Introduction to Real Estate
Economics and Cycle Analysis
Presented to
Asset Management Group
Presented by
Lawrence A. Souza, CRE
Director of Research
Thursday, September 26, 2002
OUTLINE
• Introduction
• Real Estate Portfolio Theory
• Supply and Demand Analysis
• Real Estate Cycle Theory
• Current Economic Indicators
INTRODUCTION
Real Estate in a Social, Cultural and
Economic Context
Interdisciplinary/Cross-Sectional Approach to
Real Estate Market Analysis:
•
Biological/Physiological/Psychological
•
Philosophical Systems
•
Legal Systems
•
Political Systems
•
Economic Systems
•
Financial Systems
PORTFOLIO THEORY
Institutional Real Estate
Capital Allocation Line
Movements Along the Efficient Frontier
E (r)
Direct Real Estate
Development
LEVERAGE
Market
Basket
E (r)*
Lower Risk/Return Real
Estate Investments
LENDING
Apartment Loan
Origination
Capital Allocation
Line (CAL)
100% High
Risk/Return
Portfolio
Higher Return/Risk
Real Estate
Investments
100% Low
Return/Risk
Portfolio
σ*
σ
Applications In Portfolio Theory
Balanced
Periods:
Risk-Adjusted Rate of Return
Metro
Orange County
SF Bay Area
Seattle
San Diego
Los Angeles
Sacramento
Denver
Portland
Salt Lake City
Phoenix
Tucson
Riverside
Las Vegas
Albuquerque
1986-2000
Average
Standard
Annual Return
Deviation
13.4%
7.6%
15.5%
8.8%
14.3%
9.3%
13.7%
9.4%
14.4%
9.9%
13.8%
11.0%
12.0%
11.2%
12.5%
10.0%
13.0%
11.0%
14.1%
11.4%
14.1%
11.4%
11.6%
11.9%
5.1%
6.6%
2.4%
4.4%
Risk-Adjusted
Rate of Return
1.7
1.7
1.5
1.4
1.4
1.3
1.3
1.3
1.2
1.2
1.2
1.0
0.8
0.5
Risk-Adjusted Rates of Return are calculated by dividing the Total Average
Annual Rate of Return by the Standard Deviation (Risk) for each metro area.
The Risk-Adjusted Rate of Return measures the amount of return for each unit
of risk. For example Orange County provides 1.7 units of return for each unit of
risk.
Total Returns are calculated by the year-over-year change in sales price per
square foot on a quarterly basis (Capital Appreciation) plus the annualized cap
rate (Income Return) per quarter.
Sources: National Real Estate Index (NREI) and
BRE Properties Research Department
•
•
•
•
Conditions
Long
LA/Orange County/Riverside
San Diego
Bay Area
Seattle
• Low Vacancy Rates
• High Effective Rents
• Prices Above
Replacement
•
•
•
•
Job Growth
In-Migration
Housing Demand
Positive Net Absorption
Modest Conditions of
Over/Under Supply:
•
•
•
•
for
Sacramento
Salt Lake City
Portland
Denver
SUPPLY AND DEMAND ANALYSIS
Real Estate Supply and Demand Analysis
Long-Run Market Equilibrium
Rent Growth %
Supply
Market
(Space Available)
Equilibrium
*Rent
Inflation Rent Growth
(3.5%)
Growth
Structural
Vacancy Rate
(5%)
Rents-Prices Equal
Cost of Construction
No Incentive
to Build New
Product
Demand
(Absorption)
* Existing
Inventory
# Units
Real Estate Supply and Demand Analysis
Short-Run Supply Conditions with Employment Demand Shock
Short-Run
Supply (Fixed)
Rent Growth %
*Rent
Growth
(8.5%)
Incentive to
Build New
Product
New Market
Frictional
Equilibrium Vacancy Rate
Price
(2% - 3%)
Rents-Prices Above
Replacement Costs
Rent
Spikes
*Rent
Growth
(3.5%)
New
Demand
Old
Demand
* Existing
Inventory
# Units
Real Estate Supply and Demand Analysis
Long-Run Supply Response
Rent Growth %
*Rent
Growth
(8.5%)
*Rent
Growth
(3.5%)
Rent
Growth
Declines
Short-Run
Supply (Fixed)
Old Market
Equilibrium
Price
Long-Run
Supply (Flex)
No Incentive
to Build New
Product
Rents-Prices At
Structural
Vacancy Rate Replacement
Costs
(5%)
New
Demand
* Old Level
Inventory
