the space associated with a particular lease contract may take place months after the contract is signed. Is gross absorption a good measure of marginal changes in real estate demand? For example, if gross absorption in a market is going up does this mean that the market is healthy? The answer is no because gross absorption does not account for space vacated. In other words, gross absorption measures all leasing activity, which may simply represent movements of tenants from one building to the other. As such, it does not really indicate anything about changes in aggregate demand for real estate. In fact, if the space vacated were greater than the space leased, which implies a decrease in total amount of occupied space and a weakening market, the positive gross absorption 52
measure would be very misleading. Therefore, real estate analysts should not pay too much attention to this measure. If net absorption is known then gross absorption may worth some consideration because it can provide some information regarding the extent of turnover in the market. GROSS ABSORPTION (GAT) Gross absorption is defined as the sum of all square footage (S) involved in all leases, n, signed during a particular time period t:
Net absorption is defined as the change in a market’s occupied stock and is calculated using formula (2.3). By definition, net absorption measures changes in aggregate demand for real estate and is definitely a much better indicator than gross absorption because it accounts for vacated space. Thus, net absorption can take negative values if the occupied stock of a market decreases, or in other words, if the space vacated during a period is greater than the space leased. NET ABSORPTION (ABT) Net absorption is defined as the change in a market's occupied stock during a time period. It can be calculated using (2.3), where OS denotes occupied stock:
particular
Before evaluating net absorption, it is important to understand its determinants. Since it represents change in demand, its determinants include prices/rents, changes in market size (e.g. 53
population, employment etc.), changes in income/wealth, and expectations for prices or employment growth. According to the law of demand, prices/rents should have a negative effect on net absorption while, as discussed earlier, market size, income, and expectations of price increases or employment growth should have a positive effect. WHAT DETERMINES NET ABSORPTION?
Given the different factors that may boost net absorption this measure should be interpreted with extreme caution. For example, increasing absorption may not necessarily reflect a rapidly growing employment base, but simply pent-up demand, that is, demand from previous years that remained unrealized due to supply constraints or high rents. If that is the case, developers should think twice before plunging into a construction frenzy. Similarly, increasing absorption may simply be due to expectations of future rent increases, which may induce firms to lease today more space than they currently need for future use. In fact, if such “banking” of space is the major cause of increases in absorption during a period, subsequent periods may see decreasing absorption, despite strong employment growth, because firms would have already leased the space needed to accommodate additional employees. The lesson that comes out of this discussion is that it is not enough to know whether net absorption is strong or what direction is moving in order to accurately assess the strength of the market and its prospects. It is more important to know why it is strong and why it is increasing or decreasing. Is it due to changes in rents? Employment, population or income growth? Or simply due to expectations? Normal or average absorption is simply an estimate of the average net absorption usually over a long historical period, if the available data allow it. Some real estate analysts are fascinated with the concept of average or normal absorption, but such a measure could be extremely misleading when used for forecasting purposes. As historical data for office and industrial net absorption show, this indicator moves along a wide spectrum of positive and negative levels. Thus, net absorption over a given forecasting period may fluctuate a lot, depending on how its several drivers will move. Therefore, an estimate of an average absorption over a number of years in the past is by no means an indicator of the absorption levels that will be achieved in the years ahead. To understand how misleading average absorption can be when used as a basis for developing forecasts consider this example from the Houston office market. For this example, we will assume that the year of analysis is 1986 and that we want to generate absorption forecasts for the period 1987-1990. According to CBRE/Torto Wheaton Research historical data 54
that start from 1980, the average office net absorption during the period 1980-1986 it was 5.7 million square feet. As Figure 2.3 indicates, this average was driven up primarily by very high absorption of about 15 and 10 million square feet in 1981 and 1982, respectively. In 1986, the hypothetical year of analysis, net absorption in Houston was negative 1.6 million square feet. Within this context, a typical forecast for the Houston office market in 1986, using the concept of average absorption would look like the one presented in Table 2.1. In particular, given the negative performance of the market in 1986, the analyst would most likely predict a below-average absorption in 1987, such as 2 million square feet or so, and then apply the average absorption for the remaining years of the forecast. As Table 2.1 and Figure 2.3 show, in reality the market in 1987 did not absorb 2 million square feet of additional space. On the contrary, it registered a negative net absorption of 1.4 million square feet. During the subsequent years, the market registered positive net absorption, ranging between 1.9 and 3.6 million square feet, which was considerably lower than the predicted 5.7 million square feet per year. In sum, using the concept of the average absorption, the analyst would considerably overestimate future net absorption and provide a severely misleading picture regarding the prospects of the Houston office market over the period 1987-1990. Such a forecast could easily mislead an investor or developer about the feasibility or viability of a new office development in
the market. To understand the magnitude of the error involved, consider that the cumulative net absorption of 19.1 million square feet, predicted over the whole period of the forecast using the average absorption is 261% higher than the actual cumulative net absorption of 7.3 million square feet.
55
THE SUPPLY OF REAL ESTATE In this section, we discuss first the different real estate supply concepts and then focus on the behavior of new construction, which is the most important component of the supply side from a market-analysis point of view. In particular, we discuss the fundamental law of supply, the price elasticity of supply, and the various factors that drive real estate development and investment decisions. REAL ESTATE SUPPLY CONCEPTS
The term real estate supply refers in general to a schedule that describes the quantity of commercial space or housing units supplied at various prices. Discussed in more detail in a subsequent section, the supply curve is typically portrayed as an upward slopping curve reflecting the fundamental law of supply, which states that greater quantity is supplied at higher prices. When dealing with real estate, it is useful to distinguish between three broader supply concepts: the long-run aggregate supply, the short-run aggregate supply, and new construction. Although, all three concepts are often mentioned in discussions of the supply side of real estate markets, they are not all equally useful when it comes to producing period-by-period forecasts of movements in a market’s inventory. The Long-Run Aggregate Supply: Is it Relevant? The long-run aggregate supply depicts the relationship between long-run prices or rents and the total number of units or square footage supplied over the long-run (see Figure 2.4 below). The concept of long-run aggregate supply is not very useful for market analysis purposes 56
because it is difficult to operationalize. It is being used, however, in long-run cross-market analyses as well as in theoretical studies focusing on the long-run behavior of real estate. Figure 2.4. Long-Run Aggregate Supply
Figure 2.5. Short-Run Aggregate Supply
57
The Short-Run Aggregate Supply The short-run aggregate supply refers to a market’s total stock at a given point in time. Since in the short-run the real estate stock is fixed, the short-run aggregate supply is represented in the price-quantity space by a vertical line, as in Figure 2.5. This concept is very useful in understanding short-run adjustments in real estate markets because it communicates one of their most important behavioral characteristics. The fixity of the real estate stock in the short-run is due to the construction lag, that is, the time needed to plan and develop a building. The construction lag is considered to be at least 6-12 months for residential and industrial, and at least 18-24 months for office and retail. Given this construction lag the short-run supply of real estate is insensitive to prices/rent changes or, in economic terms, is completely price inelastic. So, if for example, a 20% increase in office rents takes place in a market tomorrow the total office space stock will remain the same for quite a while before it responds to this strong rent increase. New Construction New construction is by far the most important supply concept when analyzing real estate markets, because of the long life of real estate assets. To better understand the importance of new construction in forecasting movements in a market’s real estate inventory, it is helpful to review the stock-flow identity, which describes how a market’s total real estate stock, S, is determined at any given point in time, t:
S t = S t-1 (1-d) + C t or
S t = S t-1 (1-d) + aPRM t-n
(2.4)
where: S t : real estate stock at time t d : depreciation rate C t : space completed at time t PRM : space permitted at time t-n a : percent of permits completed n : time between permit issuance and project completion The stock flow identity simply states that the stock at time t, is equal to the stock of the previous period, St-1, minus the depreciated stock, dSt-1, plus completions during period t, Ct. The depreciation rate, d, refers to three types of depreciation: physical, functional and economic. Physical depreciation refers to the physical aging and deterioration of the building. Functional depreciation refers to the functional obsolescence of an existing building compared to new buildings that provide new services or similar services more efficiently. Such efficiency advantages may be due to better layout, design, technological infrastructure and equipment, etc. Economic depreciation refers to economic obsolescence due to external or environmental factors that negatively affect the income-earning capacity of the property. Economic and functional depreciation of a market’s stock is difficult to measure. Physical depreciation may be relatively easier to measure, but there have been no systematic surveys across the different property types. 58
When a property becomes obsolete, the question of redevelopment may arise. The fundamental redevelopment rule is that the difference between the Residual Land Value (RLV) of the new building and the RLV of the existing structure should be equal or greater than the redevelopment cost. This condition is expressed below, first more generally and then more analytically: RLVnew – RLVexisting ≥ Redevelopment Cost (2.5) (Pnew –Cnew)*FARnew – Pexisting *FARexisting ≥ Redevelopment Cost
(2.6)
where: P : price C : construction cost FAR : floor-area ratio As the stock-flow identity indicates, the marginal change in a market’s stock at any period depends on the amount of new construction and depreciation. As such, new construction is the important supply concept in understanding how real estate markets move and adjust through time, and, certainly, the most important supply variable from a market-analysis perspective. What do we mean with the term new construction? The term new construction refers to completions, or otherwise, 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. It should be noted that project completion represents the last of three major stages of the development process. In analyzing the supply side of real estate markets, it is important to understand these different stages and the so-called “pipeline effect”. The real estate development process includes the following three basic stages: a) building permit b) start of construction c) completion
Permits refer to building permits issued based on approved plans.
Starts refer to the 59
beginning of construction and they are identified by inspection records. Completion refers to the end of construction and receipt of the certificate of occupancy. In sum, from the conception of a real estate development project to its completion there are at least three intervening stages during which a project may drop out of the process. We could think of this process as a “pipeline” with leaks at any of these stages. For example, not all projects get a building permit; neither all projects that get a building permit do actually start. Finally, not all projects that start are completed. The percentage of permits that become starts and the percentage of starts that become completions may vary under different market conditions. For example, in soft markets these percentages may tend to be lower, while in tight markets they may tend to be higher. Given the considerable time that intervenes between project start and project completion, new construction is forecastable to a considerable extent in the short-run. Data on starts and permits can be found in the Construction Report Series, C-40 published by the U.S. Department of Commerce. NEW CONSTRUCTION BEHAVIOR
The new construction schedule obeys the fundamental law of supply. Thus, all else being equal, the higher the property prices are the higher the quantity of the new space supplied in the market. Assuming a linear supply schedule this basic supply law is represented graphically in Figure 2.6 and described mathematically by the expression QS = -c + dP. As this figure shows, the new construction schedule is characterized by a minimum price level, Pmin, representing the asset price threshold below which developers cannot cover their development costs and make a reasonable profit. Thus, when property prices are below this threshold no amount of space will be developed. Residential developers utilize this threshold very often in their efforts to determine how affordable a development can be to specific consumer segments in the market. Figure 2.6. New Construction (Completions)
The responsiveness of new construction to asset price or rent changes is captured by the elasticity of supply, εS, which is largely determined by the cost and availability of factors of production. The more costly these factors are the less price elastic the supply is. A price elasticity of new construction of 1.5, for example, suggests that a 1% increase in property prices will induce a 1.5% increase in new construction. Thus, the price elasticity of supply is very 60
useful in grasping the magnitude of the effect of changes in prices on new construction. Consider for example the case that real estate analysts anticipate that a new government policy will raise housing prices by 10%. Then the elasticity figure of 1.5 would suggest that this new policy would stimulate a 15% increase in new construction. New construction is on average very price elastic, that is εS >>>1. This is especially true in office markets where development is very lumpy.
The most illustrative, perhaps, example of the high price elasticity of new construction can be drawn from the national office market. As illustrated in Figure 2.7, which depicts movements in office completions and real rents, during the 1980s, huge increases in construction investment took place all over the nation due to sharp increases in rents and (presumably) climbing asset values in the late 1970s and early 1980s. It should be noted that the excessive construction of the 1980’s has been also attributed to a number of other factors, such as abundant capital availability, tax breaks etc. Construction activity peaked in 1986, but seven years later (in the early 1990s) dropped down to almost zero, as property values collapsed below development costs and as increased uncertainty started settling in. This increased uncertainty was triggered by both the already deteriorated market conditions and the recession that hit the national economy in 1991. As Figure 2.7 shows, office construction continued at high levels during the 1980s despite declining real rents and very high vacancy rates. What motivated investors to continue building under such poor market conditions? Did investors form optimistic expectations in the 1980s based on office employment growth? This is not so clear from Figure 2.8 that contrasts office completions and office employment growth, because one needs to control for rents/asset values and uncertainty.20 As Figure 2.9 shows, because of the massive construction, the market became seriously oversupplied as the vacancy rate shot above 14% by 1984 and stayed above it for over a decade peaking in 1991 at 19.1%. To understand how massive the response of new construction was in the 1980s consider that during that period more space was built than all three previous decades together.
20
The completion figures presented represent the sum of completions in 31 markets covered by CBRE/Torto Wheaton Research.
61
Figure 2.7 Office Completions and Real Rents
Figure 2.8 Office Completions and Office Employment Growth
Figure 2.9 Office Space Completions and Vacancy Rate
62
What Determines New Construction? As indicated earlier, new construction is the sum of the square footage in all individual projects completed within the period of reference in the market under consideration. The major motivation for the development of every speculative commercial real estate project or housing development is profit. Within this context, the major determinants or exogenous shifters of the new construction schedule of a market are the factors that determine project profitability and the uncertainty associated with it. These include in particular: • availability and cost of factors of production • expectations regarding future real estate demand and prices, and • perceived market risk The factors of production required to complete any real estate development project include: • capital • labor • land • building materials The cost of these factors affects negatively the amount of new space developed in a market. In particular, the higher the cost of capital, labor, land and building materials the higher the cost of the project, the smaller the profit and the lesser the motivation of investors and developers to provide new space. Thus, an increase in the cost of any of these factors should induce a downward shift of the new construction schedule since a smaller amount of space will be provided at the same price level (Figure 2.10). It should be noted that the cost of the factors required for the development of a real estate project differs across the nation’s metropolitan real estate markets. For example, labor costs in Boston maybe higher than in Los Angeles because of the scarcity of labor in the former. Similarly, land prices in large metropolitan areas, such as Chicago or Los Angeles, are considerably higher than land prices in small metropolitan areas, such as Tucson or Cleveland. Figure 2.10 Effects of Exogenous Shifters on New Construction
63
On the revenue side, the most important inputs in assessing project viability are expectations regarding the strength of demand and rents/prices. In theory, such expectations can be: ♦ Myopic, where Pt+1 = Pt, if it is assumed that current demand/price levels or increases (whatever is relevant from the investor’s or developer’s point of view) will continue into the future in the same exact manner
♦ Adaptive, where Pt+1 = Pt + d, if developers and investors form their expectations by applying an adjustment, d, to current values of the variables they are interested in based on past mistakes ♦ Rational, where Pt+1 = Pt+1, if developers and investors based on all available relevant information can predict correctly how the market responds to exogenous shocks once they occur (DiPasquale and Wheaton, 1996) In reality, as many empirical studies of the real estate market suggest, real estate investors and developers form their expectations myopically. Expectations of growth in demand, rents, and/or prices should have a positive effect on new construction (thereby inducing an upward shift of the supply curve), as they may encourage developers and investors to build a greater number of housing units or square footage of commercial space. Every speculative investment, and especially those involving long gestation periods like real estate development, involves some uncertainty, which the investor needs to factor in before he/she commits capital on a specific project. Within this context, new construction levels should also be affected by market risk or the perceived uncertainty of a market in supporting profitable development of a particular property type. According to conventional investment theory, investors facing higher risk require higher returns, which in an efficient asset market should be reflected in lower prices. Since lower property market prices would tend to discourage new development, risk and uncertainty should have a negative effect on new construction. Another approach to the relationship between uncertainty and new construction involves the theory of irreversible investments. According to the “traditional” investment rule an investment occurs when asset price, P, is greater than or equal to investment cost or development cost, I. The “modern” investment rule postulates that investment will occur when asset price, P, is greater than ωI, where ω is the option value multiple and it is function of uncertainty, among others (see Dixit and Pindyck, 1994). This rule basically suggests that higher uncertainty increases the opportunity cost of investing now, thereby raising the threshold asset price required by investors/developers before making an irreversible investment, such as the development of real estate. Thus, for a given asset price an increase in risk should result to lower real estate construction. Sivitanidou and Sivitanides (2000) tested this hypothesis in the case of officecommercial construction and found that the influence of uncertainty is statistically significant but weak compared to the influences of the other determinants of new construction. In any case, one could argue that, all else being equal, markets with more volatile economies should have less construction. 64
The concept of market risk is helpful in understanding part of the variations in construction levels either across markets or within the same market through time. In cross-market comparisons, this risk is typically measured by the volatility of critical market indicators, such as demand or its major drivers, and rents or prices. For example, an investor may evaluate the risk of an office market relative to another by comparing the respective volatility indicators for such variables as local office employment, and/or office rental rates. Perceptions of risk either across markets or through time may be also shaped by indicators of market strength. For example, a market maybe considered more risky in periods during which the vacancy rate is in the high teens compared to periods during which the vacancy rate is below 10%. REAL ESTATE PRICE ADJUSTMENTS
Rents and prices play a very important role in real estate as they do in any other market. Furthermore, rents and prices are two of the most (if not the most) important inputs that market analysis needs to provide for the assessment of the financial feasibility and viability of a project. That is why it is very important to understand how market rents and prices are determined and what mechanism drives their movements. PRICE DETERMINATION MECHANISM
As in the case of any other market, real estate rents/prices are determined through the interaction of supply and demand or sellers and buyers in the marketplace. Figure 2.11 shows that graphically the market rent/price is determined as the intersection of the demand and the supply curves. This intersection point represents the rent/price at which the number of willing buyers/tenants equals the number of willing landlords/sellers. In mathematical terms this is the price at which QD= QS. To understand why this price level should eventually prevail as the equilibrium market price consider the following: Figure 2.11. Market Price Determination
65
• Suppose that the market price is at P1, which is below the equilibrium level. At this point the number of units demanded, QD, is greater than the number of units supplied, QS. In such a case, the excess demand will drive prices up so that some buyers will drop out of the market and some additional sellers motivated by the higher prices will enter the market. Once prices reach P* (at which QD = QS) buyers will have no incentive to drive prices further up. • If the market price is at P2, which is above the equilibrium level, the number of units demanded, QD’, will be smaller than the number of units supplied, QS’, and sellers experiencing low interest in their properties will be motivated to reduce prices in order to attract buyers. Prices should continue falling until QD’= QS’ at which point no seller will be motivated to reduce the price of its offering. LONG-RUN VS SHORT-RUN CHANGES
To understand the basic price dynamics associated with the simple supply-demand framework and how they apply to the real estate market let’s look, for example, what will happen to the Phoenix apartment market if the area experiences significant immigration of middle-income households. In doing so it is extremely important for market analysis purposes to differentiate between the short- and long-run rental price impacts of such demand shifts. First of all the massive immigration of households in the Phoenix market will induce an upward shift of the demand curve as more housing will be demanded for the same price level. The impact of this shift on prices in the short-run will be different from its long-run effect. In particular, housing price increases or rent inflation in the short-run will be greater than in the long-run. The reason is that in the short-run the existing residential stock in Phoenix is fixed, as indicated by the vertical line in Figure 2.12 (a), due to the construction lag. In the long-run, however, developers will have the time to respond to the increase in demand and the initial increase in prices by building new housing units. Thus, in the long-run the residential stock in Phoenix will rise to the level defined by the intersection of the demand curve, D’, and the longrun housing supply curve, S (see Figure 2.12 (b)). At that point, demand will equal supply and investors will have no motive to provide any more units unless prices or rents change again due to another exogenous demand shock.
66
Figure 2.12. Short-Run vs Long-Run Price Changes (a) Short-Run
(b) Long-Run
First of all the massive immigration of households in the Phoenix market will induce an upward shift of the demand curve as more housing will be demanded for the same price level. The impact of this shift on prices in the short-run will be different from its long-run effect. In particular, housing price increases or rent inflation in the short-run will be greater than in the long-run. The reason is that in the short-run the existing residential stock in Phoenix is fixed, as indicated by the vertical line in Figure 2.12 (a), due to the construction lag. In the long-run, however, developers will have the time to respond to the increase in demand and the initial increase in prices by building new housing units. Thus, in the long-run the residential stock in Phoenix will rise to the level defined by the intersection of the demand curve, D’, and the longrun housing supply curve, S (see Figure 2.12 (b)). At that point, demand will equal supply and investors will have no motive to provide any more units unless prices or rents change again due to another exogenous demand shock. As Figure 2.12 shows, the extent of long-run price increase as a result of this demand shift will depend on the slope or elasticity of the supply curve. The more responsive, or in economic terms, the more elastic the supply curve is to price increases the smaller its slope and the smaller the long-run price increase due to an increase in demand. If the supply is perfectly elastic (which implies a horizontal supply curve), then the long price effect will be zero. Thus, as indicated by Figure 2.12, the short-run price increase should always be greater than the long-run price increase unless the long-run supply of real estate is perfectly inelastic (vertical line), which is extremely unlikely. THE SIMPLE STOCK-FLOW MODEL: A FORECASTING TOOL
But how does the market move from the short-run effect described by Figure 2.12(a) to the long-run equilibrium state described by Figure 2.12(b)? Supply and price/rent adjustments in real estate markets are very slow due to the long gestation period of development projects, long tenant search processes, and a host of other market inefficiencies. Thus, the demand shift in the Phoenix apartment market will bring about a series of price and supply adjustments, which may 67
take several years before they bring the market to its new equilibrium state. Given the mediumterm planning horizon of most real estate development projects, short-run and medium-term changes are of primary interest from a market-analysis perspective. For this reason, it is important to trace how the market moves from (a) to (b) and what are the specific time paths of short-run changes in rents, new construction, and the apartment stock in response to the original demand shock. One of the most powerful analytical and forecasting tools that can help market analysts trace the short-run time paths of price, rent, and supply adjustments is the so-called stock-flow model. The fundamental premise of the simplest version of the stock flow model is that at any point in time, rents must adjust so that demand equals the existing stock. Such a simple principle sets the stage for identifying and forecasting time paths for not only rents or prices but also new construction (DiPasquale and Wheaton, 1996). Figure 2.13. The Simple Stock Flow Model
To better demonstrate the basics of the stock-flow model let us see what adjustments in rents, supply, and demand will follow the initial surge in apartment demand in the Phoenix metropolitan area. As indicated in Figure 2.13, since new apartment buildings can not be build instantly, the increase in apartment demand will motivate landlords to raise rents in order to dampen excess demand. Residential developers, acting on myopic expectations, respond to these rent increases by planning to supply more space. As new space is completed and added to the existing stock rents must fall to equate demand with the new stock. As rents and prices decline, but still remain above their long-run equilibrium level, residential developers continue to plan new units but at a lower rate because of reduced profits. As the new units are completed 68
and the stock increases, rents and prices have to fall further and so on. Figure 2.14 portrays this process graphically. To better comprehend the price dynamics implied by the simple stock-flow model let us review its basic equations and the short-run and long-run equilibrium conditions as they apply to the housing market. As indicated in Box 2.1, the model is described by four equations and three equilibrium conditions. Equation (2.8) describes apartment demand as a function of population (POP), income (I), and rents (R). Equation (2.9) is the stock flow equation that postulates that aggregate supply, or the stock in each period, St, equals the stock of the previous period, St-1, minus the depreciated stock, δ St-1, plus that period’s completions, Ct. Equation (2.10) describes completions as a function of rents, the cost of capital (c), and other exogenous shifters (X). Finally, Equation (2.11) describes the market rent, which according to the equilibrium condition (2.12) must be such so that at each period demand equals supply. As such, is derived by incorporating (2.10) in (2.9), equating the resulting equation with demand (2.8) and solving for the rent that clears the market. Therefore, by definition the rent equation must include all the exogenous variables included in (2.8) and (2.9). However, since completions at time t, Ct, and, therefore, stock, St, are determined by lagged values of rents and other exogenous factors, St can Figure 2.14 The Stock-Flow Model in a Demand-Supply Framework
Note: According to the simple stock flow model, during each period apartment rents adjust so that demand equals the existing stock
must
69
directly enter the rent equation, instead of its exogenous determinants. It should be emphasized that the rent equation represents a transformation of the equilibrium condition (2.12) that accounts for the behavioral equations describing demand and completions, as well as, the stock flow identity.
The short-run movements in demand, supply and rents are guided by the three equilibrium conditions (2.12-2.14). Equilibrium condition (2.12) describes the basic premise of the model that at each point in time rents adjust to equate real estate demand, Dt, with supply, St. This process is described in Figure 2.14, which depicts short-run movements in a market’s stock and rents. To understand this process consider that the stock and rents are originally at their equilibrium levels, S* and R*, respectively. In period 1 it is assumed that demand shifts upwardly from D to D’ due to a positive exogenous shock. Given the construction lag, the stock cannot respond immediately to this change. Within this framework, the stock in the short-run is considered fixed. Thus, immediately after the demand shift the quantity supplied is still S*=Q1 but R* is no longer the rent level that equates demand with supply because on the shifted demand schedule Q1 is demanded at a higher rent level R1. Therefore, during period 1 market rents have to rise to R1 in order to equate demand with supply. However, as long as the long-run supply curve is not perfectly inelastic (i.e. is not a vertical line) or demand is not perfectly elastic (i.e., a horizontal line), R1 will not be the new long-run equilibrium rent, R**; in fact it will always be greater than R**. By combining (2.9) and equilibrium condition (2.13), which states that ∆St = St – St-1 should equal zero, it can be shown that for (2.13) to hold, R** must be such that completions, Ct, equal the depreciated stock, or equivalently, Ct = δ St.9 This would ensure that the change in stock is equal to zero. Thus, since R1 is greater than R** completions in period 2 will be greater than depreciation and the stock will increase to Q2. As a result, market rents need to decrease further to R2 in order to equate demand to the increased supply. However, as R2 is still above R** the area’s apartment stock should continue to increase in subsequent periods until it reaches its longrun equilibrium level, S**. As a result, rents should continue to fall until they reach, R**, which will equate the long-run equilibrium stock, S** with demand. At this point, all three equilibrium conditions are satisfied. In particular, demand equals supply, the change in stock is zero (as by definition R** must produce Ct = δ St,) and rent change, Rt – Rt-1, is zero since with stable stock and demand there is no need for rents to change. 70
Critique of the Simple Stock-Flow Model Two points need to be discussed with respect to the simple stock-flow model just described. The first relates to the question of how cycles can be generated in the context of this model, while the second relates to the question of how good it is in describing the workings of the different real estate markets. Focusing on the first issue, it can be argued that if we assume no over-reaction on the part of supply to the initial price/rent increases, then a one-time shock can not create a cyclical pattern within the context of the stock-flow model. As illustrated in Figure 2.14, in such a case, the stock will be gradually rising and prices/rents will be gradually falling until they stabilize at their new long-run equilibrium level. Considering the workings of the stock-flow model, it can be argued that cycles can be generated by either frequent demand shocks at either direction (positive or negative) or a highly price-elastic supply. For example, repeated positive demand shocks may generate a cyclical pattern in rents and construction as both variables would rise significantly initially, once the demand increase takes place, and fall down in subsequent periods as the stock increases gradually in response to the price increases. The high price elasticity of supply may also generate a cyclical pattern because it triggers excessive construction in response to the strong initial price/rent increases. The specific time-path of the rents and construction in the case that supply over-reacts can be traced through the stock-flow model as follows. Under this scenario, the initial increase in demand triggers an increase in rents and prices, but now developers and investors over-react initiating an excessive amount of new space. As a result, the amount of new completions is so high that the stock increases above its long-run equilibrium level. This in turn causes rents/prices to decline below their long-run level in order to equate the excessive stock with existing demand. As rents and prices decline below their long-run level, construction does do. As it has been shown, the long-run completion rate should equal the depreciation rate. Thus, when the stock overshoots the completion rate needs to decrease below the depreciation rate. Given the durability of real estate, this makes sense because that is the only way the existing stock can decrease. Thus, depending on how low prices or rents will fall, construction will become zero or less than depreciation and the existing stock will start decreasing. As the stock decreases, rents and prices need to rise to equate the new lower stock level with demand. The stock will continue to decrease until rents and prices reach the level at which new construction equals depreciation and aggregate demand equals aggregate supply. At this rent/price level the stock will stabilize at its long-run equilibrium level eliminating the need for any further rent and price adjustments. The second issue regarding the simple stock-flow model relates to the question of how good this model is in describing the workings of the different real estate markets. As discussed earlier, the simple stock flow model views adjustments in real estate markets as a series of short-run price equilibria, that are realized through successive rent and price adjustments that equalize 71
demand with supply. While such a proposition is elegant in its conception, it may not be applicable to all real estate markets because of varying degrees of inefficiencies that prevent swift market adjustments. Such a conceptual construct is best applicable to markets with relatively low and rather stable vacancy rates. Such markets are relatively efficient, as they are characterized by shorter-term leases that do not prevent rents and demand from adjusting quickly to new equilibrating levels, not overly long construction lags, and information efficiencies that facilitate quick adjustment of rents to changes in market conditions. Within this context, the simple stock-flow model may be more successful in tracking short-run price adjustments in residential markets. The simple stock-flow model does not apply to markets, such as the office market, which is characterized by a high degree of inefficiencies, and, as a result, sustain high and volatile vacancy rates.
ASSESSING DEMAND-SUPPLY IMBALANCES
DEMAND-SUPPLY INTERACTIONS:
MARKET INEFFICIENCIES
At any point in time, the real estate market may not be at a demand-supply equilibrium because of frequent exogenous shocks and a number of inefficiencies that prevent demand, supply, and rents or prices to adjust quickly to these shocks. These market inefficiencies include: ♦ Lack of information: Real estate is highly heterogeneous in terms of both quality and locational attributes. Thus, timely market and project-specific information required for the evaluation of specific transactions is rarely readily available and its collection is rather costly and time consuming. These information inefficiencies force tenants and buyers to engage in lengthy searches and prevent quick adjustment of demand to price changes. ♦ Construction lags: Construction lags that last from several months to several years, depending on property type, prevent speedy adjustment of supply to demand and price changes. ♦ Long-term leases: Long-term leases, with terms ranging mostly from 3 to 10 years, prevent speedy adjustment of existing rates (not rates associated with new lease transactions) to changes in supply and demand, and hamper timely adjustments of space consumption to changes in market rates (as reflected in the latest lease transactions). These inefficiencies characterize all property types, but at varying degrees. For example, information inefficiencies are more severe in the retail and apartment market, construction lags are longer in the office and retail market, and lease contracts are much shorter in the case of apartments.
