COMMERCIAL REAL ESTATE
INVESTMENT & ANALYSIS
Complete summary whole book.
PART I. Introduction to real estate
economics
, 1. Real estate space and Asset
Markets
1.1 Space market
● The space market is the market for the usage (or right to use) real property (land
and built space). Also referred to as the real estate usage or rental market.
● The price of the right to possess and use the space for a specified temporary period
of time is commonly called the rent.
● The real estate space markets are segmented. Space markets tend to be local
rather than national, and specialized around building usage categories.
● An MSA is a Metropolitan Statistical Area and encompasses a central city and its
surrounding suburbs and tends to be relatively integrated economically, culturally and
socially.
● The major types of space markets for rental property include office, retail, industrial,
and multifamily residential. Smaller and more specialized markets are hotels, health
facilities, self-storage and others.
● The real estate market supply function is kinked. The kink represents how new
additional supply will respond to rents. When the long-run marginal cost of
development rises, so does the supply. If it falls, so does the supply. And if it remains
the same, so does supply. If space is not very restricted, as in the USA, research has
shown the middle line after the kink is the most probable outcome.
● The principal cause of rising supply function is the cost of land. In the space market
this is caused by land scarcity in the presence of growing usage demand. This
results in increasing land rent, as space users are willing to pay more real dollars
per year for the same location.
1.2 Asset market
● The real estate asset market is the market of ownership of real estate assets. Real
estate assets consist of real property and is therefore often referred to a property
market. The real estate asset market must be viewed as part of the larger capital
market, the market for capital assets of all types.
● Capital markets can be divided into four categories according to whether they are
public or private markets, and according to whether the assets traded are equity or
debt.
● Public markets have high liquidity and informational efficiency, because asset
prices respond quickly to relevant news.
● In private markets it is common to trade in whole assets, instead of ‘shares’ or ‘units’
of ownership and the transaction costs (as a fraction of the asset being traded in one
transaction) are higher.
● Cap rates are based on 1) opportunity cost of capital - as it is competition for the
investor’s money, 2) growth expectations and 3) risk.
,2. Real Estate system
2.1 Commercial Property Development Industry
● The commercial property development industry converts financial capital into
physical capital, thereby governing the stock of supply in the space market.
● The real estate system consists of three components: the space market, the asset
market, and the development industry. See book p.27 for the systems dynamics
model of the system.
○ The space market determines the current operating cash flows produced by
the real estate assets that are the fundamental subjects of the asset market.
The space and asset markets, reflecting the underlying economic base and
the capital markets, interact to produce current real estate market values.
These values represent the output from the asset market; which is the input
into the development industry.
○ A negative feedback loop within the real estate system is the ability of the
asset market to regulate the flow of financial capital to the development
industry. An example of positive feedback loop within the real estate system
was the rising asset prices that rose just because they had been rising in the
2005-2007 period.
2.2 4q model
,Within the 4Q model, the four quadrants depict four binary relationships that together
complete the linkages between the space market, the asset market, and the development
industry. It is most useful for examining simultaneously the effect on the long-run equilibrium
both within and between the space and asset markets. For further explanation see
https://www.youtube.com/watch?v=kVwHvliV1pA.
PART II. Urban economics and real
estate market analysis
3. Central Place Theory and the
system of cities
3.1 Pattern of city size and city location
● each city has a place and a role within a system of cities.
● The rank/size rule can be expressed as follows: City population = Largest city’s
population/ rank of city.
● With some exceptions, cities of similar size are not located near each other
, geographically.
● The rank/size rule and the geographical regional dispersion suggest a hierarchical
structure of cities and a division of territory into zones of influence, which suggests
two points:
○ Centralizing city causation (Centripetal) Forces are counterbalanced by
opposing decentralizing (centrifugal forces.
○ The relative strength of the centralizing and decentralizing forces differs for
different functions and activities.
● Three cumulatively causing primary centralizing forces cities to spiral growth:
○ economies of scale
○ economies of agglomeration (vertical - upstream and downstream linkages
in production processes - and horizontal linkages - synergies across firms or
work sites)
○ positive locational externalities (existence of the agglomeration attracts
other companies that can boost the economics)
● Several centrifugal forces
○ congestion, crime, high rents and urban land-costs, etc. Also: larger (and
therefore fewer) cities within a country will tend to increase rural-to-urban
transport costs, due to greater average transport distances (although this
might be possibly offset by reduced city-to-city transport requirements).
