1. The Real Estate Space Market & Asset Market
Chapter 1
The Real Estate Space Market & Asset Market
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What’s a “market”?…
A mechanism for the voluntary exchange of goods and services among owners.
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3. Two types of markets relevant to commercial property:
1. The Space Market . . .
For the usage (or right to use) “real property”.
AKA “usage market”, or “rental market”.
(e.g., tenants & landlords exchange money for leases.)
2. The Asset Market . . .
For the ownership of “real property”.
AKA “property market”.
(e.g., Oh.STRS exchanges my pension $ for an office bldg.)
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4. What’s “real property”?…
Ans: Land & built space.
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1.1.1 The Space Market…
Supply:
Property Owners
(Landlords)
Demand:
Property Users
(Tenants)
MARKET
Rents (e.g.$/SF)
Occupancy
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6. 1.1.2 “Segmentation” in the Space Market…
A market is “segmented” if it breaks up into sub-markets, or market segments.
Within each sub-market or segment, the same good may have a different equilibrium price.
The real estate space market is highly segmented.
Why?…
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Demand side:
Users require specific types of space… A lawyer can’t use a warehouse. A trucking firm can’t use a high-rise office bldg.
Users require specific locations (or types of locations)… A lawyer won’t get much business at the intersection of I-70 and I-77. A trucking firm’s trucks would spend all their time stuck in traffic if their warehouse were located in downtown Cincinnati.
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Supply side:
Buildings are of specific physical types (warehouses  high-rise offices).
Buildings are in specific locations (and they can’t move!).
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Concept check…
1. Is there a functioning market for apartment rental in Cambridge?…
2. Is there a functioning market for apartment rental in the Boston metro area as a whole?…
3. Is there a functioning market for apartment rental in the United States as a whole?…
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Concept check…
4. Is there a functioning market for “building rental” in Cambridge?…
5. Is there a functioning market for gasoline in the United States as a whole?…
6. Is there a functioning market for apartment property ownership (investment, as distinct from rental) in the United States as a whole?… [Hint: this is the asset market, not the space market.]
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11. As a result of segmentation in the space market…
As of the same point in time (in this example, Oct.1992):
Class A Office Rents =
$23/SF/yr Dntn Chicago.
$33/SF/yr Dntn New York.
Rents in Suburban Dallas
$ 7/SF/yr for Apartments.
$13/SF/yr for Retail space.
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12. “Location, location, location…”
1999 prices for a typical (same) house: 2200 SF, 4BR/2B, 2-car Garage…
City
Price
Index
Houston, TX
$115,000 50
Pittsburgh, PA
$163,000 70
Dallas, TX
$180,000 78
Atlanta, GA
$200,000 87
Cleveland, OH
$201,000
Cincinnati
$231,000
100
Chicago, IL (Schaumburg)
$300,000
130
New York, NY (Westchstr)
$353,000
153
Chicago, IL (Lincoln Pk)
$409,000
177
Boston, MA
$421,000
182
Los Angeles, CA (Hollywd)
$530,000
229
San Francisco, CA (city)
$720,000
311
New York, NY (Manhattan)
$1,144,000
495
Source: Caldwell-Banker
 New York is 10-times Houston…
Boston is almost 3-times Pittsburgh:
“Location, location, location…”
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13. Two major dimensions of space mkt segmentation:
Geographic location
Property type
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Geographic location:
Basic unit is the “metropolitan area” (“MSA”)
Sub-markets (e.g., CBD, Suburban, neighborhoods) also important
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Property type:
Residential (apartment)
Office
Industrial (warehouse)
Retail
Other (hotels, health-care, etc…)
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Example space market:
Cincinnati CBD Class A Office Mkt, 1980s-90s…
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17. Exhibit 1-1: Office Demand as a Function of Employment, the 1980s…
Note: Pretty “normal” shaped demand function
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The real estate space supply function has a more peculiar shape…
Real estate space long-run supply is kinked…
This is due to the longevity of buildings.
(You can add them a lot easier than you can subtract them!)
