1. 1 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin CHAPTER 8 LOCATION MAKES MARKETS ’INTERESTING, Competitive market conditions include: –product homogeneity –market freedom--low external controls –knowledgeable participants –many buyers and sellers who, individually, cannot influence market prices –products that are divisible and mobile

2. 2 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Real Estate Market Price Behavior Market imperfections may cause transaction prices to deviate from fundamental market values. Imperfections include: –imperfect knowledge –high transaction costs –limited number of buyers or sellers –short-run demand / supply imbalances due to location, regulation, or political constraints.

3. 3 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Location Theory Classical Location Theory –rent differences result from the accessibility of land to markets and users Neoclassical Location Theory –recognizes land as a factor of production, along with labor, capital, and entrepreneurial effort The Bid-Rent Curve

4. 4 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Location Theory Location Decision Factors of Households: –users seek to avoid transportation costs, thus having incentives to locate close to economic centers –the price of land decreases with distance from the economic activity centers within urban areas, and buyers substitute land quantity for location

5. 5 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Location Theory Location Decision Factors of Firms: –transportation costs proximity to customers proximity to suppliers proximity to work force –land requirements –type of service or product high-density / low-density demand weight-gaining / weight-losing production

6. 6 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin HOW SPACE MARKETS OPERATE Physical and Financial Asset Markets Functions of Space Markets: –to allocate existing space –to expand or contract space to meet conditions –to determine new uses for land Demand and Supply Model With Vacancy Va = S-D –natural vacancy

7. 7 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin HOW SPACE MARKETS OPERATE Demand and Supply Model With Vacancy Va = S-D Natural Vacancy Rents –equilibrium rent –net contract rent –effective contract rent

8. 8 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Housing Demand and Supply Factors Housing factors of demand include: –new household formations, age composition of new households, household income, and mortgage credit conditions. Housing factors of supply include: –prices of factors of production, productivity factors, number of builders in the market, and credit conditions.

9. 9 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Retail Demand and Supply Factors Retail factors of demand include: –number of consumers, customer income, consumer tastes and preferences, prices of substitute products, and credit conditions. Retail factors of supply include: –prices and productivity of factors of production, number of developers, developer expectations, and credit conditions.

10. 10 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Office Demand and Supply Factors Office factors of demand include: –number of local firms, types of business of local firms, growth in local firms, and office space square feet per employee. Office factors of supply include: –similar to retail market supply factors.

11. 11 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin THE ASSET MARKET Real estate values vary according to their physical characteristics, their locations, and the economic conditions of the market. Real estate values depend on income expectations and its relative riskiness.

12. 12 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin THE ASSET MARKET Prices and Value Price = PV of the expected cash flows Prices vary according to conditions in the capital market—this affects the discount rate, E(R j ). E(R j ) = R f + RP j –RP f, denotes the required risk-free rate –RPj, denotes the required risk premium

13. 13 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin THE ASSET MARKET Tobin’s Q Q (real estate) = Price (or value) Replacement Cost –If Q > 1, opportunity exists to develop competing properties and sell them for abnormal profits. –If Q < 1, properties are inexpensive relative to their replacement cost. ‘Noisy’ Prices Interaction with Securitized Market

14. 14 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Space and Asset Market Interaction The Economic Fundamentals Matter –Events in space markets that determine rents and variations in rents are fundamentally linked to values in the asset market. –Events in capital markets that affect interest rates and the relative attractiveness of all types of assets as investments affect real estate values.

15. 15 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Space and Asset Market Interaction Government Influences Do the Individuals Matter? –The reservation price is the price the seller is willing to accept in negotiating a transaction. –The offer price is the price the buyer is willing to accept in negotiating a transaction. Speculative Bubbles and Cycles