Chapter 15: The Real Estate Market and Analysis

Question 1

Free enterprise system

Answer 1

The free enterprise system is an economic system that both produces and distributes goods and services by the application of the four factors of production. The four factors of production are land, labor, capital, and entrepreneurial ability. Memory device: “CELL”.

Entrepreneurial ability refers to the risk taking and management component of production. No good or service can be delivered to the market without the application of combination of these four factors.

Question 2

What are the three questions that must always be answered with regard to the production and distribution of goods or services?

Answer 2

1. What is to be produced?
2. Who will do the producing?
3. Who will get what is produced?
   The answer to these questions is found in the relationship between production, distribution, and demand.

Question 3

Production

Answer 3

The question “What will be produced?” is not easily answered. Resources are limited, while demand is not. The number and variety of products and services that could be offered is virtually unlimited. The decision to produce an item or provide a service often meets with failure as a result.

Those who are willing to risk their time, expertise, and finances in order to assume the risk are the only ones who can answer the question “Who will do the producing?”

Question 4

Distribution

Answer 4

The price mechanism answers the question “Who will get what is produced?” The conflict between limited resources and unlimited demand can be solved by the price at which a product or service is offered to the market. As demand continues, price rises at an ever-increasing rate until those unwilling to pay the price withdraw from the market.

Under the free enterprise system, in which real estate is bought and sold, products and services are produced based on the price at which they can be sold profitably. Inefficient suppliers and producers will not be able to compete, and the risk they assumed will not be rewarded.

Question 5

Market

Answer 5

A market is anywhere a buyer and a seller can interact to conclude a transaction. The prices of items or services create different levels of competition, referred to as stratified demand. Obviously, the seller of a $500,000 home is not in competition with the seller of a $100,000 home.

Question 6

Price

Answer 6

is the amount that is actually paid for an item. It should be distinguished from an asking price or the cost to produce the item. Neither the asking price nor the cost to produce the item controls the ultimate price that will be paid in the market. It is the buyer that ultimately decides whether or not a sale will occur.

Question 7

Government- Controlled Economies

Answer 7

The free enterprise system is an open system in which anyone can participate. In contrast to the free enterprise system, some nations operate under a government-controlled system. Land is not privately owned. Government decision makers control the money supply and determine the employment offered to citizens. The government determines what products and services will be produced and who will be able to purchase them.

Question 8

What do government-controlled systems lack?

Answer 8

Government-controlled systems lack the flexibility that is needed to produce the products that consumers typically demand. In a free society, the entrepreneur replaces the government decision maker that is present in a government-controlled system.

Question 9

Supply

Answer 9

is the quantity of an item that is available, or anticipated to be available, for sale.

Question 10

Price in the real estate market

Answer 10

is a function of the number of items available in relation to the number of items in demand.

Question 11

Supply and demand in the real estate market

Answer 11

If the supply for a desired product decreases relative to demand, the price increased. At the higher price, fewer buyers may be willing or able to purchase the product and demand will fall. As demand falls, suppliers may be forced lower prices to attract interested buyers.

Question 12

Factors affecting supply

Answer 12

1. Availability of skilled labor
2. Availability of land
3. Increased productivity
4. Availability of construction loans & financing
5. Availability of Materials

Question 13

Availability of skilled labor

Answer 13

a decrease in the availability of skilled labor can increase labor costs and drive up the cost of new construction to the point where new construction prices are prohibitive. Supply would be reduced since builders would be hesitant to build in fear of not being able to sell the finished product.

Question 14

Availability of land

Answer 14

a shortage in the supply of available land can drive up the cost of acquiring land for new development.

Question 15

Increased productivity

Answer 15

through the application of new technology, builders are able to make more efficient use of labor. Builders can sometimes offset increased costs by better use of materials and labor. Increased productivity can result in an increase in supply.

Question 16

Availability of construction loans & financing

Answer 16

as interest rates on construction loans rise, the cost of borrowing money escalates and builders’ costs increase. Excessively high interest rates make new construction expensive and the finished product unable to compete for buyers with existing properties.

Question 17

Availability of Materials

Answer 17

a decrease in the availability of materials can increase the cost of materials, and drive up the builders’ costs. This results in higher finished costs and may make new construction too expensive for buyers who wish to enter the market.

