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Economics and the Real Estate Market

Economics and the Real Estate Market. Factors of Production. Basic elements in an economy Land Labour Capital stock M an-made goods like buildings, machines, etc. Also includes other types of capital: organizational, social and human Entrepreneurial skills

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Economics and the Real Estate Market

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  1. Economics and the Real Estate Market REM300 Lecture 5

  2. Factors of Production • Basic elements in an economy • Land • Labour • Capital stock • Man-made goods like buildings, machines, etc. • Also includes other types of capital: organizational, social and human • Entrepreneurial skills • Businesses use these basic elements to produce goods and services (supply) • Consumers purchase these goods and services (demand) • The government provides rules and controls • Institutions: formal and informal / government and non-government REM300 Lecture 5

  3. Statistics Canada Data - GDP • Economic figures are reported by Statistics Canada • Front page has GDP,unemployment rateandconsumerpriceindex • http://www.statcan.gc.ca/start-debut-eng.html • Expenditureapproach:Y = C + I + G + (X - M) • Gross Domestic Product (GDP) is a measure of the economic production which takes place in Canada. The term "gross" in GDP means that capital consumption costs are included. • Capital consumption costs are associated with the depreciation of capital assets (buildings, machinery and equipment) • More about GDP: http://www.statcan.gc.ca/daily-quotidien/140829/dq140829a-eng.htm?HPA REM300 Lecture 5

  4. Stats Canada Data– Labour and Capital • Stats Canada tracks employment levels, wages, and other labour force statistics • Drawn from the Labor Force Surveywhichinvolves around 29,000 Canadians across the country • Possible sampling issues • http://www5.statcan.gc.ca/subject-sujet/theme-theme.action?pid=2621&lang=eng&more=0&HPA • Capital investment is also reported through Statistics Canada. For example, this table reports spending on machinery by industry: • http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/busi03a-eng.htm REM300 Lecture 5

  5. North American Industry Classification System (NAICS) Industry Codes • 23 Building construction firms • 53 Real estate, rental and leasing • 531 Real Estate • 5311 Real estate owners generating rent • 5312 Agents and Brokers • 5313 Property managers, appraisers and other real estate activities REM300 Lecture 5

  6. Consumer Price Index • A measure of the cost of living for the typical person. Tracks the prices of 600 items • CPI Core index excludes 8 volatile areas:(1)fruit, fruit preparations and nuts;(2)vegetables and vegetable preparations; (3)mortgage interest cost; (4)natural gas; (5)fuel oil and other fuels; (6)gasoline; (7)inter-city transportation; and (8)tobacco products and smokers' supplies • Adjusted over time • Changes in prices allow for comparisons of purchasing power and inflation • Breaks out the price changes to type of good,forexample,shelter: • http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/cpis01a-eng.htm • Comprised of: rent, mortgage interest cost, replacement cost, property taxes, home and mortgage insurance, maintenance and repairs, electricity, water, natural gas and fuel oil • Shelter costs should not comprise more than 30% of gross income REM300 Lecture 5

  7. National House Price Data • Teranet – National Bank • http://www.housepriceindex.ca/ • CREA(CanadianRealEstateAssociation) • http://creastats.crea.ca/natl/index.htm • Statistics Canada New Housing Price Index • http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/manuf12-eng.htm • Royal Lepage Market Surveys • http://www.royallepage.ca/realestate/info-and-advice/market-reports-and-surveys/ • Data is collected by surveying Royal Lepage agents REM300 Lecture 5

  8. Toronto House Price Data • Toronto Real Estate Board (TREB)hasdata from all sales that took place through the MLS system • http://www.torontorealestateboard.com/market_news/market_watch/ • Abuse of dominance? • Competition Bureaucontinues case against TREB • The case against TREB alleges anti-competitive practice by restricting the availability of certain information about real estate listings – this includes such things as previous sale prices and previous listings of a property – this is controlled by TREB and is not available to the general public REM300 Lecture 5

  9. House Price Index Calculations • Step1:Calculatethe % price change between year 1 and year 2: (Year 2 Price – Year 1 Price) / Year 1 Price • Step2:Calculatethe index value • Set the index to 100 for the first year • Change the index value by the % price change each year REM300 Lecture 5

  10. House price index illustration REM300 Lecture 5

  11. Potentialissueswithhousepriceindex • Seasonality • Housingcondition • Sampleproblem REM300 Lecture 5

  12. Seasonality • There is less activity in the housing market in the winter in Canada • Construction process more difficult in cold weather • People generally prefer to move in the summers, for both weather and school-year related reasons • Data therefore shows seasonal fluctuations that can be misleading • Several ways to correct • Use annual values (2015 vs 2016) • Compare December/Q4 of this year to December/Q4 of previous year • Use seasonal indicator variables in regression analysis • Double seasonal adjustment – pushed the US from – to + GDP growthin2015Q1 REM300 Lecture 5

