ECONOMIC CHARACTERISTICS OF REAL ESTATE

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Real estate as an economic product / Relationship between supply, demand, and price / Supply factors / Demand factors / Market influences on supply and demand / Interpreting market indicators

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Real estate as an economic product

As an economic commodity, real estate is bought, sold, traded, and leased as a product within a real estate market. Like other products and services, real estate is:

• subject to the laws of supply and demand
• governed in the market by the price mechanism
• influenced by the producer’s costs to bring the product to market
• influenced by the determinants of value: utility, scarcity, desire, and purchasing power

Distinguishing features. In comparison with other economic products and services, real estate has certain unique traits. These include:

• inherent product value

Land is a scarce resource as well as a required factor of production. Like gold and silver, it has both inherent value and utility value.

• unique appeal of product

Since no two parcels of real estate can be alike (each has a different location), every parcel of real property has its own appeal. Likewise, no two parcels of real estate can have exactly the same value, except by coincidence.

• demand must come to the supply

Since real property cannot be moved, real property investors and users must come to the supply. This creates risk, because if demand drops, the supply cannot be transported to a higher demand market.

• illiquidReal estate is a relatively illiquid economic product, meaning it cannot always be readily sold for cash. Since it is a large, long-term investment that has no exact duplicate, buyers must go through a complex process to evaluate and purchase the right parcel of real estate.
• slow to respond to changes
  

Real estate is relatively slow to respond to market imbalances. Because new construction is a large-scale, time-consuming process, the market is slow to respond to increases in demand. The market is similarly slow to respond to sharp declines in demand, since the product cannot be moved and sold elsewhere. Instead, owners must wait out slow periods and simply hope for the best.

• decentralized, local market
  

A real property cannot be shipped to a large, central real estate marketplace. Real estate markets are thus local in nature and highly susceptible to swings in the local economy.

Relationship between supply, demand, and price

In a market economy, the primary interactions between supply, demand and price are: 

• if supply increases relative to demand, price decreases
• if supply decreases relative to demand, price increases
• if demand increases relative to supply, price increases
• if demand decreases relative to supply, price decreases

These relationships reflect simple common sense: if a valued product becomes increasingly scarce, its value and price go up as consumers compete for the limited supply. If there is an overabundance of a product, the price falls, as demand is largely met. On the other side, if demand for a product or service increases in

relation to supply, prices will go up as consumers compete for the popular item. If demand diminishes, the price drops with it.

The inverse of these principles also applies. By tracking a price trend, one can draw conclusions about supply and demand trends:

• if price decreases, demand is declining in relation to supply
• if price increases, demand is increasing in relation to supply

To assess price movements, the supply and demand of a product or service must always be considered together. It is always possible for demand and supply to rise and fall together at the same rate, with no detectable price change resulting.

For example, if demand for bicycles jumps a million units, and manufacturers easily produce the necessary new supply, there may be no increase in price. The price may even go down as manufacturers obtain better prices on the larger quantities of raw materials they now use.

Supply factors

Supply. In real estate, supply is the amount of property available for sale or lease
at any given time. Note that supply is generally not the number of properties available, except in the case of residential real estate. The units of supply used to quantify the amount of property available differ for different categories of property. These supply units, by property type, are:

• residential: dwelling units
• commercial and industrial: square feet
• agricultural: acreage

Factors influencing supply. In addition to the influences of demand and the underlying determinants of value, real estate supply responds to

• development costs, particularly labor
• availability of financing
• investment returns
• a community’s master plan
• government police powers and regulation

Demand factors

Demand. Real estate demand is the amount of property buyers and tenants wish to acquire by purchase, lease or trade at any given time. Units of demand, by property classification, are:

• residential: households
• commercial and industrial: square feet
• agricultural: acreage

The unit of residential demand is the household, which is an individual or family who would occupy a dwelling unit. Residential demand can be further broken down into demand to lease versus buy, and demand for single family homes versus apartments.

Residential demand can be very difficult to quantify. One measure is the number of buyers employing agents to locate property. Another measure is the net population change in an area, plus families that attempted to move in but could not.

 

The unit of commercial (retail and office) and industrial real estate demand is the square foot, further broken down into demand for leased space versus purchased space. In most instances, the area demanded refers to the improved area rather than the total lot area.

Demand for office and industrial real estate is calculated by identifying employment growth or shrinkage in a market, then multiplying the employment change times the average area of floor space a typical employee uses. For example, consider an office property market where employment in the community increases by 500 employees. If each employee uses an average of 120 square feet, the increased demand for space is 60,000 square feet.

Factors affecting demand. The demand for particular types of real estate relates to the specific concerns of users. These concerns revolve around the components of value: desire, utility, scarcity, and purchasing power.