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19. 1.1.4 Supply, Development, & Rent…
Supply function = Long-run Marginal Cost function (LRMC)
LRMC = Virtually zero (at and below existing supply)
LRMC = Development cost (beyond existing supply)
Development cost = Construction + Land (including developer profit)
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Rising LRMC (costs more to build next than last)  Land scarcity, Location demand growth
Falling LRMC (costs less to build next than last)  Loss of centrality, Location demand decline
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Rising LRMC (Islands, Growth constraints)
 Manhattan, Boston, SF, Honolulu,…
Falling LRMC (Land available, Trans/Tel Infra)  Typical CBD in Midwest & South
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22. In a market with expanding demand:
LR equilibrium rent
= “Replacement cost rent”.
= Rent the market tends to return to.
= Rent just sufficient to make new development profitable.
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23. Example: Cincinnati CBD office market, 1980s-90s…
Devlpt Cost = $200/SF (of blt space, inclu land + construction)
Mid-1980s CBD office bldgs were selling at “8% cap rates.”
That means investors at that time were willing to pay
$1 / 0.08 = $12.50
per dollar of current net income produced by the bldg.
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24. Example: Cincinnati CBD office market, 1980s-90s…
Thus, if office bldgs could generate $16/SF of net rent, then it would be just profitable to develop new buildings: $16 / 0.08 = $200 = Devlpt Cost
Thus, $16/SF is the LR equilibrium (“Replacement Cost”) rent.
Rents at $16/SF or more, with cap rates at 8% or less, would tend to trigger new development of downtown office buildings in Cincinnati in the 1980s.
But would this new development really turn out to be profitable?…
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25. 1.1.5. Forecasting Future Rents…
You need to forecast changes in both future demand and future supply, and consider that the “kink point” moves out with increases in current stock of supply…
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What happened in the Cincinnati office market at the end of the 1980s, through early 1990s…
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27. (1) Expecting demand to grow from D1 to D2,…
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(1) Expecting demand to grow from D1 to D2, developers built 1 million SF new space (Chemed Ctr & 312 Walnut). S2
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(1) Expecting demand to grow from D1 to D2, developers built 1 million SF new space (Chemed Ctr & 312 Walnut). S2
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30. Chemed Center + 312 Walnut = 1 MSF Spec, 1990
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(1) Expecting demand to grow from D1 to D2, developers built 1 million SF new space (Chemed Ctr & 312 Walnut). S2
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32. (2) Demand stayed stuck at D1.
But what happened in reality is . . .
(2) Demand stayed stuck at D1. S2
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33. (2) Demand stayed stuck at D1.
But what happened in reality is . . .
(2) Demand stayed stuck at D1. S2
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(2) Demand stayed stuck at D1 (or even fell temporarily to D0, with recession of 1991).
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(3) Net rents fell from $16/SF to $13/SF or even as low as $10/SF in the early 1990s.
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(3) Net rents fell from $16/SF to $13/SF or even as low as $10/SF in the early 1990s. (They eventually recovered by the late 1990s.)
How?…
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37. Exhibit 1-3: Change in Supply & Demand & Rent over Time
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Is The Supply Function Rising, Level, or Falling?...
Exhibit 1-4: Long-run history of real home prices, building costs, population, and interest rates in the United States.
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39. Real GDP, Population, Real Home Prices: 1952-2011…
Robert Shiller Real Home Price Index, NBER Recessions
1952= shaded bars = GDP recessions…
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Exhibit 1-5:
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41. 1.2 The Real Estate Asset Market (Property Market)…
Supply:
Investors
Wanting to Sell
Demand:
Investors
Wanting to Buy
MARKET
Property Prices:
“Cap Rates”
1/($Asset/$Income)
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For investors:
Real Estate Assets = Future Cash Flows   “Cash is fungible.”   Cash is cash is cash, whether it comes from real estate, stocks, or bonds.   Real estate assets compete against stocks & bonds. The real estate asset market is part of the broader capital market .