3.2 Central Place Theory and the Urban Hierarchy
● The empirical geographic observations as described above have lead to the
geographic theory Central Place Theory (CPT), including an extension known as
theory of urban hierarchy.
● The greater the transportation costs are, the more numerous and close together will
be the cities in optimal configuration. There are hinterlands of cities, the ‘service
areas’ that assume to have a hexagonal shape (a six-corner). The larger the
population is that is needed to support an efficient production process, the larger we
would say is the minimum or threshold market for that product or activity. A city with
large steel manufacturers and the national government require larger
● . The smaller cities also depend on the thresholds of the larger city, so that larger
city’s hinterland includes the territories served by all the lower-order cities that
depend on the higher city.
○ to summarize CPT and hierarchy theory: In order to reduce ‘spatial friction’,
places of similar size,rank and function tend to be evenly spaced across
geographical space and population.
● CPT is useful for real estate because:
○ if a territory is underserved, there is room for a new central site
○ if a central site is already effectively located to serve a territory, it is going to
be very hard to develop a new such site nearby.
● Large existing central places can cast agglomeration shadows, making it difficult
for other places of similar size or rank to develop within that shadow.
3.3 Economic base and the Growth of Cities and Regions
● The economic base can be thought of as its source of income. Economic base
analysis can help:
○ identify which cities or regions will grow
, ○ characterize what kind of growth (e.g. blue vs white collar)
○ how much growth
● The economic base has three major potential components:
○ the local production of goods and services both for local needs and export
beyond the local urban area (most important).
○ investment returns to or of capital owned in the local area, such as investment
returns on the stored financial wealth of retirees
○ government transfers, such as social security payments.
Being part of the local production component of the economic base theory, export base
theory states that economic growth of the city or region is dependent entirely on growth of
export (so-called basic) sector of the local economy. All employment is classified as either
the export (basic) sector or the service (nonbasic) sector. Thus, according to the export
theory, forecasting growth of a metropolitan area consists of two steps:
○ identifying the export base industries in the local region
○ forecasting employment growth in those industries.
● We need a way to identify which industries and business are part of the export sector
for a given region. We use the Location Quotient (LQ). The LQ is defined as the
proportion of the total local employment in a given industry divided by the proportion
of total national employment in the same industry. A city m’s LQ for industry i is
given by the following formula: see book.
○ An LQ of 1.0 —> same proportion of local workers work in a particular
industry as work in that industry in the nation as a whole
○ LQ > 1.0 —> Local area is more heavily concentrated in that industry than is
the average.
○ LQ must be much larger than 1.0 to indicate that the industry is part of the
export sector of the local economic base.
● The LQ of nonbasic (service) sector occupations will tend to be around 1.0.
● An important feature of regional economics: the number of jobs in the nonbasic
sector is generally larger than the number of jobs directly in the export sector, thus:
expansion in the export sector creates an implement multiplier effect on total local
employment, which may in turn lead to population multipliers. E.g. EMF to
Amsterdam.
○ Two types of multipliers are often considered in forecasting the growth effects
of changes in the export base:
■ Employment multiplier: Net total employment increase / export
employment increase
■ generally between 2 and 4
■ Population multiplier: net total population increase / export
employment increase
■ of course always higher than employment multiplier and
generally between 2.5 and 9
● losing export jobs works in the opposite way!
● Analysis of export base can be used to identify economic clusters.
4. Inside the city I: Some basic urban
economics
,4.1 Urban land value and use
● Urban form refers to the physical spatial characteristics of a city.
● Land derives its value from being a necessary input, a factor of production,
because it is needed to obtain other things that create value (i.e. the property on the
land). We will the discuss the residual theory of land value. Here the mobile
factors have to get paid first, cause the land itself can’t move away. Equilibrium in
the land market tends to result in land parcels being used at their highest and best
use (HBU) in the long run, which is characterized by the minimization of aggregate
transportation costs for the society as a whole.
● The role of transport costs in determining HBU and land value leads to the bid-rent
curve or the bid-rent function. The bid-rent is the maximum rent that a potential
user would “bid”, which is essentially the same as the discussed residual value of the
land. The bid-rent curve relates the user’s bid-rent to the location of the land site,
showing how the bid-rent changes as a function of the user’s distance from some
central point. The central point is the point at which the transaction costs are
minimized for that use, the point at which the bid-rent or residual value is
maximized.