72
ASSESSING THE EXTENT OF DISEQUILIBRIUM: POPULAR/SIMPLISTIC MEASURES
The term disequilibrium refers to the state of a market characterized by supply-demand imbalances, or alternatively, by excess demand or excess supply. Within the context of the conventional definition of market equilibrium one could argue that the market is truly oversupplied when rents or prices are declining and truly undersupplied when rents or prices are rising (R). There are two popular and simplistic approaches often used for assessing the extent of supply-demand imbalances characterizing real estate markets: (1) Analysis of trends in the difference between completions, C, and net absorption, AB (2) Analysis of trends in the nominal vacancy rate Construction Minus Net Absorption (C-AB) As indicated by (2.15) below, the difference between completions, C, and net absorption, AB, reflects the change in a market’s vacant stock, if depreciation is very small. Thus, if C-AB is positive it implies that completions exceed net absorption and the market’s vacant stock is rising. On the contrary, if it is negative it implies that net absorption exceeds completions and the market’s vacant stock is declining.
73
Historically, positive and/or increasing C-AB have signified troubled times in the real estate industry. Let’s look for example at the case of the Los Angeles office market. As Figures 2.15 and 2.16 illustrate, tracing the time path of C-AB does help track periods of increasing vacant stock in the market. However, C-AB is not a very good measure of disequilibrium. First of all it provides indications about trends in vacant stock levels and not necessarily about vacancy rates, which are more relevant (but not adequate) in evaluating the tightness of the market. For example, it can be shown that if C-AB is less than [ Vt-1 (C-dSt-1) ] the market’s vacant stock will
increase, while the vacancy rate will decrease. Second, it does not set the stage for looking at changes in rents, as the traditional rent adjustment model incorporates the vacancy rate and not the vacant stock. Finally, if such measure is looked in isolation it could be misleading. For example, the vacant stock may be decreasing due to strong absorption, AB, which, in turn, may be primarily due to decreasing rents.
74
Nominal Vacancy Rate (V) The second popular methodology is simply looking at trends in the nominal vacancy rate (the ratio of the vacant stock over the total stock) and make inferences with respect to likely movements in rents. This methodology is again questionable because it does not provide a measure of the extent of disequilibrium and solely looking at movements in the vacancy rate (outside of the context of the structural vacancy rate theory) can not set the stage for making inferences with respect to movements in rents. For example, looking at historical vacancy rate movements and real rent changes in the Los Angeles office market, portrayed in Figure 2.17, it
becomes clear that decreasing vacancy rates do not necessarily imply increasing rents or vice versa. In particular, in 1981 and 1982, the office vacancy rate in Los Angeles was rising, yet real rents were rising too. Furthermore, from 1992 until 1995, the office vacancy rate was declining, yet real rents kept decreasing too. Figure 2.17 Los Angeles: Real Rent Change and Office Vacancy Rate
75
ADVANCED MEASURES/METHODOLOGIES
Nominal vs Structural Vacancy Rate (V-V*) A more conceptually sound methodology for assessing the extent of market disequilibrium is to look at changes in [Vt - V*], that is, changes in the nominal vacancy, Vt, rate compared to the market’s structural vacancy rate, V*. But what is the structural vacancy rate, and why is it important to look at the deviation of a market's nominal vacancy rate from this rate? A number of analysts (Rosen and Smith, 1983), in trying to explain what the structural vacancy rate is, have made reference to the concept of the natural or frictional unemployment rate, which is considered as the minimum required rate to satisfy the search needs of employers and job seekers. In a similar way, the structural vacancy rate can be thought of as that portion of the stock that is desirable to remain vacant for two reasons. First, to satisfy landlords’ profit maximizing objectives that dictate that the marginal benefit (MB) of leaving a unit vacant is greater or equal to its marginal cost (MC). The marginal benefit of leaving a unit vacant is the potential rent increase that may take place during the period the unit remains vacant, while the marginal cost is the forgone market rent plus the interest that would be earned from this forgone rent. The second reason for which it would be desirable to have a portion of the existing stock vacant is to facilitate tenant search. At any point in time, there are firms or households looking for space to rent and their need to search the market can be best accommodated if some of the stock is vacant. It is important to look at the difference between the nominal and the structural vacancy rate for two reasons. First, it is this difference that reveals the true extent of excess vacant space in the market. Second, it is this difference that will provide clues about the direction of real estate rents in a disequilibrium situation. Although a different modeling approach (discussed in the next section) has been recently presented by Wheaton and Torto (1994), the concept of the structural vacancy rate still remains very appealing and is widely accepted in the academic and professional real estate community. The expanded stock-flow model provides an appropriate setting for better illustrating the relationship between the structural vacancy rate and rent changes in commercial real estate markets. The Stock-Flow Model with Vacancy The role of the structural vacancy rate in the functioning of the real estate market can be better understood within the context of the stock-flow model. The simple model discussed earlier, however, is not appropriate in describing the disequilibrium dynamics of real estate markets, since by definition demand equals supply during each period of analysis. Nevertheless, it can be easily modified to account for market disequilibrium by simply incorporating vacancy in the model. Figure 2.18 traces the effects of an exogenous increase in demand within the framework of such an expanded stock-flow model. Given the fixity of real estate shock in the short-run, the immediate effect of this increase in demand will be a decrease in the vacancy rate. As the figure indicates, the effect of vacancy decreases on rents could be either positive or negative. 76
The basic proposition is that rents increase only if the vacancy rate, Vt, is below the market’s structural vacancy rate, V*, and decrease when Vt is above V*. For example, let’s consider two office markets A and B, where the nominal vacancy rate decreases to 12% and 8%, respectively, as a result of office employment growth and positive net absorption. To demonstrate how the difference between the nominal vacancy rate and the structural vacancy rate V* can help assess the degree of disequilibrium let’s assume that the structural vacancy rate in both markets is 10%. In that case [VA-V*] would be equal to 2% indicating that market A is oversupplied and that a decrease in rents should be expected. In the case of market B, [ VB - V* ] would be equal to –2% indicating that there is excess demand and that an increase in rents should be expected. Thus although, the vacancy rate decreased in both markets, rents are likely to move in different directions because of the different position of each area’s vacancy rate relative to the structural vacancy rate. The dynamics of the rent-vacancy adjustments within the context of the structural vacancy concept can be better understood using a simplified graphic representation of the rent-vacancy cycle as it is presented in Figure 2.19. To begin with, let’s assume that the market is at its structural or equilibrium vacancy rate, V*, and that demand increases as a result of an exogenous economic shock. Once demand increases, the vacancy rate, Vt, will start decreasing below its equilibrium level V* As the vacancy rate, Vt, decreases below its equilibrium level, V*, rents start increasing at an increasing rate New construction responds to these rent increases and as a result the vacancy rate reaches a minimum and starts increasing If Vt > V* Rents decrease If Vt < V*
Rents increase
77
As the vacancy rate, Vt, is increasing but is still below its equilibrium level, V*, rents will continue to increase but at a slower rate. Rents reach their maximum level as the nominal vacancy rate rises back to its equilibrium level. As the vacancy rate, Vt, continues to increase above its equilibrium level, V*-- most likely because of over-shooting of construction-- rents are declining at an increasing rate As rents start declining, construction starts declining too. As a result the vacancy rate, Vt, reaches a maximum and starts decreasing but as long as it is still above its equilibrium level, V*, rents continue to decrease, but at a decreasing rate. This vacancy-rent adjustment process is described by the traditional rent adjustment equation below: ∆R = a ( V* - Vt )
(2.16)
where ∆R : percent change in rental rates a : speed of adjustment Vt : nominal vacancy rate at time t 78
V* : equilibrium or structural vacancy rate Structural Vacancy Rate Influences
A key question that has been raised in the literature with respect to the natural vacancy rate is whether it is constant or varies through time (Wheaton and Torto, 1988; Sivitanides, 1997). To better understand whether the structural or equilibrium vacancy rate is constant or variable through time we need to understand its determinants. If these determinants tend to vary considerably through time then the structural or equilibrium vacancy rate should as well. Most recent theoretical work on this issue postulates that the equilibrium vacancy rate is determined by landlord and tenant search processes. Landlord’s Perspective From a landlord’s point of view, willingness to hold vacant units or expedite lease-up time should depend on two factors: 1) Expectations for demand and rental growth. Expectations of strong demand and rent growth in the future would motivate landlords to hold vacant space in order to take advantage of the anticipated rent increases. Such a behavior should contribute to a greater amount of vacant space in the market and, therefore, to a higher equilibrium vacancy rate. Thus, the effect of such expectations on the structural vacancy rate should be positive. Assuming a myopic approach on the part of landlords, expectations for demand and rent growth should be driven by such market strength indicators as recent absorption, completions, and/or employment growth rates (see Sivitanides, 1997). 2) Costs of holding vacant space. These include the forgone rental income, R*V, that would be earned if the vacant units, V, were leased at the market rent, R, and the interest, i*R, that would be earned on that income (Hendershott and Haurin, 1988). Thus, during periods of higher market rents, and interest rates landlord’s costs of holding vacant space should be higher. Therefore, all else being equal, during such periods the structural vacancy rate should be lower as landlords should be motivated to hold less vacant space. Tenant’s Perspective The structural vacancy rate should be also affected by two major features of tenant search processes that may very well vary through time and across markets. Drawing from the discussion of tenant search processes presented by Sivitanidou (2002), these features and the factors that may influence them can be summarized as follows: 1) The length of the search. Lengthier tenant searches should prolong average lease-up time in the market, thereby contributing to a higher structural vacancy rate. The length of tenant search may depend on a number of factors including: ♦ Idiosyncratic tastes/space requirements. Tenants with idiosyncratic tastes/space requirements may on average engage in lengthier search, as a random visit to a unit is less likely to produce a match. In this sense, markets with a more diverse or heterogeneous tenant base may be characterized by a higher structural vacancy rate. ♦ Stock heterogeneity. The more heterogeneous the existing stock for a property type is in 79
terms of quality, the less likely is that a random visit by a tenant will produce a match. Thus, this factor should contribute to longer tenant search and higher structural vacancy rate. ♦ Spatial heterogeneity. Given that tenants/buyers are not indifferent to the locational attributes of the property they will be purchasing or renting, spatial heterogeneity should have the same positive effect on the length of the search, and therefore, on the structural vacancy rate, as the stock heterogeneity. Spatial heterogeneity should be greater in more dispersed markets. ♦ Information inefficiencies. All else being equal the more the information available on the properties and the space available for renting or sale the shorter a tenant’s search might be and the lower the market’s structural vacancy rate. For example, the larger and most popular investment markets may have greater informational efficiencies than smaller markets that are rarely considered by institutional investors.
2) The cost of the search. Search costs should be adversely related to the length of the search, and the structural vacancy rate, as they would motivate tenants to end their search sooner than later. In this sense, markets or time periods with higher search costs should be characterized by a lower structural vacancy rate. Stock heterogeneity and spatial heterogeneity/dispersion should also contribute to higher search costs per visit due to greater information needs, transportation costs, etc. Prevailing Rent vs Implicit Equilibrium Rent (R-R*) Latest work on rental adjustments in commercial real estate markets has introduced the proposition that adjustments in real rents occur rather as a mechanism of moving towards an implicit equilibrium rent, R*, rather than towards bringing that nominal vacancy rate at its structural or equilibrium level (Wheaton and Torto, 1994). This proposition does not really contradict the concept of the natural or structural vacancy rate, since for any equilibrium value of 80
rental rates there should be a corresponding equilibrium value for the vacancy rate. A number of studies on imperfect markets have shown that such equilibrium vacancy rate should be higher than zero. This proposition is strongly supported by a wealth of historical data on vacancy rates for commercial real estate markets that indicate that observed vacancy rates rarely fall below 5%. According to Wheaton and Torto (1994) the implicit equilibrium rent, R*, is determined by lease-up time, which in turn should be driven by tenant flows as reflected in space absorption, A, and the market vacancy rate, V. Given the sluggishness by which real estate markets respond to exogenous shocks, the rental adjustment process towards such an equilibrium rent is described by (2.17), where α represents the speed by which prevailing rents move towards the equilibrium rent. Rt – Rt-1 = α [ R*(At-1, Vt-1) – Rt-1 ]
(2.17)
The equilibrium rent should be higher with higher tenant flows and lower vacancies because they reduce lease-up time and motivate landlords to require higher rents. If historical data are available for observed rental rates, absorption, and vacancy rates the parameters of equation (2.17) can be estimated, thereby allowing the calculation of R*. The estimated R* can provide valuable insights with respect to the disequilibrium state of the market. For example, if the difference R-R* is positive and of considerable magnitude it would suggest that prevailing rents are considerably above their equilibrium value and that considerable decreases are very likely to take place in the future in order to restore equilibrium. On the contrary if R-R* is negative it would signify a soft market in which prevailing rents would need to rise in order to reach their implicit equilibrium values (Sivitanidou, 2002). Drawing from Sivitanidou (2002), and Wheaton and Torto (1994), the influences on market’s implicit equilibrium rent can be identified within the context of their direct or indirect effect on lease-up time. When considering indirect influences on lease-up time the focus is on factors that may have an effect on the matching rate between properties and searching tenants, as well as search costs. The more specific influences on a market’s implicit equilibrium rent are summarized below: 1) Demand growth. For a given vacancy rate, stronger demand growth, due perhaps to stronger employment, income, population, or output growth should reduce lease-up time and exert upward pressures on a market’s equilibrium rent. 2) Idiosyncratic space requirements/Tenant diversity. All else equal, idiosyncratic tenant tastes/space requirements may contribute to a lower matching rate and lower realized demand, as a random visit to a unit is less likely to produce a match. Thus, greater tenant diversity should contribute to a lower equilibrium rent. Sivitanidou (2002) presents empirical evidence that is consistent with a negative effect of office tenant diversity on equilibrium rents. 3) Stock heterogeneity. The more heterogeneous a market’s existing stock is in terms of quality, the lower the matching rate and the longer the lease-up time, since a random visit by a tenant is less likely to produce a match. At the same time, however, higher stock heterogeneity may increase the cost of search (due to greater information requirements) and motivate tenants to be less demanding, thereby facilitating the matching process. Because of the opposing influences of this factor on the matching rate, its effect on the equilibrium rent could be either 81
positive or negative, depending on which of the two influences prevails. 4) Spatial heterogeneity. Spatial heterogeneity is relevant in tenant search processes since tenants/buyers are not indifferent to the locational attributes of the properties they rent or purchase. Spatial heterogeneity, reflected perhaps in the number and diversity of an area’s submarkets, should have similar opposing influences on implicit equilibrium rents as stock heterogeneity. Thus, the direction of its effect can not be inferred a priori. Empirical evidence presented by Sivitanidou (2002) is consistent with a positive effect of this factor on the equilibrium rent, suggesting that its effect on search costs is greater than its direct effect on the matching rate. 5) Information Inefficiencies. On one hand, all else being equal, greater information inefficiencies may contribute to higher search costs, thereby motivating tenants to be less demanding and facilitating the matching process. On the other hand, information inefficiencies may render search processes by tenants and landlords less efficient, thereby contributing to a lower matching rate. Given these opposing effects of information inefficiencies on the matching rate its effect on a market’s implicit equilibrium rent can not be determined a priori.
CHAPTER SUMMARY In this chapter, we examined the basic economic concepts of demand, supply, and price adjustments and discussed how they relate to the real estate market. We have also discussed concepts of disequilibrium and ways of assessing a real estate market’s extent of disequilibrium. Demand for real estate property or space does obey the fundamental law of demand and its broader drivers (shifters) include: • market size (population, households, employment, or output, determined by metropolitan growth processes) • income/wealth (determined by metropolitan growth processes) • relative prices • expectations regarding prices and growth (myopic or adaptive) The most important real estate supply concept from a market-analysis point of view is new construction, which follows the fundamental law of supply. Its major drivers include: • the cost and availability of production inputs (land, capital, labor, building materials) • expectations regarding demand/rents/prices (myopic or adaptive) 82
• uncertainty and risk (volatility of local economy and real estate market) Real estate price adjustments are very slow due a host of inefficiencies that stem largely from three major factors: a) information inefficiencies, b) long-term rental contacts that hinder swift rental and demand adjustments, and c) long construction lags that force very slow supply adjustments. The expanded stock-flow model that includes vacancies can help understand and simulate short-run movements of real estate markets in response to exogenous shocks. Due to frequent exogenous demand shocks and slow adjustment processes, real estate markets are in disequilibrium more than often. Within this context, when analyzing real estate markets at a given point in time it is important to assess the state and degree of disequilibrium that may be prevailing in the market and its implications regarding future movements in rents and vacancy rates. Simplistic methodologies used to gain insights with respect to a market’s state of disequilibrium include examination of the difference between construction and absorption, as well as analysis of vacancy rate trends, while more advanced methodologies include comparison of the nominal vacancy rate to the market’s structural vacancy rate and/or comparison of the prevailing rent to the market’s equilibrium rent. QUESTIONS Demand 1) What are the major determinants of the demand for real estate? 2) What will happen to the demand for single-family housing if wages decrease? 3) What impact, if any, did the defense cuts that hit Southern California have on office space demand? 4) Is Gross Absorption a good measure of market activity? Explain. 5) Is Net Absorption a better measure of market activity than Gross Absorption? Explain. 6) Why caution is needed when examining Net Absorption trends? 7) What are the broader factors that affect Net Absorption and what is the direction of their effect? 8) Explain the concept of the price elasticity of demand in the case of single-family housing. Supply 1) Refer to the various concepts of real estate supply and discuss which ones are more relevant for market analysis and why. 2) Provide and discuss the stock-flow identity and explain why it is useful when analyzing real estate markets. 3) What are the major determinants of new construction and what is their expected effect? 4) Discuss the “pipeline effect”, which is often used when referring to real estate supply.
83
Price Adjustments 1) Explain why short-term price increases in real estate markets in response to positive demand shocks should be greater than long-run increases. 2) Discuss the workings of the simple and expanded stock-flow model. 3) Are nominal vacancy rates good measures of market disequilibrium? Explain. 4) What is the structural vacancy rate? 5) Why is it important to look at the deviation of a market's structural rate, V*, from its nominal vacancy rate, V? 6) Is the structural vacancy rate constant through time? Explain. 7) Discuss factors that may contribute to variations in the structural vacancy rate through time or across markets and their expected effect. 8) Discuss the more recently developed alternative approach to explaining rent movements in real estate markets.
Lecture 7 The Property and Capital Markets21 Relation and dynamics of real property and capital markets What is real estate? How big is the real estate sector? How does the market for the use of real estate differ from the market for real estate assets? In this chapter, our objectives are (1) to define real estate, (2) to describe how the real estate sector operates within the national economy, and (3) to distinguish between the market for real estate use (where space is rented or purchased for occupancy) and the market for real estate assets (where buildings are bought and sold as investments). The most common definition of real estate is the national stock of buildings, the land on which they are built, and all vacant land. These buildings are used either by firms, government, nonprofit organizations, and so on, as workplaces, or by households as places of residence. When defined this way, the value of all real estate makes up the largest single component of national wealth. The yearly value of new buildings put in place represents an annual investment in the nation's stock of capital. The dollar value of these new buildings also has been the largest single category of national investment in recent years. Investment in new buildings accounts for roughly 7 percent of gross domestic product (GDP). Of this 7 percent, about 60 percent is payments to the construction sector (for labor, construction equipment, etc.), with the remaining 40 percent going to the producers of building materials. It is important to note that land is not counted as part of investment or GDP since it is not a produced commodity. On the other hand, land is a national asset, and so the value of land beneath buildings should be counted as stock or wealth. The distinction between real estate as space and real estate as an asset is most clear when buildings are not occupied by their owners. The needs of tenants and the type and quality of buildings available determine the rent for space in the market for property use. At the same time, buildings may be bought,
21
Urban Economics and Real Estate Markets, Denise DiPasquale and William C. Wheaton; Prentice
Hall 1995 – Chapter 1 84
sold, or exchanged between investors. These transactions occur in the capital market and determine the asset price of space. In this chapter, we present a simple analytic framework which illustrates the connections between the market for real estate space (the property market) and the market for real estate assets (the asset or capital market). As we will show later in this chapter, this same approach can be used for owner-occupied real estate where the user of space is also the investor in the asset. Our view of the real estate market as actually two markets helps to clarify how different forces influence this important sector. If, for example, there is a sudden demand by foreign investors to purchase U.S. office buildings, the impact on rents is very different than if firms suddenly decide that they wish to rent more office space for their use. 'A reduction in long-term mortgage rates has just the opposite effect on house prices from that caused by a reduction in short-term rates for construction financing. Distinguishing between the property and capital markets provides a clearer understanding of how such forces operate in the real estate sector as a whole. In addition, there is a methodological objective in this first chapter to reacquaint the reader with simple supply and demand analysis. By considering how the markets for both real estate property and assets operate within a global economy, we recall the distinction between endogenous economic variables and exogenous economic forces.' Within the markets for real estate, economic variables like prices, sales, and output are all determined endogenously. The outcome of the market, however, may be strongly influenced by exogenous forces such as world trade, interest rates, or even climate. Studying how changes in exogenous forces affect endogenous variables is one of the most important and fundamental pursuits of economics. How this methodology is applied to the real estate markets is a major focus of this book.
THE SIZE AND CHARACTER OF U.S. REAL ESTATE Private real estate is composed of all types of buildings as well as the land they sit on. Houses, office buildings, warehouses, and shopping centers all are clear examples of real estate. Other, less obvious examples include privately owned ice-skating rinks and aircraft hangars. These are the buildings that various service firms (e.g., recreation, lodging, and travel) need for their operations. Finally, petroleum refineries, steel mills, and utility power plants are partially real estate—some portion of these structures is considered industrial "plant," while the remainder is "equipment." Public real estate is composed of all government-owned office buildings, schools, firehouses, military barracks, and the like. Like any economic variable, real estate can be measured both as a flow and as a stock. The flow of real estate is the value of new buildings put in place each year, less losses from the stock through depreciation or demolition. New completions represent an important component of national investment, which is also a flow variable. On the other hand, the total value of all existing buildings and the value of all land are stock variables, and are part of national wealth—also a stock variable. Since land is nonreproducible, it is always a stock variable and never a flow variable. Table 1.1 breaks down the value of new construction put in place in 1990. Virtually all private construction was in the form of buildings and represented $301 billion (5.5 percent of GDP). Residential buildings accounted for about 61 percent of the dollar value of private buildings constructed, with office, industrial and other commercial structures representing the remainder. In the public sector, buildings represented only about 42 percent of the $109 billion in public construction. The largest component of public construction was investment in infrastructure (roads, bridges, airports, etc.).
85
TABLE 1.1 Value of New Construction Put in Place, 1990 $ (in billions) Private Construction
338
Building s Residential Buildings Nonresidential Buildings Industrial Office Hotels/Motels Other Commercial All Other Nonresidential
301
Nonbuilding Construction
37
Public Utilities All Other
31 6
Public Construction
183 118 24 29 10 34 21
109
Buildings Housing and Development Industrial Other
46 4 41
Nonbuilding Construction
63
Infrastructure All Other
55 8
Total New Construction
Total GDP:
% of GDP 6.1
5.5 3.3 2.1 0.4 0.5 0.2 0.6 0.4 0.7 0.6 0.1
2.0 0.8 0.1 0.0 0.7 1.1 1.0 0.1
446
8.1
5,514
100.0
TABLE 1.2Value of U.S. Real Estate, 1990 $ (in Residential
6,122
% of Total 69.8
Single-Family Homes Multifamily Condominiums/Coops Mobile Homes
5,419 552 96 55
61.7 6.3 1.1 0.6
Nonresidential
2,655
30.2
Retail Office Manufacturing Warehouse
1,115 1,009 308 223
12.7 I 1.5 3.5 2.5
Total U.S. Real Estate
8,777
100.0
86
In summary, U.S. real estate is the largest single component of national wealth and the largest component of annual net private investment. This huge base of assets, however, has been accumulated by devoting only about 5 to 7 percent of each year's GDP to the construction and renovation of that base. It is, of course, the durability of real estate that allows us to devote such a small fraction of GDP to the accumulation and maintenance of such a large share of our assets.
TABLE 1.3Who Owns U.S. Real Estate, 1990
Individuals Corporations Partnerships Nonprofits Government Institutional Investors Financial Institutions Other (Includes Foreign) Total: % of All Real Estate:
All Real Estate $ (in % billi ) 5,088 58.0
Residential Only $ (in % billi ) 5,071 82.8
Nonresidential $ (in billi ) 17 0.6
1,699 1,011 411 234 128 114 92
19.4 11.5 4.7 2.6 1.5 1.3 1.0
66 673 104 173 14 13 8
1.1 11.0 1.7 2.8 0.2 0.2 0.1
1,633 338 307 61 114 101 84
61.5 12.7 11.6 2.3 4.3 3.8 3.2
8,777
100.0
6,122
100.0
2,655
100.0
100.0
69.8
30.2
THE MARKETS FOR REAL ESTATE ASSETS AND REAL ESTATE USE
Since real estate is a durable capital good, its production and price are determined in an asset, or capital, market. In this market, the demand to own real estate assets must equal their supply. Thus, the price of houses in the U.S. largely depends on how many households wish to
own units and how many units are available for ownership. Likewise, the value or price of shopping center space depends on how many investors wish to own such space and how many centers there are available to invest in. In both cases, all else being equal, an increase in the demand to own these assets will raise prices, while a greater supply of space will depress prices. The supply of new real estate assets comes from the construction sector and depends on the price of those assets relative to the cost of replacing or constructing them. In the long run, the asset market should equate market prices with replacement costs that include the cost of land. In the short run, however, the two may diverge significantly because of the lags and delays that are inherent in the construction process. For example, if demand for the ownership of space suddenly rises, then, with a fixed supply of assets, prices will rise as well. With prices 87
now above construction and land costs, new development takes place. As this space arrives on the market, demand is satisfied and prices begin to fall back towards the cost of replacement. A question to be addressed in future chapters is whether the cost of asset replacement is constant, varies with the level of development, or depends on the total stock of assets. What would cause the demand for owning real estate assets to suddenly increase? More generally, are there other determinants of asset demand besides simply the price of these assets? The answer is yes, and the most important of these determinants is the rental income that real estate assets earn. To understand rent, it is necessary to consider the market for the use of real estate. In the market for real estate use or space (referred to here as the property market), demand comes from the occupiers of space, whether they be tenants or owners, firms or households. For firms, space is one of many factors of production, and, like any other factor, its use will depend on firm output levels and the relative cost of space. Households likewise divide their income into the consumption of many commodities, only one of which is space. The household demand for space depends on income and the cost of occupying that space relative to the cost of other commodities, such as food, clothing, or entertainment. For firms or households, the cost of occupying space is the annual outlay necessary to obtain the use of real estate-its rent. For tenants, rent is simply specified in a lease agreement. For owners, rent is defined as the annualized cost associated with the ownership of property. Rent is determined in the property market for space use, not in the asset market for ownership. In the property market, the supply of space is given (from the asset market). The demand for space depends on rent and other exogenous economic factors such as firm production levels, income levels, or the number of households. The task of the property market is to determine a rent level at which the demand for space use equals the supply of space. All else being equal, when the number of households increases or firms expand production, the demand for space
use rises. With fixed supply, rents rise as well. The link between the asset market and the property market occurs at two junctions. First, the rent levels determined in the property market are central in determining the demand for real estate assets. After all, in acquiring an asset, investors are really purchasing a current or future income stream. Thus, changes in rent occurring in the property market immediately affect the demand for ownership in the asset market. The second link between the two markets occurs through the construction or development sector. If construction increases and the supply of assets grows, not only are prices driven down in the asset market, but rents decline in the property market as well. These connections between the two markets are illustrated in the four-quadrant diagram in Figure 1.1. 88
In explaining Figure 1.1, it is useful to refer to quadrants by their compass designation. The two right-hand quadrants (northeast and southeast) represent the property market for the use of space, while the two left-hand quadrants (northwest and southwest) deal with the asset market for the ownership of real estate. Let's begin with the northeast q u a d r a n t , w h e r e rents are determined in the short run. The northeast quadrant has two axes: rent (per unit of space) and the stock of space (also measured in units of space, such as square feet). The curve represents how the demand for space depends on rents, given the state of the economy. Movement along that curve depicts how much space would be demanded given a particular rent level on the vertical axis. If households or firms tend to demand the same amount of space regardless of rent levels (inelastic demand), then the curve is nearly vertical. If space usage is quite sensitive to rents (elastic demand), then the curve is more horizontal. If the economy changes, then the entire curve shifts. An upward shift occurs with an increase in firms or households (economic growth) and signifies that more space is demanded for the same rent. Economic decline causes a downward shift in the line, with the reverse implications.
