The Economics of Real Estate

real estate economicsReal estate economics is the application of economic techniques to real estate markets. It tries to describe, explain, and predict patterns of prices, supply, and demand.

Real estate economics is closely related to the field of housing economics which is narrower in scope, concentrating on residential real estate markets, while the research of real estate trends focuses on the business and structural changes affecting the industry. Recent times have seen an expansion of theoretical and empirical research on real estate economics using the paradigms and methodologies of finance and economics. Examples of this research include the working and structure of markets, the role of various institutional arrangements, the attention given mortgages and asset securitization, risk management and valuation, and public policy and regulation.

Real estate economics is the study of the markets for land and structures, including residential housing, commercial office space, and industrial warehouses. In many respects, real estate economics are similar to economics for other goods and services. There exist buyers who demand real estate by demonstrating a willingness and ability to pay for property.

In real estate economics the theory of real estate value begins with the classic concept of Ricardian rent, which predicts that more desirable real estate will command a higher rent and market price as users compete for land. In the monocentric city model, distance to the single center of the city largely explains real estate prices. In urban residential real estate pricing, workers in a city must commute to their places of work, and they are willing to pay more for housing that is closer to their employers to avoid costs of commuting.

Real estate economics also includes mortgage statistics. Residential real estate typically sells for hundreds of thousands or even millions of dollars. This is greater than most household annual income. Households typically do not save over many years to purchase housing but rather obtain financing to purchase residential real estate. Financing terms have changed considerably over the last 10 years, and they will likely change in the future.

Overview of Real Estate Markets

The main participants in real estate markets are:

Owner/User
These people are both owners and tenants. They purchase houses or commercial property as an investment and also to live in or utilize as a business.
Owner
These people are pure investors. They do not consume the real estate that they purchase. Typically they rent out or lease the property to someone else.
Renter
These people are pure consumers.
Developers
These people prepare raw land for building, which results in new products for the market.
Renovators
These people supply refurbished buildings to the market.
Facilitators
This group includes banks, real estate brokers, lawyers, and others that facilitate the purchase and sale of real estate.

The owner/user, owner, and renter form the demand side of the market, while the developers and renovators form the supply side. In order to apply simple supply and demand analysis to real estate markets, a number of modifications need to be made to standard microeconomic assumptions and procedures. In particular, the unique characteristics of the real estate market must be accommodated.

These characteristics include:

Durability
Real estate is durable. A building can last for decades or even centuries, and the land underneath it is practically indestructible. Because of this, real estate markets are modeled as a stock/flow market. About 98% of supply consists of the stock of existing houses, while about 2% consists of the flow of new development. The stock of real estate supply in any period is determined by the existing stock in the previous period, the rate of deterioration of the existing stock, the rate of renovation of the existing stock, and the flow of new development in the current period. The effect of real estate market adjustments tend to be mitigated by the relatively large stock of existing buildings.

Heterogeneity
Every unit of real estate is unique in terms of its location, the building, and its financing, especially in the area of commercial real estate loans. This makes pricing difficult, increases search costs, creates information asymmetry, and greatly restricts substitutability. To get around this problem, economists define supply in terms of service units; that is, any physical unit can be deconstructed into the services that it provides. Housing stock depreciates, making it qualitatively different from new buildings. The market-equilibrating process operates across multiple quality levels. Further, the real estate market is typically divided into residential, commercial, and industrial segments. It can also be further divided into subcategories like recreational, income-generating, historical or protected, and the like.

High Transaction Costs
Buying and/or moving into a home costs much more than most types of transactions. The costs include search costs, real estate fees, moving costs, legal fees, land transfer taxes, and deed registration fees. Transaction costs for the seller typically range between 1.5% and 6% of the purchase price. In some countries in continental Europe, transaction costs for both buyer and seller can range between 15% and 20%.

Long Time Delays
The market adjustment process is subject to time delays due to the length of time it takes to finance, design, and construct new supply and also due to the relatively slow rate of change of demand. Because of these lags, there is great potential for disequilibrium in the short run. Adjustment mechanisms tend to be slow relative to more fluid markets.

Both an Investment Good and a Consumption Good
Real estate can be purchased with the expectation of attaining a return (an investment good), with the intention of using it (a consumption good), or both. These functions may be separated (with market participants concentrating on one or the other function) or combined (in the case of the person that lives in a house that they own). This dual nature of the good means that it is not uncommon for people to over-invest in real estate—that is, to invest more money in an asset than it is worth on the open market.

