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11.433J / 15.021J Real Estate Economics Fall 2008

For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms. MIT Center for Real Estate 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. MIT Center for Real Estate 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 don’t make land), but it is part of wealth. • Accounting, measurement difficulties [book versus market value] MIT Center for Real Estate

Value of New Construction Put in Place, 2002

$ (in Billions) % of GDP

Private Construction 650 6.1 Buildings Residential buildings 422 4.0 Nonresidential buildings 167 1.6 Industrial 17 0.2 Office 38 0.4 Hotels/Motels 10 0.1 Other commercial 56 0.5 All other nonresidential 46 0.4 Nonbuilding construction Public utilities 54 0.5 All other 7 0.1

Public Construction 210 2.0 Buildings 102 1.0 Housing and development 6 0.1 Industrial 2 0.0 Other 94 0.9 Nonbuilding construction 108 1.0 Infrastructure 97 0.9 All other 11 0.1

Total new construction 861 8.1 Total GDP: 10,624 100.0

Source: Current Construction Reports, Series C30, U.S. Census Bureau. Gross Domestic Product from Economic Report of the President, 2004 Figure by MIT OpenCourseWare. MIT Center for Real Estate

The Value of US Real Estate Assets (1990)

$, in billions % of Total

Residential 6,122 69.8

Single Family Homes 5,419 61.7

Multifamily 552 6.3

Condominiums/Coops 96 1.1

Mobile Homes 55 0.6

Nonresidential 2,655 30.2

Retail 1,115 12.7

Office 1,009 11.5

Manufacturing 308 3.5

Warehouse 223 2.5

Total U.S. Real Estate 8,777 100.0

Adapted from DiPasquale and Wheaton (1996) MIT Center for Real Estate U.S. Real Estate Ownership, 1990

All Real Estate Residential Only Nonresidential Only

$, in billions % $, in billions % $, in billions %

Individuals 5,088 58.0 5,071 82.8 17 0.6

Corporations 1,699 19.4 66 1.1 1,633 61.5

Partnerships 1,011 11.5 673 11.0 338 12.7

Nonprofits 411 4.7 104 1.7 307 11.6

Government 234 2.6 173 2.8 61 2.3

Institutional Investors 128 1.5 14 0.2 114 4.3

Financial Institutions 114 1.3 13 0.2 101 3.8

Other (Including Foreign 92 1.0 8 0.1 84 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… D Rent $

Space Market: Asset Market: Rent Determination Valuation

R* D

Price $ P* Q* Stock (SF)

C*

Asset Market: Construction Space Market: Stock Adjustment

Construction (SF) MIT Center for Real Estate Systems of Economic Equations • Parameters: Constants that reflect underlying behavior, α, β, δ. • Endogenous variables: values that the model “determines: C, S, R, P. • Exogenous variables: values that determine the model’s 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. MIT Center for Real Estate 1st quadrant -β1 1). Office Demand = α1ER E= office employment R = rent per square foot

β1 = rental elasticity of demand, %change in sqft per worker/% change in rent]

α1 = sqft / E when R=$1 2). Demand = Stock = S –1/ β1 {downward sloping schedule} 3). Hence: R = (S/α1E) MIT Center for Real Estate 2nd and 3rd Quadrants 4). P = R/i i = all inclusive cap rate 5). Office Construction rate: β2 C/S = α2P P = Asset Price per square foot [“Q” theory?]

β2 = Price elasticity of supply: [% change in construction rate/% change in price] MIT Center for Real Estate 4th Quadrant 6). Replacement version (graph): E= fixed, δS = building losses ΔS/S = C/S - δ [Construction rate – loss rate equals net additions = 0 in equilibrium] 7). Steady Demand growth version: ΔE/E = δ, no losses Hence: ΔS/S - ΔE/E = C/S - δ [what happens to S/E if C/S >< δ ?] Effect of Demand Growth in Space Market: More MIT Center for Real Estate Jobs Rent $ Asset Market: Space Market: Valuation Rent Determination

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: MIT Center for Real Estate First phase… Rent $ Space Market: Asset Market: Rent Determination Valuation

D1 D0 Doesn’t 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: MIT Center for Real Estate 2nd phase… Asset Market: Rent $ Space Market: Valuation Rent Determination

D1 D0 R1 Rents spike and get rid of excess (negative) vacancy

R*

P* Price $ P1 Q* Stock (SF) Can this be a long- run equilibrium result?… C* Asset Market: Doesn’t form a Construction rectangle. Space Market: Stock Adjustment

Construction (SF) Effect of Demand Growth in Space Market: LR Equilibrium… MIT Center for Real Estate Asset Market: Rent $ Space Market: Valuation Rent Determination

D1 D0 R1 R**

R*

P** P* Price $ P1 Q* Q** Stock (SF)

In long run equilibrium new supply tempers C* initial rent spike Asset Market: Construction C** Space Market: Stock Adjustment

Construction (SF) Effect of Demand Growth in Asset Market… MIT Center for Real Estate Asset Market: Rent $ Space Market: Valuation Rent Determination

D0 11% CAP

D1 R* 8%CAP

R** SR

LR P1 Q** P* Q* Price $ P** Stock (SF)

C* Asset Market: Construction Space Market: C** Stock Adjustment

Construction (SF) MIT Center for Real Estate 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. MIT Center for Real Estate 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%+ MIT Center for Real Estate 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? MIT Center for Real Estate Prefect Historic correlation between economic recessions and Housing Production – except for the last 5 years

