Real Estate Market

Real Estate Market • Real Estate • Objective •Purpose and function of a Market • Market Structure •Market Arrangements •Market Participants •Real Estate Process •Highest and Best Use • The Most Fitting and Most Probable Use Concept Definition of Real Estate •Definition •Describe how the Real Estate Sector within the National Economy •To distinguish between the market for real estate use( where space is rented or purchased for occupancy) and the markets for real estate assets ( where buildings are bought and sold for investment) Background • What is real estate? 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 the largest single component of national wealth Background (cont’d) • The yearly value of new buildings put in place represent an annual investment in the nation’s stock of capital. The dollar value of these new building also has been the largest single category of national investment in recent years. Investment in new building accounts for 7 percent of gross domestic product (GDP) Background ( cont’d) • Of this 7 percent, about 60 percent is payment to the construction sector( for labor, construction equipment etc) with the remaining 40 percent going to producers of building materials. • It should be noted that land is not counted as part of investment or GDP since it is not a produced commodity • It is counted as stock or wealth Size and Character of US Real Estate- Value 1990 Private Construction $ in billions 338 % of GDP 6.1 Buildings Residential Non 301 183 5.5 3.3 Value of US Real Estate in 1990 Residential $ (in billions) % of Total Single family Multi family Condominium Mobile Homes Non Residential Retail Office Manufacturing Warehouse Total US Real Estate Objective • The objective of this topic is to outline the purpose and function of a market. Then market structure, arrangements, participants and process will be analyzed. The concept of highest and best use will be looked at as well as the concept of the most fitting and most probable use. Purpose and function of a Market • The purpose of a market is to arrange for the production and exchange of commodities, services or intermediate or final goods. • A market functions to enable suppliers and producers to determine the level of production • it facilitates the identification of producers and effects the allocation of goods to buyers through the price mechanism 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. • The supply of new real estate assets comes from the construction sector and depends on the price of those assets relative to the costs of replacing or constructing them Continued • The demand for owning real estate is dependent on the rental income the real estate assets earn • 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 space market) • The demand for space depends on rent and other exogenous factors such as firm production level, income levels or the number of households Continued • The link between the 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, acquiring an asset investors are really purchasing a current or future income streams. Continued • Thus changes in rent occurring in the property between the two markets 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 the supply of the assets grow , not only are the prices driven down in the asset market but rents decline in the property market as well Real Estate and the National Economy • We can trace the various aspects 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 regulation can alter the cost of supplying new space. Each has different repercussion. Economic Growth and Demand for Real Estate Use • As the economy expands, there is increase in demand to use space at current rent levels, such would occur in 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 led to greater asset prizes which in turn generate higher level of new construction Continued • Eventually this leads to greater stock of space. • Economic growth increases all variables in the real estate market, while economic contraction lead to decreases in all variables • National office market moves with the economy during recession, vacancies tend to rise, and construction falls where as the opposite occurs during recovery. The property and asset markets: property demand shifts Long Term Interest Rates and the Demand for Real Estate Assets • If the demand to own real estate shifts, the impact on the combined market 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 the interest rates rise (fall), then the existing yield from real estate becomes low (high) relative to fixed income securities and investors will wish to shift their fund from (into) the real estate sector Continued • 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 can also impact the demand to invest in real estate. If depreciation allowance for real estate increased, the same income stream generates a higher after tax yield. This will increase the demand to hold real estate assets The property and asset markets: asset demand shifts Credit, Construction Costs and the Supply of New Spaces • The final exogenous change likely to impact the real estate market is shift in the supply schedule for new construction. This can come about through several channels. • Higher short term interest rates and a general security of construction financing will increase the cost of providing a given amount of new space leading to less construction Continued • Likewise, stricter local zoning or other building regulations will also add to development costs (for a fixed level of asset prizes) reduce the profitability of new construction. This kind of negative supply changes have the effect of causing outward shift in the cost schedule. Continued • Positive changes in the supply environment, such as the easy availability of construction financing or relaxation of development regulation, move the curve inward and for the same asset price expand construction The property and asset markets: asset cost shifts Real Estate Markets and Public Policy • The real estate sector is affected by public policy changes at Local Government and National Government level • The policy may not target the Real Estate Sector specifically e.g. Interest Rates Policy on Monetary Policy clearly affects the demand for real estate assets as well as the level of new construction • Consider the following examples of major public policies Publicly Assisted Housing • Both National and Local Government provide a range of assistance programs to encourage the development low income housing. • The construction of publicly owned units generally decreases the demand for privately owned units • The decrease in demand assumes that public units succeed in attracting tenants • Rental assistance program on the other hand act to stimulate demand Local Government Development Regulation • Local