Professional Property Development

PROFESSIONAL PROPERTY DEVELOPMENT

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PROFESSIONAL PROPERTY DEVELOPMENT

John McMahan

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Copyright © 2007 by John McMahan. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-151069-9 The material in this eBook also appears in the print version of this title: 0-07-148598-8. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. For more information, please contact George Hoare, Special Sales, at [email protected] or (212) 904-4069. TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. DOI: 10.1036/0071485988

Professional

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To the developers, investors, managers, professional advisors, government officials, and academics who make real estate one of the most dynamic and rewarding industries in the world today. And most of all, to the users of real estate, without whom, none of this would be possible.

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CONTENTS

ACKNOWLEDGMENTS

xi

CHAPTER REVIEWERS

xiii

INTRODUCTION

xv

PART I

HISTORICAL PERSPECTIVE CHAPTER 1

The Inalienable Right

3

Land for all . . . Growth of urban areas . . . Dominance of suburbia . . . Search for alternatives . . . Changing leisure patterns CHAPTER 2

The Changing Ground Rules for Property Ownership

37

The evolution of planning and zoning in America . . . The environmental movement CHAPTER 3

The Restructuring of the Industry

63

Responding to consumers . . . Broadening the financial base PART II

THE ECONOMICS OF REAL ESTATE CHAPTER 4

The Economics of Real Estate at the Global Level

87

Major forces underlying globalization of real estate investment . . . Regional and country characteristics . . . Comparing potential investment markets vii

viii

Contents

CHAPTER 5

The Economics of Real Estate at the National Level

127

National demand patterns . . . National supply patterns . . . Real estate and the business cycle CHAPTER 6

The Economics of Real Estate at the Local Level

151

Local demand patterns . . . Local supply factors . . . Theories of land use development patterns CHAPTER 7

The Economics of the Individual Parcel 171 The concept of highest and best use . . . The importance of location . . . The real estate market . . . Purchase transactions PART III

ANALYZING MARKET DEMAND CHAPTER 8

Residential

193

Ownership housing . . . Rental housing . . . Planned unit developments CHAPTER 9

Retail

219 Goods and services . . . Potential demand . . . Venues . . . Tenants . . . Location . . . Analyzing market demand

CHAPTER 10

Office

243 The changing American workplace . . . Office activity nodes . . . Influence of tenancy on market analysis . . . Analyzing market demand

CHAPTER 11

Industrial

267

Theories of industrial location . . . Major changes in product distribution . . . Site selection process . . . Analyzing market demand CHAPTER 12

Transient Commercial

285

Differentiating characteristics . . . Types of facilities . . . Sources of lodging demand . . . Analyzing market demand

ix

Contents

CHAPTER 13

Multiuse Projects

303

The case for multiuse development . . . Characteristics of multiuse developments . . . Analyzing market demand . . . Market synergy . . . Market analysis for new towns PART IV

FINANCING THE PROJECT CHAPTER 14

Mortgage Financing

323

Rationale supporting real estate debt . . . Legal instruments . . . Primary mortgage market (origination) . . . Secondary mortgage market . . . Mortgage lending process . . . Financing characteristics for different types of properties CHAPTER 15

Equity Investment

347

Real estate risk and return . . . Vehicles for equity investment CHAPTER 16

Measuring Real Estate Returns

375

Simple return analysis . . . Discounted cash flow analysis PART V

BUILDING AND OPERATING THE PROJECT CHAPTER 17

Planning and Designing

411

Planning and design process . . . Planning and design aspects of various types of projects CHAPTER 18

Construction

443

Types of construction . . . Contract construction . . . Dealing with potential problems . . . Scheduling and monitoring progress

x

Contents

CHAPTER 19

Marketing

467

Internal brokerage team . . . Independent brokerage firm . . . Listing agreements . . . Commissions . . . Project promotion . . . Closing the deal . . . Monitoring progress CHAPTER 20

Property Management

489

Importance of good property management . . . Tenant relations . . . Leases . . . Rental income . . . Operating expenses . . . Capital improvements . . . Construction management . . . Security-related improvements . . . Disaster planning APPENDIX

The Appraisal Process

519

Definition of appraisal . . . Definition of market value . . . The traditional approach . . . Problems with the traditional approach . . . Future directions Glossary 537 Index 571

ACKNOWLEDGMENTS

In order to assure the reader as to the practical application of the material covered in the book, many elements were reviewed by professional managers currently active in the development and investment industry. Some of the more technical chapters also were reviewed by specialists in related areas. The section on Real Estate Investment Trusts in Chapter 3 was reviewed by Michael R. Grupe, Executive Vice President, Research & Investment Affairs, National Association of Real Estate Investment Trusts, Washington, D.C. Chapter 4 deals with a relatively new phenomenon in real estate: developing and investing on a global basis. Due to the complexity of the subject, this chapter was reviewed by a wide range of professionals and academicians involved in the various intricacies of global real estate development, finance, and management. Joel H. Cowan, William B. Turner Chair in Servant Leadership, Institute for Leadership and Entrepreneurship at Georgia Tech, reviewed the role of business in the global expansion of real estate development and investment. Hamid R. Moghadam, Chairman and CEO of AMB Property Corporation, San Francisco, contributed thoughts on the role of real estate operating companies. Sonny Kalsi, Managing Director, Morgan Stanley Investment Banking Division, New York, reviewed the chapter from a financial perspective. Jacques Gordon, Global Strategist for LaSalle Investment Management of Chicago focused primarily on country governance issues. Finally, local Asian perspective was provided by Robin How, formerly Managing Director, APC Asset Management in Hong Kong; and the European perspective by Paloma Taltavull, Professor of Applied Economics, University of Alicante, Spain. Two of the market analysis chapters were reviewed by individuals currently active in their respective property markets. John Reininga, Chairman of the Board of the Reininga Corporation in San Francisco and former Chairman of the Board of the International Council of Shopping Centers, was helpful with the retail material (Chapter 9) as was Ken Himmel, President, CEO, and Founder of the Urban Development Division of the Related Companies of New York City in connection with the chapter on mixed-use development (Chapter 13). xi

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xii

Acknowledgments

Chapter 14 on mortgage financing was reviewed by Robert B. Goldstein, Chairman of the Executive Committee of Great Lakes Bancorp, Inc., the successor company to Bay View Capital Corporation. Debra L. Viall of DLV Consulting, Inc., an experienced specialist in real estate project analysis and transaction management, offered several constructive comments on Chapter 16 on measuring equity returns. Chapter 17 on planning and design was reviewed by Gene Schnair, Managing Partner for the San Francisco office of Skidmore, Owings & Merrill LLP, with Simon W. R. Snellgrove, Managing Director of Pacific Waterfront Partners LLC, providing the developer’s perspective. Chapter 18, discussing the construction process, was reviewed by Phillip Helms-Cook, Senior Vice President and head of the San Francisco office of Marx/Okubo, a national construction management firm. Chapter 19, covering the critical process of marketing space to potential tenants, was reviewed by Jeffrey H. Congdon, Executive Managing Director of Capital Markets, Cushman & Wakefield, a global real estate brokerage firm. Finally, I’d like to express a special note of gratitude to Lena Sloan, my Research Assistant, for her role in proofreading and producing the draft manuscript as well as providing her assistance in developing many of the exhibits and the Glossary. She also was heavily involved in the development of Chapter 16 on measuring equity returns. Ms. Sloan received her master’s degree in International and Development Economics from the University of San Francisco. John McMahan

CHAPTER

REVIEWERS

Jeffrey H. Congdon Executive Managing Director Capital Markets Cushman & Wakefield San Francisco Joel H. Cowan William B. Turner Chair in Servant Leadership Institute for Leadership and Entrepreneurship Georgia Institute of Technology Atlanta Robert B. Goldstein Chairman of the Executive Committee Great Lakes Bancorp, Inc. Buffalo, New York Jacques Gordon Global Strategist LaSalle Investment Management Chicago Michael R. Grupe Executive Vice President Research & Investment Affairs National Association of Real Estate Investment Trusts Washington, D.C. Phillip Helms-Cook Senior Vice President Marx/Okubo San Francisco Ken Himmel President, CEO, and Founder Urban Development Division Division of the Related Companies New York

Robin How Former Managing Director APC Asset Management Hong Kong Sonny Kalsi Managing Director Morgan Stanley Investment Banking Division New York Hamid R. Moghadam Chairman and CEO AMB Property Corporation San Francisco John Reininga Chairman of the Board Reininga Corporation San Francisco Gene Schnair Managing Partner Skidmore, Owings & Merrill LLP San Francisco Simon W. R. Snellgrove Managing Director Pacific Waterfront Partners, LLC San Francisco Paloma Taltavull Professor of Applied Economics University of Alicante Spain Debra L. Viall President DLV Consulting, Inc. San Francisco

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INTRODUCTION

In a nationwide survey conducted several years ago, a major pollster asked Americans to identify their most favored form of investment. To the surprise of many, particularly those on Wall Street, the answer was not stocks and bonds but real estate. What’s astonishing is that there was any surprise. Real estate has always held a very special place in the hearts of most Americans. Great personal fortunes have been based on it, institutions have been built around it, and governments have risen and fallen over its use. In fact, real estate has been a premier investment since the Mayflower landed at Plymouth Rock. The history of America’s romance with the land is long and colorful. Several of the founding fathers speculated in land. Some of the largest cities in the United States began as land promotions. Land provided the motivating force behind the development and expansion of the canal and railroad systems. Florida and California probably would be largely swamps and deserts today if they hadn’t fallen prey to land speculators. The people who developed and speculated in land were equally colorful: John Jacob Astor, who made millions buying up farmlands in Manhattan; Jay Cooke, who helped finance the Civil War but couldn’t pull off one of the largest land speculations of all; and many others. And then there were those who developed buildings on the land as well: Henry Flagler, who almost single handedly built Florida; the Van Sweringen brothers, who developed Shaker Heights near Cleveland, the granddaddy of modern suburbs; Harry Black, who pioneered high-rise construction in New York; the Levitts, who made mass-produced suburbs a reality; William Zeckendorf, who revitalized many of the nation’s central cities; Trammel Crow, who pioneered suburban industrial development; John Portman, who revolutionized hotel design; Gerald Hines, who used design and management techniques to bring excitement to office buildings; and James Rouse, who created the “festival marketplace,” combining shopping and entertainment in Boston, Baltimore, New York, and other cities. Many of these bigger-than-life individuals created vast fortunes for themselves through real estate; others died penniless. All had a certain style and vision of America’s future.

xv

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xvi

Introduction

What is it about this mystical entrepreneurial pursuit of real estate that has attracted so many people through the years? The many definitions that have been proposed have been shaped by the viewpoint of the people or disciplines involved. Geographers and cartographers tend to see real estate as a physical entity that can be seen, touched, and measured. Lawyers view it as a bundle of rights people possess related to land and its use. To economists, real estate is the economic value created by activity associated with land and its use. In reality, real estate is all of these: it is the economic exploitation of legal rights to land. Let’s explore this concept a bit further. Certainly, land is the foundation of real estate activity. Physically, land is the outer crust of the earth’s surface, including soil and vegetation. Land also has certain tangible characteristics: it is durable; except for drastic acts of God, such as earthquakes and other catastrophes, land is virtually indestructible. It is also immobile; unlike tools, machinery, and other items that can be moved from place to place, the location of land is fixed. Finally, land is nonsubstitutable; every parcel of land has physical characteristics that make it unique and discernible from all other land parcels. These characteristics make it possible to ascribe certain legal rights to individual parcels of land. This bundle of legal rights has evolved through the years and affects virtually every aspect of real estate. Certain legal instruments establish the rights of ownership to land and improvements. Other instruments protect the rights of those who participate in the construction process or who lend monies using real estate as collateral. Still other instruments such as leases deal with the relationship between those who own real estate and those who utilize it on a periodic basis for personal or business purposes. In recent years, concerns about the human and physical environment have resulted in the enactment of land use and building standards to protect the public from potential abuse and to enhance longer-term natural and human values. In the private sector, legal rights are of little value, however, unless they are exploited economically. In urban areas, exploitation usually occurs through the construction and sale or lease of a building, or a portion thereof, to an owner or tenant user. The user may be an individual or family living in a home or apartment; a retailer offering merchandise in a store or shopping center; a business or government agency leasing space in an office or industrial building; or an operator managing a transient commercial facility. The buildings built for these users are referred to as

Introduction

xvii

improvements, reflecting the historic view that land values are enhanced, or improved, through the construction and use of buildings. The improvement of raw land occurs through the property development process, which is a highly creative endeavor in which physical ingredients such as land and buildings are effectively combined with financial, marketing, and management resources to create an environment in which people live, work, shop, and relax. At its best, the development process is synergistic—that is, the ultimate combination has a greater value than the sum of the individual parts. The degree to which synergy exists in a real estate project is partly a result of the location and character of the land involved. Some parcels are so well located or have such great physical beauty that value is created under virtually any development program. Most parcels, however, aren’t so fortunate and require the utmost in creative skills on the part of the developer to marshal the necessary resources and skillfully weave them together into a finished product that is economically sound, aesthetically pleasing, and environmentally responsible. These creative skills are built on an explicit or implicit understanding of the fundamentals of the development process. These fundamentals— market research, finance, planning and design, construction, marketing, and property management—must be intrinsically sound and interrelate in such a manner that the overall project becomes a viable entity. A weakness or failure in any one area can result in less-than-desired economic performance or possibly lead to the unraveling of the total effort. This book is about the fundamentals of the real estate development process and how to achieve desired outcomes. After the historic and economic stage has been set, the book pursues each of the fundamentals in a step-by-step fashion in much the same way an experienced, wellorganized developer would approach a new project. The emphasis throughout is on the important role played by each of the fundamentals and how they should mesh into a smoothly functioning process to create long-term human satisfaction and enhanced monetary value.

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PA R T I

Historical Perspective

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CHAPTER 1

The Inalienable Right

It clearly appears to me that the two great objects of America must be the settlement and cultivation of good lands and the establishment of manufactures. If we review the rise and progress of private fortunes in America, we shall find that a very small proportion of them has arisen or been acquired by commerce, compared with those made by prudent purchases and management of lands. Silas Deane, 1783 U.S. commissioner to France 1776 to 1778

Americans historically have viewed as an inalienable right the private ownership of land, whose use is to be determined exclusively by its owner. The origins of this deep-seated conviction aren’t entirely clear. Perhaps it was in reaction to the European heritage, which allowed only a few people to own land. Possibly it was linked to the ingrained American belief in the freedom of the individual. Or maybe there was so much land that no one questioned the right of individuals to do as they wished with their own property. Whatever the origins, the history of real estate in the United States, until recently, has been the story of private ownership and development of land.

LAND FOR ALL For the first hundred years after the Revolution, America was one great land speculation. Everybody was involved: European nobility; the founding 3 Copyright © 2007 by John McMahan. Click here for terms of use.

4

Professional Property Development

fathers; merchants; investment bankers; railroad tycoons; government officials; and, as speculation became better organized, many average Americans. Great fortunes were won and lost as land bubbles formed and burst. New cities appeared and disappeared almost overnight. Canals were extended, railroads built, and even wars financed—all on the basis of investors’ anticipations regarding the future value of land. Land Companies Early private speculation in land had trouble getting started because so much land was given away by the king of England in order to promote settlement. Initially, the land was distributed by colonial governors who granted land for town establishment, development, and farming to members of military or religious orders, or merely for good political connections. They also sold it to speculators. Gradually, the amount of free land diminished in the East, and speculators’ sights turned toward land west of the Alleghenies. Land companies were formed (Figure 1-1), and land grants were obtained to settle this land—until the British forbade colonial governors to make grants to individuals (the latter, incidentally, a factor leading to the Revolution). After the Revolution, land speculation resumed and in a few years reached boom proportions. It was fed not only by new lands in the West but also by the confiscation of Tory holdings and the issuance of land warrants to returning soldiers. The boom collapsed around 1800 largely because there was simply too much land for the arriving settlers. Town Jobbing As America moved into the nineteenth century, land speculation was at a low ebb. To stimulate new interest, Congress passed legislation reducing the minimum for single-purchase tracts from 640 to 230 square acres. The federal government then opened up scores of land offices to facilitate the sale of government land to settlers. Private land companies decided to accelerate their own efforts by creating new towns where entire cities would be laid out and sold to potential investors. This town jobbing resulted in the creation of Cleveland, Cincinnati, and Toledo, as well as many smaller cities in Ohio. Other entrepreneurs were active in the older cities of the Northeast. John Jacob Astor, for example, accurately foresaw that Manhattan could expand only northward, so he invested in farms and swampland in that area, which is now midtown Manhattan.

5

The Inalienable Right

FIGURE

1-1

Offering circular of the North American Land Co. (Rare Books Division, The New York Public Library, Astor, Lenor, and Tilden Foundations)

6

Professional Property Development

Town jobbing was a primary source of accumulating wealth in the United States at that time even for prominent people such as Benjamin Franklin and George Washington. Land Leases Another source of wealth for landowners was long-term land leases (also called ground leases). Landowners received payments for the use of land from tenants who could in turn develop the property and rent out smaller portions of it as well as rent out space in any buildings that were on that land. Lease terms ranged from 20 to 100 years and beyond; even today some of New York real estate sits on land leased from Trinity Church, Peter Goelet, Philip Jacob Rhinelander, and John Jacob Astor—landlords operating in the eighteenth- and nineteenth-century markets. Land Development Besides the get-rich-quick schemes of land speculation, the early nineteenth century also was a time of long-term land development both by private companies and the government. One of the first to engage in planned long-term real estate investments was the Holland Land Company, which developed 3.3 million acres of land in western New York State. Over a 20-year period, a long-term plan for development of the area was implemented under the direction of Joseph Ellicott, a professional land surveyor from Pennsylvania. The plan called for the construction of an extensive network of roads and settlement of new towns, and the development of sawmills, distilleries, gristmills, and other businesses by which to stimulate the local economy by attracting settlers. Canals and Railroads Transportation has always played an important role in the development of land in America. Proximity to good harbors and rivers was critical to the growth of cities in the early colonial period. Later, the development of an extensive canal system brought transportation into the interior and opened up vast new areas. In 1825, the opening of the Erie Canal spurred the growth of New York City and of communities along the canal route. Following the Panic of 1837, however, the recovering economy saw greater promise in the emergence of the more competitive railroads, and little new canal construction occurred after 1850.

7

The Inalienable Right

Nothing influenced land speculation in the United States as much as the development of the railroads. Although the first American railroad, the Baltimore and Ohio, began operating in 1830, railroad growth did not really get moving until several years later when the government provided grants of land along the rights-of-way the railroads had acquired for train tracks. The success of the Illinois Central Railroad, which had obtained a grant from the state of Illinois, motivated other financiers and those in different geographic areas, especially in the West, to press for grants. The Union Pacific, Northern Pacific, Central Pacific, Atlantic and Pacific (which later became the Santa Fe), Southern Pacific, Oregon and Pacific, and other railroads received land grants of more than 91 million acres from the federal government.1 These government land grants allowed railroads to go beyond just providing transportation to actually playing a larger role as land developers and investors in the suburbs and towns springing up along the planned routes (Figure 1-2).

FIGURE

1-2

Land sale at Monrovia, California, late 1880s. (Title Insurance and Trust Company, Los Angeles, California; Collection of Historical Photographs)

1 Roy M. Robbins, Our Landed Heritage: The Public Domain, 1776–1936 (Lincoln: University of Nebraska Press, paperback, 1942).

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Professional Property Development

Florida and California Florida’s and California’s enticements were not land for agriculture but sunshine. To these sunny climes came thousands from the North and Midwest: tourists, settlers, the elderly, and of course, land speculators. Land activity began booming in Los Angeles when the Southern Pacific line, linking the city with the East, was completed in 1882. Within three months town jobbers had marked off 13 new town sites along the rail lines. But by 1888 the development of new towns along this rail line was largely over. Of the 100-odd new towns plotted between 1884 and 1890, 62 had vanished. Florida experienced a similar boom after the arrival of Henry Flagler, who built a series of hotels catering to wealthy folk from colder regions. Starting in St. Augustine and extending both his hotels and his narrow-gauge railroad southward, Flagler built an empire all the way to Key West. The real estate he acquired was ultimately more profitable than the railroad itself.

GROWTH OF URBAN AREAS At the beginning of the nineteenth century, land speculation centered on land for agriculture; by the end of the century, the emphasis was on land for cities. America’s cities grew dramatically during the 1800s. In 1790, only 1 out of 30 Americans lived in towns and cities; by the end of the nineteenth century, 1 out of 3 did. In 1800, only 6 cities had populations of 8,000 or more; by the end of the century, there were almost 500.2 America was urbanizing at a rapid pace. Population Movement to the Cities Several factors enticed people to the cities. Rural areas were continually subject to extended depressions; the cities offered jobs. Many of the conveniences of the city—electricity, trolley cars, telephones—had not reached the countryside. To the rural American, the cities promised excitement and economic opportunity. America’s urbanization was also accelerated by greatly expanded immigration, particularly from Europe. These immigrants concentrated in the large cities. By 1890, one-fourth of Philadelphia’s and one-third of

2 Ibid., p. 223. John M. Blum, The National Experience, 3d ed. (New York: Harcourt Brace Jovanovich, 1973), vol. 2, p. 441.

The Inalienable Right

9

Chicago’s residents were foreign born. In New York City, four out of five were either of foreign birth or foreign parentage.3 The crush of humanity into the cities created slum areas and fostered the development in 1879 of the railroad apartment building, which allowed developers to crowd several families onto a single site. By 1890, 37,000 tenement buildings had been built in New York City alone—housing more than half of the city’s population.4 Emergence of the Skyscraper The rapidly escalating cost of urban land forced developers to discover ways of increasing the intensity of commercial properties as well. Chicago, led by the vision of architect Luis Sullivan, was the first city in which skyscraper construction was used. In 1892, the Masonic Temple rose 21 stories. Not to be outdone, New York surpassed Chicago in 1899 with the construction of the St. Paul Building. Opposition to skyscrapers raged as buildings grew higher. New York’s Flatiron Building, completed in 1902, generated much controversy, but its great commercial success encouraged other Manhattan real estate entrepreneurs (Figure 1-3). As a result, New York became the worldwide center of real estate development and speculation. The Woolworth Building, costing $13.5 million, opened in 1913 and remained the world’s tallest building until the Empire State Building was completed almost two decades later. Real estate activity in New York and other cities was curtailed by World War I and the postwar depression. It resumed in the early 1920s as America headed for its greatest binge yet. Land speculation also reached new heights in Florida (shortly afterward devastated by a hurricane), California, and New York. Construction of residential developments and office buildings continued unabated. Several men left their mark on Manhattan and the nation’s real estate community during the 1920s. Harry Black, the developer of the Flatiron Building, established high-rise construction as a viable method of providing space in major urban areas. Ellsworth Statler developed a national chain of major hotels. Fred French pioneered the concept of large, in-town residential communities with his Tudor City development on the east side of Manhattan, opening up the area for extensive development activity that would follow World War II.

3 Blum, The National Experience, p. 445. 4 Ibid., p. 446.

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Professional Property Development

FIGURE

1-3

Flatiron Building, New York City, 1904. (United Press International Photo)

Urban Apartment Buildings Rising land values and increasing numbers of people wanting to live in proximity to downtown contributed to the rise of the urban apartment buildings in the late 1800s–early 1900s. These so-called French flats, or luxury apartments, had a central location and offered most services and facilities on site, which made them popular with the wealthy. Meanwhile middle-class dwellings were located farther out from downtown along the major highways and public transportation routes. Apartment buildings really boomed in the 1920s, first in New York as a result of a severe housing shortage, and later spreading to other major urban areas. Most of the apartments were rental units, and some were sold for cooperative ownership. The largest rental apartment development of the time was the Sunnyside apartment complex in New York developed by the Metropolitan Life Insurance Company in 1922, and it consisted of 2,125 rental units. Urban Department Stores A multistory department store was another urban concept that developed in the late nineteenth century. The first major department store opened in 1846

11

The Inalienable Right

in New York—it was the Marble Palace built by Alexander T. Stewart. Subsequently, bigger and better department stores opened in many major cities, becoming major attractions and centers of downtown life. Perhaps the most famous was the 1876 Wanamaker’s Grand Depot in Philadelphia, which was the largest department store in the world at the time. The Grand Depot was built as the second of several of Wanamaker’s department stores, the first being the Oak Hall in 1861. The stores were a great success, and Wanamaker continued developing major department stores both in Philadelphia and New York, including the refurbishment of the original Marble Palace. Rail Suburbs As new migrants from rural America and Europe crowded into the cities, the wealthy moved out. The advent of good passenger rail service allowed Americans to live in the suburbs and work in a central city. The first truly modern rail suburb was Branch Hill, developed in 1887, 20 miles from Cincinnati. Soon afterward, rail suburbs sprang up around New York, Chicago, Boston, Philadelphia, and other cities. One of the most famous rail suburbs was Shaker Heights, near Cleveland (Figure 1-4). Developed in the early 1900s by the Van Sweringen brothers, Shaker Heights was one of the most successful suburban developments of the 1920s. Its innovative planning and design, including beautiful landscaping and community facilities, set the standard for later suburban development. Perhaps the most ambitious suburban rail promotion was in Los Angeles. In 1901 Henry Huntington incorporated the Pacific Electric Railway Company, which was a local railway system that reached out into the Los Angeles suburbs. Between 1901 and 1920 Huntington laid almost 1,200 miles of track for his famous red cars, which connected virtually all of the small towns in the Los Angeles basin. In 1910 Huntington’s transportation network was the largest private interurban transportation system in the world. Land serviced by the system increased in value, and Huntington and others reaped huge profits. The railway system shaped the development of the area so much that even today many of the local freeways follow the old routes of the Pacific Electric railway.

Depression and War After 1926, real estate investment, construction, and sales decreased in most markets. Those who had purchased property in hopes of selling at a

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Professional Property Development

FIGURE

1-4

Shaker Heights, Ohio, 1926. (Plain Dealer, Cleveland )

higher price were unable to do so, causing record numbers of defaults on real estate loans and property tax assessments during the 1920s. The crash of the stock market in 1929 dried up funds for many of the ambitious projects that had recently been announced. It became difficult to lease completed projects, and many buildings were foreclosed. The Empire State Building, almost one-third vacant, soon became known as the “Empty State Building.” Land values plummeted. As a result of New Deal legislation, the federal government intervened to reorganize banks and securities markets. Federal deposit insurance served to reestablish trust in financial institutions, and public works and infrastructure development projects aimed to revive the stagnant real estate market. In order to revive the construction and real estate development sector, government stepped in to reorganize mostly bankrupt savings and loan associations under the Federal Home Loan Bank System in 1932. This and other agencies such as the Federal Savings and Loan Insurance Corporation (1934), the Home Owners Loan Corporation (1933), and the Federal Housing Administration (FHA) standardized and improved practices in institutional home lending by providing mortgage insurance systems, offering tax and regulatory benefits to home lenders, introducing

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long-term amortization of mortgage loans, and reducing interest rates and loan origination fees. A notable change in lending practices was a shift toward lending based on the borrower’s projected income and ability to repay without default rather than the previous practice of lending based on the security of the property in the event of foreclosure.5 The Federal National Mortgage Association (Fannie Mae), created in 1938, developed a strong secondary market for FHA-insured mortgages. During the Depression, however, despite the federal government’s efforts to jumpstart development, only a few real estate projects proceeded. One of the projects was another residential project developed by Fred French, Knickerbocker Village, which was built in a slum area of New York’s lower east side. Another project that was built during that time was Rockefeller Center. Originally conceived in 1926 as a single building to replace the Metropolitan Opera House, it grew to 10 buildings by 1935 and introduced many precedent-setting ideas: a large open plaza, the use of a private street, underground concourses, and large underground parking facilities. It ultimately became the prototype for other large-scale multiuse projects throughout the country. When the United States entered World War II, unemployment vanished almost overnight. Consumer goods became scarce and were rationed. Except for building related to the war effort, new construction fell to virtually zero. During the war, several trends developed that would profoundly affect real estate markets in postwar America. First, overall economic activity increased dramatically. Much of the increase went toward war production, but the experience of living within an expanded economy, which would be able to handle greater domestic production after the war, proved infectious. Second, social patterns changed: marriages increased, women went into the labor force, racial barriers were eased, and people adapted to a more transitory way of life. Third, the lack of domestic construction, combined with the lower construction levels of the Depression years, led to strong pent-up demand, particularly for housing.

DOMINANCE OF SUBURBIA No factor was to affect postwar real estate more than America’s love affair with the automobile. Mass ownership of the automobile opened up 5 Mike E. Miles, Gayle Berens, and Marc A. Weiss, Real Estate Development: Principles and Process, 3d ed. (Washington, D.C.: Urban Land Institute [ULI], 2000).

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entirely new opportunities: residential suburbs in areas totally unrelated to rail service, suburban shopping centers that would literally become “new downtowns,” industrial and office parks that would ultimately shift the majority of jobs to the suburbs, and large multiuse complexes that would effectively incorporate a variety of activities in a single synergistic hub. Suburban Residential Developments The rail suburbs at the turn of the twentieth century consisted of relatively large homes directed primarily toward the wealthy. Only a limited amount of land along the railroad, however, was available for their development. In many suburban communities, land was valued according to its proximity to rail commuter stations. Mass ownership of the automobile changed this pattern. No longer was it necessary to live along the rail line. With World War II over, the combination of the automobile, higher personal incomes, and pent-up wartime demand appeared to provide all of the ingredients for a postwar suburban housing boom (Figure 1-5). But this did not occur. In 1947, housing starts were little better than in 1946; prices, however, were up substantially. It was evident that both the production and the financing of housing had to be made more efficient if any form of mass housing production were to occur. Responding to the need, Congress, which had established the Federal Housing Administration (FHA) in 1934 but had insufficiently funded it, substantially increased the FHA’s appropriation and also established the Federal National Mortgage Association (FNMA, nicknamed “Fannie Mae”) to ensure a secondary money market for FHA loans. The Veterans Administration guaranteed mortgage loans to U.S. war veterans through the GI Bill of 1944. The Housing Act of 1949 cited “a decent home and a suitable living environment for every American family” as a national goal.6 Beset by rising labor and materials costs, the private housing industry was forced to improve production efficiency. On Long Island, New York, builder William Jaird Levitt began to adapt mass production techniques to housing. Levitt and Sons acquired acreage near Hicksville, Long Island. Wishing to sell a house for under $8,000 and still make a profit, they designed a more efficient unit, used prefabricated materials, broke the house building process into components, utilized nonunion labor, and began a vertical integration process to eliminate the middleman.

6 Ibid.

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FIGURE

1-5

The farmland in (a) becomes suburbia in (b). Valley Stream, Long Island, New York. (Jones Beach State Parkway Authority)

(a)

(b)

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Directing sales primarily toward returning veterans, the Levitts sold over 17,000 units in Levittown by the time the project closed out in 1951. They went on to apply this successful formula elsewhere in the United States and Europe. Not all who moved to the suburbs wished or could afford to live in a single-family home, yet they didn’t want the conformity of a high-rise apartment. The solution was the garden apartment, which combined the convenience of apartment living with the openness of suburban life. This new design gave a boost to multifamily construction, which accounted for more than one-third of annual private housing starts during the 1970s.7 Suburban Shopping Centers As central city merchants watched their customers flee to the suburbs, they reluctantly decided they had better follow. Before long, suburban stores were outselling those in the central city. The first suburban branch stores, along with the stores of local merchants, were generally located in strips on both sides of major arterials. As the number of merchants increased, however, the strip became too long for easy shopping, parking was a serious problem, and traffic congestion threatened to stifle business activity. The answer was to assemble the merchants’ stores in a planned “center” owned by a single developer. The first major regional center was Northgate near Seattle, Washington, and others followed in suburban areas throughout the nation: Shoppers’ World near Framingham, Massachusetts; Roosevelt Field on Long Island; Cross County in Yonkers, New York; Hillsdale south of San Francisco; and Northland Center in the Detroit suburbs. These retail centers utilized a new strategy of attracting customers from a wider geographical area rather than being built to serve only an existing residential community. The single responsibility for planning and development provided shopping center developers with a unique opportunity to overcome a problem faced by all retailers—inclement weather. In 1956, the nation’s first major enclosed mall shopping center, Southdale, opened in Edina, Minnesota (Figure 1-6). Southdale also introduced the concept of having more than one department store in the same center, a revolutionary thought for retailers at the time. Other enclosed centers followed: Cherry Hill near Pennsauken, New Jersey; Topanga Plaza in Los Angeles; and Eastridge near San Jose. 7 U.S. Census Bureau, Construction Reports, series C20.

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FIGURE

1-6

The nation’s first enclosed mall shopping center, Southdale Center, Edina, a suburb of Minneapolis, Minnesota. (Dayton Hudson Properties)

Industrial Parks Not long after consumers and businesses began moving to the suburbs, industry followed suit: land was cheap and could be assembled in large parcels, buildings could be constructed on a single floor to allow more efficient flow processing, adequate parking could be readily provided, and, importantly, many executives lived in the suburbs and could avoid the commute to the central city. The first firms to build new facilities in the suburbs were large manufacturers. Smaller firms, wishing to be nearby, purchased land or leased buildings from local developers. Little regard was given to problems such as air pollution, waste disposal, parking, traffic, aesthetics, or interfaces with other nearby properties being used in other ways, such as residential. Sensing an opportunity, several developers began creating industrial districts and parks where industry could purchase or lease land and

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buildings within a planned environment that would regulate each firm’s operation according to certain minimum standards. The first major postwar industrial park, the New England Industrial Center near Boston, opened in 1953 (Figure 1-7[a]). The same year, Windsor Properties began developing the Brookhollow Industrial District outside Dallas. Other industrial parks were developed throughout the United States, the majority of them located in the suburbs.

Office Parks Eventually research and development (R&D) firms decided to follow manufacturing firms to the suburbs. As problems in the central city grew, more and more manufacturers moved their office operations to the suburbs as well. It wasn’t long before suburban office parks developed limited manufacturing and distributive uses as well. The first of these was Mountain Brook Office Park near Birmingham, Alabama, which opened in 1952 (Figure 1.7[b]). Three years later, the Middlesex Mutual Trust Company opened the Hobbs Brook Office Park on Route 128 in Waltham, Massachusetts. Suburban office parks developed in other areas as well: the Del Amo Financial Center in Los Angeles; the Executive Park near Atlanta; the Gamble Center and Norman Center in the Minneapolis suburbs; the Ward Parkway Office Center near Kansas City; the Oakland Office Research and Industrial Park in Bergen County, New Jersey; and the Denver Technological and Executive Park, one of the finest early examples of office park development.

Mixed-Use Developments As residential, commercial, industrial, and finally, office firms moved to the suburbs, developers in certain sections of the country began creating large, mixed-use projects designed to support a number of land uses within the framework of an overall master plan. The various uses would thus complement one another in a synergistic fashion, bringing the developer a greater return than single-use development. One of the earliest was Oak Brook, which opened in the Chicago suburbs in 1960. This project combined residential, commercial, hotel, industrial, and office uses. On a more urban scale, Galleria Post Oak in suburban Houston opened in 1969, connecting a shopping mall, office buildings, and a 450-room luxury hotel.

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FIGURE

1-7

Pioneer industrial and office parks: (a) New England Industrial Center, Needham, Massachusetts. (b) Mountain Brook Office Park near Birmingham, Alabama. Note the similarity in layout except for the taller buildings in the office park. ([a] Cabot, Cabot & Forbes and [b] Jackson Company)

(a)

(b)

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SEARCH FOR ALTERNATIVES By 1970, the dominance of suburbia was complete. In some suburbs, whole new “downtowns” were being created around major regional shopping centers and mixed-use complexes. As suburbs began to emulate the central cities, they also fell prey to many citylike problems: air and noise pollution, traffic congestion, waste disposal, and what many had come to the suburbs to avoid—crime. The search began for alternatives to the dominant suburban development patterns. There were clearly three: (1) improve conditions in the central cities, (2) make the suburbs more livable, or (3) develop totally new towns. First Alternative: Revitalize the Central Cities In the view of central city residents, suburbs might have the problems but they also had the resources—people, jobs, and retail sales. The central cities, on the other hand, had greater problems and dwindling resources. And their problems were further compounded by an influx of millions of poor, largely rural families. Often without jobs or even the skills to get jobs, they lived in the deteriorating housing that the middle class had left behind in its flight to suburbia. Urban Crisis During the 1960s as white middle-class Americans were moving to the suburbs, African Americans were moving into the central cities, especially in the North. At the same time, the numbers of industrial jobs in the inner cities were declining and living conditions deteriorating. In addition, the increasing African American population was still being denied access to municipal services and political representation. These conditions contributed to the already mounting racial tensions and culminated in a series of riots that swept through the country in the 1960s. The government responded with the Civil Rights Act in 1964 and the Voting Rights Act in 1965, and it also moved to implement several programs to address the deteriorating living conditions in the inner city neighborhoods. Urban Renewal The Housing Act of 1949 was the first federal program to address the task of urban renewal. The Housing Act of 1954 emphasized the rehabilitation of existing structures and the conservation of neighborhoods, offered funds to guarantee bank loans for these purposes, and emphasized commercial and industrial uses over residential. In 1959, cities were encour-

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aged to plan more comprehensively for redevelopment activities through a community renewal plan (CRP). In 1960 the Ford Foundation announced its Gray Areas program targeted at improving living conditions in minority neighborhoods. In 1962 President John F. Kennedy issued an order to ban racial discrimination in federal housing programs. In 1966, Congress established a funding mechanism to assist cities in expanding their social and economic activities under the Model Cities program. Public and private efforts came together with emergence of community development corporations (CDCs), which attempted to combine government services and citizen participation with private sector investment and management. These corporations were established in city neighborhoods throughout the country, and thousands are still active today, providing affordable housing, health clinics, job training and placement, child care, and many other community services. The Housing Act of 1968 established 10-year housing production goals and sought to eliminate substandard housing. The act also introduced government guarantees for financing and developing new towns and established a national housing “partnership” to attract more private funds into low- and moderate-income housing. Many cities throughout the nation took advantage of the various federal urban renewal programs. One of the earliest and most successful programs was undertaken in Philadelphia, where the rebuilding requirements of the central city were carefully meshed with the restoration of the city’s historic buildings (Figure 1-8). Boston used federal urban renewal funding programs to rebuild its Government Center, thereby spurring private redevelopment. Under San Francisco’s renewal program a large portion of the Embarcadero and Western Addition were rebuilt. Other cities with comprehensive urban renewal programs for their central cities included New York, Chicago, Minneapolis, St. Paul, Washington, D.C., Hartford, Richmond, Portland, and Cincinnati. Some cities, notably Cleveland, St. Louis, Detroit, and Newark, were not as successful: large amounts of cleared acreage stood vacant, with little or no developer interest. By 1972 the federal government had spent $10.9 billion on 2,481 urban renewal projects, and the private sector had spent many more billions in private construction. In 496 completed projects, assessed values had increased 228 percent over prior redevelopment levels on one-third less taxable land area.8 Still, urban renewal was considered by many to 8 U.S. Department of Housing and Urban Development (HUD), 1972 HUD Statistical Yearbook, 1974.

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FIGURE

1-8

Independence Mall, Philadelphia, Pennsylvania: (a) before mid-1950s redevelopment and (b) after 1973 redevelopment. Note Independence Hall in the foreground. (Development Authority, City of Philadelphia)

(a)

(b)

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have been a failed policy that did not address the root causes of urban deterioration. Instead, critics claimed, it resulted in the wholesale destruction of neighborhoods, displacing the very people it was intended to help. Public and Private Partnerships In the face of this criticism, urban renewal programs adopted new strategies that relied more on partnerships between private enterprise and federal, state, and local governments. Under President Ford, the Housing and Community Development Act of 1977 was signed into law, and the Community Development Block Grant (CDBG) program was formed. Under the program, individual cities received grant money to restore and upgrade existing buildings rather than tearing them down. The Housing and Community Development Act of 1977 sought to stimulate private investment in urban revitalization. The act targeted funds primarily for capital projects to conserve energy and correct violations of health and safety codes. The Urban Development Action Grant (UDAG) was extended in the 1977 act to provide grants for commercial and industrial projects that promised to boost real estate taxes and create new jobs. Tax incentives encouraged the renovation of older buildings. Between 1978 and 1983, the UDAG program provided $3 billion in grant monies to urban communities. State and local governments helped as well, providing direct aid and tax incentives to spur private development efforts. As a result, a number of cities, including Newark and St. Louis, that had been devastated by earlier urban renewal programs became revitalized. One of the major problems facing revitalization of inner city neighborhoods was a practice of redlining—refusal of home lenders and insurance companies to provide financing or insurance policies for homes located in certain low-income neighborhoods in the inner cities. Redlining was practiced even by the Federal Housing Administration and Veterans Administration until the late 1960s. A movement to end this practice was led by Gale Cincotta, a homemaker from Chicago. The movement she started against redlining eventually resulted in the passage of the Home Mortgage Disclosure Act of 1975 and the Community Reinvestment Act of 1977 (CRA). These acts discouraged redlining and encouraged affirmative lending. The Community Reinvestment Act was subsequently strengthened in 1989 and 1994, encouraging “depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound banking

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operations,”9 and it has played a vital role in providing capital for neighborhood development. Historic Preservation Some of the thrust for redevelopment in the central cities came from a revival of interest in preserving historic buildings. In 1965, New York State passed the Landmarks Preservation Law, restricting changes that could be made to designated historic buildings. This spurred Congress to establish the National Register of Historic Places (1966), and it began providing grants to states for preservation of historic sites. The movement grew and spread, and today it would be difficult to find many cities that have not undertaken at least one historic renovation project. Adaptive Uses Much of the preservation movement involved the adaptive use of a building to a new use more compatible with current market conditions. The prototype for adaptive use projects was Ghirardelli Square, an abandoned chocolate factory in San Francisco that reopened as a specialty shopping center in 1964.10 Today, nearly every major city around the country boasts a renovated old theater, factory, train station, or office building that would almost certainly have been razed 20 years ago (Figure 1-9). Federal tax laws helped to make the preservation movement possible. The Economic Recovery Tax Act (ERTA) of 1981 allowed an income tax credit of 25 percent of the cost of renovating certified historic structures. Nonhistoric buildings more than 30 years old could qualify for income tax credits up to 20 percent if the buildings were put to commercial use. Under the Tax Reform Act of 1986, tax credits were reduced but not before significant progress was made: between 1981 and 1986 an estimated $11 billion was spent to renovate some 17,000 historic buildings in 1,800 cities and towns.11 Presently, the government allows 20 percent credit for renovation of a certified historic structure and 10 percent credit for renovation of a building other than a historic structure. The Gulf Opportunity Zone Act of 2005 temporarily increased the tax credit to 26 and 13 percent, respectively, for the areas of the country affected by Hurricane Katrina.12

9 Federal Financial Institutions Examination Council (FFIEC), www.ffiec.gov/cra. 10 In 2005 Ghirardelli Square started undergoing another modification to include a high-end residential community. 11 Kurt Anderson, “Spiffing Up the Urban Heritage,” Time, November 23, 1987, p. 79. 12 Federal Tax Credit Incentive Program.

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FIGURE

1-9

St. Louis Union Station, one of the largest adaptive use projects in the country. Originally a thriving railroad terminal dating to 1894, the station, a certified National Historic Landmark, was reopened in 1985 as a hotel-retail complex, after a $150 million development effort. (St. Louis Union Station)

The preservation movement has not been without its critics, who charge, among other things, that rent increases in historic areas drive up prices and result in gentrification, the taking over of poor neighborhoods by upwardly mobile, usually young, residents. Nevertheless, few critics would deny that the move to preserve the architectural heritage of the American city has added to the appeal of urban living. New Urban Developers The efforts of the central cities to revitalize themselves created a new breed of urban developer—aggressive, resourceful, and adept at conceiving large projects requiring a close working relationship between the private and public sectors. Probably the most famous of these was William Zeckendorf, who, in addition to his activities in New York City, contributed significantly to Place Ville Marie in Montreal (Figure 1-10), Mile High Center in Denver, and L’Enfant Plaza in Washington, D.C. Zeckendorf’s high-flying bubble burst in 1965, but in 20 frantic years he had radically altered the face of many U.S. cities and proved that the central city could survive and regain its place as the vital center of a metropolitan area.

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FIGURE

1-10

Montreal was one of the early leaders in the trend toward mixed-use developments. Place Ville Marie, opened in 1962, is noted for its crucible-form central office tower and three-story underground shopping concourse. (Trizec Equities Limited)

Zeckendorf’s legacy has been carried forward by other creative, farsighted people, among them John Portman with the Peachtree Center in Atlanta; Trammel Crow with the Embarcadero Center in San Francisco; Donald Knudsen with the Gateway Center in Minneapolis; Arthur Rubloff with the Carl Sandburg Village in Chicago; and James Rouse with Baltimore’s Harborplace and Boston’s Faneuil Hall Marketplace. Second Alternative: Improve Suburban Residential Developments A second alternative was to improve the suburbs themselves. While progress was made in the areas of shopping centers and industrial parks, suburban residential development continued to reflect the depressing

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cookie-cutter subdivisions of the initial postwar years, with their inefficient provision of public services and amenities. In attempting to solve these problems, land planners developed the cluster concept, which maintained the same basic density levels as singlefamily subdivisions but clustered housing units together in groups, thereby reducing public service costs and allowing for the development of additional usable open space (Figure 1-11). While clustering solved the design problem, there remained the question of how ownership of these units could be legally recognized. Condominiums The Housing Act of 1961 provided the solution. Section 234 extended FHA mortgage insurance guarantees to a new form of housing ownership called condominiums. The condominium concept called for individual ownership of the airspace within each unit and collective ownership of common areas, such as walkways, swimming pools, and open areas. A mortgage would be issued to each individual owner, with the costs of common area maintenance paid monthly on a pro rata basis. Initially, condominiums were slow in gaining acceptance. Lenders were often reluctant to lend against airspace, buyers were confused about the new concept, and marketing efforts were often discouraging. In many cases, cities were reluctant to approve condominiums, which seemed to many a ruse for higher-density developments. The concept finally caught on, however, and by 1973 the annual production of condominium units was a major component of new housing starts in many urban areas, and it remains so today.

FIGURE

1-11

Various approaches to planning street and residence patterns for subdivisions: (a) traditional grid; (b) curvilinear, or contour; and (c) cluster.

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The development of the condominium was critical to the implementation of new planning techniques because it freed the building from a single parcel of land, allowing for more efficient clustering of units. Planned Unit Developments The legal concept of the condominium and the physical concept of cluster housing were finally pulled together through the development of a new model zoning ordinance called a planned unit development (PUD). Despite opposition from many communities, the PUD concept took hold in the 1960s. During the mid-1970s, when high interest rates made large residential projects more difficult to build, PUDs lost some popularity, but today they are regarded as a major tool in improving the residential environment of the suburbs. Third Alternative: New Town Development As important as PUDs were, many believed that what was needed were totally “new” towns in which the development of all land uses and activities could be carried out under comprehensive planning and management. England, the Scandinavian countries, France, Canada, Israel, the Netherlands, Germany, India, Brazil, and the Soviet Union had utilized government-sponsored new towns extensively since World War II to redistribute population. Early new town development in the United States was largely a private effort. In southern California, postwar population growth extended suburban frontiers far beyond the central city. Lying in the path of this “sprawl” was a series of large land holdings, many dating back to early Spanish land grants. These ranches were being used for agriculture and other relatively low-intensity uses. With approaching urbanization, increasing property taxes made it difficult to profit from these uses. This squeeze, combined with the owners’ awareness of the opportunities for potential profits from land development, led several large ranches to begin preliminary land use planning. The largest was Irvine Ranch, which covered more than 100,000 acres of land in Orange County, California. Development began on the ranch in 1962, and a part of it was incorporated as the city of Irvine in 1971. The Irvine Company, developers of the community, donated 1,000 acres for a new campus of the University of California. The development also encompassed several large residential neighborhoods, a major regional shopping and office center, an airport, and two large industrial parks.

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Today Irvine covers 41,600 acres, has a population of 180,000, and houses businesses that employ 168,000 workers.13 Other large developments in California are Janss/Conejo, Valencia, Laguna Nuguel, Westlake Village, Mission Viejo, Rancho Bernardo, Rancho California in the south, and Foster City in northern California. In the East, two major new towns were emerging near the nation’s capital. The first of these, Reston, was begun by Robert E. Simon in 1963 on 7,400 acres of rolling countryside in Fairfax County, Virginia. In 1967 Simon was bought out by his financial partner, Gulf Oil Corporation, which largely continued Simon’s original plan. In 1976 Reston Land Corporation, a Mobil Oil subsidiary, took over the development role. Reston now houses a population of over 55,000 and more than 1,000 businesses (Figure 1-12). The second major town developed in the East was Columbia, located on 16,000 acres in Howard County, Maryland. Developed by James W. Rouse, Columbia’s goals were social as well as economic, providing a

FIGURE

1-12

Lake Anne Village Center, Reston, Virginia. The shopping area at the left, the high-rise apartment building at the right, and the townhouses, condominiums, and single-family homes nestle around the 27-acre lake. (Reston Land Corporation)

13 City of Irvine, www.ci.irvine.ca.us.

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complete range of housing to meet the needs of most potential residents. In addition to residential uses, 20 percent was set aside for business and industry, 36 percent for open space and recreational areas, and the rest for cultural, medical, educational, and other facilities. Columbia’s population has grown to over 95,000. Although much of the early effort was private, the federal government became involved through the Housing Act of 1968. Title VII of the act authorized the Department of Housing and Urban Development (HUD) to guarantee financing for land acquisition and development by new town developers. In return, the developers had to demonstrate the validity of their planning, scheduling, financial resources, and development capability. Plans that were approved could receive up to $50 million in federal guarantees for the purchase of land, installation of public services, and planning and management activities. Approximately 15 new towns were announced under this program, including Park Forest South near Chicago and the Woodlands near Houston. The Woodlands today incorporates 28,000 acres of land, supports a population of almost 100,000, and provides 40,000 jobs for area residents. Not all new towns were in the suburbs. The idea of the “new town in town” was introduced by Dr. Harvey Perloff, former dean of the School of Architecture and Urban Planning at the University of California at Los Angeles. The concept involved redevelopment and rehabilitation within the boundaries of the central city. To that end, the Urban Growth and Community Development Act of 1970 (which was subsequently renamed the National Urban Policy and Community Development Act of 1970) provided funds for the new-town-in-town program until the early 1980s. Examples of projects undertaken under the act were Cedar-Riverside in Minneapolis and Roosevelt Island in New York.14

CHANGING LEISURE PATTERNS As the nation struggled to find viable methods for dealing with urban and suburban growth, major changes were taking place in the way Americans spent their leisure time. Personal incomes were rising substantially and the workweek was shrinking. Greater affluence postponed entry into the labor force and encouraged earlier retirements. The advent of jet travel expanded the geographic scope of leisure opportunities. America was slowly relaxing its work ethic. 14 Arthur Gallion and Simon Eisner, The Urban Pattern: City Planning and Design, 5th ed. (New York: Van Nostrand Reinhold, 1986), pp. 561–562.

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Growth of the Public Lodging Industry Increased travel meant that people had to have a place to stay. As a result of the Depression and war, however, America’s stock of guest rooms was old and largely obsolete. The process of creating new public lodging facilities geared to changing postwar patterns began. Hotels One man soon emerged as the leader in new hotel development and management. In the early years after the war, Conrad Hilton purchased and renovated older hotels such as the Plaza and Waldorf-Astoria in New York City, the Stevens and Palmer House in Chicago, and the Town House in Los Angeles. He introduced his famous digging for gold program, which converted unoccupied space to profitable use. His success continued, and during the 1950s he expanded to a worldwide operation. Other hotel chains in the United States were also expanding operations. Sheraton, utilizing a franchise approach, built new facilities in virtually every major American city. Western International (now Westin) expanded out of the Pacific Northwest into San Francisco, the Southwest, and, ultimately, Chicago and New York. Hyatt joined with architectdeveloper John Portman in introducing then-radical concepts of hotel design in Atlanta, Chicago, and San Francisco. Motels and Motor Hotels The hotel industry failed to note, however, the impact of the automobile on real estate in postwar America. The automobile opened up travel to a new generation of Americans, many of whom, traveling with families, could not afford hotel accommodations. Furthermore, after a hard day’s journey, travelers weren’t interested in the prestige and full service provided by traditional hotels. They wanted cheap, clean rooms that were located near the highways on which they were traveling. The answer was the motel. Although several thousand tourist courts had operated prior to World War II, the expanding postwar highway construction program as well as pent-up travel demand from gas rationing and other wartime restrictions accelerated the phenomenal growth of the motel industry. By 1954, over half the nation’s guest rooms were in motels that accounted for 16 percent of total industry sales.15 Several enterprising entrepreneurs saw exceptional opportunities in the rapid growth of the motel industry. One such man was Kemmons 15 Howard E. Morgan, The Motel Industry in the United States: Small Business in Transition (Tucson: Bureau of Business and Public Research, University of Arizona, 1964), p. 187.

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Wilson, founder of the Holiday Inn chain. He hit on a successful formula that appealed to a large segment of the American motoring public, particularly families and the commercial traveler. The formula combined many of the conveniences of hotels—large rooms, double beds, telephone and television, restaurants, and swimming pools—with motel features not offered by most hotels—accessibility to major highways, parking, lower rates, no charge for children under 12, a computerized reservation system, and an informal atmosphere that made the road-weary traveler feel welcome. The success of the Holiday Inns led to a series of other major motel chains including Ramada Inns, Quality Courts, Best Western, and Howard Johnson. Finally recognizing that motels were here to stay, several of the major hotel chains—Hilton, Sheraton, Hyatt, and Marriott—began developing “inns” at locations near airports and other sources of business activity. As the hotel chains entered the field, motels began to look increasingly like hotels. The original concept of the motel, that is, simple, cheap lodging, seemed to get lost in the shuffle. It was only a matter of time, until the wheel turned full circle and the “budget” motel was introduced. One of the pioneers of this concept was Motel 6 in California, which offered basic rooms for $6 per night, regardless of season or location. Its rates were kept low by construction and design innovations, labor-saving operating techniques, and a continuing refusal to get into the restaurant or convention business. In recent years the lodging industry has become increasingly competitive and involved with aggressive marketing techniques, and its service improvements have become important factors in the success of the individual players in the marketplace. Divots, Sitzmarks, Catwalks, and Double Faults As Americans experienced greater leisure time, they turned more and more to participation in athletic activities: golf, skiing, boating, and tennis. Initially, facilities for these activities were developed exclusively for the purpose of the sport. As the facilities grew in scale, however, developers began to see the profit potential in utilizing participation sports to sell real estate. Golf Golf was the first major participation sport to gain extensive acceptance after World War II. The number of golf courses in the United States increased from 4,808 in 1945 to 11,134 in 1974.16 Golf courses were 16 National Golf Foundation, Information Sheet, Golf Facilities in the United States, Chicago, 1974.

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developed in sprawling suburban areas as well as resort areas. Palm Springs, California, as an example, became a major resort largely through the development of a series of fine golf courses. In urban areas, golf courses were integrated into new residential subdivisions. Developers soon realized that, while they might not make money on a golf course operation, they could more than pay for the cost of the course through higher real estate values. Skiing Another sport that took off after World War II was skiing. With the refinement of the mechanical lift, downhill skiing was suddenly less arduous and much more appealing to Americans with newly found leisure time. Traditional ski resorts such as Stowe, Sun Valley, Aspen, and Lake Tahoe expanded operations. Entirely new projects were developed: Snowmassat-Aspen and Vail in Colorado, Sugarbush in Vermont, Park City and Snowbird in Utah, Killington and Stratton in Vermont, and Waterville Valley in New Hampshire. It was clear to the developers that the profit was not on the slopes but at the bottom of the hill, in the form of hotels, restaurants, and other service facilities, as well as the sale of second home lots and condominiums. Boating Americans also took to the water. As the sale of pleasure boats increased, entrepreneurs began developing marinas and other facilities. In areas such as Florida and California, boating was tied into residential and commercial real estate developments. Marina del Rey in California, one of the largest marinas in the nation, was financed largely on the basis of increased real estate values. In inland areas, marina development activity concentrated on lakes and rivers, where the promise of boating activity was often one of the major lures in attracting prospective residential buyers. Tennis Tennis boomed in the 1970s as well. As a result, tennis clubs, both outdoor and indoor, were established in virtually every city in the country. In California and Texas, tennis ranches emerged, in which a noted professional saturated hardy guests in dawn-to-dusk tennis instruction. In terms of real estate, tennis was attractive not only as a direct investment but also as a means of selling houses and renting apartments. Subdivisions that previously would have used a golf course as a marketing tool now began turning to tennis. The fact that tennis requires much less land and capital investment than golf also influenced this trend.

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Health and Fitness Resorts The growing emphasis on physical fitness in the 1980s led to yet another type of resort activity, namely, the health and fitness center. The Snowmass Club in Colorado is one example of a resort facility that capitalized on America’s fitness craze. The club combined the luxury of a first-class resort with a fully equipped health spa and athletic club. Guests could choose from a wide array of exercise classes, personal training sessions, and outdoor activities. The combination of increased travel and greater emphasis on participation sports ultimately led to the reintroduction of “destination resorts,” where harassed urban dwellers could select from a wide variety of sporting activities at a single location. Destination resorts date back to the late 1800s and early 1900s. In those days, resorts such as Broadmoor in Colorado, Biltmore in Arizona, and Homestead in Virginia relied on rail transportation to bring guests to their facilities. Today, many destination resorts are located in tropical vacation spots: Caneel Bay in the Virgin Islands; Dorado Beach in Puerto Rico; and Mauna Kea, Kaanapali, Waikoloa, Wailea, and Makina in Hawaii; and numerous others. Boom in Second Homes The idea of a second or “country” home was not new to postwar America: the wealthy had owned a second home for years. But with rising incomes, more middle-class Americans could also enjoy the luxury of a second home. This trend was further encouraged by tax advantages that allowed the owner to deduct many of the costs of ownership if the units were rented a certain portion of the year (recent changes in the tax laws have limited these deductions). Another factor was earlier retirement ages; the second home allowed a smooth transition between employment and retirement. Initially, second homes were developed by local builders in areas near major urban areas. As travel times decreased, however, second homes began emerging in more remote areas, often connected with major sporting activities: Sun Valley, Stowe, Lake Tahoe, Aspen, Vail, Jackson Hole, and others. Timesharing For those who could not afford a second home entirely, the use of timesharing provided a way to own at least a piece of second home property for a limited number of days each year. The idea started in Europe in the 1960s, and in 1969 the first U.S. timeshare resort, Kauai Kailani, opened

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The Inalienable Right

in Hawaii. Since then everything from hotels and motels to lodges, villas, and recreational vehicle parks have taken advantage of the concept. It was only a matter of time before timesharing projects evolved that combined the features of a destination resort within a community of second homes: Sea Pines Plantation in South Carolina (Figure 1-13), Sunriver in central Oregon, New Seabury on Cape Cod, Amelia Island in Florida, and Big Sky in Montana. Presently there are numerous timesharing communities, and many of them are international operations where shares are bought not for a particular property but for numerous properties worldwide. Well planned and heavily financed, these projects often appealed to wealthy individuals who were repulsed by the land use hodgepodge of older resorts. Most of the projects emphasized strong architectural design and harmony with nature. While a portion of the income was generated from resort types of operations, the profit was clearly in the development and sale of second homes. Land Sale Projects The boom in second home sales created an even greater boom in land speculation. Promoters, who offered liberal financing and used high-pressure

FIGURE

1-13

Harbour Town in Sea Pines Plantation, Hilton Head Island, South Carolina. (Sea Pines Plantation Company, Inc.)

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sales tactics, began carving up Lake Tahoe, the Poconos, the Florida coast, and much of the state of Vermont. Initially, most of these promoters were local operators; gradually, large corporations such as Boise Cascade, ITT, International Paper, GAC, General Development, American Standard, and Dart Industries moved in to dominate the industry. The public began to worry increasingly about the sales tactics the promoters were using and the environmental impact of the intended land uses in second home development areas. Finally, to address such concerns, Congress passed the Interstate Land Sales Full Disclosure Act of 1968, which required developers to register information on subdivisions of more than 50 lots. Two years later, as a result of the Housing and Urban Development Act of 1970, HUD began investigating abuses within the industry. This was only one of many indications that the development of real estate was becoming less of an inalienable right and more of a negotiated privilege offered or withheld by governmental agencies.

CHAPTER 2

The Changing Ground Rules for Property Ownership

Let us tell the developers and let us tell the rest of the country right here and now that Vermont is not for sale. Thomas P. Salmon January 1973 former governor of Vermont

The Department of Housing and Urban Development’s investigation of second home development practices was but one example of the fact that governmental agencies at all levels were increasing their roles in real estate development in the late 1960s and early 1970s. As noted in Chapter 1, government has always been involved in land development in America. Historically, however, government encouraged development through a variety of devices: granting land to the early land companies; developing transportation facilities such as canals, railroads, and the interstate highway system; expanding homeownership through such vehicles as homesteading, FHA funding, and favorable income tax treatment; and subsidizing the central cities through urban renewal programs, private-public partnerships, and public housing programs. This policy of encouraging development directly affected western expansion, the settlement of the cities, and the explosive growth of the suburbs following World War II. Implicit in governmental support of development was the tacit presumption that “growth is good” in that it creates employment opportunities, increases property values, and provides greater public revenues. Whatever the attendant problems of growth—overcrowded housing, 37 Copyright © 2007 by John McMahan. Click here for terms of use.

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traffic congestion, crime, environment degradation, unsightly urban sprawl, and others—they seemed to be outweighed by the benefits that development created. By the 1960s and 1970s, however, increasing numbers of Americans had begun questioning the growth-for-growth’s-sake concept. Many suggested that government should take a stronger role in limiting, or at least directing, the location, magnitude, and quality of land uses. The “inalienable right” of landowners to develop their property as they personally desired became less and less operative.

THE EVOLUTION OF PLANNING AND ZONING IN AMERICA City planning goes back a long way in America. Most New England towns were planned to have a village square, or common, in the center of town. The Dutch planned New Amsterdam (New York) in 1660 in a pattern similar to the Dutch towns they knew best. Williamsburg, laid out in 1699, was planned on the scale of English towns. In 1682, William Penn commissioned a plan for Philadelphia that called for two major streets crossing in the center of the city to form a public square. The streets divided the city into four separate quadrants, each with its own public park (see Figure 2-1). James Edward Oglethorpe laid out Savannah in a somewhat similar manner. In 1791, George Washington and Thomas Jefferson adopted a plan for the new capital in Washington based on a classical plan prepared by a French designer, Major Pierre Charles L’Enfant. The L’Enfant plan, patterned after French cities, called for a series of wide, radial boulevards, with the traditional gridiron layout superimposed on them.

Coping with Industrialization Despite the visionary proposals of many planners, by the early 1800s the pressures of industrialization were catching up with the cities. As more and more people came to the cities to find jobs, the pressure driving up land values intensified. In 1811, New York rejected a proposal based on the L’Enfant plan, and it decided to replan the rest of Manhattan on a tight gridiron, allowing virtually no open space (Central Park wasn’t set aside until 45 years later). This emphasis on economy set the stage for the planning of most new cities over the next 40 to 50 years. The only plan that remained rela-

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The Changing Ground Rules for Property Ownership

FIGURE

2-1

Early U.S. planning efforts. (a) Williamsburg, Virginia, 1699: A, Market Square; B, the Capitol; C, the Governor’s Palace; D, College of William and Mary; E, Bruton Parish Church; and F, Duke of Gloucester Street. (b) New Amsterdam (New York City), New York, 1660. (c) Philadelphia, Pennsylvania, 1682: A, City Square, and B, parks. Eas

t Riv

B F

A E

ED Broadway

Battery

Schuylkill River

Wall

B

B A B

B

Delaware River

er

C North

(a)

River

(b)

(c)

tively untouched was Washington’s, where industry and commerce were largely excluded. With the growth of industrialization, sanitary conditions in cities throughout the world began to deteriorate. By 1840 the typical American city was littered with garbage, and deadly diseases were commonplace. To address these conditions, a sanitary reform movement focused public attention once more on the need for city planning to alleviate sewage and drainage problems. In the second half of the nineteenth century, European cities started responding to the pressures of industrialization. In 1853, Napoleon III started a 17-year program to open up a series of broad avenues through Paris. In England and Germany, industrialists began to develop “model towns” for their workers. In 1870, Sweden established a program to lend public funds to nonprofit “public utility companies” engaged in housing. Germany and the Netherlands enacted similar legislation shortly thereafter. The British Housing Law of 1890 empowered local governments to condemn land and buildings in order to develop housing for the working class. Progress was slower in the United States, but it did occur. In 1857, Frederick Law Olmsted won a competition to design Central Park in New York City. He later designed parks in Buffalo, Detroit, San Francisco, Chicago, Montreal, and Boston. In 1867, New York passed the first law to regulate tenement building. The Boston Cooperative Company was formed to provide housing to low-income workers in the nation’s capital.

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City Beautiful In 1893, the World’s Columbian Exposition, an international fair held in Chicago, captured the imagination of cities around the country. The fair, on a site that ultimately became Jackson Park, attempted to show America’s industrialized cities the importance of good planning and architecture. The physical layout of the fair site was classical, with grand boulevards and imposing exhibition buildings. Leaders of other cities went home with glowing reports of the City Beautiful. Daniel H. Burnham, the exposition’s chief architect, prepared a plan for San Francisco after the earthquake and fire of 1906. Three years later, he developed a plan for Chicago. Other planners and architects developed similarly grandiose plans for other American cities. Although the City Beautiful movement was eventually criticized as a cosmetic approach to city problems, it did arouse Americans’ interest in urban planning. Planning organizations sprang up in most major cities. In 1909, the first national planning conference was held. In 1913, Massachusetts became the first state to require that all cities with a population of over 10,000 establish a planning board to oversee city planning. By then, 18 U.S. cities had official planning boards. This national interest in planning, however, began to conflict with the growth of America’s cities. At a time when land values in most American cities were soaring because of unprecedented industrial and commercial growth, implementation of such visionary plans seemed exceedingly difficult. A more realistic way of reconciling private property rights with broader public planning concerns was needed. Zoning The answer was zoning. Zoning is the application of the “police power” of the government to the use of land and improvements. The concept was not totally new, although most of its early applications concerned dangerous or obnoxious land uses. Boston, as an example, prohibited the storage of gunpowder near the center of town. New York, as a result of a series of tenement fires, passed laws limiting certain types of construction. In 1895, Los Angeles prohibited the operation of a steam shoding plant within 100 feet of a church. In most cases, zoning laws were imposed on certain areas of the city to prohibit certain activities in those zoned areas; other areas of the city were allowed to develop as they might. In the early part of the twentieth century, zoning was also used to enhance land values. Local governments, often working closely with land developers, would spot zone properties for land uses that would bring the

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highest current price. However, undesirable development on the spotzoned parcel could cause other owners to suffer decreases in property values. As a result, public officials were pressured to provide zoning on a more comprehensive basis. In 1891, Boston passed an ordinance limiting building height. In 1909, some of Los Angeles was divided by public officials into seven industrial districts; the rest of the city was declared residential. The most comprehensive attack on the problem of zoning, however, occurred in New York City. Under the leadership of a local attorney, Edward M. Basset, New York enacted the nation’s first comprehensive zoning ordinance in 1916. With certain modifications, the ordinance was adopted by other cities, and several court tests of the law established the legality of zoning. One of the most important of these court tests occurred in 1926 in Euclid, Ohio. In this case,1 the U.S. Supreme Court held that a community had the right and responsibility to determine the uses of land within its boundaries, provided such determination did not upset the orderly growth of the region or nation. This decision provided communities with the necessary tools to implement comprehensive planning activities. SZEA and SPEA Interest in planning, meanwhile, was increasing throughout the country. On the national level, the U.S. Department of Commerce developed two major pieces of model legislation. The first, formulated in 1922, was the Standard State Zoning Enabling Act (SZEA). This model act was designed to enable local governments to control the height, area, bulk, location, and use of buildings. It would also allow local jurisdictions to divide their land area into zones or districts with varying regulations (for example, residential, commercial, or industrial), as long as the properties within the districts were treated uniformly. In 1928, the second model act appeared. The Standard City Planning Enabling Act (SPEA) outlined a “master plan” for communities, which would be prepared under the direction of a “planning commission,” advising the local elected governmental agency. The model act discussed provisions for approval of all public improvements by the commission, procedures for subdividing land, and participation of the local jurisdiction in the regional plan.

1 Euclid v. Ambler Realty Co., U.S. Supreme Court, 272 U.S. 365.

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These two pieces of model legislation were gradually adopted by virtually every state and local government in the country, providing the basis for our current laws regarding planning and zoning. Basically, these laws prohibit undesirable land uses by stipulating that landowners can develop their land as they see fit, provided that such development isn’t specifically restricted by state and local legislation. Regional and Local Planning Planning also was proceeding at the regional and local levels. Henry Wright and Clarence Stein produced a plan for the state of New York that established the relationship between industrialization, transportation, and land use. In 1928, a plan for metropolitan New York was developed for the Regional Planning Association of New York by the Scottish planner Thomas Adams. The same year, Benton MacKaye published the New Exploration: A Philosophy of Regional Planning,2 which established many of the fundamental principles of regional planning. In 1933, the National Planning Board was established to coordinate planning activities throughout the nation. A year later, it became the National Resources Board, and it initiated a series of regional plans, generally following the guidelines of Wright and MacKaye. Many of these ideas were utilized in the development of the Tennessee Valley Authority (TVA), which encompassed seven states and 2 million people and was by far the largest and most significant regional planning program undertaken in America up to that time. Planning progress was also being made abroad. In 1937, Le Corbusier published Le Plan de Paris, illustrating how Paris could be rebuilt without losing its historic monuments. In England, the 1940 Report of the Royal Commission on Distribution of Industrial Population established many of the concepts of English new towns. In 1943, Sir Patrick Abercrombie and J. H. Forshaw published the County of London Plan, which demonstrated how London could be successfully rebuilt after the war. In the United States, postwar pressures for housing consumed large amounts of suburban land, often with little or no planning. In the central cities, the neglect and decay of the Depression and war years forced most major cities to replan and rebuild in order to survive. Recognizing this need, the federal government passed the Housing Act of 1949, which attacked both planning and rebuilding problems. The

2 Benton MacKaye, The New Exploration: A Philosophy of Regional Planning (Urbana: University of Illinois Press, 1928. Revised edition published in 1962.)

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urban renewal program was established to handle the problem of rebuilding the central cities. Planning was encouraged through Section 701, which provided federal funding for state and local planning activities. This infusion of monies enabled many communities to hire professional planners and begin formulating effective plans for transportation and land use development.

THE ENVIRONMENTAL MOVEMENT By the 1960s many communities, particularly those in high-growth areas, became concerned that planning alone would not ensure quality development in the remaining developable land areas and maintenance of open space in underdeveloped areas. Conservationists were particularly concerned about such mountain recreation areas as Lake Tahoe, the Adirondacks, and the Colorado Rockies and for coastal wetlands in areas of California, Florida, Massachusetts, New York, and the Carolinas. In addition to planning, a basic change in the legal view of the ownership of land seemed necessary. Problems with Traditional Land Ownership and Land Use Management In 1963, the American Law Institute (ALI) began investigating the legal structure of land ownership, land use, planning, and zoning as it was being practiced in the United States. The institute identified five major problems with the existing system: Exclusive dependence on zoning was an ineffective method of obtaining desirable land development. ■ The unrestricted granting of power over land use to the smallest unit of government (for example, town, village, or city) distorted metropolitan growth, rendering the governmental units almost impotent in attacking regional problems such as pollution, transportation, and housing. ■ Ordinances enacted at the local level dealt ineffectively with large-scale development, particularly in suburban communities. ■ The forces of urban growth were too dynamic to be properly controlled by the development of a “static master plan.” ■ Local zoning control created an administrative process that ran counter to general concepts of fairness and orderly procedure. ■

The institute then drew up a new model land development code to replace the SZEA legislation and SPEA local ordinances of the 1920s.

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Growth Management at the State Level While the institute was working on the new land use code, a series of court decisions and laws at the state level directly affected land development. Hawaii One of the first states to act, in 1961 Hawaii divided all land in the state into four districts: urban, rural, agriculture, and conservation. Land in the last two districts was strenuously protected against development pressures. Despite stricter criteria for district boundary changes embodied in 1975 legislation, the pressure for converting land to urban use has continued to steadily increase—between 1969 and 2004, 31,000 acres of land changed from agricultural to urban use3 (see Figure 2-2). Vermont In 1970, Vermont enacted Act 250, the State Land Use and Development Plan. This act established a state environmental board to regulate developFIGURE

2-2

Hawaii land use districts. Of Hawaii’s eight major islands, Oahu is the most urbanized, and Hawaii is one of the least. (Reprinted with permission from John M. DeGrove, Land Growth & Politics, 1984, by the American Planning Association, 1313 East 60th Street, Chicago, Illinois)

Oahu

Hawaii

Urban Agriculture Conservation

3 State of Hawaii Data Book 2004.

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ment. To secure the approval of the board, projects had to pass a variety of tests to ensure that they would not generate undue environmental problems such as water or air pollution and that they wouldn’t put too great a burden on public services or adversely affect the aesthetics of an area. Development also had to proceed according to a duly adopted plan and conform to existing local or regional plans. The legislation enacted a stiff capital gains tax on real estate transfers in 1973. However, the tax has not been successful in curtailing speculation since profits often exceed the tax imposed. In May 2006 the state government passed bill S.142, which identified areas appropriate for growth (growth centers) and encouraged investments in these areas. In addition, an accompanying bill S.165 allowed use of some property tax revenues for funding of local infrastructure. John T. Ewing, board chair for the Vermont Forum on Sprawl, called bill S.142 “the most significant land-use law in thirty years,” further stating that “Since Act 250 was enacted, Vermont has lacked a strategy to identify areas appropriate for growth and target state investments to those areas. The bill does just that.”4 Oregon The Oregon Land Use Act of 1973 (also known as “Senate Bill 100”) required all cities and counties to adopt comprehensive plans consistent with state goals. The Land Conservation and Development Commission (LCDC) and the Department of Land Conservation and Development (DLCD) were given the task of developing the official state goals. Today, the 19 state goals serve as a foundation for this program.5 Oregon pioneered the use of urban growth boundaries (UGBs), with the Portland UGB (1979) being one of the most successful cases of an urban growth boundary being imposed on an area, although it has been blamed for rising prices and decreasing supplies of affordable housing. The UGB is a tightly regulated zoning boundary around the city intended to promote development within its boundaries and limit sprawl. Florida In 1971, a major drought spurred Florida’s political leaders to look seriously at the environmental problems created by the rapid urbanization of

4 Vermont Forum on Sprawl press release, Burlington, May 23, 2006. 5 For more information, see Oregon Department of Conservation and Land Development at www. oregon.gov/LCD/goals.shtml.

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the state. In April 1972, the legislature passed four major land use laws. The most important of these, the Environmental Land and Water Management Act, established state control over those land use decisions that would have an impact outside local areas. In 1986, in response to continuing rapid expansion, Florida saw the need to coordinate its efforts. The state took an integrated approach to land use management, establishing a state plan and requiring that local plans be approved by the state planning agency. The new approach is embodied in two laws passed in 1985—the State Comprehensive Plan Act and the Growth Management Act. Florida’s state plan requires localities to undertake capital improvement projects, and it tightens development restrictions in the coastal zone, where 80 percent of new growth occurs. The state earmarked funds to assist local governments in developing and implementing their plans. Local communities that don’t invest the required amount in their capital improvement programs risk being cut off from a variety of state funds. Significant updates to Florida’s growth management laws were made in 2005. New provisions included major infrastructure funding, tighter concurrency measures, and a “pay-and-go” provision that requires developers to pay “fair-share contributions” to mitigate development impacts.6 New Jersey The State Planning Act of 1985 established the statewide planning system aimed to “conserve natural resources, revitalize urban centers, protect the quality of environment, and provide needed housing and adequate public services at a reasonable cost while promoting beneficial economic growth, development and renewal.” The act created the State Planning Commission composed of 17 members and the Office of State Planning (presently the Office of Smart Growth) to support the commission. In 1992 the commission adopted the first State Development and Redevelopment Plan. Rhode Island The Comprehensive Planning Act of 1988 required each city and town to adopt a comprehensive master plan addressing nine elements specified in the act (housing, land use, economic development, environmental impact, and so on).

