Real estate economics

Real estate economics is the application of economic techniques to real estate markets. It tries to describe, explain, and predict patterns of prices, supply, and demand. The closely related field of housing economics is narrower in scope, concentrating on residential real estate markets, while the research of real estate trends focuses on the business and structural changes affecting the industry. Both draw on partial equilibrium analysis (supply and demand), urban economics, spatial economics, extensive research, surveys, and finance.

Overview of real estate markets

The main participants in real estate markets are:

The owner/user, owner, and renter form the demand side of the market, while the developers and renovators form the supply side. In order to apply simple supply and demand analysis to real estate markets, a number of modifications need to be made to standard microeconomic assumptions and procedures. In particular, the unique characteristics of the real estate market must be accommodated. These characteristics include:

Demand for housing

The main determinants of the demand for housing are demographic. But other factors, like income, price of housing, cost and availability of credit, consumer preferences, investor preferences, price of substitutes, and price of complements, all play a role.

The core demographic variables are population size and population growth: the more people in the economy, the greater the demand for housing. But this is an oversimplification. It is necessary to consider family size, the age composition of the family, the number of first and second children, net migration (immigration minus emigration), non-family household formation, the number of double-family households, death rates, divorce rates, and marriages. In housing economics, the elemental unit of analysis is not the individual, as it is in standard partial equilibrium models. Rather, it is households, which demand housing services: typically one household per house. The size and demographic composition of households is variable and not entirely exogenous. It is endogenous to the housing market in the sense that as the price of housing services increase, household size will tend also to increase.[1]

Income is also an important determinant. Empirical measures of the income elasticity of demand in North America range from 0.5 to 0.9 (De Leeuw 1971). If permanent income elasticity is measured, the results are slightly higher (Kain and Quigley 1975) because transitory income varies from year to year and across individuals, so positive transitory income will tend to cancel out negative transitory income. Many housing economists use permanent income rather than annual income because of the high cost of purchasing real estate. For many people, real estate will be the costliest item they will ever buy.

The price of housing is also an important factor. The price elasticity of the demand for housing services in North America is estimated as negative 0.7 by Polinsky and Ellwood (1979), and as negative 0.9 by Maisel, Burnham, and Austin (1971).

An individual household's housing demand can be modeled with standard utility/choice theory. A utility function, such as U=U(X1,X2,X3,X4,...Xn), can be constructed, in which the household's utility is a function of various goods and services (Xs). This will be subject to a budget constraint such as P1X1+P2X2+...PnXn=Y, where Y is the household's available income and the Ps are the prices for the various goods and services. The equality indicates that the money spent on all the goods and services must be equal to the available income. Because this is unrealistic, the model must be adjusted to allow for borrowing and saving. A measure of wealth, lifetime income, or permanent income is required. The model must also be adjusted to account for the heterogeneity of real estate. This can be done by deconstructing the utility function. If housing services (X4) are separated into its constituent components (Z1,Z2,Z3,Z4,...Zn), the utility function can be rewritten as U=U(X1,X2,X3,(Z1,Z2,Z3,Z4,...Zn)...Xn). By varying the price of housing services (X4) and solving for points of optimal utility, the household's demand schedule for housing services can be constructed. Market demand is calculated by summing all individual household demands.

Supply of housing

A customer perusing real estate listings at an agent's office in Linxia City, China

Housing supply is produced using land, labor, and various inputs, such as electricity and building materials. The quantity of new supply is determined by the cost of these inputs, the price of the existing stock of houses, and the technology of production. For a typical single-family dwelling in suburban North America, approximate cost percentages can be broken down as follows: acquisition costs, 10%; site improvement costs, 11%; labour costs, 26%; materials costs, 31%; finance costs, 3%; administrative costs, 15%; and marketing costs, 4%. Multi-unit residential dwellings typically break down as follows: acquisition costs, 7%; site improvement costs, 8%; labour costs, 27%; materials costs, 33%; finance costs, 3%; administrative costs, 17%; and marketing costs, 5%. Public subdivision requirements can increase development costs by up to 3% depending on the jurisdiction. Differences in building codes account for about a 2% variation in development costs. However, these subdivision and building code costs typically increase the market value of the buildings by at least the amount of their cost outlays. A production function such as Q=f(L,N,M) can be constructed in which Q is the quantity of houses produced, N is the amount of labour employed, L is the amount of land used, and M is the amount of other materials. This production function must, however, be adjusted to account for the refurbishing and augmentation of existing buildings. To do this, a second production function is constructed that includes the stock of existing housing and their ages as determinants. The two functions are summed, yielding the total production function. Alternatively, a hedonic pricing model can be regressed.

