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Wheaton Ch1

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43 views21 pages

Wheaton Ch1

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amishaa jain
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n 1 Introduction to Real Estate Markets CHAPTER THE 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 reat 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 of purchased for occupancy) and the market for teal estate assets (where buildings are bong! 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 build- ings 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 equip” ‘ment, etc, with the remaining 40 percent going to the producers of building materials. It js important to note that land is not counted as part of investment or GDP since itis 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, 2 Introduction to Real Estate Markets Section 1 ‘The distinction between realestate as space and real estate as an asset is most cleat ‘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, sold, or exchanged hetween investors. These Iwansaetions occur in the capital market and determine the asser 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 oF 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 Cur view of the real estate market as actually two markets helps to clarify how dif ferent forves 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- Mortgage Rate (minus CPt inflation) ‘6 Change in House Price (1990 $s) FIGURE 1.5 Change in house price versus mortgage rates (real) 1961-1990. Sire: Price ine: 1960-69: Federal Housing Finance Bou 1980 Res & Tess ow Comsertonal Home Morigages, Anna Sammy. 1910-9 Federal Hen Loan Menges Cor Qaotin-Comcted Esising Home Price alex. unable report Moats rates 190-62: FHA nse rate ps percentage points. 196-90 Federal Housing Finance Boar 190 Rates Terns on Comtemional Hane Mortgages: Anal Sumas Figure 14, this new equilibrium results in a new solution box that is lower and more ree= tangular than the original is important to be convinced that the new solution box is as portrayed in Fig- lure 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 hhave 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 Prices, construction, and the stock. It will, however. eventually lower—tather 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 dotlars) and real mortgage rates (adjusted for inflation). Credit, Construction Costs, and the Supply of New Space The final exogenous change likely to impact the real estate market isa shift in the supply schedule for new construction, This can come about through several channels. Higher shost-term interest rates and a general scareity of construction financing will increase the costs of providing a given amount of new space, leading to less construction. Likewise 6 Introduction to Real Estate Markets Section 1 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 inthe cost schedule Cf 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 oF a relaxation of development regulations, move the curve in an easterly diree- tion, 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 (nflation-adjusted) and new home construction Finally, Figure 1.7 traces the long-run implications of a negative supply changs such as would occur with higher short-term interest rates.* For a given level of asset prices, a negative shift inthe 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 t0 rise, which will gener- ate higher asset prices in the northwest quadrant. When starting and finishing asset prices Thousands of Units Real Rate (4) ‘ ee 400 fo “2 800 HE 1961 1965 97119761981 19861991 Starts ~~~ 6-mo. Treasury Bill (minus CPI inflation) FIGURE 1.6 Single-family construction and real interest rates, 1961-1991. Sources Consesion, Fermomie Report f the President 1992: neres tes. The Federal Reser: “In Figure 17. this negative spy change rn hil nthe cost curve, which cans that he niin Teel of ast price necessity to get constton going has increased There ay also he supp changes that eave this minum asset price these, bu low erase the amour of eonstecton resulting wuld esl ina pivot nthe schedule, chiming spe bi nastics the slope Becomes ope in ane ries, Sh cha the slope becomes Mer thee sess comstrction wth nse there is more consracton ith inereases i a8 pies Chapter 1 The Property and Capital Markets ” Ascot Market eat $ Property Market Valuation Rent Determination DIR Economy) = $ Pres Stock (sq. 1) P=4C) 35) Asset Marko Ceci Property Marko: Construction (64.11) ‘Stock Agjustment bo FIGURE 1.7 The property and asset markets: asset cost shifts, fare 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, ifthe demand for space is very rent elastic (a nearly hor- izontal curve in the northeast quadrant), then the increase in rents will be slight. An inclastic (nearly vertical) demand curve will generate a larger inerease 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, ly, single individual shifts, such as are portrayed in Figures 1.2, 1.4, and 1.7, do oveur 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 fallin rents are quite consistent with Figure 1.8, 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, of SAL) industry. Deregulation is argued to have resulted in a dramatic increase in 8 Introduction to Real Estate Markets Section 1 the availability of cheap construction credit for new commercial development. As such, it ‘would have caused a singular (easterly) shilt in the construction cost schedule Its more likely the ease that economic events cause Sever neously. This is particularly true of movements in the nation’s macroeconomy, As the national economy enters & slowdown, not only is there a contraction in output and nployment (northeast quadrant), but there are usually increases in short-term interest rates as well (southwest quadrant), An economic expansion leads to the opposite combi nation. 