Fin 345: Lesson 2 (Part 3) Instructor Glenn E. Crellin Slide #1 Slide Title: Fin 345 Lesson 2 (Part 3) -Fin 345 Lesson 2 (Part 3) -Understanding Real Estate Markets -Floyd & Allen -Real Estate Principles, -10th edition -Chapter 13 No Audio Slide #2 Slide Title: Analysis of Real Estate Markets -Analysis of Real Estate Markets -Real Estate Demand -Real Estate Supply -Market Price -Price Cycles -Market Segmentation Now, let s look at real estate markets. We re going to do the same sort of an analysis drawing the same sorts of curves, but this time being specific to the nature of real estate. We ll look at real estate demand, real estate supply and then we ll look at market price and cycles in particular. I asked you earlier if you felt that real estate markets fit the classic definition, and I would say for a variety of reasons that it does not. Slide #3 Slide Title: Real Estate Demand -Real Estate Demand -Adheres to the Law of Demand -Subject to Shift Variables Similar to Ideal Competitive Markets [Image: Graphic depicting the demand curve] 1
But let s look first at the demand side. I would content that real estate demand, adheres to the law of demand; it s subject to shift variables in much the same way, the quantity demanded is dependent on price, as prices increase the quantity demanded typically declines. To put it in a context of current housing market and what we re finding is that housing prices assuredly are increasing, the sales prices of homes are increasing, yet I ve already talked about the increase of home ownership, that seems to fly in the face of the presumption that real estate adheres to the law of demand, but what s really happening is that consumers are looking not at the purchase price, but they re looking at their mortgage payments and they re saying that under the current environment of very low interest rates they re cost of home ownership has actually declined and they re willing to purchase more homes, that means that first time buyers are going to be in the market, that means that current owners are going to look at their current mortgage payments and they re going to say we can purchase a bigger, fancier home than the one we currently own and not materially change our mortgage payments. They re reflecting conditions along the demand curve; they re behaving in a rational fashion. The same thing happens in commercial real estate, the same thing happens in the rental market. What we re seeing in rental housing is that rents are not changing and in fact in many cases have actually declined in current dollars compared to the rents of a couple of years ago, why is that? The landlords are paying attention to the fact that their vacancies have increased and they need to reduce rents in order to increase their occupancy and increase their overall revenue. Slide #4 Slide Title: Shifting Real Estate Demand -Shifting Real Estate Demand -Demand for Real Property Shifts Due to Changes In: -Income -Employment -Population [Image: Graphic depicting what happens to the relationship between demand and price when there is a shift outward] What happens when there s a shift in the demand curve? Incomes may rise and the demand curve will shift outward. Employment in a community may grow and demand for real estate, both residential and commercial will shift outward because as employment grows the businesses need space for larger numbers of employees. Now, if they were operating below capacity they might be able to squeeze those extra employees into the space, but if however they were already operating near capacity, they re going to need more space for their business, more office space if it s a service business, more manufacturing space if it s a manufacturing business. Or it could be just a change in population. As our communities grow we need places for those households to live. New homes will have to be constructed; new stores will have to be constructed to satisfy the needs by those new households. A shift in demand from any of the standard sources clearly is going to affect the 2
demand curves, but it s still going to be the standard downward sloping demand curve. Slide #5 Slide Title: Slide 5 -Real Estate Supply -Supply is Fixed in the Short Run -The Supply Curve is Inelastic (Vertical) -Shifts Occur in Irregular, Lumpy Increments [Image: Graphic depicting an inelastic vertical supply curve] Now we get to the issue of real estate supply and it s really with respect to the supply of real estate that we realize that the conditions for perfect competitions don t apply. Remember our friend the gestation period? The gestation period says that it s going to take a while before new supply can come online, they ve go to be planned, they ve got to have drawings made, they have to go through the approval process and then the structures actually have to be built. That means that in the short term we can view the supply of real estate as more or less faced. It s what we economists call an inelastic supply curve. It is vertical or very nearly vertical, with shifts occurring in lumpy increments. Now, what do I mean by that? What s a lumpy increment in a supply curve? Well, when a new apartment complex is built it doesn t increase supply by a single unit, or rather an linear increase in supply, rather it could increase the supply of housing in a community by 50, 100, 200 units, when a new apartment complex comes online here in Pullman, granted a rather restricted market, we often see the vacancies in a market increase rather sharply for a period of time as landlord s, particularly landlord s of some of the older, less desirable properties have a hard time keeping their units filled until more students arrive on campus and the supply and demand conditions once again become more in balance. Slide #6 Slide Title: Slide 6 -Shifting Real Estate Supply -Supply Shifts in the Long Run as it Reacts to Changes in -Expected future demand -Creation Costs -Interest Rates -Construction Costs [Image: Graphic depicting an inelastic vertical supply curve shifted outward] What happens is that that supply curve when it shifts it shifts rather sharply, it s still going to be 3