Question 18

Measuring Supply

Answer 18

Measurements to track the supply of real estate includes the following:
• The number of vacant properties that are available for sale (vacancy rate)
• The number of properties that are currently under construction, but not completed.
• Properties that have been permitted, but are not under construction.
• Projects that have been announced, but not permitted.

Question 19

Tracking the number of permits

Answer 19

Tracking the number of permits that are being issued is a rather basic, but effective way to discern trends in market changes as well as changes in supply.

Question 20

There are both short- and long-term considerations

Answer 20

when measuring supply. Obviously, properties that are currently available for sale represent the supply available today. However, properties that are under construction will become available in the near future. Developers who have obtained permits have already made significant investments and will likely go forward with their projects. These projects will come into the market within a relatively short time and must be considered as part of the supply. Projects that have been announced, but not permitted, may or may not be constructed, but must be considered in light of current and anticipated supply and demand relationships.

Question 21

Supply may increase or decrease as a result of?

Answer 21

Supply may increase or decrease as a result of new construction, conversion from other uses, or the action of sellers in deciding whether or not to sell. Conversion from other uses is the change of a property from one type of use to another type of use, such as a factory that is converted to apartments.

Question 22

Change in supply takes time

Answer 22

Changes in supply occur over a relatively long time since construction is a time-consuming process. Even though an individual house may be physically constructed in a few months, the entire process includes a site selection and acquisition, planning, permitting, financing, coordination of labor and materials, and finally, construction. The entire process can take one to two years and even longer for major projects.

Question 23

Net Household Formations

Answer 23

The basic measure of demand for residential real estate is net household formations, which is the net difference between the number of households expected to be created within a given period-of-time and the number of households expected to be eliminated during the same period of time.

Question 24

Living Units

Answer 24

The U.S. Bureau of the Census defines a household as, “a living unit.” A single person who lives alone in an apartment is considered to be a household. Three generations of a family who share a farm home is also considered to be a household. Therefore, net household formation is a measure of living units, not population.

Question 25

Factors of Demand

Answer 25

1. Price
2. Population
3. Credit
4. Income
5. Consumer Preferences

Question 26

Price (demand)

Answer 26

price is principally the result of the interaction of material and labor costs. Demand will typically decrease as prices rise. Price and demand are inversely related.

Question 27

Population (demand)

Answer 27

as population grows, so does demand. Population and demand are positively related.

Question 28

Credit (demand)

Answer 28

as credit becomes more readily available and interest rates go down, demand increases. Credit and demand are positively related. The availability of credit is a key market indicator, and is said to be the barometer of the real estate market.

Question 29

Income (demand)

Answer 29

demand is influenced by income. Effective demand is the combination of a potential buyer’s desire for an item that is coupled with the ability to pay for the item. Demand is not created until both components are present. As income increases, so does demand; income and demand are positively related.

Question 30

Consumer Preferences (demand)

Answer 30

demand is influenced by changes in preferences. Homes today are larger and offer more amenities than those that were available a few years ago. Two or three baths, two- to three- car garages, and central heat and air conditioning have become standard amenities.

Question 31

As prices goes up

Answer 31

demand goes down

Question 32

As prices go down

Answer 32

demand goes up

Question 33

as supply goes up

Answer 33

price goes down

Question 34

as supply goes down

Answer 34

price goes up

Question 35

Market Equilibrium

Answer 35

is said to occur when supply and demand are in balance. This is a theoretical concept more than a reality. The market constantly swings back and forth from undersupply to oversupply relative to demand. The number of properties that are available for sale and represented by the number of sellers is a measure of supply. Demand is represented by the number of buyers in the market at any one time. When there are more buyers than sellers, a seller’s market exists; when there are more sellers than buyers, a buyer’s market exists.

Question 36

The imbalance between sellers and buyers

Answer 36

The imbalance between sellers and buyers is not constant. As buyers absorb existing supply, builders and other sellers have an inducement to enter the market. Eventually, supply will grow and exceed demand, which results in an oversupply. It may take months or even years for the oversupply to be absorbed into the market. Eventually, the excess will be absorbed, and there will be a limited supply relative to demand. The cycle will then reverse.