6 Florida Department of Community Affairs, www.dca.state.fl.us.

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Washington In 1990 Washington adopted the Growth Management Act to channel more growth into cities and protect agricultural land and rural areas from suburban sprawl. The Buildable Lands Amendment in 1997 required all Washington counties to prepare reports to estimate the amount of land suitable for development and projected growth. The Growth Management Planning Council of King County estimated growth targets and employment targets for each city that were then incorporated into the local development plans.7 The first five-year review and update process took place in 2002. Maryland Maryland has been actively implementing the new trend in growth management legislation—planning for smart growth—due to its concerns about rapid increase in the population between 1990 and 2015. The Maryland Economic Growth, Resource Protection and Planning Act of 1992 established procedures for review of capital improvement projects in compliance with the state growth policy.8 In 1997, Maryland passed the Smart Growth Areas Act that directs development funding to areas already developed or designated for future growth. Only those areas designated as smart growth areas are eligible to receive state funding for housing, transportation, and economic development, thus discouraging urban sprawl and promoting revitalization in existing urban areas. Pennsylvania The Pennsylvania Municipalities Planning Code of 1968 set the framework for local comprehensive planning. The code was modified by Act 170 in 1988 and once again in 1990 with introduction of the impact fees. Concerns about urban sprawl dominated land use and planning reform discussions in the 1990s and culminated in the Growing Greener initiative launched in 1999, followed by Growing Smarter in 2000. State planning legislation encourages infill development and channels growth into “locally designated growth areas.” Other states that adopted statewide growth management legislation included Georgia (1989), Arizona and Tennessee (1998), and Colorado and Wisconsin (2000).

7 Department of Planning and Development, Seattle, Washington, www.seattle.gov. 8 Maryland Department of Planning, www.mdp.state.md.us.

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Growth Management at the Regional Level In several of the larger states, recognizing that their states were so diverse that a statewide solution would not be practical, growth control was approached on a regional level. Massachusetts In 1963 the Massachusetts legislature enacted the Coastal Wetlands Protection Act to place permanent restrictions on privately owned coastal wetlands, provided that the owners of the properties consented. The owners were not compensated for the restrictions; although they had the right to appeal, only a few did so. In 2000 the state passed the Community Development Plan Program in order to encourage community development plans that would address the growing concerns of open space and resource protection, transportation development, and future housing needs. Later that year the complementary Community Preservation Act was passed that allowed local governments to establish up to a 3 percent tax surcharge to be used for preserving open space, historic resources, and recreational land and development of affordable housing.9 California In 1965, California passed the Williamson Act, authorizing counties to designate special agricultural preserves. Owners of farms of over 100 acres within these preserves received favorable property tax treatment, provided that they maintained the land in a “use not incompatible with agriculture” for at least 10 years. Many counties immediately took advantage of the new law; as an example, two-thirds of Marin County’s 300,000 acres were placed in such a preserve. Since the 1960s, there has also been an ongoing battle in California to protect the coastline. Under the California Coastal Zone Conservation Act of 1972, a permanent state commission and six regional commissions were formed to develop and carry out a long-term plan for the California coastline. In 1976 the legislature gave local government the prime responsibility for managing the coast. Currently, there are 126 local coastal programs in various stages of operation in the 74 coastal cities and counties.10

9 American Planning Association (APA), Planning for Smart Growth: 2002 State of the States, www.planning.org/growingsmart/states2002.htm. 10 California Coastal Commission, www.coastal.ca.gov.

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At the regional level, the San Francisco Bay Area Conservation and Development Commission (BCDC) was formed to regulate land and water use around the bay. At Lake Tahoe, the Tahoe Regional Planning Agency (TRPA) was formed to deal with lake pollution, landfill, and other problems besetting the “Lake in the Sky.” It took until 1984 for TRPA to come up with a regional plan, and pro- and antigrowth factions continue their ongoing debate about the future of development in the area. Growth Management at the Local Level In still other areas, local governments took the lead in tailoring growth management programs aimed at their local concerns, resources, and constituencies. Ramapo, New York Hailed as the earliest example of local growth management, Ramapo is famous for its development plan, which was upheld by the New York Supreme Court in Golden v. Ramapo in 1972. Formerly a small rural community, Ramapo is located in Rockland County 25 miles north of New York City. As a result of explosive growth it experienced in the late 1950s and early 1960s that was due to the opening of the New York State Thruway and the Palisades Parkway, in 1966 Ramapo adopted a comprehensive plan to control housing density. Ramapo then declared a moratorium on development, allowing selective developments to proceed in accordance with an 18-year capital budgeting program that covered construction of streets, sewers, public parks, and other public facilities. To obtain a special use permit, a developer had to demonstrate that these facilities would be in place by the time the project was completed. If they were not in the capital budget, the developer had to pay for the improvements or abandon the project. Although Ramapo lost an initial court test, its development control ordinances were finally upheld in a 1972 decision by the state supreme court. But an economic recession coupled with cutbacks in federal funds for much-needed sewer work slowed growth pressures. In 1983, the controlled growth program was repealed, 4 years before the 18-year capital budgeting program would have ended in 1987. Since then Ramapo has grown to be the largest town in Rockland County and home to over a third of its population (108,905 according to 2000 census). The growth rate of Ramapo (16 percent) has been twice that of the county (8 percent) between 1990 and 2000.

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A new growth management plan was adopted in 2004 to focus on open space preservation and revitalization of existing communities. Despite the failure of the initial plan, Ramapo is credited with accelerating the growth management movement and setting the stage for smart growth.11 Boulder, Colorado This city, near Denver, also took steps to control development. In 1967, the town’s voters approved a greenbelt purchase program financed out of a local sales tax. In 1971 the voters overwhelmingly approved a city council resolution to maintain growth levels well below those experienced in the 1960s and to undertake a study to determine the city’s optimum population size. This study was completed in November 1973. The city slowed growth by levying development fees on commercial and industrial developers. Hookup fees for residential development also were raised substantially. In addition, Boulder began purchasing open space on all sides under the greenbelt program instituted in 1967. In 1976 Boulder enacted a strict growth control ordinance that limited growth in the community to 2 percent per year through the allocation of residential building permits. Also, parcels of developable land were subdivided to such an extent that large developers no longer found it profitable to undertake projects in the area. By the mid-1980s these restrictions, coupled with a weak economy, resulted in growth levels below those mandated by controls. In 1985, 95 percent of the available building permits were allocated; in 1986, only 60 percent of the permits authorized were distributed.12 By the 1990s job growth in Boulder (commercial growth was not limited by the 1976 ordinance) increased the number of commuters and put a strain on the local transportation network. The Integrated Planning Project of 1993 studied the trade-offs of future development, and the result was the 1995 Nonresidential Growth Management System, which limited nonresidential square footage in an attempt to further control growth.13 Petaluma, California In the early 1970s, Petaluma began taking measures to curb its rapid growth. Petaluma is part of a rapidly growing suburban area north of San 11 Julienne Marshall, “Whatever Happened to Ramapo?” Planning Magazine, American Planning Association, December 2003. 12 Planning Department, City of Boulder. 13 Ibid.

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Francisco. The city’s general plan, developed in 1962, encouraged the growth of the area. But the flood of newcomers between 1968 and 1972 prompted Petaluma to establish a growth management program. In 1972 a five-year environmental design plan was published, and it drastically limited new housing and enacted strict criteria for evaluating new development. Petaluma was sued in 1973, and as a result, the U.S. Ninth Circuit Court of Appeals in 1976 upheld the so-called Petaluma Plan. In 1978 a second ordinance, similar to the first, was enacted, but by this time many developers had chosen to avoid Petaluma. In 1987 another general plan designated an urban limit line for the period of 1987 to 2005, and in 1998 the voters approved an identical measure: the urban growth boundary (UGB) limiting the growth of utility services until 2018. As a result of the city’s growth control strategy, the population increased an average of only 2.5 percent annually between 1976 and 2002.14 In addition to citywide growth control measures, some communities have sought to alleviate the problems of crowded downtown areas by imposing controls on commercial development in those areas. San Francisco, California San Francisco’s Downtown Plan was enacted in 1985 and amended in 1995 to control the development of new commercial properties. The plan was drawn up partly in response to the adverse impact of certain commercial developments on local housing and transportation. Under the Downtown Plan, the costs of such adverse impacts had to be incorporated into the cost of commercial developments, along with the responsibility of providing certain social amenities. For example, a development fee of $5 per square foot of transit impact and a housing assistance fee, as well as other neighborhood-specific impact fees, were added automatically to the cost of new commercial development projects. Additional open space requirements and performance standards involving sun, shadow, and wind impacts of new buildings were also part of the Downtown Plan. In November 1986, one year after the Downtown Plan was enacted, voters approved Proposition M, which incorporated citywide growth limits and imposed further restrictions on real estate development. Proposition M limited new commercial development to 475,000 square feet a year until 1998 and incorporated a long list of criteria that developers had to meet in order to receive approval for real estate projects, including, 14 City of Petaluma, General Plan 2025, www.cityofpetaluma.net/genplan/draftgp2025.html.

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among other things, provisions for adding to the supply of affordable housing, maintaining neighborhood housing, and designing structures in such a way that they do not obstruct sunlight or city views. San Francisco’s legislation has served as a model for other cities in their efforts at curbing growth. Boston, New York, and Portland have also followed the lead of San Francisco in enacting legislation to limit commercial development. Seattle, Washington While San Francisco was unveiling its Downtown Plan, Seattle was developing one of its own to update its Comprehensive Plan of 1956. Fearing the imposition of similar restrictive measures, the Seattle business community, in cooperation with city planners, developed a comprehensive incentive program. While the program contained housing fee requirements, it was less restrictive than the San Francisco plan. The planning changes included a two-tier incentive approach. Developments in excess of a floor-to-area ratio (FAR)15 of 10 had to include on-site amenities that related to the site topography, location, or sensitivity. For example, for a development located on a steep grade, bonuses were awarded for hill climb assists and hillside terraces. In order to develop in excess of a 15 FAR up to the maximum 20 FAR limit imposed by the program, the developer had to provide housing or pay into a housing fund. Subsequently, the FAR requirements were adjusted to different downtown zones (see Figure 2-3). Seattle adopted a 20-year New Comprehensive Plan in 1994 and revised it in 2004 to accommodate projections up to 2024. The New Comprehensive Plan uses the “urban village” concept as the way the city directs growth in designated areas and is aimed at limiting the amount of new developments outside urban centers and villages. Exactions and Impact Fees San Francisco also has been in the forefront of a growing trend among cities to require developers to help pay for the municipal costs, both direct and indirect, associated with their projects. In the 1970s, many cities that were experiencing rapid growth found they could no longer afford to finance the infrastructure needed to support new development. 15 The floor area ratio (FAR) is the ratio of the total square footage of a building to the total square footage of the land on which it is situated. For example, a FAR of 12 would permit the development of a building of 1.2 million square feet on a land parcel of 100,000 square feet.

The Changing Ground Rules for Property Ownership

FIGURE

53

2-3

Seattle Downtown Plan, 1985. (City of Seattle Office for LongRange Planning)

Downtown districts DOC-1 DOC-2 DRC DMC DMR (R/R (R/C PSM IDM IDR PMM DH-1 DH-2

Office core-1 Office core-2 Retail core Mixed commercial Mixed residential Residential) Residential/commercial) Pioneer square mixed International district mixed International district residential Pike market mixed Harborfront-1 Harborfront-2

( )

Height requires City Council approval

Downtown Classifications July 1985

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The federal government had reduced funding in this area, and many states followed suit. Local voters rebelled against tax increases and voted against issuing bonds to pay for growth. In the late 1970s and early 1980s, some of these communities attempted to shift more of the burden of infrastructure financing to developers through the assessment of impact fees (also called development impact fees). The idea of developers helping to pay for the infrastructure surrounding development is not new. Over the years, developers have been asked to “voluntarily” construct such things as roads and sewage systems and dedicate them to the local jurisdiction. These payments-in-kind are known as exactions. In many cases, communities discovered it was inefficient to require exactions. Some developments were so small they could not supply enough land for dedication, or a community might end up with a number of small parks, one provided by each development, rather than more carefully planned larger parks. As a result, cities began replacing exactions with impact fees, which could be pooled and used to build the required infrastructure in a more integrated fashion. Prior to World War II, developers were generally asked to pay for only the infrastructure that affected the residents of their developments. But eventually developers were asked to help pay for facilities that benefited the entire community. Such off-site infrastructure might include libraries, parking facilities, schools, or storm drainage systems. In some cases, communities gave development credits to developers who came up with ways to reduce traffic congestion and otherwise mitigate the need for new roads. Over the years, cities have greatly expanded the definition of infrastructure; impact fees are now used to support everything from street building to the purchase of police cars. In some cases the legality of impact fees assessed by cities is questionable, but often developers would rather pay them than incur the expenses involved in litigation and the resultant expensive project delay. In 1976, several courts instituted the concept of rational nexus to determine the maximum fee communities could charge developers for off-site infrastructure. Under this concept, developers could be charged only for the portion of municipal capital facilities that serve their developments. Also, fees collected from developers could not be used to build capital projects that would support the population outside the development project. These fee structures are still in place in many places. But despite restrictions in what cities can legally charge developers, there has been an

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increase in the amount of impact fees required. A national survey conducted by the Center for Governmental Responsibility at the University of Florida in 1988 and 1997 determined that the impact fees increased substantially in those years and that the increase was likely to continue.16 It should be noted that impact fees and exactions tend to limit the competition among developers and exert an exclusionary effect on the housing markets. Forcing developers to maintain higher standards and incorporate into their projects infrastructure such as parks and roadway improvements limits the competition among developers to those large enough to provide such amenities. To the extent that impact development fees can be passed along to the consumer (which usually depends on local market conditions), they exclude certain segments of the population that cannot afford to absorb the fees. Broadening the Geographic Planning Unit There also were attempts to broaden the geographic base of the local planning unit. The U.S. Demonstration Cities and Metropolitan Development Act of 1966 required that local governments who applied for certain types of federal grants-in-aid be subject to review by “an area-wide agency designated to perform metropolitan or regional planning for the area within which the assistance is to be used.” Metropolitan areas responded by forming councils of government (COGs), which were loosely organized confederations of local jurisdictions. The COGs were strengthened somewhat by the U.S. Intergovernmental Cooperation Act of 1968, which broadened the areas subject to COGs’ review to include virtually all federal grants-in-aid. The next year, the Office of Management and Budget issued Circular A-95, bringing state governments into the review process simultaneously with the COGs. Many saw this as a recognition that the powers of the COGs to deal with regional planning problems were limited. Several metropolitan areas, recognizing this same problem, attempted to enlarge the basic unit of government through city-county consolidation. The city of San Francisco and San Francisco County had operated as a consolidated unit for years. Other areas that adopted this approach were Nashville and Davidson County, Tennessee; Indianapolis and Marion County, Indiana; Jacksonville and Duval County, Florida; and the city and borough of Juneau, Alaska. 16 Mike E. Miles, Gayle Berens, and Marc A. Weiss, Real Estate Development: Principles and Process, 3d ed. (Washington, D.C.: Urban Land Institute [ULI], 2000).

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The trend toward consolidation peaked in the mid-1970s. By 1975, according to the National Association of Counties, over 20 counties were consolidated or considering it, and this figure has not increased appreciably since that time. Part of the reason has been that local voters have consistently vetoed attempts at consolidation, preferring not to change the structure of government unless there has been an overwhelming reason to do so. As an alternative to county consolidation, many communities have chosen to simply consolidate certain functions that could more effectively be carried out at the county level. For example, in Broward County, Florida, voters transferred responsibility for planning and land use control from local municipalities to the county. Minneapolis and St. Paul established the Twin Cities Metropolitan Council to deal with transportation, sewage disposal, air pollution, and other regional problems. Despite examples such as these, relatively little regional planning has been implemented. One reason is that local governments fear losing power to the regional planning agency. In the early 1970s, for example, California attempted to develop planning districts based on common economic, social, and cultural interests. The project failed badly because local communities resented the state’s initiative.17 Environmental Impact Legislation In addition to encouraging regional governments, the federal government attempted to come to grips with the impact of development on the environment. The problem was particularly acute in the case of federally funded projects, such as flood control structures, airports, highways, and other public works that have tended to significantly affect the ecology and environment of the area in which they are developed. Recognizing this problem, Congress passed the National Environmental Policy Act (NEPA) of 1969, which required federal agencies to file an environmental impact report (EIR) with the federal Council on Environmental Quality (CEQ) before making final decisions on government projects. In the EIR, the agency was required to include the following: ■ ■

A detailed description of the proposed action A discussion of direct and indirect impacts that might result from the action

17 Arthur Gallion and Simon Eisner, The Urban Pattern: City Planning and Design, 5th ed. (New York: Van Nostrand Reinhold, 1986), p. 545.

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Identification of unavoidable adverse environmental effects An assessment of feasible alternatives to the proposed action ■ A description of cumulative and long-term effects of the action on the earth’s resources ■ Identification of any irreversible commitment of resources that might result from the action ■ ■

Federal “actions” have been broadly interpreted to include approval of a federal permit or license, a grant-in-aid, policy determinants, provisos and regulations, and proposed legislation. As a result, many state and local projects, particularly those involving federal grants-in-aid, require EIRs. Several states require EIRs for all public projects, regardless of federal involvement. Other states have enacted their own version of NEPA. The experience in some of these states has been that environmental review of projects on an ad hoc, case-by-case basis results in use of the statutes as popularity contests for individual projects. Many believe this approach is a poor substitute for much-needed comprehensive planning. Since 1969, a considerable amount of time and effort have been spent searching for a practical, effective way to meet the requirements of the law. The legislation’s inexact wording has posed many problems of interpretation; determining which “actions” should require an impact statement has also posed a problem; and some agencies have actually used the impact report to confuse the public and the courts. On the positive side, however, environmental issues have been drawn into the planning process in such a way that they can be dealt with before the project is too far committed. Citizens’ groups have used the environmental impact requirement to slow or stop proposed projects; the courts have generally supported them. In 1970, conservation groups were successful in blocking construction of the Alaska pipeline because of failure to meet new environmental impact requirements. Construction of a nuclear power facility on Chesapeake Bay was halted in 1971 as a result of deficient EIRs. A landmark case in terms of land development was the Friends of Mammoth v. Mono County decision,18 in which the California Supreme Court extended the state law requirement for environmental impact reports to private development. This decision immediately affected development activity in California, as developers scurried to produce impact reports. Some suspended or shut down operations in the state.

18 C3d 247, 104 Cal Report 761, 502 P2d 1049.

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To this day, the Sierra Club and other environmental groups are involved in a wide range of lawsuits aimed at preventing development that threatens the environment. Clearly, the environmental movement and its impact on the regulation and control of land use in this country will continue to be felt for years to come. Smart Growth and New Urbanism The smart growth movement is the effort to act on many of the abovementioned trends in growth management, environmental regulation, and developers’ assuming some or all of the responsibility for mitigation of negative externalities produced by new developments. By 2001, three quarters of the states had implemented or were pursuing statewide development reforms consistent with the principles of smart growth, including the examples of statewide and regional growth management mentioned above.19 New urbanism is an urban design concept that emphasizes traditional neighborhood planning focusing on environmental responsibility, historic preservation, pedestrian friendly neighborhoods, and the integration of local ecosystems and open space into the culture of living. Several examples of developments incorporating the principles and practices of smart growth and new urbanism are presented below. Seaside, Florida One of the earliest examples of new urbanism, this beach town was developed in the 1970s by Robert Davis as a planned community reminiscent of small towns in northwestern Florida. Seaside is home to just over 1,000 people and is a recreation area well known for its wooden cottages and white beaches. Prairie Crossing, Illinois The 667 acres that constitute Prairie Crossing were purchased in 1987 with a goal to develop an environmentally sensitive community with over 60 percent of the land preserved as an open space. The development was designed with only 359 single-family homes and 36 condominiums, and it included 165 acres of restored prairies, 20 acres of restored wetlands, and 16 acres of hedge growths. All homes were built with the U.S. Department of Energy–approved green building techniques and were

19 American Planning Association, Planning for Smart Growth: 2002 State of the States.

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50 percent more energy efficient than other homes in the Chicago area. As of 2005, all of the new homes had been sold.20 Hidden Springs, Idaho Hidden Springs is a master-planned community laid out as a traditional small town northwest of Boise, Idaho. The community includes civic spaces, parks, and pedestrian trails, and it is designed to protect natural ecosystems. While Hidden Springs is not an official town, it has an option to incorporate into one should the residents decide to do so. The master plan for this 1,844-acre community keeps over 800 acres as protected open space and regulates all future development. King Farm, Maryland This higher-density suburban community integrates housing, shopping, offices, and public transit. The land was purchased for development in 1995, and it was designed as a walking community with historic architecture and modern conveniences, such as the 120,000-square-foot shopping center and the 90-acre commercial complex within walking distances to the Shady Grove metro station. The community features two residential villages and a city park, as well as complimentary shuttle service to the metro station. King Farm is an example of a high-density suburban development that has succeeded while many people have feared that such developments would be unattractive to people living outside of the city.21 Other Federal Legislation The EPA has made other attempts to control land use. One such attempt emerged from an unexpected source: the Clean Air Act of 1970. As amended, it required states to show how they intended to ensure maintenance of ambient air quality standards once the standards had been achieved. In 1974, the EPA used the Clean Air Act mandate to require that the project review process be extended to cover not only direct sources of air pollution, such as power plants, but “indirect sources,” such as concentrations of motor vehicles that might adversely affect air quality. The new regulations would affect all large private projects, not just those that were federally funded, and especially shopping centers. 20 Richard M. Haughey, Higher-Density Development: Myth and Fact (Washington D.C.: Urban Land Institute [ULI], 2005). 21 Ibid.

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This attempt at regulating private development ultimately ended in failure. As a result of strong criticism, particularly from the development community, the initiation date of the regulations was postponed several times. Finally, the new review procedures were largely invalidated under the Clean Air Act Amendments of 1977. The Clean Air Act was most recently amended in 1990 to once more address growing environmental concerns. The amendments targeted acid rain, urban air pollution, and toxic air emissions, and they called for a national permit system and a better enforcement system. The act incorporated some progressive environmental management trends—for example, market-based principles in emissions trading and a framework to encourage the use of alternative fuels. The act raised automobile emissions standards, set a definite timetable for reductions, and mandated the installment of the best available control technology (BACT) to reduce the amount of air toxins. The Takings Issue Although federal, state, and local legislation has had a major impact on land use in the United States, many of the deciding battles over the right to develop land or to prevent development have been fought and decided in the courts. In the late 1980s, landowners and local governments turned to the U.S. Supreme Court for a definitive ruling on the so-called takings issue— the debate over when zoning laws and regulations and other government provisions constitute a “taking” of private property and thus require compensation to owners under the Fifth Amendment of the Constitution. In several cases that had previously gone before the Supreme Court, the issues had not been resolved because of procedural conflicts. The series of takings cases that followed, however, established a case-by-case decision-making pattern used by the Supreme Court to deal with conflicts relating to the effects of government regulation on private property. In Penn Central v. New York City (1978), the Court ruled in favor of the city to conclude that development restrictions placed on the Penn Station as a result of the Landmark Preservation Law did not constitute a “taking.”22 In two takings cases decided in 1987, the Supreme Court upheld the plaintiffs’ claims. In the First English Evangelical Lutheran Church of 22 Penn Central Transportation Co. et al. v. New York City et al., U.S. Supreme Court, 438 U.S. 104, decided June 26, 1978.

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Glendale v. the County of Los Angeles (1987), it was decided by the Supreme Court that in cases where regulations as to the use of the property are especially restrictive, the public authority may be required to compensate the owner as if it actually had taken title.23 In Nollan v. California Coastal Commission, the Court ruled that government regulations were not sufficiently related to the public purpose when the owner of the property was forced to allow public access to his beach to provide public views of the ocean. Later, in Lucas v. South Carolina Coastal Council (1992), the Court ruled in favor of the plaintiff asserting that the residential lots purchased in 1986 before passage of the Beachfront Management Act in 1988 that prohibited any permanent habitable structure from being built on the property were in fact “taken.”24 More recently, in Kelo v. City of New London (2005), the Court ruled in favor of the city, which had decided to condemn homes in a blue-collar neighborhood in order to allow a new development to be built on the land, with the city planning to give the land to a developer for a 99-year lease for a price of $1. The Court ruled that this transaction constituted “public use” based on an analysis of what constituted the best public interest in good faith. Despite these cases, the Supreme Court has not established a formula for determining when the effect of a regulation is a taking and the degree of compensation. The Court rules based on the circumstances of each case, considering a set of relevant factors such as the economic impact of the regulation, the degree to which the regulation interferes with investor-backed expectations, and the character of the government action. Regardless of how particular land use cases are decided in the courts, the land use issues that have arisen since the 1960s will continue to have a great impact on the real estate development process in coming years. Private developers must now demonstrate that their projects will not adversely affect the environment and quality of life around the development and that they contribute to improving public amenities such as housing and day-care facilities. Local governments, on the other hand, must justify regulations restricting land use, relying on sound rationales rather than simply administering land use controls at will. Clearly, over the last 50 years, the ground rules governing real estate development have irrevocably changed. 23 Miles, Berens, and Weiss, Real Estate Development. 24 David H. Lucas v. South Carolina Coastal Council, U.S. Supreme Court, 505 U.S. 1003, decided June 29, 1992.

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CHAPTER 3

The Restructuring of the Industry

Real estate is the last of the nineteenth-century industries. Anonymous

Increasingly stringent environmental legislation wasn’t the only problem facing the real estate industry in the 1970s and 1980s. Land and building costs in urban areas were increasing faster than personal income, thus excluding a sizable percentage of the population from the private housing market. In addition, the growing size and complexity of real estate projects required broader sources of financing than had traditionally been available. Real estate, however, historically had not been an industry that adapted to rapid change. The explosive growth of the nation and the seemingly unlimited supply of land had worked to postpone structural changes that occurred in virtually every other American industry. In 1970, the real estate industry was in many ways not much different structurally from what it had been at the turn of the century: fragmented, small scale, and largely undercapitalized. During the next 35 years (1971 to 2006), outside forces and internal leadership would play a major role in reshaping the real estate development process.

RESPONDING TO CONSUMERS The first concern was the consumer of real estate products, particularly individuals and families who were finding it increasingly difficult to 63 Copyright © 2007 by John McMahan. Click here for terms of use.

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afford housing as well as going through a period of major demographic and lifestyle changes. Searching for Lower Housing Costs In the early 1970s, more and more Americans were driven out of the singlefamily market because of continuing increases in the costs of land, labor, and materials. This trend continued throughout the remainder of the decade. In 1980, the homeownership rate was 65.6 percent. That figure declined slightly between 1980 and 1987, when the rate was 64.0 percent.1 Chapter 1 discussed attempts to offset increasing land costs through cluster housing, PUDs, and other forms of more intensive land use. Combating spiraling labor and material costs, however, required more than improved design. Fundamental changes in the housing production process were necessary, it was thought, to bring housing costs back in line with the buyers’ ability to pay. The growth in the use of mobile homes suggested a possible solution to the problem. Starting with retirees moving to Sunbelt states, mobile home ownership spread throughout the nation. In 1960, 103,700 mobile homes were shipped, representing 7.4 percent of all new housing units built that year.2 By 1972, annual production of mobile homes had risen to 576,000 units, with 5 million Americans living in approximately 2.1 million mobile homes.3 Seeing the explosive growth in mobile home sales, many believed that the answer to increasing housing costs lay in applying mass production techniques on a broader scale (Figure 3-1). In 1969 the federal government initiated the Operation Breakthrough program to promote the concept of modular housing. Several cities participated in the program, and 22 firms were granted contracts to develop modular homes. But local opposition, bottlenecks in contract negotiations, and congressional funding cuts doomed Operation Breakthrough. By 1973, the project had lost its momentum. In all, just 2,794 housing units were developed.4 Modular housing suffered other setbacks as well. State laws restricted transportation of modular units across state lines. Compliance with varying local building codes increased costs. Industry expectations were high, and stocks of modular manufacturers were overpriced. 1 Savings Institutional Sourcebook, 1988, table 47, p. 44, and U.S. Census Bureau. 2 U.S. Census Bureau, Historical Statistics of the United States: Colonial Times to 1970, series N 170, pp. 639–640. 3 Federal Reserve Bulletin, December 1973, p. A63. 4 Operation Breakthrough—Lessons Learned about Demonstrating New Technology, Report to the Congress by the Controller General of the United States, November 2, 1976, p. 10.

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FIGURE

3-1

Evolution of the mobile home: (a) 1937 Shult Homes sports model compact trailer, which included such amenities as a chemical toilet and a permanent bed with box spring and mattress. (b) A modern manufactured home. ([a] Shult Homes and [b] Manufactured Housing Institute)

(a)

(b)

Builders ran into financial problems. Manufacturers overproduced, creating unwanted inventories. The basic problem, however, was that modular housing did not result in a reduction in total housing costs, only in certain components such as roof trusses and wall sections. Industrial production of these and other components was quickly absorbed into the on-site construction industry wherever efficiencies could be demonstrated.

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It was becoming increasingly evident that mass-produced housing would not be the panacea many had sought. In some cases manufactured housing resulted in cost savings of 10 to 20 percent, but it was still extremely hard to gain acceptance by the public and municipalities. In addition, manufactured housing was treated differently from conventional housing by lenders and government agencies. By the mid-1970s, it was increasingly evident that modular housing was falling far short of the goals that had been set by the government and industry leaders. The share of manufactured housing slowly declined over the years, accounting for 4 percent of new home development in 2005.5 Responding to Demographic and Lifestyle Changes The real estate industry also attempted to adjust to changes in demographic patterns and consumer lifestyles. In terms of housing, large numbers of baby boomers coming of age in the 1960s spurred demand for large apartment complexes with a wide assortment of amenities. As these individuals became older and started to establish households in the 1970s and 1980s, demand developed for condominiums and small “starter” homes. As more and more women entered the labor force, the number of affluent two-income housing units grew, and this helped fuel the demand for new retail facilities. Superregional centers evolved out of regional shopping centers, guaranteeing the busy consumer one-stop shopping. The growth of single-parent homes and two-earner households also reinforced the need for convenient shopping. Neighborhood “superstores” became popular, as did strip retail centers, where busy consumers could stop and shop on the way home from work. Catalog and Internet shopping also became increasingly popular. Single-parent homes were often less affluent, and so more affordable goods were needed; this helps to explain the growth of discount houses, the popularity of off-price shopping centers, and, of course, the success of megaretailers such as Wal-Mart and Target. By the later part of the century, a substantial number of the 80 million baby boomers were reaching middle age and the peak of their earning power, thus adding to the demand for upscale specialty shops both in shopping centers and free-standing outlets in established shopping neighborhood and resort areas.

5 Federal Reserve Bulletin, October 1988, p. A49.

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An increase in immigration and growth in ethnic households, especially Asian and Hispanic, changed retail patterns as well. Retailers, particularly in metro areas of the Southwest, found that they had to cater to the different lifestyle and cultural patterns of the immigrant population in order to be successful. Increasingly, retailing was becoming more specialized, focusing on smaller and better-defined segments of the consumer population. The growing participation of women in the labor force also added to the demand for office space and day-care facilities both on and near the work premises. The health concerns of a younger workforce led to the development of gyms, swimming pools, running tracks, and health spas in many suburban office parks. Developments in the hotel and resort industry followed changes in demographic patterns and leisure preferences as well. As trends in participation sports evolved, resort facilities began offering everything from golf courses to tennis facilities to health and fitness centers. The aging of America led to an increase in demand for retirement housing and extended-care facilities. Traditionally, elderly people lived with younger family members, but the trend in the later half of the twentieth century was toward independent living. As the number of people 85 years and older increased, so did the demand for nursing homes where they could also receive living assistance and medical care. For those elderly who required living assistance but not medical care, congregate care became an increasingly popular choice. The younger segment of the elderly population often maintained their own homes or moved into completely independent retirement communities. This trend is especially popular now with the baby boomer generation in their fifties or sixties preferring age-restricted suburban communities consisting of townhouses, apartments, or condominiums with comfortable layouts and without the hassle of maintaining a singlefamily home.6 As a new century and millennium dawned, it also became clear that a new wave of demand was about to enter the market from the echo boomer generation, the sons and daughters of the baby boomers. This generation is expected to grow to 84.9 million by 2010 and is only now entering its prime earning years.

6 Urban Land Institute (ULI) and PricewaterhouseCoopers LLP, Emerging Trends in Real Estate 2006 (Washington, D.C.: Urban Land Institute).

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BROADENING THE FINANCIAL BASE Faced with rapid population growth with an even faster evolving socioeconomic structure, it became clear that the real estate industry had to change the way it organized and financed its businesses if it were to continue to be responsive to the nation’s needs. The Traditional Real Estate Capital Markets The financing pattern of real estate for the first 45 years after World War II was fairly straightforward. Long-term residential construction was financed largely by mutual savings banks and savings and loan associations, often with mortgages insured by the federal government. Long-term financing of commercial and industrial buildings was largely undertaken by the nation’s insurance companies. Short-term, or interim, financing for virtually all types of construction was undertaken by commercial banks. A continuing surplus of mortgage funds made it possible for many developers to “mortgage out” on their projects—little or no equity capital was required. Equity capital that did have to be raised usually came from syndicates composed of a relatively few wealthy investors often seeking the tax advantages of real estate development. The investment policies of the institutions tended to nudge local real estate markets toward equilibrium and avoided major episodes of over- or underbuilding. Long-term lenders, such as insurance companies, generally required new building projects to have 25 to 50 percent of the space preleased before proceeding. If vacancy in a local market increased significantly, institutions stopped lending in that market until the oversupply was reduced. Construction lenders, such as commercial banks, generally required take-out commitments by permanent lenders before providing construction funds. Thrifts were largely restricted to residential lending. This simple framework served the nation well in the relatively calm years after the war. Strong economic growth, coupled with low inflation and a housing demand backlog, produced an environment in which most of the players prospered and were generally uninterested in altering the cozy world in which they operated. During the next 30 years, in contrast, the U.S. real estate capital market went through a dramatic change as the direct or indirect result of several major events that occurred in the economy or in society at large.

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Structural Changes in the Real Estate Lending Business Between 1975 and 2006, financial institutions went through a major restructuring of their approach to real estate lending. This was mostly influenced by several major changes in the economy and regulatory environment. Inflation Probably the single most important factor in influencing the real estate capital market during this period was the emergence of double-digit inflation in the mid-1970s. For the first time since World War II, inflationary expectations influenced investor attitudes. Savers became less interested in fixed-rate passbook accounts of life insurance policies with seriously eroding face values. Mortgage lenders watched in dismay as long-term real interest rates turned and stayed negative for over two years (that is, 1979 to 1980).7 Pension fund managers became concerned with their ability to fund retirement liabilities. Inflation also introduced a new way of thinking on the part of the real estate community—one in which projects that initially were not feasible proceeded in expectation of future inflationary rental increases. This attitude contributed to the overbuilding cycle of the 1980s. In recent years inflation has been successfully kept under control in the United States mostly through a series of well-timed interest rate cuts implemented by the Fed and a positive impact of rapid globalization on the key world economies. In fact, most developed countries have succeeded in controlling inflation, and it no longer seems to be a major concern outside of a few developing economies.8 While this dampened the speculative inflationary attitudes of earlier years, the possibility of rising inflation still exists and therefore is a factor that is still very much a part of individual and institutional decision making. Deregulation In the late 1970s, Congress began deregulating America’s financial institutions. As a result, commercial banks were allowed to operate in geographical areas other than their traditional markets, and construction 7 For a discussion of the impact of inflation on the mortgage markets, see Anthony Downs and S. Michael Giliberto, “How Inflation Erodes the Income of Fixed-Rate Lenders,” Real Estate Review, spring 1981. 8 Kenneth Rogoff, “The Myth of How Central Banks Slayed the Hydra of Inflation,” Financial Times, August 30, 2006.

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lending rapidly took on a national and, ultimately, international flavor. Thrift institutions, previously restricted to residential lending, were allowed to invest up to 10 percent of their assets in commercial properties. Deregulation had a more fundamental impact on the housing market. Prior to deregulation, interest rate ceilings had been imposed on the savings accounts of thrift institutions. Traditionally, thrifts borrowed money for the short term and used it to make long-term loans at fixed rates. When interest rates rose, customers withdrew savings and put their money in higher-yielding accounts at other institutions. This process was known as disintermediation, literally “bypassing the intermediary,” in this case the financial institution. As a result, thrifts would periodically run short of funds to lend for housing, creating a credit crunch and slowing construction activity during periods of higher interest rates. Under deregulation, interest ceilings were lifted, and thrifts were allowed to compete on an equal footing with other financial institutions for savings deposits, enabling them to continue making mortgage loans when interest rates rose. Thrifts were, in fact, more than equal in their ability to raise funds under deregulation because they combined market interest rates with federal deposit insurance guarantees. Thrifts began attracting large pools of funds, some of which were invested in land speculation or commercial loans that were outside of the thrifts’ areas of expertise. These bad investments helped to weaken the thrift industry in the mid-1980s. The government started to tighten controls on the thrift industry in 1989 by creating the Resolution Trust Corporation (RTC) to liquidate assets of insolvent S&Ls. The duties of the RTC were later reassigned to the Savings Association Insurance Fund of the Federal Deposit Insurance Corporation (FDIC) in 1995. Deregulation also brought about a shift from fixed- to variable-rate mortgages. While the lifting of interest rate ceilings allowed the thrifts to compete with other institutions, it also meant that, in times of rising interest rates, they had to offer higher rates, while continuing to earn lower yields on their portfolio of long-term fixed-rate mortgages. As a result, thrifts began to shift interest risks toward the borrower through variablerate mortgages. The goal was to bring the institution’s long-term earnings more in line with short-term interest rate fluctuations. Spread Financing Largely as a result of inflation and deregulation, many financial institutions began restructuring their investment portfolios in the late 1970s and

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early 1980s. This strategy involved not only an attempt to match income with various levels of risk but the maturity of assets and liabilities as well. The result was profit made on the spread financing between the return of the asset and the cost of the liability. If individual match-ups were successful, the thinking went, the overall performance of the portfolio also would be successful. The impact of this strategy on real estate was to tie the availability and terms of mortgage financing to the broader capital market and thus make real estate financing more volatile. In terms of permanent financing, the maturity and rate charged for a mortgage loan often became linked to the maturity and rate paid on a guaranteed investment contract (GIC). Construction financing became linked to the prime rate, the London Interbank Offered Rate (LIBOR), or some other “floating” index. This new level of volatility made it difficult to plan and execute real estate projects that might take 2 to 5 years to complete. The maturity of permanent financing dropped from 25 to 30 years to 7 to 10 years. In periods of rapidly escalating inflation, reserves for construction interest often proved inadequate, with the developer being in default before construction was complete. Tax Legislation In the 1960s and 1970s real estate received a modest tax subsidy through the deduction of interest and depreciation. Some industry elements, such as low- and moderate-income housing and historic preservation, were singled out for special treatment, but with the exception of single-family housing, real estate was not treated much differently than other investment assets. This changed with the Economic Recovery Tax Act of 1981, when Congress provided the real estate industry with a windfall by substantially reducing the recovery period for the depreciation of investment assets. In addition, the industry was granted an exemption from new at-risk rules that would limit deductions to the amount of funds invested. These factors made real estate a very attractive investment vehicle for taxable investors, and funds flowed freely into the industry. Although the recovery standards were modified somewhat by the tax bill of 1984, the subsidy still was significant, particularly when compared with other investment opportunities. Congress reversed itself with the Tax Reform Act of 1986 and took away virtually all subsidies from real estate, but not before the industry received a major infusion of new equity capital. The impact of legislation on the industry prompted major real estate companies to strengthen the National Realty Committee, presently known

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as the Real Estate Roundtable, into a powerful lobbying organization. In recent years, Congress has passed several legislative measures that have benefited the real estate industry, including reducing the depreciation period for leasehold improvements and fees, immediate write-offs for environmental costs, and a reduction in the capital gains tax. The current focus of the Real Estate Roundtable is to extend these measures and protect the interests of the real estate industry in the event of comprehensive tax reform. Mortgage-Backed Securities Attempts also were made to expand the secondary market for residential mortgages. The secondary market is made up of investors who buy and sell mortgages originated by a third party. The development of this market allowed a much broader array of investors to participate in the real estate marketplace and expanded the pool of capital funds available for development projects. Commercial real estate debt was first transformed into mortgagebacked securities in 1984; nearly $1.2 billion of commercial properties was securitized in that year. In 1985, more than $6 billion of new commercial issues came to market. By 1986, 45 percent of all new singlefamily mortgages were securitized.9 Entry of the Pension Funds Pension funds were established in the 1950s by large corporations such as General Motors, to supplement Social Security and attract and retain key employees. The investment objectives of early pension funds were relatively modest—to preserve accumulated capital, achieve sufficient returns to meet beneficiary liabilities, and maintain sufficient liquidity to pay the funds’ operating expenses. Pension fund managers generally avoided real estate equity investment on any scale until 1975.10 This hesitancy was based primarily on concerns about real estate’s nonfungibility, market fragmentation, infrequent pricing, lack of an auction market, and general lack of information about the asset class.

9 Kenneth T. Rosen, Securitization and the Mortgage Market, Bond Market Research—Real Estate, Salomon Brothers, Inc., New York, August 1987. 10 Prior to this time, insurance companies and bank trust departments did invest pension capital in whole loan mortgages and net leased properties on a fully discretionary basis, using insured accounts.

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Most fund managers also believed (and many still do) that real estate favors taxable, rather than tax-exempt, investors. As a result of these and other concerns, real estate was perceived to be riskier than financial investments such as stocks and bonds.11 The New Investment Standards Set by ERISA In 1974, Congress passed the Employment Retirement Income Security Act (ERISA). This legislation was directed primarily at preventing a repeat of pension abuses related to corporate bankruptcy (Studebaker) and union graft and corruption (Teamsters). ERISA established tough new fiduciary standards for the management of pension plans. Henceforth, managers of pension fund capital were expected to meet the following responsibilities: Discharge their duties solely in the interests of participants and beneficiaries. ■ Demonstrate “prudence” in all investment decisions. ■ Diversify plan investments to minimize the risks of large losses. ■

Penalties for violating ERISA standards became “personal and criminal” to drive home to individual trustees the serious consequences of violating the provisions of the new legislation. ERISA also established the obligation for pension sponsors to look at the total spectrum of investment opportunities. This opened up consideration of nonfinancial assets such as real estate.12 Open-End Funds Open-end funds sponsored by insurance companies and banks13 were the primary investment vehicle in the early years. These funds represented large pools of capital, reflecting a diverse investor base in which pension fund managers believed they could safely participate. Through a periodic withdrawal device, open-end funds also provided investors with a measure of liquidity. A major disadvantage was the fact that investors were buying and selling on appraised values rather than actual market transactions. Also, the queue to redeem investment capital requests was not always viewed as

11 In fairness, many pension decision makers had been trained in the management of financial assets and had little previous exposure to commercial real estate as an investment. 12 The author was the expert witness for the Department of Labor in the Mazzola case in 1980 that established fiduciary standards for pension investment in real estate. 13 The name “open end” comes from investors being able to redeem on a quarterly basis.

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being fair to all investors.14 This was a particular concern if the fund sponsor were forced to liquidate properties in order to meet redemption requests. Closed-End Funds Observing the success of financial institutions in attracting large sums of capital from pension funds, Coldwell Banker and several other large entrepreneurial real estate firms began sponsoring closed-end funds, which they believed were more reflective of the true nature of real estate as a relatively illiquid asset.15 The holding entity for closed-end funds was also a unit trust, but here the similarity to open-end funds ends. Closed-end funds have a finite life, usually 10 years. Investor dollars are “called for” to fund properties as they are acquired. The investor establishes the maximum amount of capital he or she wishes to invest in the fund, and capital is drawn against this commitment until the maximum is reached. Closed-end funds also are more focused in terms of investment strategy, acquiring properties of a particular type in a certain geographical area or properties that have other distinguishing characteristics. There are several disadvantages to closed-end funds. They generally invest in smaller properties, there is less portfolio diversification, and fund sponsors are perceived to be under greater pressure to invest. They also are highly illiquid, with investors often unable to reclaim cash until the fund is liquidated. A major concern is that liquidation might come at the wrong time in the real estate cycle, forcing investors to accept lower returns or, in some cases, a possible loss of capital value.16 Qualified Plan Asset Managers (QPAMs) In the early 1980s, Congress clarified ERISA requirements regarding the hiring of real estate managers.17 The role of a qualified plan asset 14 The major problem was that fund redemption was administered on a first-in/first-out rather than pro rata basis. This forced pension managers to notify the fund sponsor of its desire to liquidate if others were doing so, creating somewhat of a run-on-the-bank mentality. 15 Coldwell Banker utilized a limited partnership format as the investment entity. Subsequent closedend funds sponsored by RREEF, Heitman, LaSalle, and AEW used a group trust format, which was closer to being a true commingled fund. 16 Although closed-end funds didn’t use appraisals for liquidation purposes, they were used in determining annual fees. This created what many investors viewed as a conflict of interest because the manager was perceived to be less interested in selling when portfolio assets were highly valued, as this would reduce the manager’s fee income. 17 The term investment manager is used generically throughout this book to include registered investment advisors, managers of real estate investment trusts (REITs), general partners, and any other individuals or firms that serve as fiduciaries to real estate investors.

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manager (QPAM) was established to allow plan sponsors to escape direct responsibility for the management of real estate assets in their portfolios. To qualify, a manager had to (1) have the power to acquire, manage, and dispose of any real estate assets in its portfolio; (2) be registered as an investment advisor under the Investment Advisors Act of 1940 (or a bank or insurance company as defined by ERISA); and (3) acknowledge in writing that it was a fiduciary of the plan.18 Not only did this legislation lessen the liability of plan sponsors for actions of its managers, but managers who qualified were given more flexibility in the management of portfolio assets, particularly in terms of transaction approvals, management deployment, asset operating decisions, and so on. The Concentration of Pension Real Estate Investment Today, the pension real estate industry is concentrating at a rapid pace. As of 2007, the 10 largest pension investors in real estate held $70.3 billion in assets, representing 47 percent of the funds supplied by the 200 largest pension funds investing in real estate equities. Nine of the ten were public employee plans, two located in California.19 Six of the 10 largest pension plans have $9.2 billion invested in REITs. One is a corporate plan; the rest are public plans. These 6 plans represent 31.6 percent of the total capital supplied by the top 200 funds investing in REITs.20 As noted earlier, rapidly increasing inflation in the 1970s attracted pension funds to real estate investment. At the same time, foreign nationals also discovered the attractions of U.S. real estate. Both of these investor groups were generally risk averse and had little real estate experience. Furthermore, investors were often located thousands of miles from the properties they were acquiring. These needs led to the rise of the real estate investment management industry. Increasingly, pension plans have developed a positive view of real estate as an investment class. Most plan trustees are aware of real estate’s lower volatility, portfolio diversification benefits, and ability to generate cash flow. Unfortunately, pension real estate investment in the near term may be constrained due to the difficulty of increasing target allocations since it may mean lower allocations to other, more established, asset classes. 18 Natalie A. McKelvy, Pension Fund Investments in Real Estate: A Guide for Plan Sponsors and Real Estate Professionals (Westport, Connecticut: Quorum Books, 1983). 19 Pensions & Investments, January 22, 2007. 20 Ibid.

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The Evolution of the Investment Management Industry As a result of the growth of real estate investment capital on a national and international basis, a need arose for someone to acquire, manage, and dispose of assets on a local basis. The real estate investment advisory industry evolved to serve this need. Initially, the new industry was dominated by insurance companies (Equitable, Prudential, Aetna, and New England Life) and banks (Wachovia, First Chicago, Morgan Guaranty). Eventually, entrants also included firms from related fields such as mortgage bankers (Heitman, Lomas & Nettleton, Eastdil, FIA), syndicators (JMB, Balcor), developers (LaSalle Partners), security managers (Rosenberg, TCW, Boston Company), foreign advisors (Jones Lang Wooton, Richard Ellis, Lehndorf & Babson), and real estate brokers (Coldwell Banker), as well as start-up entrepreneurial firms (Aldrich, Eastman & Waltch, J.W. O’Connor). By 1988, there were over 100 investment advisory firms managing over $311 billion in assets.21 Most of these firms provided a full range of services including finding and evaluating properties, acquisition, negotiation and due diligence, portfolio management, property management, and disposition services. Most of the properties acquired were fully leased lower-risk investments, although some managers entered into higher-risk investment structures and, in a few cases, took development risks. Since most of the clients were tax-exempt or low-tax investors, leverage was seldom used, most properties being purchased on an all-cash basis. Similar to the investors they serve, the management of real estate investment capital is also concentrating. In 2006, the top 10 real estate investment managers controlled $201.8 billion in pension assets, three-fourths of which were investments in equity real estate. Nine of these firms were owned or controlled by financial institutions (including three foreign institutions), and one was a major corporation. Two of the firms were initially entrepreneurial companies but subsequently were acquired by financial institutions. These 10 firms represented 61.7 percent of the total capital managed by the 50 largest real estate managers.22 The growth of investment advisory activities helped to change the thinking of many in the real estate industry. For the first time, real estate practitioners began looking at real estate from a portfolio as well as a prop-

21 Pensions and Investment Age, September 19, 1988, p. 14. 22 Pensions & Investments, December 25, 2006, p. 26

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erty point of view. As a result of institutional policies and a rigorous regulatory process, the overall professional quality of real estate transactions has improved, as has the quality of individuals attracted to the industry. Developers increasingly looked to the investment advisory firms and their clients to provide “take out” financing or acquire the project upon completion. With this separation of the production and ownership process, many developers became merchant builders, developing for sale rather than ownership. In 2006, pension funds had approximately $162.3 billion invested in U.S. real estate equities, second only to real estate investment trusts (REITs).23 Real Estate Investment Trusts Wall Street has been periodically preoccupied with the desire to provide liquidity (and tradability) for illiquid assets such as real estate. The mortgage bonds of the 1920s were an early attempt to tackle this problem. While they provided a substantial infusion of real estate capital, they were a factor in the later collapse of the real estate market and subsequent Great Depression. A second attempt to provide liquidity to real estate markets was made in 1960, when Congress created a new investment vehicle, the Real Estate Investment Trust (REIT), to allow “pass-through” tax treatment for trusts that met certain standards and conditions. The legal entity is a corporation or trust managed by a board of directors or trustees. Here the resemblance to other public companies ends, however, reflecting the special nature of REITs. REITs are required to have at least 100 shareholders, no 5 of which can own more then 50 percent of the stock (the 5/50 rule).24 REITs also must hold 75 percent of their assets in real estate equity, mortgages, shares in other REITs, cash, and certain other securities. Rents or mortgage interest payments must make up 75 percent of the income. In addition, 95 percent of the taxable income must be distributed currently. REITs also cannot act as “dealers,” they must be integrated, and their shares must be transferable. REITs appeared to offer a promising vehicle for real estate investors. For the first time, large numbers of small investors could invest in real

23 Urban Land Institute (ULI) and PricewaterhouseCoopers LLP, Emerging Trends in Real Estate 2007 (Washington, D.C.: Urban Land Institute). 24 The original rule was modified to allow pension funds to invest by considering individual plan beneficiaries as REIT shareholders (the look-through rule).

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estate on a national basis. Illiquid assets could now be turned into securities that would trade as easily as common stocks. In the early years, however, most REITs were small, passive, and managed externally. There was little management ownership, analyst coverage, or market activity. In the late 1960s, several financial institutions created new REITs as vehicles to underwrite and fund mortgage loans that were too risky for their traditional portfolios. These were largely construction loans, often secured by speculative projects located in secondary markets. Ultimately, REITs were the largest source of mortgage financing for the 1971 to 1975 real estate boom. Most of these REITs collapsed in the mid-1970s, however, leading to a 75 percent loss in REIT market value. This gave REITs a negative image in the investment community for at least the next 10 years. Largely as a result, REITs did not attract any significant new capital and, luckily, missed the real estate “bubble” of the 1980s. In the subsequent collapse of real estate markets at the end of the decade, all forms of capital for real estate evaporated. In the early 1990s, developers and investors found themselves with highly leveraged properties, often built with short-term financing and no source of refinancing. With interest rates falling and real estate at bargain basement prices, Wall Street saw an opportunity to arbitrage private and public markets. The Kimco offering in late 1991 was the first sign that REITs could play a major role in financing real estate and, more importantly, real estate operating companies. During 1991, eight REIT initial public offerings (IPOs) raised $808 million. A similar number were completed in 1992, raising $919 million.25 While this was meaningful investment activity, particularly in a capital-starved real estate market, 1993 proved to be a real turning point, with 75 equity IPOs raising $11.1 billion. Excluding placements of less than $50 million, 39 IPOs were completed raising $8.2 billion, which amounted to approximately 14 percent of the total IPO activity in the entire securities market for the year. More real estate capital was generated by these 39 IPOs than by any other source.26 Perhaps more significantly, the character of the 1993 IPOs was dramatically different. Most of the new REITs were organized as vertically integrated real estate operating companies specializing by property type. 25 Source: National Association of Real Estate Investment Trusts (NAREIT), www.nareit.com 26 Ibid.

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They were also significantly larger: 10 equity REITs had a market capitalization of over $500 million (versus 2 at the end of 1991), and 40 had a market capitalization exceeding $200 million (versus 10 in 1991).27 Most of the 1993 IPOs were internally managed, and in most cases, management had significant equity positions, thus minimizing conflicts and enhancing congruency of objectives with investors. Many of the management groups had spent their careers specializing in a particular property type and had effectively worked together as a team for several years, through at least one full real estate cycle. The difference between the “old” and the “new” REITs could be summarized as follows: Old REITs

1960–1992 Passive investments ■ Externally administered ■ Institutional sponsors ■ Small management ownership ■ Diversified portfolio ■ Small capital base ■ Little analyst coverage

New REITs

1992–present Operating company ■ Self-administered ■ Entrepreneur sponsors ■ Large management ownership ■ Focused portfolio ■ Larger capital base ■ More analyst coverage

■

■

■

■

At year-end 1993, the REIT market was thriving. The total market capitalization of all REITs increased to $31.6 billion. The 30 largest REITs represented $15.1 billion versus $8.6 billion at the beginning of the year.28 Today, REITs invest across the entire spectrum of the real estate industry. Figure 3-2 indicates the assets that REITs held in 2006, broken out by property type. Foreign Investors Canadian Investors In the 1970s, Canadian developers, flush with cash and facing a scarcity of projects in their own country, began crossing the border and actively participating in U.S. real estate markets.

27 Ibid. 28 Ibid.

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FIGURE

3-2

REIT investment by property type, 2006.

Specialty 4.6% Self-storage 4.3%

Mortgage 6.2% Industrial/office 25.4%

Health Care 5.1% Lodging/resorts 6.4%

Diversified 6.4%

Residential 16.3%

Retail 25.2%

Source: National Association of Real Estate Investment Trusts, REIT Watch, www.nareit.com.

Canadian banks played a major role in supporting the development companies, providing a steady line of credit for development projects. This allowed the Canadians to move fast and buy up properties far more quickly than Americans could. Favorable tax laws also allowed Canadian developers tax deferrals and ensured ongoing cash flow. As a result of fierce competition in a limited market in Canada, the Canadian companies were experienced operators. Those development companies that survived were among the most innovative, and this won them many competitions to build projects in the United States. Unlike most U.S. development companies at that time, the Canadians were accustomed to operating on a large scale. The major Canadian developers had offices throughout Canada and set up a similar structure in the United States, enabling them to maintain a presence in several local markets and move resources wherever they were needed to pursue the project at hand. The sheer size of the Canadian firms enhanced their competitive stance. As projects became larger and more complex, it became increasingly clear that only those organizations with extensive resources could hope to compete effectively.

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Canadian development companies also purchased extensive land holdings in California, Arizona, and Texas for an often ill-fated expansion of their development activities. Canadian investors, such as Olympic and York, purchased undervalued office buildings in New York and other cities. Not all of the Canadian firms succeeded. Several paid too much for land, and their projects never had a chance to reach the market. Others stretched their resources too thin and declared bankruptcy or abandoned their U.S. operations. Even some of the successful firms, such as Cadillac Fairview, decided to sell off their operations and pursue other interests.29 But despite the mixed results of their efforts, the Canadian developers made a lasting impact on the organizational structure and scale of operation of U.S. real estate. Japanese Investors The Japanese, who had cautiously begun investing in U.S. real estate 15 years earlier, increased the pace in the mid-1980s, buoyed by a growing trade surplus. A shortage of real estate investment opportunities in Japan and an attractive exchange rate accelerated this process, which was directed primarily at “trophy” office buildings in major U.S. cities. In 1986, Shuwa Investment Company acquired Arco Plaza in Los Angeles for a reported $620 million and the ABC Building in New York for $175 million. In 1987, several Japanese banks began competing directly with U.S. banks and insurance companies for mortgage financing of major properties. With a lower cost of capital, the Japanese banks proved to be formidable competitors, much to the delight of American developers. The lower cost of Japanese capital also provided attractive marketing opportunities for Wall Street firms seeking investors for securitized offerings. Middle Eastern Investors The OPEC oil embargo in 1973 shifted attention to the rapid accumulation of capital by OPEC countries and the need to recycle funds into U.S. investments, including real estate. The Arabs and Iranians, in particular, were identified as potential buyers of U.S. real estate. While the amount of capital never reached the levels anticipated, there was extensive Middle Eastern real estate investment activity in Atlanta, Houston, Salt Lake City, and throughout California.

29 The $5 billion sale of assets by Cadillac Fairview to JMB Realty Corporation in November 1987 at that point was the largest real estate transaction in history.

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Other Foreign Investors European banks and pension funds invested in projects throughout the United States. Australian development and investment companies initiated operations in the western states, particularly California. Individual investors from Hong Kong, Singapore, and Latin America bought properties in Florida, Texas, and California. Globalization of Securitized Real Estate With the development of the REIT in the United States and the involvement of foreign investors in U.S. real estate, it was perhaps inevitable that securitized real estate investment would soon spread to the rest of the world and become a global force. Figure 3-3 illustrates the evolution of these markets during this period.30 As a result, the amount of securitized real estate has increased to the extent that some countries (such as Australia) have as much as 30 percent of their commercial real estate in a securitized format. Figure 3-4 indicates the percentage of real estate in selected countries that is listed on a public stock exchange, including exchanges that may be located in countries other than the one in which the property is located. FIGURE

3-3

India Germany, Finland Great Britain

Mexico

France, Austria

Singapore

So. Korea

Japan

Belgium

Canada

Brazil

Malaysia

Luxembourg

Australia

Netherlands

United States

Spain-1992

Hong Kong

Italy

Taiwan

Evolution of global REITs.

1960 1969 1985 1988 1989 1993 1994 1995 2000 2001 2002 2003 2004 2007/8 (Est) Source: AEW Capital Management LLP, European Public Real Estate Association (EPREA), and Deutsche Bank.

30 The United Kingdom launched its UK-REIT market in January 2007. Germany is expected to follow suit in 2008.

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FIGURE

3-4

Percent of real estate listed on a public stock exchange. 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% Denmark

Poland

Norway

Finland

Belgium

Spain

Switzerland

Japan

France

United Kingdom

Austria

New Zealand

Netherlands

United States

Canada

Sweden

Luxembourg

Hong Kong

Australia

0.0%

Source: European Public Real Estate Association, 2005.

Most of global securitized real estate investment activity utilizes REITs or REIT-like structures. The approximate percentage of securitized real estate owned in a REIT or REIT-like structure in 2006 was: United States, 100 percent; Europe, 80 percent; Asia and Pacific, 74 percent; and Africa and the Middle East, less than 10 percent.31 By 2007, the U.S. real estate capital market had been significantly broadened to a global market with new, more complicated financing instruments than ever before. One thing was clear: the fragmented, smallscale, undercapitalized, and loosely managed industry of the 1960s has been irrevocably altered. Real estate had caught up with the realities of the modern marketplace and was on the verge of becoming a global industry.

31 Source: National Association of Real Estate Investment Trusts (NAREIT), www.nareit.com

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PA R T I I

The Economics of Real Estate

Copyright © 2007 by John McMahan. Click here for terms of use.

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CHAPTER 4

The Economics of Real Estate at the Global Level

From north to south, from east to west. William Shakespeare Winter’s Tale, Act I, Scene 2

If securitization of real estate was the major trend of the 1990s, the big news of this decade has been globalization—the move of development and investment firms, institutional investors, real estate operating companies, and real estate services firms from a national format to a global one. The general goal has been to improve investment yields and corporate profits, commensurate with the level of risk undertaken. Real estate operating companies have gone abroad in order to better serve their customers, both U.S. and foreign. In the case of institutional investors, this interest has been driven in part by modern portfolio theory that encourages investors to diversify across as broad a market universe as possible in order to reduce investment risk through portfolio diversification. This has led to the development of regional and global real estate funds specializing in finding higher yielding investments in other countries commensurate with acceptable risk levels. Pension funds and other institutional investors are major investors in these funds. Many of these investment programs utilize analytical models that attempt to take into consideration a wide variety of quantitative measures of the current and future economic health of targeted countries and, in some cases, individual metropolitan areas. These or similar models have 87 Copyright © 2007 by John McMahan. Click here for terms of use.

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been used for several years for investment in securities of both countries and individual business entities operating within their borders. It is not the purpose of this book to evaluate these models, the analytical techniques utilized, or their application to real estate portfolio investment strategy. It is important, however, for the reader to understand some of the basic underlying risk and return issues in global real estate and their impact on strategic investment decisions. In Chapter 3 we discussed the growth and impact of real estate securitization. In this chapter, we will first cover the major underlying forces in the trend toward globalization. We will then profile the economic and social characteristics of selected countries in each region, as well as property market performance and the degree of real estate market transparency in each country. Finally, we will offer a simplified method of weighing both positive and negative factors to identify the real estate investment potential of the countries surveyed.

MAJOR FORCES UNDERLYING GLOBALIZATION OF REAL ESTATE INVESTMENT The globalization of real estate investment has come at a time of strong worldwide population growth, unprecedented global economic activity, the spread of democratic governments, improved levels of real estate investment transparency, and new technology that has enabled real estate managers to keep abreast of large multinational investment portfolios and operations. Population Growth Even though its growth rate has been steadily declining since 1962, the world’s population is still increasing at a rapid pace. In terms of the future, the world’s population is expected to increase by about 78 million in 2007 at an estimated growth rate of 1.17 percent annually as shown in Figure 4-1.1 At this rate of growth, the world will double its population in approximately 60 years.2

1 Population Division of the Department of Economics and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2006 Revision and World Urbanization Prospects: The 2005 Revision, http://esa.un.org/unpp. 2 U.S. Census Bureau, Total Midyear Population for the World: 1950–2050, 2006.

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FIGURE

4-1

World population, billions of people.

6.30 6.25 6.20 6.15 6.10 6.05 6.00 5.95 5.90 5.85 2004

2005

2006

2007*

2008*

*Projected. Source: World Bank, 2006.

Underlying this growth, life expectancy continues to increase in both developed and underdeveloped countries. In developing countries, improvements in public health have had dramatic results in extending longevity, especially in the earlier part of the twentieth century. Life expectancy in developing countries increased by 16 years since 1960, compared to 6 years in developed countries. However, most of the growth in life expectancy happened before 1990, and the gap between average life expectancy in a high-income and a low-income country is still 19 years.3 Over the next 45 years, over half of the world’s population growth is expected to occur in nine countries: India, Pakistan, Nigeria, the Democratic Republic of Congo, Bangladesh, Uganda, Ethiopia, China, and the United States.4 The population of 50 developing countries is projected to more than double while the population of developed countries (with the exception of the United States) stays constant. Japan, several 3 U.N. Development Programme, Human Development Report, 2005, and 2006. 4 Population Division of the Department of Economics and Social Affairs of the United Nations Secretariat, World Population 2004.

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countries in Europe, and most successor countries of the former Soviet Union are expected to lose population. By 2050, India will have replaced China as the world’s most populous country largely because of China’s one-child policy.5 The United States is expected to still be in third place. Russia and Japan will no longer be among the 10 most populous countries.6 Economic Growth Population growth in itself does little to improve lives, and, in fact, it may worsen them. It takes economic growth for a country to lift itself out of poverty. One of the positive features of globalization is that the overall level of economic growth in most nations has been increasing. As indicated in Figure 4-2, world real GDP per capita has been growing an average of 2.5 percent a year,7 indicating that the world as a whole is currently creating economic wealth faster than it is adding population. The World Bank expects this situation to continue for at least the next few years. FIGURE

4-2

World real per capita GDP growth rate.

4.50% 4.00%

Real GDP growth rate

3.50% 3.00%

Real GDP per capita growth rate

2.50% 2.00% Population growth rate

1.50% 1.00% 0.50% 0.00% 2004

2005

2006

2007*

2008*

*Projected. Source: World Bank, 2006.

5 In order to control population growth, China began limiting families to having only one child. Most families were able to determine the sex of a potential child and many aborted female babies, resulting in an abnormal number of young males in the population. 6 M. Leanne Lachman, Global Demographics and Their Real Estate Investment Implications, Paul Milstein Center for Real Estate, Columbia Business School, 2006. 7 World Bank, Prospects for the Global Economy, Regional Forecasts, 2006.

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This fact has not been lost on the international business community. Business firms from the United States, Europe, and Asia are looking to get in on the ground floor in emerging markets, and investors are looking to invest in firms that are expanding globally and to develop relationships with foreign local businesses to become their customers, suppliers, and partners. In terms of real estate investment, a rapidly expanding level of business activity results in a need for modern office buildings, R&D complexes, warehouses, and hotel and conference facilities. As local incomes rise over time, this growth also may spur demand for residential projects as well. Another factor improving the environment for global real estate investing is the reduction in currency risk as the result of the activity of trading blocks such as the Eurozone. There also has been an increase in the size and reach of international real estate debt markets led by lenders such as Morgan Stanley, General Electric, Bank of America, and HSBC Group which are preserving and enhancing their global market share by seeking out new countries for real estate debt investment. Equity real estate investors also have been seeking higher yields in the global marketplace. This has included investors from fully priced markets such as the United States, Britain, France, and Germany as well as smaller countries including Australia, Canada, Singapore, and the Netherlands. This has been encouraged by the spread of global equity markets supporting REITs and other real estate securities, as discussed in Chapter 3. The ability to manage cross-border real estate portfolios also has expanded through the activities of firms such as Morgan Stanley, ING, Deutsche Bank, Jones Lang LaSalle, and CB Richard Ellis. In addition, real estate operating companies such as AMB, ProLogis, Westfield Financial, and others have had the insight to expand their global operations, often at the request of their U.S., European, or Asian customers.8 Labor Force Trends While global economic growth is spurring business and investment activities around the world, investors also must consider how long this rate of growth can be sustained, particularly in the case of real estate where a large part of the investment return is in appreciation from a long-term hold. This means that economies must continue to grow into the future in order to sustain profitable real estate investments. 8 A good example is the AMB Property Corporation, which, at the request of its customers, has set up European operations in France, Germany, Spain, and the Netherlands. In Asia, AMB has operations in China, Japan, South Korea, and Singapore.

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Demographic Patterns One key to long-term economic growth is the viability of a country’s labor force (that is, 15 to 64 years of age), both in terms of numbers and also age, health, skill levels, and productivity. The number of people required to sustain a viable future labor force, in turn, is largely a function of the present demographics of the country. As a result, there is a marked difference in future outlook between presently mature economies. Based on current demographic profiles, countries that can be expected to expand their labor force over the next 40 to 50 years include Australia, Canada, Great Britain, France, and the United States. Countries with contracting labor forces most likely will include Japan, Italy, Germany, Spain, Russia, and countries of the former Soviet Union.9 Italy’s labor force began declining in 2000; labor forces in Germany and Japan will begin declining in 2010, and Spain in 2020.10 Russia’s labor force and population are already declining, and it will no longer be in the 10 most populous countries by 2050. Implications for Real Estate This situation has major implications for real estate markets. Unless offset by changes in future immigration policy, countries with contracting labor forces will ultimately become replacement real estate markets with demand for new properties coming primarily from replacing obsolete buildings and/or geographical shifts in demand between metropolitan areas.11 To the extent that new buildings are technologically superior to existing buildings, the obsolescence of existing buildings may accelerate, leading to an even more rapid decline in rents for older facilities. The trend toward replacement real estate markets in certain countries most likely will affect all types of buildings, but in varying degrees. Office space will be hardest hit since the labor force would actually be contracting. Industrial space also may be affected, but could be offset by more space being utilized for storage or the use of machines. Housing and retail should not be affected initially because the number of residents and shoppers will not decline until the population starts to decline. Tourism can be expected to continue to generate demand for hotels and, to some extent, retail.12

9 Population Division of the Department of Economics and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2006 Revision and World Urbanization Prospects: The 2005 Revision, http://esa.un.org/unpp. 10 Ibid. 11 Lachman, Global Demographics. 12 Ibid.

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Immigration These negative trends may be offset to some extent by increased immigration levels, but this may be politically difficult to implement. Future levels of immigration will be a key factor in the efforts of developed countries to maintain a strong competitive position and ensure continuing economic growth. Immigrants generally enter a country as adults and, with various levels of training, are able to become productive members of their adopted country within a reasonable period of time. Access to education and social programs within adopted countries will be an important factor in ensuring that the second generation of immigrant families is able to “move up the economic ladder” and expand the contributions that the family can make in its adopted home. In the United States, immigration currently accounts for about 35 percent of population growth, only slightly less than in early 1900s, the peak immigration years.13 Not all immigration is between developing and mature economies. Increasingly immigration is occurring between developing economies (for example, Guatemala to Mexico), generally from the less to the more developed economies.14 Offshoring Population and workforce decline may not necessarily reflect general economic decline, at least in the short run, as economic wealth can still be generated with fewer people through offshoring to other countries components of production or services. The problem is that offshoring produces little demand for real estate in the sponsoring country. Companies in Japan, Western Europe, and the United States have been utilizing offshoring for some time. In essence, work is being sent to where the workers are, instead of bringing workers to where the work is.15 This trend has been enhanced by technology and the growth of the Internet, which greatly simplifies the production, storage, and distribution problems inherent in the offshoring process. Urbanization Another major underlying factor has been the urbanization of most countries in the world. This is important because the major portion of real estate development and investment occurs in cities and other concentrations 13 U.S. Census Bureau, Statistical Abstract of the United States: 2004–2005; U.S. Department of Homeland Security, Office of Immigration Statistics, Population Estimates, August 2006. 14 Ibid. 15 This is currently a $385 billion industry expected to increase by 30 percent over the next few years. Major resource countries include India, China, Czech Republic, Poland, Hungary, and Slovakia.

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TA B L E

4-1

World’s 100 Largest Metropolitan Areas as of 2007 Country

Population

Includes

Tokyo Seoul

Metro Area

Japan South Korea

33,400,000 23,200,000

3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

Mexico City New York Mumbai Delhi Sao Paulo Los Angeles Shanghai Osaka Cairo Kolkata (Calcutta) Manila Jakarta Karachi Guangzhou Dacca Buenos Aires Moscow Beijing Rio de Janeiro Tehran London

24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55

Istanbul Lagos Paris Chicago Shenzhen Bangkok Wuhan Bogotá Nagoya Lima Washington Kinshasa Tianjin Lahore Madras Johannesburg Bangalore San Francisco Hong Kong Hyderabad Taipei Baghdad Chongqing Dallas Philadelphia Madrid Santiago Khartoum Detroit Ruhr Belo Horizonte Boston

Mexico 22,100,000 USA 21,800,000 India 21,300,000 India 21,100,000 Brazil 20,400,000 USA 17,900,000 China 17,300,000 Japan 16,600,000 Egypt 15,900,000 India 15,500,000 Philippines 15,400,000 Indonesia 14,900,000 Pakistan 14,800,000 China 14,500,000 Bangladesh 13,800,000 Argentina 13,500,000 Russia 13,400,000 China 12,700,000 Brazil 12,200,000 Iran 12,100,000 Great Britain and 12,000,000 Northern Ireland Turkey 11,700,000 Nigeria 10,000,000 France 9,950,000 USA 9,750,000 China 9,000,000 Thailand 8,550,000 China 8,550,000 Colombia 8,450,000 Japan 8,250,000 Peru 8,200,000 USA 8,150,000 Congo (Dem. Rep.) 8,100,000 China 7,950,000 Pakistan 7,850,000 India 7,800,000 South Africa 7,700,000 India 7,250,000 USA 7,200,000 China 7,050,000 India 7,050,000 Taiwan 6,950,000 Iraq 6,700,000 China 6,150,000 USA 6,050,000 USA 6,050,000 Spain 5,950,000 Chile 5,950,000 Sudan 5,800,000 USA 5,750,000 Germany 5,750,000 Brazil 5,700,000 USA 5,600,000

Yokohama, Kawasaki, Saitama Bucheon, Goyang, Incheon, Seongnam, Suweon Nezahualcóyotl, Ecatepec, Naucalpan Newark, Paterson Bhiwandi, Kalyan, Thane, Ulhasnagar Faridabad, Ghaziabad Guarulhos Riverside, Anaheim

1 2

Kobe, Kyoto Al-Jizah, Shubra al-Khaymah Haora Kalookan, Quezon City Bekasi, Bogor, Depok, Tangerang Foshan San Justo, La Plata

Nova Iguaçu, São Gonçalo Karaj

Baltimore

Soweto, East Rand, West Rand Oakland, San Jose Kowloon, Victoria City

Fort Worth

Windsor (Canada) Essen, Dortmund, Duisburg

.

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Metro Area 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100

Ho Chi Minh City Ahmadabad Miami Houston Chengdu Atlanta Dongguan Toronto Alexandria Shenyang Caracas St. Petersburg Singapore Riyadh Xi’an Yangon Poona Nanking Chittagong Kuala Lumpur Guadalajara Sydney El Djazaïr (Algiers) Berlin Harbin Abidjan Porto Alegre Barcelona Phoenix Monterrey Casablanca Hangzhou Shantou Ankara Surat Recife Montreal Melbourne Seattle Brasília Pyongyang Pusan Durban Kano Fortaleza

Country Vietnam India USA USA China USA China Canada Egypt China Venezuela Russia Singapore Saudi Arabia China Myanmar India China Bangladesh Malaysia Mexico Australia Algeria Germany China Côte d'Ivoire Brazil Spain USA Mexico Morocco China China Turkey India Brazil Canada Australia USA Brazil North Korea South Korea South Africa Nigeria Brazil

Population 5,600,000 5,550,000 5,550,000 5,450,000 5,400,000 5,350,000 5,350,000 5,300,000 5,050,000 5,050,000 4,800,000 4,775,000 4,775,000 4,725,000 4,625,000 4,625,000 4,575,000 4,525,000 4,475,000 4,450,000 4,425,000 4,375,000 4,250,000 4,225,000 4,225,000 4,175,000 4,175,000 4,150,000 4,100,000 3,950,000 3,875,000 3,875,000 3,875,000 3,825,000 3,825,000 3,775,000 3,750,000 3,725,000 3,725,000 3,700,000 3,650,000 3,575,000 3,575,000 3,575,000 3,550,000

Includes

.

Fort Lauderdale, West Palm Beach

Pimpri-Chinchwad

Zapopan

Source: Thomas Brinkhoff, The Principal Agglomerations of the World, www.citypopulation.de.

of residential and commercial activity. Since not all concentration is in a single political subdivision, these are often referred to as “agglomerations.”16 For ease of reference, we have chosen to use the term metropolitan areas or metro areas. Table 4-1 is a listing of the 100 largest metropolitan areas in the world as of 2007. They range from Tokyo with 33,400,000 residents to 16 Thomas Brinkhoff, The Principal Agglomerations of the World, 2007, www.citypopulation.de.

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Fortaleza with 3,550,000 people. The 14 metro areas located in the United States make up approximately 13.5 percent of the total population of the 100 largest metro areas. Figure 4-3 illustrates graphically the population breakdown of the 100 largest metro areas among the regions of the world. Almost half of the world’s metropolitan area population in 2007 reside in the Asia-Pacific region (49.5 percent), followed by the Americas (29.5 percent), Europe (7.2 percent), and Africa and the Middle East (13.7 percent). Market Transparency Not all expanding economies are suitable for real estate investment or, for that matter, investment of any type except perhaps by local investors. Improved market transparency is one way to reduce nonmarket risks such as unfair competition, corruption, confiscation, imprisonment, and even possible personal injury or death. In essence, if global economic forces represent potential economic returns to potential investors, market transparency reflects a way to measure nonmarket risks associated with these investments. In 1999, Jones Lang LaSalle Investment Management (LaSalle) developed the global Real Estate Transparency Index (RETI) that measures the FIGURE

4-3

Regional distribution of metro area population, 2007. AfricaMiddle East 13.7%

AsiaPacific 49.5%

Americas* 29.5%

Europe 7.2% *Includes United States. Source: Thomas Brinkoff, The Principal Agglomerations of the World, www.citypopulation.de.

