Web Exclusive: Real Estate Economics by Mark Deal, PLS
In the land surveying profession, we must always be aware of issues in many different areas. One such area is the impact of economic factors affecting real estate development. When reviewing economic issues there is one basic principle that must be kept in mind: in the long run, demand and supply will be in equilibrium. The basic law of supply and demand changes when there is a rise or fall in economic growth. A sharp rise in growth will generate more real estate transactions and stimulate new construction. A sharp drop can have the opposite effect. These are situations that can have a dramatic impact upon the business of the land surveyor.
It should be noted that there are two distinct markets within which the real estate sector operates: the property market and the asset or capital market. The market for real estate use of space is referred to as the property market, and the asset (or capital market) refers to the market for real estate assets. In the property market, businesses and consumers acquire space for their homes and businesses. In the asset market, real estate is acquired as an investment, for the revenue stream generated by rents, and the appreciation of the principle value of the investment. While each of these markets influence the other, they individually impact our profession in different ways, and can respond differently to external factors.
Real estate must also be thought of as both a flow and a stock. The flow of real estate is the value of new construction put in place each year, less losses from the stock through deterioration, depreciation and demolition. The total value of all existing buildings and the value of land represent the stock of real estate and are part of national wealth (the largest single component of national wealth).
In the asset market, investors will purchase real estate when there is sufficient reason to believe that their return on investment will be greater than the return that can be obtained through other types of investments, with risk being equal. The risk perceived in an investment will alter the return required from an investor. For an investor to receive a return on his or her investment, the cost of acquiring and maintaining the property must be less than the sum of the rents received and the appreciated value of the property. In fact, there must be sufficient differential to provide a return greater than could be obtained elsewhere. Without this, there is no reason why an investor would seek to acquire real estate.
As land surveyors, a large part of our business is derived from transactions of investment property. The factors, which influence real estate investments, are quite important to our business. Economic growth generates greater demand for real estate space, which has the short-term effect of raising the rent that will be paid for space. This stimulates the demand for investment property, provided that interest rates are favorable for borrowing money and the economic outlook is not too risky. Existing properties then become more sought after and new construction is initiated. All of this means more business for land surveyors.
As existing properties are bought and sold, the price demanded for their purchase will rise and eventually the price demanded will be too high for the investor to reach his required rate of return. Also, new construction will bring additional capacity to the property market, which will reduce the amount of rent that can be obtained. Once this happens, the asset market begins to reach equilibrium. At this stage some investors will pay too much for property, some will decide not to buy, and some will see opportunities. The market seldom reaches equilibrium smoothly, which is exemplified in the overbuilding of the 1980's. If demand is not judged carefully then the property market will become saturated with available space and rents will fall. Transaction surveys will continue to be required as some investors seek to sell their property before the market reaches bottom, so that they can divert their funds to other investment vehicles. Ultimately, new construction projects are canceled as the investment dollars dry up.
In the property market, the demand for space (both residential and non-residential) is also affected by many factors. The amount of space available, the numbers of buyers and sellers in the market, interest rates, substitutes, consumer confidence and other factors will influence demand. Prices rise as desirable space becomes scarce. The law of supply and demand is rather intuitive with regard to the ratio of buyers to sellers in the marketplace. Interest rates are very important as they determine the affordability of space. Depending upon other factors, a consumer of space may choose to substitute an older, less appealing house for a new home, or they may choose to rent an apartment as opposed to buying a home. Consumer confidence is extremely important to all sectors of the economy and the market for space is no different. If consumers are not sure of their economic future they are likely to forgo moving to a larger or newer space. These factors, in turn, affect the asset market as new projects will either be started or scrapped as demand for space changes.
As a land surveyor, I have found it very interesting to watch economics in action over the last several years. Throughout 1997 – 1998, there was a flurry of activity as investors purchased property right and left. It was not uncommon to see an apartment complex change hands several times during this period as prices rose and profits were made. Cautiously, new construction began to take place, eventually becoming quite strong. Recent years have provided our profession with a textbook example of economics in action as our national economy experienced tremendous growth. Now, as growth has substantially slowed, the markets are reaching equilibrium again.