89
In equilibrium the demand for space, D, is equal to the stock of space, S. Thus, rent, R, must be determined so that demand is exactly equal to stock. Demand is a function of rent and conditions in the economy: D(R,Economy) = S
(1.1)
Recall that in the property market the supply of stock is given from the asset market. In Figure 1.1, then, rent is determined by taking a level of stock of space on the horizontal axis, drawing a line up to the demand curve, and then over to the vertical axis. With this rent for the use of space, we then move to the asset market in the northwest quadrant.22 The northwest quadrant represents the first part of the asset market and has two axes: rent and price (per unit of space). The ray emanating from the origin represents the capitalization rate for real estate assets: the ratio of rent-to-price. This is the current yield that investors demand in order to hold real estate assets. Generally, four considerations make up this capitalization rate: the long-term interest rate in the economy, the expected growth in rents, the risks associated with that rental income stream, and the treatment of real estate in the U.S. federal tax code. A higher capitalization rate is represented by a clockwise rotation in the ray, while a decline in the cap rate is represented by a counterclockwise rotation. In this quadrant, the capitalization rate is taken as exogenous, based on interest rates and returns in the broader capital market for all assets (stocks, bonds, short-term deposits). Thus, the purpose of the northwest quadrant is to take the rent level, R, from the northeast quadrant and determine a price for real estate assets, P, using a capitalization rate, i:
_
(1.2)
This is done by moving from the rent level on the vertical axis in the northeast quadrant over to the ray in the northwest quadrant, and then down to the horizontal axis where asset price is given. The next (southwest) quadrant is that portion of the asset market in which the creation of new assets is determined. Here, the curve f(C) represents the replacement cost of real estate. In this version of the diagram, the c7:77. of.—-replacement through new construction is assumed to increase with greater building activity (C), and so the curve moves in a southwesterly direction. It intersects the price axis at that minimum dollar value (per unit of space) required to get some level of new development underway. If this construction can be supplied at any level with almost the same costs, then the ray will be close to vert i c a l . C o n s t r u c t i o n b o t t l e n e c k s , s c a r c e l a n d a n d o t h e r i m p e d i m e n t s l e a d to inelastic supply and a ray that is more horizontal. Lower levels of construction would lead to excess profits, whereas higher levels would be unprofitable. Hence, new construction occurs at that level, C, at which asset price, P, is equal to replacement costs, f(C): P = f(C)
(1.3)
In the southeast quadrant, the annual flow of new construction, C, is converted into a long-run stock of real estate space. The change in the stock, AS, in a given period is equal to new construction minus losses from the stock measured by the depreciation (removal) rate, 8:
22
'If we take the office market as an example, it would be reasonable to assume that the demand for office space use (in square feet),
D, is equal to: E(400 — 10R), where E is the number of office workers in the economy (in millions), and R is the annual rent per square foot. In the northeast quadrant, we equate this demand to the existing stock, S, solving for rent. Equation (1.1) can be
rewritten as:
90
AS = C — 8S
(1.4)
Tor the office market example, a reasonable cost function (dollar per square foot) for the development of new office space would be: 200 + 5C. The annual level of new construction, C, is in millions of square feet. If these costs are equated to the asset price (per square foot) of office space, Equation (1.3) can be rewritten to solve for the level of construction where costs equal to asset prices: C= P — 200 The ray emanating from the origin represents that level of stock (on the horizontal axis) that requires an annual level of construction for replacement just equal to that value on the vertical axis. At that level of stock and corresponding level of construction, the stock of space will be constant over time, since depreciation will equal new completions. Hence, AS is equal to 0 and S = C/6.5 Future chapters will discuss this relationship in more detail; for now, it is important only to remember that the southeast quadrant assumes a certain level of construction and determines the level of stock that would result if that construction continued forever. This completes a 360-degree rotation around the four-quadrant diagram. Starting with a level of stock, the property market determines rents, which are then translated into property prices by the asset market. These asset prices, in turn, generate new construction, which, back in the property market, eventually yields a new level of stock. The combined property and asset markets are in equilibrium when the starting and ending levels of stock are the same. If the ending stock differs from the starting stock, then the values of the four variables in the diagram (rent, prices, construction, and stock) are not in complete equilibrium. If the starting value exceeds the finishing value, then rents, prices and construction must all rise to be in equilibrium. If the initial stock is less than the finishing stock, then rents, prices, and construction must be decreased to be in equilibrium. This journey around the four-quadrant diagram provides a simple, intuitive illustration of the solution to the simultaneous system of Equations (1.1)– (1.4).6
OWNER-OCCUPIED REAL ESTATE A reasonable question is how all of this works in the case of real estate that is mainly occupied by its owner. In this case, the four quadrants still hold, but asset prices and rents are determined by the same market participants—the owner occupants. Consider for the moment the market for owner-occupied housing. The demand for single-family homes depends on the number of households, their incomes, and the annual costs of owning a home. This annual cost is equivalent to rent. A rise in the number of households shifts the demand curve out. With greater demand and a fixed stock of housing units, the annual payment to occupy a house must rise. The northwest quadrant then translates this payment into the actual price that households are willing to pay for the home. Lower interest rates, for example, imply that with the same annual payment (rent), households can afford to pay a higher purchase (asset) price. Hence, with owner-occupied real estate, decisions by the user-owner determine both rent (the annual payment) and price. These decisions, however, are influenced by the same economic and capital market conditions that influence rental properties. Thus,
91
owner-occupiers have the same investment motives as the owners of rental property. Once the purchase price is determined, then new housing development and eventually a new equilibrium stock of space follow in the other two quadrants (southwest, southeast). This same analysis can be applied to the case of corporate-owned and -occupied industrial or office space. The demand for this space is determined by the annual cost of owning it (rent) as well as the number and size of firms in the market. In equilibrium, the annual cost of owning (rent) equates demand with the fixed stock of office or industrial space. The cost of capital for the corporation (capitalization rate) converts this annual cost into the asset price that corporations are willing to pay for the space. Using Figure 1.1, we can trace the various impacts of the broader economy on the real estate market. The economy can grow or contract. Long-term interest rates or other factors can shift the demand for real estate assets. Changes in short-term credit availability or local regulations can alter the cost of supplying new space. Each has different repercussions, and these are easily determined by examining alternative solutions within the four-quadrant diagram. In each case, we can identify which quadrant is initially affected, trace the impacts through the other quadrants, and arrive at a new long-run equilibrium. This comparison of different long-run solutions (market equilibrium) in a model is called "comparative static" analysis. Economic Growth and the Demand for Real Estate Use As the economy expands, the curve in the northeast quadrant shifts out to the northeast. This reflects a greater demand to use space at current (or other) rent levels, such as would occur with increases in production, household income, or the number of households. For a given level of real estate space, rents must therefore rise if the demand to use space is to equal available space. These higher rents then lead to greater asset prices in the northwest quadrant, which, in turn generate a higher level of new construction in the southwest quadrant. Eventually, this leads to a greater stock of space (southeast quadrant). As shown in Figure 1.2, the new market equilibrium involves a dashed box that in every direction lies outside of the box that connected the four curves in the original equilibrium?
92
It should be clear that the equilibrium solution with an expanded economy must generate a box that lies outside of the original. Neither rents, prices, construction, nor stock can be less than in the initial equilibrium. The new solution, however, need not at all involve a proportional expansion of the original box. The shape of the new box depends on the slopes of the various curves. For example, if construction were very elastic with respect to asset prices (a nearly vertical curve in the southwest quadrant), then the new levels of prices and rents would be only slightly greater than before, whereas construction and stock would expand considerably.
93
Economic growth, then, increases all equilibrium variables in the real estate market(s), while economic contraction leads to decreases in all variables. Figure 1.3 compares the growth of total employment in the U.S. with construction of office space and the overall office vacancy rate. It is clear that the national office market moves with the economy: during recessions, vacancies tend to rise and construction falls, whereas the opposite occurs during recoveries. Long-Term Interest Rates and the Demand for Real Estate Assets
If the demand to own real estate shifts, the impact on the combined markets is quite different than if the demand to use real estate changes. A number of factors can cause shifts in the demand to own real estate assets. If interest rates in the rest of the economy rise (fall), then the existing yield from real estate becomes low (high) relative to fixed income securities and investors will wish to shift their funds from (into) the real estate sector. Similarly, if the risk characteristics of real estate are perceived to have worsened (improved), then the existing yield from real estate may also become insufficient (more than necessary) to get investors to purchase real estate assets relative to other assets. Finally, changes in how real estate income is treated in the U.S. federal tax code can also greatly impact the demand to invest in real estate. As will be discussed in Chapter 8, if the depreciation allowance for real estate is increased, the same income stream generates a higher after-tax yield. This will increase the demand to hold real estate assets. This book assumes that the capital market efficiently adjusts the prices of particular assets—so that each investment earns a common risk-adjusted, after-tax total rate of return. Thus, shifts in asset demand, such as described above, will alter the capitalization rate at which investors are willing to hold real estate. Reductions in long-term interest rates, decreases in the perceived risk of real estate, and generous depreciation or other favorable changes in the tax treatment of real estate all will reduce the yield that investors require from real estate. As shown in Figure 1.4 in the northwest quadrant, this has 94
the effect of a counterclockwise rotation (the ray always goes through the origin) in the capitalization rate ray emanating from the origin, raising asset prices. Higher interest rates, greater perceived risk, and adverse tax changes rotate the ray in a clockwise manner, lowering asset prices. Given a level of rent from the property market, a reduction in the current yield or capitalization rate for real estate raises asset prices, and in the southwest quadrant, this begins to expand construction. Eventually this increases the stock of space (in the southeast quadrant), which then lowers rents in the property market for space (northeast quadrant). A new equilibrium requires that the initial and finishing rent levels be equal. In Figure 1.4, this new equilibrium results in a new solution box that is lower and more rectangular than the original.
It is important to be convinced that the new solution box is as portrayed in Figure 1.4. Asset prices must be higher and rents lower, while the long-term stock and its supporting level of construction must be greater. If rents were not lower, the stock would have to be the same (or lower), and this would be inconsistent with higher asset prices and greater construction. If asset prices were not higher, rents would be lower, which is inconsistent with the reduced stock (and less construction) generated by lower asset prices. A positive shift in asset demand, like a positive shift in space demand, will raise prices, construction, and the stock. It will, however, eventually lower—rather than raise—the level of rents. This inverse relationship between asset prices and long-term interest rates can be seen in Figure 1.5, which examines the historic movements in house prices (in 1990 dollars) and real mortgage rates (adjusted for inflation).
95
Credit, Construction Costs, and the Supply of New Space
The final exogenous change likely to impact the real estate market is a shift in the supply schedule for new construction. This can come about through several channels. Higher short-term interest rates and a general scarcity of construction financing will increase the costs of providing a given amount of new space, leading to less construction. Likewise, stricter local zoning or other building regulations will also add to development costs and (for a fixed level of asset prices) reduce the profitability of new construction. These kinds of negative supply changes have the effect of causing a westerly shift in the cost schedule of the southwest quadrant: for the same level of asset prices, construction will be less. Positive changes in the supply environment, such as the easy availability of construction financing or a relaxation of development regulations, move the curve in an easterly direction, and for the same asset price expand construction. Figure 1.6 shows the powerful inverse relationship that has existed historically between short-term real interest rates (inflation-adjusted) and new home construction. Finally, Figure 1.7 traces the long-run implications of a negative supply change, such as would occur with higher short-term interest rates.' For a given level of asset prices, a negative shift in the new space supply schedule (southwest quadrant) will lower the level of construction and eventually lower the stock of space (southeast quadrant). With less space in the northeast quadrant, rent levels will have to rise, which will generate higher asset prices in the northwest quadrant. When starting and finishing asset prices equal, the new solution box will lie strictly to the northwest of the original solution. Rents and asset prices will increase, whereas construction and stock levels will be less. The magnitude of these changes, of course, will depend on the slopes (or elasticities) of the various curves. For example, if the demand for space is very rent elastic (a nearly horizontal curve in the northeast quadrant), then the increase in rents will be slight. An inelastic (nearly vertical) demand curve will
96
generate a larger increase in rents. It should be clear that if any of these variables moved in a different direction, the solution would be inconsistent--that is, not an equilibrium. Occasionally, single, individual shifts, such as are portrayed in Figures 1.2, 1.4, and 1.7, do occur by themselves. For example, the Economic Recovery Tax Act of 1981 (ERTA), greatly shortened the depreciation period for rental housing. This generated a sharp reduction in the capitalization rate for this asset, and the ensuing construction boom and fall in rents are quite consistent with Figure 1.4. Some researchers are also convinced that much of the commercial building boom and eventual fall in office rents and asset prices during the 1980s was the result of deregulating the nation's thrift (savings and loan, or S&L) industry. Deregulation is argued to have resulted in a dramatic increase in the availability of cheap construction credit for new commercial development. As such, it would have caused a singular (easterly) shift in the construction cost schedule.
97
It is more likely the case that economic events cause several shifts to occur simultaneously. This is particularly true of movements in the nation's macroeconomics. As the national economy enters a slowdown, not only is there a contraction in output and employment (northeast quadrant), but there are usually increases in short-term interest rates as well (southwest quadrant). An economic expansion leads to the opposite combination. This combination of shifts can generate any pattern of new box solutions that lies between the two shown in Figures 1.2 and 1.7. Although the analysis gets more complicated in the case of multiple shifts, the net outcome is always some combination of the impacts from each individual change. The simple framework represented by the four-quadrant diagram works well in illustrating the new equilibria that result as the exogenous environment changes. An important drawback of this framework is that it is not easy to trace the intermediate steps as the market moves to its new equilibrium. A dynamic system of equations is needed to depict the intermediate adjustments of the market, which significantly complicates our analysis. More complicated dynamic models will be developed in Chapters 10 and 12 SUMMARY
In this chapter, we defined real estate and provided a simple analytic framework to examine the operation of this important market. Real estate is defined as the national stock of buildings, the land on which those buildings sit, and all vacant land. Real estate is a very important component of our nation's wealth;
98
the total value of real estate was estimated at $8.8 trillion in 1990, representing 56 percent of the nation's net worth. Additions to the stock represent roughly 5 to 7 percent of annual GDP. The four-quadrant model divides the real estate market into the property market where space use is determined and the asset market where buildings are bought and sold. There are two critical links between these markets. First, rents determined in the property market are translated into asset prices in the asset market. Second, asset prices determine the level of new construction, which determines the amount of stock available in the property market. Exogenous shocks to the property market can have very different impacts on the operation on the real estate market than exogenous shocks to the asset market. In this chapter, we showed that:
An increase in the demand for space in the property market shifts out the demand curve in the northeast quadrant, increasing rents, which, in turn, increases asset prices, construction, and the stock of space. A decrease in the capitalization rate in the asset market increases the demand for real estate assets, which increases asset prices. Increased asset prices in turn bring forth more construction, increasing the stock of space and decreasing rents. An increase in construction costs decreases construction levels, which, in turn, decreases the stock of space, driving up both rents and asset prices.
Week 8 Intermediate exam Lecture 9 Operation of property markets: a micro and macro approach23 Pricing factors, Microeconomics of real estate (urban land and location); Macroeconomics of real estate: market growth and dynamics
What is the fair market value of a specific house? How much rent can a property manager charge for his office space? Is now the best time to develop a site? What should the density and use be? Real estate decisions such as these must be based on an understanding of the economic environment of each parcel or property. This economic environment is constantly being changed forces and events at two levels: the micro level and the macro level. Micro forces are those location-specific factors that influence the value or use of one particular site. Macro forces, on the other hand, are those broad economic factors that affect market timing and influence the profitability or use of all properties. As a discipline, the study of economics is divided into two broad fields with a similar distinction: microeconomics and macroeconomics. Microeconomics refers to the study of how 23
Urban Economics and Real Estate Markets, Denise DiPasquale and William C. Wheaton; Prentice
Hall 1995 – Chapter 2 99
individual economic agents (such as households and firms) operate, whereas macroeconomics investigates the behavior of the overall economy. Real estate economics is divided in a similar way. In this book, the study of the use, development, or pricing of individual properties or parcels of land involves a microeconomic approach. In contrast, the study of the behavior of the overall market aggregating across individual properties involves using a more macroeconomic approach. In real estate economics, location plays a crucial role in distinguishing between micro and macro approaches. Real estate microeconomics borrows heavily from the traditional urban economics literature, treating the operation of land and property markets with the explicit recognition of space or location. What is the demand for land at one site? What is that site's highest and best use? How do house prices vary across sites, and why? What factors determine office rents or the location of firms and their plants? Real estate microeconomics investigates these questions by studying the operation of urban land markets and developing theories and explanations for the spatial structure of cities. Real estate macroeconomics abstracts from the spatial dimension and considers the overall market for housing, land, or office space. The simplification that results from such aggregation can be justified on two grounds. First, as with any type of inquiry, insight often is achieved, perhaps at the expense of some realism, by abstracting or making simplifying assumptions. Without aggregating across locations and dealing with a market as a whole, the detailed time series models in Chapters 10 and 12 of this book simply could not be developed. Second, many factors that affect real estate are largely independent of location. Consider changes in interest rates or variations in the growth rate of an area's economy. These are forces that move over time and impact real estate at all locations. In these cases, it makes sense to study a market as an aggregate entity. The distinction between real estate micro- and macroeconomics clearly hinges on the notion of an aggregate market. Within this context, then, how should a market be defined? The answer is that a market should represent a group of properties that react similar y with respect to macro factors (such as interest rates and economic growth). If the behavior of properties within a market is similar, then the macro approach will work. If properties react very differently to macro effects, then such modeling will be largely unsuccessful. DEFINING MARKETS: PROPERTY TYPES In addition to the distinction between microeconomic and macroeconomic approaches to real estate, throughout this book we distinguish between residential and nonresidential property markets. This delineation has both advantages and disadvantages, but we believe there are net benefits to the distinction. At the macroeconomic level, housing markets clearly behave differently from those of nonresidential property. Movements in housing prices and residential construction do
100
not relate closely to movements in rents or construction for office, industrial, or retail properties. The institutions that guide each of these markets also are quite different. Residential contractors rarely build commercial space. Industrial or office space brokerage firms have no connection to firms undertaking residential brokerage. The financing of residential properties also takes place through a distinct mortgage origination process, and the residential mortgage market has a very active secondary market (the market in which mortgages are purchased and sold). Commercial financing takes place largely through private placements, but there is only a small formal secondary market. Thus, at the macro level, there are good reasons to consider different property types as different markets. At the micro level, the distinction between residential and nonresidential property is not as clear, largely due to the fact that both types of property use and compete for a common resource: land. The price of commercial property, for example, bears a direct relationship to the price of residential property, since both uses compete for the same fixed supply of land. The locations of commercial and residential property also are closely linked through the commuting of workers and travel of shoppers. At the same time, the behavior of participants in the residential and nonresidential property markets is based on different economic theories and motives. Finally, the extensive government regulation of land in the two uses (e.g., through zoning) has important impacts on both residential and nonresidential property markets. DEFINING MARKETS: AREAS The second issue in defining a property market involves the question of spatial aggregation: what is the appropriate geographic definition of a real estate market? Should markets be defined at the neighborhood, town, metropolitan, state, or national level? There is no definitive answer to this question, but there are both conceptual and pragmatic criteria for making the choice.
Conceptually, the geographic definition of a real estate market should encompass real estate parcels that are influenced by the same economic conditions. Clearly, national economic conditions, such as interest rate levels, influence real estate markets. But we also know that real estate markets are profoundly influenced by economic conditions such as employment and income, which vary widely across regions of the country. How should these regional or local economies be defined? Urban economists have long struggled with this question. As a practical matter, the geographic definition of a local economy is generally settled by the way in which data on urban economies are collected. The U.S. Census Bureau defines metropolitan statistical areas (MSAs) on the basis of economic behavior rather than the legal, political, or historic precedent that delineates towns or states. An MSA is generally defined as a county with a central city with a population of 50,000 or more and adjacent counties that are metropolitan in nature. The decision to include a county in an MSA is based on population density, the percentage of the population that is urban, the nonagricultural employment level, and the commuting patterns among counties and with the central city. As a result, MSAs are drawn to reflect a single labor 101
market and the mobility of workers; in addition, MSA boundaries often change over time.' Commuting within a metropolitan area should not be so burdensome that it prevents most households from living and working at any two locations. In other words, a worker at a particular location within a metropolitan area should not be severely constrained from taking any job within that area. Conversely, commuting between metropolitan areas should present enough potential obstacles to make it a rare occurrence.
This labor-mobility definition of a local economy has broad ramifications for how real estate markets operate. If a worker within a metropolitan area can be reasonably expected to live anywhere in that area, then all houses in that area are, in some sense, competitive with each other. For example, by commuting more or less, any worker could, in principle, bid on any house. Locations for firms are similarly competitive, in the sense that a business could choose any site and, in principle, still find workers willing to commute there. Between metropolitan areas, this degree of competitiveness normally does not exist. Households in San Francisco cannot reasonably be expected to work in Los Angeles, which means that the real estate markets of the two areas are in some fundamental sense disconnected. The competitiveness of properties within a metropolitan area comes from the ability of workers to change houses without switching jobs, and change jobs without moving their place of residence. The absence of such mobility between metropolitan areas separates their real estate markets.
Conceptually, if we define our unit of analysis at the macro level as the metropolitan area, what is the appropriate unit of analysis for the micro level? Within a market definition, there are distinct factors that affect the behavior of individual properties that are different from those factors that affect the overall market. This effectively means that there is something to be gained from the whole micro-macro delineation; that micro analysis is different from macro analysis, and that the two complement each other. If there were little difference between the types of theories and arguments used at the micro and macro levels, then there would not be any clear advantage to the twofold approach. In real estate economics, the role of location helps to create the distinction between the two levels, particularly when markets are defined at the metropolitan level. The mobility of households and firms across locations within metropolitan areas is fundamental to the microeconomic study of real estate. Since locations within a market differ (by commuting for example), mobile households will quickly generate higher prices for more desirable (lower commuting) sites. The theory of urban land markets provides a methodological approach based on this high degree of spatial mobility. The mobility of firms and workers within metropolitan areas also means that an economic shock occurring at one site (e.g., loss or gain of jobs) will have impacts on prices at all sites, as mobile workers adjust their demands. Thus, sites within metropolitan areas should react similarly to changes affecting the overall market.
102
Throughout this book, our macro analysis is generally focused at the metropolitan level, although occasionally we deal with a national housing or commercial real estate market— particularly when there appears to be systematic patterns of behavior across many metropolitan areas. For the micro level analysis, we generally look within a metropolitan area, often at cities and towns within an MSA. REAL ESTATE MICROECONOMICS: URBAN LAND AND LOCATION The fact that house prices vary according to the size, quality, and character of a unit's structure probably comes as no surprise. It is also true, however, that units with similar physical characteristics will vary enormously in price by location. Location characteristics that have been shown to affect house prices include commuting time or access to jobs, public services and neighborhood quality (e.g., school performance, crime rates, etc.), and natural or environmental features (water frontage, terrain with views, air or noise quality). These characteristics of a location can account for more than half of the overall value of a house. As an example of how important public services are, Table 2.1 compares the average price of a single-family house in a range of towns in 1990 metropolitan Boston to the average score of high school seniors in the town's school system on the test administered by the Massachusetts Educational Assessment Program. Figure 2.1 is a scatter plot of the house values and test scores and shows the regression line between the two variables. The relationship is striking and the statistical correlation between the two is quite strong.24
TABLE 2 1
e
Boston-Area House Values and Student Test Scores, 1990
12th-Grade Achievement Scores
Brooklin
House Values (1990 $) 377,800
Wellesle Belmont Newton Lexingto Cambrid Marblehe Needham
349,500 307,800 293,400 282,800 263,800 257,200 256,500
1437.5 1455 1435 1525 1222.5 1395 1470
1430
24
'In Table 2.1, a simple bivariate regression between test score (TEST) and house price (P) yields the following relationship: P = -280811 + 369.4 TESTR2 = 0.38 (-6.1) (4.3) N = 32 The t-statistics are in parentheses below the coefficients. Thus, across the sample in the table, towns with average test scores 100 points higher have houses that are worth almost $37,000 more. Of course, we must be careful in drawing strong conclusions from this simple regression. Certainly, some of this large effect is caused by the fact that towns with higher test scores may also have lower crime, a better park system, and so on 103
Rockport Milton Arlington Reading Watertow Stoneha Waltham Burlingto
Wakefiel Framingh Medford Sharon Dedham Peabody Ipswich Woburn Braintree
Somervill Hopkinto Malden Boston Quincy Revere Randolph
227,500 219,600 209,200 204,100 196,700 194,900 191,100 191,100 190,600 184,700 182,400 182,100 177,500 177,100 174,000 172,600 168,700 165,800 163,200 162,900 161,400 161,100 160,500 155,500
1445 1315 1375 1347.5 1280 1292.5 1267.5 1350 1282.5 1415 1207.5 1427.5 1327.5 1270 1415 1247.5 1387.5 1155 1265 1207.5 1180 1295 1212.5 1297.5
Strong statistical relationships, such as that in Figure 2.1, exist throughout the housing market between prices and many structural or location attributes. They also characterize other property markets as well. Retail space rents vary systematically with the expected pedestrian traffic on downtown streets, and office space rents are higher around mass transit lines. In each of these cases, wellestablished price premiums or discounts exist for locational or structural features of a property. Location theory holds that such price effects represent the long-term valuation of these attributes by households or firms. The theory also suggests that such valuations are relatively stable as the overall market undergoes growth or decline. In other words, rents or prices for all locations rise and fall with a market's fortune, but the relative price of more desirable versus less desirable locations changes very little
104
The general stability of relative property prices or of property price premiums can be shown empirically. In Figure 2.2, the rents for office space during two very different periods are compared across several locations in the Boston metropolitan area. In 1980, the Boston office market was coming out of a long inactive period: construction was occurring everywhere and rents were rising rapidly. The economic growth of the defense, computer, and financial sectors in Boston created a real estate boom in the early 1980s. In contrast, by 1990, the economy had cooled and unemployment was rising. A changing computer technology market and the declining defense budget hit the area hard. In 1990, the real estate market had peaked and was declining rapidly; construction had almost ceased and rents were falling. Figure 2.2 shows that the relative rents for office space across locations changed very little between the beginning and end of this decade, despite considerable price inflation and very different overall market conditions. The stability of relative property prices within metropolitan areas results from two features of the urban land market. The first is the high degree of household and firm mobility within metropolitan markets, as discussed in the previous section. Mobility acts to create a form of price "arbitrage." Locations within a market can rarely stay over- or within a metropolitan market might change is if consumer valuations of particular physical or locational attributes change. For example, a sudden increase in gasoline prices would lead consumers to value sites with shorter commutes more highly. The gradual demographic change of an area from having predominantly households with children to those without might be expected to alter the valuation of houses with many bedrooms versus smaller units. Similarly, long-term shifts in the spatial distribution of jobs might also change the relative valuation for certain kinds of office or industrial space. Generally, such price changes occur only very slowly, since they are based on fundamental shifts in the makeup of an area's population or economy.
105
The second source of shifts in relative property prices is change in the attributes of a property. Obvious examples include physical change in the property's structure such as rehabilitation, renovation, or expansion. Changes in locational or neighborhood characteristics may also dramatically impact property prices. A common example is the construction of a new highway or transit facility, which alters the pattern of commuting costs for many locations. In metropolitan areas with new transit systems or extensions of older systems, it is common to find new developments emerging around the transit system. It is often difficult to measure directly the impact of such changes in the transit system on land values and development because the impacts are too localized to demonstrate with publicly available data. Changes in neighborhood crime or town school quality can also be expected to affect relative property prices in one area versus another. Real estate microeconomics involves more than just the study of how property rents or prices are determined across locations. It also focuses on how the land market uses these prices to determine both the density of development and the location of different land uses. One of the important lessons that microeconomics teaches us is that the price of land and its density, or use, are determined simultaneously: denser uses generate higher land prices, whereas more expensive land encourages denser use. Another precept of real estate microeconomics involves the separation of uses. The land market works much as an auction, with each site being developed or occupied by that use offering the most for it. In this process, it is a natural market outcome to have each use occupying separate areas or distinct locations. The development of land proceeds under a number of such microeconomic principles. A thorough understanding of these principles of microeconomics allows us to understand the evolution of cities over time and the spatial patterns of land prices, land uses, and density. Why is residential density normally higher in downtown areas of a city, or along beaches and other natural amenities? How did Central Business Districts (CBDs) come into existence, and why has there been a recent explosive growth of suburban employment districts? What explains the distinct hierarchical pattern of retail establishments—a large number of smaller stores or centers and a small number of larger
106
centers? Why do property prices and density eventually rise as a city grows? The study of metropolitan land markets provides answers to these questions by emphasizing the long-term equilibrium outcomes of spatial competition. This microeconomic approach, however, does not examine the economic determinants of long-term metropolitan growth or the short-run cyclic behavior of metropolitan economies. Real estate macroeconomics focuses on these topics.
REAL ESTATE MACROECONOMICS: MARKET GROWTH AND DYNAMICS While microeconomics studies prices and land use across space within a particular market, macroeconomics examines the overall movement of prices and real estate development for the metropolitan market as a w ole. By abstracting from the spatial dimension, macroeconomics is able to focus more specifically on the time dimension that emphasizes short-run movements and temporary disequilibrium. As a result, macroeconomics deals with aggregate variables that are averages or aggregations of data measured at each location within the market. Given the theory of real estate microeconomics, the presumption in macroeconomics is that such aggregate measure depict the behavior of variables at most locations within the market. Some macroeconomic variables are most commonly measured as averages. These variables include market kes, rents, or vacancy. For example, samples of apartments are repeatedly surveyed by the U.SComme e Department to produce estimates of average rents in metropolitan areas. Brokerage companies periodically survey the inventory of office buildings to produce estimates of average market vacancy rates. The Federal Housing Finance Board maintains data on single-family house transactions through their survey of mortgage lenders and reports the average price of existing house sales. As an example of such data, Figure 2.3 traces house price series for the Dallas and Boston metropolitan areas in constant (1990) dollars. One of the main objectives of real estate macroeconomics is to explain the long-runtrends and shortrun movement of price or rent data such as is shown in Figure 2.3. Sometimes house prices in many different areas are affected similarly by overall U.S. economic conditions. In both Boston and Dallas, for example, house prices dipped during the economic recessions of 1974 and 1982. At the same time, local market factors also are important. Dallas prices rose during the oil boom of the late 1970s, while Boston prices were flat. During the 1980s, Boston prices soared with the boom in technology industries, while the collapse in oil led to price declines in Dallas. Often, the demand side of the market seems to account for much of the movement in prices. At other times, however, it is fluctuations in supply that explain price fluctuations. Consider the history of office-space vacancy rates in these same two markets in Figure 2.4.
