The Real Estate market and theories of supply and demand

United States commercial Real Estate values have decreased significantly according to some reports, up to 40 percent across all property types since their peak in 2007. Job losses and declining consumer spending in 2009 have had a negative impact on all classes of real estate investments, particularly office and retail properties. Vacancies are up, which drives down rental rates and decreases value (Robert T. O’Brien). Real Estate values tend to move in cycles, mirroring the economy as a whole. With a high level of employment and regular salaries increases, demand for housing and other forms of Real Estate will increase and prices will follow suit. When the unemployment rat rises and wage levels stagnate or decrease, the rate of mortgage loan foreclosures will increase. As more properties become available yet fewer persons are able to afford them, market values decline. When economic conditions become more favorable, market values are stabilized and, as conditions continue to improve, may begin to rise once again.

For Real Estate or any product to have value, there are four elements that create value and must be present. “These elements are demand, utility, scarcity, and transferability (DUST). The Element of demand is present when someone wants the property and has the financial ability to purchase it. Utility means that the property can serve a useful purpose. Scarcity is present when the property is in short supply relative demand. Transferability means that title to the property can be moved readily from one person or entity to another. When all four elements of value are present, property has a value that may be estimated by an appraiser” (Stephen I. Burr).

The market for Real Estate is simply a place for selling and buying, that is, a means for bringing together buyer and seller. The function of a market is to provide a setting in which supply or demand can establish market value, making it advantageous for buyers and sellers to trade. “The number of buyers and sellers frequently moves away from a state of equilibrium to create either a seller’s market (many more buyers than sellers) or a buyer’s market (many more buyers than sellers). Real Estate is intensely regulated, with regard both to the uses to which it can be put and to the manner in which its ownership can be transferred” (Stephen I. Burr). As a result of all these factors, as well as the fact that Real Estate is permanent, prices can be highly volatile. The most important single factor in determining Real Estate value, however, is location.

In Real Estate supply and demand continually interact in the market to create and maintain price levels. Fundamentally, when supply goes up, prices drop as more sellers compete for buyers, when demand increases, prices increase as more buyers compete for the product. When both supply and demand increase, Real Estate prices tend to remain stable. Although no one can accurately predict changes in real estate values, understanding what causes prices to go up and down can be helpful to the real estate practitioner. The level of activity in a Real Estate market is influenced by the changes in the economic and demographic factors that underlie demand and supply. Market analysis is basically and examination of these factors to forecast the impact of their changes on the price and the quantity outcomes in the market. When the level of demand increases, and this increase is accompanied by a relative smaller change in supply either and increase or a decrease, the analyst can forecast an increase in price as well as an increase in the number of units offered for sale.

Demand can be defined “as the amount of goods consumers are willing and able to buy at a given price during a given time period. In real estate, demand is based on the benefits that can be derived from using land for a specific purpose. For example, an investor who buys a corner lot in a business district to construct an office building buys the land for the rental income it will generate” (“Liberal Economy”). The local demands for housing, retail, and office space are determined in part by the economic growth of the community. Market analysts seldom prepare detailed and complete analyses of local economic conditions. Instead they generally use studies prepared by planning commissions or other public agencies. The output of such studies usually includes current employment and population estimates and forecasts which encompass changes in employment and population. Such data are basic inputs to the analyses of local housing, retail, and office space needs. (“Liberal Economy”).

Some factors that have a tendency to affect the demand for Real Estate include population, demographics, and employment and wage levels.

Refuge is a basic human need. As population grows the demand for housing grows along with it. As housing needs to increase, the demand for industrial and commercial areas should also increase. Although the total population of the country continues to rise, the demand for real estate increases faster in some areas than in others. “In some locations, however, growth has ceased altogether or the population has declined. This may be due to economic changes (such as plant closings), social concerns (such as the quality of schools or a desire for more open space), or population changes (such as shifts from colder to warmers climates). The result can be a drop in demand for Real Estate in one area, matched by an increased demand elsewhere” (“Silve Oak Managing Partners, LLC”).

