Chapter 2 The Real Estate System 2014 On

Chapter 2: The Real Estate System © 2014 On. Course Learning. All Rights Reserved. 1

The Real Estate System 1. The development industry 2. Overview of the R. E. “system” 3. The “ 4 -Quadrant” model (4 QM) 4. Using the 4 QM to understand “boom & bust” cycles in R. E. © 2014 On. Course Learning. All Rights Reserved. 2

2. 1 The Commercial Property Development Industry Financial Resources Development Industry Physical Resources © 2014 On. Course Learning. All Rights Reserved. New Built Space 3

The Development Industry Development is a creative, entrepreneurial process characterized by… Vision Greed Cooperation Risk (All the most entertaining features of American capitalism. ) © 2014 On. Course Learning. All Rights Reserved. 4

Development (cont. )… l Cooperation: § Between public & private sectors; § Between developers & financiers. l 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. © 2014 On. Course Learning. All Rights Reserved. 5

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… © 2014 On. Course Learning. All Rights Reserved. 6

Gray shade indicates GDP recession © 2014 On. Course Learning. All Rights Reserved. 7

© 2014 On. Course Learning. All Rights Reserved. 8

© 2014 On. Course Learning. All Rights Reserved. 9

2. 2 The Real Estate System © 2014 On. Course Learning. All Rights Reserved. 10

Exhibit 2 -2: The “Real Estate System”: Interaction of the Space Market, Asset Market, & Development Industry SPACE MARKET SUPPLY (Landlords) ADDS NEW LOCAL & NATIONAL ECONOMY DEMAND (Tenants) RENTS & OCCUPANCY FORECAST FUTURE DEVELOPMENT INDUSTRY ASSET MARKET IF YES IS DEVELPT PROFITABLE ? CONSTR COST INCLU LAND SUPPLY (Owners Selling) CASH FLOW PROPERTY MARKET VALUE MKT REQ’D CAP RATE CAPI TAL MKTS DEMAND (Investors Buying) = Causal flows. = Information gathering & use. © 2014 On. Course Learning. All Rights Reserved. 11

“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. © 2014 On. Course Learning. All Rights Reserved. 12

Example: A thermostat puts a negative feedback loop into a heating and cooling (HVAC) system in a building. l When the temperature in the building gets too low, thermostat triggers the heater. l When the temperature in the building gets too high, thermostat triggers the air conditioning. The result is that the building temperature remains “under control”, within a comfortable temperature range. © 2014 On. Course Learning. All Rights Reserved. 13

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? … © 2014 On. Course Learning. All Rights Reserved. 14

2. 3 The “ 4 -Quadrant Model” (4 QM)… © 2014 On. Course Learning. All Rights Reserved. 15

Exhibit 2 -3: The Di. Pasquale-Wheaton 4 -Quadrant Diagram… Rent $ D © 2014 On. Course Learning. All Rights Reserved. Space Market: Rent Determination Asset Market: Valuation R* D Price $ Q* P* Stock (SF) C* Asset Market: Construction Space Market: Stock Adjustment Construction (SF) 16

2. 4 Using the 4 QM to help understand “boom & bust” cycles… © 2014 On. Course Learning. All Rights Reserved. 17

EXHIBIT 7 -10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY PRICES OVER THE LAST QUARTER-CENTURY. . . © 2014 On. Course Learning. All Rights Reserved. 18

Exhibit 2 -4 a: Effect of Demand Growth in Space Market: Rent $ Space Market: Rent Determination D 0 D 1 © 2014 On. Course Learning. All Rights Reserved. Asset Market: Valuation R* Price $ P* Q* Stock (SF) C* Asset Market: Construction Space Market: Stock Adjustment Construction (SF) 19

Exhibit 2 -4 a: Effect of Demand Growth in Space Market: First phase… Rent $ Can this be a long- Space Market: run equilibrium Rent Determination Asset Market: Valuation result? … R 1 Doesn’t form a rectangle. © 2014 On. Course Learning. All Rights Reserved. D 0 R* Price $ P 1 P* Q* Stock (SF) C* Asset Market: Construction Space Market: Stock Adjustment Construction (SF) 20

Exhibit 2 -4 a: Effect of Demand Growth in Space Market: LR Equilibrium… Rent $ Space Market: Rent Determination D 0 R 1 R** D 1 © 2014 On. Course Learning. All Rights Reserved. Asset Market: Valuation R* P** Price $ P 1 P* Q* Q** Stock (SF) C* Asset Market: Construction C** Space Market: Stock Adjustment Construction (SF) 21

Exhibit 2 -4 a: Effect of Demand Growth in Space Market: LR Equilibrium… Rent $ Space Market: Rent Determination D 0 R 1 R** D 1 © 2014 On. Course Learning. All Rights Reserved. Asset Market: Valuation R* P** Price $ P 1 P* Q* Stock (SF) C* Asset Market: Construction C** Space Market: Stock Adjustment Construction (SF) 22

Exhibit 2 -4 a: Effect of Demand Growth in Asset Market… Rent $ Space Market: Rent Determination Asset Market: Valuation 11% OAR © 2014 On. Course Learning. All Rights Reserved. D 0 D 1 R* 8% OAR R** SR P 1 Price $ LR P** Q** P* Q* Stock (SF) C* Asset Market: Construction C** Space Market: Stock Adjustment Construction (SF) 23

EXHIBIT 7 -10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY PRICES OVER THE LAST QUARTER-CENTURY. . . © 2014 On. Course Learning. All Rights Reserved. 24

Exhibit 2 -5: Real CRE Prices & Rents: 1986 -2010: Rent Cycle & Asset Price Cycle Not Necessarily the Same… 1986=100 shaded bars = GDP recessions… © 2014 On. Course Learning. All Rights Reserved. 25

Concept check… 1. What does the 4 Q 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 4 Q Model help participants in the asset market and development industry to avoid “boom & bust” cycles? [Hint: Can the 4 Q Model help with “forward-looking” decision-making? …] © 2014 On. Course Learning. All Rights Reserved. 26