107
In the market for office space, vacancy rates sometimes do move with a market's economic growth. For example, the vacancy rate soared in Dallas just after the recession of 1970 and during the Texas economic crash of the early 1980s. Similarly, Boston's vacancy rate peaked just after the recession of 1975. But why did Boston's vacancy rate rise in the mid-1980s, just when economic growth was strongest? Why did the vacancy rate in Dallas rise during the early 1970s, when its growth was strong? The answers lie with participants in the supply side of the market who built excessive amounts of new space, at least relative to market demand.
108
Figure 2.5 portrays the growth in Dallas of office employment and office construction as a percentage of the stock of office space. Sometimes the two seem to move together, as during the period of Dallas's growing economy between 1972 and 1974, or during the decline in its economy in the mid-1980s. At other times, such as the periods between 1968 and 1970, 1974 and 1976, and 1988 and 1989, construction moved quite differently from employment growth. Clearly, the supply of real estate is not always in tune with demand, particularly over shorter intervals of time. Understanding the movements in supply and their determinants is as important as understanding the long- and short-term factors that affect property demand. These examples illustrate some of the common patterns of behavior that real estate macroeconomics seeks to explain. These patterns give rise to three general principles that govern the aggregate behavior of metropolitan real estate markets: 1. The economic growth of each metropolitan area is determined in the short run by movements in the overall U.S. economy, together with the area's industrial mix and competitiveness. In the long run, demographic changes and lifestyle preferences also play a role. Unlike different locations within a market, different metropolitan areas can simultaneously experience widely varying economic conditions. In the short run, there is no "arbitrage" between metropolitan areas. 2. The real estate market of each metropolitan area moves closely with the area's economic growth. In some situations, the supply or price of real estate can actually exert an influence on the area's overall economic development. 3. Regions or metropolitan areas adjust slowly to economic change because resources are relatively immobile between markets. In response to changes in demand, the supply of factors into an area (labor, capital, structures) often occurs very gradually. Such slow adjustments give rise to temporary imbalances and help to generate cyclical patterns.
This macroeconomic behavior stands in noticeable contrast to the microeconomic principles discussed earlier. Within markets, individual parcels of real estate are intensely competitive with each other and have prices that adjust rapidly to maintain a degree of parity. While metropolitan areas also compete with one another over the very long run, the movement of economic resources between such areas is slow 109
enough in the short run to largely uncouple the economies of different regions. Real estate microeconomics thus focuses on the equilibrium relationships between land or property parcels across locations within markets, while macroeconomics studies the disequilibrium that occurs as the markets grow and adjust to economic change SUMMARY The micro and macro perspectives outlined in this chapter are the fundamental basis of analysis used throughout much of this book. The micro approach focuses on the importance of structural and locational characteristics on the prices and rents for a particular property or development. We often treat metropolitan areas as a single real estate market. While prices for real estate and land within a single market can vary enormously across locations, the relative price of real estate across locations is generally stable over time. The micro approach is examined in detail in the next four chapters. In Chapters 3 and 4 we explore the determinants of household location within a metropolitan area and examine the willingness to pay for structural characteristics, including the density of the development. In Chapters 5 and 6, we focus on the location decisions of firms within a metropolitan area. The macro approach examines how broad economic forces such as growth or decline in a metropolitan area's economy influence the area's real estate market. Metropolitan growth is determined by growth in the national economy as well as the area's industrial mix and competitiveness. The macro approach is examined in detail in Chapters 7 through 12. In Chapter 7 we examine the determinants of metropolitan growth. In Chapters 8 through 10 we provide a detailed examination of metropolitan housing markets, and in Chapters 11 and 12 we investigate metropolitan nonresidential real estate markets
Lecture 10 Real estate market analysis Definition; Market analysis components; Macro and micro analysis; Market studies and their emphasis 25 Real estate market research is a new field of study, which builds on the accumulated stock of knowledge from urban and real estate economics to address two major questions: • How do the various real estate markets function at the broader macroeconomic, or metropolitan level, and at the more narrow microeconomic, or site level of analysis? • How exactly should one go about analyzing meaningfully real estate markets for development and/or investment purposes? These two questions highlight two major areas of knowledge in the field of real estate market 25 Market Analysis for Real Estate by Rena Mourouzi‐Sivitanidou, edited by Petros‐Sivitanides, unpublished manuscript. Copyright 2011 by Petros Sivitanides (chapter 1)
110
research that are critically linked, as the accuracy and reliability of analytical techniques and processes is directly proportional to the degree to which they reflect the functioning of the particular market analyzed. In addressing the first question, this textbook will explore the basic economic principles guiding the operation of real estate markets, placing special emphasis on their peculiarities and idiosyncratic features. As it will become apparent later, it is the knowledge of these features that helps more accurately evaluate specific real estate development or investment opportunities. In addressing the second question this textbook will explore both state-of-the art and less sophisticated techniques that market analysts can employ to proactively design and evaluate real estate development or investment programs. The major premise underlying the structure and content of the book is that a better understanding of how markets function coupled with a working knowledge of real estate market analysis tools will help analysts and real estate professionals: • become sophisticated users of market studies • communicate more effectively with colleagues in the real estate development and investment community • use skillfully available data to evaluate the prospects of a market and a specific project BOOK PREMISE, FOCUS AND OBJECTIVES The author rejects emphatically the “Field of Dreams” philosophy “Build it and they will come...” that seems to have dominated the real estate development industry during the 1980s. This philosophy is wrong as it basically suggests that supply generates demand, a proposition that runs against fundamental economic principles. On the contrary, the book advances the premise that solid market research, based on a good understanding of the peculiarities and idiosyncrasies of real estate markets, is a necessary and crucial component of the real estate decision-making process. The specific operational and bottom-line objective of market research is to help generate the knowledge and information that relates to space market operations and is necessary for assessing whether a project is likely to meet key development and investment objectives. For example, a typical key real estate development objective involves the maximization of residual land value (RLV) or, alternatively, profit per area of land. The two major factors involved in the calculation of RLV are property values or prices, and non-land development costs per square foot (see Figure 1.1). It is the strong link between property values and a property’s incomeearning capacity that underscores the importance of market analysis in real estate development and investment decision making. The strong link between property values and a property’s income is embedded in the income approach to value, the most relevant property valuation technique from an investment point of view. 1 In its simplest version, the income approach postulates that property value is 1 The income approach, which focuses on the income-producing capacity of a property, is one of the three major approaches to value. The other two approaches include the sales comparison approach, which utilizes data on the most current sales prices of properties comparable to the one under consideration, and the cost
111
approach, that focuses on the estimation of a building’s replacement cost. a function of the property’s net
operating income (NOI) and the prevailing market capitalization rate.a function of the property’s net operating income (NOI) and the prevailing market capitalization rate.a function of the property’s net operating income (NOI) and the prevailing market capitalization rate. 2 The more advanced version of the income approach is represented by the discounted cash-flow model in which a property’s income-earning capacity is again the prominent factor driving value. In this version, instead of using a capitalization rate, which represents a required income return, a required total return (referred to as discount rate) is used within the context of a multi-year discounting formula.
Movements in a property’s NOI are strongly influenced by movements in space markets. In particular, a property’s NOI is a function of the rent it commands in the marketplace and its occupancy rate. Property rents and occupancies are in turn shaped by market demand and supply forces, as well as idiosyncratic structure and location characteristics. In particular, it has been widely established in the real estate literature that movements in individual-property rent and occupancy levels are primarily driven by changes in market demand and supply conditions, while differences in rent and occupancy levels across individual properties competing within the same marketplace are determined by idiosyncratic property and location characteristics.
Capitalization rates are not typically the focus of market studies for development projects, but they are strongly influenced by movements in local market conditions as property income does. For example, empirical analysis of movements in office capitalization rates has provided evidence of the influence of market-related variables, such as absorption levels and changes in rents (Sivitanidou and Sivitanides, 1999). This underscores the additional importance for accurately evaluating real estate market prospects.
112
In sum, the role of market research is to analyze the market-related determinants of project profitability at the macro and micro level, help address questions of market entry and pro-active project design, and provide the bottom-line rent and absorption figures that are necessary for the assessment of the financial feasibility of a particular development. Within this context, the focus of this book is on the forces and processes that drive broader space-market performance; the idiosyncratic project- and location-specific factors that shape deviations of individual property performance from average market performance; and the techniques that analysts can use to forecast market performance and assess the income-earning prospects of specific development projects. Hence the four major objectives of this book are: 1) to examine the major macroeconomic processes and factors that shape broader market performance of the four major property types 2) to present advanced and less sophisticated techniques for analyzing and forecasting broader market performance for the four major property types 3) to discuss project-specific and location factors that influence individual property performance, and 4) to present techniques for analyzing and forecasting individual project performance in a way that is consistent with the analysis of the prospects of the broader market MARKET ANALYSIS IN PERSPECTIVE DEFINITION AND CONTRIBUTION
Generalizing along the lines discussed above, it can be argued that the major focus and contribution of market analysis for real estate is the assessment of the underlying determinants of a project’s income-earning capacity at two distinct levels: the macroeconomic (non-site) level and the microeconomic or project-specific level. As indicated in Figure 1.2, a property’s income-earning capacity is influenced by three major sets of factors: a) general macroeconomic and metropolitan growth forces that may affect all property types, b) macroeconomic forces that drive the demand for and supply of specific property types, and c) location- and project-specific factors that may contribute to deviations of individual property performance from market performance. We elaborate on each of these factors below. a) General Macroeconomic/Metropolitan Growth Forces These include forces that may affect the economy of a metropolitan area and all its real estate markets. Examples of such forces include increasing global competition and technological advancements that may undermine an area’s major industries; significant changes in exchange rates that may render foreign imports more attractive at the expense of domestic industries; the 113
economic well-being of America’s major trading partners, that can have a significant impact on export-oriented metropolitan economies; or changes in interest rates that may influence the volume of new construction, and, therefore, the supply of all property types nationally. These forces, being international, national or regional in scope, may very well impact a metropolitan area’s economy and local real estate market. The effect of these forces may vary from metropolitan area to metropolitan area due to differences in industrial structure and the sectoral composition of the local economy. b) Macroeconomic forces that drive the demand for and supply of specific property types. For example, as a number of empirical studies have shown (Wheaton, 1987; Rosen, 1984), the demand for office space is driven by employment in specific sectors of the economy referred to
as “office-using”. These include primarily the FIRE (Finance, Insurance and Real Estate) sector and Services, as defined in the Standard Industrial Classification (SIC) system. Thus, macroeconomic forces that affect specifically these sectors, such as the health of the nation’s financial system, are bound to have an effect on an area’s demand for office space. Similarly, Wheaton and Torto (1990) have shown that demand for industrial space is driven primarily by manufacturing and wholesale trade employment. Macroeconomic forces that affect an area’s employment in these sectors will have an impact on the local industrial market. 114
On the supply side, the major factors that drive new construction for a specific property type include land costs, which vary across different land uses within the same metropolitan area, as well as across metropolitan areas; labor costs that generally vary across metropolitan areas due to differences in labor market conditions; and the cost of construction materials. All these macroeconomic factors, both broader and more property-type specific, jointly shape movements in effective space demand, and competing supply and, hence, movements in absorption, vacancy rates, and average market rents/prices through time.
c) Location and Project-Specific Factors These include factors that affect the demand for and the competing supply of a particular real estate product at a specific location. In particular, factors such as the quality of and amenities provided by the project and its immediate location along with consumer/tenant preferences and ability to pay play a critical role in determining location and product demand. On the supply side, factors, such as, local zoning constraints and growth controls may create supply shortages and limit competition. Furthermore, the spatial distribution of existing and new comparable properties plays a key role in determining the intensity of the competition faced by a specific property at a given location, especially in the case of retail. Overall, all these factors shape the competitive position of a project within its market area, which plays a crucial role in determining the level of rents/prices and absorption it can achieve relative to the average market rent and total market absorption, respectively. To better understand the difference between the macroeconomic and microeconomic influences on real estate markets consider Figure 1.3, portraying movements in rents for two different projects/locations with different amenity levels. Notice that, although the time path of rents is similar for both project locations, there are persistent differences in levels. Variations in performance through time are due to changes in macroeconomic forces that influence a metropolitan area’s economy and affect all locations/projects similarly. Differences in performance across projects and locations at the same point in time (referred to also as crosssectional differences) are due to differences in their amenity levels and/or constraints. Long-run shifts in cross-sectional rent differentials across projects/locations within the same market are more likely due to changes in amenity/constraint differentials, or the way these differentials are valued. For example, it is being argued that dispersion of economic activity, induced by advances in information and communication technologies, is narrowing locational differentials in rents and prices as the value of locational proximity has declined (Sivitanidou, 1997). MARKET ANALYSIS COMPONENTS
A comprehensive and well-integrated market study should appropriately examine all aforementioned macroeconomic and microeconomic influences. As such, it should comprise three major components: a) metropolitan growth analysis, (b) macroeconomic analysis of real estate markets, and (c) micro-marketability analysis. The basic premise underlying metropolitan growth analysis is that real estate is durable and, 115
therefore, demand for new space is driven by growth at the margin. Can there be any demand for real estate within a metropolitan area that is not experiencing any population, employment, or income growth? The answer is yes. Two sources of such demand can be identified: 1) replacement demand, which arises because of the depreciation of the existing stock, and 2) relocation demand, arising from intra-metropolitan location adjustments, induced by advances in information and communication technologies, rent or price differentials across submarkets, or other factors influencing the location decisions of firms. It should be noted that depreciation rates are very low in the real estate sector because of its durability, and therefore, replacement demand is only a very small percentage of existing stock. By definition, these two sources of demand cannot generate an increase in aggregate real estate demand at the metropolitan level.
116
The premise underlying the macro analysis component is that macro/marketwide determinants of real estate demand and supply vary through time causing fluctuations in rents and vacancy rates, thereby creating opportunities for profitable investments. Taking advantage of these opportunities requires appropriate timing of market entry in order to profit from future increases in rents and occupancy rates, and identification of niches in terms of property types and target markets that offer the best return prospects. Within this context, the purpose of macroeconomic analysis is to assess, as accurately as possible, the most likely future movements in demand, supply, rents, and occupancy rates, and provide the basis for sound and profitable investment decisions. The premise underlying the micro-marketability analysis component is that pro-active (and not re-active) product design, matching consumer preferences for location and product attributes is necessary for maximizing project value. The underlying rationale of this premise is that not only broader market prospects but also idiosyncratic project and location features are crucial in determining project-specific performance and achievable rental revenue levels. Thus, real estate developers and investors can maximize value and profits by carefully identifying the type of product that is mostly valued by consumers in the marketplace. Table 1.1 summarizes the basic characteristics of the three major components of real estate market studies. The discussion below elaborates on these components in terms of the unit of analysis, focus of analysis, bottom-line outcome, and contribution.
Metropolitan Growth Analysis Unit of Analysis The unit of analysis during this stage could be the metropolitan statistical area (MSA), the primary metropolitan statistical area (PMSA), or the consolidated metropolitan statistical area (CMSA) within which the project is located. The rationale is dual. First, the metropolitan area represents an integrated economy that shapes the exogenous economic forces that drive movements in aggregate demand and supply for real estate, and, hence the time path of absorption, completions, vacancy rates, and rents. Second, the metropolitan area represents an integrated real estate market because, from a real estate demand point of view, each location is, to some extent, substitutable with any other location within the same metropolitan area, but hardly with locations in other metropolitan areas. For example, it would be inappropriate to perform an isolated macroeconomic analysis of a specific office submarket and completely ignore the demand and supply conditions and prospects within the metropolitan area the submarket is located. The reason is twofold. First, demand for a specific location and office building is shaped not only by growth in firms housed in that submarket, but also by growth in firms in other submarkets and new firms deciding to locate within the broader metropolitan area. Second, it is rather unreasonable to assume that an office building in one submarket does not compete at all with similar buildings in other submarkets within the same metropolitan area. Thus, an isolated analysis of the submarket could lead to underestimation of the competition the project may be faced when completed and an erroneous assessment of its prospects and viability. 117
Focus of the Analysis This stage focuses on the analysis of the sources, mechanism and consequences of metropolitan growth. In terms of sources, emphasis is placed on industry product demand shifts, industrial structure, amenity-induced migration and labor supply shifts. In terms of mechanism and consequences, emphasis is placed on the interaction between demand and supply forces in the product and labor markets, their effects on population, employment, and income growth, and their implications for real estate demand. Bottom-Line Outcome The bottom-line outcome of metropolitan growth analysis is the assessment of the pattern of growth the metropolitan area under consideration is experiencing and will likely experience (demand-induced, or supply-induced) in the years ahead; the direction and magnitude of physical growth (employment and capital stock) and growth in wealth associated with such a pattern; and the set of opportunities it presents for real estate development
and investment. Contribution Metropolitan growth analysis sets the stage for a broad assessment of the demand for real estate at the margin and provides some clues with respect to broader product type and consumer niches that may experience strong demand growth in the future. It should be emphasized that this stage never leads to a go or no-go decision for a specific project. 118
Macro Analysis of Real Estate Markets Unit of Analysis This stage focuses on the project’s competitive market area. This is the geographic area funneling effective demand for the project and encompassing the locations of all competing projects. With the exception of some retail property types, it is broadly accepted that any project competes with all similar projects that are located within the same metropolitan area. Thus, the most typical geographic unit of macro analysis for any property type is the metropolitan area within which the project under consideration is located. This definition serves also very well the increased data requirements for a more sophisticated analysis of an area’s prospects. Focus of the Analysis The analysis focuses on historical and current indicators of market strength, such as, effective market demand, competing supply, vacancy rates, and rents/prices by product design type and consumer segment, if data availability allows it. Otherwise, the focus of the analysis will be on the broader property type that is more relevant for the project under consideration. It should be emphasized that the focus is not simply on reviewing and understanding the direction of recent trends, but also on gaining a good understanding of the factors driving the movements in critical market indicators, in a way that will allow the analyst to forecast future movements as accurately as possible. Bottom-Line Outcome The bottom-line outcome of this stage includes forecasts of effective market demand (or net absorption), completions, total inventory, vacancy rates, and prices/rents at the time of sale in the case of for–sale projects, or over the expected holding period, in the case of income-producing properties. Contribution Macro analysis of real estate markets provides valuable guidance for time-ofentry decisions and can facilitate the identification of product and consumer niches. It also provides crucial inputs for micro-market analysis and financial feasibility analysis. Such inputs include forecasts of market supply and demand, as well as forecasts of the market price/rent index. Market supply and demand forecasts are necessary for calculating the project’s fair market share and absorption schedule, while market rent/price forecasts can provide the basis for forecasting movements in project rents/prices and revenues. Micro (Site-Specific) Analysis of Development Projects Unit of Analysis This stage focuses on the specific site/project under consideration and its immediate environment. Major competing developments are also identified and more carefully evaluated during this stage. Focus of the Analysis This stage focuses on the careful evaluation of location/project amenities and constraints; evaluation of user preferences as well as ability and willingness to pay for specific location and project attributes using hedonic valuation techniques and data on most recent market transactions; assessment of the project’s competitive position within the local marketplace; 119
and development of rent/price and absorption schedules using as framework the forecasts for the broader market area developed at the macro analysis stage26. Bottom-Line Outcome The bottom-line outcome of this stage includes evaluation and/or selection of the site and location, pro-active design adjustments to maximize the marketability and value of the project, and forecasts of project-specific rent/price and absorption schedules. Contribution Micro analysis of real estate markets provides inputs that are necessary for assessing the financial feasibility of the project under consideration, such as the prices or rents it will command upon completion and its most likely absorption schedule. The latter cannot only help evaluate the financial feasibility of the project, but also evaluate different project phasing alternatives. In sum, market analysis provides information necessary for: • Assessing metropolitan growth prospects and their likely influence on the local real estate market • Assessing market strength and prospects for a particular property type (e.g. office industrial, retail or apartment) • Evaluating site-specific location benefits and constraints, proactively refining product design for maximum marketability, and developing forecasts of project absorption and revenue streams It should be emphasized that market analysis differs from financial feasibility analysis since the latter utilizes price/rent and absorption schedules derived from market research in combination with other property operating data to determine whether a project meets certain financial objectives. MARKET STUDIES AND THEIR EMPHASIS
There are biases in the field regarding the relative importance of each of the three market analysis components. For example, metropolitan growth analysis is incorporated in all residential and non-residential studies, but is often being done superficially. Macro analysis of specific property markets and micro analysis of specific projects within these markets differ in emphasis. Residential Residential macro analysis often places overwhelming emphasis on effective demand and affordability, while downplaying the role of competing supply. The argument behind such analytical approach is that residential markets are not subject to wide supply fluctuations. 26
Schmitz and Brett (2001) argue that qualitative analytical approaches, such as surveys of consumer preferences for a certain type of product, are becoming increasingly important because of the increasing segmentation and specialization of real estate markets.
120
Although, this may be true in general, it does not necessarily apply to every market in the country. Residential micro analysis sometimes downplays location issues on the basis of the argument that within a residential market there are too many substitute locations. This may be true, but due consideration should be given to the relationship between the project and location attributes. Residential micro analysis does place strong emphasis on project design, as it should. In fact, this is extremely important. The biggest challenge for residential developers involves successful consumer targeting and identification of the most appropriate amenity packages to provide to the selected target groups. The book presents an example of how analysts can optimize amenity mix in residential product design. Retail Retail market studies are typically better than studies for other property types in terms of level of detail, sophistication, and substance. Retail macro analysis places emphasis on market “Void”, or “Gap”, which represents the unrealized retail sales potential within a project’s trade area if a site is given or for a given metropolitan area if the site is not given. The market void or unrealized sales potential essentially refers to the additional sales that can be captured in a metropolitan area given its demographics and its household spending patterns. Retail micro analysis places great emphasis on (a) location with respect to consumer markets and sales potential, and (b) project design that focuses on issues of tenant mix and anchor tenants. A shopping center’s retail sales are greatly dependent on consumer access. Given that retail activities are quite revenue-sensitive, the focus on consumer access is quite justifiable. The emphasis on tenant mix is also well founded given the positive effect that colocation of certain types of stores may have on sales (often referred to as shopping externalities)27. Office Office macro analysis places emphasis on the analysis of competing supply. The emphasis of office market studies on supply is not surprising given the extreme cyclical fluctuations of office construction. The experience of the 1980s has shown that it is the lumpiness and longgestation period of office construction investments, combined with a myopic-expectations behavior on the part of investors that have largely driven such fluctuations.gestation period of office construction investments, combined with a myopic-expectations behavior on the part of 27
Such synergies may exist between stores that sell complementary products, or stores selling products that are subject to comparison shopping. Stores whose co-location facilitates comparison shopping are those selling highly heterogeneous non-standardized products.
121
investors that have largely driven such fluctuations.gestation period of office construction investments, combined with a myopic-expectations behavior on the part of investors that have largely driven such fluctuations. In particular, empirical studies have shown that past increases in rents trigger office construction investments (Sivitanidou and Sivitanides, 2000). This suggests that investors, acting myopically, assume that if rents are rising in the present they will continue to do so in the future.
Although the focus on supply is well founded, the analysis of office-space demand prospects should not be overlooked. Given the considerable variation in office-employment growth rates through time, office-space demand prospects should be also thoroughly and carefully analyzed at the macroeconomic level. Increased focus on office demand prospects is especially warranted in the years ahead given indications that office employment will not continue to grow as fast as it did during the 1980s. Office micro analysis does not sufficiently focus on location, while project design is often perceived to be unimportant. Location is very important and should be more thoroughly evaluated because office tenants are cost sensitive and the best sites are those providing for the minimization of tenant costs. A survey conducted by the Urban Land Institute (ULI) several years ago concluded that neighborhood quality matters more than design. Nevertheless, design aspects should not be overlooked. Industrial Industrial macro analysis is not very developed and focuses mainly on industrial development potential at the metropolitan level. The macro analysis of industrial markets is more complicated because they are highly heterogeneous, comprising mainly production, warehouse/ distribution, and research/development (R&D) space. These different types of space may be driven by different macro influences, but with the exception perhaps of R&D, the degree of segmentation across product types is not very clear28. Industrial micro analysis typically focuses on location accessibility, as well as site and space requirements. The emphasis on location is well founded given the special access and site requirements of industrial projects, as well as problems of community acceptance. More emphasis, however, should be placed on the productive attributes of industrial sites because industrial firms are largely cost-sensitive and their location decisions are heavily influenced by the productive amenities that characterize different sites. The emphasis on site and space requirements is also well founded in light of continuous technological advances and the introduction of new manufacturing, warehouse, and distribution systems and processes. For example, latest distribution and supply chain practices emphasize flow-through, materialhandling, and vertical storage systems that require different design features for warehouse and distribution facilities. 28
Production space, for example, is largely non‐speculative or alternatively build‐to‐suit. The market for such space is driven by business investment decisions and industrial cycles parallel business cycles rather than cycles resembling those of speculative markets.
122
MARKET STUDIES IN GENERAL: EVALUATION CRITERIA
One of the objectives of this textbook is to help the reader become a sophisticated user of market studies. Within this context, it is important to have in mind what makes a good market study in general. Below we outline the major questions that need to be asked when evaluating a market study, as they relate to its overall appeal, objectives, methodologies, data, and conclusions. General Evaluation How persuasive are they? Objectives Are the issues addressed by the study clearly articulated and explained? Are the objectives of the study --primary and secondary-- clearly spelled out? Analysis Elements Are the peculiarities of the real estate market being studied clearly acknowledged and appropriately taken into account? Are the most important market-related determinants of project profitability—both at the macro and micro level—given due consideration? Methodologies, Assumptions, and Data Are the methodologies employed in the study clearly described and fully explained? Are their pros and cons discussed? Are alternative methodologies used and are their outcomes compared to assess the reasonableness of the final estimates? Are the assumptions underlying these methodologies clearly spelled out? Are future market conditions analyzed using reliable forecasting techniques, or do they merely represent simple extrapolations of most recent trends? Are the data used --primary and/or secondary-- reliable? Are numerical variables assigned a range of values to account for potential forecast errors or uncertainty? Is the impact of alternative numerical assumptions on market and project performance examined through careful sensitivity analysis? Are the data sources and/or methods of data collection clearly listed and explained? Are the data incorporated in the analysis in a coherent and integral fashion or is the study full of "boilerplate" information? Conclusions Are the conclusions of the study inherently linked to its objectives and the analysis outcomes? 123
Are they robust, that is, do they still hold for small changes in the assumed values of exogenous variables employed in the study's methodology? Are conclusions based on subjective evaluation, intuition or gut feeling distinguished from those that are derived from careful analysis? Are the results of sensitivity analysis regarding the performance of the project under alternative assumptions integrated in the recommendations of the study? BOOK STRUCTURE AND CONTENT Given the main themes of market research and the objectives of this book, the material presented is structured in six parts. The emphasis of each part is discussed below.
Part A. Introduction The second chapter of the introductory part focuses on the basic economics of real estate markets. Particular topics discussed in this section include real estate demand and the relevance of absorption concepts; concepts of real estate supply, such as stock, completions, starts, and permits; and real estate cycles with emphasis on rent and vacancy adjustments.
Part B. Metropolitan Growth Analysis This part places emphasis on how to meaningfully analyze and interpret metrowide economic trends and prospects, and how to make inferences regarding their effect on the demand for different property types. In particular, Chapter 3 focuses on the sources, mechanisms and different types of metropolitan growth, while Chapter 4 presents the steps of a broad-brush framework for analyzing metropolitan economies using the Los Angeles metropolitan area as an example.
Part C. Analyzing Residential Markets This part consists of six chapters. The first chapter, Chapter 5, focuses on the basic economics of housing markets, while the subsequent three chapters elaborate on the macroeconomic analysis of residential markets and mostly on techniques for assessing residential market strength and developing forecasts for demand, supply, vacancy rates, and rents. In particular, Chapter 6 focuses on less sophisticated or non-econometric techniques of analyzing residential real estate markets at the macro level. Chapter 7 focuses on the basics of regression analysis as a way of an introduction to Chapter 8, which elaborates on the specifics of the econometric analysis of residential real estate markets through an application to the Dallas apartment market. Chapter 9 focuses on the microeconomic analysis of residential projects, and particularly on the use of accounting and econometric techniques for the estimation of most likely project rents/prices and absorption schedule, as well as for refining project design in terms of what to 124
build (housing type, development density, attribute mix) and for whom. Finally, Chapter 10 synthesizes macroeconomic and microeconomic analysis elements in an example of a hypothetical residential development project and provides guidelines for evaluating residential market studies.
Part D. Analyzing the Market for Retail Space Part D focuses on the market for retail space and consists of three chapters. In particular, Chapter 11 focuses on the macroeconomic determinants of the demand for retail space, consumer shopping behavior, and the different retail formats that compose retail space supply. Chapter 12 elaborates on the three major phases of a retail market study. The discussion of Phase I focuses on the assessment of a market’s unrealized sales potential (either at the aggregate level or by product line), and the strategic implications of such analysis. The discussion of Phases II and III focuses on the microeconomic analysis of retail development projects and, specifically, the analysis and evaluation of retail sites, and the refinement and evaluation of the final retail development concept. Specific micro issues discussed include location and site requirements for the different types of retail developments; the identification of the most profitable tenant mix; and the assessment of potential tenant sales and supportable square footage, as well as anchor and non-anchor rents. Chapter 13, the last chapter on retail markets, presents a numerical example of the analysis for a retail development project, outlines the points of emphasis of retail market studies for different retail formats, provides guidelines for evaluating retail market studies, and reviews an actual retail market study. Part E. Analyzing Office Markets Part E focuses on the analysis of office markets and consists of four chapters. Chapter 14 elaborates on the fundamentals of office markets, and specifically on its cyclical nature and the drivers of demand for and supply of office space. The chapter concludes with a brief overview of the office-market analysis process. Chapter 15 elaborates on the macroeconomic aspects of office market analysis and, specifically, on econometric and less sophisticated techniques for analyzing and forecasting broader office market behavior. Chapter 16 focuses on the microeconomic analysis of office projects. More specifically, this chapter elaborates on location and site attributes that are relevant in the case of office developments and discusses methodologies for estimating office project rent and absorption schedules. Finally, Chapter 17 synthesizes elements of macro and micro analysis for office projects in a simple numerical example, discusses briefly the market analysis process in the case of medical office space, and outlines broader evaluation criteria for office market studies.