Demographics: “The study and description of a population is demographics. The characteristics of the population in a community are major factors in the quantity and type of housing in demand. Family size, the ratio of adult to children. The number of retirees, family income, lifestyle, and the growing number of single parent and empty nester households are all demographics factors that contribute to the amount and type of housing needed” (“Silve Oak Managing Partners, LLC”).

Employment and Wage levels: Decisions about whether to buy or rent and how much to spend on housing are closely related to income. When job opportunities are plentiful, wages are competitive, and an employee feels secure in a job, demand for housing is likely to increase. When job opportunities are scarce or wage levels low, demand for real estate usually drops. The market might, in fact, be affected drastically by a single major employer’s moving in or shutting down. Therefore, licenses must be aware of the business plans of local employers (“Silve Oak Managing Partners, LLC”).

Supply can be defined “as the amount of goods offered for sale within the market at a given price during a given time period. To be a part of the available supply, land must be readily adaptable to the desired purpose at a price market will bear” (Hassem Nadji). Some factors that have a tendency to affect the supply in the Real Estate market include the labor force, construction costs, and government controls and financial policies.

Construction costs and the Labor Force: When a shortage of skilled labor and building materials occurs, or when there is an important decrease in the amount of new construction; There is an impact in labor supply and price levels depend on the degree to which higher costs can be passed on to the buyer in the form of higher prices. As technology advances, materials become less expensive and more efficient; this may counteract the increase in prices. (“Silve Oak Managing Partners, LLC”). The distinguish feature is that the supply of new housing units is affected primarily by construction costs. As the prices of the factors of production (land, labor, equipment, loans, and materials) increase, the supply in the new housing market decreases. On the other hand, the supply in the Real Estate market for existing units offered for sale is affected primarily by the size of the existing stock and the expectations and aspirations of the owners of Real Estate. In addition, economic and demographic factors affect the owner’s willingness to sell their existing housing units.

Government controls and financial policies. “The government’s monetary policy can have a substantial impact on the real estate market. The Federal Reserve Board establishes a discount rate of interest for the money it lends to commercial banks. That rate has a direct impact on the interest rates the banks in turn charge to borrowers. These interest rates play a significant part in people’s ability to buy homes. Virtually any government action has some effect on the real estate market. For instance, federal environmental regulations may increase or decrease the supply and value of land in a local market. Real estate taxation is one of the primary sources of revenue for local governments. Policies on taxation of real estate can have either positive or negative effects. High taxes may deter investors. On the other hand, tax incentives can attract new businesses and industries. And, of course, along with these enterprises come increased employment and expanded residential real estate markets” (“Silve Oak Managing Partners, LLC”)

“Local governments also influence supply. Land use controls, building codes, zoning ordinances, and taxation policies help shape the character of a community and control the use of land. Careful planning helps stabilize and even increase real estate values. The dedication of land to such amenities as forest preserves, schools, and parks also helps shape the market. “They can have either positive or negative effects. High taxes may discourage investors. On the other hand, tax incentives can attract new businesses and industries by eliminating or reducing their taxes. (“Silve Oak Managing Partners, LLC”)

Many economists consider Real Estate cycles to be a mirror of reflection of the economy. As one of the three major factors of production such: as land, labor and capital. “Demand for Real Estate is necessary and important part of economy growth. As the population of the world grows, these additional people need a place to eat, work, sleep, shop, and be entertained, which constantly increases the amount of space needed. Many consider Real Estate a cyclical industry because its demand side is affected by economic cycles and supply historically lags demand” (William C. Wheaton).

Over the years, business activity as measures by gross domestic product (GDP) has had its ups and downs. These irregular fluctuations in activity are called business cycles. They are caused by both internal forces such as employment levels and consumer and investment spending and external forces such as wars, oil embargoes, and global economic forces. The business cycle generally can be characterized by four stages: expansion, recession, depression, and revival. Movements within the cycle generally are gradual but can be very sudden.

