Real Estate Space and Asset

Markets
Real Estate Investment Analysis
Two Types of Real Estate
Markets
A market is a mechanism for the
voluntary exchange of goods and
services among owners.
There are two types of real estate
markets for our consideration in this
course. They are:
Real Estate Space Market
Real Estate Asset Market

2
Real Estate Space Market
The term “space market” is the market
for the usage of real property.
In this market, tenants exchange rent
with landlords for the right to use land
and built space.
This market is often called “the rental
market.”

3
Real Estate Asset Market
The term “asset market” refers to the
mechanism for the voluntary exchange
of ownership of real property.
In this market, buyers exchange money
with sellers for ownership rights to land
and built space (real estate).
This market is often called “the
property market.”

4
Let’s first consider several
characteristics of “space
markets.” After that, we will
look at the characteristics of
“asset markets.”

5
Characteristics of the Space
Market: Demand and Supply
Demand side of this type of market
includes individuals, households, or
firms who want to use space for
consumption or production purposes.
Supply side of this type of market
includes real estate owners who “rent”
(used as a verb here) space to tenants.

6
Characteristics of the Space
Market: Rent
 “Rent” as noun refers to the price of the
right to use space for a period of time.
May be measured in MK per square foot per
year (office space), MK per month per unit
(apartments) or various other methods.
Determined by the interaction of supply and
demand forces.

7
Characteristics of the Space
Market: Equilibrium
When the quantity of space demanded
equals the quantity supplied, the
market is in equilibrium.
The observed rent at equilibrium is
called market rent.

8
Characteristics of the Space
Market: Market Rent Changes
The principle of supply and demand
states that equilibrium price in a market
is directly related to changes in demand
and inversely related to changes in
supply.
Market rent, therefore, is directly
related to changes in demand and
inversely related to changes in supply.
9
Characteristics of the Space
Market: Segmentation
The real estate space market is highly
segmented, meaning that it tends to be local
in nature and specialized by property usage.
Within each segment, or submarket, the
same good may have a different equilibrium
price.
Market rent for office space may differ
significantly between Seattle and Miami.
Market rent for retail space and warehouse
space in the same city may different
dramatically.
10
Why is the Real Estate Space
Market Segmented?
On the demand side:
Users require specific types of space
Users require specific locations
On the supply side:
Buildings are built for specific uses
Buildings are fixed in location
Thus, we often talk of “geographic” or
“property usage” submarkets.

11
Characteristics of the Space
Market: Demand Curve
The typical space market (or
submarket) has a “downward sloping”
demand curve.
$25

$20
REAL RENT

Real Estate Demand Curve

$15

$10

$5
3.5 4 4.5 5 5.5 6 6.5
QUANTITY OF SPACE (Mil. SF)

12
Characteristics of the Space
Market: “Kinked” Supply
The typical space market (or
submarket) has a “kinked” supply
curve.
$25
REAL ESTATE SUPPLY CURVE

$20
REAL RENT

KINK

$15

$10 EXISTING
QUANTITY

$5
3.5 4 4.5 5 5.5 6 6.5
QUANTITY OF SPACE (Mil SF) 13
Characteristics of the Space
Market: Why these shapes?
The shape of the demand curve makes sense
when we consider that users will prefer more
space when prices are low than they will
when prices are high.
The shape of the supply curve (kinked)
makes sense when we consider that the
amount of built space is fixed in the short run
because it takes a long time to add new
space and because existing space lasts a long
time.

14
Characteristics of the Space
Market: Where is the Kink?
The kink occurs at the price equal to the
marginal cost of adding new space to the
submarket.
From basic economics, we know that the
supply function for a competitively produced
product equals the marginal cost function.
The marginal cost of built space includes site
acquisition costs, construction costs, and the
developer’s necessary profits.