Part F. Analyzing Industrial Markets Part F, which consists of Chapter 18, focuses on industrial market analysis. Broader discussion topics include idiosyncrasies of the industrial market, components of industrial space demand and supply, and a brief overview of the industrial market-analysis process. Macro125
analysis topics discussed include the assessment of an area’s industrial development potential, and estimation of the industrial demand-supply gap through accounting techniques and econometric modeling approaches. Different versions of the latter are discussed depending on whether the emphasis is on the speculative or non-speculative segments of the industrial market. The discussion of micro issues focuses on the site-specific analysis of industrial development projects, and specifically, on the evaluation of site and location attributes for different types of industrial space (production space, warehouse/distribution and R&D), identification of most likely tenants, analysis of competing industrial projects, and the assessment of potential project/land absorption and achievable rents. The chapter concludes with a brief outline of evaluation criteria for industrial market studies.
Lecture 11 Theory in practice: office market analysis 29 Office space Supply and Demand analysis; micro analysis of office market office location, Income-Related Factors: market rent, vacancy rate, expectations, market volatility and risk PART E. OFFICE MARKET ANALYSIS
This is the first chapter of Part E, which focuses on the analysis of commercial office markets. The purpose of this chapter is to first discuss the idiosyncrasies and economic fundamentals of office markets and then provide an overview of the major steps involved in analyzing them. Within this context, we first discuss the determinants of office project success within the context of the idiosyncrasies characterizing the marketplace for office space and, especially, its cyclical nature. We then elaborate on the demand and supply fundamentals of such a marketplace. On the demand side, the discussion focuses on the nature of the office-using employment sectors and the major determinants of demand for office space. On the supply side, the discussion focuses on the determinants of office construction investment, and, specifically on income-related factors, cost-related factors, and the availability of capital. We conclude the chapter with a brief overview of the market analysis process, as an introduction to Chapters 15 and 16. These two chapters elaborate on the macroeconomic and microeconomic aspects of market research, as they pertain to office development projects. OFFICE MARKET IDIOSYNCRACIES AND DETERMINANTS OF PROJECT SUCCESS
Completing an analysis for office real estate development requires a thorough understanding of the idiosyncratic nature of office markets and the factors that affect the value and profitability of office properties at the intrametropolitan level. Given the idiosyncrasies characterizing the market for office space, the major determinants of office 29
Market Analysis for Real Estate by Rena Mourouzi‐Sivitanidou, edited by Petros‐Sivitanides, unpublished manuscript. Copyright 2011 by Petros Sivitanides (chapters 14 1nd 16)
126
project success are the following:
Timing Location Project Design
Timing is a very important determinant of office project success because the office market is characterized by wide fluctuations in both (marginal) demand and supply and, as such, it is highly cyclical. The high cyclicality of the office space market is evident in Figure 14.1, which portrays the time path of the national vacancy rate over the period 1960-199930. 73
As the figure shows, during the 1970s the national office vacancy rate increased from 4% to almost 15% and then returned back to 4% by the end of the decade. During the 1980s, the office vacancy rate climbed to new highs, and by the end of the decade, it was hovering around 17%. The economic recession of the early 1990’s not only pushed it even higher up to 19%, but also triggered the collapse of property values. As a result, a dramatic decrease in the construction of new office space helped the national vacancy rate to gradually decrease below 10% by 1999. Figure 14.1 The Office Vacancy Cycle 2 0 1 5 1 0 5 0 997
993
990
986
982
978
975
971
967
963 1.1 960
Source: CB Richard Ellis/Torto Wheaton Research
Wheaton (1987) showed that the office market is characterized by prolonged endogenous 30
The vacancy rate portrayed in this figure represents the weighted average of 31 office markets covered by Torto Wheaton Research.
127
cycles with long periodicity (6-10 years) and great amplitude (see Figure 14.2 for the definition of periodicity and amplitude). These cycles are generated by the synergy of the following demand, supply, and rent adjustment factors underscoring the inefficiency of the commercial office market: • Repeated and unexpected office demand shocks triggered by changes in the national and local economies • Sluggish demand, vacancy, and rent adjustments due to informational lags and inefficiencies, high adjustment costs, and long-term lease structures • Sluggish supply adjustments, due to informational inefficiencies, investmentdecision lags, and inherently-long construction lags • Highly price elastic new supply, due in part, to myopic expectations on the part of real estate investors (which reinforce and amplify the effect of exogenous shocks), and the lumpiness of investments in new office structures31. • Asymmetric stock adjustments in response to favorable vs. unfavorable exogenous demand shocks, in the sense that there is a ceiling to rent and price increases in response to positive demand shocks due to competition and supply responses, but downward rent movements are not constrained32.
31 There is evidence that in the recent years the majority of office construction is directed towards the suburbs and as a result the average office investment is becoming less lumpy. 32
This conclusion is based primarily on office supply behavior during the 1980s. There is indirect
evidence that, after the collapse of the real estate market in the early 1990s, investors and capital providers have been approaching real estate, and specifically office development projects, with greater caution compared to the 1980s (Sivitanidou and Sivitanides, 2000). If this is in fact the case, office consctruction may be becoming less price elastic. In addition, there is discussion in the industry of the increasing role public markets may be playing in the real estate market and their potential contribution in reducing its volatility through their forward
128
Location is the second important factor for office project success because of the role productive amenities valued by office tenants, and worker (non-productive) amenities valued by their employees, play in determining firm costs (labor costs, rent, etc.). Since such amenities may not be uniformly distributed within a metropolitan area, location selection can help office firms minimize such costs. In addition, because of linkages among office activities, intra metropolitan location selection may also play a role in affecting office firm costs and revenues. Project design is thought to be less important than timing and location, but still the choice of the appropriate development density can be very crucial in maximizing residual land values. OFFICE MARKET FUNDAMENTALS OFFICE SPACE DEMAND AND PROSPECTS
Office space is a required production input by firms within several SIC -code classifications, justifiably referred to as office-using sectors. The amount of space per worker required by a firm depends on the nature of its operations and expected growth. Furthermore, a firm’s realized demand for office space in the marketplace should be conditioned by prevailing lease rates. Therefore, market demand for office space is determined primarily by four major factors: 1) office employment 2) space-per-employee requirements 3) rental rates 4) expectations Sivitanidou (2002) has provided indirect evidence of the effect of three of these four factors on office space demand in a panel study of office rent differentials across the nation’s major office markets. In particular, this analyst has demonstrated that office employment levels, office employment growth rates --most likely capturing growth expectations-- and the ratio of FIRE to total office employment --reflecting the higher space-per-employee requirements in this sector-- have positive and statistically significant influences on metropolitan office rent levels. Such effects are consistent with the expected influence of these factors on the demand for office space. It should be noted that Sivitanidou (2002) provides also indirect evidence of differences in office space demand levels across markets attributable to some additional factors affecting tenant search processes. These additional factors include the diversity of the local office tenant base, and the spatial/nodal distribution of the local office space stock. In theory, such local market attributes affect absorption through their effect on the matching probability between tenants and landlords and on search costs. Given that such attributes change slowly 129
through time, these factors are more relevant in understanding differences in office demand levels across markets, as opposed to changes in office demand through time within the same market. Within this context, accurate assessment and forecasting of office space demand prospects in any market requires an understanding of how the basic forces that drive its movements through time are likely to unfold over the project’s planning horizon. Office-Using Sectors Studies by Torto Wheaton Research suggest that the two major office-using sectors of the economy are Finance, Insurance, and Real Estate (FIRE), and Services (including primarily Professional Services, Business Services and Government). Estimates show that 100% of FIRE workers and about 36% of Service workers are office space users and that these two sectors account for about 80% of total office employment, with the remaining 20% accounted for by the industrial sector (Wheaton, 1987). According to DiPasquale and Wheaton (1996), the Service subsectors that can be considered as office-using include Advertising, Computer and Data Processing, Credit Reporting, Mailing and Reproduction, Legal and Social Services, Membership Organizations, and Engineering and Management Services. Carn et al. (1988) present a different analysis that points to a somewhat lower contribution of FIRE and Services to total office employment. In particular, these authors distinguish between office-using and non-office-using occupations using 1980 Census data on the occupational composition of the different sectors. Their analysis concludes that 67% of employees in the FIRE sector and 28% of employees in the Service sector are office space users. Their analysis suggests also that some non-negligible shares of employees in the other one-digit SIC sectors ranging between 16% and 38% may also be users of office space. On Net Absorption and its Determinants Absorption of office space at the margin, or net absorption, should depend heavily on the extent of increases in office employment, as well as the other three major factors driving the demand for office space, that is, space per employee requirements, office rents, and growth expectations. Each of these factors is discussed below.
Office Employment Growth The national office market has seen phenomenal office employment growth rates (5%6% annually) in the late seventies and early eighties, which are unlikely to be repeated in the foreseeable future. Looking ahead, office employment growth rates are expected to be lower ranging between 2 and 3% for the following reasons: 130
• LFP rates are expected to be lower since the entry of baby boomers in the labor force has been completed and LFP rates by women have slowed down •
Immigration is expected to slow down as well
• The use of technology by office firms is expected to intensify, leading, perhaps, to a lower usage of the labor factor
Space-per-Worker Requirements Space requirements per office worker vary by industry. For example, it is often argued that such requirements are higher in the prestigious FIRE sector as opposed to Services. Sivitanidou (2002) provides indirect evidence that is consistent with the premise that higher shares of FIRE workers in total office employment are associated with higher office space demand33. Carn et al. (1988) suggest that space-per-worker requirements vary also by occupation, with managers and professionals occupying more square feet, and clerks and secretaries less. Therefore, it is only appropriate to assume that average square feet requirements across metropolitan markets must vary given differences in sectoral employment composition and occupational structure.
As Figure 14.3 indicates, space requirements per office worker followed basically an upward trend in the 1980s, but turned downwards in 1992 and kept declining until the end of the decade34. If this trend continues, it will contain demand for office space in the coming years. Does the downward trend that prevailed during most of the 1990s represent a secular trend, or will the market return to the tendencies of the 1980s, when occupied space per employee kept increasing? There are two potential interpretations35: ♦
A Secular Trend?
The steady decline of square feet per employee may reflect the effect of several secular trends. These may include increasing sensitivity of office firms to cost considerations because of an increasingly competitive global environment; higher productivity due to technological improvements that may be reducing space per worker requirements; and increasing telecommuting arrangements between office firms and their employees. If there is 33
Sivitanidou (2002) in an analysis of office rent differentials across the nation’s largest office markets finds that for given office employment levels the ratio of FIRE employees to total office employment has a positive and statistically significant effect. One obvious rationalization of such influence is the higher space-per-worker requirements in the FIRE sector and its positive effect on office space demand. See the paper for alternative explanations of this effect. 34 The office employment figure used for this calculation was derived by adding up total employment in FIRE and selected 3-digit SIC service sectors. 35
Due to the lack of sufficiently long historical series DiPasquale and Wheaton (1996) used lagged values of office vacancy as a substitute for rental rate levels in the absorption equation.
131
indeed a secular trend of declining square feet per employee, office demand in the coming years will not be helped. Of course, it must be noted that square feet per employee can not decrease below the level required to accommodate a minimum acceptable level of space functionality. ♦
A Temporary Trend?
A second interpretation of the decreasing office space requirements per employee in the 1990s is that it reflects only a temporary trend, brought about (at least in part) by rising real office rents during that period. DiPasquale and Wheaton (1996) have presented indirect evidence suggesting that, for given office employment levels, office space absorption, and 80
therefore, square feet per employee, vary inversely with rental rates. If this is the case then the average square feet per employee may begin rising again if real rents start declining. Figure 14.3 Office Market Trends: Square Feet/Employee
Office Space Rents As the fundamental law of demand postulates, all else being equal, increasing office rents should exert downward pressure on office space absorption, while decreasing rates are expected to influence positively office space demand. The potential influence of rental rates on space-per-employee requirements is very important because it has significant analytical implications that cast doubts on the accuracy of a very commonly used technique for forecasting office space demand (see discussion in the next chapter). 132
Expectations We can distinguish two types of expectations that may influence demand for office space at any given period: rent growth expectations and employment growth expectations. • Rent growth expectations may have a positive effect on net absorption, since firms may be motivated to lease space at the present than wait later, in anticipation of rent increases in the future. Such expectations are very likely to prevail within a tight market environment where rental rates have already started rising. • Office employment growth expectations can also have a positive effect on office space absorption, as firms are likely to lease more space than they currently need in anticipation of their expanding workforce. Since relatively slow employment growth is expected in the future, growth expectations may not have a significant effect on net absorption of office space. THE SUPPLY OF OFFICE SPACE
Since office projects take usually about two years to complete from the time of inception and one to two years for lease-up, office market studies aiming at guiding investment and development decisions need to have a three- to four-year planning horizon at minimum. Simple counts of projects permitted and under construction can provide little clues, if any, about the levels of available supply three to four years ahead of the time of analysis. For this reason, it is very important to examine past trends and evaluate future prospects in the factors that drive office construction investments at the macro analysis level. Since profitability is the prime motivation of office development, these factors include the determinants of the income-earning capacity of an office property, the perceived risk of expected income flows, and development costs. Income-Related Factors Factors pertaining to an office building’s income-earning prospects that may influence construction investment include the following: • Rents Increasing rents are likely to boost development only to the extent they rise (or are expected to rise) to or above the levels that would justify new construction. In particular, office rental rates must rise to a level for which the implied asset price would be greater than development costs in order to trigger new construction36. The experience of the 36 The reader is reminded that property value or asset price and rental rates are linked through the income capitalization formula, which postulates that value is the ratio of the property’s NOI over the market cap rat
133
1980s has shown the supply of office space to be highly price/rent elastic, but the experience of the 1990s points to a more disciplined behavior. • Vacancy Rates As indicated earlier, office vacancy rates fluctuate considerably through time, thereby inducing significant fluctuations in a property’s rental income. During periods with sufficiently low vacancy rates and, therefore, higher property income, investors may be motivated to provide capital for new office development projects. In this sense, markets with lower vacancy rates maybe facing prospects for higher levels of new office space additions in the future. • Expectations Myopic supplier expectations for improving market conditions due to improving demand indicators, such as office employment growth and declining vacancy rates, may also contribute to greater office construction levels. Office space completions are thought to largely be driven by such expectations. • Market Volatility and Risk Higher employment volatility in office-using sectors, such as, FIRE and Services, may discourage new construction investments, as it may signal a greater demand uncertainty and development risk and, as such, raise the level above which rents must rise to justify new construction. Historical data reveal that FIRE employment is much more volatile than employment in Services. A recent study by Sivitanidou and Sivitanides (2000) provides evidence of the effect of all these factors on office space additions. In particular, their analysis shows that real office rents, vacancy rates, office employment growth expectations, and FIRE employment growth volatility have a statistically significant effect on metrowide office construction. Cost-Related Factors and Availability of Capital • Cost Factors Keeping constant office-property prices, higher development costs, including the cost of financial capital (interest rates), construction costs (cost of labor and materials) and land costs, reduce investment profitability and discourage office construction. Sivitanidou and Sivitanides (2000) show that construction costs and interest rates do indeed have a negative and statistically significant effect on metrowide office completions. Kling and McCue (1987) provide also evidence of the effect of interest rates on office building investments. • Availability of Capital The availability of investment capital for new office construction projects may be influenced by government policies, the public equity market, the private equity market and the private lending industry. For example, Clapp (1993) notes that some observers have attributed the excessive overbuilding of office space in the 1980s to the abundance of capital, as lenders, facilitated by the reduced regulations put in place in the early 1980s, appeared overly zealous to provide real estate loans. In the private equity market, the focus of institutional investors on office buildings at the expense of other
134
property types may have also contributed to the office construction boom of the 1980s. In the public equity arena, publicly traded real estate management companies (REITS) help channel investment capital (a share of which may be diverted to new development projects) into real estate markets by allowing small investors to participate in real estate investments. After the office market crash of the early 1990s, institutional lenders have adopted stricter lending practices (e.g. increased preleasing requirements among others), which may have reduced the availability of capital for office construction during the 1990s. OVERVIEW OF OFFICE MARKET ANALYSIS Against this background, the purpose of office market analysis is to help pro-active (as opposed to re-active) office investment decisions and development design by looking at and evaluating the forces that determine movements in the broader office market, as well as the more specific location and site factors that may influence project success. As is the case for the other property types, we can distinguish two major components in office market studies: the macroeconomic component and the microeconomic component (see Figure 14.4).
Given the high volatility of office markets, the macroeconomic component of office market studies is especially important. Its three major objectives are to: ♦ ♦ ♦
Analyze and evaluate broader office market strength Identify the target market’s position on the rent, vacancy, and construction cycle Address questions of timing
Analyzing office market strength at the time of analysis and its position on the real estate cycle will help the analyst better anticipate the market’s potential movements over the project’s expected holding period. Identifying a market’s position on the cycle requires an assessment of the extent of disequilibrium, or the degree of mismatching between the demand for and the supply of office space. This is not an easy task because of the extreme volatility of the office space market. It is, however, a very critical step given that the fortunes of individual actors/projects within a metropolitan office market are driven to a great extent by this idiosyncratic cycle. Within this context, the macroeconomic component of office market analysis can help address prudently the question of whether it is appropriate to enter a given market at a particular point in time. Evaluating office market strength and prospects requires the analysis of office space demand at the margin (net absorption) and its determinants, existing inventory, completions and its determinants, office space rents, and supply-demand imbalances. The interplay of office space demand and supply gives rise to two summary measures of the state of the market-- rental change and supply-demand gap, which, in theory, must be consistent in terms of their implications regarding market strength.
135
136
As in the case of the other property types, the analyst can use either accounting or econometric techniques for analyzing office markets at the macro level. Accounting methodologies can help the analyst develop rather simplistic estimates of future demand, supply, and the demand-supply gap. There are, however, several issues in using these techniques, especially for longer forecast periods. Econometric techniques can help explore the underlying behavioral relationships and feedback effects among the key variables that drive the market for office space and then use them as basis for more accurately forecasting its future movements. The microeconomic component of office market studies focuses on the competitive strength and most likely performance of the proposed project. Its focus is the evaluation of office locations, the identification of the most marketable office development features for a given site, and the assessment of project viability from the office market perspective. In particular, analysis of office locations focuses on: • The site’s locational amenities and advantages, including productive amenities, that is, amenities that can increase office-firm productivity, such as proximity to other firms, freeway access, access to CBD, etc., and worker amenities, that is, amenities that are valued by the employees of office firms, such as the quality of the public school system, crime rates, access to shopping and entertainment opportunities, etc. (Sivitanidou 1994 and 1996) •
Visibility of the site and prestige of the location within the urban fabric
• Locational constraints in terms of growth regulations, local zoning and other institutional controls that may hamper commercial real estate development Analysis of office project viability from the market perspective focuses on: • Estimation of achievable office rents through competitive differential techniques or hedonic methodologies that account for lease characteristics, space characteristics, project amenities, and location attributes •
Estimation of the project’s expected absorption and revenue schedules
In the next two chapters, we elaborate first on the macroeconomic aspects of office market studies (Chapter 15) and then focus on the microeconomic analysis of office development projects (Chapter 16). CHAPTER SUMMARY The purpose of office market analysis is to look at and evaluate those factors that determine office project success. These factors include timing, location, and project design and are inherently linked to the nature and dynamics of the forces that drive the demand for and supply of office space. 137
Office space demand is primarily driven by employment growth in the FIRE and the Service sectors. Such growth is not expected to reach the highs of the 1980s in the coming years for a number of reasons. Empirical studies have shown that, for given office employment levels, office space demand responds to movements in rental rates and officeusing-firm expectations for employment growth. This suggests that estimates of office space demand by simple multiplication of expected office employment growth by a space -perworker norm may lead to serious inaccuracies, as they ignore the potential effect of movements in such factors. A trend of declining square feet per office employee has been observed in the 1990s, in contrast to the 1980s when such ratio was rising. Although these patterns seem to be connected with declining real rents in the 1980s and increasing real rents in the 1990s, other more permanent influences may be at work. Trends in this ratio will be crucial in determining office space demand in the future. The supply of office space is driven by factors influencing office-property income and development costs. As such, new office construction is driven by office rent levels, vacancy rates, expectations regarding office market strength, market volatility/risk, construction costs, the cost and availability of capital, and land costs. The experience of the 1980s has shown the supply of office space to be highly price elastic, but the experience of the 1990s points to a more disciplined behavior. Within this context, the purpose of the macroeconomic analysis of office markets is to evaluate their strength, assess their position on the rent-vacancy cycle, and make prudent forecasts with respect to their future movements. The analyst needs to focus on such crucial market indicators as existing office space inventory, vacancy rates, lease rates, net absorption, and new construction. The microeconomic component of office market analysis focuses on the evaluation of project location, identification of the most attractive office development features, and the assessment of project performance in terms of lease rates and absorption schedule. MICRO ANALYSIS OF OFFICE MARKETS Once the macroeconomic analysis of the office market under consideration is completed and a preliminary development scenario is formed, microeconomic analysis needs to be conducted to help refine the design of the proposed office project, assess its competitive position, and evaluate its revenue-generating ability. As it is the case for other property types, the major components of microeconomic analysis of office markets includes: 1) site and location analysis, and 2) project marketability analysis. The underlying premise of office location analysis is that location is a major determinant of an office project’s desirability and income-generating ability and, therefore, of its success. Matching the location and space needs of potential office tenants to site and project characteristics always enhances an office project’s competitive strength. Marketability analysis is necessary in order to assess the project’s expected rental revenue stream and absorption schedule. 138
BOX 16.1 WHAT LOCATION ATTRIBUTES MAY MATTER? ANALYZING OFFICE LOCATIONS
In analyzing office locations, it is important to bear in mind that the strength and nature of location influences exerted by site-specific factors may vary across the different types of office firms. Although, in general, office firms are not thought to be highly heterogeneous in terms of their space and location requirements, they may be differentiated in terms of: •
General type--general purpose office firms vs. medical offices or law offices
•
Type of operations performed-- front or back office functions
•
Type of labor used—executive vs. clerical etc.
•
Firm size
Below we briefly discuss the factors that are relevant in office location analysis and indicate whether some types of firms may have stronger or weaker preferences for certain location attributes. These factors are presented in Box 16.1 and include both location amenities and location constraints. Location amenities include productive amenities, worker/non-productive amenities, prestige, and visibility, while location constraints refer primarily to institutional constraints on commercial development. Productive or firm amenities refer to locational attributes the can help a firm increase its productivity and/or reduce its costs. Such locational attributes include close-by access to basic business support services, broader access to business services agglomerations, access to white-collar labor, access to airports and freeways, and jurisdictional property tax rates. Close-by access to basic business support activities, such as banking, restaurants, and shopping, provides for a more conducive working environment that can reduce the time cost of reaching basic services typically sought by employees during working hours.
139
Location Amenities Office Firm/Production Amenities (all contribute toward lower business costs) Close-by access to basic business support activities Close-by access to facilities that can provide basic services typically sought by employees during working hours, such as banking, restaurants, and shopping can help reduce the time costs of accommodating such needs Access to business service agglomerations Traditionally thought to reduce the cost of interpersonal contacts and, possibly, labor search costs, but the effect of this factor is weakening due to advances in information/telecommunication technologies Access to white-collar labor Thought to contribute toward lower labor costs; central locations may be sought if specialized labor is dispersed, while suburban locations may be sought if labor skills are clustered Airport and freeway access Facilitates business trips; airport access becomes increasingly important Property tax rates Property tax rates matter only when the spatial demand for office sites is inelastic because they are passed on to office lease rates Office Worker/Residential Amenities (contribute toward lower labor costs) Access to amenable residential communities with: High quality educational system Low crime rates High levels of public services for given levels of property taxes Access to shopping, recreational amenities (entertainment, ocean) 140
Prestige and Visibility Location Constraints (increase business rents, if binding) Development constraints: zoning and density controls, growth moratoria Broader access to business services agglomerations matters because it may reduce the cost of interpersonal contacts and, possibly, labor search costs. The more specialized the office-using activity is the greater the need for central control functions and access to business services agglomerations. Such location attribute appears to have little relevance for back office functions. Empirical evidence shows that the importance of access to business service centers may have been weakening, potentially due to advances in information and telecommunications technologies (Sivitanidou, 1997). Some more specialized firms, such as law or medical companies, tend to cluster around certain facilities that are highly associated with their business activities, such as, courthouses and hospitals, respectively. Access to white-collar labor can help office firms decrease labor costs, as it may reduce their search costs and motivate workers living close by to accept lower wages in exchange of the lower commuting costs they will enjoy. Central locations, such as downtown, may be sought if labor skills are dispersed within the urban area or if the firm is using a large and highly heterogeneous labor force. Suburban locations may be sought if labor skills are clustered. Airport and freeway access is sought by office firms since it facilitates business trips. Airport access is becoming increasingly important, especially for corporate divisions, due to the need for more frequent business trips. Sivitanidou (1996) presents evidence that strongly supports the proposition that proximity to airports matters in office location decisions. Proximity to freeways and freeway junctions may be also valued by firms as it provides access to other firms, labor, and potential customers over a larger geographic area. Property tax rates matter only when spatial demand for office sites is inelastic. All else equal, higher property tax rates should discourage development, thereby inducing an upward shift in the office property supply curve. Such an upward shift will result in significantly higher rents only if office space demand is inelastic, in which case the property tax rate differentials will most likely be passed on to the office tenant. In this sense, jurisdictional property tax rate differentials may affect firm production costs through their potential effect on rental rates. Worker/residential amenities, such as, access to amenable residential areas and communities with high quality education, low crime rates, high quality of public services for a given level of taxes, and convenient access to shopping and recreational destinations, matter in office location analysis because they may indirectly help reduce a firm’s cost. In particular, good access to amenable residential areas can facilitate recruitment of skilled labor and, thereby, reduce labor search costs. Furthermore, there is considerable empirical evidence by skill that happier workers are willing to accept lower wages. Such residential amenities become more important the higher the proportion of a firm’s managerial labor.
141
Prestige and visibility are also important from the demand side, especially for high profile firms and company headquarters. Usually, downtown locations or prestigious suburban nodes are the preferred locations for these types of firms. Location constraints refer to institutional constraints imposed by local governments on commercial development, such as zoning, density controls, and growth moratoria. If such constraints are binding, that is, if they restrict the supply of office space to levels below the ones dictated by market demand, they can lead to supply shortages and, thereby, to higher office space rents. Understanding the degree to which the project’s node or submarket is constrained can provide useful insights as to whether the site’s locational advantages are fully capitalized into office rent differentials compared to office buildings located in other competing nodes. We elaborate on this issue in the next section. But, Do Office Rents Fully Reflect Location Amenity Differentials? The location component of office rents is the result of the interplay between location amenities and location constraints. An issue that is at the heart of office location analysis is the extent to which office rents capitalize location-amenity differentials within contemporary metropolitan office markets (see Box 16.2). This issue is very important because the conventional view is that amenity differentials across office locations are fully capitalized on office rents. This view is the underlying premise of the competitive differentials technique often used to derive achievable rents for a new office building at a given location. Theoretical analysis presented by Sivitanidou and Wheaton (1992) suggests that location-amenity differentials may be fully reflected in office rent differentials only if the land market is constrained. In unconstrained markets, most of the location-amenity differentials should be reflected in wages. To understand the argument of rent and wage capitalization consider for the sake of simplicity a city with two business centers or office submarkets, that are the same in terms of size, office space rents, and worker wages. Now let’s introduce an exogenous (not related to rents or wages) productive advantage in Center 1 of, lets say, $1000 per worker per year. This simply means that it is cheaper to do business at Center 1 by that amount. As the city grows, new firms will seek space in Center 1, because of its productive advantages. As a result, Center 1 will grow bigger in terms of both employment and commercial floor space. As Center 1 grows in size the average commuting cost of its workers increases too necessitating higher wages. Center 1 will continue to expand until its wages and rents increase enough to erode its productive advantage. Thus, at the new equilibrium, the rent and wage differentials between Center 1 and Center 2 should be such that they compensate for the exogenous production cost advantage of $1,000 per worker, as in (16.1): a (R1 –R2) + (W1 –W2) = $1,000/worker ; R1>R2 and W1>W2
(16.1)
142
where a : square feet per worker R1, R2 : office space rent per square foot in Center 1 and Center 2, respectively W1, W2 : wage per worker in Center 1 and Center 2, respectively The question that arises is what percent of the production cost differential will be reflected in higher rents and what percent in higher wages. Should the analyst care? The answer is yes, because if rents do not fully or nearly fully capitalize production cost differences, the competitive differential technique may not be appropriate for estimating the rent of the subject property when comparables from different submarkets are included in the analysis. Notice, however, that the validity of this technique is questioned only as far as locational amenities are concerned37,38.
37 See Brennan, T., R. Cannaday, and P. Colwell. 1984. Office Rent in the Chicago CBD. AREUEA Journal 12 : 243-260; Sivitanidou, R. and W. Wheaton. 1992. Wage and Rent Capitalization in the Commercial Real Estate Market. Journal of Urban Economics 31: 206-229; Sivitanidou, R. 1996. Do Office Firms Value Access to Service Employment Centers? A Hedonic Value Analysis within Polycentric Los Angeles. Journal of Urban Economics 40: 1-27. 38
As the reader must know by now application of the competitive differential technique involves and a host of other attributes, such as structure and project quality and amenities.
143
As Equation (16.1) suggests, only if the wage differential between the two employment nodes is zero (W1 –W2=0) rent differentials would fully capitalize the $1000/worker productivity advantage of Center 1. Theoretical analysis shows that the more constrained (regulated) a market is the greater the percentage of the productive advantage that is capitalized on rents as opposed to wages. The reason is that the more Center 1 is constrained to expand due to development controls, the smaller its wage differential from Center 2. On the contrary, if the market is not regulated in a way that restrains office space supply and the growth of Center 1, office rent differentials between the two centers will be very small and most of the productive advantage will be capitalized on wages [for a more elaborate presentation of this analysis see Sivitanidou and Wheaton (1992)]. These findings have not yet been established empirically, but if valid, they do have some important practical implications regarding the use of the competitive differential technique for the estimation of the rent of a planned office project. More specifically, the findings suggest that such applications may be seriously inaccurate when the area’s land market is not constrained and the sample of competing properties includes office buildings located in different submarkets/nodes with considerably different location attributes. In such a case, the analyst needs to examine carefully whether variations in specific location attributes translate consistently to proportionate variations in lease rates across properties. This is a very difficult task given the multitude of attributes that may differ across comparables and underscores the need for hedonic regression techniques in assessing the true effect, if any, of location-amenity differentials on office space rents.
