Portfolio Roles and Economic Value Determinants of Real Estate Investment

Economic Drivers

The following economic factors affect the demand for major property types:

1. GDP: This is by far the most important economic factor as it affects all property types. As the GDP grows, the demand for real estate investment also increases.
2. Population Growth
3. Job Creation: Job creation leads to an increase in demand for office spaces. Increased jobs also lead to increased demand for multi-family homes and hotels as business travel and leisure increase.
4. Household Formation: This is the largest driver for household apartment demand.
5. Wage Growth: As an individual’s income increases, they can afford better quality housing.
6. Consumer Spending: Affects the demand for retail, industrial and hotel properties.
7. Retail Sales Growth: Affects the demand for retail and industrial spaces.
8. Demographic Trends: Affect the demand for retail, family, and hotel properties.
9. Consumer Confidence: Affect the demand for retail, family, and hotel properties.
10. Consumer Credit: Affect the demand for retail, family, and hotel properties.
11. Industrial Production: Affects the demand for industrial property.
12. Trade and Transportation: Affects the demand for industrial property.
13. Advances in Logistics: Affects the demand for industrial property.
14. Changing Supply Routes: Affects the demand for industrial property.
15. Business Formations: Affects the demand for retail, industrial, family, and hotel properties.
16. Business Investment: Affects the demand for retail, industrial, and hotel properties.
17. Business Confidence: Affects the demand for retail, industrial, and hotel properties.
18. Taxes: affect the demand for all property types.

Real Estate Cycle

The real estate cycle involves short-term adjustments in rent, lease rates, and occupancy in response to economic signals, along with long-term decisions to develop new properties based on current market conditions. Construction lags mean new supply often becomes available after market conditions change. The cycle has four phases:

1. Recovery: During this phase, economic uncertainty and tight credit result in minimal new construction and reduced commercial occupancy, leading property owners to cut leases. Tight credit and limited growth prospects lower real estate prices. Households delay new housing plans, reducing demand and putting downward pressure on rents and home prices.
2. Expansion: Economic growth and easier credit conditions boost demand for commercial real estate, leading to higher occupancy rates and the ability to raise lease rates. Rising consumer confidence, declining unemployment, and increasing wages drive demand for housing, pushing up rents and home prices. As the growth cycle peaks, higher interest rates and prices maximize occupancy but discourage new construction.
3. Oversupply: When economic growth slows, ongoing construction leads to a surplus of properties, reducing occupancy and rents. Uncertainty and worsening financial conditions cause real estate prices to stabilize and begin to decline.
4. Recession: Economic slowdown and tighter credit accelerate declining occupancy due to oversupply, prompting landlords to offer favorable terms. Construction hits lows, and real estate prices fall.

\begin{array}{|c|c|c|c|c|}
\hline
\textbf{Phase} & \textbf{LTV} & \textbf{DSC} & \textbf{NOI} & \textbf{Interest Rates} \\
\hline
\text{Recovery} & \text{Increases, then declines} & \text{Reaches the bottom, then increases} & \text{Reaches the bottom, then increases} & \text{Reaches the bottom, then increases} \\
\text{Expansion} & \text{Decreases} & \text{Increases} & \text{Rising} & \text{Rising} \\
\text{Oversupply} & \text{Reaches the bottom, then increases} & \text{Increases, then declines} & \text{Increases, then declines} & \text{Increases, then declines} \\
\text{Recession} & \text{Increases} & \text{Decreases} & \text{Decreasing} & \text{Low} \\
\hline
\end{array}

Role of Real Estate in an Investment Portfolio

• Current Income: real estate provides income for its owners in rent received from leasing the property.
• Price Appreciation: Investors expect the value of real estate property to increase over time.
• Inflation hedge: Investors expect rent and real estate prices to rise when inflation is high, creating an inflationary hedge.
• Diversification: Investors add real estate investments to their portfolios to lower the risk of volatility in returns since real estate returns from rent are more frequent than those of stocks that pay dividends annually.
• Tax Benefits: real estate investments receive favorable tax treatment compared to other forms of investments.

Question

George Matthews is looking to invest in real estate property with the highest cash flow volatility. Which property is he likely to invest in?

1. Shopping center
2. Industrial
3. Hotel

Solution

The correct answer is C.

The demand for hotel rooms fluctuates with economic activity, consumer and business confidence, and there are no long-term leases to protect hotel revenue streams.

A is incorrect. Shopping centers have long-term leases that protect their returns from market demand fluctuation.

B is incorrect. Industrial also benefit from the long-term lease, which protects their returns from demand fluctuation in the market.

Reading 36: Overview of Types of Real Estate Investment

LOS 36 (b) Explain economic value drivers of real estate investments and their role in a portfolio.