  13. Housing Condition • Neither the weighted average or the types of category correction solve for the house condition problem • There might be a time period where an unusually large number of sales are for houses in poor condition (in need of repairs) • If this happens, it would appear that there was a price decline • Similarly, any concentration of unusual sales can skew average house prices REM300 Lecture 5

  14. Sample problems in house price indices • The average sales price is determined based on the houses that actually sold in a given period • But what if many small houses sold in 2003? It would look as if average sales prices went down, when really, the set of houses that sold was unusual. • Or a number of large expensive properties sold driving the average higher REM300 Lecture 5

  15. Solutions for Sample Problems:#1.WeightedAverage • Royal LePage creates house type categories • Some firms use a weighted average across house types, so their value is, for example, always 40% bungalow and 60% two-storey REM300 Lecture 5

  16. Weighted AverageExample • The table shows all the sales that took place in 2013. Three condos and two houses sold. • The average sales price was 204,800. • However, the actual stock of units is actually 10% condos and 90% houses. • A weighted average would more accurately reflect prices in the market. • Weighted average = 10% * Condo average + 90% * House average • =238,300 REM300 Lecture 5

  17. Solutions for Sample Problems:#2.RepeatSales Indices • Anotherway to correct for thesampling problem is to create a repeat sales index • Only houses that sell twice are included in the index • If a house sells twice, then we can be sure that the price change is due only to time(whatabouthousecondition?) • However, the properties that trade most frequently may not be good representatives of the overall market • Chinloy et al. 2013 Transaction Frequency and Commercial Property REM300 Lecture 5

  18. Repeat Sales Example:Teranet’s Methodology • Assuming the example of 3 houses in the same region that traded during a 3 year period: With the first pair, we learn that house prices increased by 10% between 2005 and 2006. { $330,000 / $300,000 – 1 } • Assuming that the sales information from house A is correct, we can imply that the value of house B in 2006 was $275,000. { $250,000 x ( 1 + 10% ) } • Between 2006 and 2007, we can do the following inferences: • From house B, we can infer that the change was 8%={$297,000 / $275,000 -1} • From house C, we can infer that the change was 10%={$308,000 / $280,000-1} • Thus, from 2006 to 2007, the house price index change is the average of the increase in house B and house C which in this example is 9% = {( 10% + 8% ) /2} REM300 Lecture 5

  19. MarketForcesinHousing:Supply and Demand • Demandcomesfrom • families who want to buya home • Investorswhowanttoinvestinrealestate • Supply comes from homebuilders who construct homes • Not evenly distributed geographically • WhichCanadiancitieshavetheimbalanceddemandandsupply? REM300 Lecture 5

  20. Demand for Housing • Demandforhousingincreases • Withnew household formation • The two main drivers of household formation inGTAare:(i)Immigrantsand(ii)Young people moving out of their parents’ home • When the economy and employment are strong • Wheninterest rates are low and debt is widely available • When demand increases and the supply doesn’t change, then prices will increase as more people bid for the same number of houses. • This is often the case in real estate due to supply inelasticity and the development process • When supply increases and the demand doesn’t change, then prices will fall as there are many houses seeking buyers REM300 Lecture 5

  21. Canada’s Top 10 CMAs Ranked By Population And Projected Population Growth, 2014–2019 REM300 Lecture 5

  22. Unemployment rates(Ontario1976-2013) REM300 Lecture 5

  23. Unemployment rates(Canada,2016-2017) REM300 Lecture 5

  24. Interest rates REM300 Lecture 5

  25. Textbook definitions • Seller’s Market: when number of buyers exceeds number of sellers • Buyer’s Market: when number of sellers exceeds number of buyers • Balanced Market: when number of sellers equals number of buyers REM300 Lecture 5

  26. Interruptions to Market Forces in Housing • Significant government intervention • Propertytax,landtransfertax,foreignbuyertax,… • High transaction costs • Landtransfertax,lawyerfee,… • Supply increases are lagged, since building a new home takes time • HowlongdoesittaketobuildasinglefamilyhouseinToronto? • Heterogeneous products • Each location is unique, units differ • Product is immobile and fixed • Market is very local • But capital is global • Price information is private, not easily available • And it lags behind the current market. Prices are known once deals are complete and the title filed. REM300 Lecture 5

