Chapter 6: Real Estate Market Analysis 1 © 2014 OnCourse Learning. All Rights Reserved.

2 R.E. “Market Analysis” is a collection of practical analytical tools and procedures designed to help answer decision questions, such as: Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

3 Decision Questions 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? Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

4 Market Analysis usually requires quantitative or qualitative understanding (& prediction) of: Demand Side Supply Side of the Space Usage Market relevant to some R.E. decision. Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

5 Two Major Types (levels) of Market Analysis: Specific micro-level analysis  Applies to single property, site, or user  E.g., feasibility analysis or site analysis for a development project  “shoe leather…” (also mktg consultants like Claritas) Broader, more general characterization of a space market  Applies to an entire R.E. space market segment or submarket  E.g., forecast of supply & demand (&/or rents and vacancy rates) in Chicago office market, or Class A office Mkt in downtown Chicago  “research shops” (or subscriptions) Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

6 General market-level analyses focus on Five major market indicators: 1.Vacancy rate 2.Market Rent 3.Quantity of new construction starts 4.Quantity of new construction completions 5.Absorption of new space Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

7 Vacancy Rate: Percentage of the stock of space that is currently not occupied Vac.Rate = (Empty SF)/(Total SF) = 1 – Occup.Rate Watch out for sub-lease space:  Space leased but unoccupied is vacant. Vacancy Rate is an indicator of equilibrium (balance between supply & demand in the space market) Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

8 Some vacancy is normal and natural in a market, due to: Search time & moving costs (hence LT leases):  Don’t take “first deal”  Search for “good deal” (takes time to find)  More uncertainty  LL sets higher reservation rent (but tenant sets lower rent target, so deals tougher).  Higher moving costs or search costs  LL sets lower reservation rent (& tenant accepts higher rent target, so deals easier, longer term leases). “Overbuilding”:  Impossible to perfectly predict demand growth  “Lumpy supply” Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

9 The “natural vacancy rate”: Rate around which vacancy tends to cycle Rate that indicates supply/demand balance Above which rents fall, below which rents rise Tends to be higher in more volatile & faster-growth markets Tends to be lower in more supply-restricted markets Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

10 What does it look like the natural vacancy rate is in the Boston office market? Is it higher in the CBD or the suburbs? © 2014 OnCourse Learning. All Rights Reserved.

11 Rent: Rent on new leases in the market Another equilibrium variable (along with vacancy rate) Most important space market variable Tricky to accurately quantify (private info,“apples vs oranges” problems) Watch out for “asking rent” vs. “effective rent” Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

12 Example: $10 rent but 1-yr abatement in 5-yr lease: What would you say is the “effective rent”? Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

13 Example: $10 rent but 1-yr abatement in 5-yr lease: What would you say is the “effective rent”? 10*(4/5) = $8. Or, more carefully, if tenant can 8%: =PMT(0.08,5,NPV(0.08,10,10,10,10)) = $8.30. Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

14 Consider “real rent” rent adjusted for general inflation (as better indicator of market trend) Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

15 Construction: Supply side variable Starts & completions  Starts  “Pipeline”  Completions  Additions to supply side of market Don’t forget projects in permitting & planning stage too Consider net addition to supply:  Construction Completions minus Demolition & Conversion Out  Include re-habs & conversions in also Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

16 Absorption: Change in occupied space Demand side variable “Gross absorption” “Gross absorption” = Total new lease signings  Includes moves within the market “Net absorption” “Net absorption” = Net increase in occupied space Net absorption more relevant for indicating market demand: (Vacant SF) t = (Vacant SF) t-1 + (Constr) t – (Net Absorption) t Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

17 These market indicator variables: Vacancy, Rent, Construction, Absorption Can be used to help characterize & understand the current market, and forecast how it may change relevant to R.E. decisions. Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

18 e.g., The Months Supply measure: MS < Typical Construction Project Duration  Tight Market  Room for new development projects MS > Typ.Constr.Duration  May be some slack (but consider natural vacancy rate). Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

19 Perhaps enhance with a Months Excess Supply measure?... Compare this to typical construction time and what is in pipeline… Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

20 Absorption in Largest U.S. Multi-Tenant Office Markets Source: Torto Wheaton Research. Millions of square feet. Forecast

21 Construction, Absorption, & Vacancy (same scale across 3 metros) Rent Vacancy & Rent (same scale across 3 metros)

22 Recall from Chapter 1: Space markets are “segmented” – different rents can same time in different locations, or for different types of uses. © 2014 OnCourse Learning. All Rights Reserved.

23 Recall from Chapter 1: Space markets are “segmented” – different rents can same time in different locations, or for different types of uses. © 2014 OnCourse Learning. All Rights Reserved.

Defining the scope of the market analysis… Geographic/Property type market segments (or sub-markets) Time-frame of the study (historical, forecast to when?) 24 © 2014 OnCourse Learning. All Rights Reserved.

Exh.6-3:Example of geographic sub-markets: Atlanta office market as defined by CoStar (2012)… 25 © 2014 OnCourse Learning. All Rights Reserved.

Exh.6-3:Example of geographic sub-markets: Atlanta office market as defined by CoStar (2012)… 26 © 2014 OnCourse Learning. All Rights Reserved.

Exh.6-3:Example of geographic sub-markets: Atlanta office market as defined by CoStar (2012)… 27 © 2014 OnCourse Learning. All Rights Reserved.

Market analysis methodology: Simple trend extrapolation vs Structural analysis 28 © 2014 OnCourse Learning. All Rights Reserved.

