Chapter 1 The Real Estate Space Market & Asset Market 1© 2014 OnCourse Learning. All Rights Reserved

Chapter 1

The Real Estate Space Market & Asset Market

© 2014 OnCourse Learning. All Rights Reserved.

What’s a “market”?…

A mechanism for the voluntary exchange of goods and services among owners.


Two types of markets relevant to commercial property:1. The Space Market . . .

– For the usage (or right to use) “real property”. – AKA “usage market”, or “rental market”. – (e.g., tenants & landlords exchange money for

leases.)

2. The Asset Market . . .– For the ownership of “real property”.– AKA “property market”.– (e.g., Oh.STRS exchanges my pension $ for an

office bldg.)


What’s “real property”?…

Ans: Land & built space.


1.1.1 The Space Market…Supply:

Property Owners(Landlords)

Demand:

Property Users(Tenants)

MARKET

· Rents (e.g.$/SF) · Occupancy


1.1.2 “Segmentation” in the Space Market…A market is “segmented” if it breaks up

into sub-markets, or market segments. Within each sub-market or segment, the

same good may have a different equilibrium price.

The real estate space market is highly segmented.

Why?…


Demand side:

Users require specific types of space… A lawyer can’t use a warehouse. A trucking firm can’t use a high-rise office bldg.

Users require specific locations (or types of locations)… A lawyer won’t get much business at the intersection of I-70 and I-77. A trucking firm’s trucks would spend all their time stuck in traffic if their warehouse were located in downtown Cincinnati.


Supply side:

Buildings are of specific physical types (warehouses high-rise offices).

Buildings are in specific locations (and they can’t move!).


Concept check…1. Is there a functioning market for

apartment rental in Cambridge?…2. Is there a functioning market for

apartment rental in the Boston metro area as a whole?…

3. Is there a functioning market for apartment rental in the United States as a whole?…


Concept check…4. Is there a functioning market for “building

rental” in Cambridge?…

5. Is there a functioning market for gasoline in the United States as a whole?…

6. Is there a functioning market for apartment property ownership (investment, as distinct from rental) in the United States as a whole?… [Hint: this is the asset market, not the space market.]


As a result of segmentation in the space market…As of the same point in time (in this

example, Oct.1992):Class A Office Rents =

– $23/SF/yr Dntn Chicago.– $33/SF/yr Dntn New York.

Rents in Suburban Dallas– $ 7/SF/yr for Apartments.– $13/SF/yr for Retail space.


1999 prices for a typical (same) house: 2200 SF, 4BR/2B, 2-car Garage…

New York is 10-times Houston…Boston is almost 3-times Pittsburgh:

“Location, location, location…”

City Price Index

Houston, TX $115,000 50

Pittsburgh, PA $163,000 70

Dallas, TX $180,000 78

Atlanta, GA $200,000 87

Cleveland, OH $201,000 87

Cincinnati $231,000 100

Chicago, IL (Schaumburg) $300,000 130

New York, NY (Westchstr) $353,000 153

Chicago, IL (Lincoln Pk) $409,000 177

Boston, MA $421,000 182

Los Angeles, CA (Hollywd) $530,000 229

San Francisco, CA (city) $720,000 311

New York, NY (Manhattan) $1,144,000 495

Source: Caldwell-Banker


Two major dimensions of space mkt segmentation:Geographic locationProperty type


Geographic location:

Basic unit is the “metropolitan area” (“MSA”)

Sub-markets (e.g., CBD, Suburban, neighborhoods) also important


Property type:

Residential (apartment)OfficeIndustrial (warehouse)RetailOther (hotels, health-care, etc…)


Example space market:Cincinnati CBD Class A Office Mkt,

1980s-90s…


Exhibit 1-1: Office Demand as a Function of Employment, the 1980s…

$5

$10

$15

$20

$25

QUANTITY OF SPACE (Mil. SF)

RE

AL

RE

NT

3.5 4 4.5 5 5.5 6 6.5

GROWTH IN DEMAND

NEED=36000 WORKERSNEED=24000 WORKERS

OVER TIME

Note: Pretty “normal” shaped demand function


1.1.3. The real estate space supply function has a more peculiar shape…

Real estate space long-run supply is kinked…

$5

$10

$15

$20

$25

QUANTITY OF SPACE (Mil SF)

RE

AL

RE

NT

3.5 4 4.5 5 5.5 6 6.5

KINK

REAL ESTATE SUPPLY CURVE

RISING LRMC

FALLING LRMCEXISTINGQUANTITY

This is due to the longevity of buildings.(You can add them a lot easier than you can subtract them!)