Government exercise great control over the amount, and type of development permitted on privately owned land • Such regulation are in the public interest but they do impose two additional cost on private development. First, they frequently extend the time necessary for completion of a project, second they sometimes act to create scarcity of sites. This can drive up land prices and add to the site acquisition costs. • The more binding and restrictive the regulation become, the more they increase the development Taxation of Real Estate • At the local level real estate is treated quite unfavorably largely through the widespread use of taxation. Most local government financed their services through property taxation • At national level home owners are exempted from taxation of housing capital gains realized with sale of their new homes Real Estate Financial Institutions • By facilitating the flow of investment fund into mortgage lending such institutions have effectively reduced the cost of mortgage borrowing Characteristics of perfectly competitive market • • • • Large number of buyers and sellers transaction taking place frequently commodity is homogenous and divisible buyers and sellers have a sound technical knowledge of commodity • buyers and sellers entering and leaving the market at will • participants are free to compete against one another by a process of competitive bidding • zero information and transportation costs Comparison of Stock and real estate market • Stock • Highly organised institution with specific rules and procedures • geographic separation between buyer and seller is overcome • documentation sale is relatively simple and transfer can be done at a short space of time. • Have all information which adds to the market efficiency • Real estate market • institution is far less organised • buyers and sellers are spatially separated • transfer of registration is a long cumbersome process • less buying and selling • less information • inefficient market Market Structure • The market arrays itself into a series of submarkets • The Links in the sub-markets are not always of the same length and may not always operate in the same direction. See examples for Office building A, B and C. • Building A is a close substitute for B and C may be a close one for B. • In this way price changes ripple their way through the system with closely linked sub-markets affected the most and remotely linked ones hardly at all. Market Structure (contd) • Knowledge of market structure is prerequisite to defining recent sales which are comparable for use in valuing real estate assets. If the sold property is not close substitute for the subject property, then it is by definition not comparable. • Similarly when contemplating a development project, it is vital to define those other projects which will be a close substitute for it and to subject their related sub-markets to detail study. Similar comments apply to decision process when the acquisition of an income earning property is under consideration. Market Arrangements • • • • • • • • • • Arrangement Perfect competition Oligopsony Oligopoly Monopoly Bilateral monopoly Monopsony Bilateral Oligopoly Duopoly Duopsony Buyers many few many many one one few many two Sellers many many few one one many few two many Market Participants • Space Consumer Group • Space Production Group • Public Infrastructure Group Real Estate Process • Space consumer group- collective users, future users • Space production group-skills, material and capital • Public Infrastructure group • Interaction Highest and Best Use • A valuation concept that can be applied to either the land or improvements. • It normally used to mean the use of a parcel of land without regards to any improvements upon it) that will maximize the owner’s wealth by being the most profitable use of the land. • The concept of highest and best use can also be applied to a property, which has some improvements upon it that have a remaining economic life. • In this context, highest and best use can refer to that use of the existing improvements, which is not profitable to the owner. • It is possible o have two different highest and best use for the same property, one for ignoring the improvements and another that recognizes the presence of the improvements. Highest and Best Use • Highest and best use: that reasonable and probable use that will support the highest present value, as defined, as of the effective date of the appraisal. • Alternatively, that use from among reasonably probable and legal alternative uses, found to be physically possible, appropriately supported, financially feasible and which results in highest value. • It is to be recognized that in cases where a site has existing improvements on it, the highest and best use may very well be determined to be different from the existing use • The existing use will continue, however, unless and until land value in its highest and best use exceeds the total value of he property in its existing use. • Implied within this definitions is recognition of the contribution of that specific use to community environment or to community development goals in addition to wealth maximization of individual property owners. Highest and Best Use (cont’d) • Also implied is the determination of the highest and best use results from the appraiser’s judgement and analytical skills i.e. that the use determined from analysis represent an opinion, not a fact to be found. • In appraisal practice, the concept of highest and best use represents the premise upon which value is based. Most probable use and most profitable use • In the context of the most probable selling price (market value) another appropriate term to reflect the highest and best use would be most probable use. • In the context of investment value an alternative term would be most profitable use. • The concept of highest and best use of land was a commodity concept, which did not consider externalities adequately. • It is being replaced by concepts of most fitting use and the concept of most probable use. Most fitting and most probable use. • The most fitting use is that use which is the optimal reconciliation of effective consumer demand, the cost of production and the physical and environmental impact on third parties. • Reconciliation involves financial impact analysis on who pays and who benefits thus the rash of the debate on how to do impact studies. • The most probable use will be something less than the most fitting use depending upon topical constraints imposed by current political factors, the state of real estate technology and short term solvency pressures on consumer, producer or public agency. • Most probable use means that an appraisal is first a feasibility study of alternative uses for a site in search of a user, an investor, and in need of public consent.