In the case of highly regulated land markets, where office space supply is constrained, the competitive differential technique may better measure relative office rent and price differentials across competing locations, although hedonic techniques would still more accurately capture the effect of the different location attributes on rents and prices.
ANALYZING OFFICE PROJECTS: ESTIMATING ACHIEVABLE RENTS AND ABSORPTION SHCEDULES Once the location-analysis phase is completed and the development scenario has been refined to match the space needs of the tenants most likely to be attracted at a given site, the analyst needs to proceed with the evaluation of the competition. This analysis will help assess the prospects for further enhancing the project’s competitive strength and derive the bottom-line figures required for assessing its economic feasibility. These figures include: • Office rent schedule 144
• Absorption schedule, and • Revenue schedule Assessment of the project’s achievable rental rates requires analysis of the competition and quantification of how the different office structure and location attributes translate into rental rate differentials within the local marketplace. Such an assessment will help the analyst not only estimate the most likely achievable rent for the planned office structure at the specific location, but also evaluate whether modifying certain structure or project attributes will help maximize achievable rates. Furthermore, the estimation of achievable rates can help determine the optimal office development density for the specific site considered. It is important to emphasize that when analyzing office rents the unit of analysis is not the structure per se, but lease transactions. Thus, for representative samples of lease transactions, the data that need to be collected include not only the attributes of the space, building, and location associated with the lease contracts, but also a whole array of lease characteristics that may have an effect on the effective rent paid by the tenant. Assessment of the project’s absorption schedule, in combination with the estimates of achievable rental rates, can help estimate the property’s expected revenue schedule, and therefore, its feasibility from the market perspective. Furthermore, evaluation of the project’s absorption schedule under alternative entry scenarios can help make prudent decisions regarding the most appropriate/profitable time of market entry, as well as project phasing for projects involving more than one building. In estimating the expected revenue for a planned office development, the analyst needs to make sure that a reasonable lease expiration and rollover schedule, as well as rent escalation provisions, are assumed and properly accounted in the calculation. Special caution needs to be exercised when assessing the absorption schedule for space expected to be vacated by expiring leases in the future. Given the above discussion, the estimation of an office project’s most likely rental rate and absorption schedule involves the following broader steps: 1) Data collection •
Identification of comparable properties
• Collection of information on lease transactions, lease characteristics, and other attributes associated with the comparable properties 2) Data analysis • Application of simple accounting techniques, and specifically the competitive differential technique, or •
Econometric techniques, and specifically, hedonic methodologies 145
These steps are discussed in detail in the following sections. 1.
COLLECTION OF DATA FOR COMPETING OFFICE PROPERTIES
Identify Comparable Office Properties The first step in the collection of data for competitive analysis is the identification of comparable office properties through brokerage firms, multiple listing services, and/or windshield surveys. The focus of the data collection effort is somewhat different depending on whether the competitive differential or the econometric technique is used: • When applying the competitive differential technique the analysis typically focuses on comparable office properties (existing, under construction and planned) within the submarket the subject property is located in the case of larger markets. Less detailed surveys of other competing office space clusters in the metropolitan office market are also typical in evaluating the competition. • When applying hedonic analysis techniques it is not necessary to restrict the sample of office properties only within the submarket of the subject site; actually, it is preferable that the sample includes properties with significant differences in location and structure attributes. Thus, the sample may be expanded to include properties that may not be strictly competitive with the project under consideration. The analyst may be better off by applying both techniques, if time, budget, and data availability allow it. Although the econometric technique is likely to produce more accurate estimates of the project’s achievable rental rate, estimates using the competitive differential technique can provide an alternative estimate, against which the analyst can evaluate the reasonableness of the result of the former methodology. Collect Information on the Identified Comparables Once the comparable office properties and their locations have been identified, the analyst needs to compile information on lease rates, lease characteristics, property, and location attributes from local rental agents, brokers, and appraisers, and/or through field surveys. Box 16.3 presents a (not necessarily exhaustive) list of the data that should be collected. Some comments are warranted here regarding the relevance of the factors listed. Lease Rates and Lease Characteristics Lease rates are expressed in dollars per square foot per year. In trying to understand the supply-demand dynamics of office markets and how they affect market rates, the important rent measure is the “effective” rent, which is different from the asking rent and the contract or quoted rent. The effective rent is the actual rent paid by the tenant after taking into account concessions, such as free rent, excessive tenant improvement allowances, expense caps and free parking, stipulated by the lease agreement. In general, the larger the lease the more difficult is to determine the actual 146
effective rent paid by the tenant (see Peiser and Schwanke, 1992). Thus, it is important that the analyst collects information not only on base-year lease rates, but also on an array of lease characteristics discussed below. The date of lease transaction is needed in order to control for the effect of market conditions on lease rates at the time the lease was signed The base year or contract lease rate is the basic information, which, in combination with information on other lease terms, can help develop a measure of the overall effective rent implied by the lease agreement The type of lease rate is very important in developing a consistent measure of effective market rent across lease transactions since it clarifies whether the quoted contract rate is net of taxes (N), net of taxes and utilities (NN), or net of taxes, utilities, and operating expenses (NNN). The length of the lease may influence contract rates through several avenues. For example, if expectations for improving market conditions are prevalent at the time the transaction takes place, then longer leases may be associated with higher contract rates. Independently of expectations about future market conditions, however, a longer lease reduces the risk or volatility of the landlord’s cash flows. As a result, the landlord may be willing to accept lower rates for longer-term commitments by prospective tenants, especially given the high turnover costs (tenant improvements) typically associated with new tenants in office buildings. On the other hand, by accepting a long-term lease, the landlord is forgoing the ability to take advantage of potential market rent increases above those stipulated by any CPI escalation clauses included in the contract. Thus, the strength of the market at the time the lease is signed may be the deterministic factor of the relationship (positive or negative) between the length of the lease the contract rate. Data presented by DiPasquale and Wheaton (1996) suggest an average length lease of 5 years with 3-year and 10-year leases having also relatively high frequencies.
147
148
The size of the lease, or in other terms, the amount of square footage committed in the lease transaction, may be negatively associated with office rents, as landlords may be willing to offer volume discounts when leasing larger blocks of space. Rent escalation clauses provide for a formula for adjusting rents on the basis of widely used economic indicators, usually the CPI; in soft markets, rent escalation is less steep in that rents are allowed to adjust every two years or in the middle of the lease term. In the presence of escalation clauses, contract rates should be lower compared to leases with no escalation clauses. Stop clauses represent a ceiling amount for operating expenses (the dollar stop), usually determined on the basis of estimated expenses during the first year of the lease. Any expenses above that amount are paid by the tenant. Therefore, the stop amount should be positively associated with the base lease rate, since the higher the amount the higher the burden on the landlord. Concessions, including primarily free rent, constitute another important piece of information in developing an accurate and consistent measure of effective market rent through time. It appears that when the market is soft, landlords prefer to provide rent concessions and maintain a higher contract rate rather than directly lower the contract rates. As a result, concessions are more prevalent during periods of excess supply and high vacancy rates. Tenant improvements, representing tenant finish allowances for the interior space (including, ceilings, walls, flooring, and telephone and electrical outlets), and commonly referred to as TIs, are in substance an additional form of concessions. Landlords always provide some form of tenant improvement allowances, but it has been observed that during periods of serious excess supply such allowances are considerably higher and are presumably provided as an additional incentive to lure tenants. Again, information on tenant improvements can help further refine the effective rent calculation across leases and through time. Space Attributes The second set of factors that needs to be examined when analyzing lease rates in comparable office buildings includes the characteristics of the specific space the lease contract refers to. Space attributes, such as the floor on which the leased space is located or its position within the structure (corner offices) may also contribute to variations in lease rates. Structure Attributes The attributes of the structure within which the space is located, such as construction quality, quality of the lobbies and elevators, structure amenities (restaurants, shops, gyms, etc.), parking availability, easiness of access to the building, etc., represent another important set of factors that need to be taken into account when examining differences in lease rates across comparable properties. 149
Location Attributes The final set of data that needs to be collected includes the location attributes associated with the comparable properties for which lease transaction data are available. These have been discussed in detail in the previous section. 2. DATA ANALYSIS
Once the information has been collected and systematically tabulated the analyst can apply the competitive differential technique or hedonic methodologies in order to evaluate the income-earning ability of the project and assess the possibilities for enhancing its competitive position. In particular, application of these techniques will help the analyst to: • Quantify the competitive strength of the project by estimating its Competitive Position Index (CPI) • Identify the sets of attributes that contribute the most to project value, thereby setting the stage for refining project design and maximizing effective lease rates • stimate achievable lease rates given project and location attributes Using the Competitive Differential Technique to Assess Project Strength and Achievable Rental Rates The premise of the competitive differential technique, as it applies to the office market, is that differences in office lease rates across competing office properties reflect differences in lease characteristics, structure/project attributes and location amenities. In order to review the application of this technique in the office market we will use Clapp’s (1987) example of the competitive spreadsheet. In reviewing this example, we will elaborate on how it can be used to estimate project rent and absorption rate. For the sake of simplicity, Table 16.1 presents an abbreviated version of this spreadsheet that includes information only for the subject and two other comparable properties. Notice that a base rent figure for the subject property is included only for illustration purposes. When dealing with a new project the base rent typically is not known and this analysis is used as a means for estimating it39. Thus, in the analysis steps described below it is assumed that the subject’s base rent is not known (for a more detailed discussion of the calculations involved in applying the competitive differential technique see Chapter 9). (1) Construct a competitive spreadsheet where the columns represent competing office properties and the rows important lease, structure, and location attributes that may influence a property’s lease rate 39 Market rent information for an office building that is still in the pipeline may be available only if some .
150
(2) Assign weights to each attribute based on its contribution to project value or rental rate, using experience and judgment; interviewing local brokers and firms occupying competitive space regarding the importance of each attribute can help more accurately determine these weights (3) Develop scores/indices for each of the attributes of the subject property and each of the competitive properties (4) Estimate total unweighted and/or weighted amenity indices for each of the comparable properties (5) Estimate adjusted unweighted (weighted) amenity indices, as a property’s total unweighted (weighted) amenity index minus the unweighted (weighted) rent score/index, respectively. For example, the adjusted weighted amenity index for comparable 1, AWAI1, is calculated as in (16.1), where WAI1 is the weighted amenity index for comparable 1:
151
Table 16.1 An Example of the Simple Competitive Differential Technique Structure of the Competitive Spreadsheet
LEASE/SALES PROVISIONS Base Rent
Weig hts
Subject
C1 ...
Cn
$14.00
$18.00
$12.0 0
4
50.00%
100.00 %
4
$1.00
$1.25
2
Escalation
75.00%
Stop Clause
$1.50
ACCESS Homes of Executives (min)
5
3
10
3
Homes of Clerical Labor (min)
8
11
6
3
Downtown Offices (min)
12
10
NEIGHBORHOOD AMENITIES
8
4
Same across properties
BUILDING/SITE CHARACTERISTICS Parking Spaces per 1,000 sq. ft.
3.33
2.86
Parking Cost per Space
$30.00
$25.00
Parking Spaces within 15 min.
450
800
2.5
4
$35.00
4
200
4
Development of Amenity Indices Subject
C1 ...
Cn
Weig hts
LEASE/SALES PROVISIONS Base Rent
100
150
4
Escalation
133
200
100
4
Stop Clause
150
100
125
2
Homes of Executives
200
333
100
3
Homes of Clerical Labor
138
100
183
3
Downtown Offices
100
120
150
4
ACCESS
NEIGHBORHOOD AMENITIES BUILDING/SITE CHARACTERISTICS 152
Parking Spaces
133
114
100
4
Parking Cost
117
140
100
4
Parking Spaces within 15 min
225
400
100
4
TOTAL UNWEIGHTED AMENITY INDEX
1,196
1,608
1,108
TOTAL WEIGHTED AMENITY INDEX
4,146
5,798
3,900
Subject Property Base Rent Estimate Subject
C1
Amenity Index
4,146
5,798
Less : Base rent
516
400
Equals: Adjusted Index
4,146
Cn 3,900 600
5,398
3,300
Subject Amenity Index/ 1.2561 Comparable's Index Rent Estimates
0.76806 $13.82
5 $15.07
(6) Estimate the base rent, RS, for the subject property relative to each comparable using the subject’s total amenity index, TAIS, and each comparable’s adjusted amenity index, AAIi, as follows:
Note that the subject property’s total amenity index (TAIS) does not need to be adjusted since the rent of a planned project is not known and, therefore, normally a score for this variable will not be available to the analyst to be added to the total amenity score. In case that the subject is an existing property, a rent figure will most likely be available. If the analyst wants to simply evaluate whether this rent figure is consistent with the property’s competitive position, then formula (16.3) provides a means for making such an evaluation. In such a case, the subject property’s total amenity index may need to be adjusted too, depending on whether the rent score was taken into account when it was calculated. 153
Continuing with the example presented in Table 16.1, we applied formula (16.3) using comparable 1’s rent as basis, the adjusted weighted amenity index for comparable 1, and the subject property’s weighted amenity index. Hence, RS was estimated as: RS = (4,146/5,398) $18 = 0.76806 $18 = $13.82 Obviously, using formula (16.3) the analyst can derive as many alternative base-rent estimates for the subject property as the comparables for which rent information is available. These rent estimates will, in all probability, be different. The analyst can use the average of these alternative estimates as the project’s base rent if a single-point estimate is sought. In computing this average, the analyst may want to use larger weights for rent estimates associated with properties considered to better proxy the subject’s performance. Critique The results of applications of the competitive differential technique for the estimation of achievable office project rents should be viewed with skepticism. First, the methodology assumes that differences in location attributes across office properties are fully reflected in their rent differentials. As pointed out earlier, theoretical analysis suggests that this assumption may not be valid if the land market is not constrained in a binding way. Second and most importantly, the technique entails serious difficulties with objectively and accurately assigning weights to the different lease, structure, and location attributes that affect office lease rates in a way that is consistent both across attributes and across properties. Moreover, the validity of the assigned weights cannot be confirmed without using econometric techniques. In sum, competitive differential techniques should be used with great caution in the estimation of an office property’s achievable rents, but can provide an alternative estimate that can be used to test the reasonableness of estimates derived through hedonic valuation techniques. Using Hedonic Methodologies to Estimate Achievable Office Lease Rates Hedonic valuation techniques should in theory provide more accurate estimates of the rent an office project will command given its structure and location attributes. Actually, application of hedonic methodologies using a sample of lease transactions can allow the analyst to estimate the rate that a particular amount of square footage on a particular floor of the building under consideration will command, if the size of lease and floor on which the space is located are included as independent variables in the estimated regression model. Since this technique has been reviewed rather extensively in Chapter 9, this discussion will focus only on: -
the set of critical variables that need to be incorporated in the case of hedonic 154
office rent formulations -
the usefulness of the technique in office project assessment
Variables in Hedonic Office-Rent Models In estimating hedonic office rent models, nonlinear functional forms should be used for the reasons discussed in the residential section. Such nonlinear hedonic lease rate models need to account for the whole range of attributes that may affect lease rates in a given office structure. As discussed in the competitive differential technique these include: lease terms space and structure attributes location attributes Lease Rate =f (Xlease terms, Xstructure traits, Xlocation traits)
(16.4)
Table 16.2, reprinted from Clapp (1987), although not complete, provides an example of how the data used for estimating hedonic office rent equations may look like. Potentially important variables omitted from Table 16.2 include the time each lease was signed (if the sample includes leases signed in different years), other productive amenities besides access, worker amenities, other lease terms, and institutional supply restrictions (if they vary across the locations with which the leases are associated with). One of the variables included in this table is the vacancy rate, but its inclusion in the hedonic rent formulation is highly questionable from an econometric point of view40.
The important difference of hedonic office models from the residential ones is the inclusion of lease terms, as well as some location attributes that may not be as relevant in residential rent analysis, such as access to other firms, access to labor, airports, and, especially, jurisdictional and other institutional supply constraints on commercial development at the different nodes. As indicated earlier, the latter may be very relevant in terms of correctly quantifying the capitalization of amenity differentials across office locations on office lease rates. If the lease transactions included in the sample are associated with properties located in different office nodes/submarkets within the metropolitan area, it is typical to add in the specification dummy variables indicating the node/submarket within which each property is located. Furthermore, if lease transactions for different time periods (quarters or years) are 40 The inclusion of the contemporaneous vacancy rate as an independent variable may be introducing a simultaneity bias, in that rents are not only affected by vacancy rates, but they also influence vacancy rates. For example, an office building may have lower vacancy because it offers lower rates.
155
available, it is customary to include dummy variables for each time period to capture influences on office lease rates from changes in overall market conditions. So for example, if available lease-transaction data involve properties that are dispersed within n submarkets and cover a time span of m periods, then (16.4) should be expanded to include n-1 submarket dummies and m-1 year dummies.
Usefulness Hedonic office-rent models can help directly or indirectly in developing estimates of the following: • achievable lease rates for the planned office space that can provide the basis for developing asking-rent strategies and project rental revenue forecasts • marginal values for several structure and project attributes that can provide the basis for selecting the rent-maximizing set of features and optimizing office project design • residual office land value estimates (RLV) using (16.5) and (16.6) below, where P denotes office property price and C non-land office development costs
RLV = (P-C) FAR
(16.5)
Following the simple income capitalization approach to value, the price P of the office property under consideration can be calculated as:
P = NOI/CAP RATE
(16.6)
NOI is the Net Operating Income of the property (which is a function of lease rates, lease rollover schedules, and operating expenses) and CAP RATE is the market capitalization rate.
156
157
• Optimal office project development density, that is, the density most likely to maximize residual land value (see Chapter 9 for an elaborate discussion of how the results of hedonic analysis can be used to calculate optimal development densities) Critique Contrary to the competitive differential technique, the impact (weight) of the various office project and location attributes, as well as lease characteristics, on office space rents is not assumed in the hedonic approach, but derived in an objective and reliable way through rigorous statistical analysis of real market data. The complex, multi- year, and multidimensional nature of non-residential lease contracts, in general, and office leases, in particular, makes the application of this technique even more necessary. Notice that hedonic valuation techniques allow for an objective estimation of the effect of location and structure attributes on office rental rates, while controlling for variations in a multitude of lease terms and vice versa. The major limitation of this technique is that it requires the collection of data on a considerably greater number of office comps and lease transactions than the one required for the simple competitive differential technique. The scarcity of systematic, comprehensive, and consistent data on actual office lease transactions renders the application of this approach more difficult. Developing Office-Project Absorption and Revenue Schedules Office project absorption depends on the macro conditions prevailing in the metropolitan area and submarket within which the property is located and its competitive strength (determined primarily by its relative structure and location amenity levels). Within this framework, project absorption analysis brings together the findings from the macro- and micro-analysis stages discussed so far. Office space absorption for a specific project can be calculated using the same general formula utilized in the case of residential project analysis and described by (16.7):
Project Capture = (NRAS / NRAM) * CPIS * ABM
(16.7)
where NRAS : the subject’s net rentable area (NRA) in square feet that is available for leasing 158
NRAM : net rentable office square footage in the market expected to compete with the project CPIS : the subject’s Competitive Position Index calculated as the ratio of the subject’s weighted (unweighted) total amenity index over the average of the weighted (unweighted) total amenity indices for all properties considered in the analysis (including the subject) ABM : anticipated market absorption Red Flags In applying formula (16.7) for the estimation of the absorption of a planned office project, the analyst is cautioned to pay attention to the following points: The figures used for the all four terms in (16.7) should not refer to the period during which the market study is carried out, but to the period for which absorption analysis is performed. The subject’s net rentable area available for leasing, NRAS, will, most likely, not be equal to the total NRA of the planned project if the period for which absorption analysis is performed is one or more years after the completion of the project. The subject’s net rentable area available for leasing, NRAS, will certainly not be equal to the total NRA of the planned project during the year of market entry if some office space has been pre-leased. The estimate of the project’s Competitive Position Index, CPIS, for the anticipated year of completion needs to account for all competing office projects that are in the planning stage or under construction and are expected to be completed during the same year as the subject. Unless no new competing office space is expected to enter the market after the planned project is completed, CPIS should be declining during the subsequent years. The analyst needs to make sure that NRAM, CPIS, and ABM are consistent in terms of the geographic area of reference and office building type (see elaborate discussion of this issue in Chapter 9). For example, if CPIS represents the project’s competitive position relative to competing class A office properties in the project’s submarket, then NRAM and ABM must also represent total available square footage and expected net absorption of class A office space in the project’s submarket, respectively. Using available square footage and expected net absorption of class A and B office space in the metro area instead could lead to inaccurate estimates of the project’s absorption. 159
Some practitioners derive project absorption rates by adjusting the absorption rates of comparable office properties according the project’s competitive position relative to each comparable. In particular, such estimates can be derived by multiplying the project’s relative amenity indices with the absorption rates of the respective comparables (see discussion on Chapter 9 on how to estimate relative amenity indices). This methodology is the same as the one used in applications of the competitive differential technique for the estimation of the project’s lease rate. As in the case of lease rates, absorption estimates through this methodology are problematic because, by construction, must refer strictly to the time of analysis and need to be adjusted accordingly for changes in market conditions expected to take place between the time of the study and actual project market entry, as well as over the project’s lease-up period41. Using formula (16.7) is a better approach for estimating office project absorption, because it does take into account the demand-supply conditions expected to prevail at the time of project entry42. Table 16.3 presents an example of office project absorption and revenue schedule calculations. The notes in the table explain clearly the different entries and the calculations and estimation procedures involved. Notice that in this example, the methodology relates project absorption to total metro absorption. However, as mentioned earlier, often project absorption is calculated using submarket absorption estimates as framework. It should be emphasized that the formulas for calculating project absorption and revenue schedules are the same independently of whether what is labeled in Table 16.3 as “market absorption” and “competing available supply” refers to the submarket or the metro area. To help the reader better understand the figures presented in this table we elaborate on the calculations for 1998. Project absorption (column [7]) The rationale underlying this calculation is that the project’s share of total market absorption (column [2]) will be equal to its fair market share adjusted for any competitive 41 These estimates can not refer to the time of project completion simply because market studies are carried out well before project construction starts, let alone completed. Thus, the only absoprtion rates that the analyst can use are those of comparable office buildings that were completed at least within 12-24 months prior to the time of the study. Assuming a two-year period from the time the market study is carried out and the time the project is completed, and another two years until the building leases up and attains a relatively stabilized occupancy, project absorption estimates using the competitive differential approach need to be carried forward for at least three or four years. This task requires supply-demand equilibrium analysis of the project’s market over the forecast period either through econometric or accounting techniques. Equation (16.7) does account for the demand-supply equilibrium conditions expected to prevail over the forecast horizon. 42
As explained earlier, project rent estimates through the competitive differential technique can be carried out forward by applying forecasts of market-rent growth rates.
160
advantages or disadvantages that may enhance or diminish its appeal. Following (16.7) project absorption is therefore calculated as: Project absorption 1998 = Minimum of [ (32,713/1,252,160)*1*1,325,021] and 32,713 = = Minimum of [ 34,616 and 32,713] = 32,713 Since expected market absorption exceeds available supply in 1998, the fair market share of the project would be greater than the space available in the building and, therefore, project absorption will be equal to the available space. Now the reader may be wondering how it is possible for net office space absorption to be greater than the market’s available supply. The reader is reminded that the so called “structural” vacant stock, which is derived based on the assumption of a structural or normal vacancy rate, is not included in the calculation of an office market’s available supply. So obviously, what the numbers for 1998 suggest is that some of that structural vacant stock was absorbed in order to accommodate excess demand. Two points need to be made regarding the project’s Competitive Position Index in Table 16.3. First, it should be noted that an average Competitive Position Index of 1 (as opposed to greater than 1) is not necessarily unreasonable for a newly build project. A newly build project can reasonably be at an average competitive position for a number of reasons. For example, the construction and design quality of the building, as well as amenities provided by the project, may be inferior to those of other new projects or even existing buildings. Furthermore, the project’s location may not be as attractive and advantageous as those of other competing projects.
161
Table 16.3 Example of Office Project Absorption and Revenue Schedule Calculation
Market
Proj ect
FirstYear
Com pe-
Compe ting
Lease
Struct ure
titive
Proj ect
Proj ect
Gross
Cumula tive
Mark et
Availa ble
Rate
Availa ble
Posit ion
Abs or-
Leas e
Rental
Gross
Year Absorption
Supply
Index
Space
Inde x
ptio n
Rate
Revenu e
Revenue
[1 ]
[2]
[3]
[4]
[5]
[6]
[7]
[8]
[9]
[10]
1 997
1,050,9 39
1,444,8 00
138.06
120,00 0
1
87,2 87
$31.0 1
$2,706, 770
$2,706,7 70
1 998
1,325,0 21
1,252,1 60
154.63
32,713
1
32,7 13
$34.7 3
$1,136, 122
$3,897,0 28
1 999
1,010,8 45
1,651,2 00
173.18
0
1
0
$38.9 0
$3,974,9 68
2 000
1,016,3 12
1,135,2 00
176.65
0
1
0
$39.6 8
$4,054,4 68
2 001
1,326,9 22
412,80 0
181.95
0
1
0
$40.8 7
$4,135,5 57
Note: Anticipated time of entry is year-end 1996; the annual rent escalation is 2% and the length of all leases is 5 years
On Inputs and Calculations
[1] Year
[2] Market (net) absorption; estimated through an absorption regression model utilizing as independent variables, among other factors, office employment growth (provided by an econometric forecasting firm) and real rents (see Chapter 15 for a discussion of the econometric approach)
[3] Competing available supply of office space; also estimated through the econometric approach (see Chapter 14 for a detailed discussion of the calculation of availalble office supply)
[4] Office lease rate growth index; also estimated through the econometric approach
[5] Project size was determined through design specifications
162
[6] The competitive strength of the project is assumed to be average
[7] Calculated as the minimum of (([5]/[3])*[6]*[2]) and [5]
[8] The year-end 1996 hedonic lease rate for the project was calculated through hedonic regression analysis using a sufficient sample of recent office lease transactions within the market the project competes; the lease rate for subsequent years was calculated by growing the estimated current lease rate for the structure under consideration at the growth rate dictated by [4]; the numbers reported represent the annual rate per square foot
[9] Gross rental revenue refers here to the revenue only from new leases signed during the year under consideration; estimated as [8]*[7]
[10] Cumulative revenue refers here to the revenue from both new and existing leases; estimated from [9] taking into account lease length and CPI escalations stipulated by lease agreements
What may appear unrealistic in Table 16.3 is keeping the Competitive Position Index at 1 throughout the forecast. This maybe unrealistic as new buildings entering the market after the project is completed may be at a better competitive position than the subject. Hedonic lease rate (column [8]) The rationale underlying the estimate of the project’s lease rate in 1998 is that during that year it will increase (decrease) from its 1997 level at the same rate as the market office lease rates. Within this context, it is calculated below by applying the anticipated percentage change in the overall market lease rate in 1998 to the project’s 1997 lease rate (note for column [8] in Table 16.3 explains how the latter has been estimated). Project lease rate 1998 = Project lease rate 1997 * (1 + % change in market lease rate 1998) = 31.01 * (154.63/138.06) = $34.73 Gross rental revenue (column [9]) For the purposes of this example, gross rental revenue refers to the rental income attributed only to new leases, signed during the year of the analysis. In order to keep the st
calculations simple it is assumed that all new leases are signed on January 1 of the year under consideration. Within this context the gross rental revenue for 1998 will be: Gross rental revenue 1998 = Square feet leased in 1998 * 1998 lease rate = 32,713 *34.73 = 1,136,122 163
Cumulative gross revenue 1998 (column [10]) For the purposes of this example, cumulative gross revenue refers to all the rental income earned by the property from both existing and new leases. As such, it is the sum of the rental income from new leases signed in 1998 and the income from leases signed in 1997. Notice that, according to the assumed lease specifications, the contract rate for the leases signed in 1997 will increase by 2% in 1998. Within this context, the 1998 cumulative gross revenue is calculated as: Cumulative gross revenue in 1998 = (2,706,770 * 1.02) + 1,136,122 = 3,897,028 The calculation of the project’s revenue schedule is based on the assumption that all tenants in the hypothetical office building under consideration have 5-year leases. What if the tenants that occupied the building in 1997 had 3-year leases? In that case, we would first put the 87,287 square feet that were absorbed in 1997 back into column [5] (labeled “structure available space”) in 2000. Then we would need to apply the same formula used to calculate the entries in the project-absorption column (column [7]) in order to estimate how much of that space would be absorbed given the anticipated demand supply conditions for that year. Another approach is to assume a renewal percentage for expiring leases, let’s say 50%, and put back in the market under column [5] only 50% of the 87,287 square feet. CHAPTER SUMMARY The microeconomic analysis component of office market studies focuses on the assessment of the strengths and weaknesses of a given site and location for office development and the evaluation of the competitive position and revenue-generating ability of the planned office project. Office location analysis focuses on the site’s advantages and constraints. Locational attributes that are relevant in office location analysis include all factors that may directly help firms increase their productivity and reduce their costs. Such productive amenities include access to business services, access to white-collar labor, and access to airports and freeways, as well as factors that may appeal to their workers (worker/non-productive amenities), such as low crime rates, a good public education system, high levels of public services, access to shopping and recreational amenities, etc. Locational constraints that are relevant in office location analysis include zoning, density, and growth controls, as well as any other factor that may limit the site’s development potential or the overall supply of office space in the jurisdiction or county within which the 164
site is located. Analyzing constraints on office development becomes especially relevant in light of theoretical findings suggesting that office location advantages are fully or almost fully capitalized on office rents as opposed to office-worker wages only in the case of supply-constrained markets. Analysis of the income-generating ability of a planned office development focuses on forecasts of achievable lease rates, absorption schedule and revenue schedule. Achievable lease rates for office developments can be estimated through the competitive differential technique or hedonic valuation techniques. The important point to be kept in mind is that, ideally, office rent estimates must be based on the analysis of actual lease transactions and not asking rents. Proper analysis of lease-transaction rates requires collection of data not only on structure and location attributes, but also on a host of lease characteristics. Hedonic valuation techniques can better measure the effect of these multiple lease characteristics on office rents, while controlling for differences across properties in structure and location attributes, and vice-versa. Office project absorption can be estimated using the fair market share concept adjusted by the project’s Competitive Position Index. Project absorption and lease rate estimates provide the basis for generating the project’s rental revenue schedule. In deriving this schedule, the analyst needs to apply most likely CPI clauses expected to be included in lease contracts and carefully account for potentially different lease rates for space expected to be absorbed in different years. QUESTIONS 1. Discuss what location attributes may play an important role in the intrametropolitan location decisions of office firms and why. 2. Discuss what the issue of location-amenity capitalization in the office market has to do with office project analysis. 3. List and briefly describe alternative techniques and the steps involved in estimating an office project’s achievable rent and absorption schedule. 4. Describe the steps in estimating an office project’s achievable rent using the competitive differential technique. 5. Discuss in detail the differences between apartment and office hedonic rent formulations. 6. You are considering to invest in a brand new office structure expected to be completed in two years, that is, year-end 1999, at a site located in one of the Los Angeles area's most vital edge cities. The market analyst has provided you with the following sets of data, which will help you assess the property's income earning potential.