The long-run price elasticity of supply is quite high. George Fallis (1985) estimates it as 8.2, but in the short run, supply tends to be very price inelastic. Supply price elasticity depends on the elasticity of substitution and supply restrictions. There is significant substitutability, both between land and materials and between labour and materials. In high-value locations, multi-story concrete buildings are typically built to reduce the amount of expensive land used. As labour costs have increased since the 1950s, new materials and capital-intensive techniques have been employed to reduce the amount of labour used. However, supply restrictions can significantly affect substitutability. In particular, the lack of supply of skilled labour (and labour union requirements) can constrain the substitution from capital to labour. Land availability can also constrain substitutability if the area of interest is delineated (i.e., the larger the area, the more suppliers of land, and the more substitution that is possible). Land-use controls such as zoning bylaws can also reduce land substitutability.

Adjustment mechanism

The basic adjustment mechanism is a stock/flow model to reflect the fact that about 98% the market is existing stock and about 2% is the flow of new buildings.

In the adjacent diagram, the stock of housing supply is presented in the left panel while the new flow is in the right panel. There are four steps in the basic adjustment mechanism. First, the initial equilibrium price (Ro) is determined by the intersection of the supply of existing housing stock (SH) and the demand for housing (D). This rent is then translated into value (Vo) via discounting cash flows. Value is calculated by dividing current period rents by the discount rate, that is, as a perpetuity. Then value is compared to construction costs (CC) in order to determine whether profitable opportunities exist for developers. The intersection of construction costs and the value of housing services determine the maximum level of new housing starts (HSo). Finally the amount of housing starts in the current period is added to the available stock of housing in the next period. In the next period, supply curve SH will shift to the right by amount HSo.

Adjustment with depreciation

The diagram to the right shows the effects of depreciation. If the supply of existing housing deteriorates due to wear, then the stock of housing supply depreciates. Because of this, the supply of housing (SHo) will shift to the left (to SH1) resulting in a new equilibrium demand of R1 (since the amount of homes decreased, but demand still exists). The increase of demand from Ro to R1 will shift the value function up (from Vo to V1). As a result, more houses can be produced profitably and housing starts will increase (from HSo to HS1). Then the supply of housing will shift back to its initial position (SH1 to SHo).

Increase in demand

The diagram on the right shows the effects of an increase in demand in the short run. If there is an increase in the demand for housing, such as the shift from Do to D1 there will be either a price or quantity adjustment, or both. For the price to stay the same, the supply of housing must increase. That is, supply SHo must increase by HS.

Increase in costs

The diagram on the right shows the effects of an increase in costs in the short-run. If construction costs increase (say from CCo to CC1), developers will find their business less profitable and will be more selective in their ventures. In addition some developers may leave the industry. The quantity of housing starts will decrease (HSo to HS1). This will eventually reduce the level of supply (from SHo to SH1) as the existing stock of housing depreciates. Prices will tend to rise (from Ro to R1).

Real estate financing

There are different ways of real estate financing: governmental and commercial sources and institutions. A homebuyer or builder can obtain financial aid from savings and loan associations, commercial banks, savings banks, mortgage bankers and brokers, life insurance companies, credit unions, federal agencies, individual investors, and builders.

Savings and loan associations

The most important purpose of these institutions is to make mortgage loans on residential property. These organizations, which also are known as savings associations, building and loan associations, cooperative banks (in New England), or homestead associations (in Louisiana), are the primary source of financial assistance to a large segment of American homeowners.[2] As home-financing institutions, they give primary attention to single-family residences and are equipped to make loans in this area.

Some of the most important characteristics of a savings and loan association are:[2]

  1. It is generally a locally owned and privately managed home-financing institution.
  2. It receives individuals' savings and uses these funds to make long-term amortized loans to home purchasers.
  3. It makes loans for the construction, purchase, repair, or refinancing of houses.
  4. It is state or federally chartered.

