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Metropolitan Growth Analysis Macroeconomic Analysis of Real Estate Markets Microeconomic (Site-Specific) Analysis of Development Projects


Residential Retail Office Industrial





Real estate market research is a new field of study, which builds on the accumulated stock of

knowledge from urban and real estate economics to address two major questions:

• How do the various real estate markets function at the broader macroeconomic, or metropolitan level, and at the more narrow microeconomic, or site level of analysis?

• How exactly should one go about analyzing meaningfully real estate markets for development and/or investment purposes?

- 12 These two questions highlight two major areas of knowledge in the field of real estate market research that are critically linked, as the accuracy and reliability of analytical techniques and processes is directly proportional to the degree to which they reflect the functioning of the particular market analyzed. In addressing the first question, this textbook will explore the basic economic principles guiding the operation of real estate markets, placing special emphasis on their peculiarities and idiosyncratic features. As it will become apparent later, it is the knowledge of these features that helps more accurately evaluate specific real estate development or investment opportunities. In addressing the second question this textbook will explore both state-of-the art and less sophisticated techniques that market analysts can employ to proactively design and evaluate real estate development or investment programs.

The major premise underlying the structure and content of the book is that a better understanding of how markets function coupled with a working knowledge of real estate

market analysis tools will help analysts and real estate professionals:

• become sophisticated users of market studies

• communicate more effectively with colleagues in the real estate development and investment community

• use skillfully available data to evaluate the prospects of a market and a specific project


The author rejects emphatically the “Field of Dreams” philosophy “Build it and they will come...” that seems to have dominated the real estate development industry during the 1980s.

This philosophy is wrong as it basically suggests that supply generates demand, a proposition that runs against fundamental economic principles. On the contrary, the book advances the premise that solid market research, based on a good understanding of the peculiarities and idiosyncrasies of real estate markets, is a necessary and crucial component of the real estate decision-making process.

The specific operational and bottom-line objective of market research is to help generate the knowledge and information that relates to space market operations and is necessary for assessing whether a project is likely to meet key development and investment objectives. For example, a typical key real estate development objective involves the maximization of residual land value (RLV) or, alternatively, profit per area of land. The two major factors involved in the calculation of RLV are property values or prices, and non-land development costs per square foot (see Figure 1.1). It is the strong link between property values and a property’s income-earning capacity that underscores the importance of market analysis in real estate development and investment decision making.

The strong link between property values and a property’s income is embedded in the income approach to value, the most relevant property valuation technique from an investment point of view. 1 In its simplest version, the income approach postulates that property value is The income approach, which focuses on the income-producing capacity of a property, is one of the three major approaches to value. The other two approaches include the sales comparison approach, which utilizes data on the most current sales prices of properties comparable to the one under consideration, and the cost approach, that focuses on the estimation of a building’s replacement cost.

- 13 a function of the property’s net operating income (NOI) and the prevailing market capitalization rate. 2 Movements in a property’s NOI are strongly influenced by movements in space markets. In particular, a property’s NOI is a function of the rent it commands in the marketplace and its occupancy rate. Property rents and occupancies are in turn shaped by market demand and supply forces, as well as idiosyncratic structure and location characteristics. In particular, it has been widely established in the real estate literature that movements in individual-property rent and occupancy levels are primarily driven by changes in market demand and supply conditions, while differences in rent and occupancy levels across individual properties competing within the same marketplace are determined by idiosyncratic property and location characteristics.

Figure 1.1 Inputs in Residual Land Value Maximization

–  –  –

Note : Price, NOI, Rent, and Cost are in $/sq. ft.; FAR = sq. ft. of space / sq. ft. of land Capitalization rates are not typically the focus of market studies for development projects, but they are strongly influenced by movements in local market conditions as property income does. For example, empirical analysis of movements in office capitalization rates has provided evidence of the influence of market-related variables, such as absorption The more advanced version of the income approach is represented by the discounted cash-flow model in which a property’s income-earning capacity is again the prominent factor driving value. In this version, instead of using a capitalization rate, which represents a required income return, a required total return (referred to as discount rate) is used within the context of a multi-year discounting formula.

- 14 levels and changes in rents (Sivitanidou and Sivitanides, 1999). This underscores the additional importance for accurately evaluating real estate market prospects.

In sum, the role of market research is to analyze the market-related determinants of project profitability at the macro and micro level, help address questions of market entry and pro-active project design, and provide the bottom-line rent and absorption figures that are necessary for the assessment of the financial feasibility of a particular development.

Within this context, the focus of this book is on the forces and processes that drive broader space-market performance; the idiosyncratic project- and location-specific factors that shape deviations of individual property performance from average market performance;

and the techniques that analysts can use to forecast market performance and assess the income-earning prospects of specific development projects. Hence the four major objectives

of this book are:

1) to examine the major macroeconomic processes and factors that shape broader market performance of the four major property types

2) to present advanced and less sophisticated techniques for analyzing and forecasting broader market performance for the four major property types

3) to discuss project-specific and location factors that influence individual property performance, and

4) to present techniques for analyzing and forecasting individual project performance in a way that is consistent with the analysis of the prospects of the broader market



Generalizing along the lines discussed above, it can be argued that the major focus and contribution of market analysis for real estate is the assessment of the underlying determinants of a project’s income-earning capacity at two distinct levels: the macroeconomic (non-site) level and the microeconomic or project-specific level. As indicated in Figure 1.2, a property’s income-earning capacity is influenced by three major

sets of factors:

a) general macroeconomic and metropolitan growth forces that may affect all property types,

b) macroeconomic forces that drive the demand for and supply of specific property types, and

c) location- and project-specific factors that may contribute to deviations of individual property performance from market performance.

We elaborate on each of these factors below.

a) General Macroeconomic/Metropolitan Growth Forces These include forces that may affect the economy of a metropolitan area and all its real estate markets. Examples of such forces include increasing global competition and

- 15 technological advancements that may undermine an area’s major industries; significant changes in exchange rates that may render foreign imports more attractive at the expense of domestic industries; the economic well-being of America’s major trading partners, that can have a significant impact on export-oriented metropolitan economies; or changes in interest rates that may influence the volume of new construction, and, therefore, the supply of all property types nationally. These forces, being international, national or regional in scope, may very well impact a metropolitan area’s economy and local real estate market. The effect of these forces may vary from metropolitan area to metropolitan area due to differences in industrial structure and the sectoral composition of the local economy.

Figure 1.2 Influences on Project Income-Earning Capacity

–  –  –

b) Macroeconomic forces that drive the demand for and supply of specific property types.

For example, as a number of empirical studies have shown (Wheaton, 1987; Rosen, 1984), the demand for office space is driven by employment in specific sectors of the

- 16 economy referred to as “office-using”. These include primarily the FIRE (Finance, Insurance and Real Estate) sector and Services, as defined in the Standard Industrial Classification (SIC) system. Thus, macroeconomic forces that affect specifically these sectors, such as the health of the nation’s financial system, are bound to have an effect on an area’s demand for office space. Similarly, Wheaton and Torto (1990) have shown that demand for industrial space is driven primarily by manufacturing and wholesale trade employment. Macroeconomic forces that affect an area’s employment in these sectors will have an impact on the local industrial market.

On the supply side, the major factors that drive new construction for a specific property type include land costs, which vary across different land uses within the same metropolitan area, as well as across metropolitan areas; labor costs that generally vary across metropolitan areas due to differences in labor market conditions; and the cost of construction materials. All these macroeconomic factors, both broader and more property-type specific, jointly shape movements in effective space demand, and competing supply and, hence, movements in absorption, vacancy rates, and average market rents/prices through time.

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