1.1.4 Supply, Development, & Rent…

Supply function = Long-run Marginal Cost function (LRMC)

LRMC = Virtually zero (at and below existing supply)

LRMC = Development cost (beyond existing supply)

Development cost = Construction + Land (including developer profit)


$5

$10

$15

$20

$25


RE

AL

RE

NT

3.5 4 4.5 5 5.5 6 6.5

KINK


RISING LRMC


• Rising LRMC (costs more to build next than last) Land scarcity, Location demand growth

• Falling LRMC (costs less to build next than last) Loss of centrality, Location demand decline


$5

$10

$15

$20

$25


RE

AL

RE

NT

3.5 4 4.5 5 5.5 6 6.5

KINK


RISING LRMC


• Falling LRMC (Land available, Trans/Tel Infra) Typical CBD in Midwest & South

• Rising LRMC (Islands, Growth constraints) Manhattan, Boston, SF, Honolulu,…


In a market with expanding demand:

LR equilibrium rent

= “Replacement cost rent”.

= Rent the market tends to return to.

= Rent just sufficient to make new development profitable.


Example: Cincinnati CBD office market, 1980s-90s…

Devlpt Cost = $200/SF (of blt space, inclu land + construction)

Mid-1980s CBD office bldgs were selling at “8% cap rates.”

That means investors at that time were willing to pay

$1 / 0.08 = $12.50

per dollar of current net income produced by the bldg.


Thus, if office bldgs could generate $16/SF of net rent, then it would be just profitable to develop new buildings:$16 / 0.08 = $200 = Devlpt Cost

Thus, $16/SF is the LR equilibrium (“Replacement Cost”) rent.

Rents at $16/SF or more, with cap rates at 8% or less, would tend to trigger new development of downtown office buildings in Cincinnati in the 1980s.

Example: Cincinnati CBD office market, 1980s-90s…

But would this new development really turn out to be profitable?…


1.1.5. Forecasting Future Rents…

You need to forecast changes in both future demand and future supply, and consider that the “kink point” moves out with increases in current stock of supply…


What happened in the Cincinnati office market at the end of the 1980s, through early 1990s…

$5

$10

$15

$20

$25

QUANTITY OF SPACE (Mil

REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D1

S1

LRMC 16


$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D1

S1

LRMC 16

13

(1) Expecting demand to grow from D1 to D2,…

D2


$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D1

D2

S1

LRMC 16

13

S2

(1) Expecting demand to grow from D1 to D2, developers built 1 million SF new space (Chemed Ctr & 312 Walnut).


$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D1

D2

LRMC 16

13

S2



Chemed Center + 312 Walnut = 1 MSF Spec, 1990


$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D1

D2

LRMC 16

13

S2



(2) Demand stayed stuck at D1.

$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D1

D2

LRMC 16

13

S2

But what happened in reality is . . .


(2) Demand stayed stuck at D1.

$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D1 LRMC

16

13

S2

But what happened in reality is . . .


(2) Demand stayed stuck at D1 (or even fell temporarily to D0, with recession of 1991).

$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D0

D1

S2

LRMC 16

13


(3) Net rents fell from $16/SF to $13/SF or even as low as $10/SF in the early 1990s.

$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D0

D1

S2

LRMC 16

13


(3) Net rents fell from $16/SF to $13/SF or even as low as $10/SF in the early 1990s. (They eventually recovered by the late 1990s.)

$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D0

D1

S2

LRMC 16

13

How?…


Exhibit 1-3: Change in Supply & Demand & Rent over Time

$5

$10

$15

$20

$25


REAL RENT

3.5 4 4.5 5 5.5 6 6.5

D0

D1

D2

S1 S2

LRMC16

13


38

0

100

200

300

400

500

600

700

800

900

1000

0

50

100

150

200

250

1880 1900 1920 1940 1960 1980 2000 2020

Pop

ulat

ion

in M

illi

ons

Inde

x or

Int

eres

t Rat

e

Year

Home Prices

Building CostsPopulation

Interest Rates

Source: Robert Shiller (website)

1.1.6. Is The Supply Function Rising, Level, or Falling?...

Exhibit 1-4: Long-run history of real home prices, building costs, population, and interest rates in the United States.


