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 city’s 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, R&D • 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 city’s “economic base” is the group of functions that account for the export of goods and services – it’s 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 city’s “location quotient” is its concentration of jobs in a certain function relative to the national average

9. So, Why is All This Interesting? • Past and prospective real estate activity is a function of • Strength of the economic base, and a city’s ranking as a primary, secondary, or tertiary city • Historical reason for a city’s growth • Geographic direction of growth • Job growth • The first thing you’ll 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

11. 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!

12. Lennie’s 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 CAN’T 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 it’s 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

16. 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

17. 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

18. 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

19. 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 site’s 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

21. The Role of Market Research • If land prices reflect patterns of economic growth and activity, then research can help to define a site’s 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 today’s rents and your assumptions about the future

22. 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

24. The Real Estate Leasing Strategy • Real estate needs to “meet the market” • Leasing should optimize – not necessarily maximize – a property’s 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!

25. 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

26. What are Tenants Looking For? • Tenants are interested in more than just rent • Location, management, space layout and efficiency • Things that affect what they’ll pay: • Market conditions • Location within the building • Size, length of lease • Options • Miscellaneous lease covenants