Immobility
Real estate is locationally immobile (except for mobile homes, but the land underneath them is still immobile). Consumers come to the good rather than the good going to the consumer. Because of this, there can be no physical marketplace. This spatial fixity means that market adjustment must occur by people moving to dwelling units, rather than the movement of the goods. For example, if tastes change and more people demand suburban houses, people must find housing in the suburbs, because it is impossible to bring their existing house and lot to the suburb (even a mobile home owner, who could move the house, must still find a new lot). Spatial fixity combined with the close proximity of housing units in urban areas suggest the potential for externalities inherent in a given location.

Real estate economics is governed by a number of factors.

Demand for Housing

The main determinants of the demand for housing are demographic. But other factors, like income, price of housing, cost and availability of credit, consumer preferences, investor preferences, price of substitutes, and price of complements, all play a role.

The core demographic variables are population size and population growth: the more people in the economy, the greater the demand for housing. But this is an oversimplification. It is necessary to consider family size, the age composition of the family, the number of first and second children, net migration (immigration minus emigration), non-family household formation, the number of double-family households, death rates, divorce rates, and marriages. In housing economics, the elemental unit of analysis is not the individual, as it is in standard partial equilibrium models. Rather, it is households, which demand housing services: typically one household per house. The size and demographic composition of households is variable and not entirely exogenous. It is endogenous to the housing market in the sense that as the price of housing services increase, household size will tend also to increase.

Income is also an important determinant. Many housing economists use permanent income rather than annual income because of the high cost of purchasing real estate. For many people, real estate will be the costliest item they will ever buy. The price of housing is also an important factor.

Real Estate Market Tiers

Real estate market tiers categorize cities as Tier I, Tier II or Tier III depending on the stage of development of their real estate markets.

Each real estate tier has defining characteristics:

Tier I cities have a developed, established real estate market. These cities tend to be highly developed, with desirable schools, facilities, and businesses. These cities have the most expensive real estate.
Tier II cities are in the process of developing their real estate markets. These cities tend to be up-and-coming and many companies have invested in these areas, but they haven’t yet reached their peak. Real estate is usually relatively inexpensive here; however, if growth continues, prices will rise.
Tier III cities have undeveloped or nonexistent real estate markets. Real estate in these cities tends to be cheap, and there is an opportunity for growth if real estate companies decide to invest in developing the area.

Many businesses see Tier II and Tier III cities as desirable destinations, particularly in times of economic strength. These areas present opportunity for growth and development and allow businesses to expand and provide employment to people in growing cities. Additionally, the cost to operate in prime Tier I real estate is expensive, and companies often see underdeveloped areas as a way to expand and invest in future growth.

In contrast, businesses tend to focus more on the established markets in Tier I cities when the economy is in distress, as these areas don’t require the investment and risks associated with undeveloped areas. Though they are expensive, these cities feature the most desirable facilities and social programs.

U.S. cities often classified as Tier I cities include New York, Los Angeles, Chicago, Boston, San Francisco and Washington D.C. On the other hand, Tier II cities may include Seattle, Baltimore, Pittsburgh and Austin — although classifications may differ through time and based on certain criteria. Still, real estate prices often vary drastically from tier to tier. For example, real estate website Zillow estimates a median home value in Pittsburgh of $130,400, compared to $586,400 in New York City and $658,500 in Los Angeles, as of January 2018.

Risks Associated with Different Real Estate Market Tiers

Tier I cities are often in danger of experiencing a housing bubble, which occurs when prices surge due to high demand. However, when prices get too high, no one can afford to pay for real estate. When this happens, people move away, real estate demand decreases, and prices sharply drop. This means that the bubble has burst.

Tier II and Tier III cities tend to be riskier places to develop real estate and businesses. These risks stem from the fact that the infrastructures in Tier II and Tier III cities are underdeveloped and don’t have the resources to support new ventures. It’s expensive to develop these infrastructures, and there’s always the chance that the development won’t succeed, and the real estate market will end up failing.

Summary

One of the challenges facing real estate economics is that future research will be to better understand how financial product innovation contributed to the housing boom and what types of regulation would best fend off a similar future boom and bust cycle.

 


 

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