39

0

100

200

300

400

500

60019

52

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Real GDP Population Real Home Prices

Real GDP, Population, Real Home Prices: 1952-2011…Robert Shiller Real Home Price Index, NBER Recessions

1952=100 shaded bars = GDP recessions…


40

0

10

20

30

40

50

60

70

80

19881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010

Gro

ss A

skin

g Re

nt ($

/SF-

YR)

Manhattan Class A Office Market Rents: 1988-2010 Nominal & Real

Nominal dollars

Real (constant1988 dollars)

Real (constant2010 dollars)

Source: CBRE Econometrics

Exhibit 1-5:


1.2 The Real Estate Asset Market (Property Market)…

Supply:

InvestorsWanting to Sell

Demand:

InvestorsWanting to Buy

MARKET

Property Prices:“Cap Rates”

1/($Asset/$Income)


For investors:

Real Estate Assets = Future Cash Flows “Cash is fungible.” Cash is cash is cash, whether it comes from real estate, stocks, or bonds. Real estate assets compete against stocks & bonds. The real estate asset market is part of the broader capital market .


Exhibit 1-6: Major Types of Capital Asset Markets and Investment Products

Public Markets:

Private Markets:

Equity Assets:

StocksREITsMutual fundsETFs

Real PropertyPrivate firmsOil & Gas PartnershipsHedge Funds

Debt Assets:

BondsMBSMoney

instruments

Bank loansWhole MortgagesVenture Debt


Concept check…

1. What is the difference between “equity” and “debt” assets (investment products)?…

2. What is the difference between “public” and “private” asset markets?…


1.2.2 The Magnitude of Real Estate in the overall Capital Market…

Exhibit 1-7 US Capital Market Sectors, a $70 Trillion Pie…

Magnitude


Source: Authors’ estimates based on Miles & Tolleson (1997).

U.S. Capital Market Sectors, a $70 Trillion Pie

Public Debt (22% RE), 30%

Public Equity (17% RE*),

24%

Private Equity (78% RE), 30%

Private Debt (49% RE), 16%

*Corporate real estate owned by publicly traded firms, plus REITs.Source: Authors' estimates based on Miles & Tolleson (1997) updated with FRB statistics.* Corporate real estate owned by publicly-traded firms, plus REITs.

Exhibit 1-8: US Investable Capital Market with Real Estate Components Broken Out

Magnitude

U.S. Investable Capital Market with Real Estate Components Broken Out. (Source: Based on Miles & Tolleson 1997)

Stocks26%

REIT Equity0%

Agricultural/Timberlands2%

Commercial Real Estate Equity

7%House Equity17%

Private Residential Mortgages

6%

RMBS6%

CMBS1%

Private Commercial Mortgages

2%

Bonds24%

Private Debt9%


Real estate asset classes are:

Private Commercial Mortgages (2%)

CMBS (1%)

RMBS (6%)

Private Residential Mortgages (6%)

House Equity (17%)

Commercial Real Estate Equity (7%)

Agricultural/Timberlands (2%)

REITs (0.5%)


48

US Investable Asset Sectors, a $82 Trillion Pie…

Another perspective on magnitude of real estate in the overall capital market ($ trillion as of 2012)

Bonds; 38

Stocks; 15

CRE; 9

Houses; 20

Note: CRE = Commercial Real Estate. There is some double-counting here, betw MBS bonds & RE ($5T), & between REIT stocks & CRE ($0.5T).


49

Houses, $15,527

Commercial R.E., $8,922

Govt. R.E., $5,751

Net Asset Value of U.S. Structures ($ billions, 2008, source BEA)

Total = $ 30,200

How much real estate is there?...

About $30 trillion worth


50

Net Asset Value of U.S. Commercial Real Estate Structures ($ billions, 2008, source BEA)

Total = $ 8,922 Billion

Office, $1,779

Retail, $2,040

Industrial*, $1,375

Residential (apts), $1,496

Hotel & Recreational,

$813

Institutional, $1,420

*Industrial excludes factories & manufacturing/extraction plants

How much commercial real estate is there?...

About $9 trillion worth


51© 2014 OnCourse Learning. All Rights Reserved.

Property Type Square Footage $/SF Market Cap

Office 12,058,379,264 $102 $1,229,954,684,928

Industrial 23,851,606,671 $45 $1,073,322,300,195

Flex 2,907,635,121 $75 $218,072,634,075

Retail 17,336,105,191 $101 $1,750,946,624,291

Health Care 2,634,773,693 $490 $1,291,039,109,668

Hospitality 2,556,726,260 $95 $242,888,994,700

Mixed-Use 107,651,632 $95 $10,226,905,040

Multi-Family 22,643,500,000 $62 $1,403,897,000,000

Specialty, Sports & Entertainment NA $1,953,008,671,667

Total 84,096,377,832 $9,173,356,924,466

Source: Florance, Miller, Spivey, Peng, JREPM 16(2) 2010

How much commercial real estate is there?...

