1. Real Estate Chapter 23

2. Students Should Be Able to:  Calculate the real and nominal cost of capital for real estate.  Analyze the effects of changes of different elements of cost of capital on rental yields and real estate prices.

3. Hong Kong Real Estate  According to the planning department rental yields on residential apartments are more than 5%.  Rental yields are the annual rent divided by the price level.  But interest rates on mortgage loans are 2.5%.  Why don’t people want to borrow at 2.5% to make 5.1% returns?

4. Property the ultimate non-traded asset!

5. Real Estate  Real Estate is an important type of physical capital investment and a special type of financial investment. Uniqueness- Each location of property is unique, making it harder to value. Illiquid – Harder to sell than paper financial assets, longer lead times for building real property. Large share of the wealth of middle income households.

6. Rental Yields & Cost of Capital  Payoff to owning property is rent, R.  Define rental yield, y, as the ratio of rent to property prices, P PE.  Capital cost of real estate includes Interest rate, i Depreciation/Maint enance Costs δ Property Taxes: τ Other Costs: c Capital Gains,

7. Cost of Capital Theory & Real Estate  Constructing New Buildings has long lead times. For a fixed stock of buildings we can use cost of capital theory (y = ck RE ) to derive prices as a function of rents.

8. Ceteris Paribas CurveP RE R ↑ →↑ i ↑ ←↓ δ ↑ ←↓ tw ↑ ←↓ c ↑ ←↓ ↑ →↑

9. Real Estate Pricing P RE 45% P*

10. Expectations  A key determinant of the price of real estate is the expected capital gain.  Expected deflation explains why rental yields are so much higher in HK than mortgage rates.  Waves of optimism and pessimism may lead to persistent fluctuations in property prices.

11. HK Property Prices

12. Credit Cycles: Real Estate  Much of corporate collateral is real estate.  Real estate is good collateral because it cannot be easily moved and its value is relatively easy for outsiders to derive.  Fluctuations in property price have effects on cost of capital and investment.

13. Adverse Economic Shock Declining corporate net worth Lower investment and reduced demand for real estate Falling Real Estate Prices Falling collateral values and worsening bank balance sheets lead to declining bank loans Fire sales of commercial property to pay back bank loans leading to further declines in prices The Financial Accelerator