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5/26/2011

Real Estate Market Analysis: Why do it?


TOPIC 10
• “Real estate market analysis” refers to analyzing a variety of real estate
decisions.

– Where to locate a branch office?


– What size or type of building to develop on a specific site?
– What type of tenants to look for in marketing a particular building?
– What the rent and expiration term should be on a given lease?
Real Estate Market Analysis: Chicago – When to begin construction on a development project?
(Plus my overall market forecasts) – How many units to build this year?
– Which cities and property types to invest in so as to allocate capital where
rents are more likely to grow?
– Where to locate new retail outlets and/or which stores should be closed?

Broadly Speaking… Variables of Interest in Market Analysis

• Real estate market analysis usually requires quantitative or qualitative • To evaluate a real estate space submarket, analysts tend to focus on a few
understanding (& prediction) of both the demand side and supply side of the primary indicators that characterize both the supply and demand sides of the
space usage market relevant to some real estate decision. submarket and the balance (equilibrium) between them.

– Vacancy rate
– The focus might be micro-level, such as a feasibility analysis for a specific
site or property – Market Rent

– Quantity of new construction starts


– Or, the focus might be more general, such as a general characterization of
the supply/demand conditions in a particular space submarket. – Quantity of new construction completions

– Absorption of new space

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Vacancy Rate Market Rent


• By definition, the vacancy rate refers to the percentage of the stock of space • By definition, market rent is the level of rents being charged on typical new
in the market that is not currently occupied. leases currently being signed in the market.

– Vacancy Rate = Vacant Space/Total Space


– asking rents may differ from effective rents

– The vacancy rate reflects the balance between supply and demand.
– Market rent is another indicator of the balance between supply and demand
in a market.
– In most markets, it is normal for some vacancy to exist (the natural
vacancy rate) even when supply and demand are in balance.
– Can be tricky to measure because
• When actual vacancy rises above the natural vacancy rate, rents tend
to fall. • it is private information and

• When actual vacancy falls below the natural vacancy rate, rents tend
• lease terms may differ dramatically from tenant to tenant
to increase.

• Natural vacancy rate can be 6-12% • Result: Sometimes hard to get accurate “rent measures” – usually
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collected via surveys.

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Constructions Starts and Completions Absorption of New Space

• Construction is an important “supply side” indicator.


• By definition, absorption refers to the amount of additional space that becomes
occupied during a year.
– “Starts” indicate the amount of space currently in the “pipeline” and likely to
be added to the supply in the near future
• Absorption is a “demand side” indicator (i.e., does not account for amount of
– “Completes” indicate the amount of space just arriving in the market. supply available).

– Of course, we need to consider the net addition to supply (after taking – Gross absorption – total amount of space leased, regardless of where tenants
come from
demolition and renovations into account).

– Net absorption – net change in the amount of space occupied in a market.

• Positive net absorption rates: Demand increasing in market


• Negative net absorption rates: Demand falling in market

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The Concept of “Months Supply” Some Tips for Market Analysis

• The variables we just reviewed are commonly used indicators of supply/demand • Define the market carefully along geographic and usage dimensions,
conditions in space submarkets. recognizing that most metropolitan areas form markets that can be usefully
• The concept of “months supply” combines several of these variables to help us divided into smaller submarkets. The next slide describes how the Atlanta office
understand a market even better. market can be “divided.”
• By definition, months supply is the sum of current vacant space in the market
and new construction started but not completed, divided by 1/12 th of the annual
net absorption in the market. • Carefully consider the time period to be covered in the analysis
VacanctSpace  ConstructionSpace – 5 – 10 years into the future is desirable
Months Supply 
NetAbsorption /12 – 3 years is more feasible in most cases

• This measure tells how long it will take (in months) for all of the vacant space in • Recognize the differences between and the benefits of a simple trend
the market to be absorbed, driving the vacancy rate to zero. extrapolation and a structural analysis
– Analysts compare the months supply to the length of time it takes to – Trend extrapolation predicts the future purely based on historical trends and
complete new construction to see if the market can support a new project. If patterns
the months supply is much greater than the average construction period, the
market is “oversupplied.” Otherwise, it might be time to start a new project – Structural analysis attempts to predict the future by identifying and
in this market. quantifying the underlying determinants of market trends.
– Meaningless measure if net absorption is negative 9 10

Performing/Understanding a Market Analysis Recent “Hot” Office Property Markets

• In both types of analysis (extrapolation and structural) the steps are:

– First, inventory the existing supply and evaluate the pipeline.