Market Size by Property type sin Rentable Building Area and Market Cap Based on Mean Price for the Mid-Point of 2009

52

Magnitude

Office 12.05814%

Industrial 23.852

28%

Flex (Office/Indust)

2.9074%

Retail 17.33621%

Health Care 2.635

3%

Hospitality 2.557

3%

Mixed-Use 0.108

0%

Multi-Family 22.645

27%

Exhibit 1-9a: U.S. Commercial Property by Physical Stock (billions of square feet)

Total = 84 BSF (exclu Specialty/Entertnmt)

Office 123014%

Industrial 107312% Flex

(Office/Indust) 2182%

Retail 175119%

Health Care 129114%

Hospitality 2433%

Mixed-Use 100%

Multi-Family 140415%

Specialty/Entertainment 1953

21%

Exhibit 1-9b: U.S. Commercial Property by Valuation ($ billions)

Total = $9,173 billion

Exhibit 1-9: Magnitude of U.S. Commercial Real Estate by Sector, cerca 2010…

Source: CoStar.


Investable Real Estate Capital Structure

Source: Roulac Group (Investment Property Report, 12/11/02), & PPR Inc.

Total Equity: $907.6 billion

Total Debt: $1,831.9 billion

Total Capital: $2.7 trillion

+ =

Private Investors

51.6%

REITs19.0%

Public Real Estate LPs

0.1%Pension Funds20.9%

Foreign Investors

5.3%

Private Financial Institutions

1.1%

Life Insurance Companies

2.1%

Mortgage REITs0.4%Commercial

Mortgage Securities

21.4%

Government Credit

Agencies7.3%

Savings Institutions

9.0%

Pension Funds2.3%

Public Real Estate LPs

0.0%


15.9%

Commercial Banks43.7%

Total Public Equity

6%Total Private

Equity27%

Total Public Debt19%

Total Private Debt48%

Magnitude


1982: $529 Billion

Private Equity18%

Private Debt72%

Public Debt9%

Public Equity

1%

1990: $1.4 Trillion

Private Equity29%

Private Debt59%

Public Debt10%

Public Equity

2%

2002: $2.7 Trillion

Private Equity27%

Private Debt48%

Public Debt19%

Public Equity

6%

Evolution of U.S. Investable Real Estate Market

Source: PPR

Magnitude


55

How is institutional real estate financed?...

Private Debt47%

Public Debt26%

Private Equity9%

Public Equity18%

$4.2 Trillion Instl Stock

Institutional Real Estate Capital Structure: 2011

Source: PPR, 2011


56

Source: Real Capital Analytics Inc.

Exh.7-12: How is institutional real estate financed?... Buyers’ equity:

4%

9%

15%

10%

7%

7%

41%

45%

50%

31%

32%

40%

4%

6%

6%

8%

5%

5%

10%

9%

7%

18%

17%

12%

34%

24%

15%

25%

28%

28%

8%

7%

6%

8%

11%

8%

2007

2008

2009

2010

2011

H1 '12

User/Other Private Non-Listed REITPublic/REIT Inst'l/Eq Fund Cross-Border

Properties $5M+


57

Source: Real Capital Analytics Inc.

Exh.7-13: How is institutional real estate financed?... Buyers’ debt:


58


10%

Commercial Banks45%

Savings Institutions

6%

Pension Funds3%

GSE/Gov't Agencies

11%

Commercial Mortgage Securities

20%

Mortgage REITS

5%

$3.1 Trillion Debt Outstanding

Institutional Real Estate Debt Sources: Outstanding Balance as of 2011

Source: PPR, 2011

How is institutional real estate financed?...


59*Real estate represented by institutional grade investment property (NCREIF-based TBI transaction based index)

0%

5%

10%

15%

Real Estate (TBI*)

Stocks Bonds T-Bills CPI

Investment Total Return Performance (per annum avg) as of June 30, 2012

1yr. 5yr. 10yr. 20yr.

