BFX3355 Property Investment
Lecture 1: Real Estate Space & Asset Markets
Department of Banking and Finance
Monash University
Content
• Course Syllabus
• The Real Estate Space Market
• The Real Estate Asset Market
Overview of the Course
Why do you want to study property investments?
•
What is the role of Property Investment in my degree program?
o It is a specialist subject focusing on the asset class of property
o We consider property in relative to the other asset classes which compete for investor capital
•
Why is property special among all asset classes?
o It is a real asset – what does this imply?
o It can be a combination of consumption and investment
•
How do we make money through property investment?
o Rental income
o Capital gain
Why Invest in Real Estate?
Another Investment Option with Different Return & Risk Profile?
Investment Concern
Cash (T-bills)
Long-term Bond
Real Estate
Stock
Risk
Lowest
Low to Moderate
Low to Moderate
High
Total Return
Lowest
Moderate
Moderate
High
Current Yield
Moderate
Highest
High
Low to Moderate
Growth
None
None
Low
High
Inflation Protection
Best
(Mostly) Bad
Good
Good
Source: Geltner et al., 2014
Why Invest in Real Estate?
Compare RE with Long-term Government Bonds (U.S.)
Concept Check: What is Yield? What is the Yield Gap?
Source: Moody’s RCA, Bloomberg, Nareit, Quantum Real Estate Advisors
Why Invest in Real Estate?
Real Estate in Portfolios – Diversification?
Source: UniSuper
Overview of the Course
What does this course cover?
•
How can we value a property?
o The urban economics perspective (supply and demand)
o The asset pricing perspective (risk and return) – the main focus of the course
•
The focus of the subject is on commercial property, not residential property
o We will cover some topics on residential properties in the last 2 weeks
•
How do we teach you to invest in property?
o Through fundamental analysis (understand what this implies): ‘Value’, ‘Market Price’, ‘Yield’ & ‘NPV’
o Knowledge in financial mathematics is required for the course!
Overview of the Course
Teaching Activities
• Lectures are used to present new concepts and theory related to property
o Any financial math techniques used in property are reviewed
• Workshops will be introduced to the in-depth application of financial math in property
o When presented with property financial math, you may initially find it unfamiliar and incorrectly
conclude it as new.
o The financial math in this course is NOT new and has been taught in pre-requisite subjects. It
is the application of the math into a new context, property, that is novel & different.
o Through the exercises, you will gain real competence in applying financial math to property
industry
o Prerequisites course: Corporate Finance I
Overview of the Course
Tentative Topics
Week
Topic
1
Space and Asset Markets
Workshop Exercise 1
2
The Real Estate System
Workshop Exercise 2
3
Central Place Theory & Economic Base Analysis
Workshop Exercise 3
4
Real Estate Risk and Return
Workshop Exercise 4
5
Role of Leverage in Property Investment
Workshop Exercise 5
6
Property Taxation
Workshop Exercise 6
7
Valuation and Investment Analysis
Workshop Exercise 7
8
Indirect Property Investment
Workshop Exercise 8
9
Leasing Strategies
Workshop Exercise 9
10
Understanding Residential Property
Workshop Exercise 10
11
Evaluating Residential Property
Workshop Exercise 11
12
Unit Review
Unit Review Consultation
Overview of the Course
Assessment
• Within-semester Assessment: 100%
Assessment Task
In-your-own-time Moodle Quiz 1
Team Project
In-your-own-time Moodle Quiz 2
Value
Due Date
25%
Due in Week 5
• Format: Multiple-choice questions
• Cover Lectures 1-4 and Workshops 1-4
30%
Due in Week 9
• 4-5 students per group;
• Excel-based Valuation of Commercial Property
45%
Due in Week 12
• Format: Multiple-choice questions & Excel-based questions
• Cover Lectures 5-11 and Workshops 5-11 (concepts in previous
lectures might be applied though)
Overview of the Course
Is this BFX3355 a suitable elective for your learning objective?