– Second, relate the demand sources to the space usage demand.

– Third, forecast future demand for and supply of space

– Compare the forecasted demand for space with the forecasted supply of
space to see if the market will be “over” or “under” supplied in the future.

• In tight markets (under supplied, landlord market), we expect to see higher rents
and lower vacancy rates.

• In loose markets (over supplied, tenant market), we expect to see lower rents and
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higher vacancy rates.

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Recent “Cool” Office Property Markets U.S. Office Market Vacancies 2002Q1 – 2005Q1

(Average Gross Asking)

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U.S. Office Market Net Absorptions 2002Q1 – 2005Q1 Chicago Office Market (Downtown and Suburbs): 2005Q1

(Average Gross Asking) (Average Gross Asking)

Chicago Office Inventory (2004): 117 million sf


Chicago Office Vacancy(2005Q1): 15.7% (highest rate since 1996)
15 Downtown Vacancy (2005Q1) = 18.4% (21.4 million sf of space available for leasing) 16

Chicago Office Market (Downtown and Suburbs): 2005Q1 Chicago Office Market (Downtown): 2005Q1

Net absorption rate for downtown 2005Q1 was -1 million sf. 17 Construction Activity Due to Become Available in 2005-2006: 4 million Sq 18

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Asking Net Rent Prices Chicago 2004 Chicago Market Break Down

• Class A (prime): $18 - $25 per sf

• Class A (broad): $9 - $25 per sf

• Class B $7 - $15 per sf

• Predicted to fall further through 2005 given the high vacancy rates

• Concessions will increase (free month rent)

• Large amount of activity by tenants to extend leases (look in lower rates while
they have the power).

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Forecast from the Chicago Office Market (Downtown) Chicago Forecasts

• Imminent Demand
– No signs of a dramatic increase in demand on the local level (no industry
shift moving towards chicago)
– U.S. economy may be “fragile” – oil prices/global economic uncertainty
acting on a drag on U.S. economy (see recent trend in stock prices)
– Demand predictions “moderate” at best

• Supply
– Lots of slack in the office market (vacancies high and construction
continuing)
– Rents will not pick up for awhile (good for tenants).
– Still profitable to build (new construction is filling up quickly (at expense of
existing properties) – however rents in new construction still low).

• I would not develop office space in chicago at this time! Interest rates likely to
Chicago unemployment rate not decline (as of yet) – looking for a recovery? 21 rise (to fight inflation) – decreases returns to owning (along with low rents and
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high vacancies).

Chicago Office Forecasts Chicago Retail Forecasts

• Imminent Demand • Retail development is a better opportunity


– No signs of a dramatic increase in demand on the local level (no industry shift
moving towards chicago) – Vacancies are lower
– U.S. economy may be “fragile” – oil prices/global economic uncertainty acting on a
drag on U.S. economy (see recent trend in stock prices) – Effective rents have been increasing slightly
– Demand predictions “moderate” at best
• People still consuming in Chicago (both natives and tourists). Residential areas of
• Supply Chicago are still developing (south/west loop).
– Lots of slack in the office market (vacancies high and construction continuing)
– Rents will not pick up for awhile (good for tenants). • Interest rates will still likely increase – as a result, financing costs will still rise.
– Still profitable to build (new construction is filling up quickly (at expense of existing
properties) – however rents in new construction still low).

• I would not develop office properties in Chicago at this time! Interest rates likely to rise
(to fight inflation) – decreases returns to owning (along with low rents and high
vacancies).

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Other Markets: Downtown Office Boston Other Markets: Downtown Office Boston

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Other Markets: Downtown Office San Francisco Other Thoughts….

• My macro assessment

– Fundamentals “solid” not “strong”


– Oil and Inflation (has me worried)
– Consumers and Business (going strong)
– Government (too much debt)
– Net Exports (of no concern to me)

– Business investment is most stable! Lots of capacity to expand – they are hesitant
given past mistakes (late 1990s) and oil/political uncertainty.

• Residential Property Markets

– They will come down (either bubble burst or supply adjusts)


– Increase in interest rates may quicken this effect
– Re-adjustment will occur slowly (it always does)
27 – Will investors adjust to/plan for a higher (normal) interest rate regime? 28