Question 37

What is thought to be reasonably in balance

Answer 37

Supply and demand in the residential market are thought to be reasonably in balance when the vacancy rate of homes for sale is about 5%.

Question 38

The Real Estate Business Cycle

Answer 38

The real estate market is cyclical in nature and tends to follow the business cycle. The business cycle has four phases: expansion, peak, contraction, and trough.

Question 39

Expansion

Answer 39

during the expansion phase, both supply and demand increase. The market is vibrant during this period. Typically, this period is evidenced by increasing prices since supply cannot keep up with increasing demand.

Question 40

Peak

Answer 40

the peak phase is generally short-lived and is evidenced by a drop in demand. As demand declines, sales activity slows markedly. Supply continues to increase; therefore, an oversupply becomes evident.

Question 41

Contraction

Answer 41

the contraction phase is evidenced by a decline in supply from levels at the peak of the market. Some demand is still present, but the available supply is more than adequate to meet that demand. Contraction continues until the oversupply is absorbed.

Question 42

Trough

Answer 42

the trough phase is at the low end of the cycle where supply an demand are nearly static. When in the trough phase, the entire cycle is poised to repeat itself.

Question 43

Continuous Cycle

Answer 43

These four phases do not continue for specific lengths of time. The cycle, however, continues to repeat itself. The length and intensity of each phase of the cycle will vary.
Historically, however, the complete business cycle lasts between three-and-half to five years.
Key market indicators in the business cycle include vacancy rates, price and sales information, and numbers of building permits (indicating increasing or declining construction).

Question 44

Efficient Market Theory

Answer 44

Changes within a market can be measured, but nothing can be compared to itself; it must be compared to something else. This fact created a difficult problem for economists who wished to make comparisons between markets. How can the automobile market be compared with the clothing market, or the appliance market with the stock market? To compare a market, there must be a standard of comparison by which to begin.

Economists conceived the concept of an efficient market. An efficient market is a perfect market model that allows comparisons of any market to a theoretical standard.

Question 45

Conditions for an Efficient Market

Answer 45

• Goods and services are homogeneous and readily substitutable.
• Prices of goods and services are low and, therefore, affordable.
• There are a large number of market participants, thereby allowing for open competition for available goods and services; no one participant has a share of available goods that might influence pricing.
• There are no governmental regulations that interfere with or limit production.
• Goods or services are easily and quickly remanufactured to meet demand, therefore, supply and demand are never out of balance.
• Buyers and sellers are fully informed about the goods and services that are offered.
• Information about the market is readily available.
• Buyers and sellers are brought together through an organized market mechanism.
• Goods are small, lightweight, and easily transportable.
• External pressures have no effect on price.

Question 46

Highest & Best Use Analysis

Answer 46

The highest and best use of a parcel of real estate is the legal use that generates the most return on the land and any improvements on the land when compared to alternative uses.

Question 47

There are four criteria used to determine the highest and best use of a parcel.

Answer 47

1. Legally permissible
2. Physically possible
3. Financially feasible
4. Maximally productive

Question 48

These 4 criteria are applied (highest & best use)

Answer 48

These criteria are applied sequentially. If a parcel does not meet a particular use, the use is eliminated from any further consideration. The use that meets the first three criteria and produces the maximum return or greater benefit to the owner is the highest and best use.

Question 49

Legally Permissible example

Answer 49

a parcel is determined to have four legally permissible uses.

Question 50

Physically possible example

Answer 50

each use is tested to see if it is physically possible based on the size, shape, soil, terrain, and so on of the site. Out of the four legally permissible uses, one is not physically possible; therefore, that particular use is eliminated from consideration.

Question 51

Financially feasible example

Answer 51

the remaining three uses are tested for economic feasibility. One of the remaining three does not meet this test; therefore, it is eliminated.

Question 52

Maximally productive example

Answer 52

out of the two remaining uses, the one that generates the most return or provides the greatest benefit to the owner is considered to be the highest and best use of the real estate.

Question 53

Characteristics of the Real Estate Market

Answer 53

unorganized, inefficient & local in nature

Question 54

Unorganized and Inefficient

Answer 54

the real estate market tends to violate each element of an efficient market. Real estate is not a homogeneous product. Each parcel of land is unique or different in some way from all others. Due to the unique character of each parcel, the real estate market cannot be centrally organized like the New York Stock Exchange. Instead, it is unorganized and inefficient when compared with other markets.