  27. Price bubbles • A bubble is when house prices rise at an unsustainable high rate and then burst (experience a significant decline in a short period). • What is sustainable? • Population,income, interet rate, ... • This implies a bubble is only known in retrospect • Increasing house prices doesn’t always mean that there is a bubble • Canhousepriceincreaseforever? • The stock market experiences a significant decline (like a bursting bubble) – actually a correction -- every 10 to 15 years. REM300 Lecture 5

  28. Graph of U.S. andCanadaHouse Prices https://beta.theglobeandmail.com/real-estate/the-market/price-gap-between-canada-us-homes-hits-record/article18118369/?ref=http://www.theglobeandmail.com& REM300 Lecture 5

  29. Graph of TorontoHouse Prices https://globalnews.ca/news/3253661/toronto-home-prices-are-crazy-heres-when-you-need-to-worry-about-a-housing-bubble-and-when-you-dont/ REM300 Lecture 5

  30. Business Cycles • A business cycle is a series of events within the business environment that take place in roughly the same order and at the same intervals • Likely due to the significance of the interruptions to market forces, especially the lag in bringing new supply to the market REM300 Lecture 5

  31. What makes real estate different? • It is a real asset – it wears out over time due to physical deterioration and obsolescence – together creating depreciation • Poorly designed office buildings in office parks in low value areas will suffer more deterioration in performance over time • The cash flow delivered by a property asset is controlled or distorted by the lease contract between owner and tenant • Any lease issue affect profitability: repairing liabilities, lease length, break clauses, user and assignment clauses, rent review patterns … all affect future cash flows REM300 Lecture 5

  32. What makes real estate different? 3) The supply side is controlled by planning regulations, and is highly price inelastic • During a boom in demand, there is always a lag in supply: time taken to secure building permission (permit), prepare the site, and construct or refit the property • It is difficult to vary the supply of real estate upwards, and even more difficult to vary it downwards 4) Returns are heavily affected by appraisals rather than marginal trading prices • Valuations are based on previous valuations plus or minus a perception of change • Perceived changes are usually conservative leading to valuation ‘smoothing’ – reducing volatilityand risk REM300 Lecture 5

  33. What makes real estate different? • 5) Real estate is highly illiquid – it is expensive to trade: transaction costs and time to completion (time on market) • Direct investment requires specialist investment management and asset management, although these are frequently out sourced to specialists. • Individual properties are heterogeneous and sourcing appropriate opportunities can be difficult and require specialist advice. REM300 Lecture 5

  34. What makes real estate different? • 6) Real estate assets are generally quite large incapital prices – diversification is not easy. • Risk diversification can only be fully effective with unrealistically large portfolios with hundreds of holdings. • Research for the period 1994-2004, shows that 69% of specific risk was diversified with 20 properties and 82% by holding 50 properties. 7) Leverage is used in the vast majority of transactions – this distorts the return and risk of a property investment REM300 Lecture 5

  35. Ontario Profiles, Trends and Real Estate Values REM300 Lecture 5

  36. Ontario Economy • Diversified economic base • Generally good numbers for population growth, unemployment, GDP, stock market returns, productivity, growth in personal income • Long period of low interest rates in Canada • …however Ontario is not as strong as it once was REM300 Lecture 5

  37. Ontario Economy REM300 Lecture 5

  38. Ontario Household Income • Decades after the WorldWarII, Ontario household incomes surpassed the national average by 10-20% • In the last decade growth has slowed, income growth below national average, and unemployment higher • The Ontario sub-sovereign debt has doubled – largest in the world (even large than California) http://business.financialpost.com/news/economy/with-twice-the-debt-of-california-ontario-is-now-the-worlds-most-indebted-sub-sovereign-borrower REM300 Lecture 5

  39. Ontario Demographics • Population of 13.6 million • GTA 5.6 million,Canada35.16 million • Population of Ontario has grown by 1.5% per year in last 20 years • Population growth highest in the GTA compared to the rest of the province • Highlevel of immigration contributes to growth:30% not born in Canada • Aging populations due to large baby boomer cohort (people current aged about 50 to 68) • 88% urbanized • In comparison, Canada and the U.S. are about 81% urban, rate is generally higher in Europe • 54% in China, 31% in India REM300 Lecture 5

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  48. Urban Economics • Urban economics (also called urban land economics or economic geography) is a field of study about how cities are formed and what impacts the growth and shape of a city • It’s used in urban planning models and other policymakers for zoning, transportation and other decisions • It’s the foundation for location decision making by firms REM300 Lecture 5

  49. Concentric Circle Theory REM300 Lecture 5

  50. Theories for patterns of growth • The Concentric Circle Theory model was the earliest attempt to model how a city could grow • The Axial Theory was an improvement because it takes into account transportation systems. City growth tends to take place along major transportation corridors. REM300 Lecture 5

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