15
Characteristics of the Space
Market: Impact of the Kink
Placing the supply and demand curves on the
same graph, we can see the impact of the
kink on equilibrium prices in a submarket.
REAL RENT
K25 As demand increases from
D0 to D1, equilibrium price
K20 D2 increases from about $13 to
D1 about MK16. If demand
16
D0
LRMC continues to increase to D2,
K15
13
the price remains at MK16
as new space is brought
K10 online by suppliers (S2).
S1 S2
$5
3.5 4 4.5 5 5.5 6 6.5
QUANTITY OF SPACE (Mil

16
Some Important Observations
 In submarkets with rising long-run marginal costs
(rising land prices make the next building more
expensive than the prior one), the supply curve is
increasing beyond the existing supply quantity.
 In submarkets with falling long-run marginal costs
(the next building is cheaper to construct than the
prior one), the supply curve is decreasing beyond the
existing supply quantity.

17
Case Study of Space Market
Dynamics: Cincinnati, Ohio
 In the mid 1980’s, the market rent for office space was $16 per square foot per
year with about 5 million square feet of space.
 In the late 1980’s, developers increased supply by 1 million square feet in
anticipation of increased demand. (S1 to S2)
 The demand increase did not materialize and rent fell to about $13.
 In the recession of the early 1990’s, demand fell from D1 to D0 and rents fell
further to about $10.
REAL RENT
$25

$20
D1
LRMC
16
$15 D0
13

$10

S1 S2
$5
3.5 4 4.5 5 5.5 6 6.5
QUANTITY OF SPACE (Mil
18
Characteristics of the Asset
Market:
 “Asset market” refers to the market for the
ownership of real estate assets (land and the
buildings on it) rather than the use of space in real
estate assets.
 Buyers in this market purchase real estate in
expectation of receiving future cash flows (rent paid
by tenants).
 These buyers could buy other kinds of assets (stocks,
bonds, etc.) that would also produce future earnings.
 In this sense, the real estate asset market is really a
part of the larger capital market.

19
Overview of Capital Markets
Capital markets can be divided into four
categories
Public equity markets
Private equity markets
Public debt markets
Private equity markets
Where do real estate assets fit?
In all four categories, in some fashion!

20
Types of Capital Asset Markets
and Investment Products
Public Private
Markets Markets

Equity Assets Stocks Real Property

REITS Private firms
Mutual Funds Oil and gas
partnerships
Debt Assets Bonds Bank loans
MBS Whole mortgages
Money Instruments Venture debt

21
Characteristics of Capital
Markets
 Public markets are more liquid than private markets
and thus are more informationally efficient.
 Private markets are usually for transactions involving
“whole” assets rather than shares of assets (like
stocks) as we typically see in public markets.
 Debt assets give their owners the rights to future
cash flows to be paid by borrowers on loans.
 Equity assets give their owners the rights to the
residual cash flows generated by an underlying asset
after other claim holders (including debtors) have
been paid.

22
Pricing Real Estate Assets

Commercial property prices are typically

quoted in terms of “Cap Rates” (short
for “capitalization rates”)
Also known as overall rate (OAR)
Defined as:

current annual net income

Cap Rate 
property price

23
Characteristics of Cap Rates
 Cap Rate can be thought of as:
 Current yield on the investment
 Inverse of a “price/earnings” ratio
 Three major determinants of the cap rate are:
 Opportunity Cost of Capital - from the capital market.
Considers how much investors could earn on other types of
capital assets. Higher OCC implies higher cap rate.
 Growth Expectations – from the space market. Considers
how much investors think net cash flows will increase in the
future. Higher growth implies lower cap rate.
 Risk – from both the space and capital markets. Considers
how risky a property is relative to other properties and other
asset types. Higher risk implies higher cap rate.

24
Is the Asset Market Segmented?
No (not very)
 “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.
 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 can quickly and easily flow from a Manhattan office building to
a Chicago office building or a Dallas apartment building. 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

25
The Real Estate System
Module 3:
Real Estate Investment Analysis
What Links the Asset and
Space Markets?
The real asset and space markets discussed
in the previous module are linked together by
the development industry.
The manner in which the development
industry accomplishes this complex task is the
focus of this module.
The development industry, the real estate
asset market, and the real estate space
market together form the real estate system.