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level of real estate investment transparency at the country level, utilizing the following criteria:17 Accurate market and financial information Reliable performance benchmarks ■ Enforceable contracts and property rights ■ Clarity regarding the taxation and regulation of real estate ■ Fair treatment in the transaction process ■ Ethical standards among professionals hired to transact business ■ ■

LaSalle also has documented the steps countries are taking to improve transparency. Over the years of conducting this survey, LaSalle reports finding a direct correlation between growth in GDP per capita and the level of real estate investment transparency. For example, higher levels of transparency were found in the United States, United Kingdom, Australia, France, Germany, Japan, and Italy with considerably less transparency in countries such as Vietnam and Venezuela. Other positive correlating factors include favorable business conditions, the number of transactions, and the level of institutional real estate investment. LaSalle also uncovered a similar, but inverse, correlation with the level of corruption occurring in a country. Table 4-2 is a summary of LaSalle’s 2006 Real Estate Transparency Survey. A total of 56 countries were ranked: the lowest (positive) was Australia with a score of 1.15; the highest (negative) was Vietnam with a score of 4.69. The average for all of the countries ranked was 2.74. It should be noted that several countries with negative transparency rankings are showing signs of improvement. As an example, in the 2006 survey, LaSalle noted “significant” improvement (over 2004) in investment transparency in Brazil, India, the United Arab Emirates (UAE), Turkey, Romania, and Saudi Arabia. “Moderate improvement” was noted in Poland, Israel, Taiwan, South Korea, Greece, Argentina, and Egypt. Only “slight improvement,” however, was noted in China and Russia.18 There also appears to be a general correlation between most countries ranked high in LaSalle’s Transparency Index (Table 4-2) and the percent of real estate in a country listed on a public stock exchange (Chapter 3, Figure 3-4).

17 Jones Lang LaSalle Investment Management (LaSalle), Real Estate Transparency Index, 2006. 18 LaSalle, Real Estate Transparency Index, 2006.

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TA B L E

4-2

Real Estate Market Transparency as of 2006 Ranking Score, 2006

Country

2006

2004

Change 2004–2006

Tier 1 1.15 1.15 1.20 1.21 1.25 1.30 1.37 1.38 1.40 1.44

Australia United States New Zealand Canada United Kingdom Hong Kong Netherlands Sweden France Singapore

1 1 3 4 5 6 7 8 9 10

1 3 2 5 4 7 6 8 11 9

No change Moderate improvement Moderate loss No change No change Slight improvement No change Slight improvement No change Slight improvement

12 10 21 16 17 14 15 19 13 18 22 20 26 23

No change No change Significant improvement Slight improvement Moderate improvement No change Slight improvement Moderate improvement No change Slight improvement Significant improvement Moderate improvement Significant improvement Slight improvement

29 24

Significant improvement Slight improvement

Tier 2 1.63 1.67 1.77 1.84 1.85 1.85 1.88 1.91 1.94 1.96 2.14 2.21 2.40 2.44

Finland Germany South Africa Denmark Austria Ireland Belgium Spain Switzerland Norway Italy Malaysia Japan Portugal

11 12 13 14 15 16 17 18 19 20 21 22 23 24 Tier 3

2.51 2.69

Mexico Czech Republic

2.74 2.76 2.76 2.86 2.86 2.88 2.99 3.11 3.13 3.22 3.30 3.31 3.35 3.40 3.41 3.46

25 26

Average for all of the countries ranked Hungary Poland Israel Taiwan South Korea Slovakia Chile Greece Russia Philippines Brazil Slovenia Thailand Argentina India

27 27 29 29 31 32 33 34 35 36 37 38 39 40 41

25 28 30 27 34 NA 31 32 38 35 37 NA 36 40 41

Slight improvement Moderate improvement Moderate improvement Moderate improvement Moderate improvement NA Slight improvement Moderate improvement Slight improvement No change Significant improvement NA No change Moderate improvement Significant improvement

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Ranking Score, 2006

Country

2006

2004

Change 2004–2006

Tier 4 3.50 3.65 3.77 3.83 3.90 4.04 4.08 4.08 4.10 4.13 4.14 4.18 4.30 4.43 4.69

China Macau United Arab Emirates Costa Rica Indonesia Turkey Peru Romania Colombia Uruguay Saudi Arabia Panama Egypt Venezuela Vietnam

42 43 44 45 46 47 48 49 50 51 52 53 54 55 56

39 NA 45 42 44 46 NA 50 43 NA 49 NA 48 48 47

Slight improvement NA Significant improvement No change Slight improvement Significant improvement NA Significant improvement No change Significant improvement NA Moderate improvement NA No change

Source: Jones Lang LaSalle Investment Management 2006 Transparency Index.

REGIONAL AND COUNTRY CHARACTERISTICS Although most real estate development and investment occurs in metro areas, the initiation and management of laws and policies influencing economic growth and real estate values is usually centered at the country level, which is where we will focus. We will begin by trying to better understand where 18 representative countries are today in terms of demographic profiles, economic growth, property markets, and real estate market transparency. These countries were selected because they contain one or more of the 100 largest metro areas (Table 4-1) and reflect relatively major countries in their region. Europe Europe is the location of many of the world’s oldest civilizations, and it is no doubt the region most familiar to Americans and other international real estate investors. Table 4-3 is a summary of the characteristics of selected countries in Europe. Russia Demographics Despite the breakup of the Soviet Union in 1991, Russia is still the world’s largest country in land area and the eighth in

TA B L E

4-3

100

Representative Country Characteristics, European Region Russia Land Area, Sq. Mi. Population, 2007 Population Density per Sq. Mi. Population Growth Rate Age Structure Under 14 15–64 65 or older Total Median Age, Years GDP, BUSD, 2006 est. (PPP) GDP per Capita, 2006 (PPP) Real GDP per Capita Growth Rate, 3-Yr. Avg., 2004–2006. Inflation Rate, 2006 (Consumer Prices) Trade Balance, BUSD, 2006 est. Property Market, BUSD, 2005 Percentage CBD Office Yields, 2006 Investment Transparency Score Major Metro Areas*

Germany

France

United Kingdom

Italy

Spain

6,592,800 141,377,752 21
0.48%

137,858 82,400,996 598
0.03%

260,558 63,713,926 245 0.59%

94,525 60,776,238 642 0.28%

116,347 58,147,733 500 0.01%

195,364 40,448,191 207 0.12%

14.5% 71.1% 14.4% 100.0% 38.2 $1,723.0 $12,100 7.3%

13.9% 66.3% 19.8% 100.0% 43.0 $2,585.0 $31,400 1.7%

18.6% 65.2% 16.2% 100.0% 39.0 $1,871.0 $30,100 1.1%

17.2% 67.0% 15.8% 100.0% 39.6 $1,903.0 $31,400 2.1%

13.8% 66.4% 19.8% 100.0% 42.5 $1,727.0 $29,700 0.5%

14.4% 67.8% 17.8% 100.00% 40.3 $1,070.0 $27,000 1.8%

1.7% $216.6 $1,075 26.5% 5.0–6.0% 1.67 Berlin Hamburg Munich Cologne Frankfurt Stuttgart Dusseldorf †

1.5% ($39.1) $791 19.5% 4.0–8.0% 1.40 Paris Marseilles Lyon Nice Nantes

3.0% ($134.2) $1,039 25.6% 4.0–6.0% 1.25 London Manchester Birmingham Glasgow Leeds Edinburgh

2.3% $4.5 $657 16.20% 5.0–7.0% 2.14 Milan Rome

3.5% ($102.3) $378 9.3% 4.0–7.0% 1.91 Madrid Barcelona Valencia

9.8% $146.1 $112 2.8% 10.0–13.0% 3.22 Moscow St. Petersburg

Sources: All data from the CIA World Factbook, 2006, except property market, property returns, and investment transparency. *Bold type: 100 largest metro areas †Dusseldorf is a part of the Ruhr metro area, which is one of the 100 largest. Notes: Property market data based on European Real Estate Association and Colliers, International; total and current property returns from IPD Pan-European Property Index; investment transparency data based on Jones Lang LaSalle Real Estate Transparency Index, 2006; all land area and currency data converted to square miles and U.S. dollars; population per square mile, GDP per capita, and trade balance calculated; PPP stands for purchasing power parity.

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population.19 The possession of vast natural resources and nuclear weapons also enhances its position as a major superpower. In terms of future population and labor force growth, Russia is somewhat similar to Japan: as a result of their demographic profile and low population growth rates, both countries are expected to drop out of the top 10 most populous countries by 2050,20 with a resultant decline in the labor force. Economy In 2006, Russia had the second lowest GDP of the representative European countries and the lowest in per capita terms. Its three-year average in real GDP per capita growth of 7.3 percent, however, has been the highest in Europe, largely reflecting the country’s strong economic recovery in recent years. This recovery also resulted in a positive trade balance in 2006, second only to Germany’s. The country is still struggling, however, to develop a market economy and democratic system of government. Over the last few years, there has been considerable progress on the economic front, but there have been noticeable setbacks in terms of individual freedom. Real Estate Russia’s property investment market is estimated to be approximately $112 billion, approximately 2.8 percent of the European region. The market currently is booming, in at least in two major urban centers—Moscow and St. Petersburg—where per capita income is increasing and the existing building stock is old and not up to modern business or residential standards. Moscow office development is particularly strong with “international standard” space doubling since 2000. At the end of the first quarter of 2006, the vacancy rate for Class A and B office space was 2.3 percent, the lowest in Europe. Most of the new office projects under construction and scheduled for completion in 2006 were reportedly preleased.21 In terms of investment return, Russia’s central business district (CBD) office yields of 10 to 13 percent were higher than any other country in the survey except Brazil.22 Investment Transparency Despite considerable foreign investment in recent years, there has not been a major improvement in Russia’s real 19 Russia’s large land mass straddles both Europe and Asia. Its capital and large population centers are concentrated in the western part of the country, however, and for the purposes of this discussion, it is treated as a European country. 20 Lachman, Global Demographics. 21 Real Estate Quarterly, Moscow Times, second quarter 2006. 22 The 2006 CBD office current yield is used as a proxy for all real estate yields in each country in the survey.

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estate investment transparency, as reflected by a rating of 3.22 in the LaSalle 2006 survey, in which Russia was ranked thirty-fifth (Tier 3), the worst position of any major European country. Nor is the direction very positive; LaSalle termed Russia’s progress in the two years since the last survey as representing only “slight improvement.” Germany Demographics Germany is the second most populous country in Europe (behind Russia) with the second highest population density (behind the United Kingdom). In terms of population growth, Germany has a negative growth rate, eclipsed only by Russia, and the highest median age. Barring increased levels of immigration, the nation’s population should peak by 2010 and begin declining thereafter. Economy Germany has the largest economy in Europe and the third largest in the world, behind the United States and Japan. Its three-year average real GDP per capita growth rate is the third lowest in Europe at 1.7 percent. Germany’s inflation rate of 1.7 percent is consistent with other European countries except for Russia. A major portion of Germany’s economy is driven by foreign trade, and its positive trade balance is the highest in the survey.23 In a world market often subject to intense price competition, the quality of German products has allowed local firms to remain competitive. Real Estate The property market in Germany is the largest in the region with 26.5 percent of total property value. The CBD office returns in Germany averaged 5 to 6 percent in 2006. The German office market is distributed among several major urban centers posting current returns: Berlin (5.6 percent), Hamburg (5.3 percent), Munich (5.2 percent), Cologne (6.0 percent), Frankfurt (5.3 percent), Stuttgart (6.0 percent), and Dusseldorf (5.7 percent).24 Investment Transparency Germany presently does not have a REIT equivalent investment structure although it is expected that one will come to market in 2007.25 Germany does have, however, a relatively good 1.67 transparency rating, ranking twelfth in the world (Tier 2). 23 World Trade Organization, 2006 24 Europe Real Estate Publishers, B.V., Europe Real Estate Yearbook, 2006. 25 National Association of Real Estate Investment Trusts (NAREIT), REITs Around the World, 2006.

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France Demographics France is the second largest country in Europe in land area (after Russia) and the third largest in population (after Russia and Germany). Largely as a result of immigration, France has the fastestgrowing population in Europe although its population density remains less than other countries in Europe with the exception of Spain and Russia. Despite the image of France as a relatively monolithic country, it is one of the most ethnically diverse in the world with approximately 40 percent of its population estimated to have descended from non-Gallic stock. France also has the highest percentage of children, with 18.6 percent under 14. As a result, the median age in the country is 39 years, second lowest after Russia. France is expected to be the most populous country in Europe (excluding Russia) by 2050, which will be the first time this has occurred since the 1860s.26 Economy France’s current economy is “in the middle” when compared with other European nations. GDP per capita is slightly lower than Germany and the United Kingdom but higher than the rest of Europe.27 Its average real GDP per capita growth rate is 1.1 percent, the second lowest in Europe after Italy. France is the fifth largest exporter in the world and the fourth largest importer of manufactured goods. In 2006, its trade balance was negative (–$39.1 billion) but lower than Spain’s (–$102 billion) or the United Kingdom (–$134 billion). France is the number 1 agricultural producer in Europe and the number 1 tourist destination as measured by tourist expenditure.28 It is also the smallest producer of carbon dioxide emissions, largely due to its energy independence resulting from the development of nuclear power installations. Real Estate France’s property market is approximately $791 billion, reflecting 19.5 percent of the holdings in major European countries. CBD office returns were 4 to 8 percent. Most of the office market is concentrated in Paris, where current office yields range from 5.1 to 5.9 percent. 26 France’s population is not expected to peak until 2035. U.N. Population Division. The change in rank order is also due to earlier declines in other countries. 27 It is difficult to compare per capita numbers in France to other economies because the French often work fewer hours as a result of tradition, government policy, and the collective effect of work rules negotiated with trade unions. 28 Spain has a larger number of hotel guest nights annually.

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Other major markets include Marseille (7.5 percent), Lyon (7.5 percent), Nice (8.5 percent), and Nantes (8.5 percent).29 Investment Transparency In 2003, France introduced Les Sociétés Françaises d’Investissements Immobiliers Cotées (SIIC), which, by 2005, had resulted in the formation of 20 publicly traded real estate investment vehicles, representing approximately $20 billion in combined market capitalization.30 France ranks ninth in the world (Tier 1) in terms of investment transparency—better than all other European nations except for the United Kingdom, Sweden, and the Netherlands. United Kingdom Demographics The United Kingdom is the combination of Great Britain (England, Scotland, and Wales), Northern Ireland, and various surrounding islands. The United Kingdom is the smallest of the major European countries, the fourth in population, and the most densely populated. Its annual population growth rate of 0.28 percent is second only to France, also largely through immigration.31 The United Kingdom is also second to France in the percentage of its population under 14 (17.2 percent) with a median age of 39.6 years. Economy The country’s GDP and GDP per capita are second only to Germany in Europe. The United Kingdom’s trade balance in 2006 was the highest negative balance of the European nations. Real Estate The United Kingdom has the second largest property market behind Germany, with over $1 trillion in value representing 25.6 percent of the European market in major European countries. CBD office returns average 4.5 to 6.0 percent. London is the oldest and largest of the United Kingdom’s property markets with current office yields of 4.5 to 6.0 percent. Other major property markets include Manchester (5.8 percent), Birmingham (5.8 percent), Glasgow (5.5 percent), Leeds (5.7 percent), and Edinburgh (5.5 percent).32 29 Europe Real Estate Publishers, B.V., Europe Real Estate Yearbook, 2006. 30 NAREIT, REITs Around the World, 2006. 31 It should be noted that the future growth of both the United Kingdom and France will rely to a great extent on continued in-migration fueling projected population growth. In the past, a large part of this migration has been from Muslim countries, and recent events suggest this may not always be the case and, in fact, could reverse. 32 Europe Real Estate Publishers, B.V., Europe Real Estate Yearbook, 2006.

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Investment Transparency To date, investors have been able to participate in the U.K. property market only through purchasing a property outright or through limited partnerships. This has often been difficult due to the large amount of capital involved or, in the case of limited partnerships, the rates of taxation. As a result the British government introduced UK–REIT in January 2007.33 The United Kingdom is already doing quite well in terms of investment transparency, ranking fifth, the best of any major European nation, with a score of 1.25 (Tier 1). Italy Everyone seems to like Italy—residents, tourists, vacationers, other Europeans, other countries. And what is there not to like? Friendly people, beautiful cities, great clothes, delicious food, good wine, a lovely countryside, and a long, rich history with many artifacts still existing and available for visiting. Indeed, it is one of civilization’s great treasures. Demographics Unfortunately, Italy also has demographic problems that may affect existing and future citizens for generations to come. It is tied with Germany for the highest percentage of citizens 65 and older among the major European countries and has the smallest percentage of children. Italy’s internally generated population growth peaked in 2000, and it is expected to turn negative after 2010. Economy Italy has a well-diversified capitalist economy with a relatively high GDP and a per capita GDP similar to France, Germany, and the United Kingdom. Most of its industry is located in the north, with its agriculture resources in the south. In 2006, Italy was one of three countries in Europe after Germany and Russia with a positive trade balance ($4.5 billion). Most of its raw materials are imported with major trading partners being other EU countries, primarily Germany and France. Real Estate Italy’s property market is about $657 billion, representing approximately 16.2 percent of the European market. CBD current office yields range from 5 to 7 percent. Major office markets are Rome (5.8 percent) and Milan (6.1 percent).

33 NAREIT, REITs Around the World, 2006.

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Investment Transparency Italy ranked twenty-first in investment transparency in the LaSalle survey (Tier 2) with “significant improvement” since 2004. Spain Demographics Spain is the third largest country in Europe and has the lowest population density after Russia. Its population growth rate of 0.12 percent annually is less than France and the United Kingdom, but higher than Italy, Germany, and Russia. As with France and the United Kingdom, most of Spain’s population growth has been through immigration, which increased in 2005 to 700,000. Spain currently has the highest current immigration rate of any EU countries. Economy Spain’s GDP per capita was the lowest of representative European countries in 2006, except for Russia. The country’s average real GDP per capita growth rate, however, was 1.8 percent over the last three years, the third highest growth rate in Europe. One problem is that Spain’s economic growth policies in recent years have largely focused on stimulating growth in tourism, construction, and manufacturing; little has been spent on public infrastructure. This combination has led to adverse impacts in terms of land use, air quality, water resources, urban traffic, and energy consumption. While Spain has the highest percentage of university graduates in the European Union, it has not invested extensively in technology-related research and development. The lack of support for technical education is a particular problem as Spain’s workforce becomes less competitive on a productivity basis with emerging areas such as Eastern Europe and Asia. As a result, manufacturing jobs are going abroad, and there is limited ability to shift to higher-value products requiring a more highly trained labor force. Spain had a negative trade balance (–$102 billion) in 2006, the second largest in Europe. Real Estate Spain’s property market in 2005 was approximately $378 billion representing 9.3 percent of Europe’s major countries. Average CBD 2006 office returns were 4.0 to 7.0 percent. Major metro area office yields were Madrid (4.8 to 5.8 percent), Barcelona (5.0 to 6.8 percent), and Valencia (5.5 percent).34

34 Europe Real Estate Publishers, B.V., Europe Real Estate Yearbook, 2006.

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Investment Transparency Spain does not have an active real estate securities market except for two publicly traded companies represented on the FTSE–EPRA/NAREIT Global Real Estate Index—Metrovacesa and Immobiliaria Colonial—both of which invest primarily in Spanish office buildings. Spain’s investment transparency rating was 1.91 in the LaSalle 2006 survey, ranking it eighteenth out of 56 countries (Tier 2). It should be noted that there are also several smaller countries in Western Europe—Belgium, Ireland, the Netherlands, Portugal, Switzerland, and the Scandinavian countries—that have well-developed real estate markets and may be attractive to global investors. There are also several formerly Communist countries in Eastern Europe—Albania, Austria, Belorussia, Bulgaria, Croatia, the Czech Republic, Greece, Hungary, Poland, Serbia, Slovenia, Ukraine, and the Baltic States—representing emerging markets that, while often reflecting higher risk levels, may be attractive areas for future real estate investment. Asia and Pacific As noted in Figure 4-3, the Asia-Pacific region is the largest with 49.5 percent of the total metro area population. Six countries in the region have been selected for more detailed analysis. Table 4-4 summarizes these countries in terms of demographics, economic activity, and real estate investment characteristics. China Demographics China is presently the largest nation in the Asia-Pacific region (and the world) with a population of 1.3 billion, 40 percent of whom live in urban areas. As in most countries, future levels of population are highly dependent on current demographic profiles, and, as such, they are usually reasonably discernible. China’s population is expected to peak in 2030 and then start declining, largely as a result of the country’s one-child policy that has been in place over the last 20 years.35 China’s working age population is projected to reach about 1 billion in 2015 and then decline steadily.36 As a result, one of the major long-term problems China faces is to create enough savings through industry and trade to finance health care and pensions for its growing elderly population between 2030 and 2050. 35 U.N. Population Division, World Population Prospects Database, 2006. 36 Lachman, Global Demographics.

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4-4

Representative Country Characteristics, Asia-Pacific Region, 2005 or 2006 China Area, Sq. Mi. 3,705,406 Population, 2006 1,321,851,888 Population Density per Sq. Mi. 357 Population Growth Rate 0.6% Age Structure Under 14 20.4% 15–64 71.7% 65 or older 7.9% Total 100.0% Median Age 33.2 GDP, BUSD 2006 est. (PPP) $10,000 GDP per Capita, 2006 est. (PPP) $7,600 GDP Real Growth per Capita, 9.8% 3-Yr. Avg., 2004–2006 Inflation Rate, 2006 (Consumer Prices) 1.5% Trade Balance, Billions, 2006 est. $196.1 Property Market, BUSD, 2005 $288 Percentage 11.1% CBD Office Yields, 2006 8.7–9.3% Investment Transparency Score 3.50 Major Metro Areas* Shanghai Beijing Shenzhen Canton Chung King Wuhan Guanzhow Hong Kong

India

Japan

Vietnam

Malaysia

Australia

1,269,346 1,129,866,154 890 1.6%

145,882 127,433,494 874
0.1%

127,243 85,262,356 670 1.0%

127,354 24,821,286 195 1.8%

2,967,909 20,434,176 7 0.8%

31.8% 63.1% 5.1% 100.0% 24.8 $4,042.0 $3,700 7.0%

13.8% 65.2% 21.0% 100.0% 43.5 $4,220.0 $33,100 2.3%

26.3% 67.9% 5.8% 100.0% 26.4 $258.6 $3,100 6.6%

32.3% 62.9% 4.8% 100.0% 24.1 $308.8 $12,700 4.2%

19.4% 67.4% 13.2% 100.0% 37.1 $666.3 $32,900 1.8%

5.3% ($75.9) $79 3.0% 9.0% 3.46 Mumbai (Bombay) Delhi Kolkata Chennai Bangalore Hyderabad Ahmadabad

0.3% $66.2 $1,966 75.6% 3.5–5.0% 2.40 Tokyo Osaka Nagoya Yokohoma

7.5% $0.76 $5 0.2% NA 4.69 Ho Chi Minh City Hanoi

3.8% $31.4 $29 1.1% 6.0–6.5% 2.21 Kuala Lumpur

3.8% ($10.7) $232 8.9% 6.5–9.0% 1.15 Sydney Melbourne Brisbane Adelaide

Sources: All data from the CIA World Factbook, 2006, except property market, property returns, and investment transparency. *Bold type: 100 largest metro areas Notes: Property market data based on European Real Estate Association and Colliers International; investment transparency data based on Jones Lang LaSalle Real Estate Transparency Index, 2005; all land area and currency data converted to square miles and U.S. dollars; population per square mile, GDP per capita, and trade balance calculated; PPP stands for purchasing power parity.

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Economy China also faces the challenge of creating 14 million new jobs each year to support its population growth. Fortunately, China’s economy is booming, with a current GDP of around $10 trillion and a real GDP per capita growth rate averaging 9.8 percent over the last three years. This is not completely new—China’s GDP’s growth rate has ranged from 9 to 11 percent for the last 25 years.37 As a result, China is now the second largest economy in the world based on the purchasing power parity (PPP) rankings.38 China also has a favorable trade balance of $196 billion, the highest in the region. This has been a result of the country’s strategic policy that has focused on developing manufactured products for sale to Chinese and world markets.39 This strategy may be changing as interest grows in also developing and attracting firms based on intellectual capital. An example is Lenovo’s acquisition of IBM’s ThinkPad product line. While most of the initial impetus was to secure IBM’s software and product identification, Lenovo has recently dropped the ThinkPad name and has begun to feature its own brand identification.40 Part of this apparently is a reflection of the improved software development capabilities of China’s own industries. China is also attempting to build a strong biotechnology industry by restructuring its regulatory ministries to focus on the creation of intellectual property rights and deregulating venture capital.41 Developing knowledge-based industries, however, takes time and an open intellectual environment, which China has not had historically. Despite many reforms and a current trend toward more intellectual freedom, the Communist Party still largely controls the apparatus of government and its policies. The Communists are also quite involved in the ownership of business and industrial operations. Many observers are skeptical about the political situation changing any time soon, with democracy unlikely for some time.42 China also has a major gap between the economic dynamism of its urban areas and the grinding poverty of its rural areas. Many rural residents are unemployed at the same time the cities are having an increasing problem finding skilled labor.43 Unfortunately, most of the rural people 37 Robert A. Scalapino, “China Wakes: What it Means for the World,” Commonwealth, October 2006. 38 Central Intelligence Agency, The World Factbook, 2007. 39 Contrary to popular belief, China and other Asian countries rely mostly on domestic demand to grow their economies. The exceptions are Taiwan, Hong Kong, and Singapore. 40 Lenovo, the third largest PC manufacturer in the world, was founded in 1984 by 11 Chinese entrepreneurs. 41 San Francisco Chronicle, September 16, 2006. 42 Scalapino, “China Wakes.” 43 Ibid.

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migrating to the cities do not have these skills or are unable to learn them, often creating social problems in urban areas. China also is faced with the problem of feeding its future population. With less than one-fourth of the arable land of India, China must feed an additional 260 million people within the next three decades. One of the major hurdles in expanding agriculture production is limited water resources; currently China has water availability of 2,200 cubic meters of water per citizen, one-third of the global average. By 2030, this will fall to 1,750 cubic meters per person, based on a population of 1.6 billion people.44 There is also the problem of getting the water to where the people live—the area north of the Yangtze basin contains approximately one-third of China’s population, yet only receives 7.5 percent of available water. Finally, China’s banking system is fragile, and the overall economy is rife with corruption. Real Estate China has invested a large portion of its new economic wealth in physical infrastructure—new airports, modern highways, and state-of-the-art office, retail, and residential buildings in many of its major cities, particularly Beijing and Shanghai. Much of this infrastructure has been in anticipation of the Olympics in 2010, which China will host for the first time. The estimated value of China’s property market including Hong Kong is $288 billion, 11.1 percent of the total real estate market among the representative countries in the region. Average current CBD office yields are 8.7 to 9.3 percent. Current office yields in the rest of China’s major markets include Hong Kong (4.1 percent), Beijing (8.3 percent), Shanghai (7.0 percent), Guangzhou (8.6 percent), and Shenzhen (8.6 percent). With an authoritarian government, an unreliable legal system,45 and the lack of an open-market economy, foreign investment in China’s booming real estate continues to present higher risk for the investor. The one exception is Hong Kong because as a former British colony, it has an established legal framework for foreign investment that the Chinese government has, thus far, retained.46

44 Robin How, “China, India, and the United States,” presented at Aspen Group Meeting, May 2006. 45 A related issue is freehold ownership versus ground leasing, the latter being the current policy because the government owns most of the land. 46 This may be changing, however, as China appears to be tightening control over Hong Kong. It was not clear at the time of publication whether this would adversely affect Hong Kong’s ability to attract capital.

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Investment Transparency The discrepancy between the investment climate in Hong Kong and the rest of China can be seen in LaSalle’s 2006 real estate transparency report where Hong Kong is ranked sixth and China is ranked forty-second out of 56 countries surveyed. India Demographics With 500 million citizens under the age of 25, India’s working population will continue to increase through 2050, assuming the nation can continue to educate and train its skilled workforce.47 While India’s total population is not expected to pass China’s until 2030, it will have more young workers (20 to 24) by 2013. By 2020, India will have 116 million in this age group, while China will have 94 million.48 The contrasts within India are striking. One such difference is that 800 million Indians exist on less than $2 a day.49 In major cities, such as Mumbai (formerly Bombay), a new urban mall is next to crowded slums where entire families may sleep on the sidewalks. India also has the world’s second largest HIV-positive population. Economy India’s economy is diverse—agriculture, textiles, handicrafts, manufacturing, and a variety of service industries, increasingly based on technology. One of India’s major long-term advantages vis-à-vis China is its plentiful land availability and potential for expanding agriculture in the future and being able to feed its own people.50 India’s recent economic boom has its roots in sweeping reforms passed in 1991 that relaxed government control of the business and industrial permitting process. Most of the growth in the intervening years has been in the services sector, a natural outgrowth of the country’s culture and tradition of smaller-scale heavy industry. In recent years, India has leveraged this service tradition with its strong educational system (particularly in technical subjects), English language capabilities, and a common law legal system to become the “back office” of much of the western business world. Between 2000 and 2004,

47 Julia Hanna, Harvard Business School Alumni Bulletin, June, 2006. 48 International Labor Organization (ILO), U.N. Population Division, World Population Prospects Database, 2006. 49 Hanna, Harvard Business School Alumni Bulletin. 50 Not all relations between China and India are competitive. Trade between the two countries has been increasing in the last few years, and a major freeway is currently being built linking the two countries.

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Indian firms operating in business process offshoring (BPO) saw earnings increase from $4 billion to $12.8 billion, comprising 6 percent of India’s growth in GDP during this period.51 India is now leveraging this experience to supplement its service industries by major increases in manufacturing. The country’s annual growth rate in manufacturing output (9 percent) is beginning to catch up with services (10 percent). More than two-thirds of foreign investment in 2005 was invested in manufacturing.52 As an example, General Motors, Motorola, Posco (South Korea), and Mittal (the Netherlands) have recently announced large steel mills in eastern India.53 As a result of this economic boom, India’s middle class has grown rapidly and is now estimated to be 250 to 300 million, approximately 20 to 25 percent of the population.54 Real Estate The property market in India is estimated at $79 billion, which constitutes 3 percent of the regional total. Current CBD office yields average 9 percent with major activity in Mumbai, Delhi, and Bangalore. As a result of several recent liberalizations in India’s federal direct investment (FDI) rules, venture capital firms now can invest in Indian real estate provided it is in conjunction with the development of operating facilities. Foreign investors can sell their properties after a holding period of three years, which has led to the formation of several joint ventures with foreign investors to develop properties that could involve ultimate resale to foreign investors. In fact, India has recently become a world leader in attracting FDI, replacing Mexico as the third most attractive country. To date, most of the foreign direct investment has gone into new facilities being developed for operating purposes. Investment Transparency Although India does not have REITs at this point, the government has announced its willingness to consider such a vehicle to attract additional sources of capital to feed India’s extensive capital needs.55 In terms of investment transparency, India presently rates slightly better than China (41 versus 42), but, according to LaSalle, it has made 51 Hanna, Harvard Business School Alumni Bulletin. 52 New York Times, September 1, 2006. 53 Ibid. 54 Hanna, Harvard Business School Alumni Bulletin. 55 NAREIT, REITs Around the World, 2006.

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“significant progress” in improving transparency, while China has shown only a “slight improvement.”56 Japan Demographics As previously noted, the major demographic problem Japan faces is a continuing decline in its population and a widening gap between those who work and those who are retired or for some other reason do not participate in the labor force. This is often measured as a “dependency ratio,” and Japan is expected to turn negative in 2010, similar to Italy and Germany.57 It should be noted that this trend may not affect major metro areas such as Tokyo for many years as a result of migration from other locations in Japan. However, ultimately, Tokyo should be affected as well. Economy Japan’s economy is the third largest in the world in terms of purchasing power parity (PPP) and is now growing at an annual rate of 2 to 3 percent after falling behind for several years. This improvement reportedly is a direct result of Japan’s increasing role in the regional economy as a financial center, business investment provider, and the outsourcing of production work by Japanese companies to lower-cost operators in the region. Real Estate Japan’s property market is large and diversified in terms of type of investment, although most of the activity to date has been centered in Tokyo. Other major metro areas include Osaka, Nagoya, Sapporo, and Fukuoka. Current office yields average 3.5 to 5.0 percent. Estimated property market value is US$1.966 billion, which is 75.6 percent of the total real estate market of the Asia-Pacific region. Investment Transparency Japan’s securitized real estate investment began in 2001 through vehicles similar to REITs, becoming the first large securitized real estate market in Asia. There are now 20 REITs listed on the Tokyo Stock Exchange with a market capitalization of over US$18 billion.58 LaSalle ranks Japan twenty-third in investment transparency, noting “significant improvement” since 2004.

56 LaSalle, Real Estate Transparency Index, 2006. 57 Lachman, Global Demographics. 58 NAREIT, REITs Around the World, 2006.

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Vietnam Vietnam is a long, coastal country located on the South China Sea. The modern Vietnam nation was formed in 1975 after U.S. troops withdrew and North Vietnamese troops overran South Vietnam to unify the country. It is still officially a communist country, and it is known as the “Socialist Republic of Vietnam.” Demographics With 670 persons per square mile, Vietnam is one of the most densely populated countries in Asia, behind only Japan and India. Its population growth rate of 1 percent annually is third of the representative countries in the region, behind Malaysia and India. Economy Vietnam began experimenting with elements of a free market in the 1980s and today is now one of the fastest-growing economies in the world averaging a real GDP per capita growth rate of 6.6 percent over the last three years, slightly behind India (7.0 percent) and considerably behind China (9.8 percent). Vietnam also is slowly integrating into the global economy, receiving Permanent Normal Trading Relations with the United States on July 31, 2006, and it joined the World Trade Organization (WTO) on January 11, 2007. Vietnam’s GDP per capita of $3,100 is considerably lower than any other countries in the region. This is largely due to the small role (11 percent of GDP) that manufacturing currently plays in the economy. Vietnam’s exports were up 26 percent in the first half of 2006, largely due to textiles, garment manufacturing, oil, and mining.59 The banking system is underdeveloped but reportedly will soon go through major changes.60 Real Estate Major metro areas are Hanoi and Ho Chi Minh City (Saigon). The real estate market in these cities, as well as it is in other cities in Vietnam, is primarily local or governmental in nature, but with rapid economic growth, it may be loosening up to foreign investment. Investment Transparency Investment transparency is still a major hurdle, however, with Vietnam ranking last in the world on LaSalle’s 2006 survey, with “no change” from 2004.

59 “Vietnam—Next Stop for Investors,” Forbes, August 30, 2006. 60 Ibid.

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Malaysia Malaysia is located in the South China Sea, west and north of Indonesia and south of Thailand. The country, a former British colony, established its independence in 1957 and formed the Federation of Malaya in 1963. The country is divided physically between peninsular Malaysia, where most of the population lives, and East Malaysia, on the island of Borneo. Demographics The population of Malaysia is currently almost 25 million with an annual growth rate of 1.8 percent. It is a relatively young country, with 32.3 percent of its population under 14, and it has the lowest median age in the region (24.1 years). Economy Malaysia, traditionally a producer of raw materials (for example, rubber and petroleum), transformed itself between 1970 and 1997 into a multisource economy largely through the manufacture and export of a variety of products, primarily electronics. The country was hard hit by the global financial meltdown in 1997 and the subsequent slump in the information technology industry in 2001 and 2002. The economy rebounded in 2002 and maintained an average real GDP per capita growth rate of 4.2 percent annually since 2004. The country’s trade balance was an estimated $31 billion in 2006. Real Estate Value of the real estate market in Malaysia is estimated to be $29 billion, a little over 1 percent of the Asia-Pacific real estate market. Kuala Lumpur is the capital of Malaysia and the location of the major portion of the country’s real estate activity with CBD office yields currently about 6.2 percent. Investment Transparency Malaysia’s real estate financial markets are relatively open, ranking twenty-second in transparency in 2006, just ahead of Japan. As of 2005, there was only one REIT trading on the Malaysia stock exchange. Australia Demographics The “Down Under” country has a population slightly less than one-third that of California in a land area almost twenty times as great, resulting in a population density of approximately seven people per square mile. Australians have an easygoing lifestyle with the longest life expectancy in the region (87 years).

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Economy Australia maintains a western-style capitalist economy with the second highest per capita GDP in the region, on a par with the four leading European economies. The economy is fueled by mining and agriculture exports, robust domestic economic activity, and tourism. Declining exports, coupled with increasing import demand, has resulted in the trade deficit increasing from –$8 billion in 2002 to –$11 billion in 2006. Real Estate Australia’s property market value is estimated at $232 billion, which constitutes 8.9 percent of the total market of the region. Average current CBD office yields range from 6.75 to 8.75 percent in Sydney, 6.5 to 9 percent in Melbourne, 6.9 to 8.1 percent in Brisbane, and 7.5 to 8.5 percent in Adelaide.61 Investment Transparency The market is heavily securitized, with approximately 49 percent of the property market owned as listed property trusts (LPTs), the Australian equivalent of REITs.62 In terms of real estate investment transparency, Australia ranks number 1 in the world.63 Other countries in the Asia-Pacific region with publicly traded real estate securities include South Korea, Taiwan, and New Zealand. Real estate is largely traded privately in Cambodia, Laos, Myanmar (Burma), and the Philippines. Americas North and South America comprise 29.5 percent of the total population in the 100 largest metro areas of the world (Figure 4-3). Table 4-5 summarizes many of the key characteristics of three of the major non-U.S. countries: Canada, Mexico, and Brazil. Canada Demographics Canada is the second largest country in the world in land area after Russia and, as such, has one of the lowest population densities. With much of its land subject to extremely cold conditions for large portions of the year, Canada’s population tends to cluster in the Southeast, around the Great Lakes and the Saint Lawrence River. About three quarters of Canada’s population lives within 100 miles of the U.S. border. 61 Colliers International, Market Indicator Reports, 2006, www.colliers.com/Corporate/MarketReports/ UnitedStates. 62 NAREIT, REITs Around the World, 2006. 63 LaSalle, Real Estate Transparency Index, 2006.

TA B L E

4-5

Characteristics of Major Countries in the Americas and Africa and the Middle East Americas Region Canada Total Area, Sq. Mi. 3,854,085 Population, 2006 33,390,141 Population Density per Sq. Mi. 9 Population Growth Rate 0.9% Age Structure Under 14 17.3% 15–64 69.2% 65 or older 13.5% Total 100.0% Median Age, Yr. 39.1 GDP, BUSD, 2006 est. (PPP) $1,165.0 GDP per Capita, 2006 est. (PPP) $35,200 GDP Real Growth per Capita, 2.0% 3-Yr. Avg., 2004–2006. Inflation Rate, 2006 (Consumer Prices) 2.0% Trade Balance, BUSD, 2006 est. $51.8 Property Market, BUSD, 2005 $396 Percentage 54.8% CBD Office Yields, 2006 6.0–8.0% Investment Transparency Score 1.24 Transparency Tier 1 Major Metro Areas* Toronto Montreal Calgary Vancouver

Africa and the Middle East Region

Mexico

Brazil

South Africa

761,605 108,700,891 143 1.2%

3,286,488 190,010,647 58 1.0%

471,443 43,997,828 93
0.5%

302,534 71,158,647 235 1.0%

829,996 27,601,038 33 2.1%

30.1% 64.0% 5.9% 100.0% 25.6 $1,134.0 $10,600 3.3%

25.3% 68.4% 6.3% 100.0% 28.6 $1,616.0 $8,600 2.7%

29.1% 65.5% 5.4% 100.0% 24.3 $576.4 $13,000 3.9%

24.9% 68.2% 6.9% 100.0% 28.6 $627.2 $8,900 5.7%

38.2% 59.4% 2.4% 100.0% 21.4 $374.0 $13,800 2.9%

5.0% ($2.4) NA

9.8% ($35.7) $62

1.9% $140.3 NA

9.0–10.0% 4.04 4 Istanbul Ankara

11.0–12.0% 4.14 4 Riyadh Jeddah

3.4% ($4.3) $200 27.7% 9.0–9.5% 2.51 3 Mexico City Guadalajara Monterrey Tijuana Puebla

3.0% $46.1 $126 17.5% 12.0–13.0% 3.31 3 Sao Paulo Rio de Janeiro Bello Horizonte Porto Allegro Recife Brasilia

9.1–10.7% 1.77 2 Johannesburg Durban Cape Town

Turkey

Saudi Arabia

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Sources: All data except property market and investment transparency from the CIA World Factbook, 2006. *Bold type: 100 largest metro areas Notes: Property market data based on European Real Estate Association and Colliers International information; investment transparency data based on Jones Lang LaSalle Real Estate Transparency Index, 2005; all land area converted to square miles and currency data converted to U.S. dollars; population per square mile, GDP per capita, and trade balance calculated; PPP stands for purchasing power parity.

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In terms of demographics, Canada is somewhat similar to the United States although it is a little older with a smaller percentage of children. The United Nations ranked Canada the number 1 country in terms of “human development” 10 out of 19 times the index was published between 1980 and 2006.64 Economy GDP per capita is around $35,000, ninth in the world according to the International Monetary Fund. Canada’s trade balance is positive at $51.8 billion, largely due to a favorable trade balance with the United States, which receives 84.1 percent of Canada’s exports (versus 57.5 percent of Canada’s imports coming from the United States).65 Canada has a strong work ethic as demonstrated by its 2007 ranking as the seventh “most competitive” country (out of 55) in the world.66 Real Estate As noted in Chapter 3, real estate development and investment is an important industry in Canada with several large, wellmanaged companies active not only in Canada but globally as well. Real estate market value is estimated at $396 billion, 54.8 percent of the Americas region, excluding the United States. CBD current office yields range between 6 and 8 percent. Major metro areas include Toronto (6.25 percent), Montreal (8.0 percent), Calgary (6.2 percent), and Vancouver (6.2 percent).67 Investment Transparency Canadian securitized real estate investment products have outperformed the general Canadian real estate market over the last five years.68 Part of this is due to the fact that Canada ranks very high in market transparency—fourth in the LaSalle 2006 survey with a score of 1.21 (Tier 1). Mexico Demographics The southern neighbor of the United States is considerably different from Canada. Mexico has a population three times greater on a land area one-fifth as large, resulting in a density of 143 persons per square mile. Mexico’s population growth rate also is one-third higher than Canada’s.

64 U.N. World Population Prospects Database, 2006. 65 Ibid. 66 IMD International, World Competitiveness Yearbook, 2007, Lausanne, Switzerland. 67 Colliers International, Market Indicator Reports 2006, www.colliers.com/Corporate/Offices/Canada. 68 NAREIT, REITs Around the World, 2006.

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Mexico’s proportion of children is almost twice as much as Canada’s, and its proportion of older people (over 65) is less than half. Mexico’s median age of 25.6 is fifth lowest behind India, Malaysia, South Africa, and Saudi Arabia. Economy In terms of GDP, Mexico ranks thirteenth in the world and has the fifth largest income per capita in Latin America after Argentina, Uruguay, Chile, and Costa Rica.69 Major industries include agriculture, tourism, petroleum production (sixth in the world), automobile assembly, and television show production. Mexico’s large television industry provides Spanish programs for its own citizens and 44 million Spanishspeaking residents in the United States. Mexico has a mixed economy with a tradition of state-owned enterprises. In recent years, however, the country has been privatizing at a rapid rate—the number of state-owned firms dropped from more than 1,000 in 1982 to less than 100 in 2005.70 Mexico also has opened its markets by lowering trade barriers with more than 40 countries including Japan and the European Union. Trade with the United States and Canada has tripled since the passage of the North American Free Trade Agreement (NAFTA) in 1994. Mexico’s trade balance in 2006 was negative: –$4.3 billion. Real Estate Mexico’s real estate market is concentrated in major urban areas such as Mexico City, Guadalajara, Monterey, Tijuana, and Puebla. Total value of the real estate market is estimated at $200 billion, 27.7 percent of the regional countries, with average current office yields in Mexico City of 9 percent. Mexico is also a focus of resort development with major projects in Cancun, Acapulco, Zwatenao, and Cabo San Lucas. Investment Transparency In terms of real estate market transparency, Mexico scored 2.51 on LaSalle’s transparency scale in 2006, ranking it twenty-fifth out of 56 countries surveyed (Tier 3). Brazil Demographics Brazil is the largest country in South America, both in terms of land area and population. It’s density of 58 persons per square mile is the fifth lowest of the representative countries behind Australia,

69 World Bank, World Development Indicators Database, 2006. 70 Ibid.

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Canada, Russia, and Saudi Arabia. Brazil’s population growth rate of 1.0 percent is about the same as Vietnam’s. A relatively young country, Brazil has only 6.3 percent of its population over 65, which, when coupled with a large percentage of children (25.3 percent), should provide a plentiful labor force to propel the country into becoming a greater potential economic power in the future. There is also a burgeoning middle class, reported to be as many as 30 to 40 million people.71 Economy Brazil maintained an average real GDP per capita growth rate of 2.7 percent over the last three years, landing it somewhere between European countries and the growth economies of the AsiaPacific region. It has an inflation rate of 3 percent and a positive trade balance of $46.1 billion. Real Estate Brazil’s real estate market is currently booming; market value is estimated to be $126 billion, 17.5 percent of the region. Most of the market is concentrated in Sao Paulo and Rio de Janeiro, with average current office yields of 12.0 to 13.0 percent, reflecting the level of risk in the urban areas, often due to high crime rates.72 Investment Transparency In terms of real estate investment transparency, Brazil had a score of 3.31, which resulted in a ranking of 37 (Tier 3). LaSalle noted, however, that Brazil had demonstrated “significant improvement” since the 2004 survey. Africa and the Middle East Africa and the Middle East comprise 13.7 percent of the world’s metro area population (Figure 4-3) and contain at least three countries that might be of interest to global investors. South Africa Demographics The Union of South Africa is a combination of three cultures: the white cultures of the English and the Boers (Dutch) and the much larger indigenous black population. For many years, the white rulers enforced a policy of apartheid—the separate development of the races. 71 Ibid. 72 CB Richard Ellis, Marketview, 2006.

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This ended in the 1990s and ultimately led to black rule (almost 80 percent of the population is black), although white residents continue to control much of the country’s industry and business activities. Almost 30 percent of South Africa’s population is under 14 years, similar to Malaysia (32.3 percent), India (31.8 percent), and Mexico (30.1 percent). Economy Today, South Africa is a multiracial nation with an abundant supply of natural resources and established legal and financial frameworks (its stock market is one of the 10 largest in the world), bountiful energy, and a good transportation and communications infrastructure. The average real GDP per capita growth rate has been 3.9 percent, higher than Saudi Arabia (2.9 percent), but lower than Turkey (5.7 percent). Real Estate Most of South Africa’s real estate activity is concentrated in Johannesburg, Durban, and Cape Town with average current CBD office yields of 8.5 percent, 9.0 percent, and 8.5 percent, respectively.73 Investment Transparency LaSalle’s real estate transparency index placed South Africa at 177, thirteenth among the nations evaluated (Tier 2). Turkey Demographics Although most of its land area is located in Asia, modern Turkey is oriented primarily toward Western Europe and the United States. It is a member of the United Nations, NATO (second largest standing force after the United States), and it is an associate member of the European Union, and it has been undertaking economic and political reform in order to qualify for full membership. Located at the nexus of Europe and Asia, Turkey has been a historical crossroad between east and west for hundreds of years.74 Slightly larger than Texas, it has a population density of 235 persons a square mile and a population growth rate of 1 percent. Turkey has an age profile very similar to Brazil’s, with a large number of children (24.9 percent), a relatively low percentage of citizens over 65 (6.9 percent), and a median age of 28.6 years.

73 Ibid. 74 Turkey may continue to be a “crossroads” between Europe and Asia as a result of a proposed location of a new energy pipeline from the Caspian production fields to potential customers in Europe.

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Economy Turkey is moving toward a private market although the public sector still plays a major role in basic industry, banking, transportation, and communication. GDP in 2006 was $627.2 billion, with an average real GDP per capita growth rate of 5.7 percent, more comparable to the Asia-Pacific region than Europe. GDP per capita was $8,900 in 2006, with an inflation rate of 9.8 percent, one of the highest among all major countries evaluated. Turkey’s trade balance in 2006 was negative (–$35.7 billion), fifth behind the United Kingdom, Spain, India, and France. Real Estate In 1988, Turkey established a REIT-type investment structure called the Gayrimenkul Yat. These entities are exempt from corporate taxation, and they are forced to sell at least 49 percent of their stock to the public. Today, there are 10 REITs operating in Turkey, with a combined equity market capitalization of over $1.3 billion.75 Investment Transparency In terms of real estate investment transparency, Turkey ranked forty-seventh out of 56 (Tier 4), with LaSalle noting “significant improvement” over the survey two years earlier. Saudi Arabia Demographics Saudi Arabia is a desert kingdom approximately one-fifth the size of the United States. Most of the population is concentrated in cities, and only 2 percent of the land is in agriculture. The population density is 33 persons per square mile, fourth lowest after Australia, Canada, and Russia. The population growth rate is currently 2.1 percent, and the age profile is quite young—only 2.4 percent of the population is over 65 years. Economy The Saudi economy was dramatically altered by the discovery of oil in 1938. Today, the kingdom owns 25 percent of the world’s proven petroleum reserves, and it is a leading member of the Organization of the Petroleum Exporting Countries (OPEC). The petroleum sector accounts for roughly 45 percent of the Saudi GDP and 90 percent of exports. Saudi Arabia’s real GDP per capita is currently growing at an average of 2.9 percent, somewhat higher than most of Europe, but considerably lower than China (9.8 percent) and India (7.0 percent). The inflation rate is 1.9 percent. Saudi Arabia’s trade balance is currently $140.3 billion, comparable to Russia and China. 75 NAREIT, REITs Around the World, 2006.

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Real Estate Saudi CBD office building yields range from 11 to 12 percent and are concentrated largely in Ryadh, Jeddah, Dammam, and Makkah. Investment Transparency Saudi’s real estate investment transparency rating was still quite low with a worldwide ranking of 52 (out of 56) earning a Tier 4 designation. LaSalle did note that Saudi Arabia had demonstrated “significant improvement” in the two-year period between 2004 and 2006. There are two other nations in Africa and the Middle East whose inclusion was considered but was ultimately rejected at this time. Nigeria has substantial future economic potential but has yet to develop sufficient levels of market transparency (unranked by LaSalle). The second country was the United Arab Emirates (UAE). The UAE is ranked in terms of transparency forty-fourth, sufficient for a Tier 4 designation (“significant improvement”), but it has a relatively small population (2.6 million) and economy (GDP $111 billion).

COMPARING POTENTIAL INVESTMENT MARKETS Figure 4-4 reflects the 18 major countries discussed in Tables 4-3, 4-4, and 4-5. The position of the United States also is shown to provide a benchmark for investors to measure the corresponding positions of other countries. We refer to these as “potential investment markets” for international real estate investors and developers, combining a sufficiently large economic and population base with reasonably known levels of real estate market transparency. Economic potential is indicated on the vertical scale in terms of average real GDP per capita growth over the period 2004 to 2006. LaSalle’s transparency index ranking is utilized as a surrogate for risk along the horizontal scale. The chart has been divided into four quadrants, each reflecting trade-offs between economic growth (potential return) and real estate investment transparency (risk). A least-squares risk-return curve is included to reflect an average for the entire group. Each quadrant can be viewed as a stand-alone investment strategy or combined with one or more other groups to develop a “blended” strategy, depending on the investor’s investment return objectives and level of risk aversion.

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FIGURE

4-4

Real GDP per capita growth 3-yr. average, 2004–2006

Potential investment markets. 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0%

South Africa

4.0%

Australia Canada

1.0%

1.5

Most transparent

2

Vietnam

Turkey

Mexico Mexico

Brazil

Japan

Germany United Kingdom France Italy

0.0% 1

Spain

4 3

Russia India

Malaysia Malaysia

United States

3.0% 2.0%

1 2

China

2.5

3

Saudi Arabia

3.5

Real estate market transparency rankings

4

4.5

5

Least transparent

Quadrant 1. High Economic Growth, High Transparency Presently there are no countries in this quadrant reflecting the risk-return trade-off between economic growth and market transparency. Quadrant 2. Moderate Economic Growth, High Transparency These metro areas have less economic potential, but they reflect high levels of transparency. Most of the representative countries are in this quadrant, including four (Japan, Germany, Italy, and Spain) that could evolve as “replacement markets” over time. Generally, investments in these countries would appeal to a more moderate risk investor or be used as a foundation for a blended portfolio.76

76 Hong Kong also should be included in this quadrant. As a former British colony, Hong Kong has developed relatively high levels of investment transparency that reportedly have been largely retained by the Chinese government. Investment and development firms also utilize Hong Kong to hold legal rights to properties located elsewhere in China.

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Quadrant 3. Moderate Economic Growth, Low Transparency This is a higher risk strategy reflecting a similar economic growth profile as Quadrant 2 but with lower levels of investment transparency. Brazil and Saudi Arabia are the only countries in this quadrant at the present time. Both countries need to improve economic growth performance and investment transparency in order to move to a quadrant more consistent with their economic potential and become attractive to international real estate investment capital. Quadrant 4. High Economic Growth, Low Transparency Countries in this quadrant reflect high economic growth potential but lower levels of investment transparency, indicating higher levels of risk. Institutional investors may avoid investments in this quadrant, awaiting an improvement in transparency levels.77 Since it’s easier to improve investment transparency than generate economic growth, these countries may decide that such a move would be advantageous in order to attract international institutional capital. Among the five countries, India appears to have the best balance between long-term capital appreciation and investment risk. As noted earlier, India has several advantages over both China and Russia including a relatively young, well-educated, English-speaking labor force, sufficient arable land and water to feed its population, and experience with extensive Western business investment and operations in recent years. The presence of long-standing democratic traditions and an established British type of legal system are encouraging signs that any major remaining investment transparency issues should be resolved in the near future, allowing India to move closer to or perhaps into Quadrant 1. Author’s Note It is hoped that this chapter has provided a better understanding of how countries and metro areas grow and how they maintain the necessary investment transparency safeguards to protect the interests of investors and their capital.

77 The alternative would be to require higher target returns from individual investments to offset additional levels of risk.

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As noted at its outset, many of the factors discussed are subject to economic modeling. While this is a possible next step for investors to take in making investment decisions, we recommend that, in light of the accuracy and comparability of the underlying data, caution be taken in basing investment decisions exclusively on this approach.78

78 For a discussion of the problems in global investment modeling and the 1992 global economic crash, see William N. Goetzmann and Susan M Wachter, The Global Real Estate Crash: Evidence from an International Database, Yale School of Management and The Wharton School, 1996.

CHAPTER 5

The Economics of Real Estate at the National Level

You won’t have any trouble in your country as long as you have few people and much land, but when you have many people and little land, your trials will begin. Advice of Thomas Carlyle, Scottish essayist and historian, to America when it was a nation of 25 million

I

n the historical tapestry of real estate, a recurring thread is the relationship between events at the national and the local levels. The economics of real estate development do not exist in a vacuum but are an integral part of the overall national economy (and increasingly, as noted in Chapter 4, the global economy). There are fundamental relationships that bring changes in the economy at the national level to bear on real estate at the local level. Unfortunately, developers often overlook these relationships. It isn’t always clear what local real estate markets have to do with the national economy; changes in the economy may not affect local real estate for some time or may take forms that aren’t immediately recognizable. Also, more than just economic factors play a part: demographic trends and changes in lifestyles may have an important effect as well. If we view real estate as a series of socioeconomic forces (demand) creating pressure on a relatively limited resource (land), we can get a somewhat clearer perspective. At the national level, demand and supply are seldom in equilibrium; the disparities often last for years. Whether or not national equilibrium is achieved matters little to the individual 127 Copyright © 2007 by John McMahan. Click here for terms of use.

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developer. Most important is discerning broad, long-term national demand and supply trends that ultimately will have an impact on local real estate development.

NATIONAL DEMAND PATTERNS Demand for real estate at the national level is heavily influenced by the growth and characteristics of a country’s population as well as the interaction of employment and income patterns among and upon its people. Population Growth Population growth is a function of the existing level of population, or base, and the annual rate at which new people are added to the base. Population growth rates are a function of the number of births ( fertility), deaths (mortality), and net international migration. In essence, population increases when the number of people born or immigrating is ultimately greater than the number dying or emigrating. The population growth rate of the United States decreased considerably during the twentieth century, falling from 2.1 percent in 1900 to about 0.9 percent in 2006. During the first half of the century the growth rate experienced periods of volatility—going down to as low as 0.7 percent FIGURE

5-1

U.S. population components of change from 1980 to 2006. 5,000,000 4,500,000

Births

4,000,000 3,500,000 3,000,000

Net change

2,500,000 2,000,000

Deaths

1,500,000

Immigration 1,000,000 500,000

19 8 19 0 81 19 8 19 2 8 19 3 8 19 4 8 19 5 86 19 8 19 7 8 19 8 9 19 1 9 19 2 9 19 3 94 19 9 19 5 9 19 6 97 19 9 20 8 0 20 1 0 20 2 0 20 3 04 20 06

0

Source: U.S. Census Bureau, Population Division.

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during the Depression and climbing to 1.7 during the baby boom of the late 1940s and the 1950s following World War II. During the last three decades the growth rate has remained more stable—around 1.0 percent through the nineties falling to an average of 0.9 percent since 2000.1 This long-term decline in population growth rate may come as a shock to many who have been hearing of a pending population disaster. This confusion is the result of three factors. First, most of those predicting population growth problems are referring to developing countries. Second, the growth rate may be declining, but the base is so large that there will still be substantial increases in the total population for years to come. As an example, despite the long-term decline in growth rates, the U.S. population more than tripled in the last century, experiencing the largest numerical increase in history during the 1990s.2 This was primarily a result of the baby boomers’ children being born (echo boom generation), with the population of the United States increasing by 32.7 million people (13.2 percent). Third, many of the problems created by U.S. population growth are related more to the geographic distribution of the population than to its overall size. Births Changes in the fertility rate have been a major factor affecting population growth in this country. Since 1800, the U.S. fertility rate was in a longterm decline until the mid-1980s with one notable exception: the birth of the baby boomers in the years after World War II when total fertility rates3 rose as high as 3.7 children per lifetime of each woman. After 1957 fertility rates declined to 1.7 during the first half of the 1980s and slightly rose to level off at 2.1 in 2006.4 As noted in Chapter 3, many corporations entered real estate in the late 1960s, partly because a housing boom was predicted for the 1970s, based on an “echo boom” from the aberration in fertility rates during World War II. As war babies married and had children of their own, increased demand for new housing was anticipated.

1 U.S. Census Bureau, Population Division. 2 Frank Hobbs and Nicole Stoops, Demographic Trends in the 20th Century, U.S. Census Bureau, Census 2000 Special Report, Series CENSR-4 (Washington, D.C.: Government Printing Office, 2002). 3 The total fertility rate represents the average number of children a woman would have during her lifetime, based on childbearing rates in survey years. A fertility rate of 2.1 is referred to as the “natural replacement rate.” 4 U.S. Centers for Disease Control and Prevention, National Center for Health Statistics.

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There was, in fact, some evidence of an echo boom, as birth rates increased to 18.2 per 1,000 in 1970 after reaching a low of 17.5 in 1968. In 1971, however, the birth rate fell back to 17.3, and people began talking about the “birth dearth.” The increasing number of women of childbearing age was being offset by women bearing fewer children, which was occurring for three reasons: (1) women were older when they began having their children, (2) it was becoming popular to have small families, and (3) contraceptive techniques had improved.5 Deaths The lower rate of mortality also has contributed to the nation’s population growth. Life expectancy at present is approximately 74 years for males and 80 years for females, which is considerably higher than it was at the beginning of the twentieth century. Immigration Immigration has long been a source of population increase, accounting for 40 percent of the country’s population growth in the first decade of the last century. During the 1930s immigration levels dropped to virtually zero; they rose again after World War II, accounting for about 16 percent of the population growth during the 1960s.6 In 1985 there were 577,000 legal immigrants, representing about 26 percent of that year’s growth.7 This level was down from 33 percent in 1980 but considerably higher than the 1970 rate of 17 percent.8 Immigration has been on the rise in recent years. The number of legal immigrants surged to a record 1.8 million or 60 percent of population growth in 1990. With this exception, the share of legal immigration in population growth during the 1990s and until now remains at an average of about 35 percent.9 In addition, illegal immigrant population has been growing by over 400,000 people a year since 2000.10 5 Report of the Commission on Population Growth and the American Future (New York: New American Library, 1972), pp. 14–15. 6 U.S. Census Bureau, United States Population Estimates and Components of Change: 1970 to 1986, ser. P-25, no. 1006, 1986. 7 U.S. Census Bureau, Current Population Reports, ser. P-23, no. 150, 1987. This does not include illegal immigrants, which could increase these figures considerably. 8 Ibid. 9 Population Division, U.S. Census Bureau, National and State Population Estimates, Components of Population Change, 2007, www.census.gov. 10 Michael Hoefer, Nancy Rytina, and Christopher Campbell, Estimates of the Unauthorized Immigrant Population Residing in the United States: January 2005, U.S. Department of Homeland Security, Office of Immigration Statistics, Population Estimates, August 2006.

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The total population of the United States reached 300 million in October 2006, and it has continued growing. Total fertility rates of the U.S. population are projected to increase to about 2.2 by the year 2025.11 Immigration is also expected to continue being a major contributor to population growth.12 Population Characteristics Demand for real estate is determined not only by the sheer number of people but also by shifts in the nature, or demographics, of the population. Demographic factors of greatest consequence to real estate are changes in the age composition and changing patterns of marriage and household formation. These factors are not only highly interrelated but also affected by changes in the economy and lifestyle patterns. Age The median age of Americans has been increasing steadily since the turn of the twentieth century, with the exception of the post-World War II aberration created by the baby boomers. By 2005, the median age of the population was 36.2 years, up from 30 in 1980, and growing.13 The changes in the age structure of the population also point to an increase in the number of elderly citizens. Currently, 12 percent of the population is 65 years of age and over. That figure is expected to reach 16.3 percent by the year 2020 and 20.6 percent by the year 2050, as the baby boomers become senior citizens. By 2050, the population 65 years and over will more than double (86.7 million versus 37 million in 2005)14 as depicted in Figure 5-2. Marriage The number of marriages started declining in 1974, the first time since World War II, closely paralleling the continuing increase in the nation’s divorce rate during the 1970s. The median age of first marriage has been

11 Paul R. Campbell, Population Projections for States by Age, Sex, Race and Hispanic Origin 1995 to 2025, U.S. Census Bureau. 12 As of this writing, there was considerable discussion of new legislation being enacted to limit foreign immigration. If this legislation were to come to pass, it could limit the projected growth in population from this source. 13 U.S. Census Bureau, Table 1: Annual Estimates of the Population by Sex and Five-Year Age Groups for the United States: April 1, 2000 to July 1, 2005 (NC-EST2005-01), Population Division, U.S. Census Bureau, May 10, 2006. 14 U.S. Census Bureau, Projected Growth of the Older Population 2000 to 2050.

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FIGURE

5-2

U.S. population age groups from 1980 to 2050 as percentages of total population by age group. 100%

65+

90% 80%

45–64

70% 60% 50%

25–44

40% 30%

18–24

20%

5–17

10%

20 50

40 20 45

20

20 35

25 20 30

20

20

20

20

20 10

00 20 05

95

20

19

90 19

19 85

19 80

15

0–4

0%

Source: U.S. Census Bureau, Population Division.

increasing since 1970; by 1985 it had reached 25.5 years for men and 23.3 for women. By 2005, the median marriage age increased to 27.1 for men and 25.3 for women.15 There also has been a rise in the percentage of young adults who have never married. In 1970, 19.1 percent of men in the 25 to 29 age bracket and 10.5 percent of women had never married16; by 2005, those figures rose to 55.2 and 41.5 percent, respectively.17 Households The total number of households in the United States increased by about 1 million a year during the 1960s. The average population per household declined from 3.33 in 1960 to slightly under 3.0 persons by the mid1970s.18 By 2005 average household size had declined to 2.5719 and is expected to slowly decline even further.

15 U.S. Census Bureau, September 2006. 16 U.S. Census Bureau, Current Population Reports. 17 U.S. Census Bureau, America’s Families and Living Arrangements, 2005. 18 U.S. Census Bureau, Current Population Reports. 19 U.S. Census Bureau, America’s Families and Living Arrangements, 2005.

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133

This is a result of not only lower birth rates but also an uncoupling phenomenon, that is, individuals tending to set up separate households. There are several reasons for this: young people leaving home at an earlier age, increased divorce rates, parents not living with their children, and overall greater levels of affluence. According to the U.S. Census Bureau’s American Community Survey released in October 2006, married couples constituted 49.7 percent of all households in 2005, down from 52 percent in 2000.20 The number of traditional married-with-children families is currently about 22 percent of all households.21 New household formation declined dramatically and unexpectedly in the early 1980s. An average of only 1.2 million new households a year was formed between 1980 and 1990 (compared to 1.7 million new households the prior decade). The drop was caused by a combination of factors, primarily a severe recession and more conservative social attitudes encouraging young adults to stay at home longer.22 Between 1990 and 2000, the annual number of new households remained at around 1.1 million, increasing slowly to 1.2 million in 2005 and beyond.23 The Census Bureau projects the number of households to increase to nearly 115 million in 2010 with a growth rate of about 1.1 percent a year.24 The number of households maintained by a person living alone is projected to increase slightly to 27 percent in 2010. Most of the increase in the number of people living alone is expected between the ages of 45 to 64 due to the influx of aging baby boomers. Other Characteristics Time magazine has summarized other population characteristics. In October 2006, for every 1,000 Americans, 568 live in the state in which they were born. 455 are employed. ■ 405 are married. ■ 341 drive to work alone. ■ 173 speak a language other than English at home. ■ 159 have no health insurance. ■ ■

20 U.S. Census Bureau, American Community Survey, October 2006. 21 Ibid. 22 American Demographics, April 1987, pp. 30–31. 23 Jennifer Cheeseman Day, Projections of the Number of Households and Families in the United States: 1995 to 2010, U.S. Census Bureau, Current Population Reports, P-25-1120 (Washington, D.C.: Government Printing Office, 1996). 24 Ibid.

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126 live in poverty. 122 are 65 or older. ■ 155 claim Irish ancestry. ■ 23 are in prison, in jail, on parole, or on probation. ■ 8 are grandparents caring for grandchildren. ■ 5 are in the active-duty military. ■ 1 is in kindergarten. ■ ■

In terms of the future, Time noted four trends that we can expect: (1) more Hispanic less white population, (2) smaller families, (3) later marriage or no marriage, and (4) people will be more educated.25 Implications for Real Estate As illustrated in Figure 5-3, the biggest gain in population over the next 45 years (through 2050) will be in the 45 to 64 and 65 to 84 age groups. These groups represent mature adults, making a transition from preretirement to active retirement to elderly phases with different lifestyles and housing needs dominating each decade.

FIGURE

5-3

U.S. population change in major age categories from 2000 to 2050. 20,000,000 18,000,000 16,000,000 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 −2,000,000 2000–2010

2010–2020

0–19

20–44

2020–2030

45–64

Source: U.S. Census Bureau, Population Division.

25 “America by the Numbers,” Time, October 30, 2006.

2030–2040

65–84

85+

2040–2050

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2000 to 2010 During these years the biggest gain (6.5 million) is going to be in the number of 55 to 64 year olds. The next biggest group to gain in numbers is the 45 to 54 group: baby boomers born between 1956 and 1965. Most people in this age category are likely to be empty nesters with fairly high disposable incomes. Still in their prime earning years, many are looking for housing upgrades, which makes them a desirable target market for residential developers. To fully understand how the baby boomers will affect the housing market, however, we need to look at the subsequent decades. 2010 to 2020 The 45 to 54 group will transition to the 55 to 64 group in the second decade of the century, becoming a numerous and highly desirable target market over the next 20 years. The biggest gains during this decade, however, will be in the 65 to 74 age category (over 10 million people)—a transition of the 55 to 64 group from the previous decade. These are the so-called yuppie elderly or young elderly—a group of people still relatively in good health with fairly high disposable incomes. 2020 to 2030 The biggest changes in this decade will be in the 75 to 84 age category (8.3 million)—the so-called needy elderly, often surviving-spouse households that tend to have much lower income levels than the previous group and who are often dependent on the assistance of family or social institutions. The second biggest will be in the 65 to 74 age category (6 million), which makes this category the most desirable target market between 2010 and 2030. The number of people in the 55 to 64 age category will decline during these years. There are many speculations as to what kind of housing will be desired by retired baby boomers. A popular opinion is that this group will prefer active retirement in resortlike communities, with a large part of the population staying in the suburbs and some migrating to the Sunbelt states. Table 5-1 identifies the top 15 states by projected population 65 and older by 2030. Florida will experience the largest gain in people 65 and older (over 4.9 million), followed by California, Texas, and Arizona. Arizona will make the top 15 states by 2010 and will progress to seventh position by 2030, gaining over 1.7 million people in this age category. From these numbers, it would appear that attempts to capture demand created by particular groups of aging baby boomers will be a primary factor supporting residential development in the first three decades of this century.

136 TA B L E

5-1

Ranking of States by Projected Numbers of Population 65 and Older 2000 No. of People Rank

2010 % of U.S. % of State

State

65 and Older

Total

United States

Population

2030

No. of People

% of U.S.

% of State

State

65 and Older

Total

Population

No. of People State

% of U.S. % of State

65 and Older

Total

Population

19.7

34,991,753

100.0

12.4

United States

40,243,713

100.0

13.0

United States

71,453,471

100.0

1

California

3,595,658

10.3

10.6

California

4,392,708

10.9

11.5

California

8,288,241

11.6

17.8

2

Florida

2,807,597

8.0

17.6

Florida

3,418,697

8.5

17.8

Florida

7,769,452

10.9

27.1

3

New York

2,448,352

7.0

12.9

New York

2,651,655

6.6

13.6

Texas

5,186,185

7.3

15.6

4

Texas

2,072,532

5.9

9.9

Texas

2,587,383

6.4

10.5

New York

3,916,891

5.5

20.1

5

Pennsylvania

1,919,165

5.5

15.6

Pennsylvania

1,956,235

4.9

15.5

Pennsylvania

2,890,068

4.0

22.6

6

Ohio

1,507,757

4.3

13.3

Illinois

1,600,863

4.0

12.4

Illinois

2,412,177

3.4

18.0

7

Illinois

1,500,025

4.3

12.1

Ohio

1,586,981

3.9

13.7

Arizona

2,371,354

3.3

22.1

8

Michigan

1,219,018

3.5

12.3

Michigan

1,334,491

3.3

12.8

Ohio

2,357,022

3.3

20.4

9

New Jersey

1,113,136

3.2

13.2

New Jersey

1,231,585

3.1

13.7

North Carolina

2,173,173

3.0

17.8

969,048

2.8

12.0

North Carolina

1,161,164

2.9

12.4

Michigan

2,080,725

2.9

19.5

10

North Carolina

11

Massachusetts

860,162

2.5

13.5

Virginia

994,359

2.5

12.4

New Jersey

1,959,545

2.7

20.0

12

Virginia

792,333

2.3

11.2

Georgia

980,824

2.4

10.2

Georgia

1,907,837

2.7

15.9

13

Georgia

785,275

2.2

9.6

Arizona

922,010

2.3

13.9

Virginia

1,843,988

2.6

18.8

14

Missouri

755,379

2.2

13.5

Massachusetts

908,565

2.3

13.7

Washington

1,563,901

2.2

18.1

15

Indiana

752,831

2.2

12.4

Tennessee

829,023

2.1

13.3

Massachusetts

1,463,110

2.0

20.9

Source: U.S. Census Bureau, Population Division, Interim State Population Projections, 2005.

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137

2030 to 2050 These years will see the baby boomer generation moving through their late seventies and eighties. The majority of households in this age range will be one-person households and tend to be female. These will be the decades with increased demand for assisted-living communities and perhaps a growing number of multigenerational households caring for the elderly grandparents—a trend that has been on the rise during recent years. The highest growth during these decades, however, will be in the 20 to 44 age category closely followed by the 0 to 19 age category, signifying increased demand for single-family housing, condos, and apartments located near employment centers. Ethnic Composition Immigration was discussed primarily as a factor contributing to population growth. In addition, immigration is changing the population composition and will be a major force influencing real estate markets over the foreseeable future. The influence will come not only from increasing numbers of the foreign-born population in the United States but also from the fact that immigrant households experience different income patterns and lifestyles, and they tend to be dispersed unevenly throughout the nation, concentrating in states that have traditionally been attractive to immigration. Table 5-2 illustrates the top 20 metropolitan areas by net international migration and net internal migration from July 2000 to July 2006.26 Among areas with the highest number of immigrants, only 6 have positive net internal migration (highlighted in bold). In the rest of these areas immigrants are moving in as the domestic population is moving elsewhere, which reinforces the clustering of immigrant households in specific geographical areas. The foreign-born population has a different demographic composition than the native-born population. In general, the foreign-born population tends to be younger and to have lower income patterns and higher fertility rates. The median household income of Hispanic households, which account for over 50 percent of the foreign-born population of the United States, is about 69 percent of that of white households, and the median age of the Hispanic population is 28, compared to 40 for nonHispanic whites.27

26 U.S. Census Bureau, Cumulative Estimates of the Components of Population Change for Metropolitan and Micropolitan Statistical Areas, April 1, 2000, to July 1, 2005. 27 U.S. Census Bureau, Current Population Survey 2004, Annual Social and Economic Supplement.

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TA B L E

5-2

Metropolitan Areas with Highest International and Internal Migration from 2000 to 2006

Metropolitan Statistical Area

Net International Migration

Net Internal Migration

1,067,539


1,447,239

797,652 409,426 377,134 286,171 259,428 244,752 239,246 177,843 165,088 163,546 159,219 102,447 99,468 95,283 92,889 91,066 89,296 71,745 68,125


937,685
82,008
421,153 168,481 146,090
349,672
80,231 276,915 398,198
265,184
224,068
10,149
119,636 474,621
68,378 108
192,032
22,485 64,985

95,283 165,088 177,843 64,365 57,179 62,129 286,171 259,428 41,748 62,285 12,412 58,194 11,470 29,250 33,418 13,086 6,298 24,853 68,125 8,205

474,621 398,198 276,915 259,537 242,033 206,374 168,481 146,090 139,418 127,808 117,679 107,647 104,524 104,274 103,702 92,291 68,877 65,778 64,985 63,795

Highest International Migration 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

New York-Northern New JerseyLong Island, NY-NJ-PA Los Angeles-Long Beach-Santa Ana, CA Miami-Fort Lauderdale-Miami Beach, FL Chicago-Naperville-Joliet, IL-IN-WI Dallas-Fort Worth-Arlington, TX Houston-Sugar Land-Baytown, TX San Francisco-Oakland-Fremont, CA Washington-Arlington-Alexandria, DC-VA-MD-WV Atlanta-Sandy Springs-Marietta, GA Phoenix-Mesa-Scottsdale, AZ Boston-Cambridge-Quincy, MA-NH San Jose-Sunnyvale-Santa Clara, CA Seattle-Tacoma-Bellevue, WA San Diego-Carlsbad-San Marcos, CA Riverside-San Bernardino-Ontario, CA Philadelphia-Camden-Wilmington, PA-NJ-DE-MD Denver-Aurora, CO Detroit-Warren-Livonia, MI Minneapolis-St. Paul-Bloomington, MN-WI Portland-Vancouver-Beaverton, OR-WA Highest Internal Migration

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Riverside-San Bernardino-Ontario, CA Phoenix-Mesa-Scottsdale, AZ Atlanta-Sandy Springs-Marietta, GA Las Vegas-Paradise, NV Tampa-St. Petersburg-Clearwater, FL Orlando-Kissimmee, FL Dallas-Fort Worth-Arlington, TX Houston-Sugar Land-Baytown, TX Charlotte-Gastonia-Concord, NC-SC Sacramento-Arden-Arcade-Roseville, CA Cape Coral-Fort Myers, FL Austin-Round Rock, TX Jacksonville, FL San Antonio, TX Raleigh-Cary, NC Sarasota-Bradenton-Venice, FL Port St. Lucie-Fort Pierce, FL Nashville-Davidson-Murfreesboro, TN Portland-Vancouver-Beaverton, OR-WA Boise City-Nampa, ID

Source: U.S. Census Bureau, Population Division. Table 9: Cumulative Estimates of the Components of Population Change for Metropolitan and Micropolitan Statistical Areas, April 5, 2007.

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139

In the future, this trend can lead to what is referred to as a racial generation gap.28 In California, for example, by 2025 the child population is projected to be 25 percent white and more than 50 percent Hispanic. The working-age and home-buying populations are projected to be only one-third white and more than two-fifths Hispanic, while the older population will still be over 50 percent white. Other states will have their own completely different demographics dependent on migration patterns. The resulting disparity between age and race may cause disparity between need and demand for housing. For areas where demand for affordable housing is not met, this most likely will translate into increased class and race segregation and downward pressure on housing quality. Also, 50 percent of minority households and two-thirds of immigrant households rent rather than own property, which will affect demand for single-family homes in areas with a high concentration of immigrant and minority populations.29 However, homeownership rates among immigrant families have been increasing in recent years.

