Chapter 2: The Real Estate System

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.

2.1 The Commercial Property Development Industry Financial Resources Development Industry New Built Space Physical Resources

The Development Industry Development is a creative, entrepreneurial process characterized by… Vision Greed Cooperation Risk   (All the most entertaining features of American capitalism.)

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.

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…

Exhibit 2- 1 US commercial property construction starts by property type as percent of existing stock…

2.2 The Real Estate System

CAPI TAL MKTS INCLU LAND Exhibit 2-2: The “Real Estate System”: Interaction of the Space Market, Asset Market, & Development Industry 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 D EMAND COST VALUE CAP (Investors INCLU RATE Buying) LAND = Causal flows. = Information gathering & use.

“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.

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.

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?…

2.3 The “4-Quadrant Model” (4QM)…

Exhibit 2-3: The DiPasquale-Wheaton 4-Quadrant Diagram… Rent $ Space Market: Rent Determination Asset Market: Valuation R* D Price $ P* Q* Stock (SF) C* Asset Market: Construction Space Market: Stock Adjustment Construction (SF)

2.4 Using the 4QM to help understand “boom & bust” cycles…

EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY PRICES OVER THE LAST QUARTER-CENTURY . . .

Rent $ D1 D0 R* P* Price $ Q* Stock (SF) C* Construction (SF) Exhibit 2-4a: Effect of Demand Growth in Space Market: Rent $ Space Market: Rent Determination Asset Market: Valuation D1 D0 R* P* Price $ Q* Stock (SF) C* Asset Market: Construction Space Market: Stock Adjustment Construction (SF)

Can this be a long-run equilibrium result?… Exhibit 2-4a: Effect of Demand Growth in Space Market: First phase… Rent $ Can this be a long-run equilibrium result?… Space Market: Rent Determination Asset Market: Valuation D1 D0 Doesn’t form a rectangle. R1 P1 R* P* Price $ Q* Stock (SF) C* Asset Market: Construction Space Market: Stock Adjustment Construction (SF)

Rent $ D1 D0 R1 R** P** C** Q** R* P1 P* Price $ Q* Stock (SF) C* Exhibit 2-4a: Effect of Demand Growth in Space Market: LR Equilibrium… Rent $ Space Market: Rent Determination Asset Market: Valuation D1 D0 R1 R** P** C** Q** R* P1 P* Price $ Q* Stock (SF) C* Asset Market: Construction Space Market: Stock Adjustment Construction (SF)

Rent $ D1 D0 R1 R** R* P** P1 P* Price $ Q* Stock (SF) C* C** Exhibit 2-4a: Effect of Demand Growth in Space Market: LR Equilibrium… Rent $ Space Market: Rent Determination Asset Market: Valuation D1 D0 R1 R** R* P** P1 P* Price $ Q* Stock (SF) C* Asset Market: Construction C** Space Market: Stock Adjustment Construction (SF)

Rent $ D0 D1 R** P1 Q** Price $ P** Stock (SF) C** Construction (SF) Exhibit 2-4a: Effect of Demand Growth in Asset Market… Rent $ Space Market: Rent Determination Asset Market: Valuation D0 11% OAR D1 R* 8% OAR R** SR LR P1 Q** P* Q* Price $ P** Stock (SF) C* Asset Market: Construction Space Market: Stock Adjustment C** Construction (SF)

EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY PRICES OVER THE LAST QUARTER-CENTURY . . .

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?…]