To evaluate the business cycle, a number of trends can be considered at the same time. “The long term trend (referred to as the secular trend) tends to be smooth and continuous. It is most affect by basic influences such as population growth, technological advances, capital accumulation, and so on. Within this overall pattern are business cycles of varying lengths. Various segments or industries within the economy may have shorter cycles with different characteristics. Generally, residential real estate sales data reflect seasonal cycles with increases during spring and summer months influenced by climatic conditions, vacation patterns, school schedules, and similar factors” (William C. Wheaton).

The Real Estate market generally is slow to adjust to sudden variations in supply and demand. The product cannot be transferred to another market, so an oversupply usually causes prices to drop. Because there is considerable lag time between the conception of real estate development and completion of construction, increases in demand may not be met immediately. Additionally, the number of housing starts can lead the economy either into a recession or out a depression because the housing industry is very sensitive to changes in interest rates. A tight monetary policy during a period of expansion of inflation may drive the housing industry into a recession before affecting the rest of the economy. In contrast, an easy monetary policy, which results in lower interest rates, spurs consumer buying of residential real estate an may enable the home construction sector to lead the economy out of a recession.

Retail is expected to fare a little better in 2010 than it did in 2009. Consumer spending has improved, as evidenced by better-than-expected holiday sales and four consecutive months of increases in consumer spending through March 2010. Single family home prices seem to have solidified (although it could take years for home values to truly recover), which has a big impact on retail spending. There are some indications that retail real estate may be in a position to recover before the office market. In fact, healthy retailers view 2010 as an opportunity to enhance their current space, move stores to higher traffic locations or selectively expand both great pricing and strategic locations are available to retailers with ready capital. Furthermore, industrial has been hurt by the recession and resultant corporate cost reductions, with many companies closing facilities and reducing warehouse space. Tight financing and weak demand for space have also slowed any recovery, with several quarters needed to absorb existing supply.

While the hospitality and residential markets may have bottomed out, demand recovery will be slow. However, with virtually no new supply of hotels and multifamily residential coming online in the next few years, demand growth should set the table for an overall recovery.

Finally, a turnaround in the multifamily residential market could take hold in the second half of 2010, but it will depend primarily on job growth. Apartment vacancies hit a 30 year high in fourth quarter 2009 and rents fell 3 percent last year, according to The Wall Street Journal, as many young, laid off workers moved back home or doubled up to ride out the recession. One positive for multifamily property owners is continued weakness in the single family home market. The decline in home values, combined with stricter lending by banks, means fewer people are able to buy homes. Concurrently, falling rents make apartment rentals an attractive alternative. Many analysts believe that the level of homeownership, which rose to record highs in the past decade due to relatively easy and affordable mortgage financing, will return to more historical levels, which should help multifamily demand (Robert T. O’Brien).

Capital is available and waiting to deploy, and the financing environment has improved somewhat (although it still has a long way to go), yet most commercial real estate investors have waited on the sidelines for a sense that values have reached bottom. Many of these investors may remain sidelined until employment figures and consumer spending numbers improve consistently and spur a subsequent resurgence in real estate. However, some deal making that was evident during 2009 bodes well for 2010 (Robert T. O’Brien).

Most real estate asset classes are expected to bottom out and start to recover in 2010. Rent levels will begin to recover with sustained job growth and increases in consumer spending and gross domestic product (GDP) that had begun to appear in the first quarter of 2010. Hospitality and multifamily residential properties are already showing some indicators of stabilization, and may be the first to show recovery due to the relatively short term nature of their leases. The recovery for retail, office and industrial properties will be slower, a result of the longer term leases for those properties.

As the economic recovery begins to gain traction, much of real estate’s revival will depend on the pace and strength of job growth. Some opportunistic buyers and realistic sellers will complete deals in 2010 that could prove to be very positive for investors. Realistically, however, it will be 2011 or 2012 before the United States sees significant increases in real estate value and a corresponding uptick in the industry as a whole.