Employment The level and nature of national employment patterns are important to real estate for two reasons. First, the overall level determines to some degree the level of total household income that will be available for housing and retail expenditures. Periods of rising employment generally mean periods of rising total incomes; periods of continued high unemployment depress household incomes and reduce people’s capacity to spend for housing, retail goods, and other types of purchases. Second, shifts in long-term employment patterns can ultimately affect the nature of real estate demand. For example, the gradual shift from blue- to white-collar employment has significantly influenced the type of industrial and office space required. Participation in the Labor Force As noted in Figure 5-4, there were approximately 150 million Americans in the total labor force in 2006, representing 66 percent of the population.

28 William H. Frey, Housing in the 21st Century, Symposium Sponsored by the Urban Land Institute and the Center of Housing Policy, 1999. 29 Urban Land Institute, Multifamily Trends Conference, fall 2004.

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This percentage, or participation rate, has remained stable, hovering in the 60 to 66 percent range since the end of World War II. The degree of participation by various groups, however, has varied considerably. In general, participation rates of women 20 to 64 years old have been rising while participation rates of men 20 to 54 years old have been declining. Men still have higher participation rates than women, but the difference has shrunk to about 12 percent from 52.5 percent in 1950 and is projected to decline to about 10 percent in the coming years. The participation rate of both sexes 55 and over declined in the 1980s but started rising again in the early 1990s apparently because fewer people have been able to afford early retirement. The participation rate of teenagers also has been declining in recent years from the peak of 58 percent in the early 1980s to 44 percent in 2006 and is projected to decline further. The rate for men in the 20 to 24 age group declined during the Vietnam War and began rising again in the 1970s, following elimination of the draft, but it has been steadily declining to the current rate of 80 percent compared to 86 percent in 1979 and 89 percent in 1950.

FIGURE

5-4

U.S. civilian labor force participation rate from 1950 to 2014. 100 90 80 70 60 50 40 30 20 10

Source: U.S. Department of Labor, Bureau of Labor Statistics.

14

10

Both sexes 16–19 years Men 20–24 years Men 25–54 years

20

02

06

20

20

98

20

94

19

90

19

86

All civilians Both sexes 55 years and over Women 20–24 years Women 25–54 years

19

82

19

74

78

19

19

70

19

66

19

62

19

58

19

54

19

19

19

50

0

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Unemployment Since World War II, unemployment has ranged from a low of 2.9 percent to a postwar high of 9.7 percent in 1982 before declining to a level of 4.6 percent in 2006.30 Other factors also may influence the nature and overall level of employment. Demands for a changing mix of goods and services, varying educational levels, national immigration policy, and the state of the national and international economies are just a few of the factors that help to determine the unemployment rate at a particular time. Future Labor Force According to the U.S. Bureau of Labor Statistics, the total labor force is expected to reach nearly 163 million by 2015 and 166 million by 2025.31 This represents a total increase of 16 million workers, an average of about 0.8 million workers a year—an 8.7 percent growth rate in the decade from 2005 to 2015, which is just slightly more than half as large as the 13.6 percent growth in the previous 10-year period of 1995 to 2005. The projected growth rate for 2015 to 2025 is even lower, only 2 percent.32 Annual growth rates are projected at 1 percent until 2015 and 0.2 percent until 2025. This is primarily a reflection of the continued aging of the general population—the population 65 years and older is projected to decline by 16 million between 2015 and 2025 and the number of persons aged 45 to 54 is projected to decline by 3.7 million within those years. Another trend is the increase in diversity of the workforce—the share of population of Hispanic origin has increased dramatically and is now around 12 percent, up from 5.7 percent in 1980. Offshoring Over 850,000 U.S. knowledge-based jobs have been shifted overseas since 2004, and Forrester Research predicts that the total number will grow to 3.3 million by 2015.33 Since many of these jobs are office based, it is impossible to ignore the effects of outsourcing on office space markets because it will translate into a potential reduction in office space demand 30 U.S. Department of Labor, Bureau of Labor Statistics, Division of Labor Force Statistics, Data from Current Population Survey, www.bls.gov/CPS. 31 Howard Fullerton, Jr., Labor Force Participation: 75 Years of Change, 1950–1998 and 1998– 2025, U.S. Department of Labor, Monthly Labor Review, December 1999, pp. 3–12. 32 Ibid. 33 John C. McCarthy et al., Near-Term Growth of Offshoring Accelerating, Forrester Research, May 2004.

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of over 580 million square feet by 2015.34 Considering that today’s occupied office inventory is around 3 billion square feet, the decrease in demand due to outsourcing could put a possible damper on the prospects for new office space development.35 Income The level of real income determines the amount of funds that will be available for housing and retail expenditures. It also affects real estate indirectly because changes in the level of business activity affect the demand for industrial and office facilities. Per capita income is particularly important in determining the demand for housing, retail, and transient commercial facilities. In the United States, average disposable income per capita in 2006 was about $31,500.36 This figure has been rising between 2 and 4 percent in real terms annually since 1980. Averages, however, don’t tell the whole story because income is not evenly distributed. In 2005, for example, households that constituted the lowest 20 percent in terms of annual income received only 3.4 percent of total U.S. income; the highest 20 percent received 50.4 percent; and the top 5 percent received 22.2 percent.37 Expenditures for Real Estate Goods and Services Figure 5-5 illustrates the general flow of wealth from households and business firms into each of the major types of land uses. Households Most households try to provide for future needs by setting aside a portion of disposable income in the form of savings. The remainder is spent for goods and services. The relationship between the amount spent and total disposable income is called the propensity to consume, which varies with the level of disposable income, the degree to which prior debt is being retired, and household expectations about the levels and stability of future income.

34 Leanne M. Lachman, The New Exports: Office Jobs, Urban Land Institute and Paul Milstein Center for Real Estate Issue Paper, 2003. 35 This does not necessarily mean a reduction in national demand for office space as it could be offset by increased demand created by new U.S. population growth. Most likely the loss will be in regional and metro areas losing jobs. 36 U.S. Department of Commerce, Bureau of Economic Analysis, 2005. 37 U.S. Census Bureau, Share of Aggregate Income Received by Each Fifth and Top 5 Percent of Households, All Races, 1967 to 2005, Table H-2.

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FIGURE

5-5

Sources of demand for property types.

Firms

Households Population growth Demographics

Economic growth

Employment

Organization

Savings

Profits

Revenue

Income Expenditures

Apartments

Retail

Expenditures

Hotels

Office

Industrial

Source: McMahan Real Estate Services LLC.

In general, households are more inclined to consume when they expect good times or when they expect inflation. The demand for real estate goods and services is created primarily by household expenditures in housing and retail commercial activities. Housing Households traditionally have spent approximately 25 to 30 percent of disposable income on housing. In recent years this has increased to 30 to 40 percent due to escalating housing costs. The major portion of these expenditures takes the form of mortgage payments or rent. Payments on mortgages reflect demand for ownership housing: single-family homes and condominiums. The price of ownership housing, in turn, is influenced by the cost of mortgage financing and the term over which the mortgage is repaid. For example, increases in interest rates reduce the price that a household is able to pay for housing; longer repayment periods increase the price. Rental payments reflect a demand for apartments and single-family rental units. The amount of rental payments depends on the cost of land and construction, financing, and annual costs of operating the apartment building. Higher land and construction costs require higher rents, which reduces the number of households that can afford the apartment units. Higher financing and operating costs can have a similar effect.

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Retail Americans historically have spent approximately 30 to 35 percent of their consumption expenditures on retail goods and services. These expenditures, in turn, create a demand for shopping centers and other facilities in which retail goods are sold and/or services are provided. The amount of retail space created is a function of the levels of expenditures and the number of households served by the facilities. Business firms also make retail purchases, but they are small in comparison to those of households. Business Firms Business firms also spend a portion of their revenues on real estate goods and services. As with households, future income expectations usually play a large role in determining the amount and nature of these expenditures. A firm expecting future growth in earnings may purchase or rent real estate space and services beyond current needs. Space for Operations The largest expenditure made by businesses is for office and/or industrial space that is utilized in a firm’s operations. The amount of office space is largely a function of the number of current employees, plus anticipations regarding future growth, the type of activity in which the employer is engaged, and the operating “image” that the firm wishes to create and maintain. Demand for industrial space is a function of these factors, plus the space required for equipment used in the production process and storing materials and finished product inventories. Generally, increases in the level of employment will increase the amount of building space required. The amount of space is also affected by changes in technology. For example, advances in telecommunication and personal computer technology have decreased the amount of office and industrial space required per employee. The cost per square foot of office and industrial space also has an impact on space requirements; firms are likely to be more generous in the amount of working space allotted to each employee in a lower-cost office or industrial building or during a period of substantial rent concessions. Distribution Space Business firms also depend on wholesalers to supply them with goods required in the manufacturing process and to distribute the final product. The activities of wholesalers, in turn, create a demand for warehousing facilities. The level of demand for these facilities is a function of the markets served, transportation costs, and the level of inventories required to meet production levels and customer requirements.

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Again, technology may affect the amount of space required. As an example, bar coding, inventory control systems, and improved stacking and warehouse handling equipment have all served to reduce the amount of warehouse space and inventories needed to support a given level of sales. Transient Commercial Facilities Both households and business firms spend money for hotels to lodge personnel on business trips and provide venues for business meetings. Companies and professional trade associations hold conventions and conferences in hotels. Restaurant expenditures come from both local businesses (for example, business lunches) and outof-town business travelers. Firms also may spend money on golf and tennis clubs, theater tickets, or other entertainment and recreational activities. The demand for these facilities is a function of the level of firm and household expenditures and the costs of reaching the facility. Changes in travel costs may affect the distance traveled, expanding or contracting the geographic market of the transient commercial facility. For example, the advent of jet aircraft reduced air travel costs, thereby opening up new resort developments in Hawaii, Mexico, the Caribbean, and Europe— areas previously deemed too distant by most firms and households. Public Sector The public sector also spends money for real estate goods and services. Housing authorities build and/or purchase public housing in cities and rural areas. Health-care delivery and support organizations build hospitals and outpatient centers. All levels of government build or lease office and other space for their employees. Public sector employees spend money for hotels, restaurants, and other transient commercial activities.

NATIONAL SUPPLY PATTERNS National demand patterns are often tempered by factors affecting the supply of land, construction labor, materials, and investment capital. In some cases, changes in real estate tax legislation (such as building depreciation guidelines) also can have an impact. Real estate is particularly vulnerable to changing supply factors because it has been used by the federal government in attempts to influence changes in the overall economy. Land In the United States, there is not now, nor has there ever been, a national shortage of land for real estate activities. Chapter 1 noted that, as land was

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required for farms, forests were cleared and pastures plowed. In the 1920s and early 1930s, drainage and irrigation programs opened up new land for agriculture, leaving less productive lands to revert to pasture or forestry. The supply of forestry lands was further expanded by major reforestation programs begun in the early 1900s. The proportion of land allocated for different uses has changed over time. The U.S. Department of Agriculture (USDA) considers land use to be either “rural” or “urban.” In 2002, the USDA estimated that the total U.S. land area was 2.3 billion acres. Of that, the USDA categorized 2.2 billion, or 97 percent, as “rural,” which included “agricultural (range, cropland, pasture, farmsteads, and roads), forest, and other land.” The USDA further estimated rural land use to be divided among these activities in the following proportions: 20 percent as cropland; 26 percent as “grassland pasture and range”; 19 percent in forest use exclusive of parks and recreational areas; 13 percent in “special uses” (“parks, wilderness, wildlife, and related uses”). Of the total U.S. land area of 2.3 billion acres, the USDA categorized 60 million acres, or 3 percent, as “urban,” which included “residential, commercial, utilities, mixed, transitional, and other urban land.”38 The federal government can affect national land use patterns through such measures as sponsorship or support of open space areas, changes in taxation policies, and even public ownership of land. All of these measures tend to restrict or at least modify the supply of land for development purposes. The net result often is higher land prices for land available for development. This, in turn, generally leads to greater intensity of development on this land and/or the recycling of land that has already been developed. Labor A second factor affecting national supply patterns is the cost and availability of construction labor. Historically, the construction industry has been subject to wide cyclical swings as a result of over- and underbuilding. In addition, in many areas, weather determines the seasons during which construction can occur on a full-intensity basis. The combination of cyclical and seasonal fluctuations has created an unstable construction employment pattern, with periods of high unemployment. The small-scale, fragmented, competitive nature of the industry contributes further to a relatively unstable situation. 38 U.S. Department of Agriculture, Briefing Rooms, Land Use, Value, and Management: Major Uses of Land, 2002.

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To counteract these conditions, construction trade unions in some areas have adopted policies to protect its members. These policies may limit the supply and increase the cost of construction labor. The major factor influencing construction labor costs in recent years, however, has been the use of immigrant labor, both skilled and unskilled. Around 20 percent of workers in the construction industry are foreign born, 79 percent coming from the Americas and 20 percent from Europe and Asia.39 Trades with highest share of foreign-born workers (30 to 40 percent) are construction laborers, masons, drywall installers, ceiling tile installers, and tapers, and their annual wages range from $27,200 to $39,000. Immigrant construction workers have tended to concentrate in certain regions, making up over one-third of the construction workers in California, Nevada, Texas, Arizona, and Washington, D.C. In contrast, in West Virginia, North Dakota, and Montana, only 1 to 2 percent are foreign born.40 Materials There are three basic sources of structural materials for construction: wood, concrete, and steel. The supply of wood and related products is a function of the production of trees and their use for paper, synthetics, and other products. The supply of concrete and related products is relatively localized and largely inexhaustible, provided facilities are available for extraction and processing. The supply of steel is related to the availability of iron ore and coal, both relatively abundant in the United States. Increasingly, the price of structural materials is influenced by global market demand and supply forces. As an example, the very rapid growth of China and India in recent years has led to a scarcity of steel from time to time, often with fairly sizable price increases. In some cases, there may be certain trade-offs among structural materials. For example, if the supply of steel is particularly short or if prices rise too sharply, architects may shift to concrete as a substitute product. Typically, these trade-offs are made from the higher-priced material to the lower-priced one. Local prices for a given material also may vary significantly, resulting in additional cost differentials. Building materials are particularly subject to technological innovation. In many cases, innovation has increased 39 Natalia Siniavskaia, Ph.D., Immigrant Workers in Construction, December 2005. Available through National Association of Homebuilders, www.nahb.org. 40 Ibid.

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the efficiency of building construction, thereby lowering costs. For example, the development of gypsum wallboard lowered the cost of wall installation; aluminum panels proved to be cheaper than steel or masonry curtain walls. In other instances, technological innovation may lead to lower maintenance costs, as happened with fluorescent light and stain-resistant carpeting. In earlier times, improved technology also has led to greater intensity of use on a site—for instance, the development of structural steel for skyscrapers and the introduction of the elevator. Capital The supply of capital for real estate development is a function of the total supply of capital in the nation as well as funds from foreign investors. The supply of the nation’s capital is, in turn, a function of the net savings of individuals, business firms, and governments. These savings are channeled into real estate in the form of either equity investment or a debt instrument usually secured by the property. Equity Funds for real estate must compete with other uses of funds. Funds invested by the individual in equity positions in real estate must compete with other forms of investments—stocks, bonds, savings certificates, and so on. Public corporations investing in real estate must weigh the desirability of real estate investment against other uses of corporate funds. Financial institutions and pension funds must compare real estate with investments in stocks, bonds, commercial bank loans, or other debt instruments. The real estate equity market has historically been relatively informal and highly fragmented. Equity investments were generally made directly by individuals or institutions through sponsoring private investors or real estate syndicators. As noted in Chapters 2 and 3, however, the level of both private and public real estate equity investment has grown substantially in recent years, not only in the United States but worldwide through instruments such as REITs, pension funds, or private property syndicators registering their shares on a public market. Equity capital accounted for 15 percent of total real estate capital in 1988 and 20 percent in 2006.41 The sources of equity capital have changed

41 Urban Land Institute and PricewaterhouseCoopers, Emerging Trends 2007.

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dramatically, largely due to increased participation by pension funds and other institutional investors as well as the securitization of real estate through REITs and other vehicles. Debt Investments in debt instruments are generally made through financial intermediaries, such as insurance companies, savings and loan associations, or commercial banks. The market for real estate debt instruments is somewhat more formalized—yields on mortgages compete directly with the yields on other forms of investment. The risk factor is usually low since real estate debt is generally secured by real property assets at less than 100 percent of their value. However, this is offset somewhat by the relatively long-term nature of real estate investments, slow capital turnover, and the fixity of yields. The last two factors may retard the flow of funds into the real estate capital market, particularly when overall yields are relatively low. The supply of real estate capital also is affected by government fiscal and monetary policy. The federal government has traditionally sought to make real estate, particularly rental housing, a more attractive investment through the use of accelerated depreciation and other tax write-offs. The Tax Reform Act of 1986, however, took away many of the tax benefits, although the remaining benefits are still considerable. Monetary policy is also an area in which the government has a major impact on the supply of real estate debt. This impact may come indirectly, through changes in overall monetary policy that alter the flow of funds into the real estate market, or it may come directly, through the control of the cost and availability of funds for residential lending institutions. Housing is especially vulnerable to monetary policy because of interest rate sensitivity. As a result, housing construction generally tends to be a leading indicator of economic expansion or contraction.

REAL ESTATE AND THE BUSINESS CYCLE Historically, real estate construction has tended to move in a countercyclical pattern to the general business economy. This was primarily caused by the traditional dependence of real estate on large amounts of institutional mortgage financing. During periods of business expansion, demand increased for capital for other purposes (for example, plant and equipment, working capital, or consumer credit), driving up interest rates and making real estate less attractive to investors.

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As noted in Chapter 3, deregulation of financial institutions has made disintermediation and a credit crunch largely concerns of the past. Savings and loans, the traditional providers of funds to the housing market, can now offer the same rates as other financial institutions. As a result, real estate now can compete on its own merits as an investment, without the artificial constraints on capital availability imposed by a regulated marketplace. Another factor that altered real estate’s traditional countercyclical relationship with the business cycle was the revision of lending policies such that construction lenders can now make loans without permanent take-out commitments. This allows real estate projects to proceed almost regardless of the long-term financial market cycles. Deregulation also led to the evolution of national construction lenders (usually money center banks) that actively compete with each other and with local, regional, and international banks for development projects.

CHAPTER 6

The Economics of Real Estate at the Local Level

I will [tell] the story as I go along of small cities no less than of great. Most of those which were great once are small today, and those which in my own lifetime have grown to greatness were small enough in the old days. Herodotus Greek historian

Although national demand and supply patterns are important, regional and local patterns are what most critically affect the success of a particular real estate project. The strongest of national demand patterns won’t be of much use to an overbuilt project or one caught in a slowly growing region. Conversely, a project in a rapidly growing area with reasonably balanced supply forces can be successful during a period of national real estate inactivity. As noted in Chapter 5, demand for real estate at the local level comes from the expenditures of households for housing and retail services, from businesses for commercial space, and from both groups for lodging and entertainment facilities. Expenditure levels are a function of the number of households and businesses, their relative affluence, and their expectations of the future. The timing of expenditures depends on various supply factors, among them the availability of land, labor, materials, financing, and entrepreneurial talent. These factors, in turn, are directly related to the economic growth of the area.

LOCAL DEMAND PATTERNS What makes one area grow and another stagnate? Certainly, long-term shifts in population have an impact, positive or negative. But it’s something 151 Copyright © 2007 by John McMahan. Click here for terms of use.

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of a chicken-and-egg situation—people won’t move to an urban area unless there is economic activity, and there would be no economic activity without people to produce and consume goods. Historical Growth of Cities The origins of city life are not completely clear. Some have suggested that primitive peoples concentrated in certain locations to defend themselves against outside attack. Others believe the concentration of population stemmed from the desire to participate collectively in religious rites. Still others have viewed early human concentrations as political centers, where surplus agricultural production was collected by the local chieftain.1 In any event, individuals began to group together in relatively central locations to carry out those functions that could best be done in close proximity to others (see Figure 6-1). Settlements soon found they had goods they wished to exchange with other groups. The place of exchange was a convenient, central location—perhaps at the convergence of two trails or along a riverbank. In this manner, the exchange of commodities, or trade, became a major force in preindustrial cities. There was little specialization in the early cities: most people performed similar functions on a relatively uniform basis. Most goods were produced locally, and prices were established by haggling. Since there was not much specialization and since most of the population lived in the surrounding economic rural area, there was little pressure to organize land uses into specialized functions.2 The coming of the industrial age had a dramatic impact on cities. As cities began to produce greater economic surpluses, they found it more efficient to specialize in one part of the production process, particularly if they had a natural resource (for example, iron, coal, or water power) that provided a competitive advantage over other cities. Greater production became possible via specialization. To attract the labor needed to operate these larger units, entrepreneurs had to offer higher wages than the surrounding areas. As people surged into the cities, local tradespeople found increased demand for their wares, and they too expanded operations. Concurrently, a revolution was taking place on the farm. Improved production techniques made it possible for fewer people to produce the same amount of agricultural products. This further accelerated the move to the cities and provided seemingly unlimited labor for expanding urban industries. The cities, in turn, required agricultural production from the 1 Brain Goodall, The Economics of Urban Areas (Oxford, England: Pergamon, 1972), p. 24. 2 Ibid.

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FIGURE

153

6-1

Map of Tell el’Armana.

Source: Arnold Whittick, Encyclopedia of Urban Planning (New York: McGraw-Hill, 1974).

rural areas to survive, and therefore the demand for agricultural production increased. This reciprocity between urban and rural areas wasn’t totally equal, however. Agriculture’s relative share decreased, and there was a continued influx of rural migrants into the cities, long after the demand for rural labor in the cities had begun to decline. As with many of the early trading cities, sites for industrial cities were often selected on the basis of access to good transportation facilities (for example, harbors, rivers, or trails). As cities specialized, however, new and better means of transportation were developed to carry raw materials and finished and semifinished products between various points in the production process (for example, canals, rail, highway, or air). These new transportation systems often led to major shifts in the location and growth of cities. Many cities developed at points where routes crossed or goods were transported. Cities that lacked access to the

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new transportation system used political and economic pressure to be included, for they recognized that exclusion would ultimately bring economic stagnation. It became necessary, as industrialized cities grew more specialized in economic functions, to separate various areas of the city for particular types of land use. Generally, areas nearest transportation facilities— particularly those fronting on oceans, lakes, and rivers—were set aside for industry. As railroads were developed, lines often were built along this industrial corridor on the waterfront. Consequently, much of the most desirable land in America became a tangle of industrial and transportation uses, preventing residential and recreational development on the waterfront. In nonwaterfront cities, industrial uses generally concentrated around natural resources or near transportation facilities, with the wealthy commanding the higher elevations and the less affluent occupying the valleys and plains. Commercial areas generally developed around existing trading centers or along heavily traveled routes. Analyzing Economic Growth During the last two centuries, several theories and analytical frameworks have emerged in attempts to explain the economic growth of cities. Export Base Theory One factor that contributed to the growth of industrial age cities was that they exported more than they imported from other cities and/or the surrounding countryside. Observing this phenomenon, economists developed the export base theory, which holds that export industries (generally manufacturing and those exploiting natural resources) that produce goods sold outside the region usually support a certain number of local service industries. That is, one manufacturing job will support, say, three jobs in retailing, finance, education, and so on. The ratio of the export sector to the total level of local economic activity is often referred to as the multiplier effect, or the degree to which total expenditures rise faster than payrolls in the export sector.3 Not everyone agrees with the export base theory. Some believe that local service industries are the basic economic strengths of an area and that export industries merely provide an interim shot in the arm that must be replaced if the export industry disappears. Others point out that the theory is flawed because clearly the world’s economy grows without 3 Wilbur R. Thompson, A Preface to Urban Economics (Baltimore: Johns Hopkins, 1965), pp. 14, 27, and 28.

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exports; therefore, there is no reason to believe a regional economy must have exports in order to grow.4 The actual situation is probably somewhere between these positions. The growth of national service industries has lessened the relative importance of manufacturing in the overall national economy. Improved communication and transportation systems have reduced the need to be physically near raw materials. But perhaps the most important reason is the increased emphasis of both management and labor on the quality of life. Areas that have climatic advantages and/or well-developed local services such as housing, education, and cultural arts are often in a more competitive position to attract industry. Input-Output Analysis Another way to measure regional growth patterns is by input-output analysis, which involves developing a matrix consisting of regional industries and an export category. After a number of iterations, a final matrix is developed that shows how one additional or marginal dollar spent in a particular industry affects sales in each of the other industries in the matrix. Input-output tables may be useful in projecting how growth in one industry will affect the rest of the region, but often the data used are inaccurate, reducing the value of the results. Shift-Share Analysis Shift-share analysis provides a method for analyzing a region’s growth by looking at two measures of its industry in relation to the national economy. For each regional industry, a ratio is developed that compares the percentage of the region’s jobs in that industry to the percentage of the nation’s jobs in that industry. A regional economy will tend to be healthier if this ratio is greater than 1 for those industries that are also growing on a nationwide basis. This means that regional industry has more than its share of the total nationwide employment in a growing industry. The second measure used in shift-share analysis is the ratio of regional growth in a given industry to nationwide growth in the same industry. The region will be competitive if this ratio is greater than 1, that is, if regional growth rates are greater than national rates. Endogenous Growth Endogenous growth theory incorporates human capital as an input into economic growth. Increase in human capital—skills and educational levels of workers—has a positive impact on productivity and creates positive 4 Charles Wurtzebach and Mike Miles, Modern Real Estate, 5th ed. (New York: Wiley, 1994), p. 41.

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externalities as workers are able to share ideas and experience. Higher levels of human capital have been linked to higher rates of per capita income growth in cities 5 and overall increases in wages for both skilled and unskilled workers.6 Population Migration Patterns As areas expand and develop, shifts in population occur between various areas and, to some extent, within the area. These shifts in population, in turn, accelerate or retard the impact of economic growth. Certainly, the growth of areas such as California and Florida has been influenced by heavy in-migration. Similarly, it is exceedingly difficult to undertake economic development in areas of net out-migration. Regional Migration Several major long-term regional migration patterns have evolved during the last hundred years. The first is the continuing long-term shift of the population to the West. As noted in Figure 6-2, the population of the western states grew faster than other regions every decade of the twentieth century,7 with 8 out of 10 fastest-growing states located in the West. Nevada was the fastest—growing over 1,100 percent—followed by Arizona, Florida, Alaska, and Colorado. California, with a population of over 32 million, became the most populous state in the beginning of the twenty-first century and alone accounted for nearly one-sixth of the total population increase of the United States during the prior century.8 The movement to the West is also indicated by the steady westward movement of the mean center of the nation’s population. In 1790, the center was just outside Baltimore, Maryland; in 1900 it was in Bartholomew County, Indiana; and by 2000 it had moved to Phelps County, Missouri, 324 miles west and 101 miles south from its location at the beginning of the twentieth century.9 Another major long-term trend is the growth of the southern states. This area, which had consistently lost population after the Civil War, began to turn around following World War II. In the 1960s, the South 5 Edward L. Glaeser, Jose A. Scheinkman, and Andrei Shleifer, “Economic Growth in a Cross-Section of Cities,” Journal on Monetary Economics, vol. 36, August 1995. 6 Arthur O’Sullivan, Urban Economics, 6th ed. (New York: McGraw-Hill, 2006). 7 Frank Hobbs and Nicole Stoops, Demographic Trends in the 20th Century, U.S. Census Bureau, Census 2000 Special Report, Series CENSR-4 (Washington, D.C.: Government Printing Office, 2002). 8 Ibid. 9 Ibid.

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FIGURE

6-2

Population distribution by region for 1900 to 2020 (percent). 100% 90%

27.7 28.1 28.1

28

21.7 20.4 27.3 26.2 24.9 24.1

19

18.1

17

Northeast

80% 70% 60%

28.8 27.8 30.5 29.5 34.7 32.5 32.2 31.4

26

24

20.7 22.9 21.8

Midwest

50% 40% 30% 20%

32.3

32

31.6 31.3 30.8

7.4

9.7

31.3

10% 0%

5.4

8.4

10.5

13

30.7 30.9

33.3

36.8 34.4 35.6

38

21.2 22.5 23.4 24.3 15.6 17.1 19.1

South

West

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 Source: U.S. Census Bureau, Population Division.

emerged as a major growth center, with net migration of over 2.5 million. During the 1970s the southern states experienced even greater growth, with net migration amounting to 3.4 million people. More than 73 percent of this growth occurred in Florida, which grew by 2.5 million. The South Atlantic states continued their strong growth pattern into the 1980s and 1990s. Net migration to the area during 1990s was over 4 million people with almost 2 million going to Florida. The total population increase in the South during the 1990s was over 11 million people with 6 million from the start of the twenty-first century. Together, the South and the West represented over two-thirds of the population increase of the United States from 1900 to 2000. The Northeast and Midwest represented the two slowest-growing areas for every decade starting with the 1950s. Both areas experienced negative net migration in the 1990s, although both have experienced slightly positive net migration since the year 2000. The Northeast remained by far the most densely populated area during the twentieth century, and it still is today, with the average number of people per square mile increasing from 130 in 1900 to 330 in 2000.10 The South is the second most densely populated area today with a population density of 115. 10 Ibid.

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Another long-term trend appears to be the movement of Americans out of inland areas to areas near water. By 2003 an estimated 53 percent of the population lived in the coastal counties, an increase of 33 million people since 1980.11 Rural-Urban Migration The next major long-term migration pattern is the shift from rural areas to cities. This trend is one of the major reasons behind the unprecedented growth of metropolitan areas, even in regions with declining in-migration. It helps to explain, for example, the growth of Minneapolis-St. Paul during the 1970s at a time when regional population in the North Central region experienced an overall decline. This shift is a result of expanding economic opportunity in the city and declining requirements for labor on the farm. U.S. farmers are generally regarded as among the most productive in the world, with 1.3 percent of the population producing food not only for domestic needs but for export to other nations as well.12 The migration of Americans from farms to cities was a slow but continuous process. In 1790, only 5.1 percent of the population lived in communities of more than 2,500, and only half of the people lived in cities of more than 10,000. By the outbreak of the Civil War, 1 out of 5 Americans lived in metropolitan areas;13 by the turn of the century, the number was 2 out of 5. It wasn’t until 1950 that the population living in metropolitan areas exceeded the population living in rural areas. By 2000, 4 out of 5 Americans lived in metropolitan areas.14 The migration to urban areas quite naturally resulted in an increase in the number of large cities. Before 1840, only New York, Philadelphia, Boston, and Baltimore had a population of 100,000 or more. In 1840, New Orleans became the next city to surpass 100,000. By 1860, the Midwest began to emerge: the populations of Chicago, Cincinnati, St. Louis, and Pittsburgh reached 100,000. Ten years later, San Francisco became the first major urbanized area in California. By the turn of the century, there were 37 major urbanized areas in the United States with populations of 100,000 or more. By 1920, this number had doubled to 70; it doubled again during the 1950s. In 1970, there were 180 metropolitan areas in the 11 National Oceanic and Atmospheric Administration (NOAA), Population Trends Along the Coastal United States 1908–2008, September 2004. 12 Peter Fronczhek and Patricia Johnson, Occupations: 2000, Census 2000 Brief, U.S. Census Bureau, 2003. 13 U.S. Department of Commerce, Statistical Abstract of the United States, 1987, Table 1093, p. 619. 14 Hobbs and Stoops, Demographic Trends in the 20th Century.

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nation.15 During the next decade that figure doubled once more; by 2000, there were 362 metropolitan areas in the country.16 The magnitude of urban areas is also increasing. Only 4 urban areas exceeded 1 million in population in 1900; by 1970 there were 25; by 2004, 52. As noted in Chapter 4, 14 of the world’s 100 largest metro areas are located in the United States, more than in any other country except China. Urban-Suburban Migration Even in metropolitan areas with declining economic activity, the movement of the population from central city to suburbs has boosted demand for real estate in certain portions of those areas. This phenomenon accounts for real estate activity in metropolitan areas with a declining central city, such as St. Louis, Detroit, and Cleveland. Figure 6-3 illustrates this trend. At the turn of the twentieth century, approximately 38 percent of Americans lived in suburbs, and central cities were growing at a faster rate. This continued until the 1920s, when the FIGURE

6-3

Percent of total population living in metropolitan areas and in their central cities and suburbs from 1910 to 2000. 90 80

74.8

77.5

69.0

70

63.3 60

56.1

50

44.6

40 30 20

21.2

1910

1920

44.8

46.2

50

1980

1990

2000

32.3

32.5

24.8

9.2

30

Central cities

32.8 30.8

7.1

30.3

31.3

31.4

47.8

34.0 28.4

10 0

80.3

13.8

15.3

1930

1940

23.3

1950

30.9

1960

37.6

1970

Suburbs

Source: U.S. Census Bureau, Population Division.

15 Jerome P. Pickard, Dimensions of Metropolitanism, Urban Land Institute, Research Monograph 14, 1967, p. 18. 16 U.S. Census Bureau.

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suburbs began growing at a faster rate. By 1950, 23 percent of metropolitan residents lived in the suburbs. By 1970 the suburbs became dominant; by 2000, 50 percent of metropolitan populations were in the suburbs. Interaction of Population Migration Patterns These three national population migration patterns (regional, rural-urban, and urban-suburban) generally interact. Since population growth usually influences real estate development activity, areas that experience population growth pressures from all three trends can be expected to present more relative development opportunities than those that are experiencing only one or two pressures. We can generalize about the ways in which these trends interact by exploring three hypothetical situations. Situation A. All three basic population migration patterns are occurring in a positive manner: the region is growing, the rural population is migrating to the dominant urban areas within the region (rather than to another region), and people and economic activity are shifting from the central city to the suburbs. An example of this situation would be Los Angeles during the 1950s, Houston in the 1970s, or Atlanta in the early 1970s. ■ Situation B. The urban area is located in a region that is experiencing net out-migration, but the urban area is capturing a large share of the people within the region moving out of rural areas. An example of this would be the twin cities of Minneapolis-St. Paul. ■ Situation C. Both urban and rural populations are leaving the region, and the central city is deteriorating. The only strong demand forces are in suburban areas, because of the exodus from the central city. Detroit in the mid-1980s is an example of this phenomenon. ■

LOCAL SUPPLY FACTORS Local real estate markets are influenced by local supply factors as well as demand patterns. Demand patterns can vary greatly among local areas at any given time. They can also differ from national supply patterns, although such variations do not last indefinitely. Land One of the major factors affecting local real estate activity is the relative availability of land for development. Although there is no land shortage on a national level, within a local area—Manhattan Island, for example—land may be one of the dearest commodities in the local economy.

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Many factors constrain the supply of land. Natural barriers like oceans, rivers, lakes, and mountains often limit the direction in which a city can expand. Sometimes the barriers are artificial: parks, railroad yards, airports, highways, and blighted neighborhoods. Land ownership patterns may prevent the assemblage of sufficiently large parcels for development. In many areas, the unavailability of utilities like water, electricity, and waste disposal facilities may limit development. Finally, the amount of land available for some specific use may be limited by governmental planning, zoning, building codes, environmental controls, and tax policy. If the demand for land strengthens over a continuing period of time, it often becomes economically feasible to overcome some of these supply constraints. Rivers are bridged, lakes and swamps filled, mountains graded, railroad yards crossed or moved, new utility bond issues passed, zoning changed, or taxes modified (Figure 6-4). Pressures may also mount to increase the intensity of use of existing land. For example, residential zoning may be increased from single family to multifamily or it may be FIGURE

6-4

Overcoming land constraints: Copley Place, a mixed-use development in Boston’s Back Bay. The project is built on a platform over a freeway interchange. (Photograph by Bill Horsman)

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changed to commercial. Zoning and building codes may be modified to allow more intensive types of construction. Existing Building Inventories Another factor affecting local real estate development activity is the volume and quality of existing inventories of residential, commercial, and industrial buildings. Volume is important in the short run because extensive inventories created by overbuilding, such as occurred in many markets in the 1980s, can postpone new development activity. The quality of existing inventories also can affect long-term development activity if there are substantial differences between older inventories and new construction. For instance, a portion of the demand for new housing following World War II resulted from significant improvements in design since much of the existing inventory had been built in the 1920s and 1930s. The same is true of office and hotel construction in the central business districts of many cities, in which much of the existing inventory may be functionally obsolete. Labor The supply of local labor is generally a function of national labor trends. Most local areas have large enough labor pools to handle normal development activity. In areas of rapid growth, however, short-term shortages in supply may develop. They are generally corrected by the migration of labor from other areas and/or the expansion of the local labor supply through training programs. The cost of labor may also vary among local areas, depending on the presence and strength of local unions. Lower hourly costs, however, may be offset by a lack of worker skills. Materials The supply of materials varies from one local area to another, depending on the availability of basic ingredients. For instance, areas in the Pacific Northwest are more apt to use wood in construction; areas with a good supply of clay will rely on brick construction. Sand and gravel for concrete are available in most areas and generally aren’t supply problems; nor is steel in most areas. Capital Local capital sources may vary considerably, and they often affect the level of real estate development activity in a particular area. Commercial

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banks often take an aggressive role in providing construction financing and access to long-term financing from other areas. This role is particularly important in small and medium-sized communities, where long-term institutional lenders may not be active on a direct basis. Savings and loan associations and mutual savings banks have been critically important in certain areas providing needed funds for housing. Noteworthy are the savings and loans of California and Florida, which have channeled funds from other capital markets—particularly the Northeast and the Midwest—into housing in these rapidly growing areas. Mortgage bankers may be important in some communities, particularly in “packaging” the financing of highly specialized or particularly complicated real estate projects. Entrepreneurship In most local areas entrepreneurs provide the creative force behind real estate development. The role of these individuals cannot be minimized. John Portman played a major role in the revitalization of downtown Atlanta. Trammel Crow helped to make Dallas one of the major merchandising cities of the nation. Gerald Hines helped to establish Houston as a major corporate headquarters city. Nor can we overlook the earlier impact of the Tishmans and the Uris Brothers on the skyline of Manhattan or activities of Willard Rouse in Philadelphia. These entrepreneurs, and many more like them, creatively marshaled the components of development into building projects that have changed the shape of their communities.

THEORIES OF LAND USE DEVELOPMENT PATTERNS Classical Theories The first four theories were developed prior to and during World War II to explain how land is developed within an urban area (Figure 6-5). Each of these theories is based on empirical observation of the development of cities over a period of time, and each shares certain basic assumptions: a system of private land ownership, a commercial industrial economic base, a heterogeneous population, and economic competition for sites.17

17 Goodall, The Economics of Urban Areas, pp. 109–113.

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FIGURE

6-5

Classical theories of land use development.

I Central business district

II

III

IV

V

e Tra nsition zon

Low

e -income zon

e Mid dle-income zon e Com muting zon

Concentric theory

Sector theory

Axial theory

Multiple nuclei theory

Concentric Theory (1925) This theory, based on studies of the development of Chicago by Ernest W. Burgess, concludes that land uses tend to develop in concentric circles out from a central point. Five zones of land are identified: (1) a central business district (CBD), which is the center of activity from which all other zones radiate; (2) a transition zone of mixed commercial and industrial uses, many of which service the CBD; (3) a low-income housing zone containing the older housing inventory; (4) a middle-income zone consisting of many of the early suburbs; and (5) a commuting zone consisting of the newest suburban development. The main weakness of this theory is its reliance on oversimplified assumptions, such as the CBD being the desired employment destination

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of most area residents and high-income resident preference of the spaciousness of the suburbs over easier access to the CBD. Axial Theory (1932) This theory, propounded by F. M. Babcock, modifies the concentric theory to consider accessibility to the CBD. Accessibility is weighed in time-cost considerations in terms of a given transportation system. According to this theory, land uses tend to develop along the various axes to the CBD in terms of their time-cost relationships. A site farther from the CBD but adjacent to one of the axes would be more valuable than one that is closer but not near the transportation corridor. Except for its consideration of improved accessibility, this theory suffers from the same basic weakness as the concentric ring theory. Sector Theory (1939) First proposed by Homer Hoyt in 1939, this theory modifies the axial theory to consider attractiveness of one transportation corridor over another. A transportation corridor that is established early or that is more accessible would tend to attract more development than one that develops later or is less efficient. Thus, higher-income housing tends to develop in a sector around the preferred transportation artery rather than in concentric rings, as proposed by earlier theories. Although this theory was originally developed to explain residential housing preferences, it relates more to commerce and industry, where accessibility to suppliers or customers is highly critical. It also applies to lowerincome residents who often depend on low-cost transportation to the CBD. Multiple Nuclei Theory (1945) In depending on the assumption that the CBD is the focal point of virtually all economic activity, the previous three theories are weak. While this may have been true of the development of earlier cities, it by no means explains the development of cities after the advent of the automobile. Recognizing this, C. D. Harris and E. L. Ullman proposed the multiple nuclei theory, which holds that there is more than one focal point of economic activity in any urban area and that land use patterns will evolve in relation to the type of centers and proximity of land to these centers. Such centers may include the CBD, industrial districts, cultural centers, strip shopping areas, and major shopping centers. Residential land uses then arrange themselves in relation to the various commercial, industrial, and cultural centers. Of all the classical theories, the multiple nuclei theory comes closest to reflecting the changes in land use development patterns that occurred after World War II and as they exist in most American cities today.

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Perhaps more importantly, its use of multiple activity centers laid the groundwork for the theories that were to follow. Other Theories With expanding use of the computer in the early 1960s, analysts were able to create polycentric theories of land use development, based on the highest and best economic use of a parcel (the highest price people are willing to pay), subject to zoning restrictions. Three theories evolved over the next 20 years and are widely used today in the field of urban economics. Bid-Rent Theory (1961) Bid-rent theory utilizes basic concepts of microeconomics to explain the use of land throughout an urban area. The price of land (rent) depends on the value it represents for different sectors of the urban economy: office, manufacturing, residential, and so on. Whichever sector is willing to pay the most for a particular plot of land determines the use of that land. The maximum bid price depends on the revenue received by the bidder minus nonrent production costs and nonrent costs associated with a particular plot of land (transportation): Land rent (per hectare) 

total revenue
production costs
transportation costs land quantity (ha)

Using the office firm example in Figure 6-6, we can derive the basic rent slope. As distance from the downtown increases, transportation costs of the firm increase, and the amount it is willing to pay for land decreases.18 The slope of the land-rent curve will be different for other types of land uses. Bid-rent theory was first utilized to explain land use in a monocentric city. Monocentric City Theory (1964) The monocentric city theory assumes a single core around which all economic activity is concentrated and a single mode of transportation that businesses and residents can use to get around. Firms and residents compete for land closest to employment. Based on the different slopes of bid-rent curves for businesses and residents, the original model predicted that offices will outbid residents for land within one mile of the city core, residential use will locate between one and three miles from the core of the city, and agricultural use beyond three miles. 18 Assumes perfect competition, uniform population distribution, and uniform productivity among firms.

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FIGURE

6-6

Basic land bid-rent curve. P

Pmax

Rent per acre ($)

Pmax — maximum price the firm is willing to pay for land located in the central business district

Land bid rent curve

Dmax — maximum distance from the central business district the firm is willing to locate at if the rent is equal to 0

Dmax

0

Distance from the central business district

D

In order to explain the dominance of low-income residences close to the city core, the model incorporated different sloping rent curves for different households, based on the trade-off between benefits gained from moving away from the center and increases in transportation costs (Figure 6-7). While the monocentric model provided a good explanation for land use patterns of cities of earlier periods, it was not relevant to postwar America where the widespread use of the automobile encouraged the creation of additional cores of economic activity, thus changing the monocentric structure of cities. Polycentric City Theory (1982) Developed by Fujita and Ogawa in 1982, the polycentric city model departs from a linear relationship between distance and transportation costs assumed in the monocentric model. Instead, it assumes that a benefit from interaction of two firms is a negative exponential function of the distance between them. This assumption results in the exponential increase of transportation costs as the distance from the city center increases and allows formation of multiple business districts and multiple equilibriums of land use patterns. With decentralization, manufacturing firms moved out closer to major transportation highways. The manufacturing land bid-rent curve is therefore going to be less steep with respect to distance from CBD.

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FIGURE

6-7

Allocation of land in a monocentric city.

P

Rent per acre ($)

Office and manufacturing Low-income residential Residential Agricultural

0

1 mile

D

3 miles

Distance from the central business district

FIGURE

6-8

Allocation of land in a polycentric city.

P

Office

Rent per acre ($)

Manufacturing Manufacturing workers CBD workers Manufacturing workers Agricultural

0

d1

d2 d3 d4 Distance from the central business district

Source: Arthur O’Sullivan, Urban Economics, 6th ed. (New York: McGraw-Hill, 2006).

d5

D

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169

Households prefer to locate close to places of work, commuting costs being the main consideration. However, they are also willing to make trade-offs between commuting and appealing living areas—with less density, less pollution, and more living space than the CBD. Also, manufacturing employees will not need to commute to the CBD since manufacturing businesses tend to locate farther from the city center than office and retail. The agricultural curve is really a flat line since the value of the parcel of land is in the crops it produces (livestock it feeds) and it does not depend on the central or peripheral location. Equilibrium allocation of land for an urban area of a city that is not monocentric is presented in Figure 6-8. In this figure rather than gravitate toward the central business district, office and manufacturing sectors have different centers of economic activity based on proximity to desirable location factors (transportation, information, and other firms). Employees of different sectors tend to gravitate to their respective employment sectors.

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CHAPTER 7

The Economics of the Individual Parcel

Every man has by nature the right to possess property as his own. Pope Leo XIII (1810 to 1903)

W

ithin the urban framework of each metropolitan area, economic, social, and political forces operate that influence the use and, ultimately, the value of each individual parcel of land. These forces are translated into value through the sale or lease of raw land or the development and sale or lease of improvements on the land. Generally, real estate values exist when the income stream generated by the sale or leasing of the property exceeds the costs involved in developing the stream. In some cases, such as a park, the surplus generated may be expressed in terms of the satisfaction of public needs rather than in terms of monetary return.

THE CONCEPT OF HIGHEST AND BEST USE The relative ability of a parcel of land to generate a surplus of returns and/or satisfaction over its costs of utilization is called its use capacity. Assuming the same quality and type of improvement, the use capacity of an individual parcel depends upon its accessibility to markets vis-à-vis other parcels that have the same physical and legal characteristics. Generally, the closer the parcel is to markets for its particular use, the higher its use capacity—that is, the higher the real estate value that ultimately can be created. 171 Copyright © 2007 by John McMahan. Click here for terms of use.

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The ability of a given parcel to achieve its use capacity will vary over time, depending on market demand, environmental conditions, legal constraints, and the competition of other parcels. It is therefore necessary to evaluate the highest and best use of a parcel at any given time. Land is generally thought to be at its highest and best use when it is employed for purposes that have the highest comparative advantage or least comparative disadvantage in relation to possible alternative uses. In some cases, the highest and best use of a parcel at any given moment may be considerably different from or less than its use capacity. For example, a large, relatively flat tract of land may be ideally suited for industry, but limited industrial demand may dictate residential development as the highest and best use. A property’s highest and best use may change over time as a result of changes in demand, technology, social values, or the quality of the land itself. In general, office and retail uses generate the highest economic returns and usually can outbid other uses for a particular parcel of land. Transient commercial uses generate a wide range of returns, depending on the type of market and location (such as a downtown hotel, major highway motor hotel, or hotel). Residential uses are generally next, followed by industrial, agricultural, and forestry uses. There are, of course, exceptions to this hierarchy of land use priorities. For example, residential uses sometimes can outbid office or retail uses, particularly in rapidly growing areas with limited land resources and/or stringent land use controls. Not all property is utilized at its highest and best use. Because leases generally tie up a property for some time, it may be difficult to develop a property for its highest and best use immediately. For instance, in many downtown areas, long-term leases on parking lots or small commercial structures may thwart major commercial use of the property, even if commercial demand is strong. At the other extreme, properties may be overimproved in terms of their current highest and best use. An example is the older industrial and commercial area in which major structures are no longer supported by market demand, but demolition costs are too great to tear them down.

THE IMPORTANCE OF LOCATION There is an old saw in real estate that the three most important factors in determining a good site are (1) location, (2) location, and (3) location. While other factors are involved, it’s amazing how often the basic truth of this homily is forgotten. A well-located project can often survive economically, even if its development is poorly planned or its management

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weak. However, a project that is not well located may fail even with the best of planning and management. We noted in the Introduction that two basic characteristics of land are immobility and nonsubstitutability. Each parcel of land is unique and has only one location. Location, therefore, is an important element in determining land value. Certain parcels have an intrinsic locational value as a result of a good siting, particular soils or mineral deposits, or a favorable exposure to the sun. Relative Locational Value Generally, the relative locational value of a parcel is what determines value. Relative locational value is the combination of the spatial proximity of a parcel to other parcels and the linkage between them. Spatial features may be desirable or undesirable in nature. Proximity to desirable uses generally increases a parcel’s value; proximity to undesirable uses or features generally reduces value. As shown in Figure 7-1, several types of spatial proximity influence relative locational value. Proximity to physical features is often important.

FIGURE

7-1

Relative locational factors, residential site.

Environmental influence area

Shopping center Lin

ka

ge

Subject site

Linkage

ka

Lin ge

e

ag

k Lin

School Employment

Ocean

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In beachfront recreational areas, land on or near the water commands higher values than more distant land. Proximity to lakes, rivers, mountains, or deserts may increase value; proximity to floodplains, earthquake fault zones, or fog pockets may reduce value. Proximity to markets is also important. A residential development must be within a certain commuting distance to employment opportunities. Shopping centers must be within a certain proximity to sufficient resident buying power to support retail operations. Office and industrial facilities must be close to labor resources and support facilities. Hotels must be near other uses that generate guestroom demand. Without proximity to markets, other locational factors become largely irrelevant. A third factor is proximity to public services, such as water, sewers, electricity, telephone, and other utilities. In recent years, the availability of water and sewers has become particularly critical in determining the feasibility of residential developments. In some areas, proximity to these services actually determines land values, a situation that has accelerated as public agencies have learned to provide or withhold these services to effectively control and/or direct population growth. As concern for more efficient use of energy grows, proximity to sources of reasonably priced power is also becoming important in determining a site’s value. Spatial proximity in itself will not create value unless there is effective and reliable linkage between the subject parcel and other parcels. Linkage is the ability to move goods and people between two points. In turn, linkage requires a transportation system and accessibility to the parcel. The transportation system may be as mundane as a sidewalk or path or as sophisticated as a rapid transit system. The most common type of system today is the private vehicle, street, and highway system (Figure 7-2). The transportation system is useless to a particular site, however, unless its users have accessibility to the system from the parcel. For example, a frontage parcel located between interchanges on a new limited access highway may be less valuable than one located off the highway but near one of the interchanges. Increasingly, linkage is being measured in time rather than physical proximity. Site A’s nearness to a particular freeway is of little relative value if traffic congestion is so great in that area at the peak hour that it actually takes more time on the freeway to reach site A than competitive site B, which can be reached by surface streets or rapid transit. Commuters willingly may increase their commuting costs by driving out of their way to reach freeways and arterials that will reduce their overall commute time.

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There is also evidence that users are willing to make site decisions on the basis of planned accessibility as well as existing transportation systems. Construction projects often proceed in advance of freeways or rapid transit systems being built. The major consideration appears to be the certitude that the facility will be developed within a certain time horizon. Cost of Friction The cost of a single movement along a given linkage is expressed in terms of the disutility, or cost of friction, in moving goods or people between two points. Ratcliff identifies four major components of the cost of friction: Transportation costs. The direct costs of transportation can be measured in fares paid or in the vehicle operating costs. ■ Travel time. This factor is a function of the available transportation facilities, street system surfacing, traffic controls, and congestion. The time cost depends on the value placed on the time of the person who is traveling or on the disruption of schedules, loss of business, or spoilage caused by delays. ■ Personal aggravation. The discomfort of travel, the annoyances of delay and congestion, and the sense of danger are disutilities that increase friction. ■ Parking facilities. For most automobile trips, terminal facilities are as essential to the use of the motor vehicle as streets. Parking rates also may be a consideration.1 ■

Trip Frequency The economic importance of a given linkage is the product of the costs of friction for each individual trip times the frequency of the trips undertaken. A linkage having relatively high costs of friction but requiring infrequent trips may be more attractive than one involving lower-cost, but more frequent trips. As an example, the higher costs of large bulk shipments by rail may prove more attractive than lower-cost, but more frequently needed, shipments by truck between the same two points. Value Trade-Offs In making a site purchase or use decision, there are trade-offs between the cost of linkage and the value of the parcel. For example, in buying a home, 1 Richard U. Ratcliff, Real Estate Analysis (New York: McGraw-Hill, 1961), p. 69.

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FIGURE

7-2

Various forms of linkage. (a) Pedestrian skywalk in downtown Cincinnati, Ohio. (Paul L. Wertheimer) (b) Bicycle trail on Amelia Island Plantation, Nassau County, Florida. (Sea Pines Company)

(a)

(b)

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FIGURE

7-2

Various forms of linkage. (Continued ) (c) A maze of freeways surrounds downtown Dallas, Texas. (Brookhollow Corporation) (d ) Bay Area Rapid Transit (BART) car in Walnut Creek, California. (Bay Area Rapid Transit)

(c)

(d)

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an individual may trade off the lower housing costs in a neighborhood farther from his or her job against the added commuting costs. A shopping center developer may locate beyond an established residential area to obtain lower-value land (and therefore lower operating costs). An industrial firm may build a new facility on lower-cost land in a distant suburb, trading off increased employee commute costs. Surrounding Environment Another location factor is the environment influence area within which the site is located. Spatial proximity and good linkages are of little value if the environment surrounding the site will dissuade potential users from coming into the area. A classic example is a potential shopping center site in a good market area, adjacent to a freeway and public services, but located in a physically deteriorating, crime-ridden neighborhood. Future Expectations As with transportation systems, future expectations of change may be sufficient to motivate near-term investment decisions in environmentally depressed areas. If there is strong evidence that change will occur—urban renewal, upgrading of residential areas, and so forth—the negative aspects of present environmental conditions may be offset by future expectations. Site Exposure A final locational factor primarily affecting commercial properties is the exposure of a given parcel of land to passing pedestrian or vehicular traffic. Value may be created in terms of direct exposure to potential customers, such as a motor hotel located along a heavily traveled highway or a retail shop on a busy street corner.

THE REAL ESTATE MARKET If real estate were a highly organized, smoothly functioning market, the price of a property would accurately reflect its value. Theoretically, anyone wishing to know the value of a property would only have to look at price quotes in the morning paper, as with the stock or bond markets. Unfortunately, the market for real estate is inefficient, and often there are serious short-term dislocations between price and value. It’s essential, therefore, to understand how the real estate market functions and how the pricing mechanism operates.

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Market Characteristics In its most basic terms, the nation’s real estate market is the sum of all buying, selling, renting, and investing transactions involving real property. Since real estate has a fixed location, real estate markets have tended to be local in nature, although this has been changing in recent years with the emergence of large syndications, REITs, and national development corporations and with the activity of foreign buyers in the marketplace. Real estate transactions also tend to be relatively complicated legally and generally private in nature. Since the market lacks any centralized control, it is likely to be disorganized and fragmented. Consequently, the forces of supply and demand do not always function smoothly and may result in significant dislocations. Submarkets No one single real estate market exists; rather, submarkets are generally organized around the type of real estate to be sold and the characteristics of the purchasers. As depicted in Figure 7-3, each submarket has its own set of buyers and sellers, its own legal framework to govern relationships,

FIGURE

7-3

Real estate submarkets. Investment property market

Retail

Apartments

User property market

Office

Industrial

Office Surplus space leasing

Hotel

Industrial

Houses Hotel

Raw land market

Retail

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exclusive methods of financing, and specialized brokers and other individuals to handle the transactions. Raw Land This submarket deals with land that may be several years away from development. The land is generally located some distance from existing urban or recreational areas, and it is usually completely raw or being utilized for some type of agriculture. The seller is generally a farmer or other long-term landholder. The buyer is generally a speculator who plans to sell the property to a developer or another speculator. The speculator is usually an individual who is investing for long-term value appreciation. In recent years, the entry of large syndicators, public corporations, and other intermediaries has given the raw land market a somewhat institutional flavor. The major investor, however, is still usually an individual. During the 1950s and 1960s, the long-term investment nature of land speculation was further enhanced by such tax benefits as prepaid interest, depreciation of agricultural resources, and capital gains treatment on sale. Most of these tax advantages have been eliminated so that the speculative land market is once more directed primarily at long-term appreciation. Prices in this market tend to fluctuate widely in accordance with events in the local economy and/or the national economy and the amount of buying pressure. Most properties are sold on liberal terms, with the buyers making a small down payment and the sellers financing the balance. Holding periods tend to range from 6 to 10 years. User Properties The second type of submarket is composed of individuals and institutions wishing to buy or rent properties for their own use. Individual home buyers make up the largest segment of this market, which is highly organized on a local level, with extensive advertising of available properties, established legal procedures, and a strong brokerage network. Prices tend to move within fairly close ranges. Financing is largely institutionalized. Business firms also seek out properties for their own use. This may involve purchasing land for development, entering into “build-to-suit” arrangements with developers, or purchasing or leasing existing improved properties. Although this market is generally less organized than the residential user market, it tends to be more sophisticated. Available properties are usually well advertised, but individual purchase or lease arrangements may vary significantly in terms of legal framework, financing terms, and rental or sales prices.

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To provide for future expansion, user firms also may purchase or lease more space than they need and sublease the remaining space to other users. In this manner, they become both users and investors. Investment Properties A third submarket is for improved properties purchased for investment purposes. Sellers tend to be developers or other investors. Buyers are likely to be relatively sophisticated individual or institutional investors who are weighing real estate investments against other investment alternatives. The major interest of the buyer is usually the annual yield produced by the property and the possibility of appreciation. The market is relatively unorganized, with a variety of intermediaries in addition to brokers. Prices tend to fluctuate considerably, depending on the expectations of investors regarding the future in general and specific properties in particular. Legal procedures are somewhat flexible and often reflect the unique desires of buyers and/or sellers. Financing tends to be institutionalized, and in some cases institutions are the major investors. Pricing Mechanism The maximum price that buyers will pay and the minimum price that sellers will accept are determined by the pricing mechanism. Floor and Ceiling Prices Sellers of real property generally have a minimum, or floor price, below which they will not sell. It is usually subjective and varies among local areas, classes of properties, and individual sellers. The floor price may reflect the current level of income or satisfaction the seller is enjoying, the prices received by other sellers on the market, or, in the case of a user property, the cost of alternative facilities.2 This floor price may change over time particularly if the property has been for sale for an extended time (see Figure 7-4). Buyers also place an upper limit, or ceiling, on the price they will pay for a property. Home buyers generally relate this price to the amount of the down payment required and the annual or monthly debt service as related to disposable income. Most families hope not to pay more than 30 to 40 percent of their disposable income for housing. Commercial and industrial users ordinarily fix the ceiling price that they are willing to pay on the basis of anticipated revenues and operating costs. 2 Brian Goodall, The Economics of Urban Areas (Oxford, England: Pergamon, 1972), p. 54.

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FIGURE

7-4

Floor and ceiling prices.

Investors generally set a maximum price on the basis of its impact on the annual yield generated. In essence, they are establishing a minimum yield they wish to receive. This minimum yield takes into consideration their expectations about the future, the degree of risk inherent in obtaining the yield, and the yields obtainable in alternative investments. Tax considerations also may influence the investor’s determination of minimum yield.3 Market Prices A real estate transaction will occur as long as at least one buyer has a ceiling price higher than the floor price of the seller. Market prices will range between the established floor and ceiling prices, depending on the number of buyers and sellers. If there are a large number of buyers in the marketplace at one time, market prices will tend to approximate the ceiling price level. If there are a large number of sellers, market prices will approximate the established floor price. If a disproportionate number of 3 Ibid., pp. 53, 54.

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buyers or sellers exist for a sustained period of time, they will tend to bid up the price (more buyers) or depress the price (more sellers), and the floor or ceiling price levels will change. Movements in price also may affect supply. An increase in market price levels is likely to increase the rate at which properties are brought into the market. A decrease in market price levels may convince sellers to hold out for a better price, thereby reducing the supply of available properties. Changes in supply, in turn, ultimately affect the market price levels. An increase in supply will tend to depress market price levels; a reduction in supply, to drive prices upward.4 As in most markets, the pricing mechanism generally results in equalizing demand and supply over the long run.

PURCHASE TRANSACTIONS The ownership of property in the United States rests on a foundation of constitutional and statutory laws and judicial interpretations that have been formulated and tested through the years. It’s therefore advisable that an attorney be involved in the purchase of real property for development or investment purposes. The attorney can advise the prospective buyer of his or her legal rights, as well as handle many of the legal questions and, in some cases, certain aspects of the purchase negotiations. Even with an attorney involved, however, it’s still important for the prospective buyer to have a general understanding of the basic legal aspects of property acquisition. Legal Description Land is of little economic value unless certain legal rights can be ascribed to specific parcels. Distinguishing one parcel of land from another is accomplished through a survey that measures and delineates land and allows for it to be described in legal terms. In the early stages of America’s development, legal descriptions took the form of metes and bounds, through which properties were described in terms of their relationship to landmarks and natural objects such as rocks, trees, and streams. As the number of property owners increased, the rather cumbersome metes and bounds system gave way to the rectangular survey system (see Figure 7-5). North-south meridians and east-west baselines were established

4 With increasing government regulation of land use, prices are often stated in terms of dollars per allowable unit of development (for example, dollars per housing unit or dollars per FAR square foot).

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FIGURE

7-5

Rectangular survey system. W ₁₂ of NW ₁₄ of NW ₁₄ of Section 9 of Township 1 north, Range 1 west of fifth principal meridian

NE ₁₄ of NW ₁₄

NE ₁₄ of Section 9

S ₁ ₂ of NW ₁₄ S ₁ ₂ of Section 9

Section

Township

Baseline

Fifth principal meridian

at 6-mile intervals. The intersections of these lines created a township of 36 square miles; each square mile was called a section. Each section was then divided into 640 units referred to as acres.5 Land in urban areas is generally defined by the platting process, which subdivides the city or town as new development is proposed. A specific plan for the development of a subdivision (called a tract map, sub5 Recent advances in satellite technology and computer imaging make it possible to establish ownership of land parcels more accurately and effectively than ever before.

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The Economics of the Individual Parcel

division map, or plat) that indicates streets and other public areas is publicly recorded. The remaining land is identified as blocks, and within each block are individual lots. The lots, in turn, may be further subdivided by means of lot splits. Title Once the land parcels have been identified, the ownership rights, or title, accompanying the parcel are described. Real estate ownership rights involve not only the surface rights to the parcel but may also include the air rights and subsurface rights (minerals, water, oil, and other natural resources). These ownership rights, or estates, can take many forms, the most common of which are freehold, leasehold, and easement. Freehold estates give the owner legal title of the land and exclusive right to its possession. Freehold rights may be of unlimited duration ( fee simple) or for the life of a specific person (life estate). Leasehold estates convey the right to use and/or improve the land for specified periods of time (the term). An easement conveys the right to use property, either exclusively or nonexclusively, for specific purposes without a conveyance of the underlying estate. As James Graaskamp has pointed out, real estate rights include both space and time components: Real estate can be defined generally as space delineated by man, relative to a fixed geography, intended to contain an activity for a specific period of time. To the three dimensions of space (length, width, and height), then, real estate has a fourth dimension—time for possession and benefit. This can be referred to as a space-time characteristic. This space-time concept is illustrated by the terms apartment per month, motel rooms per night, square footage per year, and tennis courts per hour.6

Title to private property is generally subject to public restrictions that are enforceable under the government’s police powers. Activities that can be regulated under police power include the type of land uses (planning and zoning), the type and quality of new construction (building codes), and the quality of existing improvements (fire and health codes). To raise monies to pay for its services, the state has the right of taxation of private property. If property owners do not pay these taxes, they face the prospect of losing ownership rights. Governmental units also can acquire private property for public purposes without the owner’s consent,

6 James A. Graaskamp, Fundamentals of Real Estate Development, Development Component Series (Washington, D.C.: Urban Land Institute [ULI], 1981), p. 1.

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through the power of eminent domain, provided that the owner is justly compensated.7 Certain private restrictions may also affect property ownership. Legal covenants and restrictions established earlier may affect subsequent owners. For example, a property may carry a covenant restricting its use to residential purposes only. Generally, the courts have upheld covenants and restrictions, provided that they are not otherwise illegal.8 A property may also be subject to an easement or right-of-way giving another property owner, public agency, or utility company the right to use part of the property for roads, utility lines or cables, or other special purposes. An encroachment exists when a building or other improvement extends across the property line or into a public right-of-way. In earlier, simpler times, mere possession of property was sufficient evidence of ownership. As rights of ownership grew more complex, however, a more formal, legal method of protecting title was needed. Thus was born the abstract of title, in which the chronological history of the ownership of a parcel of property is indicated in a public place for all to see. By looking at this abstract, an attorney or title company can determine—by means of a title search—whether the title to the property is clear or defective. The title search also indicates all of the public and private restrictions on the title that are listed in public records. The owner can purchase title insurance to protect himself or herself against possible defects that might exist in the title. This insurance doesn’t guarantee that the title is clear, but it does guarantee to pay damages arising from any title defects not indicated in the insurance company’s title research and report. Institutional buyers frequently require an American Land Title Association (ALTA) extended coverage policy that involves a survey of the property, ensures that the ownership rights are true to the survey, and insures a purchase against certain other matters that may not be disclosed in the public records. When the property is sold, a deed is used as evidence of transfer of title ownership to the new owner. If the previous owner had full rights to the property, a general warranty deed may be issued in which it is warranted that the title to the property is “good and merchantable.” Some sellers may be willing to give only a special warranty deed (a grant deed) that warrants that the seller has not done anything to render the property unmarketable but that contains no general warranty as to the actions of 7 U.S. Supreme Court rulings on the takings issues are discussed at the end of Chapter 2. 8 The U.S. Supreme Court has held that covenants and restrictions based on racial or religious grounds are unconstitutional.

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previous property owners. If the previous owner had less than full rights, a quitclaim deed will transfer whatever rights the previous owner did possess. Property Transactions Deposit Receipt Once the decision has been made to try to purchase a piece of property, the prospective buyer makes an offer. The prospective buyer makes his or her offer usually by giving the seller a deposit receipt (also called a binder or offer to buy) that spells out the basic terms of the offer. The deposit receipt is ordinarily accompanied by a cash deposit, generally 10 percent of the anticipated down payment. If the terms of the offer are acceptable, the seller signs the deposit receipt and takes the deposit. If the terms are unacceptable, the seller may make a counteroffer, indicating the terms and conditions that would be satisfactory. In this manner the buyer and seller horse-trade until they reach a mutually acceptable deal or break off negotiations. Letter of Intent In recent years, institutional purchasers of real estate have utilized a nonbinding letter of intent rather than a deposit receipt or offer to buy. The letter of intent identifies the business aspects of the transaction such as the price, terms, deposit, and closing conditions, as well as the information that will be required to perform the necessary due diligence prior to closing. Because it is nonbinding, the letter of intent does not usually require the involvement of an attorney, which can thereby save costs and possibly prevent a disagreement over legal matters before an agreement can be reached on the business terms of the transaction. Depending on the creditability of the buyer, deposits may not be required until the due diligence has been completed and the transaction approved by the buyer. Purchase Agreement Once a deposit receipt or letter of intent has been accepted by both parties, attorneys for either the buyer or seller (usually the buyer) prepare a purchase agreement or contract of sale. This purchase agreement outlines in detail the terms of the sale and the actions required by both buyer and seller to complete the transaction. Generally, a purchase agreement will include at least the following items: ■ ■

The names of the parties to the transaction A legal description of the property

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Terms of the sale, including the total price, amount of the deposit, method of payment, and the amount and type of any mortgage financing that may be involved ■ A listing of any known encumbrances or title defects and a statement of the buyer’s willingness to take title subject to these items ■ A description (or copy) of the deed that will be utilized ■ A list of any personal property or fixtures that are a part of the sale ■ A list of any warranties or guarantees on the part of either the buyer or seller ■ A list of the due diligence activities to be accomplished by the buyer ■ The assignment to the buyer or seller of responsibility for the various costs of the transaction ■ The method of establishing proration between the buyer and seller of continuing expenses such as property taxes and assessments ■ The time and place for the transfer of title ■

Additional items may be included by either the buyer or the seller, depending on the terms of the deal, the state in which it is being consummated, and the requirements of other parties such as the lending institutions and/or public agencies involved. Often a variety of contingencies for consummating the transaction will be specified, including, for example, that the buyer can obtain the appropriate governmental approvals or the desired financing or that the results of soils tests or engineering reports are acceptable. Due Diligence Once a purchase agreement has been executed, the buyer begins due diligence activities. These will generally include the following: Reviewing the title report (usually obtained from ALTA) and the underwriting of any exceptions ■ Physically reviewing the property, including its architectural design, structural engineering, and mechanical and electrical engineering, as well as determining if asbestos or toxic waste is present ■ Reviewing all of the leases and contracts to establish that they are as represented by the seller ■ Obtaining a letter from the local political jurisdiction confirming that the property conforms to local zoning and other land use controls ■

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Many buyers take additional due diligence actions such as these: Auditing the books of account (if buying an existing building) Interviewing the tenants ■ Conducting a market analysis ■ ■

In performing its due diligence activities, the buyer is seeking to confirm that the property is as represented by the seller and that there are no significant problems with the property that would offset its value or prevent proceeding with the transaction. At this stage, if relatively minor problems are encountered, the buyer and seller are usually able to adjust the transaction through changes in price or terms and then proceed. However, if major problems are uncovered, the buyer may decide to terminate the transaction. If deposits have been paid, they are generally returned at his time. Transfer of Title Once due diligence has been completed and approved by the buyer, the next event in the purchase transaction is the actual transfer of title, or closing. In some states the traditional closing may involve the physical presence of all interested parties or their appointed representatives (Figure 7-6). Each of the parties produces the documents required by the contract of sale. These documents are reviewed by the other parties and, if acceptable, executed. Closing costs are calculated and agreed to between the parties. If all the documents are in order, the seller signs the deed and gives it to the buyer, and the buyer provides the necessary funds, thereby completing the transaction. A final step is the preparation of a closing statement, indicating the allocation of closing costs between the parties. In many states the transfer of property is handled by an independent third party through an escrow arrangement. The third party, or escrow holder, has custody of the monies and documents, such as the deed, and it also makes certain that all elements of the contract of sale are successfully completed. Generally, a set of escrow instructions is drawn up as part of the purchase agreement and agreed to by both parties. If circumstances change during the escrow period, these instructions can be amended, provided both parties agree. Once the escrow holder determines that all closing conditions have been satisfied, the monies and documents connected with the transaction are released to the various parties, accompanied by a closing statement. If the buyer hasn’t definitely decided to purchase the property, he or she may enter into an option agreement with the seller, which allows the

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FIGURE

7-6

Not all closings are as well attended as was the December 1961 closing of the sale of the Empire State Building to a syndicate formed by Lawrence A. Wein. (The Empire State Building Company)

buyer, for a consideration, to buy the property at a prearranged price within a specified period of time. Less binding is a right of first refusal. Here, the property owner agrees to give the holder of the right of first refusal a chance to buy the property before the owner accepts an offer to purchase from a third party. A difficulty for sellers trying to use this approach is that it may complicate the sale of the property because most buyers do not want to spend time evaluating property that may go to someone else.

PA R T I I I

Analyzing Market Demand

Copyright © 2007 by John McMahan. Click here for terms of use.

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CHAPTER 8

Residential

But what on earth is half so dear—so longed for—as the hearth of home? Emily Brontë A Little While

Once a parcel of land has been acquired or optioned, the focus shifts to formulation of a development program to create the greatest economic value possible that is consistent with aesthetic, environmental, legal, and market considerations. The first step is to determine consumer demand for each potential land use on the site. This chapter, the first of five dealing with market analysis, is concerned with assessing demand for residential land uses. Residential land uses comprise the broadest and most prevalent type of urban land use. Properties may be defined by their legal basis of use (owned versus rented), location (urban, suburban, rural), or density (single family, midrise, high rise). Occupiers are usually defined by their demographic profile (age, sex, family size, employment status, income, ethnic background, and so on). A primary home is where people live most of the time. For most people, it is their only home; the growth in the number of second home owners represents a still limited segment of the population. Primary housing includes both homes that are owned by the occupant and those that are rented, the predominant form being apartments. Ownership housing can be in the form of individual buildings on a single piece of land usually referred to as single family or in the form of multiunit buildings such as condominiums or cooperative apartments. Rental 193 Copyright © 2007 by John McMahan. Click here for terms of use.

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housing can involve a single-family house or, more typically, garden, midrise, or high-rise apartments.

OWNERSHIP HOUSING Single-family housing is the most common form of ownership housing in America. The most prevalent type is a home developed to fit on an individual lot in which the occupant owns or rents (through a ground lease) the land on which the building is located. The legal process of creating individual single-family lots is known as subdivision—literally dividing up a large parcel of land into several smaller parcels. Since single-family housing usually requires a large amount of land and is often produced in relatively large quantities, market analysis should focus on the overall magnitude of demand in the local market area, the competitive environment, and the intrinsic qualities of the subject site. If demand is strong, a project should prove successful, provided that it is well planned and designed, competitively priced, and creatively merchandised. Relatively weak demand situations require looking for “voids” in the market, usually suggesting smaller projects. The purchase of a single-family home is usually treated very seriously by the buyer, as it is the largest investment most people make in a lifetime. Furthermore, a person’s home and neighborhood often reflect personality and self-image. For this reason, buying or selling a home is often an emotional decision, fraught with ambiguities, irrationality, and indecision. Market analysis for primary housing, therefore, must effectively blend quantitative analysis with an understanding of consumer psychology. As noted in Chapter 5, overall residential demand in a local area is determined by the interaction of household preferences and expenditures (demand) with the quality and availability of existing inventories (supply). Within overall demand patterns, the type of housing is a function of the household characteristics (age, family size, incomes, lifestyle preferences, and so on), housing density patterns (zoning, land values, transportation systems, and so on), and costs of production (land, labor, materials, infrastructure, and so on). On a more practical basis, these patterns are further influenced by mortgage costs and availability, developer capabilities, government tax policies, environmental pressures, and myriad other factors that may vary from area to area and period to period. In evaluating market demand for single-family housing, the potential project must complement local housing demand characteristics in a particular geographical area. Too much emphasis on national or regional housing patterns may create a noncompetitive project within a solid local

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market. On the other hand, ignoring these broader patterns may make it hard for an otherwise sound project to “tough out” a weak housing market. Establishing the Market Area A residential market area has been defined as that geographic area “within which all dwelling units are linked together in a chain of substitution.”1 This means that all dwelling units of a particular type and price are mutually substitutable by a prospective buyer. In discussing how the potential market area is established, we have made the assumption that the subject site has already been acquired, optioned, or otherwise brought under the control of a residential developer or land investor. While it is not always possible to achieve this theoretical market area in practice, it is possible to reasonably define an area in which prospective buyers would tend to shop for housing to satisfy their needs. The first step in determining such an area is to establish the geographic market from which the subject site could draw potential demand. Figure 8-1 graphically represents the steps in establishing a residential market area. The first is to establish the areas in which potential buyers might be employed. This analysis requires an assumption as to the maximum time that most people would devote to daily commuting. In automobiledominated cities, commuting usually involves the time it takes to drive to and from work. In areas with extensive public transportation, the process may require assumptions about the modal split between one form of transportation and another. Based on assumptions regarding commuting time, a map can be drawn indicating the geographic area that can be reached within this time from the subject site. This is the market area, as illustrated in drawing 1 in Figure 8-1. Other geographic areas that will provide competition to the market areas should also be considered. These are the competitive areas (drawing 2). Judgmental adjustments should then be made to reflect possible changes that might affect the shape of the market area. For example, the opening of a new freeway or transit line could alter a resident’s commute time and, therefore, expand the market area. Similarly, concern over excessive traffic congestion could reduce commuting time assumptions, thereby reducing the market area. Physical constraints, such as mountains, oceans, and lakes, also should be considered, as well as political subdivisions such as municipal 1 Institute for Urban Land Use and Housing Studies, Columbia University, New York, Housing Market Analysis: A Study of Theory and Methods, Housing and Home Finance Agency, Washington, D.C., 1953, Chapter II.

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FIGURE

8-1

Delineating a residential market area.

Freeway

Transit

Site Freeway

Freew ay

Site

Major employment center

30 minutes 1. Establish the market area

2. Establish the competitive area

Market area

Site

Site Competitive area

3. Fit to available data sources

4. Market and competitve areas

boundaries or, when the target market includes families with children, school district boundaries. Finally, defined areas are adjusted to available data collection units (drawing 3), as defined by the U.S. Census Bureau and state and local planning agencies. The resultant area and related data should then be reviewed judgmentally so as to avoid incorporating any specialized situations that might skew the data. For example, census data may vary from one census to another because of changes in tract boundaries or collection techniques. Generally, these specialized situations are explained in the published material or can be identified by the responsible public agency.

