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This is the last version of this chapter before it was published.
Please, cite as:
Garay, U. “Real Estate as an Investment.” In Kazemi, H.; Black, K.; and D. Chambers
(Editors), Alternative Investments: CAIA Level II, Chapter 14, Wiley Finance, 3rd
Edition, 2016, pp. 343-358.
Part 3: Real Assets
Chapter 14: Real Estate as an
Investment
Real estate has been a very large and important portion of wealth for
thousands of years. Even as recently as a century ago, real estate dominated
institutional portfolios and was classified as property. During recent decades, the
preeminence of real estate has yielded to the growing importance of intangible
assets. Yet real estate remains a valuable part of any well-diversified portfolio.
The transition of real estate from dominating traditional institutional-quality
investments to being an alternative investment raises important issues in terms of
how to evaluate real estate on a forward-looking basis. This chapter provides an
overview of the attributes, asset allocation, categories, and return drivers of real
estate. The chapter concludes with a discussion of the four-quadrant model, which
is a graphical representation of a real estate system.
14.1 Attributes of Real Estate
Real estate—and any other asset, for that matter—should be included in a
portfolio until the marginal benefits of additional investment equal the marginal
costs of additional investment. An optimized portfolio is achieved when additional
investments in each asset and asset class are equally attractive. In other words,
exposure to each type of real estate investment, and to real estate overall, should
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be added until the net benefits have diminished to the point that allocations to
other investments are equally attractive.
14.1.1 Five Potential Advantages of Real Estate
What are the aspects of real estate that make it attractive or unattractive
relative to other asset classes? There are five common attributes that encourage the
inclusion of real estate in an investment portfolio:
1. Its potential to offer absolute returns
2. Its potential to hedge against unexpected inflation
3. Its potential to provide diversification against stocks and bonds
4. Its potential to provide steady cash inflows
5. Its potential to provide income tax advantages
These potential advantages, the first three of which are related to portfolio
risk, do not necessarily come without costs. In particular, to the extent that markets
are competitive and efficient, market prices of real estate will tend to adjust, such
that any relative advantages to real estate will be offset by lower expected returns.
This list of potential advantages to real estate investment is not
comprehensive. For example, another motivation would be to own all or part of a
trophy property that offers name recognition, prestige, marketing potential, and
enhanced reputation to the owner. One example would be a large high-quality
office property in a prominent location. Another potential advantage is that real
estate typically allows investors to use a high degree of leverage.
14.1.2 Three Potential Disadvantages of Real
Estate
There are also aspects of real estate that can discourage its inclusion in an
investment portfolio:
1. Its heterogeneity
2. Its lumpiness, which may prevent investors from creating optimal
portfolios
3. Its illiquidity, which may reduce the opportunity to rebalance and sell
assets at fair market prices in a short period
Real estate is a highly heterogeneous asset. Not only are the physical
features of the individual properties unique in terms of location, use, and design,
but varying lease structures can lead to large differences in income streams. This
heterogeneity is particularly troublesome as it relates to the due diligence process.
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Accordingly, due diligence of real estate investments can require specialized
analysis and managerial skill.
The second potential disadvantage of real estate is lumpiness, including the
indivisibility of direct ownership. Lumpiness describes a situation in which assets
cannot be easily and inexpensively bought and sold in sizes or quantities that meet
the preferences of both buyers and sellers. Listed equities of large companies are
not lumpy, because purchases and sales can be easily made in the desired size by
altering the number of shares in the transaction. Direct real estate ownership may
be difficult to trade in sizes or quantities desired by a market participant. While
growth in real estate investment trusts (REITs) and in a number of alternative real
estate investment vehicles has led to divisible investment opportunities at an
indirect ownership level, investors at the single-property level are still faced with
the choice of either buying the entire asset or not. The inherent indivisible nature
of individual real estate assets leads to problems with respect to high unit costs
(i.e., large investment sizes) and relatively high transaction costs, including those
transactions involving joint ventures.
The final major disadvantage relates to the liquidity of real estate. As a
private, non-exchange-traded asset with both high unit and high transaction costs,
real estate can be highly illiquid, especially when compared to traditional
securities. Important implications of illiquidity are its effects on reported returns,
extended holding periods, and the ability to transact at reasonable valuations when
either demand or supply evaporates.
All three of these characteristics complicate performance measurement and
evaluation of real estate investments. The goal of each investor is to find the level
and composition of real estate exposure that optimizes the portfolio’s intended
return-risk profile when considering all benefits and costs.
14.2 Asset Allocation
This section discusses major methods of categorizing real estate and
differentiating among real estate investments—the understanding of which leads
to two important outcomes. First, a better understanding of the breadth of real
estate investment opportunities helps refine an asset allocator's decision as to how
much capital to allocate to real estate. Second, a nuanced understanding of the
different categories of real estate facilitates the decision of how to allocate funds
within the real estate portfolio.
