Chapter 6:Chapter 6:

Real Estate Market Analysis

R.E. “Market Analysis”R.E. “Market Analysis”

is a collection of practical analytical tools and procedures designed to help answer decision questions, such as:

Decision QuestionsDecision Questions– What size or type of building to develop on a specific

site?– What type of tenants to look for in marketing a

particular building?– What the rent and expiration term should be on a given

lease?– When to begin construction on a development project?– How many units to build this year?– Which cities and property types to invest in so as to

allocate capital where rents are more likely to grow?– Where to locate new retail outlets and/or which stores

should be closed?

Market AnalysisMarket Analysis usually requires usually requires quantitative or qualitative understanding quantitative or qualitative understanding

(& prediction) of:(& prediction) of:

Demand SideSupply Side

– Of the Space Usage Market relevant to some R.E. decision.

Two Major Types of Market Analysis:Two Major Types of Market Analysis:

Specific micro-level analysis– Applies to single property, site, or user– E.g., feasibility analysis or site analysis for a

development projectBroader, more general characterization of

a space market– Applies to an entire R.E. space market

segment or submarket– E.g., forecast of supply & demand (&/or rents

and vacancy rates) in Chicago office market, or Class A office Mkt in downtown Chicago

General market-level analyses focus onGeneral market-level analyses focus onFive major market indicators:Five major market indicators:

1.  Vacancy rate

2.  Market Rent

3.  Quantity of new construction starts

4.  Quantity of new construction completions

5.  Absorption of new space

Vacancy Rate:Vacancy Rate:

      Percentage of the stock of space that is currently not occupied

      Vac.Rate = (Empty SF)/(Total SF) = 1 – Occup.Rate

      Watch out for sub-lease space:o    Space leased but unoccupied is vacant.

      Vacancy Rate is an indicator of equilibrium (balance between supply & demand in the space market)

Some vacancy is normal and natural Some vacancy is normal and natural in a market, due to:in a market, due to:

o    Search time & moving costs (hence LT leases):      Don’t take “first deal”

      Search for “good deal” (takes time to find)

o    “Overbuilding”:      Impossible to perfectly predict demand growth

      “Lumpy supply”

The The “natural vacancy rate”“natural vacancy rate”::

o    Rate around which vacancy tends to cycleo    Rate that indicates supply/demand balanceo    Above which rents fall, below which rents

riseo    Tends to be higher in more volatile &

faster-growth marketso    Tends to be lower in more supply-

restricted markets

Rent:Rent:

      Rent on new leases in the market

      Another equilibrium variable

      Most important space market variable

      Tricky to accurately quantify (private info,“apples vs oranges” problems)

      Watch out for “asking rent” vs “effective rent”

Example:Example:

$10 rent but 1-yr abatement in 5-yr lease:o    What would you say is the “effective rent”?

Consider “real rent”Consider “real rent”

– rent adjusted for general inflation (as better indicator of market trend)

Construction:Construction:      Supply side variable

      Starts & completionso    Starts “Pipeline”

o    Completions Additions to supply side of market

Don’t forget projects in permitting & planning stage too

      Consider net addition to supply:o    Construction Completions minus Demolition &

Conversion Out

o    Include re-habs & conversions in also

Absorption:Absorption:      Change in occupied space      Demand side variable      ““Gross absorption”Gross absorption” = Total new lease signings

o    Includes moves within the market

      ““Net absorption”Net absorption” = Net increase in occupied space

      Net absorption more relevant for indicating market demand:

       (Vacant SF)t = (Vacant SF)t-1

+ (Constr)t – (Net Absorption)t

These market indicator variables:These market indicator variables:

 Vacancy, Rent, Construction, Absorption

Can be used to help characterize & understand the current market, and forecast how it may change relevant to R.E. decisions.

e.g., The e.g., The Months SupplyMonths Supply measure: measure:

MS < Typical Construction Project Duration Tight Market Room for new development projects

MS > Typ.Constr.Duration May be some slack (but consider natural vacancy rate).

12/NetAbsorp

ConstrVacMS

Example market analysis:Example market analysis:

What type of decisions would such an analysis be relevant for?…What type of decisions would such an analysis be relevant for?…

Defining the Defining the scopescope of the of the market analysis…market analysis…

       Geographic/Property type market segments (or sub-markets)

       Time-frame of the study (historical, forecast to when?)

Example of geographic sub-markets: Atlanta office marketExample of geographic sub-markets: Atlanta office market

Typical Cincinnati geographical sub-marketsTypical Cincinnati geographical sub-markets

Cincinnati office market:Historical vacancy & absorption

Source: NAI Eagle

Submarkets are also characterized by type and quality level (“class”) …

Cincinnati office historical gross rent:

Source: NAI Eagle

Market analysis methodology:Market analysis methodology:

      Simple trend extrapolation vs Structural analysis

Trend extrapolation:Trend extrapolation:

      Take advantage of inertia in space market (past partly predicts the future)

      Consider trends and cycles      Potential to use statistical techniques

(time-series analysis: autoregression, ARIMA, VAR, vector error-correction)

      Potential to bring in capital market factors as predictors

Structural Analysis:Structural Analysis:

      Model the structure of the market (underlying determinants of supply & demand, e.g. population growth and employment growth)

      Forecast the underlying determinants (e.g., economic base analysis like we talked about in Ch.3), then use model to predict space market.