* New Level
Inventory
# Units
Real Estate Supply and Demand Analysis
Long-Run Supply Response in Supply Constrained Markets
Rent Growth %
Rent
Growth
(8.5%)
*Rent
Growth
(5.5%)
Moderate
Rent
Growth
Declines
SR Supply LR Supply
(Fixed) (Mod-Flex)
Old Market
Equilibrium
Price
Incentive to
Build New
ProductRehab
Rents-Prices Above
Replacement Costs
Rent
Growth
(3.5%)
Structural
Vacancy Rate
(3% - 4%)
Demand
* Old Level * New Level
Inventory
Inventory
# Units
Real Estate Supply and Demand Analysis
Long-Run Supply Response in Supply Unconstrained Markets
Rent Growth %
Rent
Growth
(8.5%)
Rent
Growth
(3.5%)
Rent
Declines
SR Supply
(Fixed)
LR Supply
(Flex)
Old Market
Equilibrium
Price
Vacancy Rate
(5%)
No Incentive
to Build New
Product
Vacancy Rate
(8%)
*Rent
Growth
(-3.5%)
Over
Supply
* Old Level
Inventory
Demand
Rents-Prices Well Below
Replacement Costs
* New Level
Inventory
# Units
Real Estate Supply and Demand Analysis
Short-Run Supply Conditions with Negative Employment Demand Shock
Rent Growth %
Rent
Growth
(3.5%)
Short-Run
Supply (Fixed)
Old Market
Equilibrium
Price
Rent
Declines
No Incentive
to Build New
Product
Structural
Vacancy Rate
(5%)
Vacancy Rate
(8%)
*Rent
Growth
(-3.5%)
Rents-Prices
Well Below
Replacement
Costs
Old
Demand
New
Demand
* Existing
Inventory
# Units
Real Estate Supply and Demand Analysis
Long-Run Supply Response with Negative Employment Demand Shock
Rent Growth %
Old Market
Equilibrium
Price
Rent
Growth
(3.5%)
Rent
Growth
(-3.5%)
Short-Run LR Supply
Supply (Fixed) (Flex)
Negative
Rent
Spikes
Structural
Vacancy Rate
(5%)
No Incentive
to Build New
Product
Vacancy Rate
(8%)
Vacancy Rate
(10%)
*Rent
Growth
(-8.0%)
Rents-Prices
Well Below
Replacement
Costs
Old
Demand
New
Demand
* Existing
Inventory
* New Level
Inventory
# Units
REAL ESTATE CYCLE THEORY
Real Estate Cycle Theory
M arket C ycle Q uadrants
P hase 2 - E xpansion
P hase 3 - H ypersupply
In
g
si n
ea
cr ncy
ca
cti
re
Co
mp
ng
e a si
In c r c y
an
V ac
on
Mo
le t
io n
s
No
P hase 1 - R ecovery
tr u
n
n
Va
w
e
N
Co
u
r
t
s
o
c ti
ns
li
n
n
Co
c
e
D
n
ni
gV
a
ac
w
e
N
cy
C
t
c
u
r
tio
w
E quilibrium
s
n
o
y
Ne
c
e
D
i
il n
ng
c
a
V
c
n
a
P hase 4 - R ecession
Legg M ason R eal Estate R esearchLegg M ason R eal E state
Real Estate Cycle Theory
S upply/D em and
Inflection P oint
-D em and grow th continues
-N ew construction begins
(Parallel Expectations)
-Space difficult
to find
-Rents rise rapidly
tow ard new
construction levels
-Supply grow th higher
than dem and grow th
pushing vacancies up
C ost F easible N ew C onstruction
E quilibrium
- Low or negative
dem and grow th
-C onstruction
starts slow but
com pletions
push vacancies
higher
-N ew dem and
confirm ed
Excess space absorbed
(Parallel Expectations)
-N ew dem and not
confirm ed in
m arketplace
(M ixed Expectations)
M arket C ycle
C haracteristics
Legg M ason Real Estate ResearchLegg M ason Real Estate
Real Estate Cycle Theory
M arket C ycle C apital Flow Im pact
C apital Flow s to Existing Properties
C ost Feasible R ents R eached
Pr
e
p
o
M
y
rt
To
C
l
ta
k
ar
i
p
a
C
t
e
le
c
y
F
l
ta
E quilibrium
lo w
C
le
c
y
C apital Flow s to N ew C onstruction
Legg M ason Real Estate ResearchLegg M ason Real Estate
Applications Real Estate Cycle Theory
Supply/Demand
Inflection Point
Riverside
San Diego
II
Equilibrium
I
III
IV
Orange Co
USA
Portland
San Francisco, Seattle
Phoenix, Denver
Source: M/PF Research Inc., Real Facts, Inc, REIS Reports, Inc. and BRE Properties Research Department.