Question 55

Local in Nature

Answer 55

the real estate market is local in nature. Each parcel of real estate is unique in size, shape, or other physical characteristics. Prices are high compared to most other goods or services. Supply cannot respond quickly to changes in demand. Market participants are rarely fully informed. The laws that control the use of land, building codes, and other factors can be ascertained only from local sources. As a result, a potential purchaser must obtain information with regard to a particular parcel of real estate from a local source.

Question 56

External Factors (Externalities)

Answer 56

The real estate market is influenced by 4 external factors, called externalities, which can originate at the international, national, regional, or local level. The land’s value is a function of the interaction of these forces.

1. Social
2. Economic
3. Governmental
4. Environmental

Question 57

Social external factors

Answer 57

social forces are related to population. The number of people, who move into or out of an area, greatly influences value in the market. The number of marriages, deaths, divorce rates, population age, and household formations are all social factors that affect the market.

Question 58

Economic external factors

Answer 58

a population’s purchasing power is a major factor that affects the real estate market. Employment and wage levels, the cost of materials and labor, vacancy rates, the cost and availability of credit, and the expansion or contraction of industry all have an effect on the market.

Question 59

Governmental external factors

Answer 59

zoning, building, and health codes can limit or support construction of new properties. Legislation that concerns homestead exemptions, rent controls, and restrictions related to condominiums and timeshare arrangements can have an enormous effect on markets, as can laws that affect mortgage loans and terms.

Question 60

Environmental external factors

Answer 60

both man-made and natural barriers can affect the environment in which real estate markets operate. Roads, bridges, airports, and rail lines are examples of man-made features which limit or affect development. Weather, terrain, soil conditions, and climate are also potential barriers.

Question 61

Physical Characteristics of the Land

Answer 61

Indestructible
Immobile
Heterogeneous

Question 62

Indestructible

Answer 62

Land is indestructible. The land may change in character, but will always occupy a space on the face of the earth. Land does not depreciate. It can always be converted to a different use. Property insurance insures the improvements to the land only, not the land itself.

Question 63

Immobile

Answer 63

Real estate is immobile, meaning that the property is fixed as to its location. It cannot be moved from location to location. Although a house or other building may be moved, the site on which it is located cannot. The expense of moving the building may be prohibitive as well. A housing shortage in one area cannot be cured by an oversupply in another area.

Question 64

Heterogeneous

Answer 64

Real estate is heterogeneous, also referred to as non-standardized or non-homogeneous, which means that no two properties are exactly alike; each property is unique.
This unique character of real estate is what makes the real estate market different from all others in many ways.

Question 65

Economic Characteristics of Land

Answer 65

Scarcity of Land Creates Value Based on Demand

Situs Value

Question 66

Scarcity of Land Creates Value Based on Demand

Answer 66

From an economic point of view, land is scarce. No more is being made. Anything with a finite supply can assume a value based on demand. In some areas, land is scarce relative to demand and, therefore, extremely expensive.

Question 67

Situs Value

Answer 67

The immobility of a parcel of real estate combined with its unique features and ability to provide benefits determines its value. Situs is a Latin term, which means, “fixed as to location.”

Situs value is used to identify the value that results from the location of a parcel of land within a community. Area preference can impact the situs value. For example, a parcel that is more desirable due to its location near a school may have a higher situs value.

Question 68

Assemblage

Answer 68

Two or more parcels of land can sometimes be combined under a single ownership to form a tract of land that provides greater utility than was available as individual parcels. Combining two or more parcels of real estate under the ownership of one party is known as assemblage.

Question 69

Plottage Value

Answer 69

If the combined parcels have a greater value together than they did as separate parcels, the increase in value is known as plottage value. Plottage value is the result of the assemblage.
For example, if two parcels, each of which has a separate value of $15,000, are combined under a single ownership, the tract value as a single parcel may equal $35,000. This assemblage of the two parcels results in a plottage value.

Question 70

Improvements are Relatively Permanent

Answer 70

The real estate market is less flexible than other markets because improvements to land are relatively permanent. Improvements are expected to remain on the land for many years. The relatively high cost cannot be justified otherwise.

