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Summary lectures Real Estate & Land Supply
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Summary of all lectures for the course Real Estate and Land Supply. Also check the summary of all graphs from the tutorials!
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Real Estate and Land supply LecturesLecture 1
10 September
Land is not a typical cost.
At least all of the units and also the implicit costs of having some vacancy in the building. You
can't incur rental units because there's typically some empty units out there, whether it's
cause of just some frictional reasons. If you have a little bit of vacancy in your building it's
easier for tenants to move in and out. Whether it's more structural vacancy, units that are
always empty although the building should not basically be created for structural vacancy so
which may always have some estimation or off how to market turns out.
Investors in commercial real estate, when they invest in a building; they speak of cap rates
or capitalization rates or yields and those are all essentially the same thing. Although there
are some different implementations often, so far for simplicity would just say here that cap
rate reflects the net operating income of property in the first year. That's the sum of all the
rent minus the operating costs which include maintenance etc.
So, you have this income in the first year of operation, and you divide that by the sales price
of the building, that will give you basically an idea of the relative price that was paid for the
property. That’s a rent to price ratio. If you would have a building that produces 1 million
euro store rent in the first year, that's not operating income. The transaction price was let's
say 10,000,000 that's a cap rate of 10%. Now the level of the cap rate is inversely related to
the left full of the transaction price. If you have a cap rate of 6% that would reflect a higher
relative price for a unit of rent as income then cap rates say 8%.
What is important to consider is that cap rates are just a reflection of the value, because
they take only the rent in first year and the price. Which is the outcome of a broader set of
consideration, because price it follows from basically all the income so all the incoming cash
flows. The sum of all the ingoing and outgoing cash flows year by year by year, so the income
being net operating income.
Discounted cash flow method ( DCF )
Basically for every year you divide the cash flow by 1 plus R where R is the basically the
discount rate. Which is 4 at the level at which investors perceived risk for this particular
property. Typically it's the yield that is ongoing in the market adjusted for particular
characteristics of the property. This might be relatively old property, so it may be a bit riskier
because it might need some more maintenance now and then. Sometimes it's actually very
subjective what discount rate is. It is being used by investors. You arrive at the transaction
price, now the yields basically just refers to well how this prize equates with the first year of
rent. But if you consider two properties that in this first year have the same level of rent they
may sell a different prices.
You might have relative different change overtime in the operating costs. One of the
buildings basically may have faster increasing operating costs, that may be reflected in the
price. You can get price differentials which will turn later on is actually rental growth. For
one property there is a prospect of the rental growth in the area where the property is
located remaining at 1% of the next few years, and the other properties in area where
,there's some fast growth while the price for the property in the area where the rental
growth is going to be higher. The price is also going to be higher because you're basically
expecting to receive more income overtime.
For example you might very well see that in the current COVID crisis that some sellers
basically undertaken some risky investments and getting hit because there's basically less
demand for space. So they might have high vacancy less income they might be in a hurry to
sell off some of their riskier properties and incur some losses.
Invest in stable or locations which may be more equipped to sustain rental income
throughout this crisis that so they might shift from very peripheral markets to central
business districts.
You'll see that central business district will become relatively expensive, relative to areas
which are more risky.
Meaning that while prices may go up fast when things are going well and they may go down
fast when it things are not going well.
Government bond rate in the entire real estate market
Cap rates consists of the risk-free rate, which is the return on 10 year government bonds.
Real estate investors tend to have a long term perspective for investment which is about 10
years. In the in the stock market, people would be looking at the six month government
bond rates. All these transactions go much faster.
If these cap rates are at 6% and government bond rates for 10 year. Rates are at 4% then
there's this excess of 2%. Beta = a sense of the variability of the returns which is measured
by beta.
It might be Apple or so that if the market goes up it goes up faster. Let's say 1.5 times faster.
The price of Apple, when a market goes down it might go 1.5 times faster downward.
1.5 and you multiply that with this excess against which that access return of the stock
market of role over these government bond rates so that's 1.5* 2% so 3.5% so then you have
this risk free rate of 4%. that 3.5% risk premium for this Apple case.
Then you know that your price for real estate is more different because you don't get to see
our particular property and performs relative to the market. It just gets bought like once
every five or eight or ten years, so it's not like the stock market where you can just look up
any hour or any day over a month for three months or a year or so.
Performances relative to the market, you can't calculate beta like that.
When we think about the yields, we do not think about it being risk free rate plus the excess
return on the market times beta for the particular assets, but we think of it basically as the
risk free rate plus a compensation for inflation.
Because if the rental income going to receive in the future due to inflation or becomes
relatively less valuable you want to be compensated for that while paying a lower price.
Let's say inflation is 2% and then you have your risk which we have assumed to be 4%. Plus
the 2% compensation on the inflation. Then adding to that there might be rental growth.
,Let's say there was a growth rate of 3 plus 10 per year then you subtract that but that
depends very much.
The rental growth rate is what you subtract from that so we have 4% percent so far for the
risk free rate plus let's say 2% compensation for inflation minus let's say 3% rental growth.
Then plus a risk premium that is specific to the property; and this includes any risk you may
have so it's vacancy risk because of the type of occupiers. If you're talking about warehouse
property this may be riskier than an office because, it's harder to find a warehouse tenant
than an office tenants.
You might be talking about environmental risk, simply your office being part of a nice CBD on
the waterfront location but where there's actually some flooding risks.
The formula of cap rate = risk free rate (which is rates on a 10 year government bond
rates) + compensation for inflation - the rental growth rates + property specific risk
premium.
Residual valuation methods tells us that lands is not a typical costs, and it's just the residual
amount of capital that remains after taking the value of the project minus all the costs to the
developer.
Land value = basically all the value that is left, after you take on the value of the project
minus all costs and the compensation for the developers.
Investment value = sum of all income – cost until building is completed. It’s about the value
after the operating phase.
Caprate = net operating income. sum of rent – operating costst.
Income in first year / sales price of the building = rent price ratio.
Cap rates or capitalization rates or yields are all essentially the same thing. It tells us an idea
of the relative price by a rent to price ratio. So if you have a cap rate of 6% that would reflect
higher relative price for a unit of rent as income then a cap rate of 8%. It’s an important
indicator. It’s a relative value because they just take select only the rent in first year and
then the price which is the outcome of a broader set of consideration, because price it
follows from basically all the income so all the incoming cash flows.
Cash flows can be discounted by the DCF formula: for every year you divide the cashflow by
1 + R. Where R is the discount rate. This is at the level at which investors perceive the risk
for this particular property. Typically, it's the yield that is ongoing in the market adjusted for
particular characteristics of the property. This discount rate can be very subjective.
Question: If you consider 2 properties that have the same level of rent, but transaction price
is different. What can be a reason for that?
Answer: Differences in rental growth or faster increasing operating costs.
How is the yield build up?
+ Risk free rate = % on 10 years government bonds
+ compensation for inflation
- rental growth rate
, + property specific risk premium, including vacancy. For example environmental risk
(flooding)
Residual valuation tells us that land is not a typical cost. The investment value is affected by
many factors. Vacancy rates is an example. And business sentiment also plays a role.
Transport costs relates with urban density. Urban density being higher in the CBD’s and
lower at more peripheral areas.
Gasoline use on the Y. Density on the X.
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