• BFX3355 might be a challenging unit, because:
o Require advanced financial math (around 40% theory + 60% calculation)
o Require using Excel as the unit financial calculator for exercises and exams
o Difficult to catch up if you miss lectures and tutorials: Terminology is unique to the property
domain
o Cannot cram in the exam week only: The course is 100% within-semester assessment
• The course will be offered every semester
o Plan your schedule!
o The teaching team will try our best to ensure you a good learning experience!
Overview of the Course
Collaboration with the Industry
For competition details go to: https://propconnex.com.au/
FMAA Monash Branch for further details: https://www.fmaa.com.au/branch/monash
Overview of the Course
A Few Additional Notes
•
Textbook
o Geltner, D. M., Miller, N. G., Clayton, J., & Eichholtz, P. (2014). Commercial Real Estate Analysis
and Investments (3rd ed.).
o The first 3 weeks (for Topics 1 - 3) of textbook readings will be provided on Moodle, in case of late
delivery when purchasing a physical copy online
•
Email Correspondence
o Send all email enquiries to your tutor. See Unit Dashboard on Moodle for details.
•
Consultation
o For questions about the course material, please attend one of consultation times with unit staff
o Questions about course material required a back-and-forth conversation and will NOT be
addressed via email
Content
• Course Syllabus
• The Real Estate Space Market
• The Real Estate Asset Market
The Real Estate Space Market & Asset Market
What is “real estate”, or “properties”?
• Real estate contains two components:
o Land & built space attached to the land
• Value of Land:
o Usually appreciate over time. Why?
o Watch out for inflation!
• Value of Built Space:
o Buildings or other improvements on the land
o Usually depreciate over time. Why?
The Real Estate Space Market & Asset Market
What defines a “market”?
• A market is a place where parties can gather for the voluntary exchange of goods and services
(Investopedia).
• What is difference between the “public” and “private” markets?
• Which type of market applies to real estate? Private or Public?
The Real Estate Space Market & Asset Market
Two types of markets relevant to commercial property
• The Real Estate Space Market:
o Trade for the usage (or right to use) “real property” for a certain period
o Also called the “usage market”, or “rental market”
o e.g., tenants & landlords exchange money for leases
• The Real Estate Asset Market:
o Trade for the ownership of “real property”
o Also called the “property market”
o e.g., a pension fund purchases an office building
• Why do we separate these two markets?
o Trade for different “goods”, resulting in different supply and demand!
The Real Estate Space Market
Two Outcomes of the Space Market: Rent and Occupancy
• What is Rent?
o The price of the right to use space for a
specified temporary period
o Quoted as “per area” (e.g., sqm) – Why?
Demand:
Supply:
Property Owners
(Landlords)
Space
Market
• What is Occupancy?
o The percentage of space being rented over
a specific temporary period
o Spatial: e.g., vacant shops in a mall
o Temporal: e.g., a flat on Airbnb
Outcomes:
Rents
Occupancy
Property Users
(Tenants)
The Real Estate Space Market
The space market is highly segmented!
• A market is “segmented” if it breaks up into sub-markets, or market segments.
o By property types: residential, industrial, retail, office, etc.
o By location: city center and sub-urban
• Within each sub-market or segment, there exist different supply and demand.
o Different equilibrium rents and occupancy
• Why is the real estate space market highly segmented?
The Real Estate Space Market
The demand-side reason of segmentation
• Users require specific types of space…
o An accountant can’t use a warehouse
o A trucking firm can’t use a high-rise office building
• Users require specific locations (or types of locations)…
o An accountant won’t get much business at the intersection of Clayton & Dandenong Roads
o A trucking firm’s trucks would spend all their time stuck in traffic if their warehouse is in the
CBD
The Real Estate Space Market
The supply-side reason of segmentation
• Buildings are of specific physical types
o and (normally) they cannot easily be converted
o e.g., warehouses cannot be used as high-rise offices
• Buildings are in specific locations
o and they cannot move!