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14.2.1 Heterogeneity within Subcategories
Not only is real estate heterogeneous among subcategories, but it can also
be highly heterogeneous within its subcategories. Although categorization and
subcategorization of real estate may serve a useful role in asset allocation and
analysis, care must be taken to avoid development of an oversimplified view of
real estate. Although assets within various real estate categories and subcategories
typically share general characteristics, there may be instances in which
tremendous differences in their economic nature exist.
For example, consider two office buildings that are similar in size,
construction, and location. The first office building has a 20-year, non-cancellable
lease with a large well-capitalized and well-hedged corporation. The lease
essentially locks in the rental revenues for the entire property for the next two
decades. In this case, the annual income of the property will be similar to that of a
corporate bond, and the value of the property to the investor will tend to fluctuate
in response to the same factors affecting the value of a corporate bond issued by
the tenant (i.e., riskless interest rate changes and changes in the credit spread on
the debt of the tenant). The principal difference affecting income and valuation
between the two is that while many commercial real estate leases allow for
periodic rent increases through contractual escalator clauses, coupon payments on
outstanding corporate bonds are not inflation-adjusted.
The second office building in the example is vacant. Both buildings are
located in a geographic area with an economy strongly linked to oil prices. The
value of this empty real estate asset will be especially sensitive to the supply of
and demand for office space in the local real estate market. Thus, the value of this
property will be driven by the forces that affect the region's economy—in this
case, oil prices. The vacant property's value may behave more like equity prices in
general and like oil stock prices in particular. However, if the building begins to
attract tenants with long-term, non-cancellable leases, the property's fundamental
economic nature may transition from being more like an oil stock to being more
like a corporate bond. (The value of the first building will become increasingly
driven by the difference in local market fundamentals relative to those implied by
the current lease terms as the maturity date approaches.)
This example shows that assets within a specific type of real estate (e.g.,
private commercial real estate) may behave like debt or equity securities
depending on the characteristics of the individual properties. Furthermore, a
particular property may experience dramatic changes in its investment
characteristics due to a specific event, such as the signing or termination of a very
long-term, non-cancellable lease.
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14.2.2 Top-Down Asset Allocation
Asset allocation approaches differ by the extent to which the process is
focused on top-down allocation versus bottom-up allocation. Top-down asset
allocation emphasizes allocation based on the analysis of the macro environment
and risk premiums, and their expected impact on general categories or types of
portfolio investments. Exhibit 14.1 illustrates the concept of target asset allocation
using one set of potential categories and weights. To the extent that the allocation
illustrated in Exhibit 14.1 is based on general portfolio objectives, the asset
allocation process is a top-down asset allocation. Section 14.3 provides numerous
distinctions that can be used to place real estate into different categories.
Exhibit 14.1: Asset allocation
For example, an asset allocator would typically be concerned about the
return, risk, liquidity, and even tax implications of the overall portfolio. In the case
of liquidity, a top-down asset allocator takes into account the concern for liquidity
when selecting portfolio weights, along with a preference for a higher return and
other perceptions as to how each category serves the overall portfolio objectives.
Thus, in considering liquidity, a pure top-down asset allocator would determine
the weights for each category based in part on an analysis of the liquidity of each
category of real estate and the extent to which illiquidity offers a risk premium
relative to the portfolio’s needs for liquidity. Therefore, if the asset allocator’s
investment policy mandates that the illiquid portion of the portfolio should not
Traditional
Assets 80% Alternative
Assets 20%
Hedge Funds
6% Private Equity
6% Commodities
2% Real Estate 6%
Domestic 4%
Public 2%
Private 2%
International
2%
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exceed some particular level, the asset allocator will have to find the optimal
allocation to various categories of real estate subject to this constraint. As a result,
this liquidity concern and other general portfolio objectives may cause the asset
allocator to make allocations at each level that ultimately determine the feasible
and desirable portfolio allocation to domestic, publicly traded equity real estate
investment products. It should be noted that further details regarding asset
allocation could be illustrated in Exhibit 14.1. For example, in the category of
publicly traded domestic real estate equity, the asset allocator may further divide
the category by property type (office buildings, industrial centers, data centers,
retail, residential, health-care facilities, self-storage facilities, and hotels) and by
investment management type (in-house vs. external, active vs. indexed).
Furthermore, other categorizations could be used, along with greater refinement of
the level of detail (e.g., international vs. domestic could be broken into finer
distinctions based on geographical profiles or demographic trends).
14.2.3 Bottom-Up Asset Allocation
Bottom-up asset allocation refers to an emphasis on the relative
attractiveness of individual investment opportunities as the primary driving factor
of the asset allocation process. The underlying analysis is typically supported by
rigorous fundamental analysis. The asset allocator may determine that some
subcategories of real estate, particular properties, or publicly traded real estate
managers offer exceptionally attractive investment opportunities, whereas other
categories, properties, or manager portfolio characteristics are unattractive. To the
extent that these analyses of individual opportunities or subcategories exert the
dominant effect on the ultimate asset allocation, the asset allocation would reflect
a bottom-up strategy.
