Chapter 2: The Real Estate System 1

Chapter 2:
The Real Estate System
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The Real Estate System
1. The development industry
2. Overview of the R.E. “system”
3. The “4-Quadrant” model (4QM)
4. Using the 4QM to understand “boom & bust”
cycles in R.E.
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2.1 The Commercial Property
Development Industry
Financial
Resources
Development
Industry
Physical
Resources
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New
Built
Space
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The Development Industry
Development is a creative, entrepreneurial
process characterized by…
Vision
Greed
Cooperation
Risk
(All the most entertaining features of American capitalism.)
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Development (cont.)…

Cooperation:
 Between public & private sectors;
 Between developers & financiers.

Risk:
 Even an economy in recession needs an existing stock
of built space.
 New space (need for development) results only from
economic growth &/or change.
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Development (cont.)…
R.E. Development is therefore dealing with
the dynamic “cutting edge” of the physical
built environment.
This makes development the most cyclical
branch of the real estate industry…
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Exhibit 2-1: U.S. Commercial Property Construction Completions by
Property Type (MSF): 1959-2011
500
Gray shade
indicates GDP
recession
450
400
350
300
250
200
150
100
50
Source: Property & Portfolio Research (CoStar Group), used by permission.
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2011
Retail
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
Industrial
1989
1987
Office
1985
1983
1981
1979
1977
1975
1973
1971
1969
1967
1965
1963
1961
1959
0
Total U.S. Energy Consumption by Sector, 1960-2004
(Trillion Btu)
100,000
90,000
80,000
Industrial
70,000
60,000
50,000
Transportation
40,000
30,000
20,000
Real Estate
10,000
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
Notes: Total energy consumption includes consumption of coal, natural gas, petroleum, nuclear electric power, hydroelectric power, wood, water,
alcohol fuels, geothermal, solar, wind, coal coke net imports, electricity net imports, and electricity delivered to site (adjusted to account for fuels
used during production of electricity).
Source: Energy Information Administration, Annual Energy Review 2004, Table 2.1a
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Total U.S. Energy Consumption by Sector, 2004
(Trillion Btu)
45,000
40,000
39%
35,000
30,000
33%
Commercial
28%
25,000
20,000
15,000
10,000
Residential
5,000
0
Real Estate
Transportation
Industrial
Notes: Total energy consumption includes consumption of coal, natural gas, petroleum, nuclear electric power, hydroelectric power, wood, water,
alcohol fuels, geothermal, solar, wind, coal coke net imports, electricity net imports, and electricity delivered to site (adjusted to account for fuels
used during production of electricity).
Source: Energy Information Administration, Annual Energy Review 2004, Table 2.1a
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2.2 The Real Estate System
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Exhibit 2-2: The “Real Estate System”: Interaction of the Space Market, Asset Market, & Development Industry
SPACE MARKET
SUPPLY
(Landlords)
ADDS
NEW
LOCAL
&
NATIONAL
ECONOMY
DEMAND
(Tenants)
RENTS
&
OCCUPANCY
FORECAST
FUTURE
DEVELOPMENT
INDUSTRY
ASSET MARKET
IF
YES
IS
DEVELPT
PROFITABLE
?
CONSTR
COST
INCLU
LAND
SUPPLY
(Owners
Selling)
CASH
FLOW
PROPERTY
MARKET
VALUE
MKT
REQ’D
CAP
RATE
CAPI
TAL
MKTS
DEMAND
(Investors
Buying)
= Causal flows.
= Information gathering & use.
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“Negative feedback loops”…
Mechanisms within a system that tend to
dampen the changes in the system, helping to
keep it in control, preventing it from spiraling
out of control.
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Example:
A thermostat puts a negative feedback loop into a
heating and cooling (HVAC) system in a building.
 When the temperature in the building gets too low,
the thermostat triggers the heater.
 When the temperature in the building gets too
high, the thermostat triggers the air conditioning.
The result is that the building temperature remains
“under control”, within a comfortable temperature
range.
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Concept check:
How do the development industry and the real estate