The Real Estate Space Market
Two Major Dimensions of Space Market Segmentation
• Geographic location:
o Basic unit is the “metropolitan area”
o Smaller sub-markets (e.g., CBD, Suburbs, Council Zones) also important
• Property segments:
o Residential; Office; Industrial; Retail; Hotel; Broadacre/Rural, etc.
o An overview of different property segments in Australia:
https://www.cbre.com.au/insights/books/australia-real-estate-market-outlook-2021
The Real Estate Space Market
Examples of Space Market Performances, by Market Segments
Industrial & Logistics Midpoint Yields (2022 Q3)
Source: CBRE Research
Large Format Retail Midpoint Yields (2022 Q3)
The Real Estate Space Market
Demand Curve follows the standard economic model
• Normal demand curve is downward sloping
$25
o How to interpret it?
GROWTH IN DEMAND
OVER TIME
• If the employment population increases:
o How will the demand curve shift?
o Given a fixed quantity of space, how will the
rent change?
REAL RENT
$20
N EE
$15
N EE
D =2 4
000 W
OR K
D =36
000
W OR
KER
S
ER S
$10
$5
3.5
4
4.5
5
5.5
QUANTITY OF SPACE (Mil. SF)
6
6.5
The Real Estate Space Market
Supply Curve has a more peculiar shape: It is “kinked”!
• For normal consumption goods (not property),
the supply curve is upward sloping
$25
REAL ESTATE SUPPLY CURVE
• In the short run, the supply is “inelastic”!
o The black vertical line in the graph (why?)
o e.g., when rent moves from $10 to $8 (or 12$),
the supply in the market is not changed (= 5).
$20
REAL RENT
• However, buildings are unique due to longevity
o You cannot easily subtract them
o Huge (re)development costs are needed before
adding supply
R ISIN G
KINK
L R MC
$15
If $12
EXISTING
QUANTITY
$10
F AL L I
N G LR
MC
Current Rent: $10
If $8
$5
3.5
4
4.5
5
5.5
QUANTITY OF SPACE (Mil SF)
6
6.5
The Real Estate Space Market
In the long run, when will the supply of space respond to rent changes?
• To answer this question, we first need to learn a new concept: “Capitalization (Cap) Rate”
• Cap Rate represents the current yield on property investments:
Cap Rate =
Income
Net Operating Income (NOI)
=
Asset Value
Property Price
o Note: Difference between Trailing Cap Rate and Forward Cap Rate (think about P/E!)
• Investments are priced based on required yield
• Market value of a property can be estimated as:
Net Operating Income (NOI)
Property Price =
Cap Rate
The Real Estate Space Market
Where is the “Kink” in the Supply Curve? Rent  Price  Development
• In the long run, when rent becomes higher than
the “kink”, developers build new properties
$25
REAL ESTATE SUPPLY CURVE
$20
REAL RENT
• What encourages the development of new
property?
o When developers can sell the new property for a
price higher than the development cost
KINK
L R MC
$15
F AL L I
N G LR
EXISTING
QUANTITY
$10
• Break-even: property price = development cost
o Property price is determined by income (rent)
o Rent increase  Market price higher than
development cost  Development
R ISIN G
MC
Current Rent: $10
$5
3.5
4
4.5
5
5.5
QUANTITY OF SPACE (Mil SF)
6
6.5
The Real Estate Space Market
Where is the “Kink” in the Supply Curve? A Numerical Example
• Dandenong Industrial Property Market (2012 – 2014)
o Cap Rate: 10%
o Development Cost (per sq. m.): $4,800
• Break-even Price of a new property: $4,800 per sq. m.
• To achieve the Break-even Price, the property has to earn a rent of:
NOI
NOI
Cap rate =
,
10% =
,
NOI = $480
Price
4800
• Given the required property yield (cap rate), the rent that provides the break-even price for
property development is called the Replacement Cost of Rent.
The Real Estate Space Market
Implications of the “Kinked” Supply Curve
• Why is this “break-even” rent called the Replacement Cost of Rent?
o Given the yield investors require to earn on the property, this “break-even” rent allows for a
property price that equals the development cost; i.e., replacing the cost.