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Exhibit 1-6: Major Types of Capital Asset Markets and Investment Products
Public Markets:
Private Markets:
Equity Assets:
Stocks
REITs
Mutual funds
ETFs
Real Property
Private firms
Oil & Gas Partnerships
Hedge Funds
Debt Assets:
Bonds
MBS
Money instruments
Bank loans
Whole Mortgages
Venture Debt
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Concept check…
What is the difference between “equity” and “debt” assets (investment products)?…      
What is the difference between “public” and “private” asset markets?…  
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45. 1.2.2 The Magnitude of Real Estate in the overall Capital Market…
Exhibit 1-7 US Capital Market Sectors, a $70 Trillion Pie…
Includes private homes, bank loans, everything. (e.g., deposits into banks loaned out as private bank loan to a business would be included here as “private debt”.)
* Corporate real estate owned by publicly-traded firms, plus REITs.
Source: Authors’ estimates based on Miles & Tolleson (1997).
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Magnitude
Exhibit 1-8: US Investable Capital Market with Real Estate Components Broken Out
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47. Real estate asset classes are:
Private Commercial Mortgages (2%)
CMBS (1%)
RMBS (6%)
Private Residential Mortgages (6%)
House Equity (17%)
Commercial Real Estate Equity (7%)
Agricultural/Timberlands (2%)
REITs (0.5%)
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48. US Investable Asset Sectors, a $82 Trillion Pie…
Another perspective on magnitude of real estate in the overall capital market ($ trillion as of 2012)
US Investable Asset Sectors, a $82 Trillion Pie…
Includes private homes, bank loans, everything. (e.g., deposits into banks loaned out as private bank loan to a business would be included here as “private debt”.)
Note: CRE = Commercial Real Estate. There is some double-counting here, betw MBS bonds & RE ($5T), & between REIT stocks & CRE ($0.5T).
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49. How much real estate is there?...
About $30 trillion worth
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50. How much commercial real estate is there?...
About $9 trillion worth
*Industrial excludes factories & manufacturing/extraction plants
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51. How much commercial real estate is there?...
Market Size by Property type sin Rentable Building Area and Market Cap Based on Mean Price for the Mid-Point of 2009
Property Type
Square Footage
$/SF
Market Cap
Office
12,058,379,264
$102
$1,229,954,684,928
Industrial
23,851,606,671
$45
$1,073,322,300,195
Flex
2,907,635,121
$75
$218,072,634,075
Retail
17,336,105,191
$101
$1,750,946,624,291
Health Care
2,634,773,693
$490
$1,291,039,109,668
Hospitality
2,556,726,260
$95
$242,888,994,700
Mixed-Use
107,651,632
$10,226,905,040
Multi-Family
22,643,500,000
$62
$1,403,897,000,000
Specialty, Sports & Entertainment NA
$1,953,008,671,667
Total
84,096,377,832
$9,173,356,924,466
Source: Florance, Miller, Spivey, Peng, JREPM 16(2) 2010
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Magnitude
Exhibit 1-9: Magnitude of U.S. Commercial Real Estate by Sector, cerca 2010…
Source: CoStar.
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Magnitude
Investable Real Estate Capital Structure
Total Equity:
$907.6 billion +
Total Debt:
$1,831.9 billion =
Total Capital:
$2.7 trillion
Mortgage
Public Real
Public Real
Total Private
REITs
Estate LPs
Total Public
Debt
Estate LPs
Commercial
Pension
Mortgage
0.4%
Equity
0.1%
0.0%
Funds 6%
48%
Securities
20.9%
Total Private
REITs
21.4%
Foreign
Equity
19.0%
Life Insurance
Excludes owner-occupied housing, corporate real estate (owner-occupied), and some smaller commercial and apartment properties.
Investors
27%
Companies
5.3%
Government
15.9%
Credit
Private
Agencies
Financial
7.3%
Institutions
1.1%
Pension
Commercial
Private
Funds
Life Insurance
Banks
Investors
2.3%
Companies
Savings
43.7%
Total Public
51.6%
Debt
2.1%
Institutions
19%
9.0%
Source: Roulac Group (Investment Property Report, 12/11/02), & PPR Inc.