4.2 Classic Monocentric City Model
● In the monocentric city model, only one central point exists and applies to all
potential uses of land, called the CBD.
● We calculate the radius to the urban boundary, recalling that the area of a circle is
pi times the radius squared, so the radius is the square root of the area divided by pi.
● The residents at houses at more central locations will not have to pay as much in
commuting costs, so they will be able to pay more rent for housing and still maintain
the same level of welfare. In fact, the real property rent must rise as we approach the
center at exactly the rate that the transaction costs will fall. This condition is required
by equilibrium. So the bid-rent curve within this example must have a slope equal to
the transportation cost per mile per acre. This slope is known as the rent gradient,
which tells us how much the equilibrium real property rent per acre declines per mile
of additional distance from the centre. The rent gradient equals the transportation
cost per mile per person times the number of people per acre. The location rent
reflects the location premium for the site.
● Other things being equal, larger cities will have higher average location rents. It is in
fact the increased length of the radius, the distance of the urban boundary to the
CBD, that cause those higher rents. The rent gradient is fixed, based on the
transportation costs and density. The rent at the urban boundary is fixed, based on
the agricultural opportunity cost and the building construction cost. Therefore, the
change in average rent is the change in the distance each point finds itself from the
urban boundary.
○ Another principle: If a city grows by increasing area rather than density,
property rent growth will be relatively greater closer to the periphery, but if a
city grows by increasing density instead of area, property rent growth will be
relatively greater the closer to the center of the city.
○ A reduction in transport costs per person per mile per year will reduce the rent
gradient. If there is no spatial expansion, and transport costs decline. This
leads to another principle: Declining transport costs (per person, per mile or
per year) holding population and income constant, will always reduce the
value of the location rent in the center of the city; the effect on the location
, rent near the periphery is nearly ambiguous, depending on changes in
density, but the overall result is certainly a flattening of rent gradients.
○ last principle: Increasing real income per capita (holding population constant)
will tend to decrease rent gradients, with a possible result of absolute
reductions in land rent at the center of the city, although a secondary
transport cost increase effect (and/or increased open space reservation) due
to higher incomes may mitigate this result or even reverse it, especially if the
spatial expansion of the city is constrained.
5. Inside the city II: A closer look
5.1 From property rent to property value: the effect of rent growth expectations and
uncertainty on speculative land value
The three factors influencing property value:
● future rent
● future rent growth (growth premium)
● risk of the future level rent
5.2 Effect of uncertainty on speculative land value
Unlike the expected future location rent growth, the risk or uncertainty surrounding such
growth does have implications for possible land speculation and delay of development, and
hence can be a determinant of land value and city size. When a developer has land in
ownership, it has a call option to develop it. In the presence of uncertainty a developer waits
and starts when it can ask high rents. So besides the construction rent and the agricultural
opportunity cost rent, developers demand an irreversibility rent before they will develop
raw agricultural land into urban use at the boundary of the city. The irreversibility rent is to
pay for the value of the call option that is being surrendered, the value of the fact that the
landowner could wait and possibly develop the property even more valuable at a later date.
● the growth and irreversibility premiums represent what is often called the
speculative value of undeveloped land.
● the above on the effect of growth and uncertainty results in a fifth principle, building
on the four principles from chapter 4:
○ Faster urban growth and greater uncertainty in that growth will tend to
increase urban property values, with the uncertainty also suggesting that a
smaller, denser city with higher equilibrium rents is optimal, as rational
development is postponed while landowners/developers wait for higher rents
to compensate for greater option value given up in irreversible development.
However, this effect is diminished the more competition there is among
developers and substitutable development sites.
5.3 New Twists to the old monocentric model
, ● The Burgess Concentric ring model of urban form suggests that similar types of
land uses will tend to locate at similar distances from the center of the city, resulting
in concentric rings of similar land uses around the CBD. The Burgess model
considered the dynamics of development, including the effect of the chronological
order in which different sections of the city are developed, the effect of the age of
structures and social factors.
● In some american cities, the wealthy live further from the bcd than the poor. An
explanation might be that if upper income people desire enough larger lot sizes or
have a strong preference for low density neighborhoods, then this density effect can
marathon offset the transportation cost effect, resulting in an equilibrium location of
higher income households further from the center. Also the wealthy might prefer
newer houses, which are often build at the edge of the city.
● After Burgess, Hoyt invented the Sector Model of Urban Land Use Structure.