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Socioeconomic Influences Once a market area for the subject site has been established, pertinent socioeconomic data relative to the market area are analyzed. These data generally fall into one of three categories: (1) general socioeconomic data that, properly interpreted, give the analyst an understanding of the market area; (2) dwelling unit data that provide an indication of housing supply; and (3) field surveys that indicate the design, planning, and merchandising strategies of competing projects and the degree of success of various elements of these strategies. Employment Employment-related data generally help establish the “profile” of the market area. Diversification of industry is important; a housing market dependent on a single industry may experience economic disruptions (for example, strikes, loss of contracts, or material shortages) that can have a negative impact on housing demand. The type of industry is also important. Usually, finance, insurance, transportation, public administration, and service industries are less volatile than manufacturing, mining, forestry, fishing, agriculture, construction, and wholesale and retail trade.2 A housing market that depends on one of these less stable industries may be more susceptible to periods of unemployment, which can depress demand for housing. A final economic factor worth noting is the overall growth in employment during the last 5 to 10 years. Generally, an area that is increasing in employment usually generates new housing demand. Also, absence of growth may indicate a relatively weak housing market with intensive competition for what market may exist. Age The age of potential buyers can also affect housing demand. In general, an area with an aging population will have less demand for new housing than one where new, younger households are being formed. On the other hand, an area with a disproportionately young population can place heavy demands on educational facilities—sometimes at the developer’s expense. Age also determines the type of housing that will be required. An area with large numbers of elderly people, young singles, or young married people may be ripe for apartments or condominiums. An area with families headed by people in the 30 to 55 age group is more apt to prefer single-family housing.

2 Based on unemployment rates by major industries.

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Mobility An area of high mobility generally has a rapid turnover in housing, with relatively sophisticated buyers who are often willing to accept new ideas and may offer less sales resistance. Areas with less mobility may indicate relatively stable social patterns and more conservative housing preferences. In evaluating past population growth, the source of growth (internally generated versus migration) may make a difference—an area that is highly dependent on migration for population growth may have its source cut off by shifts in the overall regional economy or changes in public policy. Ethnic Background With high levels of immigration from Europe, Asia, and Latin America, it is not unusual to find first- or second-generation immigrant families living in the same neighborhood. If these neighborhoods are located within or near the market area, they may represent special opportunities for housing that is designed and marketed to their unique needs in terms of age, family size, income, and cultural preferences. Analyzing Housing Demand Table 8-1 illustrates the initial steps involved in projecting total housing units in the market area as well as the number of new dwelling units for each period. Population As noted, data on population growth and characteristics are available from the Current Population Reports published by the Census Bureau. Most local planning agencies also have existing and projected population and other statistics related to their local jurisdiction and the surrounding area. In recent years, the quality of these projections has improved markedly. It’s still wise, however, to carefully review them, particularly with regard to their currency and underlying assumptions. Projections made by chambers of commerce, public utilities, environmental groups, school boards, and others with a vested interest in population change should be subjected to especially careful scrutiny. It also should be noted that, in some areas, there is a sizable nonhousehold population living in dormitories, hospitals, and military bases. If this is the case, these numbers should be subtracted from total population to arrive at the population living in households. Again, this situation may present a special opportunity worth pursuing.

TA B L E

8-1

Projecting Total Housing Units in the Market Area Actual

Household Population Persons per Household Occupied Dwelling Units (BOP) Vacant Units Construction (DU) Total Dwelling Units (EOP) Net New Additions Annual Average

Projected

Source

1995

2000

2005

2010

2015

2020

Census Census Census or Planning Agency Planning Agency Planning Agency Calculation Calculation Calculation

104,183 3.21 32,478 325 3,327 36,130

113,902 3.15 36,130 361 4,730 41,221 5,091 1,018

118,793 2.88 41,221 412 6,736 48,369 7,148 1,430

125,000 2.58 48,369 967 9,000 58,336 9,967 1,993

130,000 2.23 58,336 1,167 11,000 70,503 12,167 2,433

135,000 1.91 70,503 1,410 13,000 84,913 14,410 2,882

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Historic Data The first step is to see what has been happening in the market area historically. Generally both the local planning agency and the Census Bureau maintain data on the number of households living in census tract(s), although data from the local planning agency may be more current. Since the census tracts and market area boundaries may not be exactly the same, it may be necessary to make some adjustments to arrive at market area statistics. The next step is to establish the number of dwelling units at the beginning of the analysis period (BOP). We assume that BOP occupied dwelling units are the same as the number of households in the area, obtained from the sources mentioned above. Vacant units are then added. These include rental housing units that are vacant and single-family housing units that have been completed but are unsold. Data on new construction are then added to arrive at the EOP housing inventory. These data will most likely include both single-family and multifamily units. The distribution figures are best obtained from the local planning agency. Net new additions are then calculated and averaged on an annual basis. In some cases, historical data may provide some insights about the market area. As an example, in some areas there was slower growth in annual new construction during the period of 2000 to 2005. This most likely coincided with the economic consequences of the dot-com bust and the events of September 11, and it may reflect a volatile employment market, perhaps involving firms highly dependent on technology. Economic Projections While it’s important to understand the past, when we look to the future, we are talking about making or losing large amounts of capital based, in large part, on the reliability of economic projections. It is therefore important to understand the assumptions underlying economic projections for a prospective market area. Table 8-1 is a good example. The population projections assume that future growth in the market area will be similar to that of the past with annual increases of approximately 0.9 percent annually and a small tapering off after 2010. This assumption implies that there is sufficient vacant land and/or recycled land to support this level of growth, an assumption that should be easy to verify. The projections also assume a continuing decline in the number of persons per household. While consistent with actual trends in prior years, this assumption implies smaller households, increasing the amount of annual new construction to support the same level of market area popula-

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tion. This assumption most likely is based on a trend toward a younger population that could have important ramifications in terms of unit mix, unit features, and community features. Another underlying assumption is that vacant units are assumed to be 2 percent annually, slightly higher than the experience of the prior decade, keeping in check the anticipated demand for new units. These assumptions are important because, collectively, they increase the growth rate of new dwelling units projected for the market area from 2 to 3 percent annually in the 2000 to 2005 period to a rate of 4 percent a year thereafter. Again, there are probably good explanations for these assumptions, but it’s important to fully understand the reasons and data supporting such changes in the demographic profile of a selected market. To not do so could mean not accounting accurately for the difference between a robust market and one beset with overbuilding, cutthroat competition, and many unhappy developers. It’s also important to gather information about projected increases in supply. These figures usually can be obtained from public agencies or private sources such as real estate brokers, developers, and appraisers, as well as economic and planning consultants. Economic and planning consultants are especially useful for obtaining information about projects “on the drawing board” that, if built, could influence future market conditions. Unit Types Future demand for housing units must now be split into ownership and rental units. In most cases, local planning agencies also project these data because they are crucial in evaluating community land allocations between single- and multifamily housing. In our discussions of Table 8-1, we noted that it is anticipated that the market area will continue to attract more single people and younger, childless families, increasing the demand for apartments. Consequently, the projections in Table 8-2 assume an increase in the percentage of multifamily units from the current level of 35 to 45 percent by 2020. More importantly, the percentage of new multifamily construction in the market area is projected to increase from 25.3 percent in 1995 to 2005 to 40.6 percent in the succeeding 15 years. Pricing The approximate price range for new housing demand can be established by analyzing income data. In some metropolitan areas, special studies have been undertaken that relate family or household income to housing price–rental ranges. If these studies are not available, the analyst must

202 TA B L E

8-2

Unit Type, Market Area (in thousands) Actual 1995–2000 New Construction Percentage by Type of Unit Single Family Multifamily Total New Construction by Type of Unit Single Family Multifamily Total Average Annual New Construction Single Family Multifamily Total

2000–2005

Projected Total

2005–2010

2010–2015

2015–2020

Total

4,730

6,736

11,466

9,000

11,000

13,000

33,000

78.2% 21.8% 100.0%

72.2% 27.8% 100.0%

74.7% 25.3% 100.0%

65.0% 35.0% 100.0%

60.0% 40.0% 100.0%

55.0% 45.0% 100.0%

59.4% 40.6% 100.0%

3,699 1,031 4,730

4,863 1,873 6,736

8,562 2,904 11,466

5,850 3,150 9,000

6,600 4,400 11,000

7,150 5,850 13,000

19,600 13,400 33,000

740 206 946

973 375 1,348

857 291 1,148

1,170 630 1,800

1,320 880 2,200

1,430 1,170 2,600

1,307 893 2,200

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utilize national averages, adjusting for variances between national and local income patterns. The result of either approach should be an S-shaped curve that distributes housing units by price-rental range. Figure 8-2 indicates how such a curve might appear for the market area in which the subject site is located. From the curve, it is possible to establish the number of incremental dwelling units that would be required in each price-rental range. The target range, or combination of ranges, that most closely approximates the quality of the unit to be developed can then be selected. Table 8-3 combines the curve illustrated in Figure 8-2 with the overall projections of demand for single-family housing units for the market area (Table 8-2) in order to get a breakout of single-family demand by price range for the subject site. Projections are made for the 2006 to 2010 period because this is when the project would be developed on the subject site. After completing the projection process, we have a relatively good idea of the gross number of new units that will be required by types of unit and their approximate price range. It should be noted that this is, at best, an approximation. The market will, of course, vary considerably from one year to the next as a result of overbuilding or underbuilding, changes in mortgage rates, and changes in public policy. FIGURE

8-2

Percent distribution by price.

100.0% 90.0% 80.0% Actual

70.0% 60.0%

Projected

50.0% 40.0% 30.0% 20.0% 10.0% 0.0% $240

$250

$260

$270

$280

$290

Thousands of dollars

$300

$310

$320

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TA B L E

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8-3

Single-Family Demand by Price Range, Market Area (in thousands)

Over $300,000 $290,000–$300,000 $280,000–$290,000 $270,000–$280,000 $260,000–$270,000 $250,000–$260,000 $240,000–$250,000 Under $240,000

Actual 2001–2005

Projected 2006–2010

Units

%

Units

%

151 185 336 690 1,576 904 423 598 4,863

3.1% 3.8% 6.9% 14.2% 32.4% 18.6% 8.7% 12.3% 100.0%

293 351 468 1,170 2,048 1,053 292 175 5,850

5.0% 6.0% 8.0% 20.0% 35.0% 18.0% 5.0% 3.0% 100.0%

Competitive Survey Another important element of single-family market analysis is a survey of the competitive projects affecting the market during the development period. This survey is undertaken in the field by experienced staff personnel or an independent market research firm, focusing on projects of the type and price-rental level anticipated on the subject site. Data are usually collected from a variety of sources. The number of units planned and the number built are usually available from the local planning agency(ies). Floor plans, features, and prices for each of the models require a field survey including a visit to the sales office of each competing project. Sales-to-date data are somewhat harder to uncover but usually can be secured from local title company(ies) and/or the brokerage community. Project sales brochures collected in the field survey are a source of information regarding unit features (carpet, draperies, cable TV, sound wiring, and so on), community amenities (recreational facilities, swimming pool, sauna, and so on), and financing terms (interest rates, points, and so on). Once the data have been collected, the next step is to calculate the level of market performance for each competitive project. Key factors include the number of months the project has been on the market, the number and percent of each type of unit that has been sold to date, the absorption per month by individual model, and the percent of each project sold in total and by individual model offered.

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Marketplace Observations An example of such an analysis is illustrated in Table 8-4. Based on this analysis, we can now make several observations about the current marketplace. The more recent projects appear to be selling better than earlier ones based on monthly absorption, with the exception of Shadywoods, which is priced considerably higher per square foot than the other projects. In terms of an underlying explanation, this situation may indicate (1) superior locations, (2) an improvement in design over earlier models, (3) an improvement in outlook for the economy, (4) a change in the makeup of the buyer population, or (5) a combination of those factors. The first three explanations can be evaluated internally, and necessary modifications can be made in project design to reflect that information. A change in the buyer population may require interviews with broker and sales personnel in the area. ■ The worst-performing models in each project have been those with two bedrooms and one bath. This indicates that prospective buyers are willing to “pay up” for extra space and the convenience of an additional bathroom. This observation is corroborated by the fact that the best-performing models have been the larger units with two bedrooms and two baths. ■ Two of the projects include a den in the two- and three-bedroom units. While these units have been slower sellers than the others, 60 to 80 percent of the available units have been sold. This may indicate that including a certain number of these units may expand the overall market appeal of the project and “trade-up” potential for these usually more profitable units. ■ In terms of community facilities, it will be necessary to provide a recreational room and sauna since all of the projects have one (perhaps indicating a younger market). A swimming pool is less obvious, since the best-performing project—Village Green— doesn’t have one. ■

Time permitting, each of these observations should be tested through additional field research before finalizing the marketing strategy and refining the project plan. If possible, it’s also desirable to get some idea of the profile of people buying in each project. Such information may be difficult to obtain, and if it is unobtainable, it may be necessary to guesstimate from the competitive survey.

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8-4

Competitive Survey, October 2006 Market Performance Project

Sold

%

Sales/Month

North Glen Supreme Builders Opened 4/05 Months: 18

Arroyo Chaperal El Dorado

2bdr/1ba 2bdr/2ba 3bdr/2ba

1,450 1,500 1,650

$275,000 295,000 315,000

$189.66 196.67 190.91

75 175 100 350

75 175 100 350

55 142 47 244

73.3% 81.1% 47.0% 69.7%

3.1 7.9 2.6 13.6

Meadowbrook Cosmic Dev. Co. Opened: 7/05

Nutmeg Thyme Oregano Tarragon

2bdr/1ba 2bdr/2ba 2bdr/2ba/den 3bdr/2ba

1,300 1,350 1,450 1,600

227,500 230,000 245,000 260,000

175.00 170.37 168.97 162.50

50 225 125 50 450

50 175 100 50 375

17 142 62 41 262

34.0% 81.1% 62.0% 82.0% 69.9%

1.1 9.5 4.1 2.7 17.5

Village Green World Dev. Co. Opened: 1/06 Months: 9

Bayview Hilldale ParkLane

2bdr/2ba 3bdr/2ba 3bdr/2ba/den

1,500 1,650 1,750

295,000 325,000 340,000

196.67 196.97 194.29

150 100 25 275

125 75 25 225

105 72 20 197

84.0% 96.0% 80.0% 87.6%

11.7 8.0 2.2 21.9

Shadywoods Brown Brothers Opened: 3/06 Months: 7

Aspen Spruce Oak

2bdr/1ba 2bdr/2ba 3bdr/2ba

1,350 1,400 1,550

325,000 350,000 375,000

240.74 250.00 241.94

25 175 50 250

10 50 45 105

6 50 27 83

60.0% 100.0% 60.0% 79.0%

0.9 7.1 3.9 11.9

1,325

1,055

786

74.5%

16.0

Months:

Totals

Plan/Model

Unit Type

Size

Unit Price

Price/Sq. Ft.

Planned

Built

15

49 Features

Sales Summary by Unit Type

Project

Unit

Community

Financing

North Glen Meadowbook Village Green Shadywoods

C/D;DW C/D;DW C/D;DW C/D:DW;W

RR; Pool; S RR; Pool; S RR; S RR; Pool; S

5.0%/1pt. 4.5%/2pt. 5.0%/1pt. 5.2%/1pt.

2 bdr/1ba 2bdr/2ba 2bdr/2ba/den 3bdr/2ba 3bdr/2ba/den Totals

Planned

Built

Sold

Percent

150 725 125 300 25 1,325

135 525 100 270 25 1,055

78 439 62 187 20 786

57.8% 83.6% 62.0% 69.3% 80.0% 74.5%

Notes: C/D: carpet and drapes; DW: dishwasher; RR: recreation room; S: sauna; and W: telecommunications wiring. A modified version of this competitive survey can be utilized for the analysis of apartment markets.

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Refining the Project Plan With an understanding of the characteristics of the competitive marketplace, it’s time to begin integrating these observations into the project plan for the subject site. Dwelling units can now be finalized in terms of unit mix, size, and features and matched with specific parcels of land. Community facilities can be firmed up in terms of location, features, size, and location within the project. If required, streets and utility lines can be relocated and their engineering design finalized. As this process unfolds, it is usually helpful to get informal comments on the various elements of the evolving land use plan from professionals in the local planning agency (and private consultants, if involved). In this manner, possible entitlement problems may be avoided or at least brought to the surface and dealt with. Also, the public professionals have more opportunity to understand the reasons why certain changes are being made and may be more supportive in public meetings. The projected number of units that can be built on the site should then be translated into an absorption rate and compared to the market area economic data (Tables 8-1 to 8-3), projects in the competitive survey (Table 8-4), and the developer’s historic track record with this type of project. If the projected absorption rate is significantly higher than either, the analyst should reweigh the assumptions that imply better performance than the competition or previous projects. Finalizing the Marketing Strategy The last step is to finalize the marketing strategy and project plan based on the observations and conclusions related to the data collected and analyzed to date. It should be noted that this is largely a judgmental process that requires the utmost care and objectivity. Advantages and disadvantages of the subject site have to be considered, particularly in relation to competitive projects, in order to establish the percentage of the market the proposed project can capture. Allowance should be made for the timing of the project and any changes in the market anticipated prior to going to market. The developer’s sales abilities and the potential sales momentum that can be established also should be considered. A simple model can be created to test the influence of each of the various variables to arrive at a desirable strategy. Table 8-5 indicates how these principles might be applied to the subject site. The competitive

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8-5

Market Positioning, October 2006 Market Performance Project

Plan/Model

Unit Type

Size

Unit Price

Price/Sq. Ft.

Planned

Built

Sold

%

Sales/Month

North Glen Supreme Builders Opened: 4/05 Months: 18

Arroyo Chaperal El Dorado

2bdr/1ba 2bdr/2ba 3bdr/2ba

1,450 1,500 1,650

$275,000 295,000 315,000

$189.66 196.67 190.91

75 175 100 350

75 175 100 350

55 142 47 244

73.3% 81.1% 47.0% 69.7%

3.1 7.9 2.6 13.6

Meadowbrook Cosmic Dev. Co. Opened: 7/05

Nutmeg Thyme Oregano Tarragon

2bdr/1ba 2bdr/2ba 2bdr/2ba/den 3bdr/2ba

1,300 1,350 1,450 1,600

227,500 230,000 245,000 260,000

175.00 170.37 168.97 162.50

50 225 125 50 450

50 175 100 50 375

17 142 62 41 262

34.0% 81.1% 62.0% 82.0% 69.9%

1.1 9.5 4.1 2.7 17.5

Village Green World Dev. Co. Opened: 1/06 Months: 9

Bayview Hilldale ParkLane

2bdr/2ba 3bdr/2ba 3bdr/2ba/den

1,500 1,650 1,750

295,000 325,000 340,000

196.67 196.97 194.29

150 100 25 275

125 75 25 225

105 72 20 197

84.0% 96.0% 80.0% 87.6%

11.7 8.0 2.2 21.9

Subject Site

A B C

2bdr/2ba 3bdr/2ba 3bdr/2ba/den

1,450 1,550 1,650

270,000 285,000 295,000

186.21 183.87 178.79

100 75 25 200

Aspen Spruce Oak

2bdr/1ba 2bdr/2ba 3bdr/2ba

1,350 1,400 1,550

325,000 350,000 375,000

240.74 250.00 241.94

25 175 50

10 50 45

6 50 27

60.0% 100.0% 60.0%

0.9 7.1 3.9

250

105

83

79.0%

11.9

Months:

Months:

15

12

Shadywoods Brown Brothers Opened: 3/06 Months:

7

8.3 6.3 2.1 16.7

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projects from Table 8-4 are included as a basis of comparison. The elements of this analysis are the following: Market positioning. The project on the subject site would be positioned between Village Green and Shadywoods. Village Green has the highest total absorption rate, as well as sales success with a three bedroom/three bath/den model. Shadywoods has been on the market fewer months than the other projects, and it seems to represent the least value as indicated by its having the highest price per square foot. The project also has not had a good absorption experience with its two bedroom/one bath model. ■ Unit mix. As outlined in Table 8-5, the unit mix would call for half of the homes to be designed as two bedroom/two bath units, the best performer in the marketplace among the competitive projects. The remainder would consist of 75 three bedroom/two bath units and 25 three bedroom/two bath/den units. Both would target what appears to be a customer preference for larger units. ■ Unit features. Each unit would include carpeting and draperies, with hardwood flooring in the den of the three-bedroom models. A dishwasher would be included in all units. Consideration also should be given to telecommunications wiring of all the units, provided that it is not cost prohibitive. ■ Community features. A community recreation room and sauna would be provided for use by all residents, but no pool. ■ Number of units. The total number of units would be 200. This number would be made up of the unit mix stated above, the community features recommended, the streets and utilities required, and the natural site features identified to be preserved, and it is the number that would fit the size and configuration of the site. A preliminary analysis of the refined project plan indicates that it is feasible to develop this number of units on the subject site. ■ Market absorption. Based on 200 units and a one-year sales period, the absorption rate would be 16.7 units per month. This appears reasonable as it is less than the 21.9 units per month absorption by Village Green, the best performer in the market at present, and only slightly higher than the average for the four projects surveyed (16 units). In terms of market penetration, such a program would represent a capture of 50.3 percent. Again, each of the variables can be tested to see if there is a better mix of assumptions in terms of market absorption. ■ Market capture. Table 8-6 indicates the level of market capture the subject site would have to obtain to sell out the project within ■

210 TA B L E

8-6

Market Capture, October 2006 Market Performance Project

Plan/Model

Unit Type

Size

Unit Price

Price/Sq. Ft.

Planned

Built

Sold

Remaining

North Glen Months: 18

Chaperal

2bdr/2ba

1,500

295,000

196.67

175

175

142

33

Village Green Months: 9

Bayview

2bdr/2ba

1,500

295,000

196.67

150

125

105

45

Subject Site

A B C

2bdr/2ba 3bdr/2ba 3bdr/2ba/den

1,450 1,550 1,650

270,000 285,000 295,000

186.21 183.87 178.79

100 75 25 200

Total Competitive Units One Year’s Average Demand (Table 8-3) Market Capture by Total Competitive Units Market Capture by Subject Site

100 75 25 200 278 398 69.8% 50.3%

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a one-year sales period. There are only two competitive projects that have remaining units in the subject site’s price range—North Glen with 33 and Village Green with 45, assuming they complete their unbuilt units. This is a total of 78 units, which when combined with the 200 on the subject site, would represent a total of 278 competitive units. As noted in Table 8-3, there is a demand for an annual average of 398 units in the $270,000 to $300,000 price range projected for the 2006 to 2010 period. The three competitive projects would have to capture 69.8 percent of this demand to sell all their units. The subject site would have to capture 50.3 percent. All of these capture estimates appear reasonable.3 Often, there is a tendency at this point to “sanctify” the numbers produced by the quantitative analysis, giving them more importance than they deserve. The purpose of a quantitative analysis is to provide a rough indication of market size and relationship with the subject site. As such, a quantitative analysis is a supplement to, not a substitute for, good judgment. Also, it’s important to remember that market analysis is just an initial step in determining project feasibility. A positive market analysis says there’s potential—nothing more. The critical problems of financing, planning, designing, building, and selling or renting a project to tap this potential still exist. Failure at any of these stages can render the quantitative analysis meaningless. Not only must good judgment be utilized in developing the quantitative assumptions, but it should also predominantly determine final market feasibility. If there is a substantial difference between the numbers and what seems to make sense, question the numbers again and understand fully why the difference exists. Condominiums Condominiums represent a different planning and legal approach to the traditional single-family market. Generally people who buy condominiums as a primary home are moving from a single-family home and wish

3 Peiser observes that, in the long run, a project will capture its prorated share of total supply. For example, if a project has 100 units for sale and the total current supply is 1,000 units, the expected capture rate of the project is 10 percent. In the same manner, if demand is 100 units per month, the expected capture rate is 10 units per month, and it should take 10 months to sell 100 units. Source: Richard B. Peiser and Anne B. Frei, Professional Real Estate Development, 2nd ed. (Washington, D.C.: Urban Land Institute [ULI], 2003).

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to retain the tax and appreciation advantages of homeownership but have a smaller living space, freedom from housing maintenance, or to be located nearer cultural and entertainment facilities. Condominiums also attract individuals and business firms from other cities who want a base of operations in the metro area in which the condo is located. There is also a market for condominiums among apartment dwellers who enjoy living in a smaller space in an attractive neighborhood but wish to take advantage of tax breaks associated with homeownership and participate in possible appreciated values. This market is usually concentrated in more affluent urban neighborhoods. Market analysis focuses on the reasons people are buying condominiums in a particular market area. Once these factors are determined, the project should be examined to determine the degree a proposed project offers the features sought in the marketplace by potential buyers. The quantitative analysis is similar to our discussion earlier in this chapter about single-family housing. Condominium ownership is not equally popular in all parts of the country. Potential buyers may be reluctant to purchase a unit in such a market because they fear it will be difficult to sell quickly. In this situation, careful market analysis is necessary to ensure that the condominium concept will be accepted in the local marketplace. Manufactured Housing Manufactured housing represents a segment of the ownership housing market made up of those individuals who can’t afford to purchase traditional site-built housing or who prefer a manufactured home community for lifestyle reasons. The approach to market analysis is similar to that of single-family housing except that emphasis is placed on individuals who are earning incomes below a certain level, as well as the retirement market. If this segment is relatively large, it may indicate a good market for manufactured housing development. Second Homes Single-family homes, condominiums, or manufactured housing also may be developed as second homes. The market for secondary housing, however, is considerably different from the primary housing market. Since, by definition, an owner of a second home already has a primary home, the owner’s income must be relatively high to support the costs of two or more

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homes.4 Since a second home is usually associated with leisure activities, proximity to sources of employment is unimportant. Nearness to shopping, schools, and community services also becomes less critical. Most second home projects are in areas that have some type of natural or artificial recreational features: lakes, rivers, beaches, ski facilities, golf courses, tennis clubs, and so on. The quality of these facilities and their proximity often play a major role in establishing a strong second home market. Distance from the primary to the secondary home can also be important. Most second homes are built within two to three hours’ driving time from a major urban area. The ability to rent the second home is also a factor. A good, consistent rental market means that the owner can defray many of the costs of carrying the second home as well as treat some of the costs as tax deductions. The potential rental income also broadens the range of incomes of those who can afford secondary housing. In many cases second homes are sold on a timesharing basis, as discussed in Chapter 1. This is another way of expanding the market for second homes by making them affordable to people in a broad range of income groups. Other factors that help establish a strong second home market include the quality of land use planning, the “snob appeal” of early purchasers, and the overall promotional image created by the developer.

RENTAL HOUSING Thus far, the general assumption has been that, all other factors being equal, Americans would prefer to own rather than rent their housing requirements. This assumption has been reenforced in recent years by low mortgage rates and a general view that housing is a good investment opportunity. Changing Nature of Rental versus Ownership Housing The expanded development of condominiums, which allows ownership of smaller units with “worry-free” communal facilities and services, has allowed Americans to shed many of the responsibilities of single-family housing but still retain the tax and appreciation advantages. Unfortunately, for less affluent Americans, particularly those living at or below the poverty line, rental housing may be the only realistic 4 There are other costs as well: transportation, maintenance, and often more costly financing.

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alternative they have. Because of the increasing costs of developing new housing, the rental housing market for low-income residents, particularly in the inner cities, is often left by default to public agencies and slumlords. In some high-priced housing metro areas such as New York, Chicago, Washington, and San Francisco, residents also are forced by high home prices to rent despite personal resources or preferences. This is magnified by the transitory nature of American business and the sense that the next job may be in another metro area and it’s only pragmatic to “remain flexible.” In the broader scope of the American housing market, however, rental housing increasingly is influenced by demographics rather than individual preferences. The combination of a large, older generation retiring at the same time that their children are coming of age in an even larger generation has created the greatest potential demand for multifamily residential housing that we have seen in years. Baby Boomers Not that the generations have the same multifamily housing needs or preferences. Aging baby boomers are more affluent, often seeking upscale apartments with large rooms, high ceilings, two parking stalls, and lots of storage. Many seek to replicate their single-family housing experience without the extra bedrooms or headaches of maintaining a lawn or swimming pool. In retirement situations, they may be looking to relocate to a more urban setting, in the CBD or near a university. Others may feel more comfortable living in or near the same neighborhoods in which their singlefamily house was located and many of their friends still remain. Still others may wish to retire to a favorite vacation locale, perhaps in a more favorable climate such as Florida, Arizona, or Hawaii. Many in this generation have the financial resources to afford ownership housing, including second homes, so this market is amenable to condominium, cooperative apartment, and other ownership schemes.5 Echo Boomers Echo boomers are more similar to traditional apartment dwellers, and they represent the largest potential rental housing market for the next decade.

5 U.S. tax policy also encourages this by allowing a taxpayer to postpone capital gains taxes on the sale of a personal residence if he or she reinvests the proceeds in another home within a certain time frame.

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Generally, echo boomers want to live in metro areas with entry-level employment opportunities where they can land their first job or change to another one if they become dissatisfied or opportunity beckons. They also prefer an urban location, where they can be near entertainment opportunities as well as other young people. They also are willing to locate in transitional neighborhoods going through the revitalization process. In areas with good public transportation systems, they may find it desirable to locate near a transit station or well-serviced bus transfer point. The money they save in commuting costs is often traded off against higher rent. Usually having fewer personal financial resources than their parents, they are used to smaller living spaces and higher tenant densities. For those coming from college, the experience is not too different than that of the dormitories or fraternity or sorority houses they have recently left behind. A major generational difference from their parents’ apartment living experience, however, is that both sexes now often share living spaces, also not too dissimilar from their college experience. Some families and individuals have to rent housing because they can’t afford to purchase an ownership home. However, some people have chosen rental housing for other reasons even when it has meant forgoing the financial benefits of homeownership. Fortunately, the development of the condominium has helped to make available some of the benefits of ownership to people who prefer for whatever reason to live in multifamily settings. No longer must a person desiring a low-maintenance living unit have to settle for living in an apartment as a tenant. Some of the reasons for renting, therefore, become clearer. A person may rent an apartment because of a feeling of transience—an unwillingness to settle down, a desire to “try out” an area before making a commitment to homeownership, or an inability to come up with the necessary down payment or to qualify for the mortgage financing necessary for homeownership. Once the overall rental market has been determined, it’s important to zero in on the specific segment most likely to be attracted to the subject site. Market Analysis The market analysis for rental housing is similar to that of single-family projects and applies to both garden and high-rise projects. A note of caution, however, regarding high-rise apartments: unless there is an established local high-rise market, pioneering a project of this type may be fraught with risks. High-rise construction is substantially more expensive,

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leading to higher rents than garden apartments. High-rise projects also may involve a different lifestyle than that preferred by most residents of single-family and garden apartments. Competitive Survey Since apartments are generally rented for short periods of time, a fertile market is often found among the residents of existing projects. The first step, therefore, is to identify desirable apartment neighborhoods 15 to 30 minutes from the subject site. Apartment projects are “shopped” in order to identify the positive and negative features of each project. The data compilation and analysis format is similar to that used for single-family housing (Table 8-4). An evaluation of data provided by the competitive survey will indicate shortcomings of existing projects, which may represent possible “voids” in the local apartment market. If the proposed project overcomes these problems, existing renters may prove to be a potential market. In older projects, the focus is on the drawbacks to living in the project such as poorly designed floor plans, excessive sound transmission between units, outdated appliances, inadequate air-conditioning, poor elevator service, insufficient parking, and lack of services. In newer projects, the emphasis is on finding features that can be emulated on the subject site. The first location issue to consider is the neighborhood in which the investment is to be located. This may be an established residential neighborhood or a recently built suburban subdivision. Generally this is an area within a 5- to 15-minute drive of major employment centers. If the tenants are likely to have children, the desirable supporting educational facilities include elementary and middle schools and possibly a high school. Ideally, schools for the younger children will be located within walking distance of the project and middle and high schools a relatively short carpool or bus ride away. It is also desirable to have a neighborhood shopping center close by, as well as churches and synagogues. Regional location considerations are facilities and services located within a 20- to 60-minute drive from the apartment project. These include employment centers and entertainment nodes as well as a community or regional shopping center. Nighttime entertainment facilities such as movie theaters, restaurants, and nightclubs also should be located within this area as well as recreational facilities such as golf courses, ballparks, beaches, and boating marinas. Other Criteria Site criteria should include the visibility and access from major roads, the amount of crime and the means used to ensure public safety, day and

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nighttime noise levels, views and natural amenities, and the quality and character of nearby single-family neighborhoods. Building criteria should include the mix of units (as related to potential demand sources), unit sizes, room furniture layout potential, and tenant community facilities (for example, swimming pool, health club, fire pit, or video theater). An analysis of trends in the socioeconomic composition of the market area may also prove enlightening. An increase in the number of people in the 20 to 30 age group may indicate a market for apartments directed at single people and young married couples. Similarly, an increase in people over 55 may indicate a potential market among retired and semiretired individuals.

PLANNED UNIT DEVELOPMENTS Planned unit developments (PUDs) represent an approach to planning and zoning that is different from that usually applied to developments of a single type of land use. In many cases, PUDs involve a variety of housing types (for example, single family, condominium, or apartment), as well as compatible commercial property uses. The market analysis approach for PUDs involves an examination of the market potential for each type of housing component, utilizing the approaches outlined in this chapter for each of these types of developments. Additional consideration should be given to the incremental increases in demand that may be created by the proximity and interaction of these different land uses (for example, office, industrial, and retail). Equal weight should be given to possible conflicts between components. If such conflicts do not appear resolvable, perhaps one or more of the uses should be reduced or dropped entirely. In essence, the land uses are compared in “triage” fashion to determine the optimum mix for project success.

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CHAPTER 9

Retail

Buying and selling became not merely an incidental traffic in the conveyance of goods from producer to consumer: it became one of the principal preoccupations of all classes. Lewis Mumford The Culture of Cities, 1938

In Chapter 5, demand for retail commercial facilities was shown to be a function of household size, age, income, and spending patterns. Other factors include the number and location of retail facilities in the trade area, the prices of goods and services, and the business acumen of the retailers. In the short term, demand also may be influenced by credit availability, economic expectations, advertising, and variations in merchandising policy. The process of analyzing retail demand is more sophisticated and accurate than for any other land use. Good socioeconomic data are usually available, buyers like to talk about their shopping preferences, retailers generally keep detailed records regarding sales activity, associations like the International Council of Shopping Centers and the Urban Land Institute maintain industrywide data, and several welltested theories of shopper preference patterns provide a good base for demand analysis.

GOODS AND SERVICES Retailers offer a wide variety of goods and services, most of which can be classified by the way in which the consumer seeks them out: 219 Copyright © 2007 by John McMahan. Click here for terms of use.

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Convenience goods. Food, drugs, liquor, hardware, and other items that are bought on a convenience basis (that is, at the most convenient stores, often without comparison shopping). These goods vary little from store to store and are purchased relatively frequently. ■ Shopper goods. Items that are purchased after some degree of deliberation or shopping around. Generally, they are differentiated through brand identification, retailer image, and/or shopping area ambience. Purchases are made less often, and the products usually cost more and last longer. Shopper goods include apparel, general merchandise, household furnishings, home improvement products, and specialty items like jewelry, cameras, and books. ■ Personal services. Services provided on a relatively frequent basis, generally at the most convenient locations. Examples include laundries and dry cleaners, barber and beauty shops, video stores, and fast-food restaurants and quick serve coffee shops. ■ Specialized services. Services provided on a relatively less frequent basis. As with shopper goods, the purchaser often shops around extensively before deciding on a particular service provider. Typical service businesses include banks, insurance companies, real estate brokers, and travel agencies. ■

It should be noted that these classifications are rather broad and may overlap.

POTENTIAL DEMAND According to Richard Nelson, retail demand can be divided into three categories: Generative business. This is business activity generated by a retail operation through its own efforts, historical reputation, advertising, or promotional gimmicks. A major department store is probably the best example of an operation that depends on generative business. Usually, this type of business looks for a location easily accessible to large numbers of shoppers to maximize its merchandising efforts. ■ Shared business. This kind of business diverts customers who are attracted by the pulling power of a nearby generative business. This type of store wants to be as close as possible to department stores or other generative operations, accounting for the “satellite” store designation. ■ Suscipient business. This business activity is generated by people coming for a purpose other than shopping. Newsstands in ■

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transportation centers such as airports, subways, and train stations are examples. So are many downtown retail operations that exist to serve office workers in the immediate area.1 Generally, most stores receive their business from a combination of demand sources.

VENUES Retailing generally tends to cluster in shopping centers or retail districts. Part of the reason is that clustering increases retailers’ overall volume. Nelson attributes this phenomenon to the “theory of cumulative attraction”: “A given number of stores dealing in the same merchandise will do more business if they are located adjacent or in proximity to each other than if they are widely scattered.”2 The various types of retail “clusters” are discussed below. Again, it should be noted that these are fairly broad classifications; a particular shopping center or retail district may combine elements of several categories. A shopping center is a “group of commercial establishments planned, developed, owned, and managed as a unit; related in location and type of shops to the trade area it serves.”3 Shopping centers generally provide onsite parking, with the number of parking stalls depending on the size of the center. Pedestrian malls are provided to link anchor stores and provide retail space for smaller retailers. Superregional Centers Although usually designed and developed as a single unit, a superregional center reflects many of the defining aspects of downtown retailing, and it has emerged as one of the major forms of retail development in the United States today. In addition to new construction, many existing regional centers have evolved into superregional centers over time by adding stores and instituting a general physical makeover that has included the addition of extensive new amenities and services. Anchored by three or more department stores (generally not less than 75,000 square feet each), the superregional center ranges in size from 500,000 to more than 1.5 million square feet (typical size is 1 million square feet) and serves a market area of up to 60 minutes’ driving time.4 1 Richard Lawrence Nelson, The Selection of Retail Locations (New York: McGraw-Hill, 1958), p. 53. 2 Ibid., p. 58. 3 The source for this definition and most of the shopping center statistical data is Dollars and Cents of Shopping Centers/The Score, published by the Urban Land Institute (ULI), Washington, D.C., 2006. 4 Some market areas are larger, particularly those in areas with lower-density populations (for example, the Mall of America in Bloomington, Minnesota, serves several states and portions of Canada).

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The superregional center also may have an office building, hotel, and/or entertainment complex in or adjacent to the center’s retail operations (Figure 9-1). In some cases, superregional centers have power centers and/or neighborhood centers on the periphery. Regional Centers Serving a market area of up to 45 minutes’ driving time, the regional center was for many years what most people thought of for their big purchase needs including general merchandise, apparel, furniture, and home furnishings. FIGURE

9-1

With 5.2 million square feet of space for shopping and entertainment, Canada’s West Edmonton Mall is one of the world’s largest shopping centers. (West Edmonton Mall)

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A regional center ranges in size from 250,000 to over 900,000 square feet (the typical size is 500,000 square feet). Most regional centers are anchored by one or two full-line department stores (each averaging at least 50,000 square feet). A regional center also may have tenants such as travel agencies, home services, restaurants, entertainment outlets, banks, and other personal and business services. The key elements in a successful regional or superregional center include sufficient trade area demand, strength of the anchor department stores, variety and quality of satellite stores, ease of accessibility and parking, overall shopping ambience created by the site plan and building design, and level of aggressiveness in the center’s promotion. Weakness in any of these areas can lead to increased market penetration by competing centers. In analyzing market potential for regional and superregional centers, emphasis should be placed on the demand for shopper goods such as apparel, general merchandise, home furnishings, and specialty items. This merchandise represents the backbone of a successful superregional or regional center. Care also should be taken to relate major anchor stores as closely as possible to the income levels and lifestyles of households in the trade area. Community Centers A community center is larger than a neighborhood center, but typically it does not have a department store. It also has a considerably smaller trade area than a regional center, typically serving customers within a market radius of approximately 30 minutes’ driving time. Most community centers are anchored by large food and/or drugstores and also may include tenants selling hard lines such as appliances, electronics, and hardware as well as soft goods merchants handling men’s, women’s, and children’s apparel. There is a wide range in size of community centers, with some as small as 100,000 square feet and some as large as 500,000 square feet or even larger. The elements that make a successful community center are largely the same as those needed for a successful regional center, but there is less emphasis on anchor store strength and shopping ambience. Convenience of location and depth of trade area often play a larger role; few potential customers will drive out of their way to find a community center. The market demand analysis is generally similar to the process previously outlined for superregional and regional centers except that it need not be as comprehensive in terms of trade area or data collection. Emphasis should be on possible market voids in particular merchandise lines and on the proximity of the subject site to the greatest concentration

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of population in the trade area. In some situations, it’s desirable to look for some type of nonretail use (for example, office building, motel, or recreational facility) to help strengthen the center. Variations on the community center include the lifestyle center (national chain specialty stores in an open-air setting) and the town center (two or more pedestrian streets with street-front retail and, in some case, residential above). Power Centers In the last several years, power centers have emerged as a major competitive threat to community centers and, in some cases, smaller regional centers. Basically these centers are a collection of big-box buildings, each containing at least 20,000 square feet and leased to major (usually discount) retailers specializing in bulk foods, drugs, toys, home furnishings, sporting goods, consumer electronics, computers, office supplies, health and beauty aides, and home improvement goods and services. In recent years larger chains such as Wal-Mart5 and Target, as well as membership clubs such as Costco and Sam’s Club have begun to operate in power centers as well as freestanding locations. Traditionally, a power center required at least four of these retailers (called category killers) to provide critical mass. In most situations, these operations usually occupied 80 to 90 percent of the total center. This is less true today, with several power centers having only one big box with as much as 25 percent of the remaining space devoted to smaller tenants. A few power centers have begun including “lifestyle” components such as theaters, restaurants, and upscale retailers. Neighborhood Centers This is the most common type of shopping center, usually located within 15 minutes’ driving time of the majority of its shoppers. The neighborhood center provides customers with the “necessities” of life, such as food, drugs, personal services, or fast food, primarily through large food and drugstore chains. The size ranges from 30,000 to 100,000 square feet of gross leasable area (GLA), averaging about 60,000 square feet. Some newer centers have 75,000 to 150,000 square feet of GLA, averaging about 100,000 square feet.

5 A super Wal-Mart may have as much as 200,000 square feet of selling area.

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As supermarkets and drugstores have broadened merchandise lines, neighborhood centers have grown in size and merchandise coverage. Today’s superstore with 50,000 to 90,000 square feet is often two to three times larger than the supermarket of 20 to 30 years ago. From an investor’s viewpoint, neighborhood centers located in infill locations have become popular in recent years. This type of investment is attractive because it is less susceptible to recessionary pressures and therefore usually has a steadier cash flow. The advantage is also the major drawback—large food and drugstore anchor tenants usually have tough lease requirements and pay relatively low rent, with most of the upside coming from built-in minimum rent increases. The most important market factor in a successful neighborhood center is convenience, usually measured in terms of proximity to the customer’s residence, accessibility, and parking. The strength and reputation of the supermarket tenant is also critical, particularly the quality of the meat and produce departments. Market analysis of neighborhood centers involves a relatively small trade area. Emphasis is on data that relate to food, drugs, and other convenience goods. Establishing consumer loyalty to existing supermarket chains also may be important, particularly in trade areas with considerable competition. Convenience Centers Convenience centers are smaller than a neighborhood center and anchored by a store providing personal or convenience services, such as a minimarket. They usually contain a minimum of three stores and do not exceed 30,000 square feet. They are often anchored by “quick stop” markets such as 7-Eleven and Stop-n-Go. Many of these centers are located in corner locations abandoned by gasoline stations. Specialty Centers In recent years, a relatively new retailing concept has emerged—the specialty center. These centers can range from 40,000 to over 300,000 square feet, but their major distinguishing feature is that they have no major anchor stores. The tenants are generally small (400 to 2,000 square feet), primarily specializing in apparel, household, and specialty goods. Restaurants and gourmet food outlets are often a major element of specialty centers. Entertainment facilities, such as theaters, also may be included. Generally, the emphasis is on merchandising depth (for example, there might be several tenants in each category) rather than breadth.

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Some of these centers are directed primarily at local retail shoppers (for example, they might be off-price centers or lifestyle centers) and others at tourist shoppers (for example, they might be festival centers or outlet centers). Local Market Orientation An off-price center sells out-of-season stock, surplus stock, or discontinued items, all at a discounted price. General merchandise and apparel goods are usually featured. Market analysis should focus on potential demand from moderateincome households in the trade area, the size of which is somewhere between that of the community and regional centers. The off-price center competes with both, sometimes in adjacent locations. The lifestyle center is at the opposite end of the customer spectrum, targeting high-income shoppers. These centers are usually anchored by a specialty store (for example, a gourmet supermarket such as Whole Foods) in addition to having shops that carry fashion merchandise. These centers are often developed in high-income areas, but they can draw from broader trade areas when high-income neighborhoods are scattered. Many leading apparel merchants (for example, Chico’s, Talbots, or Ann Taylor) find these centers attractive because they provide more flexibility for tenant expansion than do superregional or regional centers. Tourist Market Orientation The concept for the festival center was originated by the Rouse Company with its development of Faneuil Hall Marketplace in Boston (Figure 9-2). These projects usually are developed around a special theme, generally through use of existing, often historic structures or, more recently, from scratch with the theme created through planning and architecture. Festival centers attempt to create a particular experience, a place where people come for the entertainment value of shopping. These projects usually contain a large number of specialty restaurants and food vendors, the more unusual, the better. Other examples include the Inner Harbor (Baltimore), Ghirardelli Square (San Francisco), Old Town (Dallas), and the Village Green at Heritage Village (Southbury, Connecticut). Outlet Centers Outlet centers are brand-name retailers that sell merchandise at discounted prices, usually with no anchor tenant. The center is often regional in scope and generally located on a major highway, often near a popular tourist

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FIGURE

9-2

Faneuil Hall Marketplace, Boston, Massachusetts, is one of the most prominent examples of the festival center. (The Rouse Company)

area. The trade area for the outlet center is regional, with a strong customer base of tourists. Analysis of the competition should cover regional centers in the trade area and specialty centers that draw heavily on the tourist trade. If the proposed center is dependent on tourist expenditures, the level of these expenditures should be established, and it is desirable to have a breakdown of where the money is spent. The proposed center should then be evaluated in terms of its potential appeal vis-à-vis other tourist attractions. Accessibility and proximity to tourist destination points may be important factors as well. Seasonal fluctuations in tourist expenditure patterns also must be considered. Other Retail Venues Shopping centers aren’t the only game in retailing; in many communities revitalized downtowns, bustling shopping districts, convenient strip centers, and competitively priced freestanding stores are popular with many shoppers, most of whom also shop at shopping centers as well, although some may actually prefer the alternative venues. Residents and office tenants also find retailing in multiuse projects to be convenient and dependable.

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Downtowns For many years the focal point of retailing in most cities was “downtown.” Ultimately, a wide variety of retail uses evolved, largely on a nonplanned basis. However, with the rise of the suburban shopping center in the 1950s, downtowns declined, and downtown retailing fell by the wayside. The 1970s rehabilitation of the central cities, however, allowed downtown retailing to stage a comeback that continues today (discussed in Chapter 1). New York, Chicago, Boston, and San Francisco are good examples of viable downtown retailing areas in the United States, and there are many such successful areas in cities in Europe and Asia. Suburban Shopping Districts These shopping areas were developed on a largely unplanned basis in older suburbs. Often these districts emerged as strip commercial areas around a major arterial running from downtown to the suburbs. In other cases, they evolved around a major department store with an “uptown” branch, many of which are now closed. In still other situations, the districts represented the “downtowns” of small rural communities that were swallowed up in the spread of suburbia. Strip Centers Strip centers are groups of 6 to 12 shops with parking in front. In recent years, tenants have included small, quick serve restaurants as well as coffee chains such as Starbucks. Market analysis should focus on convenience goods. Location is the single most critical feature of the successful strip center since the primary reason people shop at these locations is to save time. Adequate parking is also crucial to the success of such a center. Freestanding Stores Stores not located in shopping centers or districts are termed freestanding. Such stores can range from a 2,000-square-foot delicatessen to a small discount or department store. In some cases, many of these stores were developed before shopping centers existed. In other cases, this is the preferred method of operation. As an example, several clothing, home furnishing, and electronics retailers often prefer freestanding locations. Mixed-Use Developments Retail activity is often a component in mixed-use developments. The retail component can range from convenience shops to a small shopping center

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229

within the complex. Retail outlets in mixed-use developments have to be carefully integrated with other components of the complex. Because of its complexity, retail may be the most difficult land use to implement successfully in a mixed-use project. (Chapter 13 covers this in more detail.)

TENANTS The heart of any retail project is made up of the tenants with their merchandising skills. Anchor tenants are usually well-financed, professionally managed operations (frequently public companies) with strong advertising and merchandising skills. Nonanchor tenants are usually smaller, local merchants who generally do not have strong credit ratings and often require a lot of TLC from a property management standpoint. This is changing somewhat, however, as more and more national credit tenants choose to (or are forced to) utilize in-line space. Also, the popularity of franchising and the entrepreneurship of new immigrants have increased the noncredit tenant pool. Many tenants prefer freestanding pads where they can utilize a driveup window in addition to their sit-down operation. The buildings on the pads may be constructed and owned by the developer or the tenant. The developer may sell the land to the tenant, ground lease it, or enter into a build-to-suit agreement constructing the building to the tenant’s specifications.

LOCATION Since most shoppers drive to a center, there is usually a direct relationship between the size of the center and the size of the road or highway serving it. A neighborhood center, as an example, tends to be located on an arterial or large street serving the neighborhood in which it is located. Community centers also may be located on arterials, but generally they are found on expressways or smaller freeways. Regional, superregional, and power centers generally are located on or near major freeways or expressways. The overall size of a center’s GLA largely is a function of the number and income levels of households in the market area; the future growth prospects for this market; the size, type, and retailing prowess of the competition; the strength of the anchor tenants in their respective markets; and of course, the size of the land parcels. For each type of center, the footprint of the land area must be large enough to accommodate the tenant’s retail spaces, public spaces, service facilities (for example, maintenance, restrooms, or equipment), access and internal road systems, and approximately 4 to 5 parking spaces per

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1,000 square feet of GLA.6 A few high-volume tenants may require parking ratios as high as 6 spaces per 1,000 square feet. Through the years, several theories have evolved to explain how consumers choose where they will shop. These theories provide the basis for projecting potential retail sales from a particular site and determining overall project feasibility. Although some of these theories are subject to criticism, it’s important to understand their general themes. Reilly’s Law In 1929, William J. Reilly of the University of Texas studied shopping habits in various Texas towns, and based on those studies, he developed what he termed the law of retail gravitation.7 This theory postulated that under normal conditions two cities draw retail trade from a smaller intermediate city or town in direct proportion to some power of the population of these two larger cities and in inverse proportion to some power of the distance of each of the cities from the smaller intermediate city.8 In simple terms, Reilly’s law says that people will shop in the biggest retail area that they can get to most easily. Since 1929, Reilly’s law has been modified to reflect changing retail shopping patterns. Floor space of stores (or shopping centers) has been substituted for city population in the formula; driving time has been substituted for distance. Although this theory has been widely used in retail analysis, it has some major weaknesses: (1) it was developed for rural trade areas where shoppers had few opportunities for comparison shopping; (2) the theory doesn’t consider variations in income, household size, or other factors affecting retail shopping patterns; (3) by concentrating on floor space and accessibility, Reilly’s law overlooks price, store image, 6 Due to land parcels in many urban areas becoming scarcer and relatively high priced, more and more new centers develop all or a portion of the retail and parking facilities on more than one floor. 7 William J. Reilly, Methods for the Study of Retail Relationships (Austin: Bureau of Business Research, University of Texas, 1959, original monograph published in 1929), p. 16. 8 Mathematically this becomes (Ba/Bb)  (Pa/Pb)N(Db/Da)n where Ba  the business that city A draws from intermediate town T Bb  the business that city B draws from intermediate town T Pa  population of city A Pb  population of city B Da  distance of city A from intermediate town T Db  distance of city B from intermediate town T N  exponent of population n  exponent of the inverted distance Ibid., p. 48.

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advertising, shopping ambience, and other factors that may be equally important in selecting a retail facility; and (4) the theory fails to take into consideration business that arrives by public transportation. Because of these shortcomings, several attempts have been made to improve on Reilly’s law. Vacuum Theory Analysis One variation is the vacuum technique, which attempts to establish the amount of unrealized retail potential within a trade area. The trade area is established around a prospective site on the basis of driving times, adjusted for natural boundaries. The amount of retail business potential within the trade area is then calculated through population, income, and expenditure data. Existing sales volumes are estimated from national sales averages by retail line, multiplied by the square footage of surveyed stores. Existing volume then is subtracted from sales potential, and the remainder, or “vacuum,” is the potential available to the new store or shopping center. The vacuum formula was developed primarily for outlying shopping centers. Since people in these areas generally do a portion of their shopping downtown, in older centers, through the Internet, or by mail order, most of the studies tend to show a vacuum, when in fact none may exist. The approach also suffers from the same problems as Reilly’s law: it doesn’t consider the type of retailing expenditures or the nature of the proposed retail operation. Microanalysis This approach, developed by Real Estate Research Corporation, divides the trade area into a series of small units (for example, blocks or neighborhoods). The potential business from each of these units is then calculated and distributed judgmentally among the various stores in the trade area. Any potential that cannot be distributed is assumed to be available to the proposed store or center. The microanalysis approach has the advantage of dealing in units small enough to substantially reduce the chance of gross miscalculation. It also tends to produce a great deal of data about an area, some of which may be valuable in marketing the store or center. The major disadvantage is that it’s considerably more expensive, requiring extensive interviewing, to determine the flow of consumer purchases. This approach also has difficulty in dealing with rapidly growing areas, where new arrivals have shopping patterns that differ from those of

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established residents. It is still, however, a major improvement on both Reilly’s law and the vacuum technique. Consumer Behavior Theory Analysis In 1966, Claude and Nina Gruen published a technical bulletin that outlined a behavioral research approach to retail facility location.9 This approach starts with the customers themselves. A customer profile is developed through extensive interviewing at the store’s existing locations. The probability that the proposed store’s customers will be similar to customers in the survey sample is established. A market area is then delineated around the prospective store on the basis of information gathered in the interviews. The number of people in the market area possessing the profile characteristics is determined from census material. Projections of future profile residents in the market area are then made. Overlapping market areas are eliminated, and the probabilities indicated earlier are applied to the projections. The resultant projections are broken down into cash and charge sale customers on the basis of the profile interviews and then multiplied by an annual average sale to arrive at projected total annual sales for the proposed store or center. This approach has the advantage of considering characteristics of the potential consumer. While this may work relatively well for a highly specialized store, it may work less well for a multiline store or a shopping center. The approach relies heavily on interviewing existing customers, without sufficient cross-checks to confirm the veracity of the profile or its applicability to the proposed market area. Also, the approach ignores a retailing operation that attempts to change its image over a period of time.10

ANALYZING MARKET DEMAND While all of the above theories appear to contribute something to the analytical process, no single theory is sufficient. The rigorous analyst must utilize a combination of approaches, continually cross-checking throughout the analytical process to reduce the reliance on any one particular assumption. 9 Claude Gruen and Nina J. Gruen, Store Location and Consumer Behavior, Technical Bulletin 56 (Washington, D.C.: Urban Land Institute [ULI], 1966). 10 This applies to more retailers than you might think. Over the last two decades, Sears Roebuck, Broadway-Hale, JCPenney, Montgomery Ward, Target, Mervyn’s, and others have spent millions of dollars trying to modify their image.

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Preliminary Development Scenario The first step is to establish broadly the size and type of center to be developed. Table 9-1 is an example of a preliminary scenario involving the development of a possible regional shopping center on a 50-acre undeveloped parcel of land. The site is near a freeway interchange and is believed to be an excellent site for a regional center. The site is not owned but has been optioned by the developer for a period of one year with an option to extend for an additional year. The next step is to model a series of tenant mix alternatives in order to establish the most desirable scenario for the market and the site, to be confirmed, denied, or modified by the market research program. Several scenarios of possible tenant mix can be considered. Inputs utilized include the targeted number of tenants in each category, the amount of square footage that modern stores require, and, by extension, the total targeted GLA for the completed center. Based on this approach, Table 9-1 reflects an optimum scenario for the subject site. Implementation of this scenario would generate approximately 1,135,000 square feet of GLA. The next step is to determine if the subject site can accommodate such a program. Since the shopping center is located in a built-up area, the land costs are quite high and a two-story retail center is assumed. This generates a demand for 567,500 square feet of land. The parking required for such a center is then determined, again assuming a two-story building. This would require an additional 1,021,500 square feet of land area based on 4.5 parking stalls for every square foot of GLA (4,500 stalls) and 400 square feet for each parking stall. Based on this approach, the initial observation is that the subject site can accommodate the proposed development program. At this point the land for buildings and parking is summed to a total of 1,589,000 square feet. This number is then divided by 0.75 reflecting the reservation of 25 percent of the total land area for streets and greenbelt resulting in a total of 2,118,667 square feet for the entire project, or 48.64 acres. The proposed development program for such a project is assumed to take five years with the center opening in 2010. Site acquisition, market research, land planning, anchor store leasing, and entitlements would be undertaken in 2007; preliminary building design and financing in 2008; construction and leasing of other stores in 2009; and a final grand opening scheduled for 2010. The exercise outlined in Table 9-1 may appear premature, but it’s constructive at this juncture for it helps to refine the research program and make better use of planning and design resources. It identifies problems

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TA B L E

9-1

Preliminary Development Scenario, Regional Shopping Center Project, October 2006 Assumption Tenants

Shopping Center

Sq. Ft.

Building

40 3 10 30 83

4,000 150,000 10,000 3,000 9,639

160,000 450,000 100,000 90,000 800,000

1 1 10 12

70,000 15,000 2,000 8,750

70,000 15,000 20,000 105,000

Personal Services Specialized Services Total Retail (Average)

5 2 102

1,000 5,000 9,020

5,000 10,000 920,000

Office (Suites) Restaurants Theater Total Center (Average)

15 10 1 128

10,000 4,000 25,000 8,867

150,000 40,000 25,000 1,135,000

A. Gross Leaseable Area, Sq. Ft. Shopper Goods Apparel General Merchandise Household Furnishings Specialty Stores Subtotal (Average) Convenience Goods Supermarket Drugstore Other Subtotal (Average)

B. Land for Buildings, 2 Floors C. Parking, Stalls per 1,000 Sq. Ft. D. Building Area for Parking, Sq. Ft. E. Land for Parking, Sq. Ft., 2 levels F. Land for Buildings and Parking, Sq. Ft. G. Land for Streets and Green Belt, Sq. Ft. H. Total Land Required, Sq. Ft. I. Total Land Required, Acres

A/2 A  4.5 / 1,000 C  400 sq. ft. D/2 BE H
F F / 0.75 H / 43,560

Land

567,500 5,108 2,043,000 1,021,500 1,589,000 529,667 2,118,667 48.64

that might limit development of certain types of uses. If the program is under a tight time schedule, it allows brokers to start approaching tenants while the research program is proceeding. As the research program unfolds, this scenario will be tested over and over again. Establishing the Trade Area The next step is to determine the potential trade area, based on how long it takes prospective shoppers to reach the subject site. In most cases this will be determined by automobile driving time. If extensive public transportation is available, however, the trade area may be skewed along the transit service lines. The maximum arrival time should be based on the type of center anticipated in the preliminary development scenario. The following is a rough rule of thumb:

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Neighborhood centers, 15 minutes Community centers, 30 minutes ■ Regional centers, 45 minutes ■ Superregional centers, 60 minutes ■ ■

The trade area should now be adjusted judgmentally to reflect natural barriers and possible changes that may affect driving time to the subject site. The trade area is then adjusted to the nearest boundary line for appropriate data gathering purposes (for example, census or retail sales data). Figure 9-3 is a graphic example of how a trade area is established.11 Competitive Survey Now it’s time to move into the field and evaluate the potential competition. As with housing surveys, this fieldwork should be undertaken by

FIGURE

9-3

Retail trade area for a proposed regional center.

Subject site Competitive regional center Central business district Trade area for subject site Trade area for competitive regional centers Bay

Industrial area Mountains

11 Some developers like to perform a void analysis at this point to determine which major retailers are already in the trade area and which are not. Those not presently represented may be good targets for the new center; those already there also may be targets if they are located in an inferior facility and/or facing a lease renewal in the near future.

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experienced professionals or staff. Important information to develop in the survey includes the following: Size of competitive centers in gross leaseable area (GLA), with breakdown of the number of tenants and square footage by major categories of both retail and nonretail uses. ■ Identification of major anchor tenants (for example, department stores, drugstores, or supermarkets). If the type of anchor for the subject site is known, the research should focus on similar competitive stores. ■ Analysis of the marketing ability of the major tenants and other stores that would be directly competitive. This includes such factors as store appearance, marketing techniques, and price. ■ Analysis of the number of parking stalls provided and stalls per square foot of GLA. ■ Evaluation of the ease with which traffic moves through the center including ingress and egress. ■ Evaluation of the type and quality of nonretail uses (for example, offices, restaurants, or theaters). ■ Estimated retail sales and sales per square foot. ■ Year center was built or completed major renovation. ■ Qualitative evaluation of the quality of the center. This should consider shopping ambience, interstore location relationships, overall maintenance, and other factors that go into making a good center. ■ Qualitative evaluation of the general health of the trade area and existing competitive centers. ■

Centers covered in the survey should include major stores serving the trade area that are roughly comparable with those being considered for the prospective center. Table 9-2 illustrates a typical competitive survey. At this point, it’s possible to make another rough cut regarding feasibility. By multiplying the retail area by broad sales per square foot assumptions, the total sales of the competition can be ascertained. As an example, the four centers in Table 9-2 have combined sales of $672,102,000, an average of $1,570,000 for each retail store in the center, or about $247 per square foot of retail space.

Consumer Survey (Optional) A consumer survey may provide additional insight into shopper attitudes— often a critical factor in successful retailing. The problem with such a survey is that it is expensive, time-consuming, and, if not undertaken carefully,

TA B L E

9-2

Competitive Survey, October 2006 Northgate Outlets Retail Shopper Goods Apparel General Merchandise Household Furnishing Specialty Stores Total Shopper Goods

Seaside

Sq. Ft.

Outlets

River Road

Sq. Ft.

Outlets

Sq. Ft.

Morningside Outlets

Sq. Ft.

Average

Total

24 2 6 41 73

96,000 150,000 51,600 123,000 420,600

42 3 11 43 99

168,000 375,000 94,600 129,000 766,600

17 4 5 21 47

68,000 300,000 43,000 63,000 474,000

33 3 6 51 93

132,000 300,000 51,600 153,000 636,600

116 12 28 156 312

464,000 1,125,000 240,800 468,000 2,297,800

4 14 6

60,000 16,800 7,200

6 23 15

120,000 27,600 18,000

3 11 3

45,000 13,200 3,600

4 15 12

80,000 18,000 14,400

17 63 36

305,000 75,600 43,200

Total Retail

97

504,600

143

932,200

64

535,800

124

749,000

428

2,721,600

Offices Restaurants Other

12 3 7

25,200 15,000 14,000

10 5 8

21,000 25,000 16,000

8 4 9

21,000 20,000 18,000

14 16 17

29,400 80,000 34,000

44 28 41

96,600 140,000 82,000

Total Center

119

558,800

166

994,200

85

594,800

171

892,400

541

3,040,200

Convenience Goods Personal Services Specialized Services

Major Anchors

Parking Stalls Stalls/Sq. Ft. GLA Estimated Retail Sales ($000) Estimated Sales/Sq. Ft. Year Built Overall Center Quality

J.C. Nichols Crown Variety

151 3.7 $108,489 $215 1985 Good

Metro Dept. Rozenberger’s Major Drug Mainline Shoprite Mkt. 237 4.2 $256,355 $275 2003 Excellent

Sherman’s Dept. Sloan’s Variety

170 3.5 $112,518 $210 1992 Good

Amalgamated Dept. Jacqueline’s Valentine Specialty Food Mart 194 4.6 $194,740 $260 1999 Very Good

188 4 $672,102 $247

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may provide inaccurate information and lead to the wrong conclusions.12 It is discussed at this point to provide the reader with a general understanding of how such a survey should be conducted and what realistically can be expected from the final product. Questionnaire Design The questionnaire design should be undertaken by professional or staff personnel with experience in questionnaire design and interviewing consumers. A mistake in design can seriously flaw the validity of the responses. The questionnaire should focus directly on the continually refined scenario of what type of store or center is anticipated and what segment of trade area residents most likely will be attracted to such a facility. Specific questions should be raised concerning stores or centers most frequently utilized for purchases similar to those that would be carried by the subject center: attitudes toward these centers, good and bad; attitudes toward anchor stores anticipated in the scenario store or center, if known to the respondent; and classification data on respondent such as age, size of family, type of employment, and income. Trade Area Sample Selection Once the questionnaire has been designed, a sample of trade area residents should be drawn. Valid methods should be utilized in establishing the minimum sample size necessary for statistical accuracy within budget limitations. The sample is developed on a random basis from all households in the trade area. Potential respondents are identified by name, address, and telephone number. Interviews Trained interviewers should conduct the interviews, which can be either in person or by telephone. Generally, budget limitations make telephone interviewing more common, but there may be some loss of accuracy as well as missing the nuances of the respondent’s replies. The questionnaire should be pretested on a cross section of the sample and modified as necessary. Interviews should be completed within a short time period to keep external conditions as comparable as possible.

12 The anchor tenants will probably want to do their own surveying as well, which can be specifically geared to their market profile, general modus operandi, and strategy for the trade area.

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Processing of Questionnaire Responses Once the interviews are complete, the data can be coded for computer processing. The computer program should allow as much flexibility as possible in cross-analyzing various types of data, for example, analyzing purchases of particular retail goods by income level of respondent. A flexible program is the key to getting as much meaningful information as possible out of the consumer survey data. Projecting Retail Expenditures Assuming that a consumer questionnaire is not utilized, the next step is to project trade area retail expenditures, which is accomplished in Table 9-3. The first task is developing historic data related to the trade area. Population and household data usually can be obtained from local planning agencies or census publications and adjusted to the trade area established earlier.13 Household income, consumption, and retail expenditure data should then be added as illustrated in Table 9-3. Annual population and household income growth rates should be calculated to provide some basis for future scenario projections. To accomplish this, the analyst has to make some assumptions about the future. In Table 9-3, as an example, it is assumed that trade area growth rates will continue to slow as the population ages and the amount of urban land diminishes. Another possible scenario might be that increases in residential density will support a reversal in population growth rates and the area will start growing again. A demographic profile of the trade area may provide some additional data to support this conclusion. Note that in Table 9-3, disposable income as well as consumption and retail expenditures are projected to level off in 2010 (the year the center would open) and remain constant for the next 10 years. Again, additional information regarding tax policy trends, retail sales over the Web, and other key factors may lead to different conclusions regarding the future. It is generally wise to develop a simple model of the analysis that allows the testing of the sensitivity of various assumptions regarding future projections. Once a confidence level is reached regarding trade area projections, the sales of competitive centers (Table 9-2) should be deducted from trade area retail expenditures to arrive at the incremental retail expenditures that might be anticipated. 13 Trade area boundaries may have to be reconciled to the geographical areas utilized by the various government agencies.

240 TA B L E

9-3

Retail Expenditures, Trade Area, October 2006 Actual Source A. Population Annual Growth Rate B. Population/Household C. Households D. Average Household Income Annual Growth Rate E. Total Household Income* F. Percent Disposable Income G. Total Disposable Income* H. Percent Consumption Expenditures I. Total Consumption Expenditures* J. Percent Retail Expenditures K. Trade Area Retail Expenditures* *In thousands.

1995

Census

417,329

Census A/B Census

2.8 149,046 $47,242

CD Census EF Census GH Census IJ

$7,041,231 84.0% $5,914,634 89.7% $5,305,427 18.5% $981,504

Projected 2000

2005

2010

2015

2020

483,697 3.0% 2.7 179,147 $56,931 3.8% $10,199,018 83.9% $8,556,976 90.4% $7,735,506 18.4% $1,423,333

556,252 2.8% 2.6 213,943 $65,973 3.0% $14,114,462 83.8% $11,827,919 90.8% $10,739,750 18.3% $1,965,374

634,127 2.7% 2.5 253,651 $75,869 2.8% $19,244,248 83.5% $16,068,947 91.0% $14,622,742 17.9% $2,617,471

716,564 2.5% 2.4 298,568 $86,439 2.6% $25,807,919 83.5% $21,549,612 91.0% $19,610,147 17.9% $3,510,216

806,135 2.4% 2.3 350,493 $97,348 2.4% $34,119,793 83.5% $28,490,027 91.0% $25,925,925 17.9% $4,640,741

TA B L E

9-4

Projected Demand on Subject Site, October 2006 Actual Sources Trade Area Expenditures*† Annual Growth Rate Subject Site Capture Rate Projected Subject Site Retail Sales† Subject Site Retail Square Feet Subject Site Projected Sales/Sq. Ft.

Table 9-3

*Assumes leakage to other areas equals sales from other areas. †In thousands.

1995 $981,504

Projected

2000

2005

$1,423,333 7.7%

$1,965,374 6.7%

2010 $2,617,471 5.9% 10.0% $261,747 920,000 $285

2015 $3,510,216 6.0% 10.0% $351,022 920,000 $382

2020 $4,640,741 5.7% 10.0% $464,074 920,000 $504

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Projecting Demand Projected retail sales in the trade area are translated into demand on the subject site through the market capture process (Table 9-4). Trade area expenditures are taken from Table 9-3 and indicate an annual growth rate of approximately 6 percent. The capture of these expenditures by the subject site is estimated at 10 percent annually. This may be conservative in light of the relative age of many of the competitive centers (Table 9-2), plus the favorable location of the subject site near major arterials in the center of the trade area (Figure 9-3). On the other hand, this capture rate assumes that existing centers will most likely go through some form of upgrading in reaction to new competition. There is also the possibility that the prospect of growth in the trade area will attract a strong new competitor unknown at present. This potential threat should stimulate us to move forward with our program as rapidly as possible in order to head off any new competition. This is particularly true in terms of redoubling our efforts to tie up major anchor tenants as soon as possible. As a result of the process, projected retail sales are expected to be $261,747,000 in 2010, increasing to $464,074,000 in 2020. This is equivalent to $285 per square foot of retail space in 2010, increasing to $382 per square foot in 2015 and $504 per square foot in 2020. This projection is reasonably consistent with the median level of retail sales of regional shopping centers in the Urban Land Institute 2006 survey, extended at a 5 percent growth rate over the projection period. In addition to the core retail use, there also should be annual income generated by the office, restaurant, and other nonretail space. This income could come from direct operations, or, more likely, leasing the space to outside operators.

C H A P T E R 10

Office

The business of America is business. Calvin Coolidge President from 1923 to 1929

Office uses depend primarily on business firm expenditures. The vast majority of office space is used to house employees, office equipment, and supplies utilized by business firms. The amount of space required by a firm is a function of its existing operation and its anticipated future requirements. A major factor fueling the U.S. economic boom of the last 15 years has been the building of new office space. New office development was undertaken not only in traditional office cities such as Boston, Chicago, Los Angeles, Minneapolis-St. Paul, New York, Philadelphia, San Francisco, and Washington, D.C., but also in newer, evolving commercial centers including Atlanta, Dallas-Ft. Worth, Denver, Houston, Miami, Orange County (California), Phoenix, San Diego, and Seattle. Even in smaller cities, office building development has expanded dramatically, although often in less intensive physical forms. Office building development falls into two major categories: custom construction geared to the specific needs of a prospective user (who may be the owner as well)1 and buildings constructed on a speculative basis by individual developers. In addition, the public sector has been instrumental in new office development, either as tenant or, in many cases, as owner.

1 Sometimes termed build to suit. 243 Copyright © 2007 by John McMahan. Click here for terms of use.

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THE CHANGING AMERICAN WORKPLACE As we noted in Chapters 4 and 5, the United States is not typical of most industrialized nations in that the U.S. population and economy will continue to grow in the future rather than contract. While immigration will be an increasingly important factor in the nation’s population growth in the future,2 it is not solely responsible for that growth. Rather, it is the character and makeup of American-born generations (including prior immigrants) that are and will continue to be the most important factors in the growth of the U.S. population and in the makeup of the American workplace. Figure 10-1 translates population growth into generational cohorts, so that we can better understand this linkage. Demographic Changes Silent Generation (1925 to 1945) This generation had approximately 44.5 million people as of 2000 and will decline through death to approximately 35.0 million by 2010. The Great Depression and World War II heavily influenced this generation. The experience of seeing their parents out of work and having difficulty in finding new jobs resulted in a great respect for the security of employment. As a result, people selected college majors tending to be practical in FIGURE

10-1

Population (millions)

Generation cohorts. 100 90 80 70 60 50 40 30 20 10 0

Silent Boomers X Y (Echo) Z (Unborn)

2000

2010

Source: U.S. Census Bureau.

2 Steven Camarota, director of research, Center for Immigration Studies, The Impact of Immigration on U.S. Population Growth, August 21, 2001, testimony before Congress.

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nature in such fields as engineering and business. Figure 10-1 illustrates the relative size of the various generations in 2000 and projections for 2010. The experience of World War II provided this generation with respect for authority and decisive leadership. Roosevelt, Eisenhower, and Truman were all “top-down” leaders of large enterprises. This same view permeated postwar business organizations resulting in large, hierarchical organizations run according to “command-and-control” management systems. Offices were generally enclosed, with corner offices taking on special significance. Business dress consisted of a white shirt, tie, and possibly, a hat. A suit coat was usually worn in the office, even when someone was seated. Not surprisingly, the bestselling business book for this generation was William H. Whyte’s Organization Man published in 1956. Baby Boomers (1946 to 1964) Baby boomers have constituted the largest generation in American history to date with approximately 78.7 million people as of 2000, declining slightly to 76.5 million by 2010. Growing up, this generation was influenced by the Vietnam War, Watergate, TV, and The Pill. In coming of age, boomers were exposed to contrasting leadership styles ranging from idealistic leaders such as John F. Kennedy and Martin Luther King, Jr., to more realpolitik leaders such as Richard Nixon and Lyndon Johnson. Over time, boomers became cynical about leadership and began questioning authority. They also turned off to business as a career, more commonly majoring in liberal arts. As it turned out, most of them ended up in business anyway where they assumed most of the trappings of their fathers and mothers but made some modifications in personal appearance such as wearing colored dress shirts and not wearing their suit coats when in the office. The number 1 business writer of the period was Scott Adams who wrote the widely syndicated comic strip Dilbert. Often called “yuppies” and thought to be indulged and narcissistic, boomers made a serious break with their parents’ traditions of leadership and authority. Fortune magazine said it quite well in 1989: As managers . . . they espouse values that any progressive organization would endorse: lots of communication, sharing of responsibility, respect for each other’s autonomy. They are also thoroughly uncomfortable with much of what has traditionally . . . been thought of as the leader’s role. They don’t like telling others what to do any more than they like being told.3 3 Fortune, April 10, 1989.

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In retrospect, this generation was pivotal in laying the groundwork for a completely new view of business organization and management. Generation X (1965 to 1980) The boomers have been followed by a much smaller generation called, for lack of a better name, the “X generation.” As of 2000, this generation has 63.3 million people and is expected to grow slightly to 65.9 million by 2010, primarily through immigration. In growing up, Xers were influenced by Ronald Reagan, the personal computer, and AIDS. In terms of their ultimate view of their careers and the workplace, they have been most influenced by growing up in two-income households and high parental divorce rates as well as the radical downsizing of some traditionally large sectors of American industry. Xers were the first generation living in a society in which both parents worked full time outside the home. It was also the period in which divorce rates peaked, with many Xers moving back and forth between two homes. Growing up in broken families or at least families in which parents often were not home, many felt deprived of their parents’ company with some deciding not to repeat their parents’ lives. For this reason, Xers desire happy marriages in order to build traditional families and are trying to be more available to their children when they are growing up. In essence, most Xers are “working to live rather than living to work.” They value interesting work, but they want their organizations to help them find ways to integrate family life into their demanding careers. The Xers also were deeply influenced in their formative years by the massive layoffs in the early 1990s (43 million middle-management people), as American industry moved to become “leaner” in order to better compete with firms from Japan and other foreign countries. As a result, many Xers do not trust organizations and instead treasure individual independence. They are not antibusiness, however, with many having majored in business and engineering. In fact, the members of the X generation generally have strong capitalist ideals and are very entrepreneurial. A recent U.S. Census survey of business owners indicated that 36 percent of small-business owners are between 25 and 44 years old.4 Another study found that generation Xers are starting businesses at about the same rates as baby boomers.5 4 U.S. Census Bureau, Survey of Business Owners—Characteristics of Business Owners, 2002. 5 Ewing Marion Kauffman Foundation, Kaufman Index of Entrepreneurial Activity, September 22, 2005. The study also found that “immigrants have substantially higher rates of entrepreneurship than native-born individuals.”