For example, an asset allocator may have internal staff and established
relationships with outside managers that lead the allocator to believe that
particular subcategories present the portfolio with attractive opportunities relative
to the wider asset class. The asset allocator may favor some opportunities on
extensive experience and knowledge, while avoiding potentially attractive
opportunities in subcategories in which the allocator has a limited perceived edge.
To the extent that individual asset selection exerts a major effect on the ultimate
asset allocations among major categories, the asset allocation process is
considered to be bottom-up.
Most asset allocation methods are a mix of top-down and bottom-up, in that
allocations among major categories tend to be driven by general portfolio
objectives and macro analysis, whereas allocations within subcategories are
typically driven by the allocator's perceptions of the opportunities available.
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14.3 Categories of Real Estate
This section describes the main characteristics of various real estate assets,
beginning with four especially common categories that can be used to differentiate
real estate:
1. Equity versus debt
2. Domestic versus international
3. Residential versus commercial
4. Private versus public
Each of these categories is briefly discussed in the following four sections,
followed by discussions of other methods of categorizing real estate.
14.3.1 Equity versus Debt
The traditional method of distinguishing between equity claims and debt
claims is to use the legal distinction between a residual claim and a fixed claim. A
mortgage is a debt instrument collateralized by real estate, and real estate debt is
typically defined as including all mortgages. Note, however, that mortgages with
substantial credit risk can behave more like equity, and equity ownership of
properties with very long-term leases can behave like debt. The value of a
mortgage is more closely associated with the value of the real estate than the
profitability of the borrower.
14.3.2 Domestic versus International
One of the primary motivations to real estate investing is diversification.
International investing (i.e., cross-border investing) in general—and international
real estate investing in particular—are regarded as offering substantially improved
diversification. However, the heterogeneity of most real estate and the unique
nature of many real estate investments make international real estate investing
more problematic than international investing in traditional assets. Other
challenges include lack of knowledge and experience regarding foreign real estate
markets, lack of relationships with foreign real estate managers, time and expense
of travel for due diligence, liquidity concerns, political risk (particularly in
emerging markets), risk management of foreign currency exposures, and taxation
differences. For these reasons, a large share of international real estate investing is
done through shares of listed property companies (LPCs), including REITs, in
foreign countries. The continuing emergence of derivative products related to real
estate investments in particular nations or regions is an important potential
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opportunity for exploiting the benefits of international diversification without the
challenges of direct international investment.
The extent of appropriate international investing depends on the locale of
the asset allocator. A UK asset allocator or an asset allocator in another country
with a very large economy may be able to achieve moderate levels of
diversification without foreign real estate investing. However, an asset allocator in
a nation with a small or emerging economy may experience high levels of
idiosyncratic risk in the absence of foreign investments.
14.3.3 Residential versus Commercial
One of the most important drivers of the characteristics of a real estate
investment is the nature of the real estate assets underlying the investment. A
broad distinction, especially in mortgages, is residential real estate versus
commercial real estate.
Housing or residential real estate properties: Residential real estate
includes many property types, such as single-family homes, town houses,
condominiums, and manufactured housing. The housing or residential real estate
sector is traditionally defined as including owner-occupied housing rather than
large apartment complexes. According to the Federal Reserve, the aggregate value
of all U.S. homes amounted to approximately $20.7 trillion at the end of 2014,
representing an important portion of household wealth. In the UK, housing values
totaled £5.2 trillion as of January 2014, up from £3.6 trillion in 2003 (Savills
2014).
Within residential real estate, the institutional investor is primarily
concerned with investing in mortgages backed by housing and residential real
estate. Ownership in these instruments is usually established through pools of
mortgages. The global residential mortgage market had total balances outstanding
of $25.7 trillion at the end of 2013 (Market Reports Online 2015). According to
data from the Federal Reserve and MarketResearch.com, residential mortgages
accounted for approximately
$12 trillion in the United States (end of 2014),
$2.5 trillion in Japan (2013),
$1.6 trillion in the UK (2013),
$1.4 trillion in Germany (2013),
$1.2 trillion in France (2013).
Commercial real estate properties: Commercial real estate properties
include the following property sectors: office buildings, industrial centers, data
centers, retail (malls and shopping centers, also referred to as “strips”),
apartments, health-care facilities (medical office buildings and assisted-living
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centers), self-storage facilities, and hotels. Small properties may be directly and
solely owned by a single investor. Alternatively, collections of numerous smaller
properties and large commercial properties may be managed by a real estate
company, such as a publicly listed REIT, or through private equity real estate
funds, which, in turn, are owned by several institutional investors as limited
partners. Within commercial real estate, the institutional investor can access
opportunities through either debt or equity investments. The volume of
transactions fluctuate significantly depending on the stage of the business cycle,
but it is generally high enough to support large investments by institutional
investors. For example, the commercial real estate investments in 2013 and early
2014 averaged about $100 billion in the U.S., $75 billion in Europe, Middle East
and Africa and $180 billion in Asia-Pacific (Deloitte (2015)).
