Real Estate and Urban Economic Analysis

1
Real Estate and Urban Economic Analysis

• Discussion Outline
• The Basic Tools for Urban Economic Analysis
• Theories of city growth and development
• Economic base theory and the importance of job
  growth to real estate analysis
• Deriving Land Value
• Absolute and option value of land
• Purpose and Value of Market Research
• Leasing Terminology and Lease Structures

2
Why Study Urban Economics

• Understand how cities grow
• Why, when and how
• real estate typically refers to urban, not
  rural land
• Understand what types of real estate are needed
  given the patterns of growth and the economics
  forces driving that growth
• Determine what land is worth in unique locations
  in an urban setting
• Land value is a function of a citys growth
  patterns
• Location of land and its zoning and perceived
  value to end users determine its value over
  time
• Urban economics identifies land value as the
  determining factor for new development

3
Interesting Books on Urban Development

• The City in History by Lewis Mumford
• Urban sociology and history from the earliest
  civilizations
• Measuring America by Andro Linklater
• History of the origins of the land survey system
  of measurement and its contribution to the
  concept of individual ownership of land and its
  value
• How Cities Work

4
Theories of Urban Growth

• Essentially all are part of location theory ?
  all forms of services and economic activity will
  find their optimal location
• Central place theory
• Development around a business, civic, religious
  core
• Ancient cities of Greece and Italy
• Driven by transportation or lack thereof and
  the need/ability to reach your customer audience
• Axial theory
• Development along topographical and/or
  transportation features
• my home town of Manchester, NH
• Concentric circle theory a variation on central
  place theory
• Development of the CBD
• Concentric development of other, suburban nodes
• urban sprawl and edge cities

5
Drivers of Growth

• Centralizing forces
• Economies of scale
• Taking advantage of positive operating
  leverage/synergy, common physical or natural
  infrastructure
• Decentralizing forces
• Quality of life issues
• Pollution, crime, educational system, etc,
• Cost of transportation
• Dominance of one over the other is determined by
  the economic functions of an urban area

6
What are Economic Functions?

• Economic functions are essentially activities
  that drive the urban economy
• Centralizing forces government, manufacturing,
  finance
• Growth of the steel belt, industrial northeast
• Washington, DC., New York City
• Decentralizing forces light manufacturing, RD
• Raleigh Durham and the Triangle
• Is technology centralizing or decentralizing?
• What about job outsourcing overseas?

7
Higher and Lower Order Cities

• Ranking of cities is another way to evaluate land
  use patterns
• Higher Order cities ? larger populations,
  larger threshold markets to support economic
  activity
• Typically dominated by activities that require
  close proximity of participants
• Often called primary cities
• Examples NYC, LA
• Lower Order cities ? secondary and tertiary
  markets, depend on higher order cities for their
• Examples Stanford, CT., City of Commerce

8
The Economic Base, the Base Multiplier, and
Location Quotients

• A citys economic base is the group of
  functions that account for the export of goods
  and services its core economy
• Functions that produce a net return on local
  investment capital, both private and public
  sector
• This export base is what contributes to growth in
  urban areas
• The export base multiplier is the ratio of new
  jobs created in supporting functions for every
  job created in the economic base
• A citys location quotient is its concentration
  of jobs in a certain function relative to the
  national average

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So, Why is All This Interesting?

• Past and prospective real estate activity is a
  function of
• Strength of the economic base, and a citys
  ranking as a primary, secondary, or tertiary city
• Historical reason for a citys growth
• Geographic direction of growth
• Job growth
• The first thing youll find in a commercial real
  estate appraisal, or a market research study, is
  an analysis of the economic activity in the
  region, city, and submarket

10
How Location Theory Helps Us Think about Real
Estate Value

• Land has value because
• it is in limited supply in any given location
• it is a critical input in economic development
• Users will pay a location premium for sites
  that meet their specific needs
• Prestige, image, visibility
• Ease of access to customers, vendors, airports,
  etc. ? lower cost, maximize productivity
• Visibility
• However, users will weigh the cost of all of
  their needs including land cost in the
  resource allocation decision
• Land is only one of the costs

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More About Land Value

• Land is the basic building block but also the
  residual component of improved real estate
• Land is the fixed input
• Everything else the building and the economic
  activity is mobile and can locate anywhere
• Since the other inputs have a choice, they have
  to earn a market rate of return on investment
  capital in order to attract capital to them and
  their location
• In order of return
• Investors in the business activity
• Investors in the physical improvements on the
  site
• Land comes last!