Office

247

Xers generally believe that they must construct their own future, independent of business organizations, being loyal only to themselves and their peers. They view job loss as a real possibility and so want to have a “mix” of skills to help them move on if they don’t like where they are. In essence, many Xers move up by moving to another firm. The trade-off with their employers is that they are willing to work long hours while they are training for the next job. This is why they want to be informed and involved and seek out work experiences that best fit their career aspirations. Many of them also believe that businesses should be organized differently. This view of the world is possible because they are members of a relatively small generation and, to date, finding a job has not been a problem. Xers are also the first generation to be raised on computers utilized on a personal level. This gives them certain advantages such as accessing and manipulating information better than older employees, which provides, in essence, a lever over the organization. It’s not just a coincidence that Xers often mentor older employees, particularly with tasks involving technology. Xers’ linkage with technology was perhaps most evident in the dotcom boom of the mid- to late 1990s when they held many senior positions and, in some cases, the leadership of Web organizations. Some of them made phenomenal fortunes while still in their twenties and began to look forward to their goal of retiring in their thirties to begin raising a family. With the collapse of the dot-coms and the onset of a recession, however, many found their hopes dashed as reality set in, and they became thankful just to have a job. Subsequently, many have become senior executives of technology firms in what is now America’s leading industry. Echo Boomers (1981 to 2000) Also known as the “Y generation,” the sons and daughters of the boomers are members of another large generation, almost as big as that of their parents (76.7 million in 2000) and expected to be larger by 2010 (80.2). The influencing events of this generation have been the first Gulf War, the stock market boom and bust in the late 1990s, the impeachment trial of President Bill Clinton, the dawning of the twenty-first century, and the attacks on the World Trade Center and the Pentagon on September 11 and the resultant war on terrorism, including the Iraq and Afghanistan wars. Many of the echo boomers are entering the labor force now, and it’s too early to ascertain what their preferences will be in terms of a work environment. Having been raised on the Web, they are even more

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technologically proficient than the Xers and have many of the same work habits and clothing preferences. No book has yet emerged as a defining piece of business literature for this generation, although several books have been written about them. Impact of Demographic Changes on Business Organization The echo boomers will find a much different workplace than that of their parents, largely through the pioneering efforts of the X generation. Successful firms today are highly focused on customers as well as the production process. Employees are expected to do everything humanly possible to attract and retain customers. This “customer-facing” culture is now becoming deeply institutionalized within most American firms. Today, successful firms are managed by business models keyed to achieving the firm’s goals and objectives. Organizational structures are less hierarchical and more horizontal, with employees connected by technology into a series of high-performance “project” teams focused on product- and service-related tasks. Each project team contains its own marketing and financial personnel reporting to the project manager directly and the corporate marketing and finance functional managers indirectly.6 Because of increased immigration and higher educational achievements by minorities, the workplace is becoming increasingly diverse in terms of ethnic and racial composition. There are also more women in middle and senior management. In some respects, this new approach to organization is an assault on tradition, overturning established relationships and reengineering markets. It attacks long-established price points, deconstructing and reconstructing value chains. More than ever it disintermediates long-standing institutions and forces organizational change in order for businesses to survive. A new business culture appears to be emerging in which openness is encouraged and people are expected to help each other. Learning is becoming more institutionalized so that people can learn the skills necessary to do their job. Old systems are being “deconstructed” in order to provide a new foundation for creative change. In this environment, almost everyone is a leader in some way, and the challenge is to create an environment for team and individual success. Authority is delegated; collaboration encouraged. Leaders evangelize, generating a positive “buzz” about the organization and its future. Risk 6 Some firms reverse this reporting relationship.

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taking is encouraged, and everyone including the boss is expected to roll up his or her sleeves and work incredibly long hours. This revolution in the workplace has major implications for real estate not only in terms of building design and the tenant’s use of space but also for the economies and growth of American cities and towns. Changes in the Physical Workplace Largely as a result of these organizational changes, the physical work environment is becoming increasingly “open” to accommodate the forming and re-forming of project teams. Buildings are often two- or threestory walkup facilities because horizontal movement offers fewer impediments to information sharing than vertical, elevator-served space. The walkups also facilitate exercise for overworked employees. Within the building, larger floor plates with fewer columns and a minimum of floor-to-ceiling partitioning also support new organizational formats. Partitioning is utilized for conference rooms and war rooms to address the meeting requirements of high-performance project teams. Many firms also are extending work hours in order to facilitate flextime schedules and late-night sessions. Given the 24/7 work environment, common areas are necessary in order to provide employee services such as day care, food service, exercise, and dry cleaning. In large metro areas, satellite offices are being built within 60 miles of headquarters or a large regional office in order to reduce commute time. In a tight labor market, the physical environment is increasingly important in attracting and retaining key employees. Office-related employment was 12.4 percent of total nonfarm employment in 1970; by 2005 it had increased to about 30 percent.7 With business profits increasingly driven by investment in intellectual capital, where knowledge workers are a key ingredient for business success, the cost of losing good employees is usually much greater than the cost of creating adequate workspace. In most industries, however, there has been a move in recent years to reduce individual employee work areas through open space plans and shared facility programs such as hoteling.8 This not only applies to engineers and technology personnel but also to support employees and 7 U.S. Department of Labor, Bureau of Labor Statistics, May 2005 National Occupational Employment and Wage Estimates; McMahan Real Estate Services LLC. 8 This is an office concept in which employees do not have a regular office but rather a locker in which they store their personal effects. They are then assigned a workspace for a day or as long as they will be in that office. Hoteling is used by accounting and other firms with multioffice locations.

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even senior management. Over the last two decades space per office employee decreased from an average of 250 square feet to under 200.9 While any one firm’s space reduction efforts may not be important, the collective action of many firms increasing employee density could ultimately mean lower rates of growth in the demand for total workspace. This may explain, in part, how the United States was able to add so many new jobs over the last several years without adding significant amounts of new workspace. One of the reasons some employees appear willing to accept higher densities in their office environment is that they are, in many cases, spending less time there. With the mobility offered by the personal computer, cell phones, and e-mail, people are increasingly working in other venues such as their homes, second homes, hotels, clients’ offices, and airplanes. As some managers put it in a survey a few years back: “Five years ago the office was a pretty big part of my life; now it’s just another place to go. I don’t have to be here to get my work done.” “People can work out of the office or in Timbuktu. It’s never going back the way it was.” “The empire of your own box isn’t relevant anymore. Work is mobile—the cell phone, e-mail, and your computer. It’s not just technology; it’s a mindset—like casual clothes. What’s going on is a convergence of life, work, and home.”10

The drive to lower real estate costs also has led corporate real estate managers to often locate office functions in other property types, most notably industrial buildings. Industrial construction is not only cheaper but it also can be located closer to reasonably priced residential areas and designed in an open space manner that allows more flexibility in creating and disbanding task force and project teams. Individual buildings also provide external firm identification that may be lost in a multitenant building. Often located on fiber optic trunk lines, these types of facilities are increasingly offering employers attractive alternatives to CBD high-rise and midrise suburban office spaces. Changes in the Workplace Location Technology allows the dispersal of economic activity in a manner not possible before. Recognizing the importance of knowledge employees as a 9 Adrienne Schmitz and Deborah L. Brett, Real Estate Market Analysis: A Case Study Approach (Washington, D.C.: Urban Land Institute [ULI], 2001). 10 Lend Lease Corporation, Emerging Trends in Real Estate 2000.

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critical firm resource, business managers now are locating operations in areas attractive to key employees. With half of the workforce now in technology-related industries, there is increasing importance on locating in areas with strong technology infrastructure (for example, universities or training) in order to provide opportunities for employees to keep their knowledge base current. Office employment is also increasing in many CBDs, much of it in culturally attractive older office and industrial buildings. High-technology metros such as San Francisco, New York, and Seattle have reduced their vacancy levels, and even cities like Houston and Baltimore have made impressive gains. We can conclude that, driven largely by technology and generational change, the American workplace is going through major changes in organization, culture, philosophy, and leadership. This, in turn, influences building type, space planning, location selection, and, ultimately, real estate values.

OFFICE ACTIVITY NODES In most metropolitan areas, office activity tends to cluster in nodes around centers of economic activity or, in some cases, transportation facilities. Figure 10-2 indicates the major types of office nodes in most metropolitan areas.

FIGURE

10-2

Typical nodes of office building development.

University Airport

Uptown Office park

CBD Uptown

Hospital

Office park

Shopping center

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Downtowns (Central Business Districts) Office space has become the dominant land use for most downtowns. Generally, this space is occupied by financial institutions, large legal and accounting firms, governmental agencies, and headquarters of major corporations, most of which remained downtown during the flight to the suburbs (with the exception of satellite offices in key suburban office centers). Uptowns Many cities also have a strong uptown office node, generally located along a major arterial that provides access to the suburbs. Examples include Wilshire Boulevard in Los Angeles, Peachtree Street in Atlanta, Michigan Avenue in Chicago, Camelback Road in Phoenix, and Colorado Boulevard in Denver. Demand in these areas has often come from intraurban shifts, generally out of the downtown. The shape of the node is usually linear, reflecting dominance of the arterial. Access tends to be by automobile, which often creates substantial congestion during peak hours. Office Parks Chapter 1 noted the growth of office park developments in many suburban areas. Most new parks today are largely multiuse buildings involving light manufacturing, distribution, and service activities as well as traditional office use. Mixed-use office parks have grown in popularity, with a move away from parks that are classified as strictly industrial. Since the 1950s there has been a steady long-term trend of building more and more parks near interstate highways and, more recently, near airports.11 Another trend in office park development has been a shift from complexes of exclusively one-story buildings to include high-rise or midrise buildings as well. Shopping Centers The growth of major regional shopping centers has produced nodes of activity to support office building development. Frequently, this type of space is oriented toward smaller users, many serving the residential

11 Michael O’Connor, “New Survey Reveals Emerging Trends for Prepared Sites of the Future,” Site Selection Handbook 85 (Atlanta: Conway Data, 1985), p. 1148.

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households in the shopping center’s trade area. Medical office buildings are often a frequent use in these nodes. Special Nodes Office building development also occurs around special activity nodes throughout a metropolitan area. Offices serving attorneys and title companies often develop around major governmental buildings, particularly those containing public records or courts. Medical offices are built near major hospital complexes, allowing doctors easy access for their rounds and any emergencies that might arise. Universities often provide a focal point for R&D and other office building development. Firms utilizing frequent air service may rent space in office buildings near airports.

INFLUENCE OF TENANCY ON MARKET ANALYSIS The design and operation of office buildings are also influenced by the type of tenancy anticipated. Single-Tenant Buildings These are office buildings occupied primarily by a single tenant. Since the major user is identified early in the planning and development process, there are usually few marketing problems. The major analytical task is to determine future space needs of the dominant user by preparing a detailed analysis of future business activities to be conducted in the building. The business plans of operating subunits should be evaluated, as well as their relationship to other units and centralized facilities such as computer centers, libraries, and cafeterias. Staffing levels necessary to implement the plans are assigned and then translated into space requirements, utilizing space-to-employee ratios for various categories of employee (for example, executive, technical, or clerical). This process will indicate future space needs, including space for expansion to accommodate employee growth. Space not required immediately may be subleased on a short-term basis. Multitenant Buildings These are buildings usually developed by a nonuser, directed at securing a variety of tenants from the general office market. Although such a building may be anchored by one or more major tenants, it is not designed

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for their specific needs.12 The market analysis procedures discussed in this chapter generally apply to this type of building, with emphasis on nodal demand, comparisons vis-à-vis competitive buildings, and opportunities for successful preleasing activities.13 Office Parks Since office parks create their own environment to a large extent (Figure 10-3), market analysis is more difficult than with an established node. If the office park is part of a larger project, such as a new town, demand might be created by other land uses within the project. Footloose business operations also may be attracted because of the project’s overall atmosphere. Given the changes occurring in business organization and operation discussed earlier in this chapter, consideration should be given to providing low-rise buildings for light manufacturing, assembly, and distribution space as well as office facilities. Evaluation of metropolitan area data and competitive surveys also may indicate demand for a specialized type of park (for example, financial institutions or R&D firms). Medical Offices Medical and dental office projects are very specialized in terms of planning and design. The approach to market analysis also is different. The first step is to establish the number of doctors currently practicing within 20 to 30 minutes’ driving time from the subject site. This can be accomplished by checking the rosters published by the area’s medical associations or, in many cities, by checking the telephone book. A competitive survey should then be undertaken of existing office facilities in which these doctors are located. Information developed in this survey should cover the same items as in the office survey, with emphasis on proximity to major hospitals, specialized design to accommodate doctors’ needs, the amount of parking provided, and special features such as pharmacies, medical libraries, and recreational facilities within the building.

12 In some cases, the building design is modified to fit the needs of an anchor tenant if the tenant has been secured early in the development process. The goal is to keep the space (excluding tenant finish) reusable by a tenant from the general office market when the first-generation anchor tenant moves out. 13 Lenders may require an appraisal that should be coordinated with the market analysis.

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FIGURE

10-3

With its four high-rise towers and single-level Banking Pavilion, Toronto-Dominion Center is Canada’s largest office complex. (The Cadillac Fairview Corporation Limited)

If the competitive survey reveals that many doctors practice in their homes, nonmedical office buildings, or older, functionally obsolete medical buildings, there should be a relatively strong potential market for a new, functionally designed medical building. If, on the other hand, a series of modern medical facilities currently exists, the market will be difficult to penetrate unless specific lease or ownership deals can be prearranged.14 14 Prospective doctor tenants may wish to participate in the ownership of a medical building, and they often can assist in leasing the rest of the building. If poorly selected, they can also make it difficult as well.

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In all specialized nodes (for example, shopping centers, airports, or government offices), consideration also should be given to the downside risk exposure if the catalyst creating the specialized node changes or diminishes in activity.

ANALYZING MARKET DEMAND Establishing demand for commercial office space is perhaps the most difficult and least accurate of all land use analysis. Statistics on office space occupancies are hard to come by and may be dated. Furthermore, the use of long-term leases reduces turnover; a firm may have a difficult time moving to new space, even if it wants to. In addition, the tendency toward wide swings in overbuilding or underbuilding can create market distortions. Figure 10-4 illustrates graphically the stepped demand and supply patterns associated with office development. Finally, factors such as the “image” of a particular building, proximity to client firms, and quality of continuing property management are difficult to incorporate in the demand analysis.

FIGURE

10-4

Office building: hypothetical demand-supply relationship.

Square feet (millions)

50

25 Supply Demand Undersupply Oversupply

1

2

3

4

5

6 Years

7

8

9

10

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Definition of Terms In analyzing office markets, several terms utilized in office space analysis should be understood. Gross building area. The total area of the office building or combination of buildings, expressed in square feet. ■ Net rentable area (NRA). The amount of space in the buildings available for rent to an office tenant. The exact definition may vary from one metropolitan area to another, but it generally excludes elements of the building (such as the elevator core and stairs and the rest rooms) that penetrate through the floor to areas below, unless these elements are for the exclusive use of a single tenant. The ratio of the gross area to the net area is called the design efficiency ratio. ■ Net rented area. The amount of space in the buildings under legal lease to tenants, whether the space is utilized or not. ■ Net occupied area. The amount of space actually occupied by tenants. A hypothetical demand-supply relationship in an office market is presented in Figure 10-4. ■

Establishing Demand in Metro Areas Unlike housing projects or shopping centers, office buildings have no market or trade area. In essence, office activities15 can be conducted in virtually any section of the metropolitan area, depending on the type of operation, availability of a good labor market, and desires of decision makers within an organization. Another complicating factor is the wide use of computers with the rapid growth of the Internet because it is now possible to conduct office activities in nonoffice locations such as coffee shops, airplanes, and even homes. While there is no evidence to date that this phenomenon has reduced demand for office space, it clearly has had an impact on planning and scheduling the use of office space. In discussing the method of analyzing market demand for office commercial development, we will utilize a smaller metropolitan area than we used for residential or retail land uses to demonstrate the dispersal of office activities between metro areas. Table 10-1 illustrates the elements of such an analysis. 15 For the purpose of this discussion, office activities involve business activities physically separated from manufacturing or other industrial operations.

258 TA B L E

10-1

Office Space Demand, Metro Area, October 2006 Actual

A. B. C. D. E. F. G. H.

Total Private Employment Percentage Office Related Office-Related Employment Sq. Ft. per Employee Net Office Space Demand Increase for Period Average Annual Increase Average Annual Percent Increase

I. J. K.

Existing Supply Completed New Construction During Period Total

L. M. N. O.

Average Annual Supply Vacant Space EOP Average Annual Vacant Space Average Annual Vacancy Rate

Projected

Source

1995

2000

2005

2010

2015

2020

U.S. Census U.S. Census AB BOMA CD E2000
E1995, etc. (F / 5)

382,436 14.6% 55,836 203 11,344,708

437,901 15.1% 66,123 201 13,290,723 1,956,015 391,203 3.2%

478,377 15.7% 75,105 198 14,870,790 1,580,067 316,013 2.3%

519,000 16.5% 85,635 195 16,698,825 1,828,035 365,607 2.3%

563,000 17.3% 97,399 190 18,505,810 1,806,985 361,397 2.1%

611,000 18.2% 111,202 185 20,572,370 2,066,560 413,312 2.1%

Planning Agency Planning Agency

13,313,202 893,781

14,206,983 673,471

14,880,454 1,305,761

16,186,215 2,300,000

18,486,215 2,100,000

20,586,215 2,200,000

IJ

14,206,983

14,880,454

16,186,215

18,486,215

20,586,215

22,786,215

14,543,719 1,589,731 2,231,003 15.3%

15,533,335 1,315,425 1,452,578 9.4%

17,336,215 1,787,390 1,551,408 8.9%

19,536,215 2,080,405 1,933,898 9.9%

21,686,215 2,213,845 2,147,125 9.9%

(K1995  K2000) / 2, etc. K
E (M1995  M2000) / 2, etc. (N / L)

2,872,275

Office

259

The first step is to analyze the level of office-oriented employment, both on a historic basis and projected into the future. Employment data by industry (standard industrial classification [SIC] codes) and job categories within each industry are available from the U.S. Census Bureau and U.S. Bureau of Labor Statistics, and they may also be available from local planning agencies. Data obtained from government agencies are not usually broken down into office and nonoffice jobs within a job category. Some job categories traditionally rely heavily on office employment and include Management, Business and Financial Operations, Health Care, Computer and Math Occupations, Real Estate, Architectural and Engineering, and Office and Administration Support. There is no set formula as to which percentage of jobs in each category is office based, and to be accurate, most estimates should take into account specific local trends of employment in a particular job category. Trends in historical data should be evaluated. For example, a rapid buildup in employment in a certain industry may indicate a market opportunity; conversely, a decline in financial employment may reflect a shift of activities to another metro area. The relationship between office employment categories and other areas of employment also may be important. For example, a metro area with a rapid increase in manufacturing employment may indicate future demand by service-related businesses that utilize office space.16 These data are then extrapolated into the future, utilizing the same year spacing as the historic data. In Table 10-1, it is assumed that the percentage utilizing office space will increase somewhat over the projection period, consistent with the experience of the prior 15 years. This is based on the assumption that the metro area is growing and will continue to attract an increasing number of new business firms setting up regional offices in addition to encouraging its existing local firms to upgrade their office spaces and facilities. The next step is to formulate a ratio of the square feet per employee for the metropolitan area, or if unavailable, utilize national ratios. Generally, information on the amount of net rented area in a metropolitan area is available from local planning agencies or private groups such as the Building Owners and Managers Association.17 16 See the export-base theory of urban growth discussed in Chapter 5. 17 It is desirable that data are available for several years, so the discernible trends can be spotted. An increase in the space-per-employee ratio may indicate a reduction in employment, increased automation, a shift to lower-cost office space, a change in the employment mix toward higherpriced employees, or other possibilities.

260

TA B L E

10-2

Competitive Survey, Cedar Lake Node, October 2006 Leases No. 1

2

3

4

Project

Node

Construction

Floors

NRA

Floor Sq. Ft.

Vacant

%

Tenant

First Security Bank

Uptown

Steel

20

250,000

12,500

25,000

10.0%

First Security Bank Adams, Baker, et al. Moss Consulting Other Totals

Financial Services Center

Center City Financial

Royal Products Center

Uptown

Uptown

Uptown

Totals/Average

Concrete

Steel

Concrete

10

15

5

50

100,000

120,000

100,000

570,000

10,000

8,000

20,000

11,400

5,000

10,000

5,000

45,000

5.0%

8.3%

5.0%

7.9%

Zeon Securities McClatchy, Ford, et al. Madison Insurance Other Totals American Products National Financial Midtown CPA Other Totals Royal Products Murphy, Rice, et al. Allied Engineering Other Totals

Sq. Ft.

Rent/Sq. Ft.

Term

Expires

Options

$50.00

15

12/31/2009

1/5 yrs.

25,000

$55.00

10

3/31/2007

None

12,500 125,000 225,000

$60.00 Varies

5 Varies

6/30/2007 Varies

None Varies

30,000

$55.00

10

6/30/2010

1/10 yrs.

10,000

$60.00

5

12/31/2007

None

10,000 45,000 95,000

$60.00 Varies

5 Varies

2/28/2008 Varies

None Varies

24,000

$45.00

10

3/31/2012

2/5 yrs.

62,500

16,000

$40.00

5

1/31/2008

None

8,000 62,000 110,000

$50.00 Varies

5 Varies

9/30/2008 Varies

None Varies

40,000

$50.00

15

3/31/2015

1/5 yrs.

20,000

$55.00

10

12/15/2008

None

20,000 15,000 95,000

$52.50 $60.00

5 Varies

5/31/2008 Varies

None

525,000

Building Features Project

Location

Bldg. Quality

First Security Bank

Excellent

Financial Services Center

Excellent

Center City Financial Royal Products Center

Lease Terms Features

Mgt.

Excellent

C, HC, R, W

Excellent

First Security Bank

$10/sq. ft.

Very Good

C, R, W

Excellent

Financial Services Center

$10/sq. ft.

Good

Good

C, R

Good

Center City Financial

Fair

Fair

R

Good

Royal Products Center

C: conference room; HC, health club; R: restaurant; and W: telecommunications wiring.

Tenant Finish Mo. Free

Parking

Wired

Comments

2

$300/mo.

Yes

3

$250/mo.

Yes

Location not as good

$8/sq. ft.

6

$200/mo.

No

Some medical tenants

$8/sq. ft.

6

$200/mo.

No

Older building

Best overall

261

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The average ratio of office space per employee can be estimated from the data on the net rented office space and office employment in the metropolitan area. In this case, we have assumed the amount of space per employee continues to decline at the historic pace. The projected number of office-related employees is then multiplied by the space per employee ratio to arrive at the net demand for office space. Net demand is then matched with existing supply, including both completed buildings and those under construction. Incremental demand growth is then projected for each of the five-year periods. The vacant space is determined by subtracting net demand from total construction. The vacancy factor is calculated by dividing the amount of vacant space for the period by the total amount of existing supply at the end of the period. Projected levels of office space are then compared with historic building activity. Several tests of “reasonableness” can be utilized, including space per capita, absorption per year, and the experiences of similar metro areas.

Competitive Survey Once overall demand trends in the metropolitan area are understood, the competition must be analyzed. This is illustrated in Table 10-2. The scope of the competitive survey will depend on the size and nature of the contemplated project. If it’s a small or medium-sized office building directed at the general office market, a survey of the node in which the subject site is located will probably be sufficient. If the project is a large office building or involves a specialized market, it may be necessary to survey other nodes as well. In most cases, the best policy is to first undertake a detailed survey of the node surrounding the subject site followed by a more generalized survey of other nodes, particularly those deemed most competitive. As with any other survey, this should be undertaken by experienced professionals or staff. Information to be gathered includes the following: Project location Net rentable area (completed and under construction) ■ Vacant space ■ Average rent per square foot ■ Free rent concessions (if any) ■ ■

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Office

Tenant finish allowances and items, which include such elements as carpets, draperies, partitioning, telephone and electrical outlets, and the expense stop18 ■ Parking provided (stalls per 1,000 square feet) and monthly charge ■ Building amenities (for example, conference facilities, restaurants, or health clubs) ■ List of major tenants and a profile of other tenants ■ Qualitative judgment regarding overall project competitiveness ■

This information usually can be obtained from on-site inspections, discussions with leasing agents, a review of building plans, and discussions with tenants. In some situations, it also may be desirable to look for major leases that will come up for renewal within a two- to three-year period. These tenants may provide potential demand for the proposed project. Projecting Market Demand Information generated from the competitive survey explains the relative strength of major office buildings located in the node, in this case, Cedar Lake. The next step is to project future demand for the subject site, as outlined in Table 10-3.19 This is largely a judgmental process and must take into consideration the current competitiveness of the node, new office space planned or under construction, economic trends in the metropolitan area, and problems such as traffic congestion, crime, and neighborhood deterioration. A good benchmark in projecting nodal demand is the node’s current capture of metropolitan demand, which will change depending on the factors indicated above. Estimating Market Capture The next step is to determine the amount of metro area demand that will be captured by the Cedar Lake nodal area. In 2005, this was approximately 73.2 percent. This is projected to not increase in the future, but to level off at 70 percent, reflecting the fact that the node is well established with several reasonably successful office buildings (as revealed by the competitive survey). 18 An expense stop is a provision in a lease that establishes the maximum level of operating expenses to be paid by the landlord; expenses beyond this level are reimbursed by the tenant. 19 In this situation, the node (Cedar Lake) is the market area.

TA B L E

10-3

Market Demand, Subject Site, October 2006 Actual

A. Metro Area Demand B. Cedar Lake Node C. Nodal Capture Rate D. Future Nodal Demand E. Competitive Buildings F. Competitive Buildings Capture Rate G. Projected Competitive Buildings Demand H. Subject Site Capture Rate I. Projected Demand on Subject Site J. Sq. Ft. per Floor, Net K. Number of Floors (rounded) Total Net Sq. Ft.

Projected

Source

1995

2000

2005

2010

2015

2020

Table 10-1 Planning Agency

11,334,708 643,722 5.7%

13,290,723 708,094 5.3%

14,870,790 778,904 5.2%

16,698,825

18,505,810

20,572,370

5.0% 834,941

5.0% 925,291

5.0% 1,028,619

70.0%

70.0%

70.0%

584,459 25.0% 146,115 12,500 12 150,000

647,703

720,033

AC Table 10-2 Calculation/Assumption DF Assumption GH Assumption I/J JK

570,000 73.2%

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Office

265

The final step is to estimate the amount of nodal demand that can be captured by the subject site (see Table 10-3). Factors to be evaluated include location of the site within the node, other office buildings nearby, vehicular and public transportation access, views possible from the buildings, and address prestige.20 In this situation, there are no other new competitive projects that have been announced in the node, and the project will be developed in the 2007 to 2009 time frame, a period of anticipated expansion in the market area business activity. It is wise to allow for other, presently unknown, projects, so we have conservatively utilized a 25 percent capture rate in estimating the amount of demand that can be captured during this period by the subject site. The result of the analysis is a site demand projection of 150,000 square feet that at an average NRA level of 12,500 square feet per floor would result in a building of 12 floors.

20 If a major anchor tenant is reasonably firm, the analysis should consider the image and operation of the anchor tenant.

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C H A P T E R 11

Industrial

We Are Changing the Way We Do Business North Carolina Economic Development Board Strategic Plan, 2002

Virtually every type of industrial activity requires land and buildings to fabricate, assemble, store, and transport its products.1 To ensure that the result of these processes is not toxic waste or the unsustainable use of natural resources, as we noted in Chapter 2, a major objective of planning and zoning in the United States has been and continues to be the regulation of industrial land use. Today, while most communities recognize the vital importance of industry to their economic base, they also realize that these activities have to be undertaken (1) in areas where they will be least harmful to other land uses and (2) under ground rules that ensure conformity with minimum standards for health and safety. Some communities go even further, regulating the environmental and aesthetic quality of some industrial land uses and banning others altogether. Over the years, industry also has become more concerned about the way in which it utilizes land. The site selection process is considerably more sophisticated than it was in the past. Firms are concerned about the type of community in which their employees live, as well as the quality of their industrial neighbors. To some extent, the interest of firms and the communities in which they operate are more compatible now than at any time in the past. 1 Services are not included in this discussion, although some types of service firms occupy industrial types of space. 267 Copyright © 2007 by John McMahan. Click here for terms of use.

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THEORIES OF INDUSTRIAL LOCATION Over the last 180 years there have been several theories to explain how industrial firms choose their locations. Least Cost In 1826, Johann Von Thunen related the intensity of land utilized for agricultural purposes to the distance (and, hence, transportation costs) from the city center.2 A century later, Alfred Weber postulated that firms will seek that location which minimizes their labor, transportation, and raw materials costs.3 Weber further noted that the effect of the manufacturing process on transportation costs determines location to a large degree. If the product tended to lose weight through processing, the firm would most likely locate nearer sources of raw materials. If the product tended to add weight, the location would be nearer final consumption markets. Weber argued that firms will locate nearer a source of labor only if those costs savings are more than the added transportation cost. He also noted that firms in certain industries tend to cluster (“agglomerate”) in order to decrease production costs (for example, automobiles, airplane manufacturers, or motion picture production), while the tendency to decentralize (“deglomerate”) tended to increase production costs as a result of higher land costs, plant obsolescence, and so on. In 1939, August Losch, writing in The Economics of Location,4 argued that firms could penetrate their market through low prices only by locating at the lowest-cost site. That is, plants located closest to the consumer would have the lowest transportation costs and would therefore be able to capture the largest share of the market. In 1948, Edgar Hoover broadened the least-cost concept to include transfer costs such as maintaining large inventories as well as the loss of business and increased cost of distribution as a result of slow deliveries.5 He also noted that the type of transportation was often as important as the distance involved; railroads may be better for longer distances, trucks for shorter ones. In essence, Hoover argued that industrial site selection is a process of balancing various combinations of production and transfer cost. 2 J. H. Von Thunen, Der Isolierte Staat in Beziehnug auf Landwirtschaft und Nationalokonomie, Hamburg, 1826. 3 Alfred Weber, Theory of the Location of Industries, C. J. Friedrick (trans.) (Chicago: University of Chicago Press, 1929). 4 August Losch, The Economics of Location (New Haven, Connecticut: Yale University Press, 1939). 5 Edgar M. Hoover, Location of Economic Activity (New York: McGraw-Hill, 1948).

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Industrial

Profit Maximization In 1956, Melvin Greenhut challenged least-cost reasoning, maintaining that profit maximization, not cost minimization, was most critical.6 According to Greenhut, some firms will locate in a rapidly growing market area, even if it isn’t the least-cost location. Other factors that may be as important as transfer and processing costs include competitiveness of the industry, size of the market area, proximity and direct contact with customers, location of competitors, and elasticity in product demand. Greenhut also introduced the idea that personal management preferences may have an influence. Firm Orientation In 1971, building on Greenhut’s theoretical base, William Kinnard and Stephen Messner identified and classified five major categories of firms by dominant factors in the site location decision-making process: 1. Market oriented. These firms are most oriented toward the market for their final product. This group includes consumer industries, which tend to follow concentrations of population, and firms that produce for other industries, which tend to follow the industry on which they are dependent. 2. Resource oriented. These firms are oriented primarily toward resources required for production. This may include a specific natural resource utilized directly in the production process (for example, iron ore or bauxite) or specific types of fuel required by the production process (for example, hydroelectric power, natural gas, or coal). 3. Transportation oriented. In some cases, transportation cost is the major consideration in a site selection decision. In these situations, firms generally tend to locate near the type of transportation that best serves their needs. 4. Labor oriented. Some firms are primarily concerned with the availability and cost of labor. Generally, labor-intensive industries tend to concentrate in areas where labor is plentiful, at relatively low cost. The degree of unionization of the labor force also may be a consideration.

6 Melvin L. Greenhut, Plant Location in Theory and in Practice (Chapel Hill: University of North Carolina Press, 1956).

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Professional Property Development

5. Footloose. Some firms are not oriented toward any of these factors and generally locate in areas on the basis of lifestyle and image.7 To these might be added a more recent driving force—the search for areas that are skills oriented. This is particularly true in the case of technology-related industries, such as electronics, where proximity to universities and technical schools may be the most important consideration. As an example, the growth of the electronics industry in Boston, Austin, San Francisco, and Los Angeles was directly related to the presence of local universities with advanced programs in various areas of technology. By understanding the ingredients that go into a firm’s location decision, it’s possible to establish the type of industrial land required, the site services that will be needed, and the maximum price the firm can pay.

MAJOR CHANGES IN PRODUCT DISTRIBUTION Industrial location decisions are affected by business operations now more than at any time in history. This situation has evolved as the result of the coalescing of four major trends: (1) the move toward globalization in which firms operate in a variety of locations, often in multiple countries, largely in response to a massive increase in worldwide demand; (2) changes in the workplace driven by demographics and career objectives; (3) a revolution in supply chain management brought about by new technology; and (4) an evolution in industrial building design and construction that has provided new spaces for the development, manufacturing, and storage functions inherent in the production process. We discussed in Chapter 4 the move to globalization and, in Chapter 10, the demographic and lifestyle changes occurring in the American workplace. In this chapter, we will focus on supply chain management and improvements in building design and construction. Supply Chain Management The supply chain refers to the process of meeting a firm’s promise to its customers. The process includes assembling raw materials, manufacturing the product, storage on site or in a separate facility, and shipment to a retailer or 7 William N. Kinnard, Jr., and Stephen D. Messner, Industrial Real Estate (Washington, D.C.: Society of Industrial Realtors of the National Association of Real Estate Boards, 1971), pp. 53–55.

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Industrial

directly to the customer. It relies on all aspects of the firm’s operation including planning and forecasting, marketing, and customer service.8 Logistics is the management of product inventory between the time the product is produced to the moment it is finally in the hands of the customer. It also includes the procurement, shipment, and storage of raw materials that are utilized in the manufacture of the product.9 Logistics is a complex process that includes “forecasting, procurement, production planning, and scheduling, inventory control, warehousing, transportation, customer service, and related information.”10 The objective is to have the manufactured product arrive in precise quantities “just in time” to match customers’ orders, thereby reducing or eliminating the need for warehouse storage. This lowers storage costs for both materials used in the manufacturing process as well as for in-process and finished goods. More importantly, it increases the chances that the product will arrive in the customer’s hands when promised, thereby resulting in greater consumer satisfaction and enhanced competitive position.11 As noted in Figure 11-1, the average amount of inventory that firms have maintained to support sales has dropped almost 60 percent over the last 56 years (1951 to 2007). This has been primarily through the use of logistics and supply chain management. Other related tools include bar coding, inventory control systems, and devices and systems to control inventory levels.12 These developments, coupled with improved transportation systems and more efficient warehouse handling equipment, have served to reduce the amount of warehouse space required to support a given level of sales.13 Role of Transportation While there are industrial development opportunities in almost every metropolitan area, the major opportunities appear to be concentrated in major transportation hubs that have emerged during the last several years. 8 Gary S. Weiss and Rene Cire, “Industrial Real Estate—Today’s Supply Chain,” Professional Report, winter 2002, p. 23. 9 Ann Moline, “Understanding Logistics and the Supply Chain Process,” Just in Time Real Estate— How Trends Are Driving Industrial Development (Washington, D.C.: Urban Land Institute [ULI], 2004), p. 7. 10 John T. Mentzer and James S. Keebler, “Current Trends in Logistics and Distribution,” unpublished paper, 2001, p. 23. 11 As more firms adopt supply chain management techniques, however, it is becoming more of a necessity. 12 Some argue that it is also due to interstate deregulation in the early 1980s and the deregulation of intrastate transportation in the early 1990s. 13 Several large retailers, such as Wal-Mart, also have begun utilizing trucks as storage units for goods. This increases the amount of paved storage area but, unfortunately for real estate developers, reduces the amount of building area required for storage.

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Professional Property Development

FIGURE

11-1

Impact of advances in technology on distribution: private inventories to final sales. 7.00

6.00

5.00

4.00

−57.0% 3.00

2.00

1.00

19 5 19 1-I 52 19 IV 54 19 III 56 19 -II 5 19 8-I 59 19 IV 61 19 III 63 19 -II 65 19 -I 66 19 IV 68 -III 19 70 19 -II 72 19 I 73 19 IV 75 19 III 77 19 II 79 19 -I 80 19 IV 82 19 III 84 -II 19 86 19 -I 87 19 IV 89 19 III 91 19 II 9 19 3-I 94 19 IV 96 19 III 98 20 -II 0 20 0-I 01 20 IV 03 20 III 05 20 -II 07 -I

0.00

Source: U.S. Department of Commerce Bureau of Economic Analysis

These include port cities such as New York (the New York and New Jersey Port District), San Francisco, Seattle, Miami, and Los Angeles14 as well as major air hubs such as Atlanta, Dallas, Chicago, Los Angeles, Miami, Memphis, and New York.15 In terms of land-based transportation, rail became more competitive with trucking in 1980 with the passage of the Staggers Act that resulted in a 60 percent reduction in rail shipping rates between 1981 and 2001 (adjusted for inflation), reportedly saving shippers and their customers more than $10 billion per year.16 Today, intercontinental rail corridors linking ports on the West Coast (Los Angeles, Oakland, and Seattle) with Chicago and New York facilitate trade with Japan, China, India, and other rapidly growing Asian countries. Similar north-south rail links have been developed between Miami and the East and Midwest regions as well as a link between New Orleans and

14 This is primarily due to major distribution facilities located in the Riverside-San Bernardino area that are connected to Los Angeles-Long Beach ports by way of a dedicated rail link. 15 Airports Council International—North America, Washington, D.C., 2002. 16 Association of American Railroads, Impact of the Staggers Rail Act of 1980, Washington, D.C., 2003, p. 2.

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Industrial

Chicago. Cities located en route that should benefit from these links include Atlanta, Baltimore, Kansas City, Omaha, and Salt Lake City.17 Metro areas located on sea- and land-based routes that also serve large regional populations, such as New York, Los Angeles, Chicago, and Miami, are in a particularly good position to compete for distribution facilities. Within metropolitan areas, it’s critical to be reasonably close to transportation facilities since shipping time is money and the ability to get goods in and out of storage can often be critical to both the shipper and receiver of the goods. Having good access to major highways is also important since most of the goods will leave the warehouse by truck for distribution either within the metro area or to smaller cities. Proximity to rail transportation is desirable in port locations and other areas where large, heavy items are being forwarded on to other destinations.

Building Design and Construction Most new industrial buildings are built to meet prospective tenants’ operating requirements. As a result, the majority are “big boxes” with 24- to 30-foot heights18 as well as room for the circulation of forklifts and other vehicles required to move storage boxes from one place to another. Most buildings are air-conditioned or at least air-cooled to maintain relatively constant temperatures. The site should contain adequate room for truck and trailer turning and parking, as well as parking for building employees and visitors. Figure 11-2 is a schematic representation of the relationship between shipping and storage and how this has changed during the last decade. In the traditional warehouse building layout shown in the upper left hand corner, the incoming and outgoing goods arrive and depart through the same overhead doors and may even use the same docks. In the new economy warehouse, as more distribution facilities are used to break down larger shipments into smaller ones, the incoming and

17 Not to be left behind, several ocean shipping lines are building bigger, faster cargo ships to go around South America, which it is claimed will be competitive with the new rail intermodal service. Panama also reportedly is beginning a program to upgrade the Panama Canal to accommodate modern shipping standards. 18 The 30-foot height allows tenants to stack goods five pallets high, which is necessary for buildings located in transportation hubs. Generally, a 24-foot height (four pallets) is sufficient for most local markets.

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FIGURE

11-2

Types of warehouse layouts.

Traditional warehouse Storage Storage

New economy warehouse Storage

Office Staging area

Staging area Office

Storage Employee parking

Office

Staging Packaging area

Employee parking

Employee parking

Web fulfillment center

Source: McMahan Real Estate Services LLC

outgoing functions are separated, usually at opposite sides of the building, with a staging area to unpackage and repackage stored goods, generally from larger packages to smaller ones. Parking is usually provided for truck trailers, which may park overnight and load outgoing shipments early the next morning. Outgoing goods also are handled by smaller trucks serving the local metro area or other areas nearby. If the warehouse is utilized as a Web fulfillment center, the packaging may be more complex (smaller and a greater variety of packaging), and a portion of the warehouse may be devoted exclusively to this activity. As additional employees are added to perform functions within the warehouse, more of the site is utilized for parking, generally requiring a larger land parcel. Also note that the area set aside for office functions gets larger as the role of the warehouse becomes more complex. The net result is that, although distribution buildings have increased in area and height, the increase has not been sufficient to avoid shrinkage in the demand for space required to support a given level of distribution operations. Not surprisingly, the amount of new warehouse space constructed has been declining since early 2001, and older space is often difficult to lease.

Industrial

275

Matching the Site with the User’s Needs One of the principles of good industrial development is that the site should reasonably meet the operating needs of the user. The reason is that facility costs become an integral part of the costs of doing business. This applies not only to direct building rental and/or ownership expenses but also to the more indirect costs of employee or customer time lost as result of a poor location or the lack of a key transportation or communications linkage. As a result, business firms involved in manufacturing and distribution have traditionally viewed the selection and/or development of operating facilities as a key factor in their ability to compete efficiently and profitably. In light of the high level of competition in today’s modern business world, this vital consideration should be at the forefront of a developer’s thinking when considering a metro area or an individual site for an industrial development project. Locational Factors A business firm’s requirements may change over time, which makes it important to have sufficient land to allow tenants or owners room to grow without having to move. This can be accomplished through a land banking program (carrying costs being partially or fully paid by the developer) and a willingness to construct and finance a new building facility when required, assuming the firm is in good standing and a fair deal can be negotiated. Manufacturing Firms Projects directed at manufacturing firms must offer a well-balanced blend of proximity to markets, labor resources, and housing; accessibility to transportation facilities; and a reasonably good overall environment. Utilities are a part of the production process and must be available with sufficient capacity to handle all tenant or owner requirements. Development standards are important but not critical. Since manufacturing is such a broad classification, however, the developer should focus on target SIC categories that have particular promise. Warehouse and Distribution Firms Warehouse and distribution firms are primarily interested in proximity to markets and transportation facilities. A combination of rail and highway facilities is usually desirable, affording the firm flexibility in dealing with strikes. As noted earlier, airfreight is an increasingly important factor.

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Utility capacity is usually not critical, nor is proximity to residential neighborhoods. Inventory taxes may be an important consideration, if they differ significantly between areas in which competing projects are located. Development controls should be flexible, particularly in terms of interior road design, loading areas, and buildings. Research and Development Firms Research parks are considerably different. Much greater emphasis is placed on the overall quality of the subject site (for example, natural beauty, water features, views, or topography). Proximity to high-quality residential neighborhoods, universities, and cultural and recreational facilities is also important. Development controls must be high, with developer guarantees that they will be maintained. Utility availability, particularly electricity, may be important to firms engaged in prototype experimentation. High-speed underground cable service is increasingly important to all potential R&D tenants and/or owners. Proximity to airfreight facilities also may be critical to some tenants.19 Hybrid Projects In recent years, a new type of building has been developed in California’s Silicon Valley and other high-technology centers. This hybrid building contains manufacturing, R&D, office, and warehousing activities, all within the same building. Firms interested in this type of facility generally desire to have the building layout as flexible as possible in order that they may adjust the allocation and location of space to suit changes in their overall operation.

SITE SELECTION PROCESS Today, site selection for most business firms is a sophisticated process that may take a year or longer and involve outside consultants in addition to top executives. The process involves screening regions, metropolitan areas, and specific sites for criteria important to the firm. Selecting Regions In discussing regions, it is necessary to distinguish between relocation and expansion. A firm relocating its activities to another region is probably responding to dwindling markets, higher labor and transportation costs, or other negative pressures in the region from which it is emigrating. 19 Pick up and deliver services by shipping companies may suffice.

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Industrial

Such a firm will be seeking a region where these problems are reduced or nonexistent. This type of regional relocation can become so prevalent within an industry that an individual firm may be forced to relocate to remain competitive. This explains, in part, the movement of the American textile industry from New England to the Southeast and then overseas. In the case of additional regional offices, the decision is based mostly on serving markets for the firm’s products and responding to strong competition. As a geographic market expands, a firm producing in another region is increasingly tempted to open branch operations in a new market area. Often, this is accomplished when distribution branches evolve into manufacturing operations. In considering regional expansion, a firm must weigh costs of new plant and equipment against advantages of greater market penetration, lower transportation and distribution costs, and possibly lower production costs. In many cases, interregional expansion decisions are a vital component of long-term corporate planning.

Selecting Metro Areas The next step is to select a metro area within the region.20 This decision involves an evaluation of market potential, operating costs, and community and lifestyle factors that affect the overall business manager and employee living environment. Market Potential In selecting industrial sites, it often costs less to operate if the production facility can spread costs by also serving a large surrounding market area. The metro area, in essence, provides a nucleus for growth in terms of potential purchasing power as well as the area’s ability to pioneer market trends for the region. Important factors in evaluating the market potential of the metro area include population, income, and expenditure patterns in the metropolitan area; strengths and nature of competition, size and cost (including land for expansion), and channels of distribution.

20 Within geographic regions, extensive competition exists between metro areas for industrial firms: Boston and Hartford in the Northeast; New York and New Jersey in the middle Atlantic states; Atlanta and Orlando in the Southeast; Dallas and Houston in Texas; Denver and Salt Lake City in the Rockies; Portland and Seattle in the Northwest; and Phoenix, southern California, and the San Francisco Bay Area in the far West.

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Operating Costs The firm usually evaluates operating costs in each metro area under consideration. These factors include availability, cost, and skill level of labor; availability and cost of land; cost of building materials; total tax loads, including property, sales, excise, income and inventory taxes; and transportation and utility costs. Community Environment Less easily discerned are the more subtle factors related to the metro area in which the firm chooses to operate. These usually include the following: Overall “image” vis-à-vis the firm’s products and services Attitude of metro area leaders toward industrial growth ■ Degree of unionization and attitudes of local union leaders ■ Availability of residential housing resources available for all employee income levels ■ Quality of community services (for example, police, fire, schools, libraries, or recreational facilities) ■ Availability of higher-education programs for employees, particularly firms involved in high technology ■ Cultural and entertainment facilities ■ Possible tax abatement ■ Possible cost reduction of public services ■ ■

In many cases, final selection of a metro area may involve a tradeoff between these factors. The evaluation process and the ultimate decision usually will depend on the orientation of the firm and its weighing of relevant site selection factors. Site Selection Once the region and metro area have been selected, a specific site can be chosen from those available. This is generally a fairly precise analytical process, involving extensive field investigation. Factors influencing this decision include the following: Land parcel size and cost (including land for expansion) Cost of building development and operation ■ Availability of utilities (for example, electricity, gas, water, telephone, or high-speed cable) ■ Accessibility to transportation ■ Zoning and development covenants ■ Type of firms in the surrounding area ■ Proximity to residential neighborhoods ■ ■

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Community facilities (vocational training schools, graduate schools, recreational facilities, and so on) ■ Proximity to service facilities (hotels, restaurants, recreational complexes, and so on) ■ Municipal and special district taxes ■ Community concessions (subsidized infrastructure, tax abatement, utility and/or service subsidies, and so on) ■ Developer concessions (free rent, lower-cost financing, expansion land banking, and so on) ■ Other factors peculiar to the individual firm and its management ■

Each of these considerations is assigned relative weights, either explicitly or implicitly, depending on strategic and operating policies of the firm. The prospective sites are then compared and ranked, and a final list is developed. The final site selection ultimately will involve trade-offs between the various factors considered, depending on their relative importance to the firm and its employees, personal management desires, the overall outlook for the economy, and future business prospects for the firm.

ANALYZING MARKET DEMAND In analyzing market demand for a potential industrial development project, a major challenge is narrowing the focus to those industries most likely to be attracted to a specific industrial park on a specific parcel of land. This requires some assumptions about the potential attractiveness of the subject site for prospective industrial users. Overall Character of the Site The location and nature of the site and the availability of transportation facilities will provide some clues. A site located in an established industrial area may be well suited to firms servicing existing operations in the area. A site with good rail access may be more appropriate for distributive operations. A site with attractive physical features and neighborhood amenities may lend itself to a research and development park. The example sited in the following series of tables is 2,000 gross acres. Preliminary estimates are that roads and other nonsaleable land will comprise approximately 25 percent of the total acreage, resulting in a net of approximately 1,500 acres of land that can be developed for tenant or owner use. The site is gently rolling land, located on a freeway, but it does not have rail access.

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Market Area The first step is to define the market area for the subject site. Industrial land markets are generally larger than residential, retail, or office market areas because they require much larger land parcels and are dependent on various modes of transportation. As noted earlier, public agencies also tend to zone land for industry that is on the fringe of the metro area as opposed to zoning for industry in the more densely developed internal areas.21 At this point, it is desirable to gain a better understanding regarding some of the key firms that are currently expanding employment. This can be accomplished by securing a list of firms with local operations in each of the SIC classifications that are expanding employment (see Table 11-1). TA B L E

11-1

Target Industries, Market Area, October 2006 Employment SIC No.

Industry

2004

2005

5,231 4,265 3,285 2,645 2,468 2,346 996 21,236 67.7%

5,780 4,530 3,850 3,202 2,879 2,780 1,435 24,456 72.6%

6,135 4,895 4,511 3,853 3,285 3,248 1,985 27,912 77.2%

8.3% 7.1% 17.2% 20.7% 15.4% 17.7% 41.2% 14.6%

675 794 1,013 1,479 2,747 3,409 10,117 32.3%

602 743 981 1,257 2,465 3,164 9,212 27.4%

567 657 967 980 2,134 2,951 8,256 22.8%


8.3%
9.0%
2.3%
18.5%
11.8%
7.0%
9.7%

Total/Average

31,353

33,668

36,168

7.4%

Total Manufacturing Employment Target Industry Percent of Total

65,731 47.7%

76,388 44.1%

82,459 43.9%

12.1%

Expanding Employment 382 Laboratory Equip. 366 Communications Equip. 367 Electronic Components 357 Computer Equip. 381 Scientific and Research Equip. 362 Electrical Apparatus 384 Medical and Dental Equip. Subtotal/Average Percent of Total Contracting 387 507 506 386 365 363

Avg. Annual Growth Rate

2003

Employment Watches, Clocks, etc. Plumbing and Heating Dist. Electrical Goods Dist. Photographic Equip. Radio and TV Mfg. Household Appliances Subtotal/Average Percent of Total

21 The major exceptions are in-town industrial projects, most of which were the site of an earlier industrial park or under a single property owner, often a governmental agency. These properties are replatted and brought up to modern industrial standards, sometimes utilizing eminent domain to acquire the land and relocate existing residents. See also the discussion on “takings” in Chapter 2.

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Industrial

These firms then can be evaluated in terms of the nature of their local operations. It is helpful at this point to secure brochures of some of the leading firms as well as interview some of the firm managers in order to get to know better some of the firms identified because this step might provide insights that will be helpful in the land planning process.22 It also may be helpful at this point to discuss the project with local industrial brokers. Competitive Survey As a result of the preceding analysis, we know the key firms that have a local presence in each of the target industries with expanding employment. Table 11-2 analyzes competing projects in the market that have sold land or leased space to target industries. The data developed in the competitive survey are similar to what a firm would insist on in an internal site selection analysis: location, developer, project, start date, total planned acreage and acreage sold to date, annual absorption, average price per acre, accessibility to transportation (for example, water, rail, highways, or air), clear heights of buildings, percentage of office use, utility availability (water, electricity, gas, high-speed communications cable), site coverage standards, parking, contract terms (for example, land sale, build to suit, or building lease), and a judgmental evaluation of the overall competitiveness of the project. If possible, it is desirable to talk to representatives of competing projects to get their views on the market area. While they will no doubt be cautious in answering certain questions, it is possible to get some idea of the competition and their thinking about the project and the market area. In light of the fact that existing developers have sold two-thirds of their land and any project on the subject site would take at least two years before sites can be delivered, they might be more forthcoming. In any event, it’s the professional thing to do. It’s also wise to do a windshield survey of major projects of a similar type throughout the broader metro area. It’s relatively certain that industrial firms looking for a site will not limit their evaluation to any one market area and that the developer should at least have a working knowledge of each of the submarkets in the metro area. Projecting Subject Site Demand The final step is to project the future level of land absorption that can be anticipated on the subject site, as illustrated in Table 11-3. 22 This step also may identify specific marketing targets for the subject site.

282 TA B L E

11-2

Competitive Survey, Market Area, March 2006 Acreage No.

1

Project

Planned

Sold

Sold (%) Acres/Yr. Price/Acre

2002

2,200

1,500

68.2%

375

$230,000

1998

3,400

3,000

88.2%

375

2004

1,300

800

61.5%

2003

1,500

1,200

2005

1,400 9,800

Transp.

Office (%)

Clear

Utilities

Covrg. Parking

Fwy.

40.0%

24 ft.

W/E/G

30%

1/500

$150,000

Hgwy., RR

35.0%

30 ft.

W/E

40%

1/1000

400

$250,000

Fwy.

55.0%

24 ft.

W/E/G

25%

1/500

80.0%

400

$200,000

Hgwy., RR

25.0%

30 ft.

W/E/G

40%

1/1000

600

42.9%

600

$350,000

Fwy.

80.0%

24 ft.

W/E/G/HS

20%

1/400

7,100

72.4%

430

$236,000

Terms

Rating

S/L

Good

S

Fair

Meadowland Park So. Atlantic RR

3

Lake Ind. Park

4

Forest Park

John Brown Co. Spartan Dev. Co. 5

Year Opened

Freeway Park J&W Developers

2

Covenants

S/L/BTS Very Good S/L

Good

Technology Park Advanced Dev. Co. Total/Average

Notes: W: water; E: electricity; G: gas; HS: high-speed cable; RR: railroad; S: sale; L: lease; and BTS: build to suit.

47.0%

31%

S/L/BTS Excellent

TA B L E

11-3

Subject Site Demand, October 2006 Actual Source

2003

Projected

2004

2005

2006

2007

2008

2009

2010

2011

2012

Totals

A Target Industry Employment

Table 11-1

31,353

33,668

36,168

B Expanding Employment

Table 11-1

21,236

24,456

27,912

31,541

35,325

38,858

42,355

45,744

48,946

51,882

C Annual Growth Rate

Table 11-1

15.2%

14.1%

13.0%

12.0%

10.0%

9.0%

8.0%

7.0%

6.0%

D Employees per Acre

Assumption

8.3

9.4

12.4

12.5

12.8

13.0

14.0

15.0

16.0

17.0

E Acres Required

(B / D)

2,559

2,602

2,251

2,523

2,760

2,989

3,025

3,050

3,059

3,052

17,935

430

430

400

375

375

350

340

2,270

2,700

2,270

1,840

1,440

1,065

690

340

0 2,712

Competitive Projects F

Land Sales

Table 11-2

G

Remaining Land

(G
F) Lagged

H Incremental Demand

(E
F)

I

Subject Site Capture Rate

Assumption

J

Subject Site Sales

(H  I)

Rounded

2,093

2,330

2,589

2,650

2,675

2,709

Design

Develop

15.0%

15.0%

15.0%

15.0%

13,335 12.0%

388

398

401

406

1,593

390

400

400

410

1,600

283

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Professional Property Development

The target industry employment information is taken from Table 11-1. Those industries that are expanding employment are then broken out and projected to grow at a declining annual rate to reflect current trends in the marketplace. The number of employees per acre is assumed to increase as a result of increases in land values and a greater intensity of office uses. The employee-per-acre ratio is then applied to employment projections to arrive at the number of acres required. The level of demand for net industrial acreage is then projected indicating an increase of approximately 18,000 acres during the six-year period between 2007 and 2012, the period in which the subject site will be involved in developing and marketing the project. The competitive projects reviewed in Table 11-2 are assumed to be the major competitors for this demand and, conservatively, are assumed to complete their land sales during the 2008 to 2012 period, although at a slower absorption rate, dropping from an average of 430 acres per year thus far to 350 to 400 acres over the remaining four years when they will be competing directly with the subject site.23 The subject site (Table 11-3) is expected to capture 15 percent annually of the remaining demand over the 2008 to 2012 marketing period. This would result in a total of 1,600 acres of net acreage demand over the period, reasonably consistent with the estimated potential of 1,500 acres of net saleable acres.

23 It should be noted that the subject site is in a somewhat more flexible competitive position having more land available for sale in the early years of the project. As the competitive projects reduce their land inventory, they have less flexibility in meeting potential customer requirements.

C H A P T E R 12

Transient Commercial

There is nothing which has yet been contrived by man by which so much happiness is produced as by a good tavern or inn. —Samuel Johnson (1709 to 1784)

Transient commercial land uses consist of hotels, motels, motor hotels, resort hotels, and other types of development related to the commercial lodging industry. Most facilities provide travelers with a room to sleep in and a restaurant or a bar for convenient dining and entertaining. Some facilities also provide areas where travelers can assemble for meetings, speeches, and banquets, as well as retail stores where they can purchase various items. Transient commercial facilities also may serve as focal points for local activities. Throughout history, the local inn has been a gathering spot for eating, drinking, talking, debating political issues, and even holding courts of law. Today, the successful hotel, motel, motor hotel, or resort hotel is among the most sophisticated land uses, effectively blending real estate fundamentals with sound business management and merchandising pizzazz.

DIFFERENTIATING CHARACTERISTICS Transient commercial facilities have several features that set them apart from other types of real estate: ■

Management plays a much more critical role in the success of the business operation. Transient commercial facilities are basically 285

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Professional Property Development

service providers, and the quality of service is largely a function of management. A facility in a good location with poor management will have a difficult time surviving; excellent management may overcome a deficient site location. ■ Successful room rental is the key to operating success. While income from restaurants, bars, and other services is important, the maximization of room revenue is essential in developing and maintaining a successful operation. This is because the gross margins on room operations are so much greater than they are for food and beverage service. ■ The maximization of room revenue requires a skillful balancing act between pricing policy and occupancy. Often, it’s better to break even on room rentals than to have them stand empty. Nothing is as unprofitable as a vacant hotel room. Occupancy levels are highly vulnerable to changes in seasons, business cycles, lifestyles, and the supply of hotel rooms. They must be projected and monitored carefully.

TYPES OF FACILITIES Over the years a wide variety of transient commercial facilities have developed to serve the weary traveler. Motels A motel is a facility without a restaurant or other hotel types of services. Generally, most overnight guests arrive by car and drive directly to their rooms upon checking in. Pleasure travelers and limited expense account business make up the major source of demand for this type of facility. Proximity to major highways, preferably being visible directly from the highway, is extremely critical. Motor Hotels Motor hotels are motels that offer some types of hotel services and facilities. These generally consist of an on-site restaurant, bar, and small banquet rooms, although room service usually is not available. Pleasure and business travelers and some conference business constitute the major source of demand. Proximity to major highways and airports is essential. Proximity to business and industrial areas is also important in terms of business traveler demand.

287

Transient Commercial

In recent years a type of motor hotel has emerged in which all or a major portion of the rooms are suites, sometimes containing a kitchen. This type of facility often appeals to business or pleasure travelers who plan an extensive stay in one location. For such travelers, other features may prove important, such as photocopying and secretarial services and on-site grocery shops. Hotels Hotels provide a full range of services, including rooms, restaurant and bar, and room service, plus retail services such as barber shops and beauty salons. Most hotels are located in major nodes of activity such as downtowns, airports, and major uptown centers. The majority of hotels have some type of banquet and meeting facilities. Hotels with extensive facilities of this type, as well as exhibit facilities, are considered convention hotels. The primary sources of demand for this type of facility are the business traveler and the conventioneer. Since the hotel’s public space facilities must cater to a market other than hotel guests, proximity to outside sources of activity is important. Resort Hotels Resort hotels are directed primarily at the pleasure traveler, although they may cater to group business in the off-peak season. These facilities generally provide all the services of a hotel, as well as extensive recreational facilities. Proximity to a major natural or artificial amenity and favorable weather critically affect the success of a resort hotel operation.

SOURCES OF LODGING DEMAND The demand for lodging at transient commercial facilities arises from expenditures of both individuals and groups. Individuals may be traveling for pleasure or business; group business usually consists of conventions or tours. Figure 12-1 indicates the relationship of these major sources of demand. Pleasure Travelers Pleasure travelers require lodging facilities both en route to their destination and, in some cases, once they arrive.1 During the journey, they are 1 Pleasure travelers are often referred to as free, independent travelers (FITs).

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Professional Property Development

FIGURE

12-1

Sources of lodging demand.

ot

s el B re ndividuals usin I su

Re so r

Groups

e nv Co

tion Conven

th

nt io ns

s

u To

rs

es

Ple a

s el

M ot

Mo to rh

tel ho

s

ot e ls

primarily interested in lodging that is easily accessible to the highway, rail station, or airport. Rooms should be clean, with a minimum of frills, and do not have to be very large. The most important features are the bed and the shower. A swimming pool is desirable, particularly for families traveling with children. An on-premises restaurant may be a good idea, depending on the proximity of other eating facilities. In virtually all situations, price is extremely important. Once pleasure travelers arrive at their destination, the nature of demand may change.2 Proximity to some type of natural resource (ocean, lake, mountains) or other attraction (golf course, Disneyland) is of utmost importance. Because the stay tends to be considerably longer, much time will be spent in the room, making its size and amenities more important. An on-premises restaurant and bar are essential, as is good room service. Recreational facilities such as swimming pools, golf courses, and tennis courts are important, particularly if there is no natural attraction. Price is less significant, and it will often be tied into a package deal with transportation. Business Travelers Many people travel to accomplish a specific business purpose3 and will generally stay two to five days. Since the hotel will probably be utilized as a base of operations, it’s necessary to be near business contacts. The 2 Quite obviously some travelers proceed directly to their destination with no stops en route. 3 Business is used here in its broadest sense and includes employees of government agencies, labor unions, schools and universities, and other nonprofit associations.

289

Transient Commercial

business traveler will probably want a little larger room with good telephone service, desk area, and an Internet connection. An on-premises restaurant with a bar or lounge is highly desirable, as is an exercise room and/or swimming pool. If sales presentations are necessary, an adjoining display area may be required. In some cases, separate meeting rooms are desirable. Price is generally a factor, particularly to the business traveler on a commission or per diem expense account. Conventioneers The conventioneers’ average length of stay is two to three days. Proximity to the conference or convention facility is essential. In some cases, conventioneers are accompanied by their spouses. The guest room should be the same as for the business traveler, unless entertaining is planned. An on-premises restaurant and bar, preferably with room service, are essential. A swimming pool, exercise facility, or other recreational facilities also are desirable and in some cases essential. Room rates are often negotiated as part of an overall conference or convention package. Tour Groups Tour groups are either created by members of existing organizations or specially formed to take a pleasure trip. Tours are arranged primarily by sponsoring groups or associations, touring companies, and travel agents. Airlines, railroads, bus companies, and car rental firms also may organize tours as part of a travel package. The individual or firm selecting facilities for tour groups is usually interested in getting the best price possible because the tour organizers’ profit is made on the spread between actual cost and the participant’s charge for the tour package. Tour groups are usually given price breaks because they represent a guaranteed source of demand, especially during shoulder and off-seasons. Touring groups also may be assigned to less desirable rooms that otherwise might not be occupied. Mixed Sources of Demand Most transient commercial facilities spread their business over several types of travelers. A motel geared to pleasure travelers may also cater to business travelers, particularly traveling salespeople. Major hotels often

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Professional Property Development

cater to both business travelers and conventioneers, although the facility may not be the convention headquarters. A convention hotel may attempt to attract general business travelers when convention business is slow. In recent years, resort hotels have begun soliciting convention and conference business, particularly in off-peak seasons. This type of overlap among sources of demand is highly desirable as it tends to stabilize occupancy throughout the year.

ANALYZING MARKET DEMAND The differing needs of the various types of transient commercial users, coupled with a wide variety of competing facilities, make the task of analyzing demand for a potential project somewhat difficult. The situation is further complicated by the impact of possible seasonal variations in demand by each user group. The suggested approach is to initially establish an operating scenario for the subject site and then analyze the sources of potential demand from each potential user group. These results are then compared with the quality, location, and features of competing facilities in determining what share of potential demand might be captured by the subject site. Identifying Potential Demand Sources Market analysis for a proposed transient commercial facility should initially determine the most likely primary source of demand. Commonsense reasoning, by and large, should do the trick. If the site is near a major natural or artificial attraction, vacationers are the most likely prospect. If the site is near a highway or airport, pleasure and business travelers will predominate. If the site is near other hotels or convention facilities, conventioneers may provide the major source of demand. The business traveler will generally be the most frequent customer for a project located in an office or industrial area. Next, ascertain whether there are supplemental sources of demand that can be accommodated in the same facility without reducing demand from the primary source. Sometimes people from more than one demand source can be accommodated simultaneously (for example, both business and pleasure travelers). A more realistic approach is to anticipate use of the facility by different groups during certain periods of the year. A convention facility, for example, could be redirected to serve pleasure travelers and tour groups in the summer. A resort hotel in a ski area could develop a conference business in the spring and fall seasons.

Transient Commercial

291

A motel servicing pleasure travelers in the summer could appeal to the business traveler during the rest of the year by adding a restaurant and bar. In all cases, the basic strategy is to maximize occupancy throughout the year by attracting new, complementary sources of business without destroying primary demand. Projecting Market Area Demand Once an operating scenario of the primary and supplemental sources of demand has been formulated, potential demand in the market area should be established. The following example involves a potential hotel site where the primary source of demand is expected to be conventioneers and business travelers. Conventions Understanding how conventions are planned and organized is the first step in analyzing demand from conventioneers. Associations plan conventions; individuals attend them. Associations may range from the 100 or so members of the regional 4-H Club to the thousands of members of national and international associations.4 Most of these associations have at least one meeting annually, generally planned three to five years in advance. Most associations like to spread their convention business around; therefore, a city that has recently housed a convention is unlikely to be considered again for several years. Associations also are sensitive to the desires of their members who usually have their own favorite venues. Postmeeting questionnaires are often used to illicit comments and avoid choosing a disappointing venue and recognizing (and ultimately rewarding) a positive prior experience. Several factors determine which cities are to be considered. An early element in the selection process is the membership attitude toward a particular city. If they’ve already attended a conference there, they will be significantly biased by the earlier experience. Another factor is the attractiveness of shopping and after-hours activities—cities like New York, Chicago, Los Angeles, San Francisco, Miami, Las Vegas, and Honolulu have built their convention business around these attractions (Figure 12-2).5 This can be especially important if a large number of conventioneers are traveling with their spouses.

4 Associations are usually classified according to geographical coverage: international, national, regional, state, and district. 5 Associations and other convention groups are increasingly considering international venues.

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Professional Property Development

FIGURE

12-2

The Marriott Marquis Hotel in Times Square, New York City, designed by John Portman. (New York Marriott Marquis Hotel)

Perhaps the most important factor, however, is the quality of exhibition and meeting facilities. Exhibitors generally subsidize a portion of convention costs and moreover are tough business people who know exactly what exhibit facilities they need and how much they should pay. If these facilities aren’t available or they are deemed inadequate, this factor can play an important role in blackballing a proposed convention city. This is why most major cities have developed modern exhibit facilities, often at public expense. The next most important factor is the public rooms for the various events associated with the convention. This usually involves a large auditorium for general sessions and several smaller rooms for break-out sessions. A large banquet facility is also essential, preferably one that is

Transient Commercial

293

separate from the auditorium and meeting rooms. Ideally, these rooms will be contained within a single hotel, and the hotel will also include or be near the exhibit facility. The number and quality of available rooms also can be a deciding factor. Most cities maintain reasonably accurate inventories of available rooms at various hotel facilities.6 The proximity of delegate hotels to each other also matters. The ideal situation is a cluster of hotels within walking distance of one another as is the case in Chicago, Miami, New York, Honolulu, and San Francisco. If proximity does not exist, there should at least be adequate ground transportation between the various hotels and the exhibit and meeting facilities. The final consideration is the headquarters hotel. As the command center of the entire convention, this hotel must have certain basic facilities. For small and medium-sized conventions, the headquarters hotel probably will provide all the facilities: guest rooms, entertainment suites, banquet facilities, meeting rooms, auditorium, and exhibit facilities. For larger conventions, the exhibit and auditorium activities can be separate but should be in close proximity. The headquarters hotel must also provide sufficiently large rooms and suites to handle the entertaining that inevitably accompanies a convention. In addition, a large block of rooms must be made available for delegates. Needless to say, the management of a headquarters hotel must be totally committed to satisfying the requirements of a convention in a speedy and cooperative manner. Once the nature of the convention demand is understood, the market area demand can be projected, as illustrated in Table 12-1. The first step is to establish the number and type of conventions that will be coming to the market area by season. Since convention arrangements are made several years in advance, this is less difficult than it might seem. The local convention and visitors bureau in most cities maintains this type of information. A target year should be selected for projection purposes—say, in three to five years. Convention attendance for the projection year should be broken down according to the size of the convention, that is, district, state and regional, and national. The number of attendees should then be converted into guest room demand. This is accomplished by dividing the number of attendees by a factor representing the average number of persons per room for each season.

6 Most hotels have a policy regarding the percentage of guest rooms that will be made available for convention purposes.

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Professional Property Development

TA B L E

12-1

Projected Convention Demand Market Area, 2007 Season Winter

Spring

Summer

Fall

Total

18,000 30,000 80,000 128,000

60,000 50,000 200,000 310,000

30,000 40,000 160,000 230,000

90,000 40,000 120,000 250,000

198,000 160,000 560,000 918,000

Persons per Room National State and Regional District Average (weighted)

1.50 1.25 1.00 1.10

1.50 1.25 1.00 1.11

1.50 1.25 1.00 1.08

1.50 1.25 1.00 1.18

1.50 1.25 1.00 1.12

Rooms Required National State and Regional District Total

12,000 24,000 80,000 116,000

40,000 40,000 200,000 280,000

20,000 32,000 160,000 212,000

60,000 32,000 120,000 212,000

132,000 128,000 560,000 820,000

4.00 2.50 1.00 1.62

4.50 3.00 1.50 2.14

4.00 2.50 1.00 1.51

4.50 3.00 1.50 2.58

4.40 2.80 1.30 2.02

48,000 60,000 80,000 188,000

180,000 120,000 300,000 600,000

80,000 80,000 160,000 320,000

270,000 96,000 180,000 546,000

578,000 356,000 720,000 1,654,000

Convention Attendees National State and Regional District Total

Duration of Stay (Days) National State and Regional District Average (weighted) Room Night Demand National State and Regional District Total

The resultant figure is the number of rooms that will be required to handle the projected convention business. The number of rooms is then multiplied by a factor representing the average duration of stay for each convention attendee, producing the number of room nights that will be required for each season. In some cases, data for this analysis have been developed by local convention bureaus on the basis of questionnaire sampling. If these data are unavailable or only partially complete, rough rules of thumb can be relied on, such as the following:

295

Transient Commercial

National State and Regional District

Average Persons per Room

Average Duration of Stay

1.5 persons 1.25 persons 1.0 persons

4.45 days 2.75 days 1.25 days

These factors will vary to some extent, depending on the type of association, the stage of the economic cycle, and the geographic area where the convention is held. Religious and fraternal associations generally have more convention guests and therefore double up more frequently. In periods of recession, the convention guest factor and average duration of stay will decline, and the average number of persons per room will increase. If the convention is held in a vacation area or in a city with broad appeal (for example, San Francisco, New York, Las Vegas, or Honolulu), all factors generally will be higher. Table 12-1 summarizes the analysis of potential convention guest demand. Business Travelers Once the primary source of demand has been established, the focus should shift to identifying possible supplemental areas. In the case of a convention-oriented hotel, business travelers are often a good supplemental source. If the subject site is located in a well-defined business or industrial area, demand projections can be established through the interview process. By contacting each major firm in the business or industrial area, the interviewer can obtain the number of people calling on these firms daily or weekly.7 Some firms may maintain records of the home base of the calling business people, which will help establish the proportion that comes from out of town. This same interview process should also establish the local firms’ requirements for banquets and meeting room facilities. If the subject site is not located in a well-defined business or industrial area, it may be necessary to use broad estimates of employment growth and annual business travel. Another indicator is the volume of overnight traffic at the local airport. If the site is near a major freeway, it may also be helpful to analyze the volume of vehicular traffic on the artery, particularly in nonpeak hours. Anticipated demand from business travelers should be translated into room night demand by season, employing the appropriate estimates

7 The purchasing agent often is a good source. Visitor logs maintained in the lobby are another.

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of number of persons per room (generally 1.0) and duration of stay (generally one to three days). Pleasure Travelers A second supplemental source might be pleasure travelers, particularly in the summer season, when convention and business traveler demand may be slack. Room demand generated by pleasure travelers tends to vary with the location of the city, the amenities available for vacation purposes, and the time of year. In resort areas, data on vacationing visitors are generally maintained by local tourist promotion organizations. In more urbanized areas, the data may be more difficult to secure and often may require considerable refinement. In all cases, it is necessary to translate the number of total visitors into total guest room demand. This is accomplished by the same procedure as for conventioneers and business travelers, bearing in mind that the average number of persons per room is usually greater (1.5 to 2.5) and the duration of stay longer (three to seven days). The demand indicated from each source should now be synthesized into a total demand projection for the target year by season and compared to present and prior periods, as shown in Table 12-2. Any overlapping among sources should be eliminated at this point. Also, if any of the projections are contingent on another event (for example, construction of a convention center or airport), an alternative set of projections should be available, indicating what will happen if the event does not occur. Competitive Survey A competitive survey of all existing and planned facilities in the market area is the next step in the analytical process. Table 12-3 shows a typical survey. TA B L E

12-2

Total Room Night Demand, Market Area, 2007 Season

Business Travelers Conventioneers Pleasure Travelers Total

Winter

Spring

Summer

Fall

Total

550,000 188,000 150,000 888,000

500,000 600,000 100,000 1,200,000

830,000 320,000 370,000 1,520,000

600,000 546,000 100,000 1,246,000

2,480,000 1,654,000 720,000 4,854,000

TA B L E

12- 3

Competitive Survey, Market Area, 2007 Public Space, Sq. Ft. No.

Facility

Guest Rooms

Restaurant

Banquet

Meeting

Average Room

Exhibit

Retail

Rate

Occupancy

Features

Rating

1 2

Travel Inn King Royal

750 1,000

650 800

16,000 20,000

14,000 15,000

7,000 10,000

10,000 None

$150 $135

75.0% 62.0%

TV, I, P, HC, C TV, P

Excellent Good

3 4

Brown’s Motor Inn Majestic Inn

600 1,200

450 900

10,000 25,000

None 18,000

None 12,000

2,500 5,000

$115 $165

55.0% 70.0%

TV, P TV, I, P, HC, C

Fair Excellent

5

Amble Inn Total Average

850 4,400 880

700 3,500 700

14,500 85,500 17,100

12,000 59,000 (1) 14,750

5,000 34,000 (1) 8,500

None 17,500 (1) 5,833

$140

65.0%

TV, P

Good

(2) $145

(3) 66.9%

Assumptions: 1. Includes only those facilities having one. 2. Weighted by occupied room nights. 3. Weighted by number of rooms. Notes: TV: television; I: Internet; P: pool; HC: health club; and C: concierge.

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Information to be developed from the survey includes the following: Name and location of facility Number of guest rooms ■ Restaurant, bar, and nightclub facilities ■ Banquet seating available ■ Meeting room facilities ■ Exhibit facilities ■ Retail facilities ■ Average room rate ■ Average occupancy8 ■ Room features (for example, king-sized bed, television, speaker phone, Internet connection, safe, or no-smoking rooms) ■ Facility features (for example, bar, pool, golf course, or tennis courts) ■ Overall rating ■ ■

This information can be developed largely by observation and discussions with facilities managers. Several hotel guides are also published that contain data on facilities (these data should be verified in the field).9 Projecting Subject Site Demand Market capture estimates should be based on the competitiveness of the subject site as compared with other facilities of a similar type and quality, as identified in the competitive survey. Capture estimates should be applied to incremental changes in demand, taking into consideration existing supply. (See Table 12-4.) In developing capture estimates, the location of the subject site visà-vis the competition should be considered. Proximity to demand generators should be especially noted: a convention hotel should be near exhibit facilities, a motel or motor hotel near a major highway or airport, and a resort hotel near major recreational facilities. Any significant “voids” in existing facilities that may be filled by the proposed facility also should be considered. Finally, the quality of the proposed management of the facility should be considered in terms of merchandising, reservation system, food and beverage operation, convention handling abilities, and so on. If an operator is not known at the time of the market analysis, the characteristics

8 One rough indication of occupancy is the number of room boxes containing two keys, particularly late in the evening. 9 Examples are the Hotel and Motel Red Book, AAA Guide, and, in Europe, the Michelin Guide.