For the most part, residential and commercial real estate require very
distinct methods of financial analysis. For example, the credit risk of mortgages on
residential real estate is typically analyzed with a focus on the creditworthiness of
the borrower. Mortgages on commercial real estate tend to focus on the analysis of
the net cash flows from the property.
14.3.4 Private versus Public
Exposure to the real estate market, especially the equity side, can be
achieved via private and public ownership. Private real estate equity investment
involves the direct or indirect acquisition and management of actual physical
properties that are not traded on an exchange. Public real estate investment
entails the buying of shares of real estate investment companies and investing in
other indirect exchange-traded forms of real estate (including futures and options
on real estate indices and exchange-traded funds linked to real estate).
Private real estate is also known as physical, direct, or non-exchange-traded
real estate. Private real estate may take the form of equity through direct
ownership of the property or debt via mortgage claims on the property. The private
real estate market comprises several segments: housing or residential real estate
properties, commercial real estate properties, farmland, and timberland. The
relative advantages of investing in the private side of real estate equity are that
investors or investment managers have the ability to choose specific properties,
exert direct control on their investments, and enjoy the potential for tax-timing
benefits.
Public real estate is a financial claim in the form of equity, debt, funds, or
derivative positions, and may be a claim on either underlying private real estate
positions or underlying public real estate positions. Public real estate is also
known as securitized, financial, indirect, or exchange-traded real estate. Thus,
public real estate enables the ownership of private real estate through one or more
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levels of contracts designed to facilitate real estate ownership, reduce costs, or
increase liquidity relative to direct ownership. For example, securitization—
particularly in the form of commercial mortgage-backed securities (CMBS)—has
substantially increased the liquidity and accessibility of real estate investments,
while allowing structured investments based on specific institutional investor
return-risk profile targets.
REITs are securitized pools of real estate that constitute an important form
of public real estate especially in the United States, which has the largest market in
the world, followed by Australia, France, the United Kingdom, and Japan. The
relative advantages of investing in public commercial real estate (as opposed to
private) include liquidity, greater investor access, relatively low transaction costs,
the potential for better corporate governance structures, and the transparency
brought by required SEC filings and pricing in public capital markets (Idzorek,
Barad, and Meier 2007).
One of the most important characteristics of REITs is that, due to the trust
structure, income distributed by a REIT to its shareholders is taxed not at the REIT
level but at the investor level after it flows through the REIT. In order to enjoy this
tax status in the United States, REITs are subject to two main restrictions: (1) 75%
of the income that they receive must be derived from real estate activities, and (2)
the REIT is legally obligated to pay out 90% of its taxable income in the form of
dividends. Other restrictions relate to the ownership structure of the REIT. As long
as a REIT is in compliance with the relevant restrictions, it may deduct dividends
from its income when determining its corporate tax liability (i.e., it pays corporate
income taxes only on retained taxable income). REITs enjoy similar tax
efficiencies in other parts of the world—for example, in the UK and in Germany.
In the United States, REITs can invest both in the private real estate market
(equity REITs) and in real estate–based debt (mortgage REITs), though,
practically speaking, each specific REIT tends to manage its portfolio by focusing
nearly exclusively on either equity ownership (including the use of joint ventures)
or debt (including derivatives). Generally, if a REIT has 50% or more of its assets
in the private real estate equity market, it is viewed as an equity REIT; if over 50%
of its assets are invested in real estate debt, it is viewed as a mortgage REIT. This
distinction is important in return analyses. For example, unlike equity REITs,
mortgage REITs tend to move in line with other rate-sensitive securities due to
their underlying asset base. Equity REITs dominate the REIT sector, in terms of
both number available and market capitalization. In the United States, as of the
end of 2015, equity REITs, as proxied by the FTSE NAREIT All Equity REITs
Index, had a market capitalization of $882 billion, whereas mortgage REITs (the
FTSE NAREIT Mortgage REITs Index) had a market cap of $52.5 billion. And
globally, as of September 30, 2015, Cohen and Steers put the total market
capitalization for real estate securities at $1.8 trillion across 487 companies (see
Exhibit 14.2).
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Exhibit 14.2: Global Real Estate Securities Market by Region on September 30,
2015; Market Capitalization in US$ billions
Sources: Cohen & Steers, FTSE, FactSet, and Standard & Poor’s
14.3.5 Real Estate Categorization by Market
Institutional investors often categorize private commercial real estate equity
investments by the size of the real estate market in which the property is located.
Real estate assets are said to trade in the primary real estate market if the
geographic location of the real estate is in a major metropolitan area of the world,
with numerous large real estate properties or a healthy growth rate in real estate
projects. Primary real estate markets tend to have easily recognizable names.