relatively fixed, it s still going to be highly inelastic, it s going to take some time before some new development comes online and the impacts can be caused by interest rates, they can be caused by construction costs, but the supply curve is going to be shifting and remaining highly inelastic. Slide #7 Slide Title: Slide 7 -Real Estate Market Price -Market Price is Demand Determined in the Short Run Because Short Run Supply is Invariant and Inelastic [Image: Graphic depicting the intersection between the demand curve and an inelastic supply curve] Just like the perfect competition model we re going to be establishing the supply and demand equilibrium in exactly the same way except that the quantity because it is fixed in the short run is illustrated here by the solid supply line rather than by a dotted equilibrium line. Supply then determines the market and that intersection of supply and demand indicates what price level is going to prevail. Slide #8 Slide Title: Slide 8 -Shifting Real Estate Demand -Market Price Will Increase in the Short Run as Demand Shifts Outward [Image: Graphic depicting the intersection between an inelastic supply curve and a demand curve shifted outward] Now what happens when there is a shift in demand? In this case we are presuming an outward, upward shift in demand and what is going to happen is that the supply is going to remain fixed, remember this is a short run phenomenon, so the supply is unchanged, the price is now determined by the intersection of D2 and the supply curve, the price P* is noticeably higher than the price would have been under the conditions implied by the original D1 equilibrium. An increase in demand will increase real estate prices in the short term, there s just no way around it. Now, think about what s happening. We re currently hearing that the demand for second homes has increased markedly as the Baby Boom Generation is looking for perhaps a place where they re going to be retiring or simply looking for a second home. With that supply constrain particularly in resort locations and a sharp increase in demand caused by demographics, population and by affordable interest rates what we ve seen has been a very rapid increase in the values of real estate in some of those locations. I m going to use San Juan 4
County, Washington as an example with statistics that I actually saw the day before this taping where the medium selling price of a home in San Juan County, Washington currently stands at a level 58% higher than the price level that prevailed one year ago. A resort community, clearly with very limited supply and a rapidly increasing demand, more than 2 ½ times as many homes, sold in the month in question as what had sold a year earlier. High demand and the result is a very, very rapid increase in price, it will be interesting to see what happens to supply in San Juan County in the months and years ahead. Slide #9 Slide Title: Slide 9 -Shifting Real Estate Supply -Market Price Can Drop Dramatically when Supply Eventually Adjusts The Magnitude of the Price Change Depends on the Size of the Supply Shift [Image: Graphic depicting the intersection between an inelastic supply curve and a demand curve when both are shifted outward] What happens when we add the extra dimension of an increase in supply? This particular graph shows both the demand shift that we discussed in the previous example and now the addition of a great deal of additional supply into the market and it s easiest to think of these impacts not so much in terms of house prices because houses come online in a bit less lumpy a fashion than commercial real estate or apartments, so let s think of it as apartment construction in this particular example. Remember that we start at the intersection of the solid D1 and S1 lines, we then moved to an equilibrium reflecting an increase in demand which was shown at the solid S1 vertical line and the red dashed D2 demand line at a price substantially higher than the initial equilibrium and now suddenly we have new apartments that have come online. This extreme example shows a very large increase in supply and our new equilibrium is at the intersection of the dashed lines, the S2 supply line and the D2 demand line yielding that equilibrium price P*. What is noticeable about P* is not only is it substantially lower than the previous equilibrium, but it s even lower than the initial equilibrium in that particular market. Now, what obviously the developers are presuming is that D2 represents only an intermediate equilibrium, an intermediate demand and that in the very near future demand is going to shift outward yet again producing a new equilibrium at S2 s supply curve, which is going to result in a price that is at least higher than the initial S1, D1 equilibrium but probably not as high as the S1, D2 equilibrium. Slide #10 Slide Title: Cyclical Price Movement 5
-Cyclical Price Movement -Let Price begin at Level 1 -Price Moves Up as Demand Shifts Outward -Price Drops when Supply is Added -Price Recovers as Demand Continues to Shift [Image: Graphic depicting the cyclical price movement] It takes time. What we re saying is that the changes are not instantaneous, we re not applying the basic laws of supply and demand, but the result is a more cyclical market than perhaps we have for other goods and services that we accustomed to, but a lot of talk lately about the potential of a real estate bubble. While I m not particularly concerned about a real estate bubble in the state of Washington from where I sit right now in the middle of look at the markets in California, particularly up along the coast, whether we re talking about San Diego, San Francisco, Monterrey, L A or anywhere in between and I m looking at places where a typical selling price of a single family home is now well in excess of $500,000, contrast that to metro Seattle where the medium selling price in early 2004 was $300,000 and I do have some concern that there are bubble elements in the California marketplace. Think about it now in terms of the graph that you have in front of you where we moved along that graph from the initial equilibrium to a much higher price, saw a new supply come online with a reduction in price to a level below the initial equilibrium and finally returning to an equilibrium that is very near the original price, but clearly at a much higher quantity than what we had seen previously. This is typical for real estate markets, prices, while I have been talking about them as generally increasing, they do decrease from time to time but what we find in the housing market is that in most cases the declines in price are very modest and since consumers rarely engage in real estate transactions the only people that are really hurt during a period of price decline are the people that bought at the very high prices and then for whatever reasons, a transfer, a change in job situation, a change in family status are forced to make another sale in the very short term. They might suffer an economic loss, most people will be able to ride out the cycle and end up in a place where the price they receive for their property when they sell it is greater than the price that they paid several years previously, but it is a cyclical market and we have to acknowledge that and that s one of the reasons that we pay attention to market analysis as we go through a real estate curriculum. 6