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TA B L E

12-4

Room Night Demand on Subject Site, 2007 Season Winter

Spring

Summer

Fall

Total

Market Area Demand Business Travelers

550,000

500,000

830,000

600,000

2,480,000

Conventioneers

188,000

600,000

320,000

546,000

1,654,000

Pleasure Travelers

150,000

100,000

370,000

100,000

720,000

Total

888,000

1,200,000

1,520,000

1,246,000

4,854,000

18.3%

24.7%

31.3%

25.7%

100.0% 1,606,000

Seasonal Percentage Existing Supply Competitive Set

293,898

396,682

502,678

412,742

Other

397,643

536,709

680,121

558,438

2,172,912

Total

691,541

933,391

1,182,799

971,180

3,778,912 1,075,088

Incremental Demand

196,459

266,609

337,201

274,820

Estimated Market Capture Rate

25.0%

30.0%

20.0%

25.0%

24.7%

Room Night Demand

49,115

79,983

67,440

68,705

265,243

of a hypothetical operator should be assumed on the basis of operators not now serving the market area. Number of Rooms Projected room night demand for the subject site should now be translated into the number of rooms to be built. This is often difficult, particularly in areas with great seasonal variation. The problem is to provide enough rooms to handle peak demand, but not so many as to create high vacancy at other times of the year. The objective is to maximize the total annual number of occupied room nights. This is accomplished by determining the number of effective room nights, as illustrated in Table 12-5. The number of unoccupied room nights reflects the costs of building excess room capacity that is not supported by projected demand. The reverse situation—not building enough rooms to satisfy demand pressures—can also be costly and must be calculated. This is accomplished by subtracting the available room nights from demand projections. If the number is positive, there is unrealized demand. Negative numbers reflect unoccupied guest rooms. Note that each situation will be one or the other: unoccupied room nights or unrealized demand. They cannot occur simultaneously within the same scenario in any one season. By summing the effective room nights for each season, it is possible to determine which scenario optimizes demand and supply in order to obtain the highest number of total annual room nights.

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TA B L E

12-5

Optimum Number of Guest Rooms, Subject Site, 2007 Season Rooms Projected Room Night Demand

Source

Table 12-4

Available Nights per Season

Winter

Spring

Summer

Fall

Total

49,115

79,983

67,440

68,705

265,243

90

92

92

91

365

Available Room Nights under Various Scenarios 500 600 700 800 900

Calculation Calculation Calculation Calculation Calculation

45,000 54,000 63,000 72,000 81,000

46,000 55,200 64,400 73,600 82,800

46,000 55,200 64,400 73,600 82,800

45,500 54,600 63,700 72,800 81,900

182,500 219,000 255,500 292,000 328,500

500 600 700 800 900

Calculation Calculation Calculation Calculation Calculation

4,115 (4,885) (13,885) (22,885) (31,885)

33,983 24,783 15,583 6,383 (2,817)

21,440 12,240 3,040 (6,160) (15,360)

23,205 14,105 5,005 (4,095) (13,195)

82,743 46,243 9,743 (26,757) (63,257)

Effective Room Nights under Various Scenarios

Recommended Program

700–800

Another forecasting method is to determine the fair share of room demand for each market segment that the proposed project would receive, based on the number of rooms as a percentage of the total market inventory. The fair share then can be adjusted up or down, depending on the project’s competitive market advantage (disadvantage) for each market segment. This fair-share approach also provides a comparable check on the more detailed room night analysis outlined above. Public Spaces Once the number of rooms has been established, it’s possible to estimate the amount and types of public spaces (for example, restaurants, bars, theaters, or retail operations) that should be developed. The first step is to determine what percentage of expenditures by room guests can be captured. By estimating the daily meal, bar, and retail expenditures for the type of guests who are anticipated and multiplying expenditures by the number of room nights projected, one has a rough idea of total expenditure.

Transient Commercial

301

Capture estimates should then be made for each type of expenditure, based on the location of the subject site vis-à-vis other restaurants, bars, and retail facilities. In the case of convention guests, projections of the amount of banquet activity that can be anticipated should be made. Demand generated by people who are not guests of the facility should also be considered. If the facility is in an area of great activity (for example, downtown, shopping center, or industrial park), demand from nonguests may exceed that from guests. A restaurant in a motor hotel, particularly if it is located on a major traffic artery, also may appeal to passing travelers. Restaurants in resort hotels may attract vacationers other than those staying in the hotel. Total expenditure for each activity then should be projected by season and translated into physical facilities by dividing them by appropriate sales per unit averages. Restaurant sales should be divided by average dollars per place per meal.10 This number, in turn, should be divided by the average table turnover anticipated. Banquet demand is calculated in a similar manner but without an allowance for table turnover. The resultant figure will be the average number of tables required to service demand. Bar sales should be calculated as a percentage of food sales11 or, if there is no food operation, based on an average expenditureper-stool basis. Retail space should be calculated on the basis of sales per square foot for the type of retail operations anticipated.12

10 In some situations, such as areas with little weekend business, it’s advisable to calculate on a dayby-day basis. 11 Bar sales generally run about 25 percent of food sales. 12 A rough method is to add approximately 25 to 30 percent to the sales-per-square-foot figures published in the Dollars and Cents of Shopping Centers/The Score, 2007, Urban Land Institute (ULI), Washington, D.C.

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C H A P T E R 13

Multiuse Projects

They all laughed at Rockefeller Center. Now they’re fighting to get in. George and Ira Gershwin “They All Laughed” from Shall We Dance, 1937

T

hus far, we have discussed projects involving primarily one land use. Real estate projects have grown larger and more complex, however, and they now often involve multiple uses in one building, a multibuilding complex, or, in the case of new towns, a single community. Multiuse development is not a new concept. From ancient Greece to medieval Europe, commercial and residential land uses were closely connected. This intermingling of a variety of land uses—grocery stores, bakeries, shops, and offices on the ground floor of residential apartment buildings—is still a major ingredient in the charm of many European cities. The early development of cities in the United States also was characterized by a broad mix of land uses in a concentrated area. Without access to good transportation, it was necessary for townsfolk to shop, live, and work close to home. But this changed with the advent of the automobile. People no longer had to be tied to an area of just a few blocks, making the wide separation of land uses feasible. As noted in Chapter 2, zoning laws evolved as a way of creating a more orderly environment out of what some considered the “sloppy” look of the turn-of-the-century city. As a result, the idea of multiple land uses existing side by side gradually lost favor as a way of structuring communities. Since the early 303 Copyright © 2007 by John McMahan. Click here for terms of use.

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1960s, however, the concept of multiple land use development has once again been growing in popularity, and today there are several hundred such projects in the United States.

THE CASE FOR MULTIUSE DEVELOPMENT There are many reasons for this renewed enthusiasm for multiuse development. In urban areas, increasing land values have forced developers to utilize their properties as intensely as possible. Many developers also believe that multiuse development may create market synergy, resulting in a greater income stream than would be the case with a series of single-use projects. In an office-hotel-shopping center complex, as an example, office tenants may shop in the shopping center and eat and attend conferences in the hotel. Hotel guests may shop in the shopping center or call upon tenants of the office building. Heavy infrastructure costs such as utilities and parking also can be spread over several uses, often on a sharing basis, thereby reducing the amount of infrastructure required, depending upon the level and timing of the various activities. Local public agencies also are becoming more favorably inclined toward multiuse development because many of the projects provide a catalyst for renewal of a center city or neighborhood, resulting in increased revenues from property and sales taxes (Figure 13-1). Suburban communities and smaller towns may use multiuse development to create a “sense of place” in the community for residents and, in some cases, visitors from other areas. In addition, with increasing congestion in the suburbs as well as the central cities, the idea of being able to satisfy multiple needs—housing, shopping, and working—in a single location is an appealing public policy objective. But the most important reason is that the public likes multiuse projects and seeks them out—whether as a shopper, office tenant, resident, or hotel guest. The superior physical environment created by such a project, particularly the dramatic interior spaces, is simply more enjoyable and exciting than the hodgepodge urban and suburban growth that occurs when a series of individual owners develop small parcels of land. On a larger scale, the employment base of a new town provides jobs to attract residents for the housing and shoppers for the retail stores. In essence, the multiuse project captures incremental demand that would otherwise go to another area or project.

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FIGURE

13-1

Canal Place, a large MXD riverfront development in New Orleans. The complex includes a 650,000-square-foot office tower, a 260,000-square-foot shopping center, a 500-room hotel, and a 1,500-car garage. (Canal Place)

CHARACTERISTICS OF MULTIUSE DEVELOPMENTS Multiuse development encompasses a variety of projects involving more than one use of land. These are generally categorized as multiuse buildings, mixed-use developments, and new towns. Multiuse Buildings Multiuse buildings combine several uses in a single structure. In the United States, Chicago has been a major center for this type of project including the John Hancock Center (office, retail, and residential), 900 North Michigan (office, hotel, residential, and retail), Park Tower (hotel and residential), and Water Tower Place (retail, office, hotel, and residential). Other cities featuring multiuse buildings include New York, Boston, Washington, and San Francisco. The concept also has been utilized in other countries. The Jin Mao tower in Shanghai is an 88-story building (tallest in China) completed in 1999, and it contains office, hotel, and retail uses. In Taipei, Taiwan, the Taipei 101 building (tallest in the world) houses the Taiwan Stock Exchange and has a shopping center, restaurants, and cultural facilities in its base.

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More recently, mixed-use buildings have focused on making each of the separate uses strong in its own right and yet incorporated through good design and marketing into a viable whole. A good example is the Four Seasons multiuse building in San Francisco, which has a hotel, condos, and a major health club. The hotel provides banquet facilities and room service for the condo owners who can work off the calories at the health club. Another example is the Time Warner building facing Central Park in New York City. Retailing is provided in the first few levels and contains some of the most exciting retailers and award-winning restaurants in the world. The Mandarin Hotel is located in the next series of floors, followed by office uses with major anchor tenants (Times Warner, Apollo Real Estate Advisors, and The Related Companies1) as well as smaller spaces for individual office tenants. The project’s capstone consists of full-floor residential units with views of both Central Park and the Hudson River. Parking for all uses is provided underground. Mixed-Use Developments Over the past decade, the concept of mixed-use developments (MXD) has become increasingly popular. The Urban Land Institute has defined mixed-use development as a subset of multiuse development that is characterized by three distinct features: The project has at least three significant revenue-producing uses (office, retail, hotel, residential, or entertainment). ■ Although usually developed in separate buildings, there is significant physical and functional integration of the various uses. This may be achieved thorough a common atrium as well as a single physical base encompassing parking and support facilities for all of the uses. ■ Development is carried out according to a coherent plan.2 ■

By its very nature, a mixed-use development is a large-scale project, usually at least 500,000 square feet. This scale is necessary not only to effectively accommodate the various uses but also to create market synergy and attract potential users to the project (see Figure 13-2). Mixed-use development has evolved over the years, with each generation of projects taking on a flavor that is different from its earlier

1 The Related Companies were project developers. 2 Dean Schwanke et al., Mixed-Use Development Handbook, 2000, 2d ed. (Washington, D.C., Urban Land Institute [ULI], 2003).

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FIGURE

13-2

MXD conceptual scheme. Early conceptual scheme for Westmont Square in Montreal. Working

Hotel

Living

Shopping concourse Street

Shopping concourse Parking garage

Street

Source: Dean Schwanke et al., Mixed-Use Development Handbook, 2000, 2d ed. (Washington, D.C.: Urban Land Institute [ULI], 2003).

counterparts. The first projects emerged in the 1930s with the development of the Union Station complex in Cleveland, a pioneering redevelopment of a downtown railway station.3 Perhaps the most famous, however, was Rockefeller Center in New York City: a 24-acre project including office, retail, theater arts facilities, and, ultimately, hotel uses—all integrated through the use of public open spaces (25 percent of the land area) and a series of underground streets and loading facilities. There was not a lot of interest in building mixed-use developments for the next 30 years, but in the 1960s, MXDs saw a resurgence in popularity, and many primarily central business district (CBD) projects were launched at that time. These included the Prudential Center in Boston, Penn Center in Philadelphia, Peachtree Center in Atlanta, Charles Center in Baltimore, and Constitution Center in Hartford. Projects also were developed in largely residential areas including Century City in Los Angeles, Westmount Square in Montreal, and Crystal City near Washington, D.C. In the 1970s, MXDs such as Embarcadero Center in San Francisco, the Illinois Center in Chicago, the Crescent in Dallas, and the World Trade 3 The complex was redeveloped in the 1980s and is now known as “Tower City Center.”

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Center in New York became major attractions, combining office, hotel, and retail uses. Many of the projects of this period were inward facing; that is, they were totally self-contained, often around large atria. These included the Galleria in Houston, Chicago’s Water Tower Place (Figure 13-3), the St. Louis Centre (Figure 13-4), the IDS Center in Minneapolis, and the Renaissance Center in Detroit. Many of the projects built in the 1980s and 1990s focused on waterfront redevelopment including Rowes Wharf in Boston; Washington Harbor in Washington, D.C.; and Canary Wharf in London. As noted, most early MXDs were built in or near the CBDs of major cities. As the concept caught on, however, more and more suburban projects were developed. Several of these were located in office parks (Forrestal Village in northern New Jersey) or shopping centers (South Coast Plaza in southern California). Some MXD projects have become the focal points of new suburban downtowns (Las Colinas near Dallas; Tysons II in suburban Washington; Santana Row near San Jose; Renaissance Place in Highland Park, Ilinois; and CityPlace in West Palm Beach). Resort areas such as Vail in Colorado FIGURE

13-3

Vertical mall in Chicago’s Water Tower Place, a 74-story, L-shaped MXD built in the 1970s. The complex includes a hotel, luxury condominiums, office space, and eight levels of retail shops. (Urban Land Institute)

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FIGURE

13-4

Retail uses form the largest component of St. Louis Centre, a mixed-use development incorporating hotel, office, retail, and parking in the heart of downtown St. Louis. (St. Louis Centre)

and Station Mont Tremblant near Quebec also became focal points for MXD development. Residential uses are once again becoming popular, particularly in the central city where more and more people are rediscovering the benefits of living close to work, shopping, and cultural activities. Retail also has become more “festive” in nature, with inviting walkways, unique shops, and merchandising promotions. Hotels are emerging as a favored use to establish an identity for the MXD, often unifying the various uses. Cultural and entertainment facilities also have been found to be effective in establishing a positive project image. There also has been more concern that the mixed-use development blends in well with the surrounding environment, prompted in part by

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strong criticism of the “fortress” look of projects such as Renaissance Center in Detroit. Several communities, including Denver, Dallas, Baltimore, Louisville, and Salt Lake City, have pioneered the development of mixed-use districts where several blocks of existing buildings4 are combined into a special district to promote greater physical and economic development. MXDs also are being tied in more closely with transportation systems. As an example, Bethesda, Maryland, focused mixed-use development at a suburban transit station. New Towns Chapter 1 discussed the fact that several new towns have been developed in the United States, modeled in part on similar projects in England, France, and other countries. Four basic types of new towns have evolved: Pioneer New Towns The most ambitious type of new town is a completely independent community of more than 250,000 people, located a considerable distance from existing urban centers. This type of new town has been utilized in situations involving the exploitation of natural resources in remote areas or where privacy is critical to the activities of the new town. As an example, the federal government utilized this approach in developing the “atomic” cities of Oak Ridge, Tennessee, and Los Alamos, New Mexico. The extensive infrastructural costs (for example, roads, sewers, or schools) and the marketing problems of a remote area, however, have deterred most private developers. Expanded Communities This type of new town involves the expansion of an existing smaller community. Although this approach avoids many of the problems and costs of infrastructure, the problem of dealing politically with the existing community arises, which may substantially reduce the developer’s leverage and flexibility in getting the new town off the ground. The question of the image of the existing community and its effect on marketing the new town also may come into play. Satellite New Towns This type of new town is created within the framework of an existing metropolitan region—close enough to draw on

4 In the case of Salt Lake City, the mixed-use district replaced abandoned rail yards.

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the employment and cultural base of the urban center, yet removed enough to create a new environmental setting. New Towns in Towns As described in Chapter 1, this is basically a totally planned city within an existing urban area, designed to make a major economic and environmental impact on the surrounding and, usually, deteriorated neighborhood. It is hoped that the scale of the new town will be sufficient to offset existing environmental problems. The economics of high land cost are usually offset through urban renewal or the sale of surplus governmental property.5 This type of new town has not been very successful to date. Virtually all the new towns in the United States have been satellite new towns. Proximity to existing metropolitan areas usually permits a tie-in to existing public infrastructure, as well as improving changes of obtaining more favorable private financing.

ANALYZING MARKET DEMAND A major key to the success of a multiuse project is a sound analysis of the potential market for a proposed project. Multiuse Buildings The prospective demand for potential uses in a multiuse building should be analyzed by means of the techniques discussed in Chapters 8 to 12, depending on the individual land use being considered. It’s important to be sure that there is strong demand for several potential uses.6 If demand for one use is significantly greater than for others, consideration should be given to designing the entire building for the strongest use. Since multiuse buildings are designed and built as a single unit and changes are difficult, if not impossible, to make once the building is completed, a problem with this type of project is choosing the right mix of land uses and locations within the building. For example, a highly successful office building may be diluted by an unsuccessful apartment component within the same building. 5 It’s interesting that one of the earliest new towns in towns, Cedar-Riverside in Minneapolis, was assembled largely through private channels. 6 Ground floor retail is usually related more to the demand characteristics of the surrounding neighborhood than to the uses on the upper floors. Few retailers could survive exclusively on the retail expenditures of the tenants and residents of the building in which they are located.

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It’s also important to determine the degree of synergy between the uses—office demand should benefit from apartment or hotel proximity, and vice versa. Retail should benefit from all other uses as well as making those uses more appealing. Such an analysis should suggest certain types of firms, residents, and room guests. It then becomes essential to know whether these potential users are present in sufficient numbers in the marketplace and, more importantly, if they can be attracted to the project. Mixed-Use Developments The technique used to analyze market demand for mixed-use projects involves many of the techniques discussed in Chapters 8 through 12 regarding individual land uses. However, some additional considerations should be noted: The cornerstone land use must be established early in the analytic process. In every multiuse project, one major land use is absolutely critical to the overall success of the project. If the nature of this use is not obvious from a judgmental point of view, it can be identified through a sensitivity analysis of each of the individual land uses. By removing each land use, in turn, from the analytic projections, it’s possible to establish the one that will have the greatest impact on project success. ■ The synergy among land uses must be established. It’s essential to know how much demand comes from other uses within the project and how much from outside sources. Figure 13-5 is a graphic representation developed by the ULI of the synergistic potential of each of the independent land uses. ■ In the use of these analytical tools, the timing of market demand for each land use is critical, particularly if one land use is dependent on successful prior development of another. In essence, it’s a chicken-and-egg challenge—to create sufficient employment base to supply jobs for residents and, at the same time, recognize that firms will not locate in a project unless certain housing resources are available. This is particularly true in evaluating the feasibility of new town development. ■

Office Offices are the most common use in MXD projects. Most developers approach the office market on a speculative basis without a specific tenant in mind. This means that the office market analysis is extremely important in establishing the viability of the project.

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FIGURE

13-5

Framework for estimating on-site support and synergy in a mixed-use project. Degree of Support for and Synergy with Other Uses

Use Office

•• ••••• •••• •••

Residential Hotel Retail/Entertainment* Cultural/Civic/Recreation Residential

••• ••• •••• •••••

Office Hotel† Retail/Entertainment Cultural/Civic/Recreation Hotel

••••• ••• •••• ••••

Office Residential Retail/Entertainment Cultural/Civic/Recreation Retail/Entertainment

••••• ••••• ••••• •••

Office Residential Hotel Cultural/Civic/Recreation Cultural/Civic/Recreation

•••• ••••• ••••• •••

Office Residential Hotel Retail/Entertainment 1 = Very weak or no synergy 5 = Very strong synergy

2 = Weak synergy

3 = Moderate synergy

4 = Strong synergy

*Restaurants and food services are the main source of benefit for offices. †Synergy is the strongest between high-end hotels and condominiums, less for midpriced hotels and residences. Source: Dean Schwanke et al., Mixed-Use Development Handbook, 2000, 2d ed. (Washington, D.C.: Urban Land Institute [ULI], 2003).

The potential type of office tenants for the project must be thought through carefully. As an example, large tenants desiring corporate identification may not be attracted to an MXD project where individual tenant identity is uncommon (other than the building directory) and entrances may be difficult to locate.

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Smaller tenants, particularly professional organizations, on the other hand, may be attracted to the dramatic exposure of the MXD space and the overall vitality provided by the interaction of retail, hotel, and other uses. It should be noted that market capture estimates become more difficult to formulate under these conditions. Retail Retail establishments are an integral part of virtually every MXD project, but historically retail has not been considered a cornerstone use. In recent years, however, this has been changing with retail increasingly being viewed as a major MXD component. This change is partly the result of public policy strategies to encourage a return of retailing to the CBD (Horton Plaza, San Diego) or private decisions to expand existing suburban shopping centers (South Coast Plaza, Tysons II, and others). Not that developers need extensive prodding—retail provides excitement and entertainment, helping to increase the overall level of activity for the MXD. In evaluating market demand, the first step is to determine if major retail is possible in the project, perhaps even as a cornerstone use. The analysis is similar to the research program discussed in Chapter 9. Particular care should be taken in establishing market capture rates to distinguish the unique features (positive and negative) of the MXD project, particularly if it is located in the CBD. If a major retail facility is not feasible, the retail component will consist primarily of convenience and service facilities, serving the needs of the MXD as well as small specialty shops directed at shoppers attracted to the shopping facilities. In essence, retail becomes a support to the other uses rather than a stand-alone component. The size and character of this type of retail should await the market analysis of other uses in order to determine the amount of synergistic demand that can be created. Hotels Hotel uses are the third most common use in MXD projects. The average number of guest rooms ranges from 250 to 300 in suburban projects to 400 to 500 in central business district projects. Luxury hotels are the most common type of facility, followed by commercial and convention hotels. Hotel uses are increasingly being viewed as a cornerstone use, largely due to certain characteristics that add to the overall success of the project. The 24-hour, 7-day operation of hotels infuses vitality into an MXD project that few other uses can match. The identification of a major hotel chain also can help promote the MXD, as well as serving as a focal point for entertainment and recreation.

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Hotels also can be attractive financially. From the developer’s perspective, they are generally more profitable than other uses; for the city, a hotel may generate more tax revenue than an office building of comparable size. In preparing the market analysis for potential hotel uses, the source of demand is critical, particularly in selecting the other land uses. If conventions are the primary source of demand, retail may be a more compatible use than office space. Luxury and commercial hotels generally complement office and residential uses. The source of demand also may dictate the type of hotel operator required, which may be a factor in establishing the overall image of the MXD. Residential About half of MXDs contain residential uses, considerably less than those with office, retail, or hotel uses. With the exception of New York, Chicago, Washington, San Francisco, and a few other cities, demand for high-rise residential is usually not strong. Even if potential demand is in evidence, the high cost of land may make residential development difficult. In an attempt to overcome these market hurdles and encourage downtown living, many local municipalities, including San Francisco and Washington, D.C., require developers to include housing in MXD and other commercial projects. In many cases a stated portion of this housing must be dedicated to low- and moderate-income households, further reducing the financial contribution that the residential portion can generate for the project.7 In terms of market analysis, it is important to establish the acceptance of high-rise residential living in the market area before proceeding with the project; this is not a use that should be pioneered. Special attention should be given to the respective shares of the local market devoted to rental versus owner-occupied housing since a rental residential project might have a different impact on the market than would ownership housing, particularly in terms of age, incomes, and interests of residents potentially attracted to the project. The market analysis also should consider the possibility of selling and/or leasing units to corporations as well as individuals. An interview program with local firms may be helpful in this regard.

7 In some cases, jurisdictions may allow a developer to substitute contributions to off-site projects or low- and moderate-income housing programs. This is still an increase in development costs, but it would have less impact on market demand.

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Other Uses Other uses that have been a part of MXD projects include convention centers (Franklin Plaza, Philadelphia), trade marts (Peachtree Center, Atlanta), sports arenas (Poydras Plaza, New Orleans), performing arts centers (Williams Center, Tulsa), marinas (Marina City, Chicago), ice rinks (Houston Galleria), and health clubs (Plaza of the Americas, Dallas). The major issue in introducing uses of this type is weighing the degree to which they will increase overall demand for the other uses against the cost and possible congestion associated with their introduction. The attraction of large numbers of people, for example, may lead to increased security and maintenance costs.

MARKET SYNERGY Once the stand-alone demand for each of the potential uses has been established, including the approximate size of each use, the effects of possible synergy between uses should be estimated. This is accomplished primarily on a judgmental basis, based on the market data compiled in the market research conducted for each independent use. There are several types of synergistic demand. The first is direct demand created by proximity to other uses. The retail component of the project is likely to benefit the most from this form of synergy, experiencing a significant increase in demand because of proximity to office, hotel, cultural, recreational, or other uses. This impact may translate into higher sales per square foot during normal retail hours (for example, office workers shopping during their lunch hour) or in the ability to lengthen the retail day (to accommodate hotel guests, residents, cultural event goers, or recreational event attendees). The synergy created by an MXD also may allow for a broader mix of retail uses, including some that would not succeed on a stand-alone basis. Hotels within an MXD may realize increased revenues from demand generated by out-of-town visitors to office buildings or residential units located in the project. If a convention facility is a part of the MXD, the hotel may stand to add significant additional revenue, perhaps enough to justify more rooms and/or additional public space. The MXD hotel also may benefit from the retail component of the project, provided that it is relatively large and diverse, as shoppers may spend the night in the hotel or make use of its restaurants or other facilities. Less direct is the impact of synergy on office and residential demand. It is doubtful that additional office demand can be generated through proximity to other uses, but it may be an important factor in

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obtaining higher rents and/or having to make fewer tenant concessions. The proximity of the offices to other desirable uses also may prove helpful in reducing the lease-up period and minimizing tenant turnover. Residential uses in MXDs also may benefit from the effects of synergy, although this impact is generally overestimated. Several early MXD projects included residential and office uses on the assumption that people wanted to live and work in the same complex. Follow-up studies indicated, however, that this was not the case—very few residents worked in an office located in the MXD. Perhaps a more important factor in determining residential demand is the location and environment surrounding the MXD, including the convenience afforded by proximity to retail, hotel, cultural, and recreational uses in the neighborhood. Consideration also should be given to demand created by virtue of the sheer scale of the MXD project. This is particularly true of projects located in remote areas or in transitioning neighborhoods. As this is the most difficult type of synergistic demand to identify, great care should be taken to be certain it is not overestimated in planning the project. Once synergistic demand has been established, it is generally helpful to use a computer model to test the sensitivity of the project’s success to synergistic demand. If a large amount of demand is based on projected synergy created by the mix of uses within the MXD, the developer should proceed cautiously. In essence, synergistic demand should be viewed as the added “extra” that helps the project succeed, not the foundation for the project itself. Computer modeling also can assist in the planning and design phase, weighing the costs and benefits of the incremental demand produced by synergy among and between project uses. It may be that the revenues generated by incremental demand are more than offset by additional infrastructure costs (for example, parking) or negative impact on other uses (for example, traffic congestion; additional security requirements).

MARKET ANALYSIS FOR NEW TOWNS A vital component in the analysis of the market for a new town is the determination of the relationship between housing and employment. The key is the proximity of the new town to existing suburbs and the strengths of suburban employment. If an extensive employment base exists in the suburbs and the new town is within reasonable commuting time (30 to 40 minutes), the pressure to develop an independent employment

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base in the early years is less intense. Although individual commercial tenants may be attracted, the emphasis is primarily on housing and related uses (Figure 13-6). The housing market is analyzed in largely the same fashion as discussed in Chapter 8. The market area will, of course, need to be drawn a little larger; but it should focus on a reasonable commuting time to and from employment resources in the nearest suburbs. Capture estimates should consider the planning and environmental advantages of the new town as well as what is hopefully a substantial improvement vis-à-vis the housing product available in competitive neighborhoods. If the new town is not within reasonable commuting distance, the emphasis should shift to developing an employment base. Hopefully, firms can be attracted from the central city or suburbs of the metro area or other nearby metro areas. Analyzing the market for a satellite new town largely involves determining how much of the activity in the metro area can reasonably be captured by the new town. This activity will come not only from growth

FIGURE

13-6

Downtown Columbia, Maryland, one of the nation’s largest satellite new towns, developed by James W. Rouse. (The Rouse Company)

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of the metro area but also from shifts in housing and employment preferences from the central city and existing suburbs.8 The degree to which the new town can achieve a successful capture rate will depend on the location of the new town, the effectiveness of its planning, the quality and price of the housing and employment opportunities offered, and the degree to which these factors are missing in the suburbs and or the central city in the metro area. The marketing program is much more apt to be successful if a great contrast exists between the current living and working environment and that being created by the new town. The central city, if it is deteriorating, is subject to high incidents of crime, or is unduly congested, may represent a good source of candidate firms. If the metropolitan area is growing rapidly, new firms entering the market also may prove a fruitful target. An analysis should be made of office and industrial development trends in the metropolitan area, generally along the lines discussed in Chapters 10 and 11. If this analysis indicates that an employment base can be created, this objective should be emphasized initially, even to the point of subsidizing the cost of sites sold to firms willing to locate in the project. From this basic employment and population analysis, a projection model of household and business expenditures can be developed. Household expenditure patterns should be translated into demand for retail commercial facilities, as outlined in Chapter 9. The combined expenditures of households and business firms should be translated into demand for transient commercial facilities, as discussed in Chapter 12. It may be desirable to develop shopping and hotel facilities earlier than demand warrants, in order to provide facilities for housing, office, and industrial uses. Demand projections from the various land uses can now be translated into an overall model of market demand for the proposed new town. As with other multiuse projects, it’s important to identify the level of synergy created among the uses and the sensitivity of each of the major uses in estimating the project’s potential success. As with all market analyses, however, these numbers are, at best, rough estimates of how the private marketplace may react, and they should be continually subjected to the tried and tested screens of common sense and good judgment.

8 There are some indications that satellite new towns tend to pull more people from older suburbs than from inner cities. The new town, in essence, becomes a new “suburb” to employment opportunities in existing suburbs.

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PA R T I V

Financing the Project

Copyright © 2007 by John McMahan. Click here for terms of use.

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C H A P T E R 14

Mortgage Financing

Bankers are just like anybody else, except richer. Ogden Nash

Once sufficient market demand for one or more land uses on a particular site has been established, a preliminary analysis of the financial feasibility of a project should be made. As we noted in Chapter 5, the supply of capital available for real estate development is a function of the net savings of individuals, business firms, and government. A portion of these savings is channeled into real estate in the form of (1) debt financing secured by the property, with loans generally made by financial institutions or sellers, and (2) equity investments made directly by individuals or institutions, through ownership of property. This chapter deals with debt financing.

RATIONALE SUPPORTING REAL ESTATE DEBT The tradition of lending money on real estate is an old and proven one that rests on certain foundations: Financial institutions require outlets for accumulated capital that provide safety for funds lent and yet offer a steady source of repayment of capital and interest. ■ Land is a relatively durable form of investment that has represented security throughout world history. ■

323 Copyright © 2007 by John McMahan. Click here for terms of use.

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Improvements placed on the land also are relatively long term in nature, adding to the security of the real estate package. ■ The economic return from developed real estate usually flows on a sustained, fairly predictable basis, thus providing a consistent source of repayment for monies advanced toward its development. ■ Real estate projects generally require sizable amounts of money, often beyond the resources of the individual or firm undertaking the investment. ■ Over time, a tested, legal framework has evolved to facilitate real estate financing in an orderly, reliable manner. ■

For these and other reasons, debt financing secured by real estate has become one of the major investment sources for financial institutions, business firms, and individuals.

LEGAL INSTRUMENTS Real estate finance makes use of a variety of legal instruments for debt financing, all of which contribute greatly to its scope and stability. Mortgages Real estate debt financing most commonly involves the use of mortgages. A mortgage is the placement of a lien or an encumbrance on a property to secure repayment of a debt. If the debt is repaid by the borrower (mortgagor), the lien is released; if it is not repaid, the lender (mortgagee) can take legal steps to have the property sold to satisfy the debt. The debt is generally evidenced by a negotiable promissory note, which contains the amount of the debt, rate of interest, schedule of payments of interest and principal, and the date when the loan is due. The note may be an integral part of the mortgage or a separate document that is related to the mortgage security by reference. The promissory note is secured by the mortgage, which normally contains a description of the property; the terms of the promissory note (directly or by reference); the obligations of the mortgagor to maintain the property, pay taxes and other assessments, and insure the property in favor of the mortgagee; a defeasance clause, which voids the mortgage upon payment of the debt; and a default clause, which defines the rights of the mortgagee in the event the mortgagor fails to meet the terms of the agreement.1 1 These are the basic elements. Mortgages may contain other terms and conditions, depending on the state in which the property is located and the agreement between the parties.

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Theories of Title A mortgage involves an interest in real property, and the nature of the interest may vary significantly between jurisdictions. Two basic legal theories have evolved in the United States: title theory and lien theory. Some older states, mostly east of the Mississippi, still adhere to the title theory, in which the title transfers to the mortgagee (creditor) until the debt is repaid. In title theory states, the mortgagee normally has the right of possession and can dispossess the mortgagor (debtor) at any time. The mortgagor retains physical possession of the property but only at the sufferance of the mortgagee. The mortgagor can regain title through the defeasance clause, upon meeting the obligations of the mortgage. Recognizing that this approach unduly penalizes the mortgagor, most states now utilize the lien theory, in which title and right of possession remain with the mortgagor. The mortgagee has a lien on the property, as security for the loan, which is extinguished when the loan is repaid. Under both the title and lien theories, if the mortgagor meets all the terms of the note and the mortgage, the mortgage becomes void through the defeasance clause. If the mortgagor defaults on any of the terms of the mortgage, the mortgagee can utilize the default clause to take steps to satisfy the debt. Foreclosure Process Although these proceedings vary from state to state, the general actions are usually the same in that the mortgagor usually is allowed a period of time in which to satisfy (or reinstate) the obligations of the mortgage. If the mortgagor’s obligations are not satisfied within this period, the property can be sold at public auction to satisfy the debt. The mortgagee is usually allowed to enter a bid at this sale, up to the amount of the debt. In some states, if the proceeds of the public sale are less than the amount of the debt, the mortgagee can pursue a deficiency judgment against the mortgagor for the balance due. There usually is a time period after the public sale in which the mortgagor can repay the debt and regain title to the property. Relationship to Leases A mortgage can be placed on either the landlord’s or the tenant’s interest in a property under lease, but the mortgage typically will be subject to the lease. This means that foreclosure of the mortgage will not affect the tenant’s leasehold estate if the mortgage is on the landlord’s interest, and it will not affect the landlord if the mortgage is on the tenant’s interest.

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Conversely, mortgaged property can be leased, but the lease is subject to the mortgage—that is, foreclosure of the mortgage will terminate the lease unless the mortgagee and the lessee have entered into an attornment and recognition agreement providing that foreclosure will not terminate the lease. In most cases, the mortgagor can sell his or her property, and the mortgage can be assigned to the new owner.2 The mortgagee also can assign his or her rights under the mortgage to another mortgagee. Deeds of Trust An alternative form of security instrument used in some states is a deed of trust (or trust deed), which conveys legal title to a third party, or trustee, who holds it as security for repayment of the debt. As long as the mortgagor (trustor) is meeting the terms of the promissory note and the deed of trust, the trustee’s title lies dormant. However, upon default, the trustee may sell the property, usually at public auction (similar to a defaulted mortgage) and pay the proceeds to the mortgagee (beneficiary). Any surplus reverts to the mortgagor. Junior Mortgages Sometimes the property owner wishes to raise more capital than is possible through the first mortgage. Junior mortgages, which are subordinate to the first mortgage, can then be issued. The designation of second, third, or even fourth mortgage or trust deed indicates the seniority of the instrument as determined by the date of public recording. Since junior mortgages carry more risk, they usually are written for shorter periods of time and have a higher interest rate. Terms of Repayment There are also variations in the terms of repayment of the note or other debt instrument. As depicted in Figure 14-1, a straight-term mortgage requires no principal payments during the term of the mortgage (also called an interest-only or flat mortgage). A fully amortized mortgage calls for constant periodic payments (usually monthly, quarterly, or annually) of principal and interest, so that the principal is fully amortized over the term of the mortgage. Interest constitutes the major portion of the payments in the early years; principal dominates the later stages.

2 Many mortgages require approval of the mortgagee in the event of assignment. Failure to obtain approval may be an event of default, leading to the entire debt being due and payable.

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FIGURE

14-1

Methods of amortizing. The charts below are based on a $10 million loan at 10 percent for 30 years.

A partially amortized mortgage requires periodic payments of principal at selected points during the term of a mortgage, with the balance due at the end of the term. This balance is referred to as a balloon payment. Mortgages can be structured in any combination of these repayment schedules.

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Inflationary pressures in the 1970s led to the adoption of mortgages in which the interest rate and/or payment schedule may vary over the life of the mortgage. In some cases, the interest rate is tied to a predetermined index (for example, Treasury bonds or a thrift industry cost-of-funds index) that reflects changes in the cost of capital; this is called a variable-rate mortgage. The adjustable-rate mortgage (ARM) is a form of the variable-rate mortgage, but it has a cap on the interest that can be charged to the borrower. With other instruments, a portion of the interest payable may be tied to the economic performance of the property (for example, percentage of sales, hotel room receipts, or gross rentals); this is termed a contingent interest mortgage. Similar to contingent interest mortgages, shared appreciation mortgages allow for lower interest rates in exchange for a future sharing of equity by the lender. The graduated payment mortgage is attractive to first-time home buyers because it permits smaller payments in the early years of the mortgage when borrowers’ incomes are lower. Growing equity mortgages offer variable payment schedules, with increasing payments going to reduce principal. Interest rates on renegotiable or rollover mortgages are fixed for a specified period of time (usually one to three years), then adjusted based on prevailing market rates. Two relatively new mortgages attempt to give homeowners greater flexibility in changing financial markets. The convertible ARM allows the borrower to convert from a variable- to a fixed-rate payment schedule when rates are more favorable. The reduction-option mortgage allows the borrower to reduce the interest rate (on a one-time basis) between the second and fifth year of the mortgage, provided rates drop at least 2 percentage points in a single year. In the commercial property lending field, the fear of inflation was also a determining factor in the development of quasi-equity or hybrid mortgages, which provide the lender with a measure of equity participation. In the case of a participating mortgage, the mortgagee does not have an equity interest in the property but has the contractual right to participate in cash flow beyond a certain point and, in some cases, in sales or refinancing proceeds beyond a certain value. The convertible mortgage gives the mortgagee an option that can be utilized at a future date (generally 5 to 10 years) to convert to full or partial ownership of the property. In some instances, the features of both of these instruments are combined in the participating-convertible mortgage. These instruments also are used by equity investors in situations in which the property owner does not wish to sell or wishes to defer sale for tax or other reasons.

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Another type of instrument, the all-inclusive, or wraparound, mortgage, places a new junior loan on a property without removing existing loans. The new loan generally exceeds the remaining balance on the existing loans, thereby releasing new funds and/or facilitating the sale of the property. The wraparound mortgage usually is written for a longer term than the existing mortgage and has a higher overall interest rate. The new mortgagee then makes payment to the old lender who holds the existing mortgage. This is also referred to as a blanket, or extended, first mortgage. Sometimes the seller of a property takes back the mortgage directly, not involving a financial institution. This purchase money mortgage is often used to facilitate the sale of raw land or improved properties where institutional financing isn’t available or attractive. Purchase money mortgages frequently contain a subordination clause making the instrument a junior lien behind a construction or permanent loan utilized to finance the building of structures on the property. The purchase money mortgage isn’t the only method of financing property between buyer and seller without a financial institution. Investors in some states use the installment land contract, in which title remains with the seller (vendor) until the buyer (vendee) has made a predetermined number of periodic payments or until the last installment has been paid. The vendee usually has the right to use the property while making payments. Both the vendee and the vendor have the right to sell or borrow on their interest in the property, subject to the terms of the contract. This form of financing is used in the sale of subdivision lots and for improved properties that are difficult to sell or during periods of market inactivity. Ground Leases A long-term ground lease is a form of real estate financing in which the developer obtains use of the land in return for periodic rent payments over an extended period of time (in essence the developer “borrows” from the landlord the value of the land). Although the period of ground leases varies, generally it is long enough to permit financing of the improvements and permit the developer to recover its investment costs, plus earn a return on investment. At the end of the ground lease, the land and improvements revert to the owner of the land. This is known as a reversionary right. A ground lease is normally used in connection with a leasehold mortgage obtained to finance the construction of improvements. The ground lease will be senior to the leasehold mortgage financing and requires that the mortgage be based on the value of the ground lessee’s leasehold interest.

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If the ground lessor is willing to subordinate its fee interest to a first mortgage, the amount of the mortgage can usually be increased because the mortgagee has prior claim to both land and improvements. Ground leases usually have escalation clauses providing for periodic rental increases based on increases in the consumer price index or some other price movement standard. Leaseback Financing Mortgages placed on a lessee’s leasehold interests in property are called leasehold mortgages. Complex financing arrangements may involve both leasehold and fee mortgages on the same property. Over the years, various combinations of debt and lease instruments have come into use. In a sale-leaseback transaction, for example, a property owner sells the property and leases it back over a period of years. The property owner secures funds for development of the project in the form of sales proceeds; the lending institution (lessor) receives what amounts to an annuity of rental payments in an amount sufficient to amortize its investment and provide the desired return, plus reversionary interests in the land and improvements. In a land sale leaseback with a leasehold mortgage (or leveraged lease transaction), the land and improvements are separated; the land is sold and a mortgage is obtained on the improvements. If the land is subordinated, the proceeds may be sufficient to create 100 percent financing.

PRIMARY MORTGAGE MARKET (ORIGINATION) Table 14-1 indicates U.S. mortgage debt outstanding as of June 30, 2006. This table is presented in millions of dollars, with the groups of holders and the property type securing the loan in rank order as indicated by their mortgage holdings as of the date indicated. Note that almost 80 percent of all outstanding mortgages were used to finance one- to four-family dwelling units, followed by commercial buildings (13.1 percent), multifamily units (5.7 percent), and farms (1.3 percent). Almost half (46.0 percent) of all mortgages are held in governmentsponsored mortgage pools, followed by financial institutions (38.1 percent), individuals and others (12.2 percent), and federal agencies (3.7 percent).3 3 Most of these assets represent properties that are being warehoused to ultimately place in a pool or have been foreclosed upon.

TA B L E

14-1

Mortgage Debt Outstanding, by Property Type and Holder, as of June 30, 2006 (in millions of dollars) One- to Four-Family Mortgage Pools or Trusts Federal National Mortgage Assoc. (FNMA) Private Conduits Federal Home Loan Mortgage Corp. (FHLMC) Government National Mortgage Assoc. (GNMA) Federal Agriculture Mortgage Corp. Subtotal Financial Institutions Commercial Banks Savings Institutions Life Insurance Companies

Commercial

$1,924,826 1,692,865 1,381,468 370,882

Multifamily

Farm

Total

% Group

% Total

$1,813

$2,005,027 1,786,520 1,400,955 405,848 1,813

35.8% 31.9% 25.0% 7.2% 0.0%

16.5% 14.7% 11.5% 3.3% 0.0%

$228,309

$1,813

$5,600,163

100.0%

46.0%

$80,201 93,655 19,487 34,966

$5,370,041

$1,870,311 1,013,538 4,669

$1,063,834 104,585 228,309

$147,213 102,198 43,156

$49,847 697 14,441

$3,131,205 1,221,018 290,575

67.4% 26.3% 6.3%

25.7% 10.0% 2.4%

Subtotal

$2,888,518

$1,396,728

$292,567

$64,985

$4,642,798

100.0%

38.1%

Individuals and Others

$1,219,266

$149,377

$89,561

$30,552

$1,488,756

$47,499

$35,727 11,423 42,571

$3,200

Federal and Related Agencies Federal National Mortgage Assoc. (FNMA) Federal Housing Administration (FHA) Federal Home Loan Mortgage Corp. (FHLMC) Federal Land Banks Federal Agriculture Mortgage Corp. Government National Mortgage Assoc. (GNMA) Federal Deposit Insurance Corp. (FDIC)

331

Subtotal Total Percent Source: Federal Reserve Bulletin, November 2006.

$219,323 12,975 21,133 3,335

53,339 787

31 1

2

1

$256,798 $9,734,623 79.9%

$47,501 $1,593,606 13.1%

$89,722 $700,159 5.7%

$57,326 $154,676 1.3%

12.2%

$255,050 75,097 63,704 56,674 787 31 4

56.5% 16.6% 14.1% 12.6% 0.2% 0.0% 0.0%

2.1% 0.6% 0.5% 0.5% 0.0% 0.0% 0.0%

$451,347 $12,183,064 100.0%

100.0%

3.7% 100.0%

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These mortgage holders include primary market players who underwrite individual mortgages and may hold them or sell them into the securitized secondary market, mostly organized on a “pooled” basis. Investors such as pension fund mortgage REITs and others then invest in one or more of the mortgage-backed pools. In the primary mortgage market, the lender deals directly with the borrower to originate the loan. Financial institutions are the major originators including commercial banks, savings institutions (savings banks and savings and loan associations), life insurance companies, and mortgage companies. The evolution of major sources of institutional debt capital is presented in Figure 14-2. In originating the loan, the institution performs basic underwriting of the borrower and the property(s) involved. Factors considered include the following: Property risks. Location, age, construction, condition, purchase price (if home); appraised value (if commercial property); strength of applicable market; and so on. ■ Borrower risks. Occupation, income, experience with previous mortgages or other loans, experience with the lending institution, credit rating, and so on. ■

FIGURE

14-2

Institutional sources of real estate debt capital from 1988 to 2004. REITs

100%

Pension funds

90% Savings associations

80%

Other

Fed.-related mgt. pool Nongovernment CMBS and ABS issuers

70% Foreign investors

60% Life insurance companies

50% 40% 30% 20%

Commercial banks

10%

89

90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04

19

19

19

88

0%

Source: Urban Land Institute and PricewaterhouseCoopers.

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Economic outlook. Economic expansion versus contraction cycle, local versus national, and so on. ■ Money market conditions. Interest rates, capital available, possible government guarantees, and so on. ■ Secondary market. Ability to sell the loan into the secondary market (if not held). ■

As noted, the major players in the primary mortgage market are commercial banks, savings institutions, and life insurance companies. Commercial Banks History In the nation’s formative years, both state and national commercial banks were active in real estate. But an amendment to the National Banking Act of 1863 prohibited national banks from lending on real estate. With the Federal Reserve Act of 1913, national banks entered the real estate lending field again. The act allowed them to lend on farms, on the basis of 50 percent of value. From this point on, legislation expanded the scope of real estate lending by national commercial banks; deregulation of the banking system in the late 1970s further relaxed lending rules. Today, national banks can lend up to 90 percent of appraised value, with an amortization of up to 30 years. In practice, loan-to-value ratios are more apt to be in the 70 to 80 percent range. Regulatory Requirements The proportion of real estate loans in a bank’s portfolio varies with legislative standards, economic conditions, and bank policy. Legal loan limits for state banks vary considerably, depending on state law. Nationally chartered banks currently can lend up to 70 percent of time and savings deposits or 100 percent of capital stock and surplus, whichever is greater. The volume of real estate loans will tend to vary within these limits, depending on the tightness of money and alternative loan opportunities. Current Mortgage Holdings As noted in Table 14-1, at the end of the second quarter of 2006, commercial banks held 25.7 percent of all mortgages in the United States and 67.4 percent of those held by financial institutions. About 60 percent of commercial bank mortgage holdings were one- to four-family dwellings, second only to the mortgage pools sponsored by FNMA. Banks also held two-thirds of all commercial property mortgages.

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Construction Loans In addition to long-term mortgage financing, commercial banks are the largest providers of interim financing during the property development phase. Construction loans of up to two years on residential property and five years on commercial and industrial properties are exempted from the 70 percent limitation. These loans usually require a firm commitment by a reputable longterm lending institution (for example, a life insurance company or a savings and loan) to take out the loan upon completion of construction or maturity, whichever comes first. Commercial banks also are involved indirectly in other forms of real estate lending—through home improvement loans, equipment loans, and commercial lines of credit to real estate firms such as REITs, mortgage bankers, and developers. Savings Institutions Savings institutions include both savings banks and savings and loan associations. Savings Banks The first savings bank in the nation was the Philadelphia Savings Fund Society, which began operations in 1816. It was a mutual savings bank; that is, it was owned by its members, the savers and borrowers of the institution.4 Savings banks were the most active mortgage lender in America until the Great Depression. As a result of losses through foreclosure during this period, savings banks started taking a much more conservative attitude toward mortgage lending. This posture kept the institutions from emulating many of the progressive steps of other institutions in the 1930s and 1940s. In recent years, mutual savings banks have been limited geographically, primarily to the Northeast—especially Massachusetts and New York. Savings and Loan Associations The first savings and loan association, started in Pennsylvania in 1831, was patterned largely on “building societies” in England. These early institutions were frequently small, local groups of citizens who banded together to encourage homeownership through forced savings. People saved for their own homes, and if they moved or did not build homes, their savings were heavily penalized upon withdrawal. 4 Savings banks also can operate under a form of permanent stock ownership.

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As savings and loan institutions grew, the virtues of thrift were extolled to encourage saving for future needs. The institution’s early role was to safeguard the depositor’s savings as much as possible. Essentially these institutions “borrow short and lend long.” In periods of rising interest rates, the rate paid on savings accounts must increase in order for the institutions to remain competitive, which requires increases in the interest rate charged on new loans. As interest rates on home mortgages increase, the demand for loans dries up, and savings and loans find it harder to maintain a “spread” over the increasing expense of higher interest rates on all savings. In essence, they receive the benefit of high mortgage rates on only a fraction of their portfolio. Even with the deregulation of savings institutions in the late 1970s and early 1980s, savings and loans have continued to invest the bulk of their assets in mortgages; therefore, their portfolios (and earnings) are quite susceptible to changes in competing money market rates. In recent years, the variable-rate mortgage has helped to protect savings and loans from the adverse effects of rising interest rates on their portfolios, but it has not solved the problem of weak loan demand in times of high interest rates. As of mid-2006, savings institutions held 10 percent of the total mortgages outstanding in the United States, 83 percent of which were secured by mortgages on one- to four-family dwellings (Table 14-1). Life Insurance Companies Life insurance companies are the oldest and most diversified real estate lending institutions. During most of the nineteenth century, mortgages represented their major source of investment, accounting for as much as 60 percent of total assets in 1869. Portfolio Trends As corporate and government bonds grew in favor, dependence on real estate as an investment source diminished to approximately 30 percent by the turn of the twentieth century. During the 1920s, the percentage increased to 40 percent, but it then fell to less than 20 percent during the Depression.5 After World War II, investment in mortgages picked up, rising to nearly one-third of total assets by the mid-1970s but falling back to a level

5 Henry E. Hoagland and Leo Stone, Real Estate Finance (Homewood, Illinois: Irwin, 1973), p. 241.

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of 20.6 percent by the end of 1987.6 By the second quarter of 2006, they represented 2.4 percent of the U.S. mortgage market, 78.6 percent of which was invested in commercial properties, where they were a distant second to commercial banks (Table 14-1). The percentage of assets an insurance company invests in real estate depends on a variety of factors. Since insurance companies can invest in other assets, such as bonds and common stocks, real estate must compete with these instruments in terms of yield, risk, and liquidity. Generally, funds flow away from mortgages and into other debt instruments in times of increasing interest rates. Funds also flow out in periods of recession, when yields on real estate decline and foreclosures mount. Investment in real estate often is determined by the quality of real estate projects available and the overall credit of project tenants. Insurance companies are in a somewhat vulnerable position during periods of inflation when yields on existing mortgage portfolios remain fixed at a time of rising money market interest rates. To offset this problem, many companies participate in the project’s equity, whether through direct ownership, a percentage of the income stream, or both.

SECONDARY MORTGAGE MARKET Mortgage loans and securities backed by mortgages originated in the primary loan market are increasingly sold (primarily through intermediaries) to investors for inclusion in investment portfolios. History President Franklin Roosevelt laid the groundwork for the nation’s secondary mortgage market in the 1930s as the result of a multifaceted program to encourage homeownership and increase the level of mortgage lending. Important elements of the program were: Development of the Federal Home Loan Bank system Establishment of insurance on saving deposits through the Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC) ■ Creation of mortgage insurance programs (VA and FHA) ■ Introduction of the fixed payment, fully amortized mortgage ■ Creation of the Federal National Mortgage Association (Fannie Mae) as a secondary market agency ■ ■

6 Federal Reserve Bulletin, November 1988.

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Fannie Mae set several key objectives for the operation of the new secondary mortgage market: Integrate local capital markets with national capital markets. Facilitate the movement of funds from capital surplus markets to those with a shortage. ■ Provide liquidity for mortgage originators and investors. ■ Help the federal government implement housing and mortgage market policies. ■ ■

The secondary mortgage market was generally dormant during World War II, but it exploded shortly thereafter as returning veterans bought homes and sought VA-guaranteed mortgages. This growth brought attention to several weaknesses in the program. Many potential investors were not interested in investing in direct mortgages. Also, since private mortgages weren’t included, the integration of national and local markets was difficult to accomplish. In 1968, the Government National Mortgage Association (GNMA) was created. The new agency was given the power to issue securities backed by direct mortgages. The second problem, the inclusion of privately insured mortgages, was solved through the creation of the Federal Home Loan Mortgage Corporation (Freddie Mac), and for the first time, privately insured mortgages could be bought and sold in a secondary market. As noted in Table 14-1, mortgage pools or trusts today are by far the largest holder of mortgages with 46.0 percent of the total mortgages outstanding. The FNMA is the largest agency with 16.5 percent, followed by private conduits (14.7 percent), and the GNMA (11.5 percent). Virtually all (99.9 percent) of the mortgages held in pools or trusts are residential buildings, primarily one- to four-family homes.

Mortgage-Backed Securities The secondary mortgage market offers investors several advantages over direct investments in whole loans: Investors have more and better information about the characteristics of mortgages in the pool. Independent financial analysts also have an opportunity to evaluate each pool against others. ■ As a result of better information, investments in pools are more liquid. ■ Individual security units offer the small investor the ability to create a diversified portfolio. ■

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■

Government guarantees and private insurance provide an additional layer of default security. Overcollateralization of the pool also helps in this regard (120 to 240 percent of cash outflows). Derivative Securities

These are securities in which investors invest in tranches of mortgage principal repayment rather than a pro rata share of the whole pool. This allows them to better match individual pools with their risk profile or events in their life, such as retirement. The first common form of derivative was the collateralized mortgage obligation (CMO), which was first introduced in 1983. This vehicle resulted in double taxation, and it was replaced in 1986 by the real estate mortgage investment conduit (REMIC). Since then, there have been several additional restructurings of cash flows as the secondary mortgage market attempts to serve a broader range of investor tastes and risk preferences.

MORTGAGE LENDING PROCESS The foundation of the secondary mortgage market consists of millions of individual loans secured by real estate. While the mortgage lending process is continually evolving, there are some essential steps that are critical to the security of the individual loan and, collectively, to that of secondary mortgage markets. Decision to Lend The first step in the mortgage lending process is the decision by the financial institution to invest funds in real estate. Such a decision generally depends on the current state of the institution’s investment portfolio, money market conditions, and expectations for the future, in terms of inflation and deflation, interest rates, economic growth, and so on. If an institution feels it has too high a proportion of mortgages in terms of its desired liquidity, it may decide not to lend until it has reduced its existing portfolio and/or expanded its capital base. However, in some cases an institution with a high proportion of mortgages may enter the market to improve the quality or average yield of its existing mortgage portfolio or to replace maturing loans. The current status of the money market also critically affects the lending decision. If interest rates are high, institutions may want to secure as

Mortgage Financing

339

many good-quality high-interest-rate mortgages as possible. However, this objective often is thwarted by a reduction in the supply of money, brought on by expanded demand for nonmortgage loans, changes in government monetary policy, or, most likely, a combination of these forces. When interest rates are lower, reflecting an expanded supply of money, institutions are under pressure to “get the money out” as rapidly as possible. It is during these periods that marginal loans frequently are made that often come back to haunt the institution. Management’s future expectations also influence the degree to which institutions actively enter the mortgage market. If rising interest rates are expected, lending may be postponed until greater yields can be obtained (although the growing acceptance of the variable-rate mortgage has mitigated this problem). If falling rates are anticipated, management may attempt to lock in as many high-yield mortgages as possible. Expectations about the overall economy also have an effect. If a recession or depression is expected, the institution may shift from mortgages to more liquid investments, including mortgage-backed securities. If a sustained inflationary period is anticipated, management may seek out participation loans that partly offset fixed yields. These events and expectations are tightly interwoven and always changing. An institution may be out of the market one month and back in it the next. Also, most institutions set aside a portion of their portfolio to take advantage of “opportunity situations” that may arise and to finance developers with whom they have had long and successful relationships. Evaluation of the Individual Loan In evaluating a loan on an investment property, the institution considers two basic factors: risk and yield. Risk The value of the project itself is one way of measuring risk. This is generally established through an appraisal of the property, utilizing the techniques discussed in the appendix. Most institutions are limited by law or internal policy to lending only a certain percentage of this value. Another element of risk is the magnitude and reliability of the income stream generated by the project and the degree to which this stream “covers” the interest and principal payments on the loan. In speculative situations in which no user is in evidence, most institutions look for a coverage of 11/2 to 2 times the annual debt service. If the user is known in advance, this

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coverage ratio may be reduced, depending on the credit strength of the user. Coverage ratios also may vary by geographical area and product type. A final element of risk evaluation, particularly in new projects, is the financial strength and the proven ability of the developer to complete the proposed project on time and within budgeted costs. Yield Yield is a function of the annual interest rate and fees and the term of the loan. The interest rate generally is conditioned by the current state of the money market and the internal costs of the institution’s funds. In many cases, the interest rate is supplemented by points7 that are paid directly from or charged as a discount from the loan proceeds. The term of the loan also influences the yield; longer loans generally require a higher yield, particularly when the interest rate is fixed rather than variable. Both interest rates and yield are closely tied to the degree of risk associated with the loan. Generally, the greater the risk, the greater the yield that will be required. Loan Packages Most institutions require that loan applications be submitted in the form of a loan package so that they can assess properly the risks and yield of an individual loan. Although the exact composition of this package varies with the nature of the project and the institution involved, it generally includes the following: Formal application for loan Description of the project ■ Market study indicating demand for the proposed uses ■ Preliminary plans ■ Preliminary specifications ■ Preliminary cost estimate ■ Projected income and expenses ■ Identification of any precommitted tenants with related credit information ■ Information regarding the developer, architect, engineer, general contractor, and leasing agent and their experience with similar projects ■ Financial statements on the borrower ■ ■

7 These generally are expressed as a percentage of the total loan (1 point equals 1 percent; 1/2 point equals 1/2 percent, and so on).

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Lenders may also require other material, such as copies of precommitted leases, title reports, appraisals, and, in the case of construction financing, evidence of a permanent loan commitment. Sometimes, information is submitted to a lender without a formal application in order to elicit an informal reaction to the project prior to the final loan application. In evaluating an individual loan, lenders look not only at the information contained in the loan package but also at the quality of the presentation itself—and the degree to which it reflects the developer’s experience and track record. Role of the Mortgage Banker After World War II, the United States experienced strong demand for housing. Simultaneously, there was a surplus of funds in government bonds and other securities. Life insurance companies and mutual savings banks wanted to invest their funds in mortgages as rapidly as possible, and therefore they selected knowledgeable real estate people in major cities to represent them as correspondents who would analyze, originate, and service loans in their local area. At first, these firms were largely mortgage brokerage operations; gradually, many began utilizing their own funds to finance projects on a short-term basis prior to permanent financing. Funds for this purpose were usually borrowed from local banks through a “warehousing” line of credit. Ultimately, some of the larger mortgage bankers began to make long-term loans of their own. Traditionally, the mortgage banker played an important role in real estate financing, giving distant institutions valuable insight into a local market area without their having to develop a large, internal staff. On the basis of continuing relationships with one or more financial institutions, the mortgage banker could direct a loan application to the institution that was most likely to lend on that project, thus saving the loan applicant much time and aggravation. Mortgage bankers also provide other services such as loan administration and servicing (that is, collecting mortgage payments), property management, insurance, and, in some cases, real estate brokerage. With the growth of a large and complex secondary mortgage market in recent years, the role of the mortgage banker has expanded, and it has become more formalized, dominated by large mortgage banking firms operating on a national scale.

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FINANCING CHARACTERISTICS FOR DIFFERENT TYPES OF PROPERTIES This discussion pertains primarily to new construction, although the principles are basically the same for existing projects. Primary Homes Commercial banks and savings and loans generally provide construction lending on for-sale housing projects. Funds may be advanced with or without long-term permanent loan commitments on the individual dwelling units. Key factors considered in making the loan include the overall demand for housing in the market area, the price and quality of the units proposed, the margin of profit between the total price and total costs (for example, land, building, selling, interest), the builder’s track record, and the builder’s financial situation. Construction loans are generally for a period of one to three years, at rates based on the cost of short-term money to the lending institution. These loans usually are 11/2 to 2 percent over the prime rate, plus a fee of 1 to 2 percent of the commitment amount. The construction loan is repaid by funds from long-term loans and down payments on each unit. A savings and loan or savings bank usually makes the loan to the individual home buyer, which generally reflects 70 to 95 percent of the unit’s sales price. The loans are based on the creditworthiness of the prospective homeowner, and they take into consideration the amount of down payment, the personal income of the borrower, income in relation to the debt service required, and the general character and attitude toward debt repayment of the borrower. If the loans are to be insured by the FHA, Department of Veterans Affairs (VA), or private mortgage insurance companies, there may be additional requirements. The interest rate and term of home loans vary with the region of the country, the current state of the money market, and the type of loan involved. Second Homes Lending practices on second homes are much more stringent than on primary homes. A major consideration is the borrower’s ability to support payments on two mortgages simultaneously. The magnitude and nature of the applicant’s income is therefore important. Since loans on second homes are felt to be more risky, they generally are at lower loan-to-value ratios, for shorter terms, and at higher interest rates.

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Mortgage Financing

Apartments The same institutions that lend on for-sale housing projects frequently undertake construction lending on apartment projects. The major difference is that a precommitted, permanent loan is usually required. Savings and loans, savings banks, and insurance companies generally provide these permanent loans. In making a loan, factors to consider include the overall demand and rental rates for apartments in the market area; the quality of the project and projected rental levels; the degree of debt service coverage provided by the projected income stream; the developer’s track record in construction, rent-up, and management; and the developer’s financial strength. FHA-insured loan requirements are more precisely defined, and they include strict design requirements. Most apartment loans are for 75 percent of the total market value, as determined by an appraisal. Loan terms range from 15 to 25 years, depending on the type of project and its overall economics. Interest rates are generally higher than the prevailing rate on home mortgages. Shopping Centers Commercial banks usually make construction loans for shopping center development, and they almost always require some type of precommitted, permanent financing. Insurance companies, thrifts, REITs, or pension funds usually provide permanent financing. The key factor in shopping center financing is securing long-term leases from creditworthy retailers for a sizable portion of the gross leasable area. Most lenders like to see their loan fully or almost fully amortized by the base rentals for these anchor tenants. Other factors include the projected retail demand for the center, the projected rentals from the nonanchor tenants, and the proven ability of the developer to perform. Shopping center permanent loans most often are for 15 to 25 years, at rates 2 or 3 percentage points above the prevailing rate for equivalent maturity U.S. government securities. Office Buildings Loans for office and industrial buildings resemble shopping center loans. A precommitted, permanent loan almost always is required by an insurance company, commercial bank, thrift, REIT, or pension fund. Preleasing a portion of space (generally 30 to 40 percent) by one or more creditworthy tenants also is a general requirement. In some cases, the loan amount is staged in increments as the building is successively leased.

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The anchor tenant requirement may be waived or reduced if the building is in an exceptional location in a strong office market and the developer has 10 to 20 percent equity at risk. Office building loans generally are for 75 percent of appraised value, with fixed-rate loan terms ranging from 5 to 10 years and variable rates from 20 to 30 years. Industrial Buildings Loans on industrial buildings may or may not require leasing precommitments, depending on the size of the building and the strength of industrial space demand. In strong growth areas, speculative buildings sometimes are erected on the basis of a developer’s financial strength, and they are subsequently leased on a short-term basis at relatively high rental rates. Loans to finance this type of development are usually for 5 to 10 years. Longer-term loans require long-term leases from users with strong credit. This type of loan generally is considered the least risky, and rates usually are the lowest of all real estate mortgages, often at loan-to-value ratios approaching 100 percent. In essence, both the lender and the investor are buying an income stream; the real estate is somewhat incidental. With a strong, seasoned developer, a miniperm loan might be used that requires payment of interest only during the construction and leaseup period (generally three to five years) and then converts to a fully amortizing permanent loan when the project cash flow reaches sufficient levels. In some instances, miniperms also may be used to finance office buildings and shopping centers. In a build-to-suit situation, a building is built to the specific specifications of the occupying tenant who begins paying rent only when the building is completed to the required specifications. This is usually an attractive loan because the tenant and lease terms are known in advance and the major risk is the ability of the developer to deliver on the building contract. Transient Commercial Facilities Loans on hotels, motels, and other transient commercial facilities generally require a precommitted operating lease or management agreement by an established, financially sound operating company. As with shopping centers, operating leases on hotels and motels usually call for a base rental that is sufficient to amortize the loan. Additional rent is provided by percentage clauses, depending on the success of the operation.

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Mortgage Financing

In addition to the strength of the operator, lenders—usually insurance companies—look at the overall occupancy rate experience of similar facilities in the market area, the mix of revenue between guest rooms and public areas, cost per room, and the breakeven occupancy level of the proposed operation. Being somewhat riskier, hotel loans generally are for shorter terms and at higher rates than other commercial mortgages. Multiuse Projects Multiuse projects require the greatest amounts of financing in real estate, often several hundred million dollars. With large amounts of capital required and the fact that the development period of the project may be as long as 10 to 15 years, the financing may come from several sources. The developer must also have strong financial resources as the front-end costs may run into the millions before permanent financing can be secured. In order to share the risk, the developer may enter into joint venture arrangements with financial institutions, other developers, or tenants. Life insurance companies provide the bulk of permanent financing on multiuse projects, with banks providing construction financing. Public financing (through UDAG grants, state and local programs, land writedowns, infrastructure subsidies, and/or tax abatements) often contributes to multiuse projects, especially where adaptive use or rehabilitation of existing buildings is involved. In the lender’s analysis of financial feasibility, the project generally is viewed as a single one whose revenue comes from a variety of sources. Each element of the income stream is tested as if it were a single-use project. Leasing precommitments from anchor tenants generally are required for office and retail areas. Some consideration is given to the synergistic impact of this type of project on income, but such symbiosis must not determine the project’s success or failure; the project must stand on the strength of its individual components. New towns generally require several sources of financing. Infrastructure financing is provided by government agencies or insurance companies. Long-term commercial financing is supplied by an insurance company (often the same one providing infrastructure financing), a REIT, or a pension fund. Long-term for-sale or rental housing financing is provided by savings and loans or mutual savings banks. One or more commercial banks usually provide construction financing for virtually all elements of the project.

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It should be noted that this brief discussion of the debt financing of various types of real estate projects is meant to give the reader a broad overview of those factors that various types of institutions consider important when they make loans on different types of projects. As mentioned earlier, this situation is very dynamic, and it is subject to major shifts as a result of changes in economic trends, the money market, government policy, and the investment objectives of individual institutions.

C H A P T E R 15

Equity Investment

Buying real estate is not only the best way, the quickest way, and the safest way, but the only way to become wealthy. Marshall Field American merchant (1834 to 1906)

Real estate may not provide the only path to wealth, but it certainly offers one of the best-known, most proven ways. The historical attraction of individuals, corporations, and financial institutions to real estate as an investment has been noted throughout this book. Scores of other books exist on how to utilize real estate to achieve and maintain wealth. In part, the attraction of real estate as an investment has its roots in certain emotional feelings about “the land.” Emotional considerations aside, several very practical economic reasons explain why real estate has been sought out as an investment—reasons that were reinforced in the last half of the twentieth century and the first decade of the twenty-first. As noted in Chapter 7, real estate is divided into three submarkets: raw land, user-owned properties, and investment properties. The focus of this book is on investment properties, and the focus of this chapter particularly is on understanding the attraction and risks of real estate, how equity investments are made, and what various investment vehicles exist for holding selected assets. Such investments are, after all, the ultimate goal of the development process.

347 Copyright © 2007 by John McMahan. Click here for terms of use.

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REAL ESTATE RISK AND RETURN Development Process The risk curve for real estate during the development process is illustrated in Figure 15-1. Note the steepness of the curve in the early years of the holding period before entitlements are obtained. This is why real estate yields (and risks) are highest for those developers willing to take a property through the approval process. Once the entitlements have been secured, the risks begin falling as uncertainty is removed during the planning and design, financing, leasing, construction, and operations stages. In essence, the developer “rides the risk curve” by shouldering the development risks that most investors are not willing to assume. In so doing, the developer is adding value throughout the development process by orchestrating land, materials, labor, and services into a finished product—and is paid a development profit for undertaking this endeavor and assuming these risks. Role of Synergy in Creating Value One of the attractions of participating in the development process is the role played by synergy in making it happen. Figure 15-2 indicates how synergy creates value by systematically reducing the level of risk in the final building product. FIGURE

15-1

Real estate risk and return. Risk and return

High

Medium

Low

n

nni

Pla

nd ga

n g ns ns ns ng nts ign sin ctio nci atio atio atio me Lea nstru ina itle per per per F t O O O n o E C

des

Development process

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FIGURE

15-2

The role of synergy in creating property value. $5.0M Land

$10.0M

+

Materials

$2.0M

$3.0M

+

Labor

+

Services

$20.0M

=

Property cost

Developer profit

$5.0M Property value $25.0M

Source: McMahan Real Estate Services LLC.

In the figure, note that adding up all of the individual cost items in the development process results in a total of $20 million, but an investor will pay $25 million for the rights to own the building, assuming the building is sufficiently preleased, generating a profit of $5 million to the developer for putting all of the pieces together. This is not too different than the role played by an investment banker in bringing a private company public, as illustrated in Table 15-1. The real estate example is the same as in Figure 15-2. Different terms are utilized to describe the new stock issue, but the process is essentially the same. The book value of the firm is $20.0 million, which is the same as the cost of creating the real estate project. Earnings are assumed to be the same in both cases—$2.5 million annually. TA B L E

15-1

The Value Creation Process: Common Stocks and Real Estate

Cost to Create Book Value (Property Cost) Earnings (NOI) P/E (Cap Rate) Value to Investors P/E (Cap Rate) Market Value Entrepreneurial Profit Source: McMahan Real Estate Services LLC.

Common Stocks

Real Estate

$20.0 million

$20.0 million

$2.5 million 8 times earnings

$2.5 million 12.5%

10 times earnings $25.0 million $5.0 million

10.0% $25.0 million $5.0 million

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The stock investor utilizes a price-to-earnings (P/E) ratio of 10 times earnings to arrive at a value of the company of $25 million. The real estate investor divides by the reciprocal of the P/E ratio (10 percent) to arrive at the same $25 million in value. In both approaches the annual earnings are equal, the capitalization process essentially similar, and the final estimated value the same. More importantly to the entrepreneurs in both cases, the profit in creating the investment opportunity is identical.1 The amount of development profit will depend on the degree to which leasing risk has been removed or lowered through preleasing and the risk-return expectations of the real estate investor. The degree of spread will vary between projects and geographical markets depending on general market conditions as well as the risk perceptions of the investor. As an example, in soft markets, investor yields generally rise to reflect increased market uncertainty and greater availability of investment alternatives. Developer yields fall proportionally, but they also may be influenced by leasing concessions and the additional time required to lease the property. If the yield spread becomes too thin, the developer may begin buying properties since there is little incentive to take on development risks at this point in the business cycle. In a tight market, the spread widens and development profits increase. During these periods investors may decide to integrate back into the development process (move up the risk curve) in order to secure some of the profits that would otherwise go to the developer. Financial institutions, for example, may decide during such periods to become joint venture partners rather than merely lenders. Investors may attempt to market time these yield changes over time, acquiring properties when yields are relatively high and holding them until yields move down and properties can be sold at a more advantageous price. As an example, assume a $100 million hypothetical portfolio and a 200-basis-point downward movement in capitalization rates (from 9.5 to 7.5 percent). The result is a 26.6 percent increase in real return, all other factors being equal. Swings in market conditions also may lead to investors preferring one type of real estate product over another (for example, retail or residential over office or industrial). Investors also may attempt to arbitrage yields between different local markets or, as noted in Chapter 4, between different countries. 1 Depending on investors’ expectations, the successful “launch” of a public company may result in a much greater increase in value than a real estate project, but the downside risks can be higher as well.

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Risks and yields also may vary depending on the degree of franchise that a property enjoys. A well-located regional shopping center, downtown office building, or major hotel property may have lower yields because future income streams are perceived as being more certain. A project in a community with strong growth controls also may enjoy a franchise as a result of anticipated lower levels of future competition. The less of a franchise a property enjoys, the more it behaves like a commodity—nondifferentiated, easy to reproduce, interchangeable with other properties. An example is the distribution warehouse, which varies little from site to site and market to market. Role of Location As noted in Chapter 7, economic growth is critical in supporting new real estate development not only at the national and regional level but most particularly at the local level. Metro Area Growth Chapter 4 noted that the United States is growing faster than most other industrial countries. This does not necessarily apply to all metro areas because some are growing faster than others. Much of this growth is tied directly to job creation. While technology-oriented metros dominated job growth in past years, some of the momentum has shifted to cities with lower costs, growing populations, and reliable and stable employment sectors such as health care and government. Tourism also is a magnet for many job seekers. The Milken Institute of Los Angeles ranks the largest 200 metro areas in the United States by a series of job-creating factors including new job formation, growth in salaries and wages, and annual increases in gross domestic product. Table 15-2 illustrates Milken’s ranking of the top 10 job-creating metro areas out of the top 200 in the United States as of November 2005. In the past, Milken has made the following comment: Entrepreneurs are necessary visionaries of the economic potential of new technologies and how to apply them to business concept innovations. Regional economic dynamism is epitomized by fast-growing, entrepreneurial companies—“gazelle” companies. For a metro area to be successful over the long haul, it has to have capable entrepreneurs. Over the long-term, cities with strength in entrepreneurship will be among our Best Performing Cities.2 2 Milken Institute, Best Performing Cities, 2003.

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TA B L E

15-2

Ranking of Leading Job Creating Metro Areas 2005 Rank

Metro Area

2004 Rank

1 2 3 4 5 6 7 8 9 10

Melbourne, FL Fort Meyers, FL Naples, FL McAllen, TX Deltona–Daytona Beach, FL Orlando, FL Washington, DC Fayetteville, AR Fort Lauderdale, FL Riverside–San Bernardino, CA

31 1 15 18 5 29 11 7 9 8

Source: Milken Institute, Best Performing Cities, 2005.

Milken goes on to define the qualities of these entrepreneurial people: A region’s most important source of competitive advantage is the knowledge embedded in its people. In the past, firms attracted people; in the current, increasingly intangible economy, concentrations of talent are attracting firms. The knowledge, skills, experience and innovative potential of talented individuals have greater value than capital equipment. A successful enterprise accesses, creates and utilizes knowledge to sustain competitive advantage.

Since the Milken Index measures the annual rate of growth, it tends to favor smaller metro areas with smaller statistical bases. Of the U.S. metropolitan areas listed among the largest world agglomerations outlined in Chapter 4 (Table 4-1), Washington, D.C., scored highest, placing 7th, followed by Phoenix (15th) and Miami (73rd). The remaining metro areas were in the second 100 on the Milken list including Atlanta (118th), Los Angeles (124th), Dallas (125th), Seattle (127th), Philadelphia (128th), Houston (129th), Boston (157th), New York (161st), San Francisco (173rd), and Chicago (183rd). Detroit was not included in the top 200. Land Use Policy A metro area may be rapidly growing in population but not necessarily represent a good target for real estate investors. It is important, therefore, to also understand the varying policies of various local government agencies in approaching the issue of economic growth. In terms of land use policy, metro markets in the United States can be divided into commodity and constrained markets.