165
Lecture 12 Real Estate Investment 43 Components of investment analysis: Determine Market Support, Test Financial Feasibility; Is After-Tax Return to Equity Sufficient?; Compare Value to Cost ; Real Estate Investment Characteristics and risk
Evaluating the potential of a proposed real estate investment requires a carefully designed, analytical plan. By logically arranging a series of questions, a plan can be developed that minimizes the chance of overlooking an important fact about the property. Questions are answered through a careful evaluation of the specific data assembled for the analysis. When there is a lack of data, no further consideration should be given to the proposed real estate investment until the data are available; the temptation to ignore the question must be resisted. Of course, prior to beginning the analysis, the investor must establish criteria for evaluation whether or not an answer to a question is satisfactory. Although there can be any number of questions, they can be considered under four broad categories.
Determine Market Support The presence of sufficient market support is determined by analyzing the supply and demand for space within a defined market area. Factors that define market areas vary according to property type; a retail space market is defined differently than an office space market. In no case are market areas defined simply by drawing circles having radii of one or two miles. Within a defined market area, the supply and demand for space for particular market segments is then identified. What types of space are available in the market? How much space of each type is available in the market? What types of space users are in the market now? What types of space are in demand? What changes in the demand for space are foreseen? What is the underlying cause of the expected change in future demand? Is an expected increase in the demand for space related to the expansion of businesses within the market area that will require additional office space? Or, is an expected increase in the demand for retail shopping space related to an increased residential population in the market? When will there be a need for additional space? By answering these questions, the investor can determine if there is an unmet need for space in the market area. If so, the research should conclude with an estimate of the number of square Investment by Design: A Primer in Real Estate Analysis;Real Estate Center (May 1995) ISBN10: 1562480081 ISBN-13: 978-1562480080 43
166
feet of space required and the price users are willing to pay for it. Marketing research usually is thought of in connection with new developments. Developers, lenders and investors want to know if there will be sufficient demand for the to-be-built space. But marketing research can play an equally important role when an investor is considering changing a property’s existing use or when an investor is considering investing in a property when the use will remain the same. How does “choosing a good location” differ from marketing research? Good locations are important and are based on the needs of particular activities. For instance, certain commercial activities require minimum lot sizes along a major arterial street with particular kinds of ingress and egress. Additional requirements may include easy access to wholesalers, shippers, customers or market centers. Locating such a site does not automatically make it suitable for the activity, however. There must be adequate demand for the space; a good location cannot assure demand. What are the benefits of good marketing research? Obviously, identification of an unmet need increases the probability of success. The late Professor James A. Graaskamp suggested the identification of an unmet need provides a competitive edge for the investor that can result in a fully leased property–perhaps at a premium rent. This competitive edge provides the best defense against future properties entering the market–satisfied tenants are less likely to move to a competing property. Because a property’s value is a function of its ability to generate rent, an increased rent results in an increased value. Ultimately, the investor will enjoy a greater rate of return from the identification of an unmet need. In addition, marketing research can protect against the consequences of the competitive price cutting that takes place in overbuilt markets. Although reducing the rental rate in an overbuilt market may cause some additional space to be leased, the lower rate also may result in less total rent being collected. For example, decreasing the rental rate for retail space will bring some additional space users into the market, but it is unlikely to result in substantial numbers of entrepreneurs deciding to enter the retail business or encourage existing retailers to expand. These decisions will depend on factors other than the price of retail space. Furthermore, because all other owners will likely decrease their rental rates as well, the rental income of all owners will decline if the average market rental rate declines sufficiently. Thus, price cutting by the owners of vacant retail space in such a market will neither significantly increase the demand for space nor provide the investor with a superior competitive position. Good marketing research can help an investor avoid overbuilt markets. If there are no strong indications that the investment under consideration will fill an unmet need, it should not be given further consideration.
167
Test Financial Feasibility The investor, having established that a particular property will fill an unmet need, next tests the project’s financial feasibility. If the property can generate adequate net operating income to support sufficient debt to finance the property and provide a satisfactory cash return to the developer-investor, the project is financially feasible. This is a test of the property’s ability to generate adequate cash in the short run.
Making this determination requires answers to
questions such as: How much will the project cost? How much rent will the project produce? What are the expected operating expenses? How much net operating income will the project generate? Given current market conditions and lending requirements, how large a loan will the net operating income support? And, given the estimated cost of the project and the desired equity contribution of the developer-investor, can the project be financed? A project’s financial feasibility is best explained as a balance among the:
property’s expected cost, property’s expected operating performance,
lender’s requirements and mortgage market conditions and
investor’s required before-tax, cash-on-cash return.
If there is a proper balance among these factors, the property should generate enough rent to pay all the operating expenses, to repay the debt used to finance the property and meet the investor’s expected cash return. Properties that do not meet this test have little promise even when there is a demand for the space. And, when properties promise little in the short run, it is risky to assume that they will improve in the long run. If, however, an investor determines there is both a demand for the space and the property is financially feasible, the analysis moves to longterm considerations.
Is After-Tax Return to Equity Sufficient? The expected after-tax rate of return from a real estate investment is determined by the expected benefits of the investment–after-tax cash flow and appreciation–and the cash required to purchase the property. The expected rate of return can then be compared with the minimum return the investor requires to undertake the investment. The investor’s required return is established by examining the returns available from other investments having a similar level of risk. A proper calculation of the rate of return involves the use of present value techniques so that the rate will reflect both the amount and timing of the cash inflows and outflows. This rate is known as the internal rate of return. Why must the project’s after-tax internal rate of return be considered even if the project is 168
financially feasible? The investor’s required return, as used in the determination of financial feasibility, is based on a single year’s before-tax income–it is a short-term measure and does not encompass the period during which the investment is expected to be held. As a consequence, the investor must consider the effect of taxes, financing and future events on the property; this is the essential contribution made by the after-tax internal rate of return calculation. Real estate is particularly affected by future events because of its characteristics: large economic size, physical immobility and long economic life. In short, a property investment involves a relatively sizable dollar investment that cannot be moved and that must generate income during a long period. Thus, successful real estate investing involves making decisions about the future level of rents, operating expenses, appreciation rates and tax laws. These, in turn, depend on the rate and direction of urban growth, price inflation, international events, political events and so forth. As the information is gathered, the investor necessarily will be addressing questions about risk. Risk exists in all projects, but some are more risky than others. The degree of risk depends on the difference between expected and actual outcomes. If the expected outcome is guaranteed, then the risk is negligible; if there is substantial uncertainty about the expected outcome, then the risk is great. For a single project, the best way to reduce risk is to improve the analysis of the variables that produce the project’s expected rate of return. In this way, the spread between expected and actual outcomes can be minimized. As the scope of discounted cash flow analysis is examined, one of its prime benefits becomes clear. In gathering the data required to make the analysis, much will be learned about the investment under consideration.
Estimating the rate of return may be secondary to the
knowledge gained from gathering the information. Nevertheless, the prospective investment must promise a satisfactory rate of return or its consideration should be abandoned.
Compare Value to Cost The investment value of any asset is equal to the present value of its future cash flows, discounted at the appropriate rate. A property’s investment value is not the same as fair market value or loanable value. It is the value that an investor determines after establishing a set of investment requirements and expectations about the property; this value is compared to a property’s offering price or cost to see if it exceeds the cost of the property. The investor anticipates cash benefits in the form of after-tax cash flow and appreciation. The lender generally receives a mortgage payment in an amount agreed upon in advance but also may expect a share of other benefits such as rents, cash flow or appreciation. It usually is assumed that the amount loaned is equal to the present value of the lender’s expected benefits discounted at the 169
lender’s required rate of return (generally the face interest rate of the loan).
A property’s
investment value is equal to the present value of all the cash benefits expected by the equity investor, discounted at the investor’s required rate of return, plus the amount of the mortgage. The property’s investment value is based on all the projections, assumptions and so forth that have been made by the equity investor and the lender. In addition, the required rate of return and the specific tax rates are taken into account. Thus, the investment value is for a particular property and for a particular set of circumstances. Because it is not an estimate of fair market value, there is no reason to expect that the property can be purchased for the estimated investment value. Rather, this is the value of the property under a particular set of circumstances, and if unreasonable assumptions, projections and so forth are made, the investment value calculated for a particular investor may be different from the property’s market price. However, the terms of purchase, financing or a particular investor’s tax situation can increase the property’s investment value. This may explain why one investor may be willing to pay more for a property than another: the assumptions used and the terms available produce a higher estimate of investment value. Nevertheless, if the property’s investment value does not equal or exceed its cost, the property should not be purchased. As the investor progresses through the analysis, the property’s suitability as an investment will be established. If the answer to any one of the questions is negative, the analysis should be abandoned. There is no logical reason to proceed to any of the remaining questions. Furthermore, positive answers to one or more of the questions should not induce the investor to disregard a negative answer to the next question. By adhering to a carefully designed analytical plan, an investor can maximize the probability of choosing real estate investments that will prove successful in the long run. Real estate investments generate cash flows from three principal sources: operations, appreciation and equity build-up.
Cash flow from operations represents the cash benefit the property provides
after operating expenses, debt service and income tax are paid from the rental income. These benefits are expected throughout the investment’s economic life.
Appreciation represents an important source of real estate returns. Over time,
well-located and well-maintained properties are expected to generate increased income that will be reflected in higher property value.
Equity build-up results from the periodic reduction in the mortgage. These
benefits can be obtained only if 170
the property is refinanced, or it is sold at a sufficiently high price.
As investors estimate the present value of these future cash benefits, they are necessarily concerned with risk exposure because the value of any asset is equal to the present value of its future cash flows. If an investor is certain the actual cash flows will be the same in amount and timing as those expected when the investment is made, the investor will not consider it risky. If, however, the probability of variation between expected and actual cash flows is high, the investment will be considered risky. Because investors expect a higher return from undertaking a risky investment, they apply higher discount rates when they estimate the present value of an investment. The result? A stream of risky cash flows is worth less than a stream of more certain cash flows.
Real Estate Investment Characteristics The risks of an income property’s future cash flows cannot be evaluated without understanding how they are related to real estate characteristics. Although real estate investments have many characteristics, three are particularly important. First, real estate investments are physically immobile–they cannot be moved. Second, they have a long economic life–they must produce cash returns over a long period if their cost is to be recovered. Economic life is the time required for the property’s cost to be recovered from operations; it differs from the investor’s expected holding period. Even when an investor anticipates a five- or ten-year holding period, the future buyer of the property anticipates a satisfactory cash flow during a future holding period and so on. Third, they have a large economic size–a single property requires a large dollar investment compared to the minimum purchase of common stock, for instance. Although it is difficult to relate these three characteristics to each of the seven risks, the characteristics accentuate real estate’s risk exposure.
Relationship of Characteristics to Risks Business Risk.
Real estate’s physical immobility and long economic life are strongly
associated with business risk–the risk of failing to generate sufficient income. This failure can result from attracting too few tenants, lower than anticipated rental rates caused by high vacancies in competing properties, declining business conditions in the market area and so on. Consider the plight of a shopping center owner when demographic changes adversely affect the center’s market area. The center’s tenants can follow their customers to other neighborhoods 171
and markets, but the shopping center cannot be moved. Its owner must suffer the consequences of reduced cash flow from operations and lowered expectations of cash flow from appreciation and equity build-up. And because the shopping center has a long economic life, it must sustain its operational cash flow for a long period. A property may appear to be ideally located when it is constructed; the adverse demographic changes may take place some years after its construction.
Because of the property’s long
economic life, the center’s cost may not be recovered even after generating sufficient cash flow for several years.
Management Risk Real estate’s physical immobility and long economic life also are strongly associated with management risk–the risk of failing to respond properly to changing business conditions to maintain the efficiency and profitability of the property. Because real estate cannot be moved and must sustain its cash flow during its economic life, the probability of changing business conditions is high during the property’s economic life. Considering the shopping center example, one might ask what a good manager could have done to predict the demographic changes and react to minimize their impact on the property’s cash flow. Some investment managers may perceive such changes in business conditions and act rapidly to forestall their effect, while others may take no action or act improperly.
Financial Risk Because real estate investments traditionally are financed with debt, financial risk is significant; furthermore, real estate’s physical immobility, long economic life and large economic size accentuate the financial risk. Because the debt is unlikely to be repaid in a short time, the property must generate adequate cash flow throughout its long economic life. As with business risk, many changes can occur during this time that adversely affect the property’s income stream. Because the property cannot be moved, the probability of changes adversely affecting the owner’s ability to meet the mortgage payment is increased. Real estate’s large economic size often requires investments to be financed with high loan-to-value ratio turns into an equal disadvantage when the property’s income declines. Financial leverage is truly a “two-edged sword.” This is a particularly significant risk when the terms of financing are arranged during periods of high interest rates. Political Risk 172
Because real estate is located permanently within a particular political jurisdiction, it is subject to the community’s attitude toward property. Accordingly, it is subject to zoning, landuse regulations and building codes imposed by that jurisdiction. Because of its long economic life, such regulation might become more severe during the economic life. But increased regulation can prevent competition, thus enhancing the value of existing properties. Finally, large projects may be reviewed more strenuously by regulators at all levels. Of course, the long economic life also subjects the investor to tax law changes. For instance, the 1986 Tax Reform Act altered real estate’s status as a tax sheltered investment. Prior to the act, many investors expected tax benefits to be a significant portion of total cash flow; when this portion of the investment’s cash benefits was eliminated, the value of their investment declined. The act also increased the capital gains tax liability generated by the sale of real estate. Many investors anticipated a lower rate of capital gains taxation when they invested. Thus, they not only must anticipate a larger tax on the sale, they also may expect a future buyer to offer less for the property because for that buyer the expected flow of cash benefits has been reduced. Inflation Risk Because real estate investments have a long economic life, investors must correctly anticipate the inflation rate for the long term. When future cash flows are reinvested, they will buy less than expected if the inflation rate is greater than expected; furthermore, future cash flows may be less than expected as a result of inflation–operating expenses may exceed expectations, for example. Although inflationary gains should not be confused with appreciation, real estate values generally have performed well during periods of moderate inflation. However, higher than expected inflation rates may induce others to purchase and develop real estate to hedge against inflation. If, as a result, the supply of rentable space exceeds the demand for rentable space, rental rates and property values will fall. Finally, inaccurate inflation forecasts result in choosing inaccurate discount rates that can have an important effect on the present value of future benefits.
Liquidity Risk Real estate’s physical immobility and large economic size make it particularly subject to liquidity risk. Its physical immobility makes it unique–a severe hindrance to selling it quickly without loss. The liquidity of real estate investments also is hampered because of their large economic size–the buyer of the property must invest more cash than required for many other investments.
173
Interest Rate Risk Real estate investment’s long economic life and large economic size increase the exposure to interest rate risk. Because many investors value properties by capitalizing their net operating income, i.e., net rental income less the property’s operating expenses, the capitalization rate is an important determinant of value. Although there are two basic approaches to developing this rate, both approaches produce a result that is highly correlated with interest rates.
Case Study: Wilma and the FTZ John Y. Massey The oversupply of developed commercial real estate in most Texas markets means little new commercial development activity in these markets in the near term. Those who hope to continue some level of development or redevelopment activity would do well to reflect on an important point made by the late Professor James A. Graaskamp of the University of Wisconsin at Madison. He says that developers cannot be successful if they supply a product that is already in the market. Instead, they must seek an unmet need; in supplying that unmet need, they must achieve a sustainable competitive edge that will allow them to reap the benefits of their monopoly position. These benefits were analyzed in “Scarcity Benefits Investors.” Identifying an unmet need and designing a strategy to achieve a sustainable, competitive edge are not easy tasks. This section provides a case analysis of one real estate developer’s pursuit of these goals. Wilma Southwest, Inc., of Houston is a subsidiary of Wilma International, a development firm headquartered in the Netherlands. Wilma undertakes property development projects on its own and with joint-venture partners. Because Wilma and its investors are conservative and because of the well-known difficulties of developing in the Houston market, speculative development is avoided. In the early 1980s, Wilma owned 457 acres near Houston’s Intercontinental Airport with good access to the city’s freeway system and to rail transportation; Wilma executives wanted to develop the site to its maximum value. This property was marketed as Central Green Business Park. Wilma’s land could have been developed for a variety of users, but lenders and investors required developments to demonstrate financial feasibility. This meant that before construction began, Wilma needed to locate tenants willing to lease the completed space at rental rates sufficient to service the debt and provide an adequate return to Wilma’s investors. With other completed space in the market area remaining unleased, Wilma’s site had to fill special needs if it were to be developed. Although near the airport, it was not the only site there. 174
Likewise, it was not the only site with access to Houston’s freeway system and to rail transportation. Thus, Wilma needed to devise a development strategy taking advantage of these attributes and permitting the site to fulfill an unmet need that competitive sites could not supply.
Finding the Unmet Need Market segmentation means dividing a market into distinct subsets of customers. Many manufacturing and service firms use this approach to aid in product development and marketing; it also can be applied to real estate markets. In the case of real estate, the market is divided into tenant subsets with the goal of locating one or more subsets with unmet needs. Thus, it is a conceptual approach to isolating an unmet need. The distinction between market segmentation and product differentiation is important. For real estate markets, product differentiation means supplying several product styles in hopes that various The distinction between market segmentation and market area also must be borne in mind. A market area has boundaries; it is a defined geographical area. Distinct subsets of customers may exist within the defined geographical area. Thus, medical doctors desiring office space are a distinct subset of customers; they may desire to lease office space in particular market areas. Development Strategy Because Wilma Southwest was a subsidiary of a Dutch parent firm, developing sites for firms involved in international trade was not unknown to them. And because Houston is an important foreign trade hub with both an international airport and a major seaport, many importing and exporting firms are located in Houston. Therefore, Wilma began to seek a way to attract these firms to Central Green Business Park. To assist in attracting these firms, Wilma Southwest sought a foreign trade zone (FTZ) designation from the Foreign Trade Zones Board (a U.S. government agency) in mid-1985. When a site is established as an FTZ, it is deemed to be outside the United States for duty and revenue purposes, even though it is physically located within the country’s borders. This attracts firms engaged in importing and exporting for the following reasons. •
Normally, duty payments are made when imported goods arrive in the United States. If
the goods are imported and warehoused in an FTZ, however, duty payments are delayed until the goods are shipped to a U.S. customer. Delaying the payment provides a time value of money benefit for the importer-exporter located in the FTZ.
175
The duty payments made when goods are imported into the United States can be avoided by the importer-exporter located in an FTZ if goods are exported after storage, sorting, testing or repackaging. A business location outside the FTZ does not provide this advantage. Often the duty on parts is charged at a higher rate than the duty on the finished products. Because duty is not paid when parts are imported into the FTZ, finished products can be assembled within the FTZ and then sold to U.S. customers. Duty on the finished products will be charged at the lower rate. Assembling products outside the FTZ will not provide this advantage. Sometimes part of imported material becomes scrap during the assembly or manufacturing process. Because duty is not paid when parts are imported into the FTZ and assembled into finished products, duty on the scrap will be avoided when the products are sold to U.S. customers. In addition, duty on the finished products may be charged at the lower rate. Assembling products outside the FTZ will not provide this advantage. • Imported goods and goods stored for export are federally exempt from the annual personal property tax levied by local governments. For these reasons, locating in an FTZ could prove attractive to an import-export firm, even though competing space located outside an FTZ might be otherwise competitive in design, price or location. In fact, an import-export firm considering leasing space within an FTZ could estimate the added value of the location. If, for example, the duty saved is $50,000, a tenant occupying 36,000 square feet saves $1.39 per square foot per year (a little less than 12 cents per square foot per month). Increased volume over time could further raise the location’s value. The FTZ also would provide Wilma with a sustainable competitive edge. Although other FTZs could be approved in the area, authorities would prefer the current one to be fully developed before approving others. And the application process for a new FTZ takes 12 months to two years. This gave Wilma adequate time to find sufficient tenants to test the quality of the idea. Success of the Strategy In late 1987, Wilma obtained an FTZ designation for approximately 13 acres of their total 457 acres at Central Green Business Park. After this designation, progress was slow. Eventually, Phase I–a 100,000 square-foot multi-tenant office-warehouse complex–was completed in January 1986 and totally leased. The complex was sold to an investor group in 1989. Construction of Phase II, a second office-warehouse complex, was initiated in August 1990, the only project of this type constructed in the north Houston market during 1990. By year’s end, 90 percent of this 104,000-square-foot facility was preleased at rates that supported the cost of the new construction. Phase II was completed in January 1991 and fully leased by January 1992. As the business benefits of the FTZ became known, the increased interest by potential 176
tenants caused Wilma to consider expanding their FTZ. An application to increase the FTZ from 13 acres to approximately 43 acres was submitted in November 1990. The request was granted in April 1991. A second increase, requested in June 1991 to expand the FTZ from 43 acres to 156 acres, was approved in December 1991. Not all Phase I and II tenants were engaged in international commerce; about 43 percent of the Phase II tenants chose the project because it was located in the FTZ. Obviously, Central Green Business Park had a broad appeal. Among the tenants attracted to Wilma’s Phase I and II developments in Central Green Business Park because of the FTZ were: •
two distributors of imported industrial valves;
•
seven freight forwarding firms (assist other businesses in their export activities);
•
three customshouse brokerage firms (assist other businesses in their import activities);
•
several firms that crate exports for shipment;
•
a specialist in handling dangerous goods; and
•
an international parcel-package-letter express delivery service.
Wilma Southwest, Inc., recognized firms in the import-export business as a particular market segment. The increasing importance of foreign trade to the U.S. and Texas economies and the potential effects of the North American Free Trade Agreement on Texas-Mexican commerce suggest an increasing need for space in FTZs. Because FTZs provide specific financial advantages to firms engaged in international commerce, there may be other development opportunities in the market. Knowledgeable real estate brokers may wish to discuss the advantages of FTZs with their clients when appropriate. What Is the Lesson? Real estate development can succeed in difficult markets. The key is to locate tenants who need something not currently available in the market and deliver that product to them. In addition, the developer must secure the strongest monopoly position possible by being the first to recognize an opportunity so that the competitive edge can be maintained.
177
Lecture 13-14 General principles of Valuation of Real Property International Valuation Standards; Valuation methodology: market approach, cost approach, income approach; Real estate value, price and cost 44 International Valuation Standards45
Rapid economic changes taking place in the 1970s served to enhance the recognition given by market participants to the importance of professional property valuations. The quickening pace in the globalisation of investment markets further underscored the need for internationally accepted standards for reporting the value of property. It became obvious that without international valuation standards there was considerable potential for confusion. Differences of viewpoints among national professional valuation bodies might lead to unintentional misunderstandings. In 1981 was founded The International Assets Valuation Standards Committee (TIAVSC) in 1981. The Committee changed its name in 1994 to the International Valuation Standards Committee (IVSC). The objectives of the Committee are twofold: • To formulate and publish, in the public interest, valuation Standards for property valuation and to promote their worldwide acceptance; and • To harmonise Standards among the world’s States and to identify and make disclosure of differences in statements and/or applications of Standards as they occur. Long run experience of professional property valuers and the dialog around International Valuation Standards show that there is the ubiquitously accepted valuation methodology all over the world. Apart from the minor differences across the borders (because of the different practices or local law requirements) the main concepts of valuation and valuation approaches are the same in whole world. The latest version of the standards was published in 2013 and came into effect on 1 January 2014. Below is an outline of the structure of the International Valuation Standards.
IVS Framework The IVS Framework includes generally accepted valuation concepts, principles and definitions upon which the International Valuation Standards are based. This framework should be considered and applied when following the individual standards and valuation applications. 44 45
The appraisal of real estate , Appraisal Institute, Foundations of appraisal, http://www.ivsc.org/
178
General Standards The three General Standards have general application for all asset types and valuation purposes, subject only to variations or additional requirements specified in the Asset Standards or the Valuation Applications. The General Standards are IVS 101 Scope of Work, IVS 102 Implementation and IVS 103 Reporting.
Asset Standards The Asset Standards consist of a standard and a commentary. The standard sets out requirements that either modify or augment the General Standards and include illustrations of how the principles in the General Standards are generally applied to the particular asset class. The commentary provides additional background information on the characteristics of each asset type that influence value and identifies the common valuation approaches and methods used.
Valuation Applications Valuation Applications are produced for common purposes for which valuations are required. Each application contains a standard and guidance. The standard includes any additions to or modifications of the requirements in the General Standards and illustrations of how the principles in the General Standards and Asset Standards apply when undertaking valuations for that purpose. The Valuation Applications are IVS 300 Valuations for Financial Reporting and IVS 310 Valuations of Real Property for Secured Lending.
Technical Information Papers (TIPs) There are currently three finalized TIPs on Discounted Cash Flows, The Cost Approach for Tangible Assets and The Valuation of Intangible Assets. The Standards Board are currently working on additional papers.
Factors of Value The economic concept of value is not inherent in the commodity, good, or service to which it is ascribed. Rather, it is created in the minds of the individuals who make up the market. The relationships that create value are complex, and values change when the factors that influence value change. Typically, four interdependent economic factors create value:
utility 179
scarcity
desire
effective purchasing power
All four factors must be present for a property to have value. The four factors interact in the marketplace to influence the relationship of supply and demand.
Utility Utility is the ability of a product to satisfy a human want, need, or desire. All properties must have utility to tenants, owner-investors, or owner-occupants. In general, residential properties satisfy the need for shelter, and commercial properties house business activities. Both may have design features that enhance their attractiveness. These features are called amenities. The value of amenities is related to their desirability and utility to an owner-occupant or tenant-occupant. The value of ownership may be measured from the prices paid for residences. The value to a tenant can be measured as the rent paid for the occupancy. The benefits derived from income-producing properties can usually be measured in terms of cash flow. The influence of utility on value depends on the characteristics of the property. The utility, or usefulness, of a property may relate to its size, design, location, and other specific characteristics. Time/distance relationships clearly affect the value of property. These different forms of utility can significantly influence property value. The benefits of real property ownership are derived from the bundle of rights that an owner possesses. Restrictions on ownership rights may inhibit the flow of benefits and, therefore, lower the property’s value. Similarly, a property can only achieve its highest value if it can legally perform its most useful function. Environmental regulations, zoning regulations, deed restrictions, and other limitations on the rights of ownership can enhance or detract from a property’s utility and value.
Scarcity Scarcity is the present or anticipated supply of an item relative to the demand for it. In general, if demand is constant, the scarcity of a commodity makes it more valuable. Land, for example, is still generally abundant, but useful, desirable land is relatively scarce and, therefore, has greater value. No object, including real property, can have value unless scarcity is coupled with utility. Air, which has a high level of utility, has no definable economic value because it is abundant, but to a scuba diver who is 100 feet underwater with a tank that is almost empty, it is extremely valuable. The question again becomes one of supply and demand. 180
Desire Desire is the wish of a purchaser or user for an item to satisfy human needs (e.g., shelter, clothing, food, companionship) or individual wants beyond the essentials required to support life. Desire could include a business need such as the need for a place to sell or manufacture products. This type of desire supports commercial real estate development.
Effective Purchasing Power Effective purchasing power is the ability of an individual or group to participate in a market— that is, to acquire goods and services with cash or its equivalent. A valid opinion of the value of a property includes an accurate assessment of the market’s ability to pay for the property.
Supply and Demand The complex interaction of the four factors that create value is reflected in the basic economic principle of supply and demand. The utility of a commodity, its scarcity or abundance, the intensity of the human desire to acquire it, and the effective power to purchase it all affect the supply of and demand for the commodity in any given situation. Demand for a commodity is created by its utility and affordability. Demand is also influenced by desire and the forces that create and stimulate desire. Although human longing for things may be unlimited, desire is restrained by effective purchasing power. Thus, the inability to buy expensive things affects demand. Similarly, the supply of a commodity can be influenced by its utility and limited by its scarcity. The availability of a commodity is affected by its desirability. Land is a limited commodity, and the land in an area that is suitable for a specific use will be in especially short supply if the perceived need for it is great. Sluggish purchasing power keeps the pressure on supply in check. If purchasing power expands, the supply of a relatively fixed commodity will dwindle and create a market-driven demand to increase the supply for which there is latent or pent-up demand. Distinctions Among Price, Cost, and Value Contemporary appraisers make careful distinctions among the related terms price, cost, and
value. The term price refers to the amount a particular purchaser agrees to pay and a particular seller agrees to accept under the circumstances surrounding their transaction. A price, once finalized, refers to a transaction price and implies an exchange. The exchange can be temporary— 181
as in a lease—or permanent—as in a sale. But in all cases, price is a fact. Price is the buyer’s expression of the property’s utility and scarcity combined with the buyer’s desire and purchasing power. Some people use cost and value synonymously, but appraisal practice requires more precise definitions. The term cost is used by appraisers in relation to production, not exchange. Cost may be either an accomplished fact or an estimate. Costs may be identified with the project phase to which they pertain— i.e., either actual construction cost or overall development cost. The construction cost of components or an entire building normally includes the direct costs of labor and materials, as well as indirect costs such as administrative fees, professional fees, and financing costs. Development cost is the cost to create a property, including the land, and bring it to an efficient operating state. Development cost includes acquisition costs, actual expenditures, and the profit required to compensate the developer or entrepreneur for the time and risk involved in creating the project. Real estate-related expenditures for labor and capital are directly linked to the price of goods and services in competitive markets. For example, the costs of roofing materials, masonry, architectural plans, and rented scaffolding are determined by the interaction of supply and demand in specific areas. Thus, they are subject to the influence of social, economic, governmental, and environmental forces. The terms price, cost, and value are used and defined carefully by appraisers.