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 compli- cated 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 itis not easy (0 te as the market moves to its new equilibrium. A dynamic system of equations is needed 10 depict the intermediate adjustments of the market, which significantly complicates our analysis, More complicated dynamic models will be developed in Chapters 10 and 12. 1 shifts to occur simulta the intermediate steps REAL ESTATE MARKETS AND PUBLIC POLICY The real estate sector is affected by public policy changes at the federal, state, and local levels. However, the real estate sector may or may not be the primary target of a specific policy. For example, national monetary policy has several goals and implications. As a prime determinant of interest rate movements, monetary policy clearly affects the ‘demand for real estate assets as well as the level of new construction. The four-quadrant diagrams presented in the previous section illustrate the impucts of such policy changes fon the real estate markets. The public sector also creates policies that are aimed specifi cally at the real estate sector. In developing such policies, government decision makers ‘must be able {0 anticipate the impacts of their actions on the broader real estate market ‘The framework represented by the four-quadrant diagram permits a useful analysis of the impacts of these policies. Consider the following examples of major public policies designed to impact the real estate markets directly, Publicly Assisted Housing Both federal and state governments provide a range of assistance programs to encourage the development of low- and moderate-income housing. Some programs dircetly build units for targeted groups, while other programs assist households in making rental pay ‘ments. The construction of publicly owned units generally decreases the demand for pri vately owned rental units. This decrease in demand assumes that public units sueceed in attracting tenants, This seems a safe assumption since public units generally carry subsi dies, which mean that the units are offered at below market rents. tn fact, in many urban areas in the U.S., there are long waiting lists for public housing units. This decrease in Chapter 1 The Property and Capital Markets 19 demand for private units results in an inward shift in the demand curve in the north {quadrant which will in tu stock of private units. Thus, building public housing produces a new equilibrium that is exactly the opposite of that illustrated in Figure 1.2. where demand is increasing. The reduction of private building activity due to public construction programs is sometimes, referted to as public displacement of private construction, Rental assistance programs, on the other hand, act to simulate housing demand in \ will shift out the s. prives, construe- tion, and the stock. as occurred in Figure 1.2. Proponents of rental assistance programs argue that such programs will encourage construction and have only a modest impact on. rents, Hence, they atgue that the net effect of such programs will be to expand the hous ing opportunities of low-income households, Opponents of such policies suggest tha rental assistance only serves fo increase rents in the market and has very little impact on hey argue that the main beneficiaries of the program ate landlords, Clearly. the size of the impact on construction and rents depends on the relative elastic lies oF the curves presented in igure 1.2, 1 decrease rents, asset prices, construction and ultimately the much the same way as an expansion in the economy. These progra demand curve in the northeast quadrant, resulting in increases in ret ‘construction, Hence, Local Government Development Regulations In the U.S., local governments exercise great control over the amount and type of devel- ‘opment permitted on privately owned land, Such regulations often are in the public inter cest, but they do impose two additional costs on private development. First, they frequently extend the time necessary for completion of a project, since local govern- ments require developers to apply for various permits in order to proceed. Second, they sometimes act 10 ereate a scarcity of sites. This can drive up land prices and add to site aquisition costs, The more binding or restrictive such regulations become, the mote they increase development costs. This increase in costs will shift the supply schedule in the southwest quadrant in a westerly direction, as occurred in Figure 1.7 ‘The Taxation of Real Estate ‘The federal tax code generally treats real estate favorably in several ways. Interest pay ents on real estate debt are fully tax deductible for both firms and houscholds. Home- owners also are effectively exempt from the taxation of housing capital gains realized ‘ith the sale of their homes. For investors, generous depreciation deductions are allowed each year far in excess of actual economic obsolescence, Favorable provisions like these act to reduce the current yield necessary from real estat, us the tax advantage supple- ‘ments property income. This will rotate the capitalization schedule of the northwest quad- rant in a counterclockwise manner and lead to the higher asset prices and other impacts

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