Los Angeles
Sacramento
Salt Lake City
Applications Real Estate Cycle Theory
Los Angeles
99%
Occupancy Rate
Rent Growth
14%
Forecast
Structural Occ. Rate (95.7%)
12%
98%
10%
97%
8%
6%
II III
I
IV
96%
95%
4%
2%
0%
94%
-2%
93%
-4%
1984
1986
1988
1990
1992
1994
Occupancy Rate
1996
1998
2000
2002
2004
2006
Rent Growth
Source: M/PF Research Inc., Real Facts, Inc, REIS Reports, Inc. and BRE Properties Research Department.
Applications Real Estate Cycle Theory
San Francisco
Occupancy Rate
98%
Rent Growth
25%
Forecast
Structural Occ. Rate (95.0%)
96%
II
I
94%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%
III
IV
92%
90%
88%
1984
1986
1988
1990
1992
1994
Occupancy Rate
1996
1998
2000
2002
2004
2006
Rent Growth
Source: M/PF Research Inc., Real Facts, Inc, REIS Reports, Inc. and BRE Properties Research Department.
Applications Real Estate Cycle Theory
Phoenix
100%
98%
Occupancy Rate
Rent Growth
12%
Forecast
Structural O cc. Rate (90.5%)
10%
96%
8%
94%
6%
II
I
92%
90%
88%
III
IV
4%
2%
0%
86%
-2%
84%
-4%
82%
-6%
1984
1986
1988
1990
1992
1994
Occupancy Rate
1996
1998
2000
2002
2004
2006
Rent Growth
Source: M/PF Research Inc., Real Facts, Inc, REIS Reports, Inc. and BRE Properties Research Department.
Applications Real Estate Cycle Theory
Apartment Occupancy Rate Cycles
Metro Area
Peak-to-Peak
Peak-to-Trough
Trough-to-Trough
Trough-to-Peak
Supply Constrained Markets
NOTE: Dates are approximate and do not represent the exact beginning or ending of cycles.
Los Angeles
1993 to 2000
1993 to 2008
2000 to 2017
2000 to 2008
7 years
15 years
17 years
8 years
Orange County
2004 to 2010
1992 to 2004
1998 to 2013
1998 to 2004
6 years
12 years
6 years
15 years
Portland
2000 to 2004
1991 to 2000
1995 to 2000
1995 to 2004
4 years
9 years
5 years
9 years
Salt Lake City
2000 to 2007
1988 to 2000
1995 to 2000
1995 to 2007
7 years
12 years
5 years
12 years
San Diego
2002 to 2013
1987 to 2002
1998 to 2002
1998 to 2013
11 years
15 years
4 years
15 years
S.F. Bay Area
2003 to 2010
1988 to 2003
1996 to 2003
1996 to 2010
7 years
15 years
7 years
14 years
Seattle
2001 to 2005
1993 to 2001
1997 to 2001
1997 to 2005
4 years
8 years
4 years
8 years
2001 to 2008
1990 to 2002
1995 to 2002
1995 to 2008
Average Duration
7 years
12 years
7 years
13 years
in Years
Applications Real Estate Cycle Theory
Metro Area
Peak-to-Peak
Peak-to-Trough
Trough-to-Trough
Trough-to-Peak
Supply-Unconstrained Markets
NOTE: Dates are approximate and do not represent the exact beginning or ending of cycles.
