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11.433J / 15.021J Real Estate Economics


Fall 2008

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Week 1: Introduction
The space versus asset market: 4 Quadrant math. Real Estate Micro Economics: Hedonics, Location, density, government regulations. Real Estate Macro Economics: timing behavior (search, moving, contracts), cycles, regional growth.

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The Role of Real Estate in the Economy


Construction [6% of GDP] Service flow, Shelter, rent plus imputed rent [20% + of GDP] Assets [55-60% of total national wealth] Land? Not part of GDP (we dont make land), but it is part of wealth. Accounting, measurement difficulties [book versus market value]

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Value of New Construction Put in Place, 2002
$ (in Billions) % of GDP

Private Construction Buildings Residential buildings Nonresidential buildings Industrial Office Hotels/Motels Other commercial All other nonresidential Nonbuilding construction Public utilities All other Public Construction Buildings Housing and development Industrial Other Nonbuilding construction Infrastructure All other Total new construction Total GDP:

650 422 167 17 38 10 56 46 54 7 210 102 6 2 94 108 97 11 861 10,624

6.1 4.0 1.6 0.2 0.4 0.1 0.5 0.4 0.5 0.1 2.0 1.0 0.1 0.0 0.9 1.0 0.9 0.1 8.1 100.0

Source: Current Construction Reports, Series C30, U.S. Census Bureau. Gross Domestic Product from Economic Report of the President, 2004

Figure by MIT OpenCourseWare.

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The Value of US Real Estate Assets (1990)
$, in billions Residential 6,122 % of Total 69.8

Single Family Homes Multifamily Condominiums/Coops Mobile Homes

5,419 552 96 55

61.7 6.3 1.1 0.6

Nonresidential

2,655

30.2

Retail Office Manufacturing Warehouse

1,115 1,009 308 223

12.7 11.5 3.5 2.5

Total U.S. Real Estate

8,777

100.0

Adapted from DiPasquale and Wheaton (1996)

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U.S. Real Estate Ownership, 1990
All Real Estate Residential Only Nonresidential Only

$, in billions Individuals Corporations Partnerships Nonprofits Government Institutional Investors Financial Institutions Other (Including Foreign 5,088 1,699 1,011 411 234 128 114 92

% 58.0 19.4 11.5 4.7 2.6 1.5 1.3 1.0

$, in billions 5,071 66 673 104 173 14 13 8

% 82.8 1.1 11.0 1.7 2.8 0.2 0.2 0.1

$, in billions 17 1,633 338 307 61 114 101 84

% 0.6 61.5 12.7 11.6 2.3 4.3 3.8 3.2

Total:

8,777

100.0

6,122

100.0

2,655

100.0

% of All Real Estate

100.0

69.8

30.2

Adapted from DiPasquale and Wheaton (1996)

Exhibit 2-3: The DiPasquale-Wheaton 4-Quadrant Diagram

Rent $
Asset Market: Valuation

D
Space Market: Rent Determination

R* D

Price $

P*

Q*

Stock (SF)

C*
Asset Market: Construction Space Market: Stock Adjustment

Construction (SF)

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Systems of Economic Equations


Parameters: Constants that reflect underlying behavior, , , . Endogenous variables: values that the model determines: C, S, R, P. Exogenous variables: values that determine the models variables, but which the models variables in turn do not influence: i, E. Equilibrium: Solution to the endogenous variables given exogenous values and parameters. Comparative Statics: How changes in exogenous variables change equilibrium endogenous ones.

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1st quadrant 1). Office Demand = 1ER-1 E= office employment R = rent per square foot 1 = rental elasticity of demand, %change in sqft per worker/% change in rent] 1 = sqft / E when R=$1 2). Demand = Stock = S 3). Hence: R = (S/1E)1/ 1 {downward sloping schedule}

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2nd and 3rd Quadrants 4). P = R/i i = all inclusive cap rate 5). Office Construction rate: C/S = 2P2 P = Asset Price per square foot [Q theory?] 2 = Price elasticity of supply: [% change in construction rate/% change in price]

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4th Quadrant 6). Replacement version (graph): E= fixed, S = building losses S/S = C/S - [Construction rate loss rate equals net additions = 0 in equilibrium] 7). Steady Demand growth version: E/E = , no losses Hence: S/S - E/E = C/S - [what happens to S/E if C/S >< ?]

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Asset Market: Valuation

Effect of Demand Growth in Space Market: More Jobs Space Market: Rent Determination

Rent $ D1

D0

R*

Price $

P*

Q*

Stock (SF)

C*
Asset Market: Construction Space Market: Stock Adjustment

Construction (SF)

Effect of Demand Growth in Space Market:

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Asset Market: Valuation

First phase Space Market: Rent Determination

Rent $

D0

D1

Doesnt form a rectangle.

R* Excess (negative) vacancy Price $ P* Q* Stock (SF)

C*
Asset Market: Construction Space Market: Stock Adjustment

Construction (SF)

Effect of Demand Growth in Space Market:

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Asset Market: Valuation

2nd phase Space Market: Rent Determination

Rent $

R1

D0

D1 Rents spike and get rid of excess (negative) vacancy

R*

Price $

P1

P*

Q*

Stock (SF) Can this be a longrun equilibrium result?