Using the United States for illustration, examples range from cities such as
Orlando, Florida, to specific metropolitan areas, such as Manhattan in New York
City. Large institutional investors focus on investments in these primary markets.
Secondary real estate markets include moderately sized communities as well as
suburban areas of primary markets. Tertiary real estate markets tend to have
less recognizable names, smaller populations, and smaller real estate projects.
U.S.
39%
Asia-Pacific
25%
Emerging
Markets
20%
Europe
14%
Other Developed
2%
U.S. $698
Asia-Pacific $451
Emerging Markets $354
Europe $263
Other Developed $44
TOTAL $1,810
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14.3.6 Risk and Return Classifications
From the perspective of an asset allocator, the most useful categorization
approach of real estate should center on the most important characteristics of the
portfolio. The primary characteristics of a portfolio are risk and return. Therefore,
asset allocators should consider including a categorization approach that focuses
on the risk and return profiles of the assets.
Chapter 16 discusses a classification of real estate that includes three types:
core, value added, and opportunistic. These three categories assist the analysis of
real estate and asset allocation decisions by grouping together real estate products
that possess similar risk and return properties. The heterogeneity of real estate
within each subcategory may lead an asset allocator to focus on distinguishing
investments based on their risk and return, perhaps using the core, value-added,
and opportunistic categories to classify them.
14.3.7 The Focus on Private Commercial Real
Estate
Most of the focus in Chapters 15 through 18 is on private commercial (i.e.,
income-producing) real estate rather than on public real estate, residential real
estate, or commercial mortgages. There are three reasons for this:
1. Most commercial real estate throughout the world is privately held rather than
publicly traded.
2. Most of the equity of residential real estate is held by the occupier of the
property rather than by an institutional investor.
3. The pricing of the equity claims to private commercial real estate drives the
pricing of the credit risk in the pricing of commercial mortgages. In other
words, real estate debt may be viewed through the structural model as being
well explained through an understanding of the risks of the equity in the same
property.
Thus, in our remaining four chapters focusing on real estate, the material
emphasizes the risk and returns of equity ownership of private commercial
properties, whether owned directly or held through limited partnerships.
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14.4 Return Drivers of Real Estate
Real estate returns are generally perceived as being fundamentally different
from the returns of other assets. For example, real estate is generally believed to
offer substantial inflation protection and distinct diversification benefits. These
distinctions are often justified based on historical tendencies, derived through
empirical analysis of past prices and returns.
An understanding of the inflation-protection potential of real estate requires
a distinction between anticipated inflation and unanticipated inflation. The
anticipated inflation rate is the expected rate of change in overall price levels.
Expectations vary across market participants and are generally unobservable.
Accordingly, indications of anticipated inflation are often based on surveys of
consensus estimates, derived from past inflation, or inferred from other market
information, such as interest rates.
To the extent that a market is informationally efficient, the level of
anticipated inflation should already be incorporated in the price and, thus, the
expected rate of return on various assets. For example, the Fisher effect states that
nominal interest rates equal the combination of real interest rates and a premium
for anticipated inflation (while other models include the effect of expected
taxation):
Nominal Interest Rate (ex ante) = Real Interest Rate (ex ante) + Anticipated
Inflation
The net result is that every asset in an informationally efficient market
provides identical protection from anticipated inflation, since every asset's price
adjusts to compensate the buyer for anticipated inflation. Thus, stable or
previously anticipated inflation rates should not be a return driver, or determinant,
by themselves.
The more challenging issue is that of unanticipated inflation.
Unanticipated inflation is the realized rate of inflation minus anticipated
inflation:
Unanticipated Inflation = Realized Inflation Rate – Anticipated Inflation
The effect of unanticipated inflation on an investment's realized return is
crucial, and the risk of unanticipated inflation is an important consideration in risk
analysis. Realized inflation in a particular period exerts its primary effect through
its role in modifying future expectations of inflation. Because changes in expected
inflation can exert substantial effects on prices, realized inflation can be an
important driver of most real estate returns. In other words, deviation in realized
inflation rates relative to previously anticipated inflation rates (i.e., unanticipated
inflation) can be a very important return driver due to its role in changing
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anticipations of future inflation rates. Volatility of the inflation rate is another
source of risk related to inflation. Finally, unanticipated inflation can have
differential effects on relative prices, which represents another source of risk. For
example, higher unanticipated inflation may lead to an immediate rise in labor
costs while having a muted effect on certain real estate properties.
The sensitivity of various real estate investments to unanticipated inflation
may be analyzed through empirical analyses of past returns or a fundamental
analysis of the investment's sources of risk and return. A challenge in empirical
analysis of the effects of unanticipated inflation is in developing an objective and
accurate estimate of the consensus-expected inflation rate. An estimate of the
anticipated inflation rate is necessary to estimate the unanticipated inflation rate as
the difference between the realized and expected inflation rates.
