Real Estate Demand and Property Value Gains

real estate demand

Understanding what triggers increases in demand for real estate is the smart thing to do if you are a property investor. According to the conventional economic theory, real estate demand increases in the face of constrained supply constitute the major force that triggers strong property rent and value gains, which are necessary in generating high property investment returns. Property value and rent increases are critical when targeting double-digit returns in real estate, as explained in our cornerstone post entitled High-Return Property Investing. Within this context, it is important to understand the different dimensions of real estate demand (see Figure).

Dimensions of Real Estate Demand

First, demand for real estate is multi-dimensional, as it encompasses size, quality, functionality, layout, and other characteristics of the property. Equally important, perhaps even more so, are the characteristics of the immediate and broader location of the property, since real estate is fixed at a given location.

Second, real estate demand is segmented, not only along major property types, such as residential, office, retail, and industrial but also along sub-types within each type and quality subcategories within each sub-type. For example, we can distinguish several distinct sub-types of residential properties, such as single-family detached houses, townhouses, and apartments. Furthermore, within each of these housing sub-types, we can distinguish quality segments, such as high-quality, medium-quality and low-quality units. Notice that demand is segmented along these housing sub-types and qualities. For example, households looking for a single-family house are unlikely to end up buying an apartment. Furthermore, households looking for a high-quality single-family house are unlikely to end up buying a medium-quality house.

Major Dimensions of Real Estate Demand

real estate demand

Third, real estate demand is segmented along tenure mode, since the economics of renting and owner-occupancy are quite different. While the dominant mode in housing is owner-occupancy, office and retail real estate markets are primarily rental markets. For example, almost 80% of the office space in the US office market is rented, not owner-occupied (Wheaton, 1987). The distinction of demand by tenure mode is important in understanding the dynamics of the various property markets.

Demand for owner-occupied property and demand for rental property are connected because they are substitutes. For example, when the demand for owner-occupied housing decreases, the demand for rental housing should increase (if the total number of households in the market remains constant). People who do not want, or cannot afford, to own a house have no alternative but to rent. Thus, factors that tend to cause significant increases in demand for owner-occupied housing, such as sharp decreases in interest rates, will tend to cause decreases in demand for rental housing and vice versa. The increasing vacancy rate and declining apartment rents in the United States (according to data provided by Torto Wheaton Research) over the period 2001-2003, when interest rates declined to record low levels, are probably the result of such dynamics.[1]

Substitutability between tenure modes implies that when prices for one tenure mode rise, some demand should be redirected to the other mode. For example, the high housing prices that have prevailed in the recent years may have forced households that planned to buy a house to turn to the rental market, because they could not afford to pay the increased down payment that goes with higher prices. This scenario does not seem to have happened during 2001-2003, since apartment rents were declining and the vacancy rate was rising, but it may have started happening in 2004, when the apartment vacancy rate declined and nominal rents registered a small rise (according to data reported by Torto Wheaton Research).

Fourth, demand for real estate is segmented across locations and, particularly, across metropolitan areas. This is so because demand for rental and owner-occupied property in one metropolitan area can rarely be satisfied by properties in another metropolitan area, due to distance considerations, unless two metropolitan markets are separated by a small distance. For example, a person working in Boston, Massachusetts is unlikely to look for housing in Stamford, Connecticut. Similarly, a firm serving clients in the Los Angeles area is unlikely to seek space in San Diego when its lease in a Los Angeles office building expires. Demand is only weakly segmented across locations within a metropolitan area, since household and firm demand for properties or space can be satisfied in many alternative locations within an urban area. In other words, there is considerable substitutability across locations within the same metropolitan area.

Finally, in thinking about demand for any type or subtype of real estate, we need to distinguish between aggregate demand at the market level and demand at a specific location within that market (locational demand). Although there is considerable substitutability across locations within the same metropolitan area, increases in aggregate market demand for a specific property type will not be equally distributed to all locations within that market because of the uneven distribution of locational advantages.

Within this context, it appears that the best-case scenario for getting the strongest value gains is to invest in the most attractive locations within markets expected to experience strong increases in aggregate market demand. Of course it goes without saying that targeted markets should not be oversupplied at the time of the investment.  The investor needs to assess carefully the spatial dynamics of the urban area in which he/she is investing, and confirm that the locations that appear to be the most attractive at the time of investment are expected to remain so in the years ahead. In other words, the investor needs to evaluate whether the attractiveness and competitiveness of such locations is threatened, in the medium term, by future developments in the area. Furthermore, the investor needs to ensure that these attractive locations are not oversupplied, nor are expected to become oversupplied in the years ahead.

[1] Torto Wheaton Research, 200 High Street, 3rd Floor, Boston, MA 02110-3036, Tel: 617-912-5200, Fax: 617-912-5240

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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