Question 71

Demand cannot be Quickly Satisfied

Answer 71

The real estate market is slow to respond to changes in demand. If real estate is in demand, the demand cannot quickly be satisfied because the production of improvements to real estate (i.e. the development process), is time-consuming.

Question 72

Oversupply cannot be Quickly Absorbed

Answer 72

An oversupply of housing in a market area must be absorbed in that market area, and that can take an extended period-of-time. The real estate market is slow to respond to changes in supply.

Question 73

Institutional Characteristics of the Real Estate Market

Answer 73

The institutional characteristics of the real estate market include government regulation, real estate laws, customs, and trade organizations.

Question 74

Government Regulation

Answer 74

plays an enormous part in the real estate market. Zoning, comprehensive land use plans, rent controls, tax laws, public assistance and housing programs, restrictions and laws which affect financing, laws that restrict or affect development, and the use of land are examples of government regulation.

Question 75

Real Estate Laws

Answer 75

are based on the concept of private ownership of legal rights in land. When real property is exchanged in the market, the commodity that is transferred is a bundle of legal rights.

Question 76

Customs

Answer 76

affect the nature and type of improvements constructed in local, state, and regional areas. Consumer attitude changes from time-to-time so the market must be able to respond to those changes.

Question 77

Trade Organizations

Answer 77

serve to unify, empower, and promote the interests of its members. The principal organizations within the real estate business are the National Association of Realtors (NAR) and the National Association of Home Builders (NAHB). Both exert a powerful influence on the real estate business.

Question 78

The Neighborhood Life Cycle

Answer 78

Neighborhoods are thought to go through a cycle of change. There are typically four stages in the life of a neighborhood: growth, stability, decline, and eventual revitalization.

Question 79

The Neighborhood Life Cycle- Growth

Answer 79

The growth period begins when newly cleared land is made available for construction, or existing properties are converted to other uses. Neighborhood growth usually coincides with periods of economic expansion.
The growth period may last several years or end abruptly due to sudden changes in demand or shifts in market preferences. Increased costs of construction or high interest rates may also cause growth to diminish sharply. However, growth will continue as long as costs remain low, interest rates continue to be favorable, and demand in the area is sustained.
During the growth period, properties are generally constructed to standards of materials and designs that are favored in the market. Properties built during this period tend to be similar in appearance and style, thus reflecting preferences in the market.

Question 80

The Neighborhood Life Cycle- Stability

Answer 80

Stability is characterized by neither growth nor decline. This period may begin when it is no longer profitable to build in an area or when other neighborhoods are seen as better values by market participants.
During a period of stability, values are relatively stable, supply and demand are in balance, and turnovers are low. Neighborhood standards conform to the market, and properties are well kept as residents have sufficient income to maintain them.

Question 81

The Neighborhood Life Cycle- Decline

Answer 81

When a neighborhood can no longer compete with comparable neighborhoods in the same market, decline is imminent.
Maintenance declines as residents may not have sufficient income to continue to keep the properties in proper condition. “For Sale” signs appear with greater frequency, and a higher than normal number of properties become available for rent. Small businesses that formerly served the neighborhood residents may close from lack of local support.

Question 82

The Neighborhood Life Cycle- Revitalization

Answer 82

Changing land use patterns, preferences, and migration patterns may cause a period of decline to suddenly end. Deteriorated buildings may be demolished to make way for new, more modern structures. Community efforts, redevelopment, and historic preservation programs may also contribute to a reversal of the pattern of decline.
A relatively new phenomenon called gentrification has occurred in some older neighborhoods. Younger, single people and small families who want to live in proximity to urban services may purchase properties in areas that have lost favor in the market and rehabilitate or renovate them. This process begins a period of revitalization, which provides both positive and negative effects to the community.
As properties are rehabilitated, values increase, which in turn increases assessed value for taxation purposes. On the negative side, poorer residents who have moved into older neighborhoods are displaced. Gentrification usually begins initially on a small scale, with only one or two properties. As the market realizes the potential benefits associated with the area, it encourages revitalization to continue.
This cycle is typical and describes how neighborhoods usually evolve. However, the life cycle of a neighborhood may or may not conform to this pattern since changes in the market do not always change in sequence. Licensees should understand that this is a model that helps relate to conditions that may be observed in the market.