• Implications of the Replacement Cost of Rent:
o If rent < replacement cost, new development will NOT occur. This will result in the stock of
space falling over the long run, because the current stock will depreciate gradually due to wear
and tear. Rent will then increase due to the shortage of supply.
o If rent > replacement cost, new development will occur. This will likely result in the stock of
space rising over the long run. Rent is then likely to decrease due to oversupply.
o “Negative” feedback loop that stabilizes the market.
The Real Estate Space Market
After moving above the “kink” point: Long-run Marginal Cost (LRMC)
• The supply function for any competitively
supplied market:
o the marginal cost function for producing an
additional product
REAL ESTATE SUPPLY CURVE
$20
REAL RENT
• For the supply in the space market:
o LRMC = marginal cost of developing new
buildings
o This cost includes land acquisition
o It is usually upward-sloping: scarcity of land
o But it can be falling when a location loses its
centrality
$25
KINK
R ISIN G
L R MC
$15
F AL L I
N G LR
MC
EXISTING
QUANTITY
$10
$5
3.5
4
4.5
5
5.5
QUANTITY OF SPACE (Mil SF)
6
6.5
The Real Estate Space Market
Forecasting Future Rents: Would the new development really turn out to be profitable?
• Need to forecast changes in both future demand
and future supply
Real
Rent
D1
• Example:
D3
o The rent of apartments in Melbourne CBD in 2018: $480
(D1 and Yellow Curve)
$480
o Developers expected demand would increase from D1 to
D2 in 2020, so they build more from S1 to S2
$400
o Once constructed, a new kinked supply curve is formed
(yellow to red)
o Expected rent in 2020: $480 (D2 and Red Curve)
o However, demand did not shift as expected: Rent = $400
o During COVID, demand shifted to D0: Rent = $300
D2
$300
Addition of New
Built Space
S1
S2
Quantity of Space (million sq. m.)
Content
• Course Syllabus
• The Real Estate Space Market
• The Real Estate Asset Market
The Real Estate Asset Market
Not much segmented like the space market!
• Real Estate Assets = Future Cash Flows
o “Cash is fungible.”
o Cash is cash, whether it comes from real
estate, stocks, or bonds.
• The real estate asset market is part of the
broader capital market.
o It “competes” against other investment
options like stocks & bonds.
• Investors care about yield and risk
o Not much segmented – why?
Demand:
Supply:
Investors
Wanting to Sell
Asset
Market
Outcome:
Property Price
Based on the Cap Rate
(Required Yield)
Investors
Wanting to Buy
The Real Estate Asset Market
Three Determinants of Cap Rates (1)
1. The Opportunity Cost of Capital (OCC)
o
How much return can investors expect to earn in other types of investments, like stocks,
bonds, money market?
o
With higher interest rates or higher expected returns in other types of investments, investors
will require higher expected yields in real estate, and therefore higher cap rates, other things
being equal.
o
This comes from the capital market.
The Real Estate Asset Market
Three Determinants of Cap Rates (2)
2. Growth expectations in the property’s future cash flows
o
How much can investors expect that this property’s net cash flow (rents - expenses) will be
able to grow over the coming years?
o
Higher (realistic) growth expectations will allow a lower cap rate, as investors will be willing to
pay more $ today for a given amount of current net income, in order to own the property
(since this income is expected to grow in future).
o
This comes from the space market.
The Real Estate Asset Market
Three Determinants of Cap Rates (3)
3. Risk perceptions and preferences among investors, regarding the property.
o
How risky is an investment in this property, and how much do investors care about that risk?
o
Property investments with greater risk will require higher cap rates (lower asset values per $
of current income).
o
This comes from both the space market and the capital market (risk is relative).
Summary of the Real Estate Space & Asset Markets
Financial Capital vs. Physical Capital
• Physical Capital: Physical assets that produce goods or services over an extended period
o Heterogenous and relatively immobile
• Financial Capital: “Money”
o Fungible and very mobile
• Why do we consider real estate in two types of markets?
o The space market deals with physical capital
o The asset market deals with financial capital
o Financial capital is used to purchase physical capital assets in the asset market, and then
physical capital assets generate income in the space market