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Chapter 2:
The Real Estate System
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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.
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3. 2.1 The Commercial Property Development Industry
Financial
Resources
Development
Industry
New
Built
Space
Physical
Resources
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4. The Development Industry
Development is a creative, entrepreneurial process characterized by…
Vision
Greed
Cooperation
Risk
(All the most entertaining features of American capitalism.)
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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.
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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…
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Gray shade indicates GDP recession
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2.2 The Real Estate System
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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.
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12. “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.
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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.
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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?…
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2.3 The “4-Quadrant Model” (4QM)…
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16. Exhibit 2-3: The DiPasquale-Wheaton 4-Quadrant Diagram…
Rent $
Space Market:
Rent Determination
Asset Market:
Valuation R* D
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Price $ P* Q*
Stock (SF) C*
Asset Market:
Construction
Space Market:
Stock Adjustment
Construction (SF)

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2.4 Using the 4QM to help understand “boom & bust” cycles…
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EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY PRICES OVER THE LAST QUARTER-CENTURY . . .
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Exhibit 2-4a: Effect of Demand Growth in Space Market:
Rent $
Space Market:
Rent Determination
Asset Market:
Valuation D1 D0 R*
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Price $ Q*
Stock (SF) C*
Asset Market:
Construction
Space Market:
Stock Adjustment
Construction (SF)

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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*
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Price $ Q*
Stock (SF) C*
Asset Market:
Construction
Space Market:
Stock Adjustment
Construction (SF)

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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*
© 2014 OnCourse Learning. All Rights Reserved. P1 P*
Price $ Q*
Stock (SF) C*
Asset Market:
Construction
Space Market:
Stock Adjustment
Construction (SF)

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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*
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P** P1 P*
Price $ Q*
Stock (SF) C*
Asset Market:
Construction
C**
Space Market:
Stock Adjustment
Construction (SF)

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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
© 2014 OnCourse Learning. All Rights Reserved. LR P1
Q** P* Q*
Price $
P**
Stock (SF) C*
Asset Market:
Construction
Space Market:
Stock Adjustment
C**
Construction (SF)

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EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY PRICES OVER THE LAST QUARTER-CENTURY . . .
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25. Exhibit 2-5: Real CRE Prices & Rents: 1986-2010:
Rent Cycle & Asset Price Cycle Not Necessarily the Same…
1986= shaded bars = GDP recessions…
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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?…]
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