Chapter 2:

The Real Estate System

 The Real Estate System

System
1. The development industry

2. Overview of the R.E. “system”

3. The “4-Quadrant” model (4QM)

4. Using the 4QM to understand “boom & bust”

cycles in R.E.

2.1 The Commercial Property

Development Industry

Industry
Financial
Resources
Development New
Industry Built
Physical Space
Resources
 The Development Industry

Industry
Development is a creative, entrepreneurial
process characterized by…

Vision

Greed

Cooperation

Risk

(All the most entertaining features of American

capitalism.)
 Development (cont.)…
z Cooperation:
• Between public & private sectors;

• Between developers & financiers.

z Risk:
• Even an economy in recession needs an
existing stock of built space.

• New space (need for development) results

only from economic growth &/or change.
 Development (cont.)…
R.E. Development is therefore dealing with
the dynamic “cutting edge” of the physical
built environment.

This makes development the most cyclical

branch of the real estate industry…
Exhibit 2- 1 US commercial property construction
starts by property type as percent of existing stock…
2.2 The Real Estate System

System
Exhibit 2-2: The “Real Estate System”: Interaction of the Space Market, Asset Market, & Development Ind
Industry
ustry

SPACE MARKET
LOCAL
SUPPLY DEMAND &
ADDS (Landlords) (Tenants) NATIONAL
NEW ECONOMY

RENTS
&
OCCUPANCY FORECAST
FUTURE

DEVELOPMENT
INDUSTRY
ASSET MARKET
IF IS SUPPLY
YES DEVELPT CASH
(Owners
PROFITABLE FLOW
Selling) CAPI
?
TAL
PROPERTY MKT MKTS
CONSTR MARKET REQ’D
DEMAND
COST VALUE CAP
(Investors
INCLU RATE
Buying)
LAND

= Causal flows.

= Information gathering & use.

 “Negative feedback

loops”…

loops”…
Mechanisms within a system that tend to
dampen the changes in the system, helping
to keep it in control, preventing it from
spiraling out of control.
 Example:

A thermostat puts a negative feedback loop into a

heating and cooling (HVAC) system in a building.

• When the temperature in the building gets

too low, the thermostat triggers the heater.

• When the temperature in the building gets

too high, the thermostat triggers the air
conditioning.

The result is that the building temperature

remains “under control”, within a comfortable
temperature range.
 Concept check:

check:
How do the development industry and the real estate
asset market work together to provide a (long-
run) negative feedback loop in the Real Estate
System?…

How can “forward-looking” behavior (good

forecasting of the space market) in the
development industry and R.E. asset market
(capital market) improve this negative feedback
loop?…
2.3 The “4-Quadrant Model” (4QM)…

(4QM)…
 Exhibit 2-3: The DiPasquale-Wheaton 4-Quadrant
4-Quadrant Diagram…
D
Rent $

Space Market:
Asset Market:
Rent Determination
Valuation

R*
D

Price $ P* Q* Stock (SF)

C*
Asset Market:
Construction Space Market:
Stock Adjustment

Construction (SF)
2.4 Using the 4QM to help understand “boom &
bust” cycles…
EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY

PRICES OVER THE LAST QUARTER-CENTURY . . .

.
Price Level Index U.S. Institutional Real Estate

2.0
1.8
Overbuilding Tax reform
1.6
S&L Dereg Disinflation
1.4 Boom, Tax incentives
S&L Crisis: FIRREA
1.2 ERISA: MPT
=>P.F. demand Recession
1.0 REITs
inflation fears
Securitizatn:
0.8 REIT bust,
- REITs
Recession
0.6 - CMBS
0.4
0.2
0.0
69 71
73 75 77
79 81
83 85
87 89
91 93
95 97
99
 Exhibit 2-4a: Effect of Demand Growth in Space Market:

Rent $
Space Market:
Asset Market:
Rent Determination
Valuation

D0 D1

R*

Price $ P* Q* Stock (SF)

C*
Asset Market:
Construction
Space Market:
Stock Adjustment

Construction (SF)
 Exhibit 2-4a: Effect of Demand
Demand Growth in Space Market: First phase…

Rent $ Can this be a long-

Space Market:
Asset Market: run equilibrium
Rent Determination
Valuation result?…
D0 D1
R1 Doesn’t form a
rectangle.

R*

Price $ P1 P* Q* Stock (SF)

C*
Asset Market:
Construction
Space Market:
Stock Adjustment

Construction (SF)
 Exhibit 2-4a: Effect of Demand
Demand Growth in Space Market: LR Equilibrium…

Rent $
Space Market:
Asset Market:
Rent Determination
Valuation

D0 D1
R1
R**

R*

P**
Price $ P1 P* Q* Q** Stock (SF)

C*
Asset Market:
Construction
C** Space Market:
Stock Adjustment

Construction (SF)
 Exhibit 2-4a: Effect of Demand
Demand Growth in Space Market: LR Equilibrium…

Rent $
Space Market:
Asset Market:
Rent Determination
Valuation

D0 D1
R1
R**

R*

P**
Price $ P1 P* Q* Stock (SF)

C*
Asset Market:
Construction
C** Space Market:
Stock Adjustment

Construction (SF)
 Exhibit 2-4a: Effect of Demand
Demand Growth in Asset Market…

Rent $
Space Market:
Asset Market:
Rent Determination
Valuation

D0
11% OAR

D1
R*
8% OAR

R**
SR

LR
P1 Q*
P* Q* *
Price $ P** Stock (SF)

C*
Asset Market:
Construction
Space Market:
C** Stock Adjustment

Construction (SF)
EXHIBIT 7-10: THE "ROLLER COASTER RIDE" IN COMMERCIAL PROPERTY

PRICES OVER THE LAST QUARTER-CENTURY . . .

.
Price Level Index U.S. Institutional Real Estate

2.0
1.8
Overbuilding Tax reform
1.6
S&L Dereg Disinflation
1.4 Boom, Tax incentives
S&L Crisis: FIRREA
1.2 ERISA: MPT
=>P.F. demand Recession
1.0 REITs
inflation fears
Securitizatn:
0.8 REIT bust,
- REITs
Recession
0.6 - CMBS
0.4
0.2
0.0
69 71
73 75 77
79 81
83 85
87 89
91 93
95 97
99
Concept check…

check…
1. What does the 4Q Model reveal about the
interaction of the space market, the asset
market, and the development industry in
causing “boom & bust” cycles?

2. How can the an understanding of the 4Q Model

help participants in the asset market and
development industry to avoid “boom & bust”
cycles? [Hint: Can the 4Q Model help with
“forward-looking” decision-making?…]