Another challenge is that there are typically different rates of anticipated
inflation over different time horizons. Changes in anticipation of inflation over
various time horizons could each be expected to exert different effects on various
real estate investments. Furthermore, realized rates of inflation may be studied
over various time intervals. Thus, the price reaction and inflation protection
offered by an investment should be expected to differ based on whether the
realized inflation signals a long-term change in expected inflation or a more
transient shift in inflation anticipation.
Inflation may have different effects on different types of properties.
Inflation may hurt the value of bond-like properties that have long-term leases at
fixed rates. Though properties are often valued on a pre-tax basis and before
financing costs (interest), investors in real estate equity that are leveraged with
adjustable-rate mortgages may also suffer from higher financing costs during
times of inflation. Likewise, higher/lower inflation can benefit/harm owners of
leveraged properties that are financed with fixed-rate debt. Properties with lease
structures that may benefit from high inflation include those with short-term leases
or leases in which payments contractually rise with the rate of inflation. In fact,
many leases governing long-term commercial real estate leases in the United
States contain an escalator clause, which periodically adjusts lease payments
based on some agreed upon measure of inflation.
The following factors also influence real estate returns: the state of the
economy, demographics, interest rate level, the tax treatment of real estate income
and financing costs, and trends. The next section examines the impact that some of
these factors may have on the real estate market, the asset market, and the
development (construction) industry in the framework of the four-quadrant model.
15
14.5 The Four-Quadrant Model
In this section, which draws from Geltner, Miller, Clayton, and Eichholtz
(2014), we describe the four-quadrant model of DiPasquale and Wheaton
(1992), which allows for the simultaneous assessment of the long-run equilibrium
within and between the real estate space and asset markets. A real estate system
consists of three components: the market for real estate space, the asset market,
and the construction industry. The four-quadrant model is a graphic representation
of the dynamics of a real estate system; hence, it is also referred to as a systems
dynamic model.
Exhibit 14.3 shows the four quadrants of the model. The two right-hand
quadrants correspond to the property market for the use of space, while the two
left-hand quadrants characterize the asset market for the ownership of real estate.
The four-quadrant model and the real estate system can be explained as follows:
1. Property market rent: This is the equilibrium rental rate and is
determined through the interaction of supply of space and demand for
space. It is typically assumed that the supply of space is fixed in the
short run. Demand, on the other hand, is a function of economic
conditions as well as the characteristics of the property. This appears in
the northeast quadrant.
2. Asset market value: The equilibrium rent of the previous step
determines the income that a property generates. Assuming relatively
fixed income in the short to medium term, the market value of the
property can be calculated as the present value of future cash flows.
Given the required capitalization rate of a property, its market value will
be equal to net operating income divided by the capitalization rate.
Rental income is a major determinant of net operating income, and the
current economic condition and the rate of return available on other
investments are the major determinants of the capitalization rate
required by an investor’s other investments. This appears in the
northwest quadrants
3. Construction activities: Given the equilibrium value of properties
determined above, the construction industry will compare the market
value to construction costs. This will be one of the factors that will
determine the level of construction activities in the economy. Of course,
other variables—such as the availability of credit, economic conditions,
and demography—will affect construction activities as well. This
appears in the southwest quadrant.
4. Property market: The construction activities of the previous item
determine how the supply will change, eventually affecting the supply
space, which was assumed to be fixed in the short-run. This means, that
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while the supply is fixed in the short-run, the level of rental income will
spill over into construction industry, which with some time lag affect
the supply of space. This appears in the southeast quadrant.
Now that we have discussed the overall logic of the model, below we
provide a more detailed analysis of the four-quadrant model.
The northeast (NE) quadrant has two axes: rent (which is measured in $ per
unit of space, such as square feet) and the stock of space (measured in the same
units of space). This quadrant describes how rents in the space market are
established. In equilibrium, the demand for space, the downward-sloping line D, is
equal to the stock of space, S. Assuming that the stock of space is fixed—a
plausible assumption for the short run—rents must be determined so that the space
demand is exactly equal to the stock of space. Demand is a function of rent and
conditions in the economy. Rent (R*) is found by plotting a level of stock of space
on the x-axis up to the demand line and over to the y-axis. In the short run, rents
are determined in the NE quadrant.
The northwest (NW) quadrant has two axes: rent ($) and price ($ per square
feet). The ray starting off out of the origin represents the ratio of rent to price for
real estate assets. The ratio of net operating income to price is known as the
capitalization rate (i). Here we use the rental income as a proxy for net operating
income. Generally, the capitalization rate is taken as exogenous and is a function
of the following four variables: the expected growth in rents, the risks related to
the income stream from rents, the long-term interest rate in the economy, and the
tax code treatment of real estate income. A higher (lower) capitalization rate is
represented by a clockwise (counterclockwise) rotation in the ray. The NW
quadrant takes the rent level (R*) from the NE quadrant and establishes a price for
real estate assets (P*) based on the capitalization rate (i). That is, given a required
income yield and given the income generated by a property, we can value the
property as
Rent/Capitalization rate.