Commercial banks

Main article: Commercial bank

Due to changes in banking laws and policies, commercial banks are increasingly active in home financing. In acquiring mortgages on real estate, these institutions follow two main practices:[2]

  1. Some banks maintain active and well-organized departments whose primary function is to compete actively for real estate loans. In areas lacking specialized real estate financial institutions, these banks become the source for residential and farm mortgage loans.
  2. Banks acquire mortgages by simply purchasing them from mortgage bankers or dealers.

In addition, dealer service companies, which were originally used to obtain car loans for permanent lenders such as commercial banks, wanted to broaden their activity beyond their local area. In recent years, however, such companies have concentrated on acquiring mobile home loans in volume for both commercial banks and savings and loan associations. Service companies obtain these loans from retail dealers, usually on a non-recourse basis. Almost all bank or service company agreements contain a credit insurance policy that protects the lender if the consumer defaults.[2]

Savings banks

Main article: Savings bank

These depository financial institutions are federally chartered, primarily accept consumer deposits, and make home mortgage loans.[2]

Mortgage bankers and brokers

Main article: Mortgage broker

Mortgage bankers are companies or individuals that originate mortgage loans, sell them to other investors, service the monthly payments, and may act as agents to dispense funds for taxes and insurance.[3]

Mortgage brokers present homebuyers with loans from a variety of loan sources. Their income comes from the lender making the loan, just like with any other bank. Because they can tap a variety of lenders, they can shop on behalf of the borrower and achieve the best available terms. Despite legislation that could favor major banks, mortgage bankers and brokers keep the market competitive so the largest lenders must continue to compete on price and service. According to Don Burnette of Brightgreen Homeloans in Port Orange, Florida, "The mortgage banker and broker conduit is vital to maintain competitive balance in the mortgage industry. cWithout it, the largest lenders would be able to unduly influence rates and pricing, potentially hurting the consumer. Competition drives every organization in this industry to constantly improve on their performance, and the consumer is the winner in this scenario."[2]

Life insurance companies

Life insurance companies are another source of financial assistance. These companies lend on real estate as one form of investment and adjust their portfolios from time to time to reflect changing economic conditions. Individuals seeking a loan from an insurance company can deal directly with a local branch office or with a local real estate broker who acts as loan correspondent for one or more insurance companies.[2]

Credit unions

Main article: Credit union

These cooperative financial institutions are organized by people who share a common bond—for example, employees of a company, labor union, or religious group. Some credit unions offer home loans in addition to other financial services.[2]

Federally supported agencies

Under certain conditions and fund limitations, the Veterans Administration (VA) makes direct loans to creditworthy veterans in housing credit shortage areas designated by the VA's administrator. Such areas are generally rural and small cities and towns not near the metropolitan or commuting areas of large cities—areas where GI loans from private institutions are not available.

The federally supported agencies referred to here do not include the so-called second-layer lenders who enter the scene after the mortgage is arranged between the lending institution and the individual home buyer.[2]

Real estate investment trusts

Real estate investment trusts (REITs), which began when the Real Estate Investment Trust Act became effective on January 1, 1961, are available. REITs, like savings and loan associations, are committed to real estate lending and can and do serve the national real estate market, although some specialization has occurred in their activities.[2]

In the United States, REITs generally pay little or no federal income tax but are subject to a number of special requirements set forth in the Internal Revenue Code, one of which is the requirement to annually distribute at least 90% of their taxable income in the form of dividends to shareholders.

Other sources

Individual investors constitute a fairly large but somewhat declining source of money for home mortgage loans. Experienced observers claim that these lenders prefer shorter-term obligations and usually restrict their loans to less than two-thirds of the value of the residential property. Likewise, building contractors sometimes accept second mortgages in partial payment of the construction price of a home if the purchaser is unable to raise the total amount of the down payment above the first mortgage money offered.[2]

In addition, homebuyers or builders can save their money using FSBO in order not to pay extra fees.

See also

Notes

  1. ↑ "Effects of Economic Factors on performance of Real Estate in Kenya" (PDF).
  2. 1 2 3 4 5 6 7 8 9 10 11 Mishler, Lon; Cole, Robert E. (1995). Consumer and business credit management. Homewood: Irwin. pp. 123–128. ISBN 0-256-13948-2.
  3. ↑ "How Much Is PMI Really?". Real Estate Mad. January 11, 2012.

References

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