5 3.2

4 2.8

3 2.4

2 2.0

1 1.6 0 1.2

-1 0.8 of units millions Total housing starts, housing Total employment, millions employment, -2 0.4 Year-over-year change in total -3 0.0 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)

Sources: BLS, BOC, TWR. MIT Center for Real Estate Prefect Historic correlation between economic recessions and Housing Prices – except for the last 5 years

Housing and U.S. Job Growth

6% 12%

5% 10%

4% 8% 6% 3% 4% 2% 2% 1% 0% job growth job 0% -2% -1%

-4% prices home median real based on 4-qtr -2% moving averages -6% -3% -8%

3 3 3 3 3 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1

1969Q1971Q11972Q1974Q11975Q1977Q11978Q1980Q11981Q1983Q11984Q1986Q1987Q1989Q1990Q1992Q1993Q1995Q1996Q1998Q1999Q2001Q2002Q2004Q2005Q2007Q

Job Grow th Real Median Home Price Grow th (lagged) MIT Center for Real Estate With offices, building booms follow rents. The booms then generate falling rents = endogenous cycle?

Office construction and rent growth (TWR sum of markets) 140 15 Forecast 120 Completions - 10 Historical average 100

5 80

60 0

40 -5 20

0 -10 2 3 4 5 6 7 8 9 8 9 0 1 2 3 4 5 6 7 8 9 0 1 0 0 0 0 0 0 0 0 8 8 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 9 9 9 9 9 9 9 9 9 9 9 9 0 0 2 2 2 2 2 2 2 2 1 1 1 1 1 1 1 1 1 1 1 1 2 2 Completions in msf (L) TWR rent inflation in % (R)

Figure by MIT OpenCourseWare. MIT Center for Real Estate 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% 20.00 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Total Employment Growth (L) Real Rent (R) Completion Rate (L) MIT Center for Real Estate Historically: Rents over the “cycle” mean revert around Development costs

PPI: Construction TWR Rent Index 200 31

190 29 180 27 170 25 160 150 23 140 21 130 19 120 110 17 100 15

1 1 Q1 88 89Q 90Q1 91Q1 92Q1 95Q 96Q1 97Q1 98Q1 99Q1 02Q1 03Q1 04Q1 05Q1 06Q1 19 19 19 19 19 1993Q11994Q119 19 19 19 19 2000Q12001Q120 20 20 20 20 2007Q12008Q1 PPI: Construction Materials and Components TWR Rent Index

Source: BLS, TWR Office Outlook XL, Summer 2008 MIT Center for Real Estate Over the long run there also are:

little cycles and Big cycles Broken 18% Ground Construction as % of Stock Projects 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% 1901 1910 1919 1928 1937 1946 1955 1964 1973 1982 1991 2000 Downt own Suburban MIT Center for Real Estate Index of Historic Housing Prices in Amsterdam (Real Guilders) gy ( g)

400

350

300

250

200 Price Index Price

150

100

50

0

8 8 8 8 8 8 8 8 68 78 88 98 08 18 28 28 38 48 58 68 78 88 64 65 6 6 6 6 7 7 7 80 81 8 8 8 8 8 8 8 96 1628 1638 1 1 1 1 1 1 1 1 1 1738 1748 1758 1768 1778 1788 179 1 1 1 1 1 1 1 1 1 1898 1908 1918 1928 1938 194 195 1 Year MIT Center for Real Estate

CPI Apartment Rent Indices for Selected "traditional" Cities: 1918-1999 (constant $)

400

350

300

250

200

150 Apartment Rent Apartment

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 Y ORK BOSTON CHICA GO WASHINGTON D. C. SA NFRA NCISCO MIT Center for Real Estate 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 MIT Center for Real Estate 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. MIT Center for Real Estate House prices reflect both unit characteristics and location attributes

17.19 ) e l a s ( n I

8.52 5.71 In(sqrt) 9.34

Sale amount against square feet, Phoenix

Figure by MIT OpenCourseWare. MIT Center for Real Estate Repeat-Sale House price indices (CSW) for 15 submarkets within the greater Boston CMSA: 1982-2002 (current $)

House Price Indexes, Eastern Massachusetts, by City/Town Location

300

250 Boston Southeast Western 1 200 Far North Shore 495 North 95 South 95 North 150 Western 2 Lowell Area 495 West North Shore Price Index (1990=100) 100 South Shore Worcester Area Cambridge Area North Central 50

0 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Year MIT Center for Real Estate 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 MIT Center for Real Estate OfficeOffice RentsRents MoveMove togethertogether CyclicallyCyclically butbut notnot alwaysalways secularlysecularly

40 TW Rent Index, 2003$ per sqft

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 Riv erside San Diego MIT Center for Real Estate Closely Correlated Industrial Rent Movements:Movements: fewfew secularsecular differencesdifferences 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 Riv ers ide San Diego MIT Center for Real Estate 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 MIT Center for Real Estate 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 MIT Center for Real Estate 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) ? MIT Center for Real Estate 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? MIT Center for Real Estate BetweenBetween MarketsMarkets –– therethere cancan bebe hugehuge differencesdifferences inin bothboth longlong termterm growthgrowth andand cycliccyclic riskrisk

1980=100 (Constant $2005) 350

300 Boston

250 Los Angele s 200 Chicag o

150 Nation

100 Da lla s

50

0 1980 1985 1990 1995 2000 2005 MIT Center for Real Estate 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

House Price House 130

110

90

70

50

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Year

Atlanta Dennver Houston Los Angeles Phoenix MIT Center for Real Estate 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

House Price House 130

110

90

70

50

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Year

Boston Chicago New York Sanfrancisco Washington D.C.