In the four-quadrant model, the price of the real estate asset is determined
by moving first from the vertical axis (rent level) in the NE quadrant over to the
ray in the NW quadrant, and then down to the price level on the horizontal axis.
Continuing moving in a counterclockwise manner, the next quadrant (southwest,
or SW) is the section of the asset market where the construction of new real estate
assets is determined. Here, the line f(C) represents the replacement costs (RCosts)
of real estate. Construction costs increase with greater construction activity, and
therefore the curve moves in a southwesterly direction, intersecting the price axis
at the minimum dollar value per unit of space required to generate construction
activity.1 The level of new construction is established where asset prices equal
17
replacement costs. This is determined by a move to the SW quadrant where the
replacement cost curve determines the level of construction given the price of real
estate assets from the NW quadrant. Higher levels of construction would be
unprofitable, whereas lower levels would generate excess profits. Therefore, real
estate prices (P) equal construction costs (RCosts), both of which are a function of
the construction level (C).
Exhibit 14.3: The Four-Quadrant Model
Source: DiPasquale and Wheaton (1992)
In the southeast (SE) quadrant, the long-run stock of space is created by the
annual flow of new construction. The change in the stock of space in a certain
period (ΔS) is equal to new construction (C) minus the depreciation rate (d, which
represents losses from the stock) times the stock (S). The ray emanating from the
origin corresponds to that level of the stock of space (on the x-axis) that requires a
level of annual construction for replacement just equal to that value on the y-axis.
Rent ($/SF)
Stock (SF)
Price ($)
Construction (SF)
Property Market:
Stock Adjustment
Asset Market:
Construction
Property Market:
Rent Determination
Asset Market:
Valuation
Q*
R*
P*
C*
D = S
P = R/i
P = RCosts = f(C)
ΔS = C - dS
18
At that level, the stock of space will remain constant over time, given that
depreciation will be exactly equal to new completions. Therefore, Δ is equal to
zero and C = dS.
14.5.1 An Illustration of the Four-Quadrant
Model: Explaining Real Estate Market Booms
and Busts
Let us assume that the real estate market is experiencing a boom, and that
demand for space surges unexpectedly (for example, due to an unanticipated
increase in employment, production, or the number of households). In Exhibit
14.4, this is represented by a shift to the right in the demand curve for rents in the
NE quadrant (from D0 to D1). In the short run, rents rise from R* to R1 (the rent
level that relates the original stock of space Q* to the new demand function D1),
and real estate prices increase from P* to P1 in the asset market (NW quadrant), as
there is no time for new space to be constructed in response to the unexpected
increase in demand. However, this is not a long-run equilibrium. After a year or
two, new space is developed, and rents decrease from R1 to R** (and real estate
prices from P* to P**), which is nonetheless still above the initial equilibrium rent
of R* (and the initial equilibrium real estate prices, P*). This occurs because the
long-run marginal cost function of the real estate market is outward-sloping (SW
quadrant). Furthermore, notice that Q** > Q*, and thus the long-run equilibrium
quantity of space is higher than it was at the original level of demand for rental
space. This result will hold as long as the demand for rents exhibits at least some
price elasticity.
We have just observed that, in the short run, an unexpected increase in
demand for rental space (NE quadrant) leads to an increase in rents, given that the
level of real estate space is fixed. These higher rents then cause a rise in real estate
prices (NW quadrant), which, in turn, stimulates new construction (SW quadrant).
In the long run, this leads to a greater stock of real estate space (SE quadrant). The
slopes of the different curves determine the size of the changes in these four
variables. For instance, if construction were very inelastic with respect to real
estate prices, then the new levels of rents and asset prices would be much higher
than before, and new construction and the level of stock of space would have
expanded only slightly.
Shifts in the demand for real estate assets may result from a number of
factors, such as changes in short-term or long-term interest rates, the tax treatment
of real estate, and the availability of construction financing, as pointed out by
DiPasquale and Wheaton (1992).
19
Exhibit 14.4: The Four-Quadrant Model: Booms in the Real Estate
Market
If interest rates in the rest of the economy rise (fall), then the existing yield
from real estate becomes low (high) relative to fixed-income securities, and
investors will wish to shift their funds from (into) the real estate sector. Similarly,
if the risk characteristics of real estate are perceived to have changed, then the
existing yield from real estate may also become insufficient (or more than
necessary) to get investors to purchase real estate assets relative to other assets.
Finally, changes in how real estate income is treated in the U.S. tax code can also
greatly impact the demand to invest in real estate. Favorable depreciation rules for
real estate (e.g., short tax life and accelerated depreciation schedule) increase the
after-tax yield generated by real estate, which increase the demand to hold real
estate assets. Reductions in long-term interest rates, decreases in the perceived risk
Rent ($/SF)
Stock (SF)
Price ($)
Construction (SF)
Property Market:
Stock Adjustment
Asset Market:
Construction
Space Market:
Rent Determination
Asset Market:
Valuation
Q*
R*
P*
C*
D0D1
R**
P**
C**
R1
P1Q**
20
of real estate, and generous depreciation or other favorable changes in the tax
treatment of real estate will cause a reduction in the income that investors require
from real estate.