27
Property Development
Industry
Property development is a creative,
entrepreneurial process characterized by…
 Vision
 Greed
 Cooperation
 Risk
(Some of the most entertaining features of
American capitalism.)

28
Development is highly cyclical.
Buildings are “long-lived” assets, it is
only the demand for new built space
that supports the development industry.
Because this demand is sensitive to
general economic changes, the
development industry is subject to
“boom-bust” cycles.

29
Where does Development fit
in the Real Estate System?
 The development industry is the converter of financial capital
into physical capital.

Financial
Resources
New
Development Built
Industry Space
Physical
Resources

30
An Overview of the Real
Estate System
 In addition to converting financial capital into physical capital, the development industry
serves as a feedback loop from the asset market to the space market, adding to the supply
side of the space market.
SPACE MARKET
LOCAL
SUPPLY DEMAND &
ADDS (Landlords) (Tenants) NATIONAL
NEW ECONOMY

RENTS
&
OCCUPANCY FORECAST
FUTURE

DEVELOPMENT
INDUSTRY
ASSET MARKET
IF IS SUPPLY
YES DEVELPT CASH
(Owners
PROFITABLE FLOW
Selling) CAPI
?
TAL
PROPERTY MKT MKTS
CONSTR MARKET REQ’D
DEMAND
COST VALUE CAP
(Investors
INCLU RATE
Buying)
LAND

31
The 4-Quadrant Model
To explain the long-run equilibrium
simultaneously between and within the asset
and space markets requires a more detailed
model than the simple supply/demand model.
We will consider the DisPasquale-Wheaton
“4-Quadrant Model” that depicts four distinct
relationships simultaneously.
The model is really nothing more than 4
simple graphs shown with a dashed rectangle
linking them together.

32
A Personal Note:

 My eyes glazed over and I started sweating profusely the first

time I looked at this model and heard one of its authors discuss
it at an academic conference, but it’s really not so bad when
you understand its component parts.
 Once I took it apart and put it back together, I discovered it is a
pretty clever way to describe about how things “work” in real
estate markets.
 Our text book authors do a great job of explaining the model,
but it may take several “readings” before you fully grasp it.

33
The 4-Q’s in the 4-Quadrant Model

The four main issues addressed by the model

are:
How are rents determined in the space market?
(NE quadrant)
How are properties valued in the asset market?
(NW quadrant)
What determines the amount of new construction?
(SW quadrant)
How is new construction related to the existing
stock of space? (SE quadrant)

34
 The 4-Quadrant Model
Rent $
Asset Market:
D Space Market:
Valuation
Rent Determination

R* D

P*

Price $ Q*
Stock SF
Asset Market: C*
Construction Space Market:
Stock Determination

Construction SF
35
Northeast Quadrant: Rent
Determination
Horizontal axis is the physical stock of space
in the market in square feet.
Vertical axis is the rent for space in $ per
square foot per year.
Demand for space is shown as the downward
sloping line, just as in the familiar
supply/demand model.
Existing space is shown as Q*
Equilibrium rent is shown as R*

36
Northwest Quadrant:
Valuation
Horizontal axis is price per square foot of
space in the asset market.
Vertical axis is the rent per square foot of
space.
The line represents the cap rate, which we
know expresses the price of real estate as a
yield measure.
The equilibrium price is shown as P*
 Note the we are assuming that prices increase as we move left
along the horizontal axis in this quadrant.

37
Southwest Quadrant:
Construction
Horizontal axis is price per square foot of
space.
Vertical axis is the amount or rate of
construction activity.
The line represents the relationship between
property values (prices) and construction
activity.
The equilibrium amount of construction
activity is shown as C*
 Note that we are assuming that price increases as we move left
on the horizontal axis and that construction increases as we
move down the vertical axis. 38
Southeast Quadrant: Stock
Adjustment
Horizontal axis is the physical stock of space
in the market in square feet.
Vertical axis is the amount or rate of
construction activity.
The line relates the average rate of
construction per year to the total stock of
space that can be maintained in the market.
The equilibrium level of supply of built space
is shown as Q*

39
What’s the Big Deal about the
4Q Model?
 The 4-Quadrant model helps explain Boom and Bust
Cycles in Real Estate Markets.
 Boom means that space markets see an extended
rise in occupancy and rents.
 Bust means that space markets see an extended
period of falling occupancy and rents.
 Similarly, property prices (in the asset market) tend
to exhibit periods of rising and falling prices
corresponding to ups and downs in the space market.