Hoyt states that similar land uses do not always lay at the same distance from the
center. Hoyt noted that when a particular use of land use becomes predominant in a
particular direction from the center, or on a particular side of town, then new
development tends to continue that land use in the same direction outward from the
center as the city grows.
● Both Burgess concentric ring model of urban form and Hoyts Sector Model of Urban
land use structure model recognize that similar land use cluster together, because if
one land use is the highest and best use at a particular location, that same general
type of use will typically also be the highest and best use at nearby locations.
Boundaries of these districts will affect the location rent and land value of the sites
adjacent to them and nearby. This effect can be both bringing
synergy/increase(compatible land uses) in value and incompatibility and decrease
in value.
● Compatible land uses can have negative locational externalities however, for
example living 2 blocks away from the shopping centre is desirable, but it is less
desirable to live across it because of the noise and traffic.
Polycentric cities
● Many large cities have other Major Activity Centers (MACs) besides the CBD and
traditional cities are sprinkled with Neighborhood Business Districts (NBDs).
● Some cities have never had a single very dominant CBD in the center. Polynuclear
cities not only have subcenters, but also multiple major centers.
● Fundamentally, cities in the real world could never be perfectly monocentric because
different land uses have different and multiple central points (locations where their
relevant transportation costs are minimalized).
● Thus, real cities are collections of major and minor central points within the
metropolitan area.
● A general effect of polycentrism and especially the type of “edge cities” is a flattening
of the rent gradient. The development of multiple and mixed-use centers scattered
throughout the metropolitan area has the effect of reducing the distance people need
tot travel.
Neighborhoods dynamics and life cycle
● There is a natural dynamic, or process of evolution, of neighborhoods within a city,
this process is referred to as the neighborhood succession theory, which is
focused on a single location (e.g. district) within a city, instead of a city as a whole or
as part of a bigger city. Succession theory suggests two things about the course of
, location rents and values over time. Firstly, location rent and values will tend to
remain nearly constant, in real terms, over long periods of time (once urban
development has occurred in a neighborhood), even in successful locations. But
second, a possibility exists of occasional, possibly sharp or sudden changes in
location rent and value, due to changes in the optimal role and function of the
neighborhoods within the metropolitan area, that is changes in the neighborhood
HBU.
5.4 Property Life Cycle and the Effect of Building Structure Depreciation
● Like the neighborhood life cycle, the property life cycle is important for real estate
investors because it is fundamental to the nature of the investment returns that can
realistically be expected from a given property.
● Fundamentally, property value is the sum of land value and structure value. Often the
total is easier to calculate than breaking the value down in the two components,
which depends on the conceptual definition of the land value component.
● Two perspectives on the concept of land value:
○ The land appraisal value, what is the current market value of the land
without a structure on it.
○ The value of land ownership derives purely from the development /
redevelopment option value that such ownership entails, consistent with the
real options model of land value as a development option.
● See the Components of Property Value over time at p 95. The market value of the
property at any point in time consists of structure value plus the land value. In the
beginning structure value makes up for the bulk of the market property value, but
over time it declines because of physical, functional and economic
obsolescence. With physical obsolescence the structure physically wears out,
functional obsolescence refers to the effect of changing technology and changing
tastes or user requirements on the optimal physical design of a new structure for the
relevant HBU. Economical obsolescence refers to the fact that the structure may
become unsuited to the HBU of the site as the HBU evolves over time.
● The other component of the property value is the land value (labeled L or C
depending on the Land appraisal value or Call option value of land perspective). The
economic land value component consists only of the value of the redevelopment
option, including the growth and irreversibility premia. Defined this way, the land
value is very small just after redevelopment, because the building is then at HBU for
the site, so the profitability of further development, if any, is a long way off in the
future. The curve of the C value traces out an exponential growth that is quite rapid
between the construction points, because all the return on the land value must be
earned in the form of appreciation of the option value. The appraisal definition of land
value tends to be a roughly constant percentage of the usage value of the site. It
grows slower and is less volatile than the option value.
● The optimal time for redevelopment occurs when the entire value of the site equals
its land value alone; that is, the current structure has become worthless ad such due
to the value of the redevelopment option on the site. At such points in time, both
definitions of land value are the same, and this also equals the entire property value (
C = L = P). In the exhibit, R is depicted as occurring when the old value of L or C
equals the old value of P.
● Typically, the structure and land value are bundled and cannot be purchased
separately.
● The discontinuous jumps in property value at the points in time of reconstruction
reflect the injection of new capital into the property via the construction process,