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Lennies Land Rule

• If land gets paid last, then
• Projects are only feasible if and when the
  combined cost of the land and other physical and
  subjective attributes, can command rents which
  are sufficient to achieve a market rate pf return
  on capital
• The cost of land must be limited as a percent of
  the total project cost
• CANT OVERPAY FOR LAND AND EXPECT THE REST OF
  THE DEAL TO BAIL YOU OUT !!!!

13
The Bid Rent Curve

• Explains land value as an allocation of resources
  between location and proximity
• To employees, customers, vendors, distribution
  points, etc.
• If location is less important, then more can
  be spent on transportation versus proximity
• Therefore, uses will move out from the core
• Land outside the core will be less dense,
  therefore less expensive
• Companies will buy more of it because its cheaper

14
The Bid Rent Curve in Action

• ZONING!!!!
• Cities codify their development patterns in
  zoning laws that
• centralize density in the core
• restrict density in the suburban areas
• Floor area ratios (FAR), setbacks, height
  restrictions, etc.
• All keep density down
• If land is one cost of input, and users have to
  acquire more of it to build in zoning restricted
  areas, they will be willing to pay less for it

15
Five Rules of Urban Land Valuation

• Rule 1
• Larger cities will have higher land prices,
  higher rents ? and higher salaries
• Greater pressure on the fixed stock of land and
  its use
• Salaries are higher because the cost of living is
  higher
• The cost of living is higher because the fixed
  input of production land is more expensive

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Five Rules of Urban Land Valuation (cont.)

• Rule 2
• If a city grows by increasing its available land
  area, the outlying acreage will increase in value
  faster than the CBD
• more demand at the margin for lower cost

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Five Rules of Urban Land Valuation (cont.)

• Rule 3
• Declining transportation costs all else being
  equal decreases the absolute value of land near
  the center and increases the relative value of
  the periphery
• Remote, less dense land becomes more desirable
  because fewer resources are allocated to
  transportation

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Five Rules of Urban Land Valuation (cont.)

• Rule 4
• An increase in per capita incomes will cause an
  absolute reduction in CBD land prices
• People have more money to spend on transportation
  so will move away from density
• Urban flight

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Five Rules of Urban Land Valuation (cont.)

• Rule 5
• Faster growth and greater uncertainty about
  future uses will increase land values
• The option value of land
• Speculative fever in land

20
Land as an Option

• Ownership of land implies a development option
• What it might be worth in the future at its
  highest and best use
• Once you put land into development, you have
  defined its use and therefore its value
• There is option value in the uncertainty of the
  sites prospective use
• Investors who buy land for investment hold it
  until it is ready for development
• Ie, when someone will pay them the value of the
  option

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The Role of Market Research

• If land prices reflect patterns of economic
  growth and activity, then research can help to
  define a sites history,and make predictions
  about its future use, and the rents is might
  command
• The value (i.e., the PV) placed on that site is a
  function of todays rents and your assumptions
  about the future

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Primary Forms of Market Research

• Trend Analysis
• Extrapolation of recent, past activity
• Risk of lagging economic forces that can change
  recent trends
• Structural Analysis
• More specific, quantitative forecasting of supply
  and demand, such as
• Retail per capita income, population growth,
  housing starts
• Office net absorption, market vs. in place
  rents, job growth
• Single family housing job growth, household
  formation, public investment in infrastructure
• Most good research incorporates elements of both
  approaches

23
Market Research and Leases

• Use Market Research to evaluate
• What market trends and conditions tell you about
  current and future lease rates
• What kind of leasing strategy to employ
• The probability of achieving your leasing and
  revenue forecasts
• What return parameters are appropriate for
  investment capital

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The Real Estate Leasing Strategy

• Real estate needs to meet the market
• Leasing should optimize not necessarily
  maximize a propertys financial performance in
  the context of
• Market conditions and Investment strategy
• Leasing is a choice between
• current and future revenue
• recurring versus choppy cash flow
• Revenue concentration or diversification
• ALWAYS cheaper to keep an existing tenant than to
  get a new one!

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Key Conditions to Look For in Setting a Leasing
Strategy

• Net new job growth
• Market rental rates
• In place versus current asking rents
• The vacancy rate
• Physical versus economic vacancy
• New construction starts and completions
• Measurement of new supply
• Absorption
• net increase in occupied space
• Comparable leasing and sales transactions

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What are Tenants Looking For?

• Tenants are interested in more than just rent
• Location, management, space layout and efficiency
• Things that affect what theyll pay
• Market conditions
• Location within the building
• Size, length of lease
• Options
• Miscellaneous lease covenants