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54. Evolution of U.S. Investable Real Estate Market
Magnitude
Evolution of U.S. Investable Real Estate Market
Source: PPR
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55. How is institutional real estate financed?...
Institutional Real Estate Capital Structure: 2011
Source: PPR, 2011
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56. Exh.7-12: How is institutional real estate financed?... Buyers’ equity:
Properties $5M+
Source: Real Capital Analytics Inc.
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57. Exh.7-13: How is institutional real estate financed?... Buyers’ debt:
Source: Real Capital Analytics Inc.
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58. How is institutional real estate financed?...
Institutional Real Estate Debt Sources:
Outstanding Balance as of 2011
Source: PPR, 2011
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59. Real Estate vs Stocks & Bonds…
Investment “total return” includes income + capital growth:
Note differing volatility, differing average total performance, across asset classes. This is only lecture in course where Ch.7 type historical risk&return picture is covered (though more in 432).
*Real estate represented by institutional grade investment property (NCREIF-based TBI transaction based index)

60. 1.2.3. The Pricing of Real Estate Assets:
“Cap Rates”…   Commercial property prices are typically quoted in terms of “Cap Rates” (short for “capitalization rate”), AKA “OAR” (short for “overall rate”).
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The Cap Rate is like:
Current yield on the investment.
Inverse of “Price/Earnings” Multiple.
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62. Property value can be represented (or estimated) as:
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63. Three major determinants of cap rates …
1) The Opportunity Cost of Capital (OCC)
This comes from the capital market.
How much return can investor’s expect to earn in other types of investments, like stocks, bonds, money mkt?…
Higher real interest rates or higher expected returns in other types of investments will require higher expected returns in real estate, and therefore higher cap rates, other things being equal.
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64. Three major determinants of cap rates …
2) Growth Expectations in the property’s future cash flows
This comes from the space market.
How much can investor’s expect that this property’s net cash flow (rents - expenses) will be able to grow over the coming years?…
Higher (realistic) growth expectations will allow a lower cap rate, as investors will be willing to pay more $ today for a given amount of current net income, in order to own the property (since this income is expected to grow).
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65. Three major determinants of cap rates …
3) Risk perceptions and preferences among investors, regarding the property.
This comes from both the space market and the capital market (risk is relative).
How risky is an investment in this property, and how much do investors care about that risk?…
Greater risk, and greater sensitivity to risk, will require higher cap rates (lower asset values per $ of current income).
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Concept check…
Other things being equal, which would have the lower cap rate, Property “A”, or Property “B”?…
A: An apartment building in a declining neighborhood. B: An apartment building in a growing neighborhood.
A: An office building with full of long-term tenants. B: An office building full of short-term tenants.
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Concept check…
Other things being equal, which would have the lower cap rate, Property “A”, or Property “B”?…
A: Real estate when LT bonds yield 6% (with 3% infla). B: Real estate when LT bonds yield 8% (with 3% infla).
A: A surface parking lot in a thriving downtown. B: A 10-story parking garage in a thriving downtown.
A: An office bldg with short-term below-mkt leases in a growing rental market. B: An office bldg with short-term above-mkt leases in a declining rental market.
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68. 1.2.4 Asset Markets Are Not (very) Segmented…
“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.
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69. Physical Capital and Financial Capital
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.
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Financial Capital
Financial capital can quickly and easily flow from a Manhattan office bldg to a Chicago office bldg or a Dallas apt bldg. Returns are returns are returns, because $$$ are $$$ are $$$, whether those $$$ come from New York office rents, Chicago office rents, or Dallas apartment rents.
Therefore:
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71. THE REAL ESTATE ASSET MARKET IS NOT SEGMENTED LIKE THE SPACE MARKET
Integrated (not segmented) real estate asset market    Asset prices are such that expected returns are the same for properties with the same risk, across different property market segments…  
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72. Exhibit 1-10: Typical Cap Rates, 3rd Qtr 1994:
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Concept check…
Why are the cap rates lower for mall?…
Why are the cap rates higher for hotels and offices in “oversupplied” markets?…  
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