Value can have many meanings in real estate appraisal. The applicable definition depends on 8
the context and usage. In the marketplace, value is commonly perceived as the anticipation of benefits to be obtained in the future. Because value changes over time, an appraisal reflects value at a particular point in time. Because value is an economic concept, the monetary worth of property, goods, or services to buyers and sellers is an expression of value. To avoid confusion, appraisers do not use the word value alone. Instead they refer to
market value, fair value, use value, investment value, assessed value, and other specific kinds of value. Market value is the focus of most real property appraisal assignments. Anticipation and Change The human actions that collectively shape market operations reflect the pursuit of economic goals. The fundamental principles of anticipation and change must be addressed to effectively analyze the many 182
dynamic and interactive factors that influence people’s attitudes and beliefs about value.
Anticipation Value is created by the anticipation of benefits to be derived in the future. In real estate markets, the current value of a property is usually not based on its historical prices or the cost of its creation. Rather, value is based on the market participants’ perceptions of the future benefits of acquisition. The value of owner-occupied residential property is based primarily on expected future advantages, amenities, and the opportunity cost of ownership and occupancy. Prior to the property’s sale, the primary investment return is measured in these amenities and the economic benefit of owning rather than renting property, not in the receipt of income. The value of income-producing real estate is based on the economic benefits (income and appreciation) it is expected to produce in the future. Therefore, real property appraisers must be aware of local, regional, and national real estate trends that affect the perceptions of buyers and sellers and their anticipations of the future. Historical data on a property or a market is relevant only insofar as it helps interpret current market anticipations. The result of the cause and effect relationship among the forces that influence real property value influence the demand for and supply of real estate and, therefore, individual property values. Appraisers attempt to identify current and anticipated changes in the market that could affect current property values, but, because change is not always predictable, opinions of value are said to be valid only as of the specified date of valuation. An appraiser’s analyses and conclusions reflect what the market anticipates, rather than what the appraiser or the owner anticipates. Shifts in market preferences also provide evidence of change. Real estate is not readily adaptable to new consumer preferences and thus often suffers obsolescence, i.e., an impairment of desirability and usefulness. The physical, functional, and external impairments observed in buildings as they age result in depreciation, which is defined as a loss in property value from any cause. Depreciation may be seen as the difference between the cost to reproduce or replace a property and its present value. In general, losses in property value are caused by deterioration or obsolescence. Because obsolescence can begin in the design phase and deterioration may start while a building or improvement is still being constructed, the different types of deterioration and obsolescence found in a property have unique implications in appraisal.
183
VALUATION METHODOLOGY46 The valuation process is a systematic procedure an appraiser follows to provide answers to a client’s questions about real property value. It is a model that can be adapted to a wide variety of questions that relate to value. It can also be used—perhaps with some modification—to answer questions not directly related to value, as in the case of review and consulting assignments. The valuation process begins when the appraiser enters into an agreement with a client to provide a valuation service. Generally, the terms of the agreement are satisfied when the appraiser delivers the assignment results (opinions and conclusions) that were agreed upon with the client. The objective of most appraisal assignments is to develop an opinion of market value. The valuation process contains all the steps appropriate to this type of assignment. The model also provides the framework for developing an opinion of other defined values. The valuation process is accomplished through specific steps. The number of steps followed depends on the intended use of the assignment results, the nature of the property, the scope of work deemed appropriate for the assignment, and the availability of data. The model provides a pattern that can be used in any appraisal assignment to perform market research and data analysis, to apply appraisal techniques, and to integrate the results of these activities into an opinion of defined value. In addition to assisting appraisers in their work, models that apply the valuation process are recognized by the market of appraisal users and facilitate their understanding of appraisal conclusions. Research begins after the appraisal problem has been identified and the scope of work required to solve the problem has been determined. The analysis of data relevant to the problem starts with an investigation of trends observed at the market level—international, national, regional, or neighborhood. This investigation (i.e., the market analysis) helps the appraiser understand the interrelationships among the principles, forces, and factors that affect real property value in the specific market area. Research also provides raw data from which the appraiser can extract quantitative information and other evidence of market trends. Such trends may include positive or negative percentage changes in property value over a number of years, the population movement into an area, and the number of employment opportunities available and their effect on the purchasing power of potential property users. In assignments to develop an opinion of market value, the ultimate goal of the valuation process is a well-supported value conclusion that reflects all of the pertinent factors that influence the market value of the property being appraised. To achieve this goal, an appraiser studies a property from three different viewpoints, which are referred to as the approaches to value. 46
The appraisal of real estate , Appraisal Institute, Foundations of appraisal, 2013
184
1
In the cost approach, value is estimated as the current cost of reproducing or replacing the
improvements (including an appropriate entrepreneurial incentive or profit), minus the loss in value from depreciation, plus land value. 2
In the sales comparison approach, value is indicated by recent sales of comparable
properties in the market. 3
In the income capitalization approach, value is indicated by a property’s earning power,
based on the capitalization of income. Traditionally, specific appraisal techniques are applied within the three approaches to derive indications of real property value. One or more approaches to value may be used depending on which approaches are necessary to produce credible assignment results, given the intended use. The three approaches are interrelated. Each requires the gathering and analysis of data that pertains to the property being appraised. Each approach is outlined briefly in this chapter and discussed in detail in subsequent sections of this book. From the approaches applied, the appraiser develops separate indications of value for the property being appraised. To complete the valuation process, the appraiser integrates the information drawn from market research, data analysis, and the application of the approaches to reach a value conclusion. This conclusion may be presented as a single point estimate of value or, if the assignment permits, as a range within which the value may fall (or as a point referenced from a benchmark). An effective integration of all the elements in the process depends on the appraiser’s skill, experience, and judgment. The components of the valuation process are shown in Figure 4.1.
185
186
Identification of the Appraisal Problem The first step in the valuation process is the development of a clear understanding of the problem to be solved. This sets the parameters for the assignment. To solve any problem, the problem must first be identified, and only then can the appropriate solution to the problem be determined. In appraisal practice, problem identification logically precedes scope of work determination. Identification of the appraisal problem involves identifying each of the following: •
client
•
intended users, if any, in addition to the client
•
intended use of the appraisal
•
type of value and its definition
•
effective date of the opinions and conclusions
•
identification of the characteristics of the property that are relevant
to the type and definition of value and intended use of the appraisal (including its location, the property rights to be valued, and other features) • assignment conditions, including extraordinary assumptions, hypothetical conditions, and additional requirements to be followed Before identifying the characteristics of the property and any extraordinary assumptions and hypothetical conditions that are relevant to the purpose of the assignment, the appraiser must clearly identify the client, intended users, and intended use of the appraisal, the purpose of the assignment, and the effective date of the opinion of value. Once the appraisal problem has been identified, the appraiser can determine the appropriate scope of work for the assignment. Scope of Work Determination Scope of work is the most critical decision an appraiser will make in performing an assignment. (The topic is discussed in more detail in Chapter 9.) Solving an appraisal problem involves three steps: 1
Identifying the problem
2
Determining the solution (or scope of work)
3
Applying the solution
None of the three steps can be omitted, and each must be performed in order. To analyze the problem, the appraiser identifies seven key assignment elements: (1) client, (2) intended users in 187
addition to the client, (3) intended use, (4) objective of the appraisal, or type of value and its definition, (5) effective date, (6) property characteristics that are relevant to the assignment such as the interest to be valued and physical and legal characteristics), and (7) assignment conditions such as hypothetical conditions, extraordinary assumptions, and other requirements. These elements provide the framework for the assignment and allow the appraiser to identify the problem to be solved. The second step is to determine the scope of work to solve the problem. Scope of work encompasses all aspects of the valuation process, including which approaches to value will be used; how much data is to be gathered, from what sources, from which geographic It is important that appraisers fully understand the importance of determining the scope of work. More information on scope of work can be found in the handbook Scope of Work published by the Appraisal Institute. area, and over what time period; the extent of the data verification process; and the extent of property inspection, if any. The scope of work decision is appropriate when it allows the appraiser to arrive at credible assignment results and is consistent with the expectations of similar clients and the work that would be performed by the appraiser’s peers in a similar situation.
Planning the Appraisal To complete an assignment efficiently, each step in the valuation process should be planned and scheduled. Time and personnel requirements will vary with the amount and complexity of the work. Some assignments may be completed in a few days. For more complex appraisal problems, weeks or months may be spent gathering, analyzing, and applying all pertinent data. Some assignments can be performed by a single appraiser, while others require the assistance of other staff members or appraisal specialists. Sometimes the assistance of specialists in other fields is needed. For example, in valuing a hotel property, the appraiser’s findings may be augmented by the professional opinion of a personal property appraiser. Recognizing when work can or must be delegated improves efficiency and enhances accuracy, but appraisers should also be aware of the responsibilities inherent in the use of reports prepared by others. (These types of concerns are addressed in the Appraisal Institute’s Guide Note 4 and Standards Rule 2-3 of the Uniform Standards of Professional Appraisal Practice.) The appraiser or appraisers signing the certification bear the ultimate responsibility for the assignment. That is, any appraiser who signs any portion of an appraisal report must sign the certification. With a comprehensive view of the assignment, the appraiser can recognize the type and volume of work to be done and schedule and delegate that work properly. 188
The appraiser’s work plan usually includes an outline of the proposed appraisal report. The major parts of the report are delineated, and the data and procedures involved in each section are noted. Using this outline, data can be assembled intelligently and the appropriate amount of time can be allocated to each step in the valuation process.
Data Collection and Property Description Following the preliminary analysis (i.e., the identification of the appraisal problem and determination of the scope of work), the appraiser gathers data on the market area, the subject property, and comparable properties in the market. The data needed by appraisers can be divided into general data and specific data. General data includes information about trends in the social, economic, governmental, and environmental forces that affect property value in the defined market area. A trend is a momentum or tendency in a general direction brought about by a series of interrelated changes. Trends such as population shifts, declining office building occupancy rates, and increased housing starts in a market area are identified by analyzing general data. General data can contribute significantly to an appraiser’s understanding of the marketplace. Specific data relates to the property being appraised and to comparable properties. This data includes legal, physical, locational, cost, and income and expense information about the properties and the details of comparable sales. Financial arrangements that could affect selling prices are also considered. Data on comparable properties can be either general data that an appraiser has on file or specific data that must be gathered for a particular assignment. More often, comparable property data is specific supply and demand data that relates to the competitive position of properties similar to the subject. Supply data includes inventories of existing and proposed competitive properties, vacancy rates, and absorption rates. Demand data may consist of population, income, employment, and survey data pertaining to potential property users. From this data an estimate of future demand for the present or prospective use or uses of the subject property is developed. The amount and type of data collected for an appraisal depend on the approaches used to develop an opinion of value and on the defined scope of work. In a given valuation assignment, more than one approach to value is often appropriate and necessary to arrive at a value opinion. Depending on the problem or problems to be addressed, one approach may be given greater emphasis in deriving the final opinion of value. In conducting a particular assignment, the appraiser’s judgment and experience and the quantity and quality of data available for analysis may determine which approach or approaches are used. 189
The data collected should be meaningful and relevant. All pertinent value influences, facts, and conclusions about trends should be clearly indicated in the report and related specifically to the property being appraised. Because the data selected forms the basis for the appraiser’s judgments, a thorough explanation of the significance of the data reported ensures that the reader will understand these judgments. Irrelevant data should be excluded because the inclusion of that data may detract from the credibility of the appraiser’s analyses and conclusions. Data on prior sales of the subject property is almost always relevant. It is not sufficient to simply report the subject’s sales history. When an opinion of market value is to be developed, professional standards require that the appraiser analyze all sales of the subject property that occurred in the three years prior to the date of value. Any agreements of sale (e.g., contracts), options, or listings that are current as of the date of appraisal and available in the normal course of business must also be analyzed. Listing the sales or other agreements is just a start. Declining markets prove a challenge. In the 2013 market, analyzing sales of the subject property that occurred within the previous three years was difficult. Many agricultural, residential, industrial, and office properties went through the foreclosure process, and the titles to these properties were transferred to banks and other lenders. Information on the details of these transactions was often not available. Data Analysis Once the appropriate data on the market area, subject property, and site has been collected and reviewed for accuracy, the appraiser begins the process of data analysis, which has two components: market analysis and highest and best use analysis. Even the simplest valuation assignments must be based on a solid understanding of prevalent market conditions and the highest and best use of the real estate. The two forms of analysis are related. In fact, an appraiser’s investigation into trends affecting the economic base of the market area leads directly into the determination of highest and best use. Market Analysis Market analysis is a study of market conditions for a specific type of property. A description of prevalent market conditions helps the reader of an appraisal report understand the motivations of participants in the market for the subject property. Broad market conditions provide the background for local and neighborhood market influences that have direct bearing on the value of the subject property. Analyses of market conditions and highest and best use are crucial to the valuation process when a market value opinion is the objective of the assignment. 190
Market analysis, which is discussed in detail in Chapter 15, serves two important functions. First, it provides a background against which local developments are considered. Second, a knowledge of the broad changes that affect supply and demand gives an appraiser an indication of how values change over time. The data and conclusions generated through market analysis are essential components in other portions of the valuation process. In fact, most of the time and effort involved in the valuation process are devoted to market analysis, which includes collecting, verifying, and analyzing data. Market analysis yields information needed for each of the three traditional approaches to value. In the cost approach, market analysis provides the basis for adjusting the cost of the subject property for depreciation, i.e., physical deterioration and functional and external obsolescence. In the income capitalization approach, all the necessary income, expense, and rate data is evaluated in light of the market forces of supply and demand. In the sales comparison approach, the conclusions of market analysis are used to delineate the market and thereby identify comparable properties. The extent of market analysis and the level of detail appropriate for a particular assignment depend on the appraisal problem under examination. Appraisers who are doing business in a generally stable market on a daily basis should have all the necessary demographic and economic information to document market conditions on file. When the appraisal assignment is complex— e.g., an analysis of the feasibility of a subdivision development—a more detailed market analysis will be required. Regardless of the assignment’s complexity, the logic of the market analysis should be communicated clearly to the reader in the appraisal report. The level of detail may depend on the needs of the client and other intended users and on the intended use of the report. Highest and Best Use Analysis Whenever a market value opinion is developed, highest and best use analysis is necessary. Through highest and best use analysis, the appraiser interprets the market forces that affect the subject property and identifies the use or uses on which the final opinion of value is based. (Highest and best use analysis is discussed in detail in Chapter 16.) Although highest and best use analysis is an essential part of the valuation process, it is often one of the weakest areas in an appraisal. It is too often viewed as a necessary but fruitless exercise, when it is really the heart of the assignment in an analysis of market value. If highest and best use is not adequately addressed, the appraiser may inappropriately analyze the property being appraised. When the assignment objective is to develop an opinion of market value, the appraiser must address the question of the highest and best use for whatever is being valued. In valuing an 191
improved property, the appraiser must address the question of the highest and best use as cur-
rently improved. In valuing a vacant site, the appraiser must address highest and best use as though vacant. In valuing a site as if vacant (for example, in applying the cost approach to an improved property), the appraiser must address the question of the highest and best use as if
vacant. Analyzing the highest and best use of the land as though vacant helps the appraiser identify comparable properties. Whenever possible, the property being appraised should be compared with similar properties that have been sold recently in the same market. Potentially comparable properties that do not have the same highest and best use are usually eliminated from further analysis. Estimating the land’s highest and best use as though vacant is a necessary part of deriving an opinion of land value. There are two reasons to analyze the highest and best use of the property as improved. The first is to help identify potentially comparable properties. Each improved property should have the same or a similar highest and best use as the improved subject property, both as though vacant and as improved. The second reason to analyze the highest and best use of the property as improved is to decide which of the following options should be pursued: •
Maintain the improvements as is.
•
Cure items of deferred maintenance and retain the improvements.
•
Modify the improvements (e.g., renovate, modernize, or convert).
•
Demolish the improvements.
In some situations, a property may be subject to restrictions (e.g., historic preservation) that prevent the improvements from being demolished. In this case, the highest and best use is limited by the restriction. The highest and best use conclusion should specify the optimal use (or uses), when the property will be put to this use or achieve stabilized occupancy, and who would be the most likely purchaser or user of the property (e.g., an owner-operator of the property or an equity or debt investor).
Land Value Opinion Land value can be a major component of total property value. Appraisers often develop an opinion of land value separately, even when valuing properties with extensive building improvements. Land value and building value may change at different rates because improvements are almost always subject to depreciation. For many appraisals, a separate opinion of land value is required. 192
Although a total property value estimate may be derived in the sales comparison or income capitalization approach without separating land and improvement values, it may be necessary to estimate land value separately to isolate the value the land contributes to the total property. In the cost approach, the value of the land must be estimated and stated separately. Developing an opinion of land value can be considered a separate step in the valuation model or an essential technique for applying certain approaches to value, depending on the defined appraisal problem and on the highest and best use analysis. The relationship between highest and 2
best use and land value may indicate whether an existing use is the highest and best use of the land. Typically, land valuation is performed as part of a cost approach analysis, but if the cost approach is not applied in the assignment, it is possible to develop a well-supported appraisal without a separate land value conclusion. As one example, a land value conclusion is not required in the appraisal of one condominium unit in a large residential condominium project. An appraiser can use several techniques to obtain an indication of land value: •
sales comparison
•
extraction
•
allocation
•
subdivision development
•
land residual
•
ground rent capitalization
Usually the most reliable way to estimate land value is by sales comparison. When few sales are available, however, or when the value indications produced through sales comparison need additional support, procedures like extraction or allocation may be applied. The other methods of land valuation, which all involve income capitalization techniques, are subject to more limitations and are used less often in everyday appraisal practice. The subdivision development technique is a 3
specialized valuation method useful in specific land use situations. The land residual technique is used more often in highest and best use analysis to test the feasibility of various uses than to estimate land value as part of one of the traditional approaches to value. Ground rent capitalization can be used when land rents and land capitalization rates are readily available—e.g., for appraisals in well-developed areas. (These land valuation techniques are discussed in detail in Chapter 17.)
193
Application of the Approaches to Value The valuation process is applied to develop a well-supported opinion of a defined value based on an analysis of pertinent general and specific data. Appraisers develop an opinion of property value with specific appraisal procedures that reflect three distinct methods of data analysis:
sales comparison approach
Income capitalization approach
cost approach
One or more of these approaches are used in all estimations of value. The approaches employed depend on the type of property, the intended use of the appraisal, the applicable scope of work, and the quality and quantity of data available for analysis. All three approaches are applicable to many appraisal problems, but one or more of the approaches may have greater significance in a given assignment. One of the three approaches to value—sales comparison, income capitalization, and cost— may be especially effective in a given situation. An appraiser often employs more than one approach. For example, the sales comparison approach is usually emphasized in the valuation of singleunit residential properties. However, this approach may not be applicable to specialized properties such as garbage disposal plants because comparable data may not be available. The income capitalization approach is used to value most income-producing properties, but it can be particularly unreliable in the market for commercial or industrial property where owneroccupants outbid investors. The income capitalization approach is not typically applied in valuing homes. The cost approach may be more applicable to new and special-purpose properties and less applicable in valuing properties with older improvements that suffer substantial depreciation, which can be difficult to estimate. Appraisers should apply all the approaches that are applicable and for which there is data. The alternative value indications derived can either support or refute one another.
Sales Comparison Approach The sales comparison approach is most useful when a number of similar properties have recently been sold or are currently for sale in the subject property’s market. Using this approach, an appraiser produces a value indication by comparing the subject property with similar (i.e., comparable) properties. The sale prices of the properties that are judged to be most comparable tend to indicate a range in which the value indication for the subject property will fall. 194
The appraiser estimates the degree of similarity or difference between the subject property and the comparable sales by considering various elements of comparison: •
real property rights conveyed
•
financing terms
•
conditions of sale
•
expenditures made immediately after purchase
•
market conditions
•
location
•
physical characteristics
•
economic characteristics
•
legal characteristics
195
•
non-realty components of value Dollar or percentage adjustments are then applied to the
known sale price of each comparable property to derive an indicated value for the subject property. Qualitative analysis techniques may also be applied for elements of comparison for which quantitative adjustments cannot be developed. Through this comparative procedure, the appraiser renders an opinion of the value that was defined in the problem identification as of a specific date. The sales comparison approach can provide an indication of value for fee simple, leased fee, or leasehold interests, depending on what real property rights are represented in the sales of comparable properties. Income multipliers and capitalization rates may also be extracted through analysis of comparable sales, though these factors are not regarded as elements of comparison in the sales comparison approach. Instead, they should be applied in the income capitalization approach. Income Capitalization Approach In the income capitalization approach, the present value of the anticipated future benefits of property ownership is measured. A property’s income and resale value upon reversion may be capitalized into a current, lump-sum value. There are two methods of income capitalization: direct capitalization and yield capitalization. In direct capitalization, the relationship between one year’s income and value is reflected in either a capitalization rate or an income multiplier. In yield capitalization, several years’ forecast income and a reversionary value at the end of a designated period are converted to present value using a yield rate. The most common application of yield capitalization is discounted cash flow analysis. Given the significant differences in how and when properties generate income, there are many variations in both direct and yield capitalization procedures, which are addressed in Chapter 20. Like the sales comparison and cost approaches, the income capitalization approach requires extensive market research. Data collection and analysis for this approach are conducted against a background of supply and demand relationships, which provide information about trends and market anticipation. The specific data that an appraiser investigates in the income capitalization approach might include the property’s gross income expectancy, the expected reduction in gross income caused by vacancy and collection loss, the anticipated annual operating expenses, the pattern and duration of the property’s income stream, and the anticipated reversionary value. After income and expenses are estimated, the income streams are capitalized by applying an appropriate rate or factor or converted into present value through discounting. In discounted cash flow analysis, the quantity, variability, timing, and duration of a set of periodic incomes and the quantity and timing of the reversion are specified and discounted to a present value at a specified yield rate. The rates 196
used for capitalization or discounting are derived from acceptable rates of return for similar properties. Like the other approaches to value, the income capitalization approach is applicable in the valuation of various property interests. Real property that produces income in the form of rent is usually leased, which creates legal estates of the ownership interests of the lessor and lessee (i.e., the leasehold and leased fee interests). The valuation of the fee simple interest of leased property, which is not an uncommon appraisal assignment, may or may not require the valuation of the individual interests.
Cost Approach The cost approach is based on the understanding that market participants relate value to cost. In the cost approach, the value of a property is derived by adding the estimated value of the land to the current cost of constructing a reproduction or replacement for the improvements and then subtracting the amount of depreciation (i.e., deterioration and obsolescence) in the structures from all causes. Entrepreneurial incentive (the amount to developer expects to receive) or entrepreneurial profit (the amount actually received) may be included in the value indication. This approach is particularly useful in valuing new or nearly new improvements and properties that are not frequently exchanged in the market. Cost approach techniques can also be employed to derive information needed in the sales comparison and income capitalization approaches to value, such as the costs to cure items of deferred maintenance. The current costs to construct the improvements can be obtained from cost estimators, cost manuals, builders, and contractors. Depreciation is measured through market research and the application of specific procedures. Land value is estimated separately in the cost approach. Typically the cost approach provides an indication of the value of the fee simple interest. The value indication may need to be adjusted accordingly if a leased fee or other partial interest is being valued.
Final Reconciliation of Value Indications The final analytical step in the valuation process is the reconciliation of the value indications derived into a value conclusion. Reconciliation occurs within each approach to value, but the final reconciliation occurs at the end of the valuation process. The value conclusion can be expressed as a single number, as a range of numbers, or as a number greater than or less than a specified, benchmark amount. The nature of reconciliation depends on the appraisal problem, the 197
approaches that have been used, and the reliability and adequacy of the data used. When all three approaches have been used, the appraiser examines the three separate indications and considers the relative dependability and applicability of each approach. In the reconciliation section of the report, the appraiser can explain variations among the indications produced by the different approaches and account for differences between the value conclusions and methods applied.
Report of Defined Value An appraisal report is the tangible expression of the appraiser’s work. The preparation and delivery of the appraisal report is generally the last step in the valuation process. The report may be communicated to the client in writing or orally. Chapter 31 describes the requirements for appraisal reports and the circumstances under which they are prepared and submitted. The report of the value opinion, which is the last step in the valuation process, addresses the data analyzed, the methods applied, and the reasoning that led to the value conclusion.
198
Different Types of Value "Market Value"(definition and the conceptual framework settled by the International Valuation Standards Council), which is defined as: The estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.
Value in Use IFRS Definition from IAS 36: “The present value of the future cash flows expected to be derived from an asset or cash-generating unit.” Fair Value i. The estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties. For use in financial reporting under International Financial Reporting Standards, fair value has a different meaning: ii. In IFRS 13 “Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Investment Value The value of an asset to the owner or a prospective owner for individual investment or operational objectives. Liquidation Value The net amount that would be realized if a business is discontinued and its assets are sold individually. The appropriate bases of value and any appropriate additional qualifying assumptions should also be stated. Net Book Value 1. In relation to a business enterprise: The difference between total assets (net of accumulated depreciation, depletion, and amortization) and total liabilities as they appear on the balance sheet. 2. In relation to a specific asset: The capitalized cost less accumulated amortization or depreciation as it appears on the books of account of the business enterprise 199
Net Present Value The value, as of a specified date, of future cash inflows less all cash outflows (including the cost of investment) calculated using an appropriate discount rate. Present Value The value, as of a specified date, of a future payment or series of future payments discounted to the specified date (or to time period zero) at an appropriate discount rate. Replacement Cost The current cost of a similar asset offering equivalent utility. Reproduction Cost The current cost of creating a replica of the asset Residual Value 1. The anticipated value of an asset at the expiration of its useful life. See also: Salvage Value 2. IFRS definition (IAS16): “The estimated amount that an entity would currently obtain from disposal of an asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.” The application of the IFRS definition is described in IVS 300 Valuations for Financial Reporting. Salvage Value The value of an asset that has reached the end of its economic life for the purpose it was made. The asset may still have value for an alternative use or for recycling. Special Value An amount that reflects particular attributes of an asset that are only of value to a special purchaser. Terminal Value The value at the end of an explicit forecast period of all remaining projected cash flows.
200
Literature 1. The Appraisal of Real Estate , Appraisal Institute (US), Editor Michael McKinley, 2013. ISBN 978-1-935328-38-4 2. Real Estate Principles; Charles J. Jacobus; ISBN-13: 978-0324787498 ISBN10: 0324787499 Edition: 11th; 2009; 3. Market Analysis for Real Estate by Rena Mourouzi‐Sivitanidou, edited by Petros‐Sivitanides, unpublished manuscript. Copyright 2011 by Petros Sivitanides, 4. http://isites.harvard.edu /icb/icb.do? keyword=k87530&pageid= icb.page505436&pageConte ntId=icb.pagecontent11988 08&view=view.do&vi ewParam_directory=/RCA 5. Urban Economics and Real Estate Markets, Denise DiPasquale and William C. Wheaton; Prentice Hall 1995 6. Investment by Design: A Primer in Real Estate Analysis;Real Estate Center (May 1995) ISBN10: 1562480081 ISBN-13: 978-1562480080; 7. Civil code of Georgia, article 149. 8. Liparteliani D, Urban Land Cadastre in Georgia / D. Liparteliani // Caucasian geographical review/ Geographic Society of Georgia- Tbilisi, 2003.-#2.- p.33-37. 9. Law of Georgia. Conservation of soils and improving the fertility, http://www.cenn.org/wssl/programs/niadagis_konservacia_Soil_Conservation.pdf 10. http://geostat.ge/cms/site_images/_files/georgian/agriculture/sakartvelos%20bunebrivi%20resurs ebi%20da%20garemos%20dacva_2012.pdf 11. http://greenwich.ge/?page=service&lang=geo&id=26 12. http://www.nerrs.noaa.gov/doc/siteprofile/acebasin/html/gis_data/gisint2.htm http://ivs.org/
201
![[PDF] Download Real Estate Economics Pages Full - Google Sites](https://m.moam.info/img/260x300/pdf-download-real-estate-economics-pages-full-goog_6477cdf3097c474c228c6ee1.jpg)
![[PDF]Download Urban Economics and Real Estate ... - Google Sites](https://m.moam.info/img/260x300/pdfdownload-urban-economics-and-real-estate-google_647740e0097c4786708b8150.jpg)
![[PDF] Real Estate Economics - ALL Ebook Downloads ... - Google Sites](https://m.moam.info/img/260x300/pdf-real-estate-economics-all-ebook-downloads-goog_6478269a097c4744708c81f5.jpg)
![[PDF BOOK] Urban Economics and Real Estate: Theory ... - Google Sites](https://m.moam.info/img/260x300/pdf-book-urban-economics-and-real-estate-theory-go_64779507097c47a9708bdf60.jpg)
![[PDF] Download Books Real Estate Economics Review ... - Google Sites](https://m.moam.info/img/260x300/pdf-download-books-real-estate-economics-review-go_647766fb097c4786708bab9b.jpg)
![[PDF] Download Urban Economics and Real Estate ... - Google Sites](https://m.moam.info/img/260x300/pdf-download-urban-economics-and-real-estate-googl_6477bb6e097c4744708c0a40.jpg)
![[PDF] Download International Real Estate Economics ... - Google Sites](https://m.moam.info/img/260x300/pdf-download-international-real-estate-economics-g_6476fe8b097c474d228b657c.jpg)
