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AFX3355 Property Investment
Tutorial 1 GM Chapter 1: Q’s 1.1 – 1.8 and 1.16
Q 1.1 What is the real estate space market?
What is the real estate asset market?
Answer: Space market is the market for the usage , or the right to use, real property (land and
build space) – sometimes referred to as the rental market (based on type of property)
or the real estate usage market.
The real estate asset market (also referred to as the property market) is the market for
the ownership of property (real estate) assets. Property assets consist of real property,
that is, land parcels and improvements on the land (buildings).
Q 1.2 Draw and label a supply curve for real estate (income property) space, and
explain why it is “kinked”.
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Answer:
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Q 1.3 What are the typical causes of a rising long-run marginal cost function in the
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space market for built space?
Answer: The long run marginal cost (LRMC) function is the long run supply function in the
market. It tells the cost of adding incrementally to the stock of supply in the space
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market. This is the cost of developing new buildings. This consists of construction
cost plus land cost. Construction cost is typically about the same (in real terms) for
the next building as for the last, in a given market (holding quality constant). So the
cause of a rising LRMC function is typically increasing land cost, in other words,
increasing scarcity of land. This, in turn, will be caused by growth in demand for built
space in the market combined with a lack of new buildable sites in the market. Lack
of buildable sites can be caused by geographical, physical constraints (such as an
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island or mountains), or by legal or political constraints (such as zoning or
environmental controls).
The kink occurs at the point where the LRMC of supplying additional space is equal
to the marginal revenue. If demand for built space changes, rents will adjust to reflect
these changes which, in turn impacts on the return to those who invest in these assets.
Buildings last a very long time, possibly more than 50 years, which means that the
supply of buildings cannot be reduced in line with reducing demand for space. A
rising LRMC cost curve is evidence that the real cost of developing new buildings is
greater than the cost of developing the last building. If the cost of supplying new
space is less than the development cost of previous buildings, then the supply
function is falling.
Q 1.4 Why, or along what dimensions, are real estate space markets segmented? What is
an important implication of real estate space market segmentation?
Answer: Because both supply and demand are location and type specific, real estate
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space markets are highly segmented. The demand for a particular type of
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space is local, for example a shopping centre may be located in a suburban
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area to service the needs of people in that local area.
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Since the demand for space is local, rents will be determined by the strength
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of demand in this local area and may be very different in some other area. For
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example, rents and housing prices have increase more in Western Australia
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that in Melbourne and Sydney because demand is greater in WA (due to the
resource boom).
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Q 1.5 Suppose the demand for built space in a local market is growing. Does this
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imply that rents will rise? Why or why not? Differentiate between rent
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changes in the short run and the long run. [Hint: for the long-run, explain the
conditions necessary for real rents to rise in a market.]
Answer:
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Q 1.6 If demand for built space is declining, does this imply that real rents (that is,
rents measured net of inflation) will fall in the market? Why or why not? As in
the previous question, differentiate between short-run and long-run rent
adjustments.
Answer: Yes, real rents will definitely fall if demand for built space is declining. The reason is
that the supply of space is largely fixed, even in the medium to long run, because
buildings do not wear out quickly. So supply cannot shrink as fast as demand, leading
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rents to decline in the equilibrium between supply and demand. Of course, if this
process is too extreme, or continues too long, then rents will fall so far that it will be
unprofitable to maintain or operate buildings at all, and their owners will close them
down and they will fall apart, perhaps occupied by squatters. So supply can fall in the
long run.
Q 1.7 Why are cycles inevitable for real estate space markets? Do you think the
nature of cycles differ by property type?
Answer: Cycles are a common phenomenon in the property market, that is space
markets have exhibited extended periods of rise in building occupancy and
rents followed by extended periods of falling or low occupancy and rents.
In the short run it is not possible to add new space in response to an
unanticipated surge in usage demand. Hence, in periods of strong demand
rents may increase significantly causing property prices to also increase
significantly. The attractive yields in the property market will encourage
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developers to increase supply. Unless developers and the capital market can
correctly anticipate demand growth it is likely that excess space will be
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supplied – leading, in the long-run to a downward spiral and ultimately the
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‘bust’ part of the cycle.
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Cycles for the various types of property (office, retail, residential, etc.) will
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have different periodicity and amplitude because underlying circumstances
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differ. Developers may be able to respond to changes in market demand for
certain property types more quickly and additional supply may be better
controlled. For example, the decision to add new retail space in a small mall
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or shopping strip may result in a relatively small addition in a retail space
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market. The addition of a large office building may result in significant over
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supply of this type of space. The overhang (the period for which excess
supply exists) in the office market is likely to be much longer, and is likely to
have a bigger impact on rents, than is the case in the retail market.
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Q 1.8 What is the difference between a private and a public asset market? Why do
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public asset markets tend to be more informationally efficient than private
asset markets?
Answer: Securities in a private asset markets are not traded while those in public
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markets are. Real estate space is typically bought and sold in the private
market. Listed or public markets, are more efficient due to constantly updated
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prices which are visible whenever the exchange in operating.
Q 1.10 What are the three major factors influencing property prices or cap rates
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(OARs) in the real estate market? How (i.e., in which direction) does each of
these influence the rate?
Answer:
1. Opportunity cost of capital (OCC), that is, what investors can expect to earn
from other investments elsewhere in the capital market. Higher OCC
higher cap rates.
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2. Growth expectations for the property net income. The more favorable are
conditions in the space market where the property is located, the greater will
be the expected future growth of rents the building can charge, making
investors willing to pay a higher price for the property per dollar of its
current income. So higher growth Lower cap rates.
3. Risk in the property investment, that is, how much uncertainty there is in the
property’s ability to generate income in the future (a function of the space
market), and how much uncertainty there is in the future OCC relevant for
this property (a function of the capital market). Greater risk Higher cap
rate.
Q 1.16 Total development costs are $250/SF. Investors are willing to pay property
prices of $11.76 per dollar of current rental income.
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What is the implied cap rate?
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What is the “replacement cost rent” in this market?
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Answer: Cap rate = Rental Income/Price = 1/11.76 = 8.5%
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Replacement cost rent = rent at which development is just profitable (i.e. NPV = 0
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or cost = value)
Setting cost = value, we have 250 = rent/0.085
→ rent = Cost x Cap rate = 250 x 0.085 = $21.25
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