40
Demand increases can trigger
a boom-bust cycle
Let’s use the model to see how an
increase in demand can lead to a boom-
bust cycle.
To do so, we first must understand how
the model responds to two types of
demand changes
Demand changes in the space market
Demand changes in the asset market

41
Demand Increase in Space
Market
Let the line DD shift to DD1 resulting in a
new equilibrium quantity, Q**
The initial reaction is a dramatic price
increase (boom).
To maintain a steady state (long run
equilibrium), price and other equilibrium
points must change as shown by the new,
larger dashed rectangle on the next slide.

42
 The 4-Quadrant Model with a
Space Side Demand Increase
Asset Market: Rent $
D1
Space Market:
Valuation D
Rent Determination

R**
D1
D

P** Q**
Price $ Stock SF
Asset Market:
Construction Space Market:
C**
Stock Determination

Construction SF
43
So, what does the model say?
Initially, a demand increase in the space
market would result in a price increase in the
asset market, then fall back a bit (bust) as
the market returns to its long-run steady
state due to new construction.
A demand increase in the space market in the
long run results in
a rent increase
a price increase in the property market
an increase construction
an increase equilibrium stock of space
44
Demand Increase in the Asset
Market
Continuing along our path to explaining
booms and bust, now we will consider what
the model tells us about an increase in
demand in the asset or property market.
Such an increase is equivalent to an increase
in the price investors are willing to pay for
real estate per dollar of rental income, or,
equivalently, a decrease in the cap rate.
This situation is shown graphically on the
next slide.

45
 The 4-Quadrant Model with an
Asset Side Demand Increase
Asset Market: Rent $
Valuation Space Market:
D
Rent Determination
11%
8%
D
R**
Q**
Price $ P** Stock SF
Asset Market:
Construction Space Market:
C**
Stock Determination

Construction SF
46
Now what does the model
say?
Initially, prices would rise dramatically
(boom), but then fall back a bit (bust) as the
market returns to its long-run steady state
due to new construction.
An increase in demand in the asset market
(lower cap rate) in the long run leads to
An increase in prices
An increase in construction
An increase in equilibrium stock of space
A decrease in equilibrium rent

47
Back to the Boom-Bust Idea…
 We just saw how usage demand growth and investor
demand growth can individually cause an
“overshooting” of real estate asset pricing.
 When both types of demand increases happen
simultaneously, the overshooting may be even more
dramatic: prices rise significantly, then fall back even
deeper, thus exacerbating the boom-bust cycle.
 If market participants had perfect foresight about
how much prices/rents should initially move, the
overshooting would not happen and the cycle would
be avoided.

48
Real Estate Investment
Analysis
Module 4: Real Estate Market
Analysis
Real Estate Market Analysis:
Why do it?
 The term “real estate market analysis” refers to use of a practical
collection of analytical tools and procedures that relate the
fundamental principles of real estate market dynamics to the specific
decision at hand.
 Where to locate a branch office?
 What size or type of building to develop on a specific site?
 What type of tenants to look for in marketing a particular building?
 What the rent and expiration term should be on a given lease?
 When to begin construction on a development project?
 How many units to build this year?
 Which cities and property types to invest in so as to allocate capital
where rents are more likely to grow?
 Where to locate new retail outlets and/or which stores should be
closed?

50
Broadly Speaking…
Real estate market analysis usually requires
quantitative or qualitative understanding (&
prediction) of both the demand side and
supply side of the space usage market
relevant to some real estate decision.
The focus might be microlevel, such as a
feasibility analysis for a specific site or property
Or, the focus might be more general, such as a
general characterization of the supply/demand
conditions in a particular space submarket.