asset market work together to provide a (long-run)
negative feedback loop in the Real Estate System?…
How can “forward-looking” behavior (good
forecasting of the space market) in the development
industry and R.E. asset market (capital market)
improve this negative feedback loop?…
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2.3 The “4-Quadrant Model” (4QM)…
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Exhibit 2-3: The DiPasquale-Wheaton 4-Quadrant Diagram…
Rent $
D
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Space Market:
Rent Determination
Asset Market:
Valuation
R*
D
Price $
Q*
P*
Stock (SF)
C*
Asset Market:
Construction
Space Market:
Stock Adjustment
Construction (SF)
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2.4 Using the 4QM to help understand “boom &
bust” cycles…
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EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY
PRICES OVER THE LAST QUARTER-CENTURY . . .
Price Level Index U.S. Institutional Real Estate (nominal $)
3.0
2.5
2.0
1.5
REITs
1.0
0.5
Tax reform
Overbuilding
Disinflation
S&L Dereg
Boom,
S&L
Tax incentives
Crisis:
ERISA: MPT
=>P.F. demand
REIT bust,
inflation fears
Recession
FIRREA
Recession
Securitzn:
- REITs
- CMBS
Recession
but asset
demand
0.0
69 71 73
75 77
79 81 83
85 87
89 91 93
95 97
99 01 03
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Exhibit 2-4a: Effect of Demand Growth in Space Market:
Rent $
Space Market:
Rent Determination
D0
D1
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Asset Market:
Valuation
R*
Price $
P*
Q*
Stock (SF)
C*
Asset Market:
Construction
Space Market:
Stock Adjustment
Construction (SF)
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Exhibit 2-4a: Effect of Demand Growth in Space Market: First phase…
Rent $
Can this be a long-
Space Market:
run equilibrium
Rent Determination
Asset Market:
Valuation
result?…
R1
D1
Doesn’t form a
rectangle.
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D0
R*
Price $
P1
P*
Q*
Stock (SF)
C*
Asset Market:
Construction
Space Market:
Stock Adjustment
Construction (SF)
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Exhibit 2-4a: Effect of Demand Growth in Space Market: LR Equilibrium…
Rent $
Space Market:
Rent Determination
D0
R1
R**
D1
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Asset Market:
Valuation
R*
P**
Price $
P1
P*
Q*
Q** Stock (SF)
C*
Asset Market:
Construction
C**
Space Market:
Stock Adjustment
Construction (SF)
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Exhibit 2-4a: Effect of Demand Growth in Space Market: LR Equilibrium…
Rent $
Space Market:
Rent Determination
D0
R1
R**
D1
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Asset Market:
Valuation
R*
P**
Price $
P1
P*
Q*
Stock (SF)
C*
Asset Market:
Construction
C**
Space Market:
Stock Adjustment
Construction (SF)
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Exhibit 2-4a: Effect of Demand Growth in Asset Market…
Rent $
Space Market:
Rent Determination
Asset Market:
Valuation
11% OAR
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D0
D1
R*
8% OAR
R**
SR
P1
Price $
LR
P**
P*
Q*
Q*
*
Stock (SF)
C*
Asset Market:
Construction
C**
Space Market:
Stock Adjustment
Construction (SF)
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EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY
PRICES OVER THE LAST QUARTER-CENTURY . . .
Price Level Index U.S. Institutional Real Estate
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
Overbuilding
S&L Dereg
Boom, Tax incentives
ERISA: MPT
=>P.F. demand
REITs
inflation fears
REIT bust,
Recession
Tax reform
Disinflation
S&L Crisis: FIRREA
Recession
Securitizatn:
- REITs
- CMBS
69 71
73 75 77
79 81
83 85
87 89
91 93
95 97
99
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Exhibit 2-5: Real CRE Prices & Rents: 1986-2010:
Rent Cycle & Asset Price Cycle Not Necessarily the Same…
1986=100
shaded bars = GDP recessions…
120
110
100
90
80
70
60
50
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
CRE Same-Property Real Prices (TBI)
CRE Real Rents (7 major office mkts)
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Concept check…
1. What does the 4Q Model reveal about the
interaction of the space market, the asset
market, and the development industry in
causing “boom & bust” cycles?
2. How can the an understanding of the 4Q Model
help participants in the asset market and
development industry to avoid “boom & bust”
cycles? [Hint: Can the 4Q Model help with
“forward-looking” decision-making?…]
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