Chapter 2: 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.

Chapter 2:Chapter 2:

The Real Estate System

The Real Estate SystemThe 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.

2.1 The Commercial Property 2.1 The Commercial Property Development IndustryDevelopment Industry

FinancialResources

PhysicalResources

NewBuilt

Space

DevelopmentIndustry

The Development IndustryThe Development Industry

Development is a creative, entrepreneurial process characterized by…

VisionGreed

CooperationRisk

 (All the most entertaining features of American

capitalism.)

Development (cont.)…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.

Development (cont.)…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…

Exhibit 2- 1 US commercial property construction Exhibit 2- 1 US commercial property construction starts by property type as percent of existing stock…starts by property type as percent of existing stock…

2.2 The Real Estate System2.2 The Real Estate System

Exhibit 2-2: The “Real Estate System”: Interaction of the Space Market, Asset Market, & Development IndustryExhibit 2-2: The “Real Estate System”: Interaction of the Space Market, Asset Market, & Development Industry SPACE MARKET

SUPPLY (Landlords)

DEMAND (Tenants)

RENTS &

OCCUPANCY

LOCAL &

NATIONAL ECONOMY

FORECAST FUTURE

ASSET MARKET

SUPPLY

(Owners

Selling)

D EMAND

(Investors

Buying)

CASH

FLOW

MKT

REQ’D

CAP

RATE

PROPERTY

MARKET

VALUE

DEVELOPMENT INDUSTRY

IS DEVELPT

PROFITABLE ?

CONSTR

COST INCLU LAND

IF YES

ADDS NEW

CAPITAL MKTS

= Causal flows.

= Information gathering & use.

““Negative feedback Negative feedback loops”…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.

ExampleExample: : 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.

Concept check: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?…

2.3 The “4-Quadrant Model” (4QM)…2.3 The “4-Quadrant Model” (4QM)…

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

Rent $

Stock (SF)Price $

Construction (SF)

Space Market:Stock Adjustment

Asset Market:Construction

Space Market:Rent Determination

Asset Market:Valuation

Q*

R*

P*

C*

D

D

2.4 Using the 4QM to help understand “boom & 2.4 Using the 4QM to help understand “boom & bust” cycles…bust” cycles…

69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Price Level Index U.S. Institutional Real Estate

REITs

REIT bust,Recession

ERISA: MPT=>P.F. demand

inflation fears

Boom, Tax incentivesS&L Dereg

Overbuilding Tax reform

Disinflation

Recession

S&L Crisis: FIRREA

Securitizatn: - REITs - CMBS

EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY PRICES OVER THE LAST QUARTER-CENTURY . . .PRICES OVER THE LAST QUARTER-CENTURY . . .

Rent $

Stock (SF)Price $

Construction (SF)

Space Market:Stock Adjustment

Asset Market:Construction

Space Market:Rent Determination

Asset Market:Valuation

Q*

R*

P*

C*

D0D1

Exhibit 2-4a: Effect of Exhibit 2-4a: Effect of Demand GrowthDemand Growth in Space Market: in Space Market:

Rent $

Stock (SF)Price $

Construction (SF)

Space Market:Stock Adjustment

Asset Market:Construction

Space Market:Rent Determination

Asset Market:Valuation

Q*

R*

P*

C*

D0D1

R1

P1

Exhibit 2-4a: Effect of Demand Growth in Space Market: Exhibit 2-4a: Effect of Demand Growth in Space Market: First phase…First phase…

Can this be a long-run equilibrium result?…

Doesn’t form a rectangle.

Rent $

Stock (SF)Price $

Construction (SF)

Space Market:Stock Adjustment

Asset Market:Construction

Space Market:Rent Determination

Asset Market:Valuation

Q*

R*

P*

C*

D0D1

R1

P1

Exhibit 2-4a: Effect of Demand Growth in Space Market: Exhibit 2-4a: Effect of Demand Growth in Space Market: LR Equilibrium…LR Equilibrium…

R**

P**

C**

Q**

Rent $

Stock (SF)Price $

Construction (SF)

Space Market:Stock Adjustment

Asset Market:Construction

Space Market:Rent Determination

Asset Market:Valuation

Q*

R*

P*

C*

D0D1

R**

P**

C**

R1

P1

Exhibit 2-4a: Effect of Demand Growth in Space Market: Exhibit 2-4a: Effect of Demand Growth in Space Market: LR Equilibrium…LR Equilibrium…

Rent $

Stock (SF)Price $

Construction (SF)

Space Market:Stock Adjustment

Asset Market:Construction

Space Market:Rent Determination

Asset Market:Valuation

Q*

R*

P*

C*

11% OAR

8% OAR

D0

D1

P1

P**

R**

Q**

C**

SR

LR

Exhibit 2-4a: Effect of Demand Growth in Exhibit 2-4a: Effect of Demand Growth in AssetAsset Market… Market…

69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Price Level Index U.S. Institutional Real Estate

REITs

REIT bust,Recession

ERISA: MPT=>P.F. demand

inflation fears

Boom, Tax incentivesS&L Dereg

Overbuilding Tax reform

Disinflation

Recession

S&L Crisis: FIRREA

Securitizatn: - REITs - CMBS

EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY PRICES OVER THE LAST QUARTER-CENTURY . . .PRICES OVER THE LAST QUARTER-CENTURY . . .

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?…]

Concept check…Concept check…