Chapter 15: The Real Estate Market and Analysis Flashcards
Free enterprise system
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.
What are the three questions that must always be answered with regard to the production and distribution of goods or services?
- What is to be produced?
- Who will do the producing?
- Who will get what is produced?
The answer to these questions is found in the relationship between production, distribution, and demand.
Production
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?”
Distribution
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.
Market
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.
Price
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.
Government- Controlled Economies
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.
What do government-controlled systems lack?
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.
Supply
is the quantity of an item that is available, or anticipated to be available, for sale.
Price in the real estate market
is a function of the number of items available in relation to the number of items in demand.
Supply and demand in the real estate market
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.
Factors affecting supply
- Availability of skilled labor
- Availability of land
- Increased productivity
- Availability of construction loans & financing
- Availability of Materials
Availability of skilled labor
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.
Availability of land
a shortage in the supply of available land can drive up the cost of acquiring land for new development.
Increased productivity
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.
Availability of construction loans & financing
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.
Availability of Materials
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.
Measuring Supply
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.
Tracking the number of permits
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.
There are both short- and long-term considerations
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.
Supply may increase or decrease as a result of?
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.
Change in supply takes time
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.
Net Household Formations
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.
Living Units
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.
Factors of Demand
- Price
- Population
- Credit
- Income
- Consumer Preferences
Price (demand)
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.
Population (demand)
as population grows, so does demand. Population and demand are positively related.
Credit (demand)
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.
Income (demand)
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.
Consumer Preferences (demand)
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.
As prices goes up
demand goes down
As prices go down
demand goes up
as supply goes up
price goes down
as supply goes down
price goes up
Market Equilibrium
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.
The imbalance between sellers and buyers
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.
What is thought to be reasonably in balance
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%.
The Real Estate Business Cycle
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.
Expansion
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.
Peak
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.
Contraction
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.
Trough
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.
Continuous Cycle
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).
Efficient Market Theory
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.
Conditions for an Efficient Market
- 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.
Highest & Best Use Analysis
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.
There are four criteria used to determine the highest and best use of a parcel.
- Legally permissible
- Physically possible
- Financially feasible
- Maximally productive
These 4 criteria are applied (highest & best use)
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.
Legally Permissible example
a parcel is determined to have four legally permissible uses.
Physically possible example
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.
Financially feasible example
the remaining three uses are tested for economic feasibility. One of the remaining three does not meet this test; therefore, it is eliminated.
Maximally productive example
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.
Characteristics of the Real Estate Market
unorganized, inefficient & local in nature
Unorganized and Inefficient
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.
Local in Nature
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.
External Factors (Externalities)
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.
- Social
- Economic
- Governmental
- Environmental
Social external factors
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.
Economic external factors
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.
Governmental external factors
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.
Environmental external factors
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.
Physical Characteristics of the Land
Indestructible
Immobile
Heterogeneous
Indestructible
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.
Immobile
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.
Heterogeneous
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.
Economic Characteristics of Land
Scarcity of Land Creates Value Based on Demand
Situs Value
Scarcity of Land Creates Value Based on Demand
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.
Situs Value
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.
Assemblage
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.
Plottage Value
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.
Improvements are Relatively Permanent
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.
Demand cannot be Quickly Satisfied
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.
Oversupply cannot be Quickly Absorbed
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.
Institutional Characteristics of the Real Estate Market
The institutional characteristics of the real estate market include government regulation, real estate laws, customs, and trade organizations.
Government Regulation
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.
Real Estate Laws
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.
Customs
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.
Trade Organizations
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.
The Neighborhood Life Cycle
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.
The Neighborhood Life Cycle- Growth
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.
The Neighborhood Life Cycle- Stability
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.
The Neighborhood Life Cycle- Decline
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.
The Neighborhood Life Cycle- Revitalization
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.