51
Variables of Interest in Market
Analysis
To evaluate a real estate space submarket,
analysts tend to focus on a few primary
indicators that characterize both the supply
and demand sides of the submarket and the
balance (equilibrium) between them.
Vacancy rate
Market Rent
Quantity of new construction starts
Quantity of new construction completions
Absorption of new space

52
Vacancy Rate
By definition, the vacancy rate refers to the
percentage of the stock of space in the
market that is not currently occupied.
Vacancy Rate = Vacant Space/Total Space
The vacancy rate reflects the balance between
supply and demand.
In most markets, it is normal for some vacancy to
exist (the natural vacancy rate) even when supply
and demand are in balance.
When actual vacancy rises above the natural vacancy
rate, rents tend to fall.
When actual vacancy falls below the natural vacancy
rate, rents tend to increase.
53
Market Rent
By definition, market rent is the level of rents
being charged on typical new leases currently
being signed in the market.
asking rents may differ from effective rents
Market rent is another indicator of the balance
between supply and demand in a market.
Can be tricky to measure because
it is private information and
lease terms may differ dramatically from tenant to tenant

54
Constructions Starts and
Completions
 Construction is an important “supply side”
indicator.
“Starts” indicate the amount of space currently in
the “pipeline” and likely to be added to the supply
in the near future
“Completes” indicate the amount of space just
arriving in the market.
Of course, we need to consider the net addition to
supply (after taking demolition and renovations
into account).

55
Absorption of New Space
By definition, absorption refers to the
amount of additional space that
becomes occupied during a year.
Absorption is a “demand side” indicator.
Gross absorption – total amount of space
leased, regardless of where tenants come
from
Net absorption – net change in the amount
of space occupied in a market.

56
The Concept of “Months
Supply”
 The variables we just reviewed are commonly used indicators of
supply/demand conditions in space submarkets.
 The concept of “months supply” combines several of these
variables to help us understand a market even better.
 By definition, months supply is the sum of current vacant space
in the market and new construction started but not completed,
divided by 1/12th of the annual net absorption in the market.
Vacancy  Construction
Months Supply 
Net Absorption/ 12
 This measure tells how long it will take (in months) for all of the vacant space in the market
to be absorbed, driving the vacancy rate to zero.
 Analysts compare the months supply to the length of time it takes to complete new
construction to see if the market can support a new project. If the months supply is
much greater than the average construction period, the market is “oversupplied.”
Otherwise, it might be time to start a new project in this market.

57
Some Tips for Market Analysis

 Define the market carefully along geographic and usage dimensions,

recognizing that most metropolitan areas form markets that can be
usefully divided into smaller submarkets.
 Carefully consider the time period to be covered in the analysis
 5 – 10 years into the future is desirable
 3 years is more feasible in most cases
 Recognize the differences between and the benefits of a simple trend
extrapolation and a structural analysis
 Trend extrapolation predicts the future purely based on historical
trends and patterns
 Structural analysis attempts to predict the future by identifying and
quantifying the underlying determinants of market trends.

58
Market analysis methodology:
Simple trend extrapolation vs Structural
analysis

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Trend extrapolation:
Take advantage of inertia in space
market (past partly predicts the future)
Consider trends and cycles
Potential to use statistical techniques
(time-series analysis: autoregression,
ARIMA, VAR, vector error-correction)
Potential to bring in capital market
factors as predictors

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61
Structural Analysis:
Model the structure of the market
(underlying determinants of supply &
demand, e.g. population growth and
employment growth)
Forecast the underlying determinants
(e.g., economic base analysis like we
talked about in Ch.3), then use model
to predict space market.
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Formal analysis requires:
Demand model (including elasticities)
Supply model (including elasticities & lags)
Equilibrium model (including landlord behavior)
Useful for gaining fundamental understanding
of the market, and making long-term
forecasts
Used more primarily in consultants reports
and academic studies

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Performing a Market Analysis
 In both types of analysis (extrapolation and structural) the steps
are:
 First, inventory the existing supply and evaluate the pipeline.
 Second, relate the demand sources to the space usage demand.
 Third, forecast future demand for and supply of space
 Compare the forecasted demand for space with the forecasted
supply of space to see if the market will be “over” or “under”
supplied in the future.
 In tight markets (under supplied, landlord market), we expect to
see higher rents and lower vacancy rates.
 In loose markets (over supplied, tenant market), we expect to
see lower rents and higher vacancy rates.