C*
Asset Market: Construction Space Market: Stock Adjustment

Doesnt form a rectangle.

Construction (SF)

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Asset Market: Rent $ Valuation

Effect of Demand Growth in Space Market: LR Equilibrium Space Market: Rent Determination

R1 R** R*

D0

D1

P** Price $ P1 P* Q* Q** Stock (SF) In long run equilibrium new supply tempers initial rent spike

C*
Asset Market: Construction

C**

Space Market: Stock Adjustment

Construction (SF)

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Asset Market: Valuation

Effect of Demand Growth in Asset Market Space Market: Rent Determination

Rent $

D0 D1

11% CAP

R* 8%CAP

R**
SR

P1 Price $

LR

Q**
P* Q*

P**

Stock (SF)

C*

Asset Market: Construction

C**

Space Market: Stock Adjustment

Construction (SF)

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Using the 4-Quadrant Model to assess the impact of other changes.


What happens if Construction costs rise or the supply schedule shifts? Suppose depreciation speeds up (functional obsolescence dictates shorter life spans of buildings)? How to interpret owner occupied space (e.g. Single Family Housing)? EXERCISE #1.

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Current Issues: using the diagram


Zero (or negative) population and labor force growth in: Japan, Germany, Italy, Spain? Increasing use of the Internet for retail shopping? Expanded availability of (subprime) mortgage credit to households previously ineligible? Continued global saving glut from growth in Asia where savings rates are 20%+

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Real Estate Macro-economics: Real Estate Cycles and Secular Trends


What are real estate cycles? Truly independent oscillations or just reactions to the economy. Cycles vary with Property type. Cycles are related to broader capital markets. Secular trend: growth rates of the stock (construction) slow as economy matures. Secular trend: Prices adjusted for inflation rise over time?

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Prefect Historic correlation between economic recessions and Housing Production except for the last 5 years
5 Year-over-year change in total employment, millions 4 3 2 1 0 -1 -2 -3 3.2 2.8 2.4 2.0 1.6 1.2 0.8 0.4 0.0 Total housing starts, millions of units

Sources: BLS, BOC, TWR.

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 New Jobs (L) Total Housing Starts (R)

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Prefect Historic correlation between economic recessions and Housing Prices except for the last 5 years
Housing and U.S. Job Growth
6% 5% 4% 3% job growth 2% 1% 0% -1% -2% -3%
69 19 Q3 71 19 Q1 72 19 Q3 74 19 Q1 75 19 Q3 77 19 Q1 78 19 Q3 80 19 Q1 81 19 Q3 83 19 Q1 84 19 Q3 86 19 Q1 87 19 Q3 89 19 Q1 90 19 Q3 92 19 Q1 93 19 Q3 95 19 Q1 96 19 Q3 98 19 Q1 99 20 Q3 01 20 Q1 02 20 Q3 04 20 Q1 05 20 Q3 07 Q 1

12% 10% 8% 6% 4% 2% 0% -2% based on 4-qtr moving averages -4% -6% -8% real median home prices

19

Job Grow th

Real Median Home Price Grow th (lagged)

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With offices, building booms follow rents. The booms then generate falling rents = endogenous cycle?
140 120 100 80 60 40 20 0 -5 Office construction and rent growth (TWR sum of markets) Forecast Completions Historical average 10 15

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Completions in msf (L)

TWR rent inflation in % (R) Figure by MIT OpenCourseWare.

2009

-10

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National Office Market


Completions Rate vs. Real Rent
$ Per Sqft
Forecast

34.00

8.00% 32.00

6.00%

30.00

4.00%

28.00

26.00 2.00% 24.00 0.00% 22.00

-2.00% 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

20.00

Total Employment Growth (L)

Real Rent (R)

Completion Rate (L)

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Historically: Rents over the cycle mean revert around Development costs
PPI: Construction
200 190 180 27 170 160 150 140 130 19 120 110 100
19 88 Q 19 1 89 Q 19 1 90 Q 19 1 91 Q 19 1 92 Q 19 1 93 Q 19 1 94 Q 19 1 95 Q 19 1 96 Q 19 1 97 Q 19 1 98 Q 19 1 99 Q 20 1 00 Q 20 1 01 Q 20 1 02 Q 20 1 03 Q 20 1 04 Q 20 1 05 Q 20 1 06 Q 20 1 07 Q 20 1 08 Q 1

TWR Rent Index


31 29

25 23 21

17 15

PPI: Construction Materials and Components

TWR Rent Index

Source: BLS, TWR Office Outlook XL, Summer 2008

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Over the long run there also are: little cycles and Big cycles
Construction as % of Stock

