Value Drivers and Property Types

Economic Value Drivers

Common macro factors affecting all types of real estate include GDP growth, wage growth, and job creation. An improving economy initially leads to an increase in rents and a reduction in vacancies, which encourages additional supply, but that supply takes time to emerge because of the long lags in developing real estate.

Job creation and wage growth lead to higher personal income, which results in rising household formation. This establishment of new residences leads to an increase in demand for residential real estate, both rental and owner occupied.

Low home prices relative to incomes, as well as low mortgage rates, tend to increase the demand for owner occupied housing. This, in turn, spurs new construction. Figure 31.4 shows the typical pattern in the housing market.

Figure 31.4: Real Estate Cycle

The real estate cycle follows several phases:

The recovery phase begins during a business cycle trough. Tight credit conditions and an uncertain business environment discourage new construction, while lower wages put downward pressure on rents. During this phase, interest rates, NOI, and DSC reach a bottom and start rising, while LTV peaks and begins to fall.

The expansion phase coincides with improvement in the business cycle. This leads to wage growth and improved credit conditions, while rents begin increasing, spurring new construction. At the peak of the economic cycle, rising interest rates and property prices reduce demand for new construction.

Interest rates, NOI, and DSC continue to rise, while LTV continues to fall.

The oversupply phase occurs as the economy softens and construction projects in the pipeline are delivered to the market. This contributes to excess supply and decreases prices and occupancy rates. Interest rates, NOI, and DSC peak and begin to fall, while LTV reaches a bottom and begins to rise.

The recession phase occurs as the economy continues to soften, leading to credit tightening and further declines in real estate prices and occupancy rates. Interest rates, NOI, and DSC continue to fall, while LTV increases.

Portfolio Characteristics

Real estate has similarities with and differences from traditional asset classes such as stocks and bonds. Properties generate bond like fixed lease payments, while also having exposure to equity like speculative returns from capital appreciation.

Portfolio characteristics of real estate investment include the following:

Current income. Rental income differs from fixed rate coupons on bonds because leases often include step up clauses. Some leases are variable rate, where the rents are indexed to a market variable such as the Consumer Price Index.

Retail properties may have an overage clause that results in a higher rent when a tenant’s sales exceed a specified level. Some leases require the tenants to bear the operating costs of the property. When the real estate investor’s holding period exceeds the lease term, the investor faces rollover risk related to finding a new tenant at the end of the lease term.

Capital appreciation. The market value of a property tends to increase over time. Due to the illiquidity and heterogeneity of real estate, a precise measure of capital appreciation is only possible at the time of sale.

Inflation hedge. Real estate can act as an inflation hedge both through rising rents and via property value appreciation. Longer term leases often use variable rental rates that are indexed to inflation.

Diversification. Low historical price correlations with traditional assets such as stocks and bonds can make real estate an attractive portfolio diversifier.

Tax benefits. Many countries have tax code provisions that provide depreciation deductions, sometimes exceeding the economic loss from deterioration of property value. Also, REITs are exempt from double taxation in many jurisdictions.

Commercial properties derive their income and value from the economic use of the property, which is influenced by industry specific factors. Some different types of commercial properties, and their associated value factors and risks, include the following:

Office properties. These may be built to serve the needs of a key tenant (e.g., company headquarters), or to serve many tenants. Traditionally, demand for offices was driven by business start ups.

However, the work from home phenomenon that gained momentum during the COVID 19 pandemic has put a significant dent in demand for office space.

Industrial and warehouse properties. This kind of real estate is sometimes developed for specific clients. Growth in e commerce has increased demand for warehouse properties.

Repurposing these properties to new uses often requires expensive redevelopment.

Retail properties. These include anchor department stores and regional shopping centers. Growth in e commerce has generally reduced the demand for retail properties, in some cases leading to expensive repurposing.

Proximity to local workers and residents is an important attribute for valuing retail properties.

Hospitality properties. These include hotels and other lodging. Their value is influenced by demand for business and leisure travel.

Trade shows and conventions are important business drivers for large properties built as convention centers. Business travel is cyclical, which affects room rates and occupancy levels.

Mixed use. These encompass office/retail, residential/retail, and other combinations that derive value from exposure to multiple classes of commercial properties.

Other specialty. This broad classification includes senior housing, self storage, hospitals, cell towers, data centers, college dormitories, and parking facilities. Each property type has exposure to different risks.

The independent living category of senior housing, for adults who need only minimal assistance, requires less management. A continuing care facility, by contrast, provides seniors more help with daily tasks, which is management intensive. The growing population of seniors is increasing demand for both types of senior housing.

Self storage features short term rentals, which allows frequent repricing of rents, though occupancy rates can fluctuate.