Total Investment Return Per Annum as of 2012(2Q)0 Real Estate (TBI*)Stocks Bonds T-Bills CPI

1yr. 12.51% 5.45% 8.32% 0.04% 1.66% 3yr. 12.06% 16.40% 5.65% 0.10% 2.09% 5yr. 0.59% 0.22% 6.64% 0.86% 1.95% 10yr. 8.84% 5.33% 5.36% 1.76% 2.46% 20yr. 9.24% 8.35% 6.24% 3.16% 2.49%

Real Estate vs Stocks & Bonds…Investment “total return” includes income + capital growth:

1.2.3. The Pricing of Real Estate Assets:

“Cap Rates”… Commercial property prices are typically quoted in terms of “Cap Rates” (short for “capitalization rate”), AKA “OAR” (short for “overall rate”).

iceoperty

IncomeNetAnnualCurrentRATECAP

PrPr


The Cap Rate is like:

Current yield on the investment.Inverse of “Price/Earnings” Multiple.


Property value can be represented (or estimated) as:

RATECAP

IncomeNetAnnualCurrenticeoperty PrPr


Three major determinants of cap rates …

1) The Opportunity Cost of Capital (OCC) This comes from the capital market. How much return can investor’s expect to earn

in other types of investments, like stocks, bonds, money mkt?…

Higher real interest rates or higher expected returns in other types of investments will require higher expected returns in real estate, and therefore higher cap rates, other things being equal.


2) Growth Expectations in the property’s future cash flows This comes from the space market. How much can investor’s expect that this

property’s net cash flow (rents - expenses) will be able to grow over the coming years?…

Higher (realistic) growth expectations will allow a lower cap rate, as investors will be willing to pay more $ today for a given amount of current net income, in order to own the property (since this income is expected to grow).


3) Risk perceptions and preferences among investors, regarding the property. This comes from both the space market and the

capital market (risk is relative). How risky is an investment in this property, and

how much do investors care about that risk?… Greater risk, and greater sensitivity to risk, will

require higher cap rates (lower asset values per $ of current income).

1. A: An apartment building in a declining neighborhood.B: An apartment building in a growing neighborhood.

2. A: An office building with full of long-term tenants.B: An office building full of short-term tenants.

Concept check…Other things being equal, which would have the lower cap rate, Property “A”, or Property “B”?…


3. A: Real estate when LT bonds yield 6% (with 3% infla).B: Real estate when LT bonds yield 8% (with 3% infla).

4. A: A surface parking lot in a thriving downtown.B: A 10-story parking garage in a thriving downtown.

5. A: An office bldg with short-term below-mkt leases in a growing rental market.B: An office bldg with short-term above-mkt leases in a declining rental market.

Concept check…Other things being equal, which would have the lower cap rate, Property “A”, or Property “B”?…


1.2.4 Asset Markets Are Not (very) Segmented…

“Physical Capital” = Real physical assets that produce real goods or services over an extended period of time.

“Financial Capital” = Money. Physical capital is specific and relatively

immobile. Financial capital is fungible (homogeneous) and

very mobile.


Physical Capital and Financial Capital

In the real estate asset market, financial capital is used to purchase physical capital assets.

The real estate space market deals with physical capital.

The real estate asset market deals with financial capital.


Financial Capital

Financial capital can quickly and easily flow from a Manhattan office bldg to a Chicago office bldg or a Dallas apt bldg. Returns are returns are returns, because $$$ are $$$ are $$$, whether those $$$ come from New York office rents, Chicago office rents, or Dallas apartment rents.

Therefore:


THE REAL ESTATE ASSET MARKET IS NOT SEGMENTED LIKE THE SPACE MARKET

Integrated (not segmented) real estate asset market Asset prices are such that expected returns are the same for properties with the same risk, across different property market segments…


Exhibit 1-10: Typical Cap Rates, 3rd Qtr 1994:

Cap Rates (OARs) for Commercial PropertyAs of 3rd Quarter, 1994

7.73%

9.79% 9.60% 9.73%9.44%

8.73% 8.90%

10.57%

9.35%8.88%

11.20% 11.27%

0

0.02

0.04

0.06

0.08

0.1

0.12

Malls Office(CBD) Office(LA) Office(DC) Warehouse Hotels(Lux)

Property Type/Location

Cap

Rate

(Inc

ome

/ Ass

et V

alue

)


73

5%

6%

7%

8%

9%

10%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Exhibit 1-11: Average Commercial Property Transaction Cap Rates: 2001-2010

Apts

Indust

Office

Retail

Sourc e: Real Capital Analytics Inc


Concept check…

1) Why are the cap rates lower for mall?…

2) Why are the cap rates higher for hotels and offices in “oversupplied” markets?…


Documents

Chapter 1 The Real Estate Space Market & Asset Market 1© 2014 OnCourse Learning. All Rights Reserved