The Real Estate System
The commercial real estate market is according to Geltner & Miller (2001) divided into the space market and the asset market. An additional component in the real estate market is the commercial property development industry. The space market and the asset market are linked together by the development industry. Together they form the real estate system.
The Space Market
The space market is according to Geltner & Miller (2001) the market for the usage of real property. It is often also referred to as the rental market. The demand side of the space market are individuals and firms that want to use space for either consumption or produc-tion purposes. The supply side consist of owners who rent space to tenants.
The real estate space market is hugely segmented because both supply and demand are lo-cation and type specific. In turn, the rental prices for physically similar spaces can differ widely from one location to another or from one type of building to another.
The typical demand function looks essentially like the classical demand functions of eco-nomic theory. As demand grows, the downward-sloping line moves out and to the right. The increase of the demand is usually due to both national and local factors.
The supply side, on the other hand, looks completely different from the classical supply function. Instead, the supply function is illustrated as being “kinked”, meaning that it is not continuous, but has a corner or break in it. Due to the extremely long lifetime of built space the supply of a space is almost completely inelastic, which means that if demand falls, the space can not be reduced (at least not in the long run). So for several years the market will essentially maintain the same quantity of supply. (Geltner & Miller, 2001)
The “kink” in the supply function occurs at the quantity of built space at a rent level that relates to the long-run marginal cost of supplying additional space to the market. The mar-ginal cost, in the case of the space market, is the cost of developing new buildings. When the development cost of new buildings is greater than the last one built, then the supply line is rising above the “kink” point. If it would cost less, the supply function is falling. The shape of the supply function fundamentally determines the level of rents as demand changes over time. In general, the “kink” means that if the space market is currently in equilibrium, future increase in demand will result in a small or zero increase in rent levels in the long run. Due to that, the “kink” in the supply curve in the real estate space markets have often tended to be cyclical, with periods of excess supply followed by tight markets. This happened in many real estate markets in the late 1980s and early 1990s. The demand could not match the supply which in turn resulted in falling rent levels. (Geltner & Miller, 2001)
The Asset Market
Real estate assets consist of real property, that is, an estate or property consisting of lands and of all appurtenances to lands, as for example buildings. These assets are according to Geltner & Miller (2001) in an economic perspective, consisting of claims to future cash flow, e.g. the rents that the building can generate. The asset market is also often referred to as the real estate/property market or the investment market.
According to Geltner & Miller (2001), the demand side of the asset market is composed by investors wanting to buy property. The supply side is made up of other investors who want to sell the total or reduce a part of their holdings of real estate assets. The balance between supply and demand determines the overall level of real estate asset values. Specific property values is determined by the perception of potential investors, what the investors are willing to pay, regarding the level of and risk of the cash flow that the property can generate in the future. The most widely, especially in commercial property markets, used measure is the capitalization rate (cap rate). Cap rates provide a tool for investors to use for roughly valu-ing a property based on its income (e.g. rental income generated from lease contracts). It is the ratio between the cash flow produced by an asset (the real estate) and its capital cost (the original price paid to own the asset). The rate is calculated in a simple fashion as fol-lows:
annual cash flow / cost (or value) = Capitalization Rate The property value can thus be represented as:
Earnings (essentially net rents) / cap rate
The Development Industry
As stated before, buildings are “long-lived” assets. It is therefore only the demand for new built space that supports the development industry. Because the demand is sensitive to general economic changes, the development industry is subject to “boom and bust” cycles. (Geltner & Miller, 2001)
The development industry is according to Geltner & Miller (2001), the converter of finan-cial capital into physical capital. In addition, the development industry serves as a feedback loop from the asset market to the space market, adding to the supply side of the space market. The development industry is governing the amount of physical space on the supply side of the space market.
According to Geltner & Miller (2001), investors’ perceptions of the risk and returns of the real estate assets and forecast about the future of the space market determine the current cap rate. These interactions between the asset market and the space market produce the current real estate asset values. These values represent the output from the asset market and the input in the development industry.
When forecasting the investors’ must take both the economic base underlying the demand side of the space market and the activity in the development industry on the supply side of the space market into consideration. In addition, they must consider forecasts of the capital market and macroeconomic factors such as interest rates and inflation. (Geltner & Miller, 2001)
Return and Risk Management
In the commercial real estate market risk is defined as the possibility that future investment performance will vary over time in a manner that is not entirely predictable at the time when the investment is made. Risk is a crucial factor to consider when investing in real es-tate. Understanding how risk is related to returns is a basic part of understanding the real estate investment. Other things being equal, real estate investors will prefer less risky in-vestments. There is an underlying risk for the investors to loose all of the capital they invest or to loose any of the capital invested. An investor’s primary financial goal is to maximize wealth by accept capital investments that offers some optimal combination of return and risk that fulfil the investor’s preferences. For the most of the time investors want their rate of return to be very high since they prefer more return than loss. Also, other things being equal, the rate of return should be dependable and stable, which means that they prefer less risk to more risk. (Geltner & Miller, 2001)
Risk is related to the possible future returns that the investment might earn and the degree of deviation or dispersion of those expected returns. Standard deviation is the most com-mon measure of statistical dispersion. The greater the standard deviation in the possible re-turn, the greater is the risk. A diversified portfolio of real estate assets has a smaller stan-dard deviation. Risk is represented by the range of deviation of the possible future return outcomes. If an investor has to choose from two assets with the same expected return, the investor should choose the more risky asset since it will typically have a greater chance of returning a larger profit. It is a fundamental fact that expected returns are greater for more risky assets. Risky assets must offer a higher expected return in order to compensate inves-tors for taking on risk when they buy these assets. Even though standard deviation is one of the most widely used measurement of risk it is worth mentioning that measuring the ex-act risk of an investment is highly difficult. (Geltner & Miller, 2001)
In the commercial rental market, risk is viewed from a different angle. Risk is instead asso-ciated with creating long lasting stabile relationships between real estate companies and their tenants. Risk is also connected to the diversification and spread of the expiring of a contract portfolio. A diversified contract portfolio consists of a mix of tenants with diversi-fied tenant structure and lease maturity structures. Real estate companies have different risk perceptions and preferences. For example, small real estate companies may not be able to diversify their portfolios and therefore they are exposed to more risk.
1.2 Problem and Research Questions
2.1 Deductive vs. Inductive Research Approach
2.2 Qualitative vs. Quantitative Research Methods
2.3 Approach and Method Chosen
2.4 Validity and Reliability
3 Frame of Reference
3.1 The Real Estate System
3.3 Cash Flow Projections
3.4 Economic Indicators
3.5 Vacancy Rate
3.6 Market Rents
4 Empirical Findings
4.1 The Economic Indicators in Sweden
4.2 The Commercial Rental Market in Gothenburg
4.3 The Commercial Rental Market in Stockholm
4.4 The Property Clock
4.6 Factors Affecting the Setting of Rents
5.1 Analysis Structure
5.2 Factors Affecting the Setting of Rents
5.3 The Commercial Rental Market in Stockholm and Gothenburg
6.1 Suggestions for Further Studies
8.1 Intervju underlag
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