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 29 © 2014 OnCourse Learning. All Rights Reserved.

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. 30 © 2014 OnCourse Learning. All Rights Reserved.

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 31 © 2014 OnCourse Learning. All Rights Reserved.

Exh.6-4: Widely used decision-making tool: Basic short-term (1-3 yr) structural market analysis: Inventory existing supplyIdentify sources of space usage demand Quantify relationship between demand sources and quantity of space usage Forecast demand sources SUPPLY SIDEDEMAND SIDE Inventory construction pipeline Forecast of new demand Forecast of new supply Forecast space shortfall or surplus Decision implicatons? 32 © 2014 OnCourse Learning. All Rights Reserved.

Property TypeDemand Drivers Residential single family (Owner occupied)  Population  Household formation (child rearing ages)  Interest rates  Employment growth (business & professional occupations) Residential multifamily (Apartment renters)  Population  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) OfficeEmployment 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 visitors Exh.6-5: Major drivers of the demand side of the space market: 33 © 2014 OnCourse Learning. All Rights Reserved.

34 A simple formal structural model of a space market: Supply side... Stock (aggreg.supply) response: (2) Construction (developer behavior): (1) R(t) = Rent at time t ($/SF). L = Construction lag (yrs). K = Replacement cost rent level. ε = Price elasticity of supply (responsivenesss) Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

35 A simple formal structural model of a space market: Demand side... Tenant demand: N = Underlying “need” (e.g., employment) η = Price elasticity of demand τ = Technology parameter (e.g. SF/employee) (3) Occupied space: (lag to implement demand reflects search & move time) (4) Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

36 A simple formal structural model of a space market: Supply & demand sides (equilibrium)... Rent adjustment (landlord & potential tenant behavior): (6) v(t) = Vacancy rate at time t. V = “Natural” vacancy rate for the mkt. Vacancy rate “physics” (definition): (5) Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

37 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 lagL = 3 years Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

38 Exh.6-6 Simulated Space Mkt Dynamics 11-year cycle, even though no business cycle! © 2014 OnCourse Learning. All Rights Reserved.

39 Vacancy peaks just before rent troughs RE mkt cyclical even when underl demand not Devlpt cycle exagerates rent&vac cycle. New supply enters just as vacancy peaks Vac quarter- cycle lead ahead of rent. © 2014 OnCourse Learning. All Rights Reserved.

40 Market Dynamics The real estate cycle may be different from and partially independent of the underlying business cycle in the local economy. The cycle will be much more exaggerated in the construction and development industry than in other aspects of the real estate market, such as rents and vacancy. The vacancy cycle tends to slightly lead the rent cycle (vacancy peaks before rent bottoms). New construction completions tend to peak when vacancy peaks. Geltner MIT/CRE Specifics depend on the parameter values. (& CAVEAT: This is a simple model, ignores forward-looking behavior.) © 2014 OnCourse Learning. All Rights Reserved.

41 Market Dynamics In the preceding model, were any of the market participants forward-looking? What features of the above results do you think are due to myopia or purely adaptive behavior on the part of the market participants? In the real world, what factors or elements in the real estate system will tend to be forward-looking? In the real world, will it be possible to perfectly forecast the future? Will some market participants likely be somewhat myopic or adaptive in their behavior? Geltner MIT/CRE © 2014 OnCourse Learning. All Rights Reserved.

42 SPACE MARKET SUPPLY (Landlords) DEMAND (Tenants) RENTS & OCCUPANCY LOCAL & NATIONAL ECONOMY FORECAST FUTURE ASSET MARKET SUPPLY (Owners Selling) DEMAND (Investors Buying) CASH FLOW MKT REQ’D CAP RATE PROPERTY MARKET VALUE DEVELOPMENT INDUSTRY IS DEVELPT PROFITABLE ? CONSTR COST INCLU LAND IF YES ADDS NEW CAPI TAL MKTS = Causal flows. = Information gathering & use. Geltner MIT/CRE Rising supply  Falling cash flow  Falling asset prices  Less dvlpt… Forward-looking decisions & negative feedback equilibrates the system… Consider constr pipeline, underl demand evolution… Exhibit 2-2 © 2014 OnCourse Learning. All Rights Reserved.

43 SPACE MARKET SUPPLY (Landlords) DEMAND (Tenants) RENTS & OCCUPANCY LOCAL & NATIONAL ECONOMY FORECAST FUTURE ASSET MARKET SUPPLY (Owners Selling) DEMAND (Investors Buying) CASH FLOW MKT REQ’D CAP RATE PROPERTY MARKET VALUE DEVELOPMENT INDUSTRY IS DEVELPT PROFITABLE ? CONSTR COST INCLU LAND IF YES ADDS NEW CAPI TAL MKTS = Causal flows. = Information gathering & use. Geltner MIT/CRE Rising prices  Increased demand  Rising prices… But positive feedback can cause spirals that result in cycles… Rising prices  Increased demand  More dvlpt… Exhibit 2-2 © 2014 OnCourse Learning. All Rights Reserved.

44 Geltner MIT/CRE Both the space market & the asset market can tend to be cyclical, but the cycle is not necessarily the same… © 2014 OnCourse Learning. All Rights Reserved.

45 Geltner MIT/CRE Both the space market & the asset market can tend to be cyclical, but the cycle is not necessarily the same… Space mkt cycle Asset mkt cycle Both mkts cycle together © 2014 OnCourse Learning. All Rights Reserved.