Formal analysis requires:Formal analysis requires:

o    Demand model (including elasticities)

o    Supply model (including elasticities & lags)

o    Equilibrium model (including landlord behavior)

      Useful for gaining fundamental understanding of the market, and making long-term forecasts

      Used more primarily in consultants reports and academic studies

Widely used decision-making tool:Widely used decision-making tool:Basic short-term (1-3 yr) structural market analysis:Basic short-term (1-3 yr) structural market analysis:

Inventory existing supply Identify sources of space usage demand

Quantify relationship between demand sources and quantity of

space usage

Forecast demand sources

SUPPLY SIDE DEMAND SIDE

Inventory construction pipeline

Forecast of new demandForecast of new supply

Forecast space shortfall or surplus

Decision implicatons?

Property Type Demand Drivers

Residential single family(Owner occupied)

        Population        Household formation (child rearing ages)        Interest rates        Employment growth (business & professional occupations)

Residential multifamily(Apartment renters)

        Population        Household formation (non-child-rearing ages)        Local housing affordability        Employment growth (blue collar occupations)

Retail         Aggregate disposable income        Aggregate household wealth        Traffic volume (specific sites)

Office Employment in office occupations:        Finance, Insurance, Real Estate (FIRE)        Business & professional services        Legal services

Industrial         Manufacturing employment        Transportation employment        Airfreight volume        Rail & truck volume

Hotel & convention         Air passenger volume        Tourism receipts or number visitors

Major drivers of the demand side of the space market:Major drivers of the demand side of the space market:

A simple formal structural model of a space market:A simple formal structural model of a space market:

Supply side . . .Supply side . . .

)()1()( tCtStS Stock (aggreg.supply) response:

(2)

otherwise

KLtRifKLtRtC

,0

,)(),)(()( Construction (developer behavior):

(1)

R(t) = Rent at time t ($/SF).L = Construction lag (yrs).K = Replacement cost rent level.

A simple formal structural model of a space market:A simple formal structural model of a space market:

Demand side . . .Demand side . . .

)()()( tNtRtD

Tenant demand:

N = Underlying “need” (e.g., employment)

(3)

)1()( tDtOS

Occupied space:(lag to implement demand reflects search & move time)

(4)

A simple formal structural model of a space market:A simple formal structural model of a space market:

Supply & demand sides (equilibrium) . . .Supply & demand sides (equilibrium) . . .

))/))(((1)(1()( VVtvtRtR

Rent adjustment (landlord & potential tenant behavior):

(6)

v(t) = Vacancy rate at time t.

V = “Natural” vacancy rate for the mkt.

Vacancy rate “physics” (definition):

)(/))()(()( tStOStStv (5)

Put these six equations together . . .Put these six equations together . . .

Numerical example:       Supply sensitivity = 0.3       Demand sensitivity = 0.3       Technology = 200 SF/employee       Demand intercept = 10 million SF       Rent sensitivity = 0.3       Construction lag L = 3 years

Exh.6-5 Simulated Space Mkt DynamicsExh.6-5 Simulated Space Mkt Dynamics

0

10

20

30

40

50

60

70

80

90

100

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 57 59

Year

Vac

, Ren

t, E

mp

l.

0.000

0.100

0.200

0.300

0.400

0.500

0.600

0.700

0.800

Co

nst

r. M

SF

EMPL VAC% RENT CONST

Market DynamicsMarket Dynamics

The real estate cycle may be different from and partially independent of the underlying business cycle in the local economy.

The cycle will be much more exaggerated in the construction and development industry than in other aspects of the real estate market, such as rents and vacancy.

The vacancy cycle tends to slightly lead the rent cycle (vacancy peaks before rent bottoms).

New construction completions tend to peak when vacancy peaks.

In the preceding model, were In the preceding model, were any of the market participants any of the market participants

forward-looking?forward-looking?

What features of the above What features of the above results do you think are due to results do you think are due to

myopia or purely myopia or purely adaptiveadaptive behavior on the part of the behavior on the part of the

market participants?market participants?

In the real world, what factors In the real world, what factors or elements in the or elements in the real estate real estate

systemsystem will tend to be forward- will tend to be forward-looking?looking?

In the real world, will it be In the real world, will it be possible to possible to perfectlyperfectly forecast forecast the future? Will some market the future? Will some market

participants likely be participants likely be somewhat myopic or adaptive somewhat myopic or adaptive

in their behavior?in their behavior?