Broken Ground Projects

18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2%


1901 1910 1919 1928 1937 1946 1955 1964 1973 1982 1991 2000

Downtown

Suburban

Price Index 100 150 200 250 300 350 400


16

50

16 16 16 16 16 16 16 17 17 17 17 38 48 58 68 78 88 98 08 18 28 38 48 58 68 78 18 18 19 19 19 19 19 19 19 88 98 08 18 28 38 48 58 68 17 17 17 17 17 17 18 18 18 18 18 18 18 18 28 18 08 98 88 78 68 58 48 38

28

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Index of Historic Housing Prices in Amsterdam (Real Guilders)

Y ear

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CPI Apartment Rent Indices for Selected "traditional" Cities: 1918-1999 (constant $)
400 350 300 Apartment Rent 250 200 150 100 50 0 1918 1921 1924 1927 1930 1933 1936 1939 1942 1945 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996

Year NEW YORK BOSTON CHICAGO WASHINGTON D. C. SANFRANCISCO

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Long run Appreciation? Just inflation (3.5%) for 100 years in NYC, but lots of decade risk
Price Index 1899 = 1.0 constant dollars/square ft.
1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 1899 1909 1919 1929 1939 1949 1959 1969 1979 1989 1999

Source: MIT 2002 Thesis

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Real Estate Micro-economics: Cities and Land Markets


No two properties are identical [complete product differentiation] Properties are close if not perfect substitutes for each other at some price differential. Price differentials are extremely large, and very predictable. Price differentials tend to be stable over time: local neighborhoods do not have independent cyclic movements.

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House prices reflect both unit characteristics and location attributes

17.19

In(sale) 8.52 5.71 In(sqrt) Sale amount against square feet, Phoenix 9.34

Figure by MIT OpenCourseWare.

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Repeat-Sale House price indices (CSW) for 15 submarkets within the greater Boston CMSA: 1982-2002 (current $)
House Price Indexes, Eastern M assachusetts, by City/Tow n Location
300

250 Boston Southeast W estern 1 Far North Shore 495 North 95 South 95 N orth W estern 2 Lowell Area 495 W est North Shore South Shore W orcester Area Cam bridge Area North Central

Price Index (1990=100)

200

150

100

50

0 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Year

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Home Prices within South California


Median Home Price,

Thousands ($ 2002.4)

$400 $350 $300 $250 $200 $150 $100 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02

Los Angeles

Orange County

Riverside

Ventura

San Diego

Sources: OFHEO, Torto Wheaton Research

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Office Rents Move together Cyclically but not always secularly


TW Rent Index, 2003$ per sqft

40
Forecast

35 30 25 20 15 1980 1981 1982 1983 1985 1986 1987 1988 1990 1991 1992 1993 1995 1996 1997 1998 2000 2001 2002 2003 2005

Los Angeles

Orange County

Ventura County

Riverside

San Diego

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Closely Correlated Industrial Rent Movements: few secular differences


TW Rent Index, 2003$ per sqft

10.00
Forecast

9.00 8.00 7.00 6.00 5.00 4.00 1980 1981 1983 1984 1986 1987 1989 1990 1992 1993 1995 1996 1998 1999 2001 2002 2004 2005

Los Angeles

Orange County

Ventura County

Riverside

San Diego

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Manhattan Office Rents vs. NJ and Conn. Suburbs


TW Index, $2002 per sqft

65 60 55 50 45 40 35 30 25 20 1980 1981 1982 1983 1985 1986 1987 1988 1990 1991 1992 1993 1995 1996 1997 1998 2000 2001

Suburban Markets

Manhattan

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Office Suburban Rents in Detail


TW Index, $2002 per sqft

50 45 40 35 30 25 20 15 10 1980 1981 1982 1983 1985 1986 1987 1988 1990 1991 1992 1993 1995 1996 1997 1998 2000 2001

Northern New Jersey

Long Island

Stamford

Westchester

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Prices and Development


Prices bring forth development: of any urban land use.. Development occurs so as to maximize the residual value between: Price-capital costs (construction). This residual is land value. Development maximizes land value. Land Development is a natural real option: incur heavy capital costs to realize an income stream or- wait (to do the same later) ?

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What is a real Estate Market?


Within markets all properties should move together: high substitutability, easy mobility. Between markets there exists frictions, transportation costs, immobility of resources and low substitutability. MSA as market? CMSA?

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Between Markets there can be huge differences in both long term growth and cyclic risk
1 9 8 0 = 1 0 0 (C o n s ta n t $ 2 0 0 5 ) 350
B o s to n

300

250

200

Los A n g e le s Ch ic a g o Na tio n

150

100

Da lla s

50

0 1980 1985 1990 1995 2000 2005

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Metropolitan Housing Markets can even move independently


FIGURE 5. Repeat Sale House Price Indices for Selected "new" Cities: 1975-1999 (constant $)
250 230 210 190 170 150 130 110 90 70 50
75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 99

House Price

Year Atlanta Dennver Houston Los Angeles Phoenix

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Although sometimes they are subject to a common economy wide Shock


FIGURE 4. Repeat Sale House Price Indices for Selected "Traditional" Cities: 1975-1999 (constant $)
250 230 210 190 170 150 130 110 90 70 50
75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 99

House Price

Year Boston Chicago New York Sanfrancisco Washington D.C.

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