End of Chapter 2 Discussion Questions and Answers

1. Define a submarket. How does an office submarket differ from a residential submarket?

Answer: The market in which the property of interest (the ‘subject’ property) competes is called a submarket. Submarkets are arbitrary but should be based on properties that compete in the mind of the typical buyer or tenant for such property, thus they tend to have a geographic component, a price or rental range, and some form of quality range. For example with office property we have class A, B, and C. For residential properties we may have neighborhoods for the geographic component and size and price range as important submarket parameters. Submarkets could be based on zip codes or census tracts or counties depending on the size of the relevant market in which the subject property competes.

2. Why is the supply of real estate considered inelastic in the short run? What are the implications of changes in demand if supply is held fixed?

Answer: The supply of real estate is considered inelastic in the short run because of the inability of the market to add real estate in the near to intermediate term. It often takes years to conceive, design, permit and build a new property. Graphically a short term supply curve is a vertical line at one point on the supply side. Due to the inelasticity of supply in the short run any changes in demand have a direct impact on vacancy, rents and prices. An increase in demand instantly causes an increase/decrease in vacancy, rents or prices.

3. What is the implication of the kink in a kinked supply curve? What level of price is necessary in the market before new supply would be added? Answer: The kink (or corner) in the supply function occurs at the economically feasible rent level that equates (on a present value basis) to the long-run marginal cost of supplying additional space into the market.

When prices are below the kink the current value of real estate is below replacement cost (including acquisition, construction costs and normal profit) and no new space will be built. When prices are above the kink, new supply will begin.

4. List the primary attributes of real estate markets compared to perfectly competitive markets. What are the implications of each attribute on the markets ability to respond to changes in demand? Answer: 1) Homogeneity: Real estate markets are often heterogeneous with unique locations and customization so property comparison is more difficult and uncertain. Comparison is more difficult and price dispersion a trait of the market. 2) Large numbers of buyers and sellers: Real estate markets are often thin with few buyers and sellers so it takes more time to sell real estate adding to liquidity risk. 3) Low transactions costs: Real estate market transactions costs are high making speculation more difficult and short term ownership non-economic. 4) Full information: Real estate market decision makers often rely on less then full information using samples or observations. This adds to price and value uncertainty and requires more research prior to contracting.

5) Similar expectations: At the margin real estate is no different then perfectly competitive markets however a real estate property price must be further from equilibrium in order to induce new buying or selling then in the case of markets with low transactions costs. The high transactions costs means that real estate prices must appear well below fair market value in order to take advantage of this difference.

5. Why is it difficult to speculate in the real estate market in response to probable market trends or increasing prices? Why is it difficult to take advantage of a downward price trend in the real estate market?

Answer: The high transactions cost (brokerage and other costs) make it difficult to buy real estate if it appears to be slightly below market value and make any return from this apparently good deal. Assume a property is worth 1 million but is available for $950,000. The costs to sell and time value of money make short term ownership uneconomic. Also the large size of the economic unit means that debt is usually necessary and this adds to the transaction costs and slows down the ability to respond quickly. Last, there is no “short” market available in real estate so downward price expectations do not create profit opportunities.

6. How efficient do you believe real estate markets are? Can you describe some types of markets likely to be more or less efficient? Answer: In the real estate market, most participants are working with less than full information, as it is costly to collect and analyze data. This is changing over time with improvements in communication technology and better and more standardized data storage and retrieval. In some cases, inside information may also come into play allowing some participants to profit at the expense of others, otherwise known as excess profits. Thus real estate markets are not as efficient as perfectly competitive markets and each of us will have a different belief on the degree of efficiency. In large higher price property markets, say $10 million and up, the players are fairly sophisticated and knowledgeable and the markets are likely to be efficient in the sense of reflecting all available information. Competitive markets like commodities (oil, pork, corn) where the cost of substitution and information are negligible are much more efficient than Real Estate Markets. Thin markets for unique items like old stamps and old art or old jewelry and antiques may be less efficient than Real Estate Markets as comparative information may be difficult to obtain.

7. What drives the housing market in the short run (less than one year)? When do you think the nest time to buy might be? When do you think the best time to sell might be? Why is it difficult to do both at the best time of year?

Answer: Interest rates and seasonal patterns (holidays and weather induced) are significant drivers in the short run. Once in a while extreme movements in the stock market could influence the real estate market. For example, in 2001 and 2002 home ownership seemed less risky than stocks and many people reallocated wealth towards personal housing helping to create a brisk and increasing housing market. The best time to buy a house might be winter or during holidays when markets are slow, but these are often double transactions as some buyers must also sell their existing home, so it is difficult to pick the best time to buy when you are also selling.

8. Employment can be described as related to the export or service sector of the local economy. Define each. Which is more important for driving employment and population growth? Answer: Employment that brings revenues into the region is called the "export sector". Employment geared towards serving the local population is called the "service” sector. The export sector is more important for driving long term employment and population growth as the service sector is dependent on the export sector. As workers become more independent of location the quality of life may start to be more important for driving population growth and as more people retire stored wealth may also be an important factor giving seniors the ability to choose quality of life and lower cost and tax environments.

9. Why are cycles inevitable for real estate markets?

Answer: Cycles are inevitable for a variety of reasons including the lumpy nature of real estate, the fact that developers must jump into the market before the demand has actually materialized and in the absence of collusion such increases in supply often exceeds actual demand leading to market adjustments. Lease terms also have historically been less than perfectly proportional in terms of expiration patterns so some years see a greater proportion of expirations and new lease negotiations and adjustments.

10. Describe the impact of the Internet on one type of property: residential, office, retail or industrial properties? Which property types will likely be redesigned? Which will grow larger or smaller? Answer: Increased usage of Internet has enabled people to do knowledge work from their homes. There is no geographic restriction on these workers with respect to the distance from their offices, as they do not have to commute regularly. This may impact residential properties. Residential properties will see growth in areas with a better quality of life. Office usage could decrease and could be redesigned to suit the needs of the lives of telecommuters who occasionally go to the office. We should see more office sharing and we will also need offices at home. Warehouses that can ship small orders will see increasing demand while traditional format warehouses will see less growth as a result of more e-commerce. Hence the supply of smaller package warehouses will increase.