 

Residential users are concerned with:

• employment
• quality of life
• neighborhood quality
• convenience and access to services and other facilities
• dwelling amenities in relation to household size, lifestyle, and costs

Retail users are concerned with:

• sufficient trade area population and income
• the level of trade area competition
• sales volume per square foot of rented area
• consumer spending patterns
• growth patterns in the trade area

Office users are concerned with:

• costs of occupancy to the business
• efficiency of the building and the suite in accommodating the business’s functions
• accessibility by employees and suppliers
• matching building quality to the image and function of the business

Industrial users are concerned with:

• functionality
• the availability and proximity of the labor pool
• compliance with environmental regulations
• permissible zoning
• health and safety of the workers
• access to suppliers and distribution channels

 

Base employment and total employment. The engine that drives demand for real estate of all types in a market is employment– base employment and total employment.

 

 

Base employment is the number of persons employed in the businesses that represent the economic foundation of the area. For example, the auto industry has traditionally been the primary base employer of the Detroit metropolitan area.

Base industries lead to the rise of supporting and secondary industries in the market. If the auto industry is the base, auto parts manufacturers and assembly industries will develop to support the auto manufacturing plants. In addition, service businesses emerge to support the many needs of the local population engaged in primary and secondary employment.

Thus, base employment feeds total employment. Total employment in a market includes base, secondary, and support industries. Total employment creates a demand for a labor force. From total employment derives demand for industrial and office space on the one hand; on the other hand, as employment grows, so grows the population, leading to the demand for housing and for retail support. In addition to creating demand for real estate, employment creates the purchasing power necessary for households to acquire dwellings and retail products.

Without employment, a real estate market evaporates, as there is no demand for commercial or industrial facilities, nor is there demand for retail services or housing. The best example of this phenomenon is a gold rush boom town: as soon as the gold runs out, there is no more mining. Without mining employment, everyone moves away and the town becomes a ghost town.

Market influences on supply and demand

Numerous factors in a market influence the real estate cycle to speed up or slow down. These influences can be local or national, and from the public or private economic sector.

Local market influences. Since the real estate market is local by definition, local factors weigh heavily in local real estate market conditions. Among these are:

• cost of financing
• availability of developable land
• construction costs
• capacity of the municipality’s infrastructure to handle growth
• governmental regulation and police powers
• changes in the economic base
• in- and out-migrations of major employers

National trends. Regional and national economic forces influence the local real estate market in the form of:

• changes in money supply
• inflation
• national economic cycles

In recent years international economic trends have increasingly influenced local real estate markets, particularly in border states, large metropolitan areas, and in markets where the economic base is tied to foreign trade. In these instances, currency fluctuations have significant impact on the local economy.

Governmental influences. Governments at every level exert significant influence over local real estate markets. The primary forms of government influence are:

• local zoning power
• local control and permitting of new development
• local taxing power
• federal influence on interest rates
• environmental legislation and regulations

A good example of government influence over the local real estate market is a city government’s power to declare a moratorium on new construction, regardless of demand. Such officially declared stoppages may occur because of water or power shortages, insufficiency of thoroughfares, or incompatibility with the master plan.

Interpreting market indicators

Real estate supply and demand, like supply and demand for other economic products, interact in the marketplace to produce price movements.

As the exhibit illustrates, prices, construction, and vacancy move up and down in the cycle. Construction represents the addition of new supply. Vacancy is the amount of total real estate inventory of a certain type that is unoccupied at a given time. Absorption is the amount of available property that becomes occupied over a period of time.

Taking the point of undersupply, or high demand, as a starting point in the cycle, vacancy is low and prices are high. This situation stimulates suppliers to construct additional housing or commercial space. New construction, by adding supply, causes vacancy to rise and prices to fall until supply-demand equilibrium results. As more new space is added, supply begins to outstrip demand, vacancy continues to rise, and prices continue to fall. At the bottom of the cycle, prices and vacancy are at unacceptable levels, and construction ceases. The market “dies” until excess supply can be absorbed. The absorption process continues through the equilibrium point until price and vacancy conditions are sufficiently attractive to encourage renewed construction. Then the cycle repeats.

Thus, by considering indicators such as vacancy rates, construction numbers, building permits, supply and demand factors, sales volume, and price levels over time, one can identify where a market is in the supply-demand cycle and gain some insight into what is coming next—whether prices will rise or fall, tending to favor buyers (buyers’ market) or sellers (sellers’ market); and by comparing submarkets within a market, one can identify trends in area preferences: which local areas are now or soon likely will be most sought out, which ones are falling into disfavor, and so on.