Denver
2000 to 2008
1986 to 2000
1994 to 2000
1994 to 2008
8 years
14 years
6 years
14 years
Phoenix
2000 to 2008
1986 to 2000
1994 to 2000
1994 to 2008
8 years
14 years
6 years
14 years
Riverside
1997 to 2002
1997 to 2007
2002 to 2008
1993 to 2002
5 years
10 years
6 years
9 years
Sacramento
2001 to 2008
1989 to 2001
1995 to 2001
1995 to 2008
7 years
12 years
6 years
13 years
2001 to 2005
1990 to 2001
1994 to 2001
1994 to 2005
Average Duration
4 years
11 years
7 years
11 years
in Years
Notes: A Peak represents top of an occupancy cycle and a Trough represents the bottom of an occupancy cycle.
Source: MP/F Research, RealFacts, RealSource, REIS Reports, Marcus & Millichap, Clayton-fillmore, ULI, and BRE Propertie
CURRENT ECONOMIC
INDICATORS
Manufacturing Continues To
Recover
ISM Mfg: PMI Composite Index
SA,50+ = Econ Expand
65
65
60
60
55
55
50
50
45
45
40
40
35
35
88
89
90
91
92
93
94
95
96
S our ce: I nst it ut e f or S upply Management / Haver Analyt ics
97
98
99
00
01
02
The Markets Appear To Have
“Disconnected” From The Economy
Stock Pr ice Index: Standar d & Poor 's 500 Composite
1941-43=10
Industr ial Pr oduction Index
SA, 1992=100
1600
150
145
1400
140
1200
135
1000
130
800
125
600
120
97
98
99
00
Sour ces: Wall S t r eet Jour nal, Feder al Reser ve Boar d / Haver Analyt ics
01
02
Housing Has Remained A
Bright Spot
New Plus Existing Home Sales
(Mi l l i ons)
7
7
6
6
5
5
4
4
3
3
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
The Consumer Has Remained
Relatively Active
Per sonal Consumption Expenditur es: Dur able Goods
% Change - Year to Year
SAAR, Bi l . $
20
20
10
10
0
0
-10
-10
-20
-20
88
89
90
91
92
93
94
95
Sour ce: Bur eau of Economic Analysis / Haver Analyt ics
96
97
98
99
00
01
02
As Income Growth Has
Outpaced Inflation
Per sonal Income Less Inflation (CPI)
YOY % Change
6
6
4
4
2
2
0
0
-2
-2
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
Consumer Confidence Has
Slipped Recently
Confer ence Boar d: Consumer Confidence
SA, 1985=100
160
160
140
140
120
120
100
100
80
80
60
60
40
40
85
90
Sour ce: The Conf er ence Boar d / Haver Analyt ics
95
00
Investor Fear Remains Very
High
Investor Anxiety Index
350.00
300.00
250.00
200.00
150.00
100.00
Ja A
J
J
J
O
J
A
J
O
A
O
J
A
n. pr. ul.8 ct . a n. pr. ul.9 ct . a n. pr. ul.9 ct . a n. pr.
86 87 8 8 9 91 92 3 9 4 96 97 8 9 9 01 02
Overall, Conditions Are Not
That Dire
The Miser y Index
Unempl oyment Pl us Infl ati on
24
24
20
20
16
16
12
12
8
8
4
4
65
70
75
80
85
90
95
00
Inflation Expectations Are
Increasing
Feder al Open Mar ket Committee: Fed Funds Tar get Rate
EOP, %
ECRI Futur e Inflation Gauge
1992=100
7
125
6
120
5
115
4
110
3
105
2
100
1
95
94
95
96
97
98
99
00
01
S our ces: Feder al Reser ve Boar d, Economic Cycle Resear ch I nst it ut e / Haver Analyt ics
02
Inflation Expectations Are On
The Rise
10-Year Tr easur y Bond Yield at Constant Matur ity
% p. a.
ECRI Futur e Inflation Gauge
1992=100
8
125
120
7
115
6
110
105
5
100
4
95
94
95
96
97
98
99
00
01
S our ces: Feder al Reser ve Boar d, Economic Cycle Resear ch I nst it ut e / Haver Analyt ics
02
Eurodollar Futures Indicate The
Fed Will Tighten Through 2003
3.00%
2.81%
2.48%
2.50%
2.00%
2.14%
1.82%
1.81%
1.78% 1.78%
1.78%
1.89%
1.50%
1.00%
0.50%
0.00%
September '02
January '03
Eurodollar Futures
December '0
CONCLUSIONS
• Real Estate Portfolio Theory
• Supply and Demand Analysis
• Real Estate Cycle Theory
• Current Economic Indicators