Property Prices and Rents: The Dynamics of Real Estate Markets

property prices

Real estate investors pursuing double-digit returns need to identify property markets in which property prices will register strong increases over the planned holding period of the property. This is the case because a strong capital return will be required in order to pull the annual return on investment above 10%.  Obviously, in order to apply this strategy investors need to understand the dynamics of real estate markets and what may cause rents and property prices to rise.

In order to identify what factors and process may cause rents and property prices to increase, one needs to understand how property rents and sales prices are determined in a free, competitive real estate market. According to conventional economic theory, price in a competitive market is the result of the interaction between buyers, who represent the demand side of the market, and sellers, who represent the supply side.

The fundamental process by which the market mechanism works in a free economy is that prices/rents adjust until demand (or the quantity demanded) and supply (or the quantity supplied) change as much as needed in order to become equal. The crucial element of this mechanism is how demand and supply behave in response to price/rent increases. This is where the fundamental laws of demand and supply enter the picture. As much as I want to refrain from economic and technical language, I cannot avoid discussing these laws since the supply-demand framework is the theoretical foundation for understanding how property prices are determined in a free economy.

The law of demand postulates that quantity of properties or space demanded decreases as property prices increase. For example, if office rents rise, the demand for office space should decrease (all else being equal). Thus, the demand curve is graphed in the quantity-price space as a downward-sloping curve (see Figure 1).

The law of supply postulates that quantity supplied increases as prices increase. For example, if property values and prices rise developers will construct and bring into the market more space (all else being equal). Thus, the supply curve is graphed in the quantity-price space as an upward-sloping curve. As Figure 1 demonstrates, the price at which the demand and supply curves intersect (PE) is the price that equalizes the quantity demanded with the quantity supplied. This is the equilibrium price towards which property prices are moving when the demand is not equal to supply. So if there is excess demand in the market it means actually that prevailing market prices are below the equilibrium price and need to rise to that price in order to bring the market back to equilibrium. Similarly, when there is excess supply prevailing market prices are actually above the equilibrium price and they need to fall in order to bring the market back to equilibrium.

Before proceeding to the more specific discussion of the price/rent determination mechanism in the real estate market, it is important to clarify that at any point in time, there are two markets operating at different, but quite interlinked levels (see Figure 2):

  1. The asset market, where properties are offered for sale, and
  2. The rental market, where properties and space are offered for lease.

Figure 1 – A Simple Graphic Illustration of the Demand-Supply Framework

classic demand supply.png                   

The buyers in the asset market are investors (and households, in the case of owner-occupied housing), and the sellers are landlords, or investors liquidating their investments. The buyers in the rental market are firms and households, while the sellers are landlords/investors. Notice that the interaction of demand and supply in the asset market determines property prices, and therefore property values, while the interaction of demand and supply in the rental market determines lease contract rates, that is, market rents, and occupancy rates.

As Figure 2 shows, there is an important link between the asset and the rental market. In particular, rental income levels, which are determined in the rental market, determine a property’s Net Operating Income (NOI) (rental income – operating expenses), which along with capitalization rates, determine the prices investors are willing to pay in the asset market. Notice that each investor may be using a different required income return. Investors with higher required income returns will have a lower ceiling price, while investors with a lower required income return will have a higher ceiling price. The role of the ceiling price investors are willing to pay in order to acquire a property will become clearer in the discussion that follows.

Figure 2 Price and Rent Determination Mechanism in the Real Estate Market

Price determination

As Goodall (1979) suggests, a transaction will take place as long as one or more potential buyers have ceiling prices above the floor price of a seller. The market price/rent will be higher the stronger the seller’s bargaining position is. For example, when the market is under-supplied, sellers have a greater negotiating power, compared to periods during which the market is oversupplied. If there are many buyers with ceiling prices above the floor prices of the sellers, property prices and rents will be determined through competitive bidding. In a perfectly competitive real estate market, property prices will stabilize at the level for which the amount of space offered by the sellers equals the amount demanded by the buyers. This price level is what the economists refer to as the equilibrium price.

To better understand how market rents are determined, and how rent/price increases may occur, assume for a moment that the amount of space demanded by companies is greater than the amount of space offered for leasing in the office market. In such a case, landlords with vacant space experiencing high demand will raise asking rents. This increase in asking rents will trigger changes, in both demand and supply. On one hand, some additional landlords will enter the market, offering additional space for lease as market rents move above the minimum (floor) rent they require in order to lease space. On the other hand, some renters will “drop out” of the market, as asking rents move above the maximum (ceiling) rent they are willing to pay. These adjustments will continue until the amount of space available for lease equals the amount of space demanded by renters. At that point, no renter will have any incentive to further bid up rents.

In case the amount of space demanded is smaller than the amount of space supplied, landlords will start reducing asking prices in order to attract renters, and eventually, rents will fall enough so that the amount of space demanded becomes equal to the amount of space supplied. Is there any evidence that the real estate market operates in such a way? The answer is yes. Rosen and Smith (1986) and Wheaton (1988) presented evidence from the housing market and the office market, respectively, which demonstrates that rents/prices have been decreasing in response to excess supply.

 

Rererences

Sivitanides, P.  2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.

Wheaton, W. and R. Torto. 1988. Vacancy Rates and the Future of Office Rents. American Real Estate and Urban Economics Association Journal, Vol. 16, No. 4.

Rosen, K. and L. Smith. 1986. The Resale Housing Market. American Real Estate and Urban Economics Association Journal, Vol. 14, No. 4.

Goodall, B. 1979. The Economics of Urban Areas. Oxford, UK: Pergramon Press.

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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