64
Exh.6-4: Widely used decision-making tool:
Basic short-term (1-3 yr) structural market analysis:
SUPPLY SIDE DEMAND SIDE

Inventory existing supply Identify sources of space usage demand

Quantify relationship between

demand sources and quantity of
space usage

Inventory construction pipeline Forecast demand sources

Forecast of new supply Forecast of new demand

Forecast space shortfall or surplus

Decision implicatons?

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Exh.6-5: Major drivers of the demand side of the space market:
Property Type Demand Drivers

Residential single family  Population

(Owner occupied)  Household formation (child
rearing ages)
 Interest rates
 Employment growth (business &

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professional occupations)
Residential multifamily  Population
(Apartment renters)  Household formation (non-child-
rearing ages)
 Local housing affordability
 Employment growth (blue collar
occupations)
Retail  Aggregate disposable income
 Aggregate household wealth
 Traffic volume (specific sites)

Office Employment in office occupations:

 Finance, Insurance, Real Estate
(FIRE)
 Business & professional services
 Legal services
Industrial  Manufacturing employment
 Transportation employment
 Airfreight volume
 Rail & truck volume

Hotel & convention  Air passenger volume

 Tourism receipts or number
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visitors
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A simple formal structural model of a space market:

Supply side . . .
Construction (developer
behavior):
C (t )   ( R (t  L)  K ), if R (t  L)  K ,
(1)
0, otherwise
R(t) = Rent at time t ($/SF).
L = Construction lag (yrs).
K = Replacement cost rent level.
ε = Price elasticity of supply
(responsivenesss)
Stock (aggreg.supply)
response:
S (t )  S (t  1)  C (t )
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Geltner MIT/CRE
A simple formal structural model of a space market:
Demand side . . .
Tenant demand:

D(t )    R (t )   N (t ) (3)

N = Underlying “need” (e.g.,

employment)
η = Price elasticity of demand
τ = Technology parameter (e.g.
SF/employee)
Occupied space:
(lag to implement demand reflects search & move time)

OS t)  D
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Geltner MIT/CRE
A simple formal structural model of a space market:

Supply & demand sides (equilibrium)

...
Rent adjustment
(landlord & potential tenant behavior):
R(t )  R(t  1)(1   ((v(t )  V ) / V )) (6)
v(t) = Vacancy rate at time t.
V = “Natural” vacancy rate for the
mkt.
Vacancy rate “physics” (definition):
v(t )  ( S (t )  OS (t )) / S (t ) (5)

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Geltner MIT/CRE
 Put these six equations together . . .
Numerical example typical parameters:
 Supply sensitivity  = 0.3
 Demand sensitivity  = 0.3
 Technology  = 200
SF/employee
 Demand intercept  = 10 million
SF
 Rent sensitivity  = 0.3
 Construction lag L = 3 years
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Geltner MIT/CRE
 A Simple, But Sophisticated Model of
Real Estate Space Market Dynamics

 Section 6.2 of the Geltner-Miller text presents a formal “stock-

flow” model for forecasting equilibrium changes in a real estate
space market.
 The model is really just six linked equations that reflect the
relationships among supply, demand, construction, rent, and
vacancy over time.
 The model allows simulation and forecast of rents, vacancy,
construction, and absorption in a market each year.
 We won’t concern ourselves too much with the mathematical
details of the model, but it is helpful to see how changes in the
inputs to the model alter the forecasts of the future.
 Putting the equations into Excel gives us an opportunity to “play
around” with the inputs and see what happens to the forecasts.
This will be part of the homework assignment.

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