These changes can also be examined using the four-quadrant model. As
noted by DiPasquale and Wheaton (1992), higher interest rates, greater perceived
risk, and adverse tax changes rotate the ray in a clockwise manner. Given a level
of rent from the property market, a reduction in the current yield or capitalization
rate for real estate raises asset prices and in the SW quadrant, expands
construction. Eventually this increases the stock of space (in the SE quadrant),
which then lowers rents in the property market for space (NE quadrant). A new
equilibrium requires that the initial and finishing rent levels be equal to each other.
This new equilibrium results in a new solution that is lower and more rectangular
than the original. In the new equilibrium, asset prices must be higher and rents
lower, while the long-term stock and its supporting level of construction must be
greater. If rents were not lower, the stock would have to be the same (or lower)
and this would be inconsistent with higher asset prices and greater construction. If
asset prices were not higher, rents would be lower, and this would be inconsistent
with the reduced stock (and less construction) which lower asset prices would
generate.
As we have seen, the four-quadrant model is a useful tool for analyzing the
short-run and long-run equilibrium, as well as its potential perturbations, in the
property market (rent determination), the asset market (valuation and
construction), and the property market (stock adjustment).
14.6 Conclusion
This chapter has reviewed the attributes, asset allocation, categories, and
return drivers of real estate. It also presented the four-quadrant model, which
allows the simultaneous assessment of the long-run equilibrium within and
between the real estate space and asset markets, and provides a graphic
representation of the dynamics of a real estate system.
The next four chapters will help us gain a deeper understanding of real
estate as an investment in a number of fronts. Chapter 15 examines real estate
indices and performance evaluation. The chapter discusses the two main
approaches to indexation (appraisal-based and transaction-based), and focuses on
the consequences and remedies of data smoothing in real estate. Chapter 16
examines investment styles (core, value added, and opportunistic, the main
approach to categorizing investments within the category of private commercial
real estate equity), portfolio allocation, and the challenges of using real estate
derivatives to hedge market risk in real estate markets. Chapter 17 presents the
21
main characteristics of unlisted (open-end funds and closed-end funds) and listed
real estate products (REITs and ETFs based on real estate indices), as well as the
extent to which analysis of publicly traded real estate securities may be used to
provide information on the risks and returns of private real estate. Finally, Chapter
18 examines international real estate investments, examining their potential
opportunities (mainly enhanced returns, diversification benefits, potential tax
advantages, and leverage), as well as the main challenges when going international
(lack of local knowledge, agency costs, regulatory restrictions on foreign
ownership, higher transaction costs, complex taxation, and exchange rate risk,
among others).
References
Cohen & Steers. “About REITs.” https://www.cohenandsteers.com/insights/education/about-reits
Deloitte, 2015, “2015 Commercial Real Estate Outlook,”
http://www2.deloitte.com/us/en/industries/real-estate.html?icid=top_real-estate
DiPasquale D., and W. C. Wheaton. 1992. “The Markets for Real Estate Assets and Space: A
Conceptual Framework.” Journal of the American Real Estate and Urban Economics
Association 20 (1): 181–97.
Federal Reserve. 2015. “Z.1 Financial Accounts of the United States.” Federal Reserve
Statistical Release, December 10. http://www.federalreserve.gov/releases/z1/
Geltner, D., N. Miller, J. Clayton, and P. Eichholtz. 2014. Commercial Real Estate Analysis and
Investments. Mason, Ohio: OnCourse Learning.
Idzorek, T., M. Barad, and S. Meier. 2007. “Global Commercial Real Estate.” Journal of
Portfolio Management 33 (5): 37–52.
Market Reports Online. 2015. “Residential Mortgages: Global Industry Guide.” January.
http://www.marketreportsonline.com/395332.html
National Association of Real Estate Investment Trusts. 2016. “REIT Industry Fact Sheet.”
January.
https://www.reit.com/sites/default/files/media/PDFs/MediaBriefs/MediaFactSheetDec201
5.pdf
Savills. 2014. “UK Housing Stock Value Climbs to £5,205,000,000,000 but the Gap Between the
Haves and the Have Nots Grows.” January 27.
http://www.savills.co.uk/_news/article/72418/172125-0/01/2014/uk-housing-stock-value-
climbs-to-%C2%A35-205-000-000-000-but-the-gap-between-the-haves-and-the-have-
nots-grows
22
Notes
1. The ray would be almost vertical if construction could be supplied at any level with almost the
same costs. However, land scarcity, bottlenecks, and so on, lead to an inelastic (i.e.,
insensitive) supply and, hence, to a ray that is more horizontal.