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353

Commodity Markets In these markets, emphasis is on job formation, with real estate being viewed largely as a factor of production. As a result, commodity markets generally reflect a strong pro-growth and pro-jobs philosophy. In fact, the often-stated public objective of these policies is to keep land and building costs low so that the area continues to be attractive to new firms and existing firms don’t leave. These policies are implemented by a very general plan, relatively lenient zoning restrictions, and an expedited entitlement process. The usual result of these policies is real estate markets with relatively low market rents and high vacancy rates. This situation also encourages a considerable amount of shifting between urban nodes as new product becomes available, often at lower costs. Among larger metro areas, those supporting such a policy include Atlanta, Charlotte, Dallas, Houston, Memphis, Orlando, and Phoenix. Constrained Markets In constrained markets, real estate supply is restricted as an integral part of public policy. This is accomplished through a strong general land use plan and a rigorous process by which new projects are approved. By limiting supply, this process tends to allow rents to seek market levels and, in most cases, results in appreciation in real property assets. Constrained markets include Boston, Chicago, Los Angeles, Miami, New York City, Philadelphia, San Francisco, San Diego, Seattle, and Washington, D.C. Many institutional real estate investors believe that public policy creating commodity markets implicitly favors real estate speculators at the expense of long-term real estate investors. Of the top 10 target markets identified by institutional investors in 2005, none were commodity markets.3 The intuition of institutional investors is supported by a certain amount of research. Figure 15-3 is based on a study by Lawrence Souza of the same-store net operating income (NOI) of selected multifamily REITs between 1996 and 2001.4 The REITs were grouped into constrained and commodity categories, based on their investment strategy and the geographical location of the major portion of their portfolio.

3 Pension Real Estate Association, www.prea.org. 4 The Johnson/Souza Group Inc.

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FIGURE

15-3

Supply-constrained versus commodity markets (same-store NOI growth). 12.0% 10.0%

Avg.

8.0% 500 bp

6.0%

Avg.

4.0%

Supply Constrained Markets: -Avalon Bay -BRE -Essex -C.E. Smith

Commodity Markets:

2.0% 0.0% 1996

1997

1998

1999

2000

2001

-Camden -Gables -Post Properties -Summit Properties

Source: Johnson/Souza Group, Inc.

The Souza study concluded that multifamily REITs operating in constrained markets generated annual NOI returns averaging approximately 500 basis points higher than multifamily REITs operating in commodity markets over the period studied.5 Submarket Location Factors Each metro area market is generally composed of a series of submarkets, each distinguished by local real estate factors. Figure 15-4 is a stylized view of key factors that often influence individual real estate development and investment decisions. In most metro areas there are one or more growth corridors that influence urban growth over the medium term (5 to 10 years). These corridors may reflect the development of new arterials or upgrading of existing ones. In some metro areas, the development of high-speed or light-rail service also may influence urban growth patterns. Transportation is not the only growth inducer; higher-density rezoning, urban renewal projects, new sewer lines, and neighborhood revitalization programs are just some of the changes in urban living and working patterns that may lead to new real estate development opportunities. Since these changes generally span a number of years, the key issue for the real estate developer is one of timing—you don’t want to be too early or too late to benefit from the increase in real estate values that generally accompanies this type of change in the urban fabric. 5 Note that the Souza study is based on real estate returns, independent of stock values.

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FIGURE

15-4

Submarket analysis. Growth corridor

Constrained supply

Metro area

Source: McMahan Real Estate Services LLC.

Since zoning is usually a province of local government, it is also possible to find submarkets that are constrained more than others, reflecting local voter preferences. Wilshire Boulevard, Beverly Hills, California; Camelback Road, Scottsdale, Arizona; Peachtree Street, Buckhead, Georgia; and Dulles Airport corridor, Tyson Corner, Virginia, are examples of classic real estate investment situations in which a constrained submarket is located in the path of an economic growth corridor, creating upward pressure on land and building values. Property Level At the property level, there is a wide variety of factors influencing future value enhancement. With today’s emphasis on good site planning, the sheer size of a parcel can influence the ability to develop a creative site plan with the capacity to phase in development over time. Soil conditions also can be a factor in the ability to build down (parking) and up (building size). In earthquake-prone areas, it may be a dominant factor. A “perfect storm” of factors contributing to property value appreciation would be a land parcel or improved property located in (1) a regionally constrained market, (2) a local jurisdiction with a constrained growth policy, and (3) the path of a growth corridor. Unfortunately, many of the existing opportunities have already been captured; thus the challenge is to find or create the next perfect storm!

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Role of Market Timing Many successful real estate developers, when queried about their investment strategy, reply that they are market timers—that is, they are deciding on the basis of fluctuating market conditions when to enter or leave a given market. Figure 15-5 indicates how a developer might use knowledge of the real estate cycle as a foundation for a market timing investment strategy. An immediate reaction to Figure 15-5 might be, “Why not buy or sell at the peak or trough of the cycle?” The reason to not try to do that is twofold: first, it’s very difficult to tell in advance exactly when the peak or trough of a cycle is going to be reached, let alone put together a development or marketing program to maximize value (minimize cost); and second, buying or selling before the peak ensures less competition in the marketplace. It’s generally better to be a leader on the upside and leave greater profits (or losses) to others who will discover that their precision in timing was diluted by intense market competition to get into (out of) the market. This is not to say that developers should be unaware of the importance of good timing in decision making, but they should not depend on it as a fundamental strategy. Role of Property Management Once a project is completed and leased, the major market risk remaining for the developer is the uncertainty regarding lease terms and rental rates FIGURE

15-5

Real estate cycle investment strategy. Years 20%

Investment return

15%

1

2

3

Sell

10% 5% 0% −5% −10% −15%

Source: McMahan Real Estate Services LLC.

4

5

6

7

8

9

Sell

10

11

12

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as leases turn over during the holding period and the final sales price of the property. Regardless of where a property is located, it still has to be managed, and in some cases, effective property management can make a difference in investment value. Unfortunately, many developers and investors are oriented to reducing and maintaining the lowest building operating costs possible, which is not always the best way to optimize value. The major reason is that most real estate operating costs are relatively fixed in nature and there is little that managers can do about them. It’s true that property taxes can be protested, insurance coverage can be negotiated, janitorial and other service contracts can be put out to bid, repairs can be postponed, and some building service costs can even be passed on to tenants. All of these steps can and should be considered, but they have to be weighed against the impact on tenants, their views of the building, and their willingness to consider other buildings when their lease comes up for renewal. The bottom line is that a building’s location is fixed, but the tenants’ locations are not, or at least they aren’t when their leases come up for renewal. Tenants who believe they are receiving fair value are more likely to stay or consider other locations in the building, provided that their space requirements can be met. Chapter 20 focuses on how this can be accomplished. Attractions of Real Estate as an Investment Through the years, real estate has been an attractive investment for a wide range of individuals and firms. There are many reasons for this attraction, with many investors focusing on a single underlying motive or perhaps a reinforcing combination of factors that few other investment vehicles can provide. Still others invest in real estate as a complement to other investments in a mixed-asset portfolio. Appreciation The last half of the twentieth century witnessed often significant appreciation in real estate values, largely as the result of rapid growth of America’s urban centers; and this trend has continued, and in some cases it has accelerated, in the twenty-first century. Market demand pressures on a limited supply of well-located land tend to increase the real value of land and buildings over time. The amount of appreciation depends on the location of the property, its purchase price, the uses to which it can be put, and the overall demand for these uses in the local marketplace. To the extent that this appreciation exceeds the

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inflation rate, the property will experience increases in real (after inflation) value. Inflation Hedge Another attraction of real estate is its ability to provide a hedge against unanticipated inflation.6 This is possible because new construction costs usually equal or exceed the general price index. Rents on new buildings also are often linked to the impact of new building rentals on overall market conditions. Rents on new buildings, in turn, are generally priced to return a yield consistent with new construction costs. In addition, owners of older buildings are unlikely to lower rents in a market experiencing higher price levels. This does not mean that older buildings will generate the same rent as new buildings—although this does occur in certain markets—but rather, that the differential between older and newer buildings will be generally consistent over time. Another reason real estate is such a good inflation hedge is that many commercial leases today are tied to a price index or they “go to market” at selected intervals. This allows all or a portion of the rented space to adjust to changes in inflation at certain intervals. Fortunately for property owners, very few leases are indexed downward to provide for rental reductions if price levels fall, although market price adjustment may result in lower rents, particularly in soft markets. A final factor is that increases in operating costs are often borne by the tenant, with increases in revenue falling through to the bottom line. The combination of these factors gives real estate the ability to adjust— with some lag effect caused by lease rollovers—to changes in price levels. In essence, protection against inflation is more or less built in so that it is not necessary to liquidate the investment in order to protect yields during periods of inflation. Real estate’s effectiveness as an inflation hedge has been documented by extensive analysis of real estate investment portfolios. In comparing portfolio returns during a generally inflationary period (1973 to 1983), Hartzell, Hekman, and Miles found that real estate experienced higher returns than other assets (for example, Standard & Poor’s and Treasury bonds and bills) with less variability. They also reported a high degree of correlation between real estate returns and changes in the general price level.7 6 Investors can hedge against anticipated inflation in the bond market. 7 David Hartzell, John Hekman, and Mike Miles, “Diversification Categories in Investment Real Estate,” AREUEA Journal, vol. 14, no. 2, 1986, p. 230.

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Cash Yields Real estate also provides a cash return in addition to inflation protection and the possibility of real appreciation.8 In fact, real estate is one of the few inflation hedges that also can provide the investor with a monthly, quarterly, or annual cash return. The amount of the cash yield will generally range from 6 to 12 percent annually, depending on the local market and the type of property. The cash yield, when added to (or subtracted from) the appreciation (depreciation) in the property, produces the total return. By deducing the inflation rate for the holding period, it is possible to determine the real total return for the investment. Zerbst and Cambon, in a wide-ranging 1984 survey of real estate returns, determined that pretax real returns from completed and leased investment properties ranged from 4.5 to 6.0 percent over most five-year or longer holding periods. This level of real return was less than it was for common stocks but higher than it was for bonds.9 Today, real estate may outperform common stocks as well. Lower Volatility There is also some indication that returns from real estate investment properties have been less volatile than those from equity securities.10 While the studies undertaken in this area are by no means conclusive, there is some logic to support this contention. Most investment properties are leased to corporations, which pay rent before they pay stock dividends (and in some cases, bond coupons), as lease payments are a nondiscretionary expense. A corporation simply has to pay its rent to stay in business. Since it is possible to evaluate the credit of the tenant and since rent payments can be reliably projected over the life of the lease, it stands to reason that the income stream from a real property is less volatile than corporate earnings. Since an income property generally sells on a capitalization of the income stream, changes in market value should be less volatile as well. Reduction of Systematic Risk There also are data that suggest that real estate performs inversely with securities.11 This means that when stocks are rising in value, real estate is 8 Raw land and user properties also may provide cash returns if they enter the investment property market. 9 Robert H. Zerbst and Barbara R. Cambon, “Real Estate: Historical Returns and Risks,” Journal of Portfolio Management, spring 1984, p. 20. 10 Ibid., p. 17. 11 Ibid., p. 19.

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declining; when stocks are down, real estate is up. The inclusion of real estate in a portfolio of stocks would therefore tend to offset movements in the stock market and lower systematic (nondiversifiable) risk.12 With lower volatility, real estate would tend to dampen the overall volatility of a mixed-asset investment portfolio. Leverage For some, a major attraction of real estate investment is the ability to utilize “other people’s money” to finance development activities. Under certain circumstances, leverage can increase the rate of return on equity investment (and the risks as well). Positive leverage exists when the rate of return is higher through the use of borrowed funds than it would be without these funds. Negative leverage occurs when the return is lower. The degree of leverage is a function of the proportion and interest rate of borrowed funds utilized and the overall earnings potential of the real estate project. Generally, the yield impact of leverage can be established by comparing the annual cost of amortizing the borrowed funds (debt service) with the annual income from the project. If the cost of borrowing is less than the income, leverage will be positive; if it is greater, leverage will be negative.13 Leverage is an advantage only if the economics of the project are sound. Small changes in the income stream can create negative leverage, and, if adverse conditions continue over an extended period of time, they can have an adverse impact on the investment. Fortunately for most investors, postwar America’s inflationary pressures have prevented this. Income streams, often tied to cost-of-living indexes, have tended to increase, creating a higher spread over debt service charges established at a given point in time. Business recessions or the advent of a full-scale depression can create negative leverage situations for real estate investments.

12 The risk associated with a given asset portfolio can be divided into two components: systematic risk is the amount of variance in the expected return of an asset that is due to overall changes in the market; nonsystematic risk is the variance in expected return caused by the underlying risks of a particular asset. 13 In the interest of simplicity, this discussion is concerned with a pretax situation. It should be noted that tax considerations may substantially alter the impact of leverage. An after-tax analysis over the anticipated holding period of the investment is therefore desirable in order to ascertain the true impact of leverage.

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Tax Advantages Since World War II, real estate has enjoyed several tax advantages over other forms of investment. These advantages have tended to increase the yield of the projects themselves and, in some cases, reduce taxes from other sources of income.14 The major tax advantage associated with real estate is depreciation, a tax allowance for reduction in the value of an asset over time. Annual depreciation charges increase expenses, thereby reducing taxable income. However, since depreciation is essentially a bookkeeping entry, no cash is required to cover the expense item. Thus, monies that otherwise would have been paid in taxes are available for other purposes.15 Annual depreciation can be utilized to offset other income to the extent that such depreciation exceeds the cash requirements for the project. Prior to the Tax Reform Act of 1986, depreciation could be calculated either on a straight-line basis or an accelerated basis. Straight-line depreciation is the value of the depreciable assets, less salvage value, divided by the number of years of useful life. Accelerated depreciation involves larger amounts of depreciation in the early years of a project’s useful life and lesser amounts in the later years. Today, straight-line depreciation for real property is the only method allowed under current tax law. The Internal Revenue Service divides property into two categories for depreciation purposes: residential rental property, which must be depreciated over 27.5 years, and nonresidential property, which must be depreciated over 39 years. Capital Gains The Tax Reform Act of 1986 greatly reduced individual tax rates. Congress consequently saw no need to extend preferential treatment for capital gains, which are now taxed as ordinary income. Individual Property Risks As with most investments, real estate investment entails certain risks as well. These risks relate to individual properties and nondiversified portfolios.

14 Tax policy and practice change almost daily. This discussion is intended to give the reader an overview of tax considerations relative to real estate at the time this book was written. For more specific questions, consult a CPA or tax attorney. 15 This sum can be calculated roughly by multiplying the amount of the annual depreciation by the taxpayer’s marginal tax rate. The marginal rate is the incremental tax rate on the owner’s new income added to an existing base.

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Individual property risks often can be reduced, or at least mitigated, through rigorous analysis and effective management. In certain cases, the risk can be hedged by someone else, usually for a price. Liquidity Liquidity is one area in which real estate does not compare favorably with securities. The disposition of real property is a time-consuming process (usually three to six months). Generally, real estate should be disposed of on a well-planned basis so that the investor can take advantage of market conditions and desirable timing in terms of the life cycle of the property. Investors, therefore, should not count on real estate to provide liquidity but rather view it as a long-term asset, only to be sold in concert with a planned disposition strategy. Loss of Legal Ownership This risk arises primarily in situations in which the equity owner cannot meet debt service obligations under the mortgage. In some states, this loss can exceed the amount of invested capital if the mortgagee can secure a deficiency judgment. In some cases, this also can happen if the investor has personally guaranteed the mortgage. While the risk of loss of legal ownership cannot be eliminated when a property is leveraged, it can be substantially reduced by limiting the amount of the mortgage and reducing the breakeven level required to meet debt service. As an example, the amount of leverage could be based on the percentage of the property leased to major credit tenants on a long-term basis. Loss of Yield Investors also face a possible loss of yield as a result of revenues or costs being less or greater than anticipated. The major risk usually is in the development phase, when revenues are pro forma and costs are real. There is also a yield exposure with operating properties, particularly when leases are turning, but it is much lower than in the development phase. It should be noted that prolonged earnings risks may ultimately turn into capital risks. If leveraged, continued cash outflows can eventually affect a project’s ability to meet debt service payments and foreclosure may result. Rates of return that do not match inflation may reduce the price at which a property can be sold. Loss of Purchasing Power During inflationary periods, there is a risk that, while the major amount of the original investment can be recovered, inflation may have eroded its purchasing power. However, this is usually less likely to happen with real

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estate because the appreciation of real property historically has tended to meet or exceed inflation. Local or Regional Economic Decline The market value of a property may be adversely affected by long-term economic decline in a regional or local economy, such as is being experienced currently in parts of New England and the Rust Belt in the Midwest or was experienced by many of the southern states in earlier periods. This risk is aggravated if the portfolio is overly concentrated in the area experiencing the decline. Changes in Government Policy Real estate also can be adversely affected by changes in land use regulations. As an example, land values in many Californian coastal areas were seriously undermined by the passage of the Coastal Initiative, which regulates new development along the Pacific Coast. Similarly, local governmental changes in floor-to-area ratios, parking requirements, and other development standards can adversely affect property values. Changes in government fiscal policy also can affect real estate. At the local level, a decision to increase property taxes or special assessments might reduce net operating income, particularly if increased expenses cannot be passed on to tenants. Changes in federal fiscal policy also can have an impact, particularly if these are primarily tax sheltered investments. When the time has come to dispose of the property, buyers may not be willing to pay the same price for properties that no longer carry the same level of tax shelter benefits. Unfortunately, there is no simple way to underwrite changes in government policy, particularly at the individual property level. Furthermore, there are few opportunities to shift the risk of such change. So the developer and investor must rely on analytical skills and business judgment to manage the risk process as best as possible. To the extent that adverse economic change can be foreseen, investments can be withheld, reduced, phased, or shared with others in order to minimize risk. But once a commitment has been made, it’s much more difficult to mitigate risk, particularly since real estate is a capital-intensive, somewhat illiquid asset. Outdated Technology In some cases the touted technology of one period may be the albatross of another. Buildings constructed between 1942 and 1974 were often insulated or fireproofed with the “wonder material” of the period: asbestos.

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Today, owners of these buildings are faced with monumental cleanup problems, the cost of which may not be recoverable through increases in rent. Failure to solve this problem could lead to a worse situation: condemnation of the building, loss of tenants, and the possible threat of lawsuits. Physical Destruction Real estate is a physical asset, fixed in location and subject to damage or destruction by a natural disaster. A real estate portfolio that is concentrated geographically intensifies this risk exposure. The classic case is the earthquake or tornado that destroys 30 to 40 percent of a real estate portfolio in a single stroke. While it is technically possible to protect the physical assets through insurance, this does not guarantee that the buildings can be re-leased after the disaster, which may be so intense that the overall economy of the area is adversely affected for many years. The major mitigation for physical loss and other property risks is to diversify the portfolio so that the odds are favorable that the loss of a portion of the assets will not seriously adversely affect the overall portfolio’s ability to continue to generate income.16 Portfolio Diversification Experienced investors in securities know that diversification of risk is important in protecting their investments. The rationale for the diversification of securities portfolios and the means to achieve it have been well established in the academic and financial communities for some time.17 While the advantages of diversification of real estate risks are not as well understood or accepted, there are some important parallels to the securities industry—and some notable exceptions. While the most realistic solution is to develop a portfolio of assets, the major problem is undue portfolio concentration because it subjects a major portion of the portfolio to adverse consequences for the investors. Geographical Diversification Most observers agree that geographical diversification is important in protecting a real estate portfolio from the risks of natural disasters and economic and regulatory change. 16 A recent example is the hurricane and flooding in New Orleans in August 2005. 17 Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review, June 1958; W. F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance, September 1964.

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Geographical diversification is generally considered at the metropolitan area level, although some areas (Los Angeles, for example) are so large that it may be possible to hold multiple properties in the area and still remain diversified. It also is essential to establish the linkage of metropolitan areas with similar economic or geographical characteristics. A portfolio of properties in Houston, Tulsa, Oklahoma City, and Denver, for example, involves metropolitan areas economically linked to energy production and would not be adequately diversified. Metropolitan areas subject to the same potential for natural disasters also would be considered closely linked and not satisfactory for diversification purposes. As an example, properties located in different metropolitan areas but along California’s San Andreas Fault would not be considered an adequately diversified portfolio. Property Type Concentration in a particular type of property can expose a portfolio to increased risk as a result of shifts in market preferences. Portfolios unduly concentrated in shopping centers in the late 1970s, for example, came under intense pressure as investor interest declined and market capitalization rates rose. This situation reversed in the 1980s as office buildings came under similar pressures as a result of overbuilding, and shopping centers again returned to favor. Property-type concentration also can lead to problems as a result of technological innovation. Portfolios of older office buildings have been hurt by advances in energy conservation resulting from innovative design and new technology, forcing owners to retrofit their buildings (if possible), lower rents, or lose tenants. There is some research indicating that diversification by property type, when combined with geographical diversification, can be quite effective in reducing risk.18 Clearly, property-type diversification within a single metropolitan area would not protect the portfolio from natural disasters, although it may provide some protection from economic change. Tenant Industry Another view is that the best form of economic diversification is across leaseholds, with no single industry dominating the tenant mix of a portfolio.19 Utilizing this approach, existing areas of concentration would 18 Paul B. Firstenberg, Stephen A. Ross, and Randall C. Zisler, “Managing Real Estate Portfolios,” Goldman Sachs Real Estate Research Publications, New York, November 16, 1987. 19 Ibid.

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be eliminated as leases turn by accepting only major tenants (in the same portfolio) from other industries. New properties would not be added to the portfolio if they increased industry concentration; leasing programs for properties under development would focus on tenants in industries that diversified the existing portfolio. While such an approach may be intuitively appealing, it may be difficult to implement, particularly for the developer or investor in a soft market in which it is a relief to secure any tenants, regardless of industry. The approach also penalizes developers who have specialized in serving the needs of a particular industry. Lease Term A more realistic approach is lease term diversification that attempts to avoid having too high a percentage of the portfolio “turning” in any one year. Lease turn exposure is evaluated across the entire portfolio. This is accomplished on a continuing basis and provides an important input in the development or acquisition of additional properties for the portfolio. For example, a property with a high percentage of leases turning in 1990 should not be placed in a portfolio already having a high percentage of leases turning in the same year, or if it is added, every effort should be made to diversify the ending dates of existing leases. Unfortunately, this approach is also difficult to implement because of the tendency of developers to write leases that have similar maturities. Many developers do this despite the fact that a property with staggered lease maturities would command a premium in the marketplace, particularly in metropolitan areas that tend to be consistently overbuilt. Investment Vehicle Investment vehicle concentration may subject a portfolio to adverse pressure as a result of increases in inflation. Portfolios having a high proportion of fixed-rate mortgages, for example, were severely affected by the inflation of the 1970s and early 1980s. Utilizing this approach, a portion of the portfolio would be in equity ownership and a portion in mortgages or hybrid instruments. The objective would be to obtain a steady cash flow from mortgages to offset the possibility of variability in equity cash flow. Diversification by investment vehicle is generally of more interest to investors than developers because most investors have committed their careers to building equity portfolios and have little interest in holding mortgages or hybrid investments. In fact, developers could probably achieve the same objectives this approach suggests, with greater liquidity, by having some of their portfolio holdings in the bond market.

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Minimum Number of Properties to Achieve Diversification What is the minimum number of properties required to achieve an acceptable level of real estate portfolio diversification? This was one of the questions addressed in a landmark court case, Donovan v. Mazzola, brought by the U.S. Department of Labor in 1981 against Plumbers Union Local No. 38 in San Francisco.20 In that case, the author testified for the Department of Labor that the ownership of at least six properties was required to achieve a minimum level of portfolio diversification, assuming the properties in the portfolio were located in different geographical areas and involved different property types. Since the Mazzola case, additional research on the diversification issue has been undertaken. In an analysis of a portfolio of 166 properties, Miles and McCue found that nonsystematic portfolio risk could be diversified relatively rapidly as portfolio size increased.21 The study demonstrated, for example, that a portfolio consisting of 4 properties resulted in diversification of more than two-thirds of the portfolio’s nonsystematic risk; 6 properties, over three-fourths. Miles and McCue also found that adding properties to the portfolio beyond this point didn’t proportionately reduce risk. With 20 properties in the portfolio, for example, nonsystematic risk reduction increased to 86 percent. In summary, the research indicates that a diversified real estate investment portfolio should include four to six properties located in economically independent metropolitan areas. If possible, tenants should be diversified by industry and lease term. Diversification by property type also may be desirable, provided geographical diversification has already been achieved. Diversification by investment vehicle, while a desirable objective for some investors, may not be as critical to developers. The Developer’s Dilemma Despite the advantages of diversification, the natural tendency of most developers is to concentrate their activities on one type of real property, located in one or a few metropolitan areas.

20 Employee Benefit Case (BNA) 2115 (N.D. California, 1981), U.S. Court of Appeals for the Ninth Circuit. 21 Mike Miles and Tom McCue, “Diversification in the Real Estate Portfolio,” Journal of Financial Research, vol. 7, no. 1, spring 1984, p. 57.

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There are several reasons for this. Intimate knowledge of a local area may be essential in locating good sites for development, securing necessary governmental approvals, and dealing successfully with contractors and subcontractors. Experience in a particular property type also may be important in understanding design trade-offs and in establishing credibility and consistency with key tenants. In formulating and implementing an investment strategy, the developer is faced with an interesting dilemma. As a creator of investment value, the developer benefits from concentration; as a holder of investments, from diversification. Faced with this situation, one response on the part of the developer is to become a merchant builder and pass on most of the responsibilities for diversification to investors acquiring properties upon completion. The production portfolio (that is, land and buildings under construction), however, is still subject to geographic concentration risk, although the time frame is shorter and the risk is more manageable. Another solution is to become a regional or national developer or to undertake the development of more than one property type. As noted in Chapter 3, this has been a motivating factor on the part of many of the national development firms that have evolved over the last decade. Still another approach to portfolio diversification, one not widely utilized thus far, is to trade equity interests with developers and investors who have properties in other geographical areas or investors who are holding other types of real estate. In this way the risks inherent in concentration can be shared, while the production advantages of concentration are retained, without having to build a large regional or national organization, with all of the attendant overhead costs and management responsibilities that entails.

VEHICLES FOR EQUITY INVESTMENT Equity investment in real estate can come from a variety of institutional and private sources. Major sources of institutional equity capital are presented in Figure 15-6. In addition, equity investment in real estate can be made through a variety of entities, each having intrinsic advantages and disadvantages. The selection of the proper vehicle to hold real estate is largely a function of the investment objectives of the person or firm involved and the resources available for investment purposes. Figure 15-7 indicates graphically the structure of each of the investment entities.

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FIGURE

15-6

Institutional sources of real estate equity capital between 1988 and 2006. 100%

Commercial banks

90% Life insurance companies

80%

Savings associations

Foreign investors

70% 60%

REITs

50% 40% 30% 20%

Pension funds

10%

06

05

20

04

20

03

20

02

20

01

20

00

20

99

20

98

19

97

19

96

19

95

19

94

19

93

19

92

19

91

19

90

19

89

19

19

19

88

0%

Source: Urban Land Institute and PricewaterhouseCoopers.

FIGURE

15-7

Forms of equity investment. Individual

Individual

Individual

Individual

Title Joint tenancy/tenancy-in-common Limited liability

Title Sole proprietorship

Individual

Individual

Individual

Individual

Individual

Limited partners

Individual

Title

Title

General partnership

Limited partnership

Individual

Individual

Share- holders

Corporation

Individual

Limited liability

Limited liability

General partner

Individual

Individual

Individual

Share- holders

Advisor

Trust

Title

Title

Corporation

Real estate investment trust

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Proprietorships Sole proprietorship or direct ownership of the equity fee is the simplest form of equity ownership. The sole proprietor completely controls the development, management, and disposition of the property. However, one problem with this type of ownership is that the sole proprietor bears the entire equity financing burden of the project, and he or she is subject to unlimited liability. Continuity of management upon the death of the sole proprietor also can be a problem. More than one person can own property directly, either through joint tenancy or tenancy in common. Under joint tenancy, each participant is personally liable for all expenses associated with the property. When one of the joint tenants dies, the property automatically goes to the surviving joint tenants. While this solves the problem of transfer at death, it considerably restricts the marketability of the joint tenant share. Under tenancy in common, each participant is personally liable only for his or her proportionate share of expenses. The rights of a tenant in common can be willed to others, which solves the problem of transfer at death and to some extent improves the marketability of those rights. Partnerships Often it is desirable to have more than one investor in order to spread liability and financial risk. This can be accomplished by establishing a partnership to own, develop, and manage real property. In most states, a partnership is a separate entity that is capable of transacting necessary business activity in the partners’ interests.22 In terms of taxes, a partnership is a conduit that allows income and expense to flow directly to the individual partners. A general partnership gives each partner full personal liability for all the debts of the partnership. Upon a partner’s death, the partnership is terminated and the property is liquidated. The deceased partner’s share is received by his or her estate. The limited partnership, more common in real estate investment, establishes at least one general partner and one or more limited partners. The general partner is responsible for managing the activities of the partnership and has general liability beyond that established for the limited partner. The limited partner is a “passive” investor with little voice in managing or controlling the partnership. Generally, the liability of a limited

22 Most states have adopted the Uniform Partnership Act of 1962.

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partner does not extend beyond the amount of the individual’s investment. Income and expenses, as well as any sales proceeds, flow directly to the limited partner, based on a predetermined percentage. Limited partnerships hold many advantages for the real estate investor. They represent a flexible form of ownership, offering the limited partner limited liability, uninvolvement in management, and direct pass-through of income and expenses for tax purposes. They provide the general partner with a source of financing without undue restrictions on management as long as the partner lives up to the terms of the partnership agreement. In 1981 a new type of partnership, the master limited partnership (MLP), was created. The MLP is not a separately defined entity for tax or legal purposes. Rather, it is simply a large partnership that is publicly registered and its shares are freely traded. The MLP has all the benefits of the limited partnership, and in addition, it solves the problem of illiquidity, the one major drawback of the traditional limited partnership.23 Corporations The corporate form of ownership also resolves the transferability of interest problem. A corporation is an artificial entity,24 created under state enabling powers.25 A corporation may acquire, develop, and dispose of real property, as well as engage in any other legitimate business activity. The corporation has a continuity of life, regardless of changes in its stockholders’ status. As in a limited partnership, the stockholders’ personal liability is limited to the amount of their investments, although under certain circumstances courts will “pierce the corporate veil” and impose liability on shareholders. The organization and maintenance of corporations constitute a complex legal area in which careful coordination with an attorney is essential. The stockholders’ interests are evidenced by units of ownership (shares) that can be transferred to other investors, depending on the legal nature of the stock26 and market conditions. 23 Recent congressional tax legislation has severely reduced the tax benefits of one level of taxation as applied to non-real estate investments. Industry concern over the possible extension of this legislation to real estate has substantially reduced the number of new MLPs being formed. 24 IRS regulations establish four basic “tests” for determining whether an entity (even an entity that has a different legal form, such as a partnership) is deemed to be a corporation for tax purposes: (1) centralized management, (2) free transferability of interests, (3) limited liability, and (4) continuity of existence. If the entity has two or more of these characteristics, it will be taxed as a corporation. 25 In most states, this involves the articles of incorporation and corporate bylaws. 26 Common stock may bear a legend that specifies various restrictions on its transferability, or various permits or registrations may be required under federal and state securities laws.

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The major disadvantage of corporate ownership of real estate is the impact of taxation. A corporation is taxed independently of its owners as a separate legal entity, currently at a maximum federal tax rate of 34 percent. The rate of state taxation varies according to the state of incorporation and operation; generally it ranges from 4 to 10 percent. When the corporation distributes income to its stockholders in the form of dividends, the income is taxed again, this time as ordinary income to the individual. On the other hand, if a corporation loses money, the shareholder cannot deduct these losses from his or her income from other sources.27 Furthermore, the corporation is subject to additional taxes if earnings are accumulated or if the corporation begins to assume the characteristics of a personal holding company. In certain cases, the taxation problem can be avoided by organizing a corporation under Subchapter S of the Internal Revenue Code. Owners of a “Sub S” corporation can choose to have the corporation’s income and expenses passed through to them as individuals, much the same as in a partnership. However, these corporations are subject to several restrictions: for example, there can be no more than 35 shareholders, and losses from operations must not be greater than the stockholders’ total investment, including stockholder loans to the corporation. Numerous other regulations govern establishing and maintaining a Subchapter S corporation. REITs As discussed in Chapter 3, REITs provide a vehicle with the transferability and personal liability advantages of a corporation as well as passthrough tax advantages. As long as the REIT meets various IRS tests, cash flows directly to the individual investor as a tax-free return of capital. Transferability certainly has been enhanced by the public market that has been established in REIT shares. In order to qualify for tax-free status at the corporate level, REITs must meet certain qualifications. First, 95 percent of the income of the REIT must be paid out annually to shareholders. Also, at least 75 percent of the REIT’s income must come from real estate. Finally, there must be at least 100 shareholders, and the shares held by 5 or fewer shareholders cannot exceed 50 percent of total ownership.

27 The corporation, however, can carry losses forward or backward to apply against profits in other years.

373

Equity Investment

Joint Ventures A joint venture is an entity established between two or more parties to undertake a single project or a group of projects. It may involve individuals, partnerships, corporations, or REITs. Generally, the terms of the joint venture are outlined in an agreement stipulating the purpose of the joint venture, the interests of the parties, and the accounting of funds. Joint venture arrangements have been utilized extensively between developers and lending institutions. Such arrangements allow developers to raise substantial funds and financial institutions to realize a better-thanaverage return on their investment, minus the problem of project management. Legally, a joint venture is similar to a general partnership, but there is normally a closer relationship among the partners in a general partnership than there is among the participants in a joint venture.

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C H A P T E R 16

Measuring Real Estate Returns

Without development there is no profit, without profit no development. Joseph Alois Schumpeter American economist (1883 to 1950)

In evaluating the potential rewards of a proposed real estate investment, one of the key factors is a projection of the annual return that can be expected on the equity funds invested. Surprisingly, this is less simple than it sounds: return on investment (ROI) may vary considerably among projects, depending on the nature of the project, the impact of leverage, the type of legal entity, tax considerations, and the method and assumptions used in the calculations. Therefore it’s important to understand how ROI is calculated by many real estate practitioners, how it should be calculated, and what it ultimately means in the overall evaluation of an investment opportunity.

SIMPLE RETURN ANALYSIS The traditional method of calculating return on real estate investment is the simple return analysis. This approach, despite many fundamental shortcomings, is still utilized by a large portion of the real estate community. Figure 16-1 indicates conceptually how the simple return analysis operates. Gross revenue is estimated for a normal or stabilized year of operations. An allowance for vacancy is deducted to arrive at effective gross 375 Copyright © 2007 by John McMahan. Click here for terms of use.

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FIGURE

16-1

Conceptual framework for simple return analysis. Gross revenue

Vacancy

Effective gross revenue

Operating expense

Net operating income

Total investment

Free and clear return (capitalization rate)

Debt service

Mortgage

Loan constant

Spendable income

Equity investment

Income stream $

Investment $

Net spendable (cash on cash return)

Return %

revenue. Annual operating expense is deducted to arrive at net operating income (NOI). The NOI is divided by the total investment to arrive at the free-and-clear return (also called the capitalization rate). If the property is leveraged, the annual cost of debt service (principal and interest) is deducted from the NOI to arrive at the amount of spendable income. Spendable income is then divided by the amount of equity investment to arrive at the net spendable, or cash-on-cash, return. The following discussion applies this approach in step-by-step fashion to a 100,000-square-foot office building located in the suburbs of a major American city. The project requires one year to construct and a second year to reach stabilized operations. Both leveraged and unleveraged situations are considered. In the leveraged scenario, a $12 million loan is assumed with an interest rate of 12 percent for the construction loan and 10 percent for the permanent loan.

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Measuring Real Estate Returns

Total Investment The first step in utilizing the simple return method is to estimate the amount of funds—both debt and equity—that will be required to develop the project. While many of these cost items must await definitive planning and design before they can be finalized, general estimates can help in determining the financial feasibility of the project on a preliminary basis. Table 16-1 outlines the total investment for the example property, totaling approximately $17.1 million on an unleveraged basis and $20.2 million on a leveraged basis. All of the costs are for the first year except for tenant finish and leasing commissions, which occur in the second year, and construction interest, which occurs in both years. Land The cost of land should be expressed in terms of its current market value ($10 per square foot in the example). If the land is being purchased, this will not be difficult—the price is clearly established. However, if the land has been held for a considerable length of time, its current market value must be established through an appraisal, as discussed in the appendix. Many developers and investors make the mistake of putting the land into the financial analysis on the basis of its original cost; this tends to understate the value of the land and to inaccurately increase the ROI.1 Construction Site improvement includes all costs needed to prepare the land for building construction, such as the demolition of existing structures, site preparation (for example, grading and soil import or export), off-site improvements (for example, sewer and street improvements), and on-site improvements (for example, utilities). They are calculated by extending a unit cost ($4 per square foot) by the amount of the total land area (217,800 square feet). Landscaping costs are calculated at $6 per square foot multiplied by the land area net of building, streets, and parking (25,000 square feet). These costs can be broken down in detail if necessary, especially when multiple contractors are involved; here, we combine them in order to simplify the analysis. Building construction costs are estimated by applying unit costs ($85 per square foot) to the gross building area (100,000 square feet). In the development of commercial and industrial buildings, allowances should be made for the provision of minimum tenant finish (electrical outlets, lighting, air-conditioning, partitioning, carpeting, 1 The illogic is apparent when an extreme case is considered: land that has been inherited and incurred no cost to the investor.

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TA B L E

16-1

Total Investment Calculations and Assumptions Unleveraged Hard Costs Land Construction Site Improvement Landscaping Building Construction Shell Finish* Parking Total Construction

Leveraged

Units

Price/Unit

$ 2,178,000

$ 2,178,000

217,800 Sq. Ft.

$10.00

$

$

871,200 150,000

217,800 Sq. Ft. 25,000 Sq. Ft.

$4.00 $6.00

8,500,000 2,208,000 420,000 $12,149,200

8,500,000 2,208,000 420,000 $12,149,200

100,000 Sq. Ft. 92,000 Sq. Ft. 350 Stalls

$85.00 $24.00 $1,200.00

$14,327,200

$14,327,200

Architecture and Engineering $ 364,476 Developer Overhead 375,410 Property Taxes 107,454 Leasing* 489,440 Construction Interest† Finance Fees Permits 71,000 Legal 45,000 Project Overhead (3%) 429,816 Other 100,000 Total Soft Cost $1,982,596

$ 364,476 375,410 107,454 489,440 2,578,896 360,000 71,000 45,000 429,816 100,000 $4,921,492

Total Hard Costs

871,200 150,000

Soft Costs

Reserves Project Contingency Total Reserves Total Project Costs First-Year Costs Second-Year Costs

$815,490 $815,490

$962,435 $962,435

$17,125,286

$20,211,127

$14,427,846 $2,697,440

$15,794,423 $4,416,704

3% of construction costs 3% of construction costs + A&E Calculated at 1.5% rate 5% of building leases

3% of total hard costs

5% of soft and hard costs

* Second-year costs. † First- and second-year costs.

painting, wall covering, and so on). The level of finish will vary according to the type of the project, local leasing customs, and the market strength of the project. Once these factors have been established, the cost of providing tenant finish is determined on a unit basis ($24 per square foot), multiplied

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Measuring Real Estate Returns

by the amount of net rentable area (92,000 square feet).2 Note that the net rentable area is less than the gross building area to allow for elevators, ducts, and other nonrentable space. The ratio between gross and net areas is called the design efficiency ratio. Parking is calculated on the basis of the number of stalls (350) multiplied by a unit cost per stall ($1,200). The total of all land and building costs (in this case, $14,327,200) is often referred to as the hard costs of a project. Soft Costs In addition to land and building costs, a series of expenses will be incurred between the time the decision is made to proceed and stabilized operations are achieved. These are often referred to as interim, or soft, costs. Architectural and engineering (A&E) fees are a percentage (3 percent in the example) of the total construction costs calculated to date; developers’ overhead is a percentage (3 percent) of all construction costs including the A&E fees. Most jurisdictions assess property taxes as construction occurs; some also may increase the assessment on the land to reflect the increased value owing to development. Interim property taxes are calculated on the basis of the effective tax rate (that is, the legal tax rate times the assessed value as a percentage of market value) applied to the average value of land and construction in place at the time of assessment. In the example, an effective tax rate of 1.5 percent is multiplied by 50 percent of the total land and construction (hard) costs. If the construction period had been two years, the effective rate would be applied against 25 percent of the total investment in the first year and 75 percent in the second year. Leasing costs are incurred following the completion of construction and tenant occupancy (second year in the example). These costs are calculated as a percentage (5 percent) of the annual amount of effective rent (that is, after any rental concessions) times the number of years in the lease. In the example, it is assumed that 60 percent of the space is leased for three years and 40 percent for five years. The calculation is the following: Three-Year Leases 92,000 square feet  0.6  $28  3  0.05  $231,840 Five-Year Leases 92,000 square feet  0.4  $28  5  0.05 

257,600 $489,440

2 These costs are more frequently underestimated than any other. Often, there is a strong temptation to increase tenant allowances in order to close a deal, particularly in soft markets.

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In the leveraged scenario, interim costs also would include one-time financing fees (points) on the construction (2 percent) and permanent (1 percent) loans. Interest is calculated on the basis of the average construction value in place each year of the construction period. During the first year this would be 50 percent ($7 million times 12 percent) and 100 percent during the second year ($14 million times 12 percent). Other interim costs include permits, legal fees, and miscellaneous costs, such as escrow, title insurance, and appraisal fees. These are generally lump-sum estimates. Net Operating Income The next step is to estimate the annual earnings that the proposed project will generate in a stabilized year of operations. These estimates should be based on information developed in the market analysis, adjusted to reflect nearterm market demand and merchandising considerations (see Table 16-2). Revenue Building revenue is based on the scheduled rent ($28 per square foot) times the net rentable area (92,000 square feet). Parking revenue is TA B L E

16-2

Net Operating Income Lease-Up

Gross Revenue Building (92,000 sq. ft. $28) Parking ($35 per month per stall) Subtotal

Percent

Dollars

Stabilized Income

50.0% 50.0%

$1,288,000 73,500 $1,361,500

$2,576,000 147,000 $2,723,000

Vacancy Allowance (8.0%)

217,840

Effective Gross Revenue (EGR) Operating Expense Property Taxes (1.5%) Utilities ($1.40 per rented sq. ft.) Repairs and Maintenance ($1.60 per rented sq. ft.) Property Management (3.5% of EGR) Subtotal Net Operating Income (NOI)

100.0%

75.0%

$1,361,500

$2,505,160

$214,908 64,400

$214,908 118,496

73,600 65,761 $418,669

135,424 87,681 $556,509

$942,831

$1,948,651

Measuring Real Estate Returns

381

assumed at $35 per stall per month. A vacancy factor is then applied to account for the building not being fully leased at all times. The vacancy factor will vary depending on local market conditions, strength of tenants, and, of course, the risk perception of the developer or investor. Vacancy The rationale for a vacancy factor is based on the belief that there is a natural vacancy rate established when real rental rates are not under pressure to change. Smith outlines five reasons for this: (1) time is required for landlords to search for tenants and tenants to search for rental space; (2) time is required for landlords to make leasehold improvements; (3) new construction is “lumpy” as projects come on the market all at once, creating lease-up vacancies; (4) returns may be maximized at less than full occupancy; and (5) in soft markets, landlords may withhold space from the market to avoid having to enter into long-term leases at less than desired rents.3 Vacancy allowances typically range from 5 to 15 percent; an 8 percent vacancy is assumed in the example. The vacancy factor is deducted from gross revenue to arrive at effective gross revenue. Fixed and Variable Expenses Operating expenses are then considered. Fixed operating expenses are those that do not vary with occupancy, such as property taxes. These are calculated as a percentage of the total investment as outlined in the discussion of interim costs. Variable operating expenses vary to some degree with the occupancy of the building. Utilities and repairs and maintenance are calculated on the basis of unit costs times the amount of rented square footage (84,640 square feet in a stabilized year, assuming 8 percent vacancy, and 46,000 square feet in a lease-up year, assuming 50 percent vacancy). Property management is calculated as a percentage of effective gross revenue (3.5 percent). All or a portion of operating expenses may be reimbursed or paid directly by the tenants, depending on the terms of the lease. In the case of industrial and hotel properties, expenses are typically paid directly by the tenant or operator. In the case of shopping centers, they are paid by the landlord but reimbursed by the tenants.4 Apartment landlords generally absorb all operating expenses except utilities, provided they are separately metered. 3 Lawrence B. Smith, “Adjustment Mechanisms in Real Estate Markets,” Salomon Brothers Bond Market Research—Real Estate, New York, June 1987. 4 Leases in which the tenant pays or reimburses for operating expenses are called net leases. In a triple net lease (net-net-net), the tenant is responsible for all operating costs.

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Most office building leases contain a provision establishing a maximum level of operating expenses to be paid by the landlord after the first year of the lease (expense stop). Expenses beyond this level are reimbursed by the tenant. This expense stop varies depending on market conditions; it will be greater in soft markets, when tenants can negotiate more favorable terms. In the simple return analysis example, no tenant reimbursement is assumed because the landlord absorbs all of the operating expense in the stabilized year of operation. With the stabilized year calculated, it is now possible to determine the NOI during the lease-up year. Vacancy is estimated to be 50 percent, with operating expenses calculated based on rented area or as a portion of the stabilized year expenses, reflecting the fixed nature of most operating costs, even those considered variable. Capital Structure Certain assumptions about the capital structure of the project must now be made (see Table 16-3). Operating earnings during the leasing period are considered in both the unleveraged and leveraged situations. The next step is to estimate how much can be borrowed against the property. This requires a rough appraisal, along the lines discussed in the potential loan that might be obtained ($12 million in the example). The percentage utilized will depend on the type of financial institution, the TA B L E

16-3

Capital Structure

Unleveraged Total Investment Sources of Capital Lease-Up NOI Equity Leveraged Total Investment Sources of Capital Lease-Up NOI Mortgage† Equity

Developer

Investor*

$17,125,286

$20,089,186

942,831 $16,182,455

$20,089,186

$20,211,127

$20,089,186

942,831 12,000,000 $ 7,268,296

12,000,000 $ 8,089,186

* Purchased at 9.7 percent capitalization rate. † 30 years at 10 percent; due in 10 years; 10.53 constant.

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Measuring Real Estate Returns

legal loan requirements under which the institution operates, the strength of the project, the credit strength of any known tenants, and the overall strength of the developer. Generally, this percentage will range between 60 and 100 percent of total investment (60 percent in the example). The amount of loan anticipated then should be cross-checked in terms of other tests, such as the amount of loan per unit, loan per square foot, and most important, the coverage of annual debt service by net operating income, called the coverage ratio (1.5 in the example). It’s wise to work with two or three possible loan alternatives: best possible, most likely, and worst possible. This gives a range of possibilities for analytical purposes. Any secondary financing also should be considered at this time. By deducting the amount of the anticipated loan(s) and leasing year NOI from the total investment, the amount of equity investment can be determined ($7.3 million in the example). Table 16-3 also analyzes on a preliminary basis the capital structure that an investor would have if he or she were to purchase the building upon completion and lease-up. A capitalization rate of 9.7 percent is assumed in the example, divided into the net operating income for the first stabilized year of operations. The $12 million loan would then reflect approximately 60 percent of the purchase price, requiring the investor to come up with $8 million in equity funds. Return Calculation At this point, the simple return on investment can be calculated (see Table 16-4). If the project is unleveraged, the free-and-clear return can be determined by dividing the NOI by the amount of the total equity investment (12 percent in the example). If leveraged, the annual debt service (principal and interest) is deducted from project earnings to arrive at the annual spendable ($685,051). The amount of net spendable is then divided by the amount of equity capital required ($7.3 million), with the quotient (cashon-cash return) expressed as a percentage (9.4 percent). Dividing the total equity investment by the NOI will result in the number of years it will take to pay back the investment (payback method). Problems with the Simple Approach While the simple approach is commonly utilized by real estate practitioners, it suffers from several major shortcomings. By utilizing an early year of operations, the approach doesn’t consider the effects of varying flows in future years, including possible inflation and real appreciation. Since it does not consider free rent or other tenant concessions, the simple approach tends to

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TA B L E

16-4

Simple Return Calculation Developer

Developer Profit

Investor

Unleveraged Net Operating Income (NOI) Equity Investment Free and Clear Return (Capitalization Rate)

$1,948,651

$1,948,651

$16,182,455

$20,089,186

$3,906,731

12.0%

9.7%

230 basis points

Leveraged Net Operating Income (NOI)

$1,948,651

$1,948,651

Debt Service

$1,263,600

$1,263,600

Net Spendable Equity Investment Net Spendable Return (Cash on Cash)

$685,051

$685,051

$7,268,296

$8,089,186

9.4%

8.5%

$820,890 90 basis points

overstate property values in soft markets. It also does not consider capital expenses as leases turn, such as leasing commissions and tenant improvements. Nor does it take into consideration the tax aspects of the project. Perhaps the most fundamental problem, however, is that it projects current returns infinitely into the future, ignoring the time value of money. For these reasons, the net spendable and other simple approaches may lead to the wrong decision and should be utilized only for preliminary tests of feasibility.

DISCOUNTED CASH FLOW ANALYSIS Most of the problems associated with the simple return approach can be overcome by the use of discounted cash flow (DCF) analysis. The cash flow associated with a property includes the cost of proceeding with the project (investment), the annual cash flows during the holding period, and the proceeds from the sale of the project at the end of the holding period (usually 10 years). The cash flow from each year is then discounted to reflect the present worth of the annual flows. The discounted flows may be compared to a predetermined minimum investment standard (target rate, hurdle rate, and so on) in which a positive net present value (NPV) indicates an acceptable investment. More commonly, cash flows are translated into an internal rate of return (IRR), which is then compared to a minimum percentage standard.

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Measuring Real Estate Returns

Time Value of Money One of the fundamentals of finance is that the same amount of money does not have the same value at different points in time. A year from now, $1,000 will not be equal to $1,000 today. The main reasons behind this are that the capital could be producing returns in alternative, generally less risky investments (for example, government-guaranteed savings accounts). For example, $1,000 invested at 10 percent today will be worth $1,000(1  0.1) = $1,100 a year from now. Similarly, if you are expecting to earn a 10 percent return on your investment, $1,100 a year from now needs to be discounted by the expected return (opportunity cost of capital) to arrive at its present value (value today): $1,100/(1  0.1) = $1,000. Basic present and future value formulas are used as a foundation for multiperiodic cash flow valuation discussed later in this chapter: PV  FV

1r

FV  PV(1  r)

Expected rate of return ( r ) is estimated based on the risk-free rate of return ( r f ) plus the premium ( rp ) consistent with how much riskier the investment is than the risk-free alternative asset (usually government bonds are used as a risk-free proxy). For example, if a government bond offers a 5 percent annual return, a more risky asset would have to offer a higher return (for example, 10 percent) in order for the investor to choose it over the risk-free alternative. The difference between the risk-free rate (5 percent) and the higher risk asset return rate (10 percent) is called the risk premium (in this case, 10 percent
5 percent  5 percent). The composition of the rate of return is therefore presented as follows: r  r f  rp If there are multiple periods of time between the initial investment (present value) and the payout (future value), we can adjust the formula as follows: $1,000 invested for 1 year at a 10 percent annual return rate equals $1,000  (1.1)  $1,100. If the same $1,000 were invested for 2 years at the 10 percent return rate, at the end of 2 years we would have the following: Year 1: $1,000  (1.1)  $1,100 Year 2: $1,000  (1.1)  $1,210 We can shorten the calculation to: $1,000  (1.1)  (1.1)  $1,000  (1.1)2  $1,210

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Therefore, our formula becomes: FV  PV  (1r)N where N is the number of periods of time between the investment and the payout. Similarly, PV  FV N (1  r )

We can extend the formula to reflect more than one payment over the course of time. For example, to calculate the present value of three annual payments of $1,000 (at an annual return rate of 10 percent), we can use the following: $1, 000 $1, 000 $1, 000 $1, 000 $1, 000 $1, 000      1.1 (1  r)1 (1  r ) 2 (1  r ) 3 1.12 1.13 $1, 000 $1, 000  $909.09    $2, 486.85 1.210 1.331

PV 

When we consider calculating the present value of the development project similar to the one described in the simple returns example, the present value formula becomes: NPV  CF0 

CF3 CF1 CF2 CFn   . . . (1  r1) (1  r2) 2 (1  r3)3 (1  rn) n

CF0 is the amount of initial investment and is always negative, CF1 is the cash flow amount in year 1, CF2 is the cash flow amount in year 2, and so on until the year n. This formula allows for different rates of return expected from different years. Remember that the rate of return depends partly on how risky the investment is perceived to be. Therefore, it is possible to have different rates of return for different years for the same property. For example, if the office building is currently leased for three years, the revenues from the rented space are fairly certain for those years, and therefore we may be willing to accept a lower rate of return than we would accept for the years after the turning year. The net present value (NPV) is the difference between initial investment and the present value of the annual cash flows and the net proceeds from the sale of the property at the end of the holding period. Net present value is determined by discounting cash flows by appropriate discount rates. If the NPV is greater than or equal to zero, the project is generally considered a desirable investment. In order to demonstrate the discounted cash flow approach, the twostory, 100,000-square-foot suburban office building project utilized for the simple return analysis is broadened to incorporate the necessary additional assumptions. Table 16-5 summarizes these assumptions, which are linked

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Measuring Real Estate Returns

TA B L E

16-5

DCF Assumptions Leasing (% rentable sq. ft.)

Space Land Building Gross Net Parking

217,000

sq. ft.

100,000 92,000 350

sq. ft. sq. ft. stalls

Unit costs Land Site development Landscaping Building Shell Finish Parking A&E fee Developer overhead fee Refurbish Stay Leave

$10.00 $4.00 $6.00

per sq. ft. per sq. ft. per sq. ft.

$85.00 $24.00 $1,200.00 3.00% 3.00%

per sq. ft. per sq. ft. per stall

$4.00 $9.00

per sq. ft. per sq. ft.

Tenant mix Three Five Stay Three Five Leave Three Five

60% 40% 60% 75% 40% 25%

Vacancy allowance Frictional vacancy Free rent Leaving Staying Tenant default

5

months

3 1 1%

months month building revenue

$28.00 $35.00 5.00%

per sq. ft. per stall building revenue

9.70% 9.70% 3.50%

NOI NOI sales price

1 10 3.00%

years

Rent Operating expense Utilities Repairs and maint. Property mgmt. Replacement reserve

$1.40 $1.60 3.50% 1.00%

Market building rent Market parking rent Leasing commission

Sale Stabilized cap rate Disposition cap rate Sales expense

Finance Construction Amount Term Rate Points Permanent Amount Term Amortization Rate Points Constant Balance at 10 years

$12,000,000 2 years 12% 2% $12,000,000 15 years 30 years 10.00% 1.00% 10.53% 90.90%

Stabilized year Holding period Growth rate Convention Inflation rate

end of year 3.00%

directly to each of the following tables in order to facilitate changes in assumptions and, if desired, sensitivity analysis. Formulas are explained as they are introduced utilizing the substitutions outlined in Table 16-6.5 Years 1 and 2 are designated (
2) and (
1) 5 The formulas are designed for use with Excel or a similar spreadsheet analytical program. Years are shown as subscripts.

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TA B L E

16-6

Abbreviations Used in Formulas DCAP FL FRTL FRTS FS FV GR GRA GRTL GRTS LCOM LCOMF LTR MBR MFL MFS MPR NOI NRA PR RR S SCAP SE SL SP SS STR T TBR TD TL TOE TR TS TV Y

Disposition capitalization rate Cost to refurbish tenant living space Free rent for leaving tenants Free rent for staying tenants Cost to refurbish staying tenant space Frictional vacancy Gross revenue Gross building area Gross revenue from leaving tenants Gross revenue from staying tenants Leasing commission ($) Leasing commission (%) Tenant reimbursement by leaving tenants Market building rent Market refurbishment for leaving tenants (sq. ft.) Market refurbishment for staying tenants (sq. ft.) Market parking revenue Net operating income Net rentable area Parking revenue Replacement reserve (%) Space occupied by tenants Stabilized capitalization rate Sales expense (%) Space occupied by leaving tenants Sales proceeds Space occupied by staying tenants Tenant reimbursement by staying tenants Percentage of space leased Total building revenue Tenant default allowance Percentage of space occupied by leaving tenants Total operating expense per square foot Tenant reimbursement Percentage of space occupied by staying tenant Termination value Lease term (years)

Note: years are denoted by subscript numbers.

so that the stabilized year becomes the first year (1) of the 10-year holding period. The property is sold at the end of the tenth year, based on the eleventh year’s NOI. The analysis is on a pretax basis.6 6 The impact of taxation on investment return will vary depending on the investment vehicle utilized and the overall tax situation of individual investors. As noted in Chapter 3, most tax advantages of real estate were eliminated in the Tax Reform Act of 1986.

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Measuring Real Estate Returns

Space Analysis The first step in the DCF analysis is to establish the amount of space that will be leased in each period (see Table 16-7), distinguishing between three- and five-year leases. Three-Year Leases

Five-Year Leases

NRA  T3  S 3 92 , 000 sq. ft.  0 . 6  55 , 200 sq. ft.

NRA  T5  S 5 92 , 000 sq. ft.  0 . 4  36 , 800 sq. ft.

In the lease-up year, these formulas are factored by an occupancy rate of 50 percent. For the years involving lease turns, the total amount of rentable space is multiplied by the lease mix and the percentage of tenants staying (TS) or leaving (TL). Tenants Staying Three-Year Leases

Five-Year Leases

NRA  T3  TS 3  SS 3 92 , 000 sq. ft.  0 . 6  0 . 6  33 , 120 sq . ft.

NRA  T5  TS 5  SS 5 92 , 000 sq. ft.  0 . 4  0 . 75  27 , 600 sq. ft.

Tenants Leaving Three-Year Leases

Five-Year Leases

NRA  T3  TL 3  SL 3 92 , 000 sq. ft.  0 . 6  0 . 4  22 , 080 sq . ft.

NRA  T5  TL 5  SL 5 92 , 000 sq. ft.  0 . 4  0 . 25  9 , 200 sq . ft.

If actual leases are in place at the time of the analysis, the terms of the leases should be substituted with appropriate staying and leaving assumptions. Net Operating Income The next step is to estimate the NOI for each of the projected years, as outlined in Table 16-8. Market Rent As noted in the simple return analysis, market building rent (MBR) is forecast for the stabilized year at $28 per square foot. It is assumed that this rent level is the same as in the leasing year. From the stabilized year forward, it is assumed that market rent increases at a 3 percent annual growth rate. MBR  1.03 Parking rent (MPR) was developed in a similar fashion. MPR  1.03

390 TA B L E

16-7

Space Analysis (in square feet ) Activity

Three-Year Leases (S3) Nonturning Years Lease-Up Year Turning Years Stay Leave Five-Year Leases (S5) Nonturning Years Lease-Up Year Turning Years Stay Leave Total Space Leased

Construction

Leasing

Year
2

Year
1

Operations Year 1

Year 2

55,200

55,200

Year 3

Year 4

Year 5

55,200

55,200

Year 6

Sale Year 7

Year 8

55,200

55,200

Year 9

Year 10

Year 11

55,200

55,200

27,600 33,120 22,080

36,800

36,800

36,800

33,120 22,080

36,800

36,800

33,120 22,080

36,800

36,800

36,800

36,800

18,400 27,600 9,200 46,000

92,000

92,000

92,000

92,000

92,000

27,600 9,200 92,000

92,000

92,000

92,000

92,000

92,000

391

Measuring Real Estate Returns

Gross Revenue The gross revenue (GR) for most mixed-tenancy office buildings tends to move in a “stepped” fashion—steady flows for two or three years followed by increases (decreases) as leases turn.7 In all years except the lease-up year and turning years, the formula is (for example, year 4) as follows: Three-Year Lease S3,4  MBR 3  GR 4 55, 200 sq. ft.  $29.71  $1, 639, 992

Five-Year Lease S5,4  MBR1  GR 4 36, 800 sq. ft.  $28.00  $1, 030, 400

Note that the market rent is the base year of the lease, not the current year. In turning years, the model should reflect the fact that building space will turn in a manner consistent with the original lease-up pattern in which the average lease begins at midyear. This is accomplished in the case of staying tenants by assuming that one-half of the revenue in the turning year will be at the base year market rate and one-half will be at the prevailing rate for the turning year. As an example, the formula for space occupied by three-year tenants, turning for the second time in the sixth year, is the following: Staying Tenants

Leaving Tenants

(SS6  MBR 3  0.5)  (SS6  MBR 6  0.5)  GRTS6

(SL 6  MBR 3  0.5)  (SL 6  MBR 6  0.5)  GRTL 6

(33,120 sq. ft.  $29.71 0.5)  (33,120 sq. ft.  $32.47  0.5)  $1, 029, 701

(22, 080 sq. ft.  $29.71 0.5)  (22, 080 sq. ft.  $32.47  0.5)  $686, 467

Gross revenue for five-year leases is determined in a similar fashion, utilizing the appropriate tenant mix and staying and leaving assumptions. Parking revenue is a product of the number of stalls (PA) times the monthly charge per stall (MPR), converted into an annual number, as seen in the following example for the third year: PA 3  MPR 3  12  PR 3 350  $37.13  12  $155, 946 Vacancy Allowance Unfortunately, most buildings do not operate at full occupancy throughout the holding period, and some allowance must be made for future vacancy. Simple return analysis utilizes an annual allowance (8 percent in the example) applied against scheduled gross revenue. With DCF analysis, it’s

7 Unless, of course, the leases are subject to an annual inflation adjustment.

392

TA B L E

16-8

Net Operating Income (in dollars) Activity Construction

Leasing

Year ⴚ2

Year ⴚ1

Operations Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Sale Year 7

Year 8

Year 9

Year 10

Year 11

Market Rent ($/sq. ft.): Building (MBR)

$28.00

$28.00

$28.84

$29.71

$30.60

$31.52

$32.47

$33.44

$34.44

$35.47

$36.53

$37.63

Parking (MPR)

$35.00

$35.00

$36.05

$37.13

$38.24

$39.39

$40.57

$41.79

$43.04

$44.33

$45.66

$47.03

$772,800

$1,545,600

$1,545,600

$1,639,992

$1,639,992

$1,792,344

$1,792,344

$1,957,944

$1,957,944

Gross Revenue (GR): Building Three Year Stay

955,678

Leave Five Year

1,029,701

637,118 515,200

1,030,400

1,030,400

1,030,400

686,467 1,030,400

Stay

Parking Total Gross Revenue

1,159,936

750,058 1,159,936

1,159,936

1,159,936

821,376

Leave Total Building Revenue

1,125,086

1,344,304 939,090

273,792

313,030

1,288,000

2,576,000

2,576,000

2,623,196

2,670,392

2,735,160

2,876,104

2,952,280

2,952,280

3,035,080

3,210,064

73,500

147,000

151,410

155,946

160,608

165,438

170,394

175,518

180,768

186,186

191,772

197,526

1,361,500

2,723,000

2,727,410

2,779,142

2,831,000

2,900,598

3,046,498

3,127,798

3,133,048

3,221,266

3,401,836

3,499,774

273,551

120,923

298,963

326,585

140,144

81,672

72,206

89,259

97,506

83,683

Vacancy Allowance (V): Frictional Vacancy (FV) Free Rent (FR) Staying Tenants

3,302,248

72,496

179,234

Tenant Default (TD)

Leaving Tenants 25,760

25,760

163,999 26,232

26,704

27,352

28,761

29,523

29,523

195,794 30,351

84,019 32,101

Total

25,760

25,760

545,454

26,704

292,977

596,217

29,523

29,523

650,236

339,947

279,982*

1,361,500

2,697,240

2,701,650

2,233,688

2,804,296

2,607,621

2,450,281

3,098,275

3,103,525

2,571,030

3,061,889

3,219,792

288,817

Effective Gross Revenue (EGR)

Operating Expense: Property Taxes

214,908

214,908

221,355

227,996

234,836

241,881

249,137

256,611

264,309

272,238

280,405

Utilities

64,400

118,496

122,051

125,713

129,484

133,369

137,370

141,491

145,736

150,108

154,611

159,249

Repairs and Maintenance

73,600

135,424

139,487

143,672

147,982

152,421

156,994

161,704

166,555

171,552

176,699

182,000

Property Management

65,761

87,681

94,558

78,179

98,150

91,267

85,760

108,440

108,623

89,986

107,166

112,693

418,669

556,509

577,451

575,560

610,452

618,938

629,261

668,246

685,223

683,884

718,881

742,759

6.05

6.28

6.26

6.64

6.73

6.84

7.26

7.45

7.43

7.81

8.07

2,140,731

2,124,199

1,658,128

2,193,844

1,988,683

1,821,020

2,430,029

2,418,302

1,887,146

2,343,008

2,477,033

Net Operating Expense (NOE) Total Operating Expense/sq. ft.

Net Operating Income (NOI)

942,831

*8% of total gross revenue; used to calculate terminal value only

393

394

Professional Property Development

possible to break out the three components of vacancy and match them with the time period when they occur. Frictional Vacancy (FV) This occurs when a tenant moves out of the space at the expiration of a lease and is replaced by another tenant. The allowance is stated in terms of months, and it includes the time to find a new tenant and build out the space. The factor is applied to the amount of market rent paid on a new lease. As an example, three-year leases turning in the sixth year with five months’ frictional vacancy (5/12, or 0.417) would be calculated as follows: SL 6  MBR 6  0.417  FV6 22, 080 sq. ft.  $32.47  0.41 7  $298, 963 The same formula would also apply to five-year leases. Free Rent This applies to free rent concessions made to new tenants (FRTL) and, if in a particularly soft market, staying tenants as well (FRTS). This is also calculated in terms of months and is applied against the market rent for the new lease. The formula is similar to that used to determine frictional vacancy (year 6 example): Leaving Tenants (3 Months’ Free Rent)

Staying Tenants (1 Month’s Free Rent)

SL 6  MBR 6  0.25  FRTL 6

SS6  MBR 6  0.083  FRTS6

22, 080 sq. ft.  $32.47  0.25  $179, 234

33,120 sq. ft.  $32.47  0.0 083  $89, 259

The amount of rental concessions will vary, of course, with the overall softness or tightness of the market. Tenant Default This is a problem posed by tenants who default on leases as a result of bankruptcy, “kickout” clauses,8 or other reasons to stop paying rent before the lease term expires. Since this phenomenon is not associated with a lease turn and furthermore is generally unpredictable, the only way to account for it is an annual percentage charge against gross building revenue, which may vary depending on the softness or tightness of local markets. This percentage will generally be approximately 1.0 percent. The formula is (sixth-year example) as follows:

8 A kickout clause is a clause found in retail leases that allows the tenant to get out of a lease if he or she doesn’t reach certain volume levels or a competitor is allowed into the center.

395

Measuring Real Estate Returns

TBR 6  0.01  TD 6 $2, 876,104  0.01  $28, 761 The total vacancy charge for the sixth year becomes: Frictional Vacancy Free Rent: Leaving Tenants Staying Tenants Tenant Default Total

$298,963 179,234 89,259 28,761 $596,217

Note that, in contrast to the simple analysis, parking vacancy is not included in calculating the allowance. This is because parking revenue is not always affected by building vacancy, or, if it is, the magnitude is not sufficient to warrant separate treatment. Total vacancy is then subtracted from the scheduled gross revenue to arrive at the effective gross revenue (EGR). Operating expenses must now be subtracted to arrive at the NOI. Operating Expenses Operating expenses flow in a somewhat different fashion than revenue because expenses are subject to change each year and tenant reimbursement may vary, depending on the terms of each lease. There also may be a lag effect caused by the billing of actual expenses in the year succeeding the one in which they were incurred. Each operating expense is calculated in a manner similar to that discussed in the simple approach, distinguishing between fixed and variable costs. Total operating expenses for the lease-up period average about 75 percent of the expenses in the stabilized year. Expenses after the stabilized year are adjusted by the assumed growth rate. A different growth rate may be utilized for expenses than is used for revenue or, in some cases, between individual expense items, depending on the characteristics and customs of the marketplace. Once a total for each year has been computed, it is divided by the amount of rentable square feet to arrive at the operating expense per square foot. Cash Flow Table 16-9 transforms net operating income into cash flow projections over the holding period by including capital expenses and the proceeds from the sale of the asset at the end of the holding period. The level of

396

TA B L E

16-9

Unleveraged Cash Flow (in dollars) Activity Construction

Leasing

Year ⴚ2

Year ⴚ1

Operations Year 1

Total Investment
$14,427,846
$2,697,440 Net Operating Income (NOI) $942,831 $2,140,731 Turning Costs: Market Refurbishment Costs Stay (MFS) 4.00 4.00 Leave (MFL) 9.00 9.00 Tenant Refurbishment Costs Stay (TRS) Leave (TRS) Total Turning Costs

Year 2

$2,124,199

4.12 9.27

Leasing Commissions Total Turning Costs Replacement Reserve Disposition Cap Rate Disposition Price Selling Costs Disposition Proceeds Unleveraged Annual Cash Flow Deflation Rate Real Unleveraged Cash Flow

27,230

27,274

Year 3

Year 4

$1,658,128 $2,193,844

4.24 9.55

Year 6

Sale Year 7

$1,988,683 $1,821,020 $2,430,029

Year 9

Year 10

$2,418,302

$1,887,146

4.92 11.07

5.07 11.40

5.22 11.74

140,429 210,864 351,293

124,200 93,288 217,488

153,677 230,515 384,192

167,918 251,712 419,630

144,072 108,008 252,080

90,200

68,871

98,579

107,687

79,818

441,493

286,359

482,771

527,317

331,898

29,006

30,465

32,213

34,018

31,278

31,330

Year 11

$2,343,008 $2,477,033

4.64 10.44

28,310

4.78 10.75

Year 8

4.50 10.14

27,791

4.37 9.84

Year 5

9.70% 25,536,423 893,775 24,642,648 ⴚ14,427,846 1.000

ⴚ1,754,609 1.000

2,113,501 1.000

2,096,925 1.03

1,188,844 1.061

2,165,534 1.093

1,673,318 1.126

1,307,784 1.159

2,398,751 1.194

2,386,972 1.230

1,327,616 1.267

26,619,740 1.305

ⴚ14,427,846

ⴚ1,754,609

2,113,501

2,035,850

1,120,494

1,981,275

1,486,073

1,128,373

2,009,004

1,940,628

1,047,842

20,398,268

397

Measuring Real Estate Returns

total investment is based on Table 16-1, taking into consideration that tenant finish and leasing commissions occur in the second year of the development period. Breakdown of cash flow by sources is illustrated graphically in Figure 16-2. Turning Costs The first capital expense to consider is the cost of refurbishing the space as leases turn. For staying tenants, this generally involves, at a minimum, cleaning the carpet and draperies, and it may include painting. For new tenants, it may be necessary to rebuild partitions as well. The first step in calculating refurbishment costs is to estimate market costs per square foot of undertaking the required work, making a distinction between staying (MFS) and leaving (MFL) tenants. These estimates should then be inflated at the assumed inflation rate. The amount of space turning is multiplied by the market refurbishment cost for the prevailing year. The example is for a three-year lease with a ninth-year turn: Staying Tenants

Leaving Tenants

SS9  MFS9  FS9 33,120 sq. ft.  $5.07  $167, 918

SL 9  MFL 9  FL 9 22, 080 sq. ft.  $11.40  $251, 712

FIGURE

16-2

Unleveraged investment cash flow.

25 20

Millions of dollars

15 10 5 0 −2

−1

1

2

3

−5

4

5

6

7

8

9

10

11

Years

−10 −15 Vacancy

Net operating expense

Net operating income

Capital

Appreciation

398

Professional Property Development

Leasing commissions (LCOM) are calculated on leaving space only. The custom in most markets is to apply the percentage commission (LCOMF) against the market building rent (MBR), multiplied by the lease term (Y), less any free rent concessions (FRTL). For example, space occupied by three-year tenants, turning in the third year, would require leasing commissions as follows: LCOM(SL 3  MBR 3  Y)
FRTL 3  LCOMF  0.05(22, 080 sq. ft.  $29.71  3 yr.)
$163, 999  0.05  $90, 200 In determining commissions on five-year leases, five years would be substituted for three years in the above equation. Total turning costs are the sum of tenant refurbishment costs and leasing commissions for each year. Impact of lease turnover is illustrated in Figure 16-3. Replacement Reserve The replacement reserve is utilized to provide a reservoir of capital to handle the replacement of capitalized items (for example, elevators, roofs, or HVAC systems). There are many thoughts on how to handle replacement reserves. Perhaps the most rigorous approach is to calculate the anticipated life of each component and reserve sufficient annual funds to meet these obliga-

FIGURE

16-3

Impact of lease turnover. 800

Vacancy (free rent, frictional vacancy, tenant default)

Thousands of dollars

600 400 200 Years 0 −2

−1

1

2

3

4

5

6

7

8

9

10

200 400 600 800

Capital expense (replacement reserve, tenant refurbishment, leasing commissions) Free rent Replacement reserve

Frictional vacancy Tenant refurbishment

Tenant default Leasing commissions

399

Measuring Real Estate Returns

tions, assuming interest earned on the reserve funds. Clearly, once a property has been developed or acquired, this is the preferred approach. In the early stages of the development process, however, it is sufficient to use a surrogate, such as a percentage of assets, or gross revenue. This discussion utilizes a factor of 1.0 percent of annual gross revenue. Disposition Proceeds Having accounted for operating cash flows over the holding period, it is now necessary to establish a termination value for the asset. The most common approach is to utilize some capitalization of net operating income, reflecting the fact that this is the way in which investment properties are sold. While this approach mixes the simple return approach with discounted cash flow analysis, it makes sense in light of the universal use of the technique and the problems associated with a more sophisticated approach. Conceptually, the alternative would be to calculate the present value of the succeeding 10 years of holding, but, as the reader will quickly grasp, this could be an infinite process. In utilizing the capitalization approach, it is necessary to determine the NOI year to capitalize and the appropriate capitalization rate. In most markets, properties are sold on a capitalization of the next year’s pro forma earnings (eleventh year in the example), and this is the approach utilized. Using Table 16-8, a summarized sales pro forma for the eleventh year would be the following: Gross Revenue Vacancy Allowance (8.0%) Effective Gross Revenue Net Operating Expense Net Operating Income

$3,499,774 $279,982 $3,219,792 $742,759 $2,477,033

Note that the vacancy allowance has been adjusted to reflect the simple return approach. There is considerable controversy as to what capitalization rate to use. One body of thought maintains that the disposition capitalization (DCAP) rate should be lower than the stabilized capitalization (SCAP) rate in order to reflect the market appreciation of a mature property. Others suggest raising the capitalization rate to reflect functional obsolescence. Clearly, lowering the capitalization rate builds in a distortion of investment return and would not be appropriate. In utilizing a higher cap rate, however, the analyst is faced with the magnitude of the adjustment—to what extent would the market discount a property for technical obsolescence?

400

Professional Property Development

One suggested approach to resolving this dilemma is to utilize the market capitalization rate prevailing in the stabilized year and assume that similar market conditions will prevail in the year of termination.9 While this approach neutralizes the impact of the sale cap rate assumption, it is problematic in extreme cap range periods (high or low) and may distort the conclusions of the analysis.10 There is also the matter of sales costs (SE) such as the brokers’ commissions, promotional brochures, advertising, and the seller’s closing costs. In our example these costs are assumed to total 3.5 percent of the sales price. The formula to establish the amount of sales proceeds (SP) therefore becomes the following: NOI11  (1.00
SE)  SP DCAP $2,477,033 035)  $24, 642, 648  (1
0.0 0.097 The various flows in Table 16-8 are then summed by year to arrive at nominal cash flow. Real Cash Flow Nominal cash flows can be deflated at this point in order to eliminate any distortion brought about by the inflation. We will assume an inflation rate of 3 percent for the duration of this discussion. This also allows comparison of results between time periods. The reader might ask, “Why use an inflation assumption at all? Simply work with real numbers throughout.” The problem is that this would not reflect the different ways in which inflation affects independent variables in the management of an actual property. The most extreme example is the leveraged case in which debt service payments continue in fixed terms while rental income, adjusted for inflation, is reported in nominal terms. But there are also varying impacts in the nonleveraged case. Rents may increase at a different rate than operating costs. Tenant refurbishment costs may increase (decrease) at a different rate than rents (and leasing

9 Note that it is the market cap rate that is important, not the purchase price cap rate, which could vary considerably from one market to another. 10 As an example, the currently low cap rate environment, while it has been common in Europe for some time, is historically rare in the United States where markets are less regulated and often tend to be oversupplied.

401

Measuring Real Estate Returns

commissions based on rents). Tenant reimbursement is based on a comparison with a base year in which costs could be substantially different (that is, long-term lease). One possible solution is to utilize an inflation assumption in developing the cash flow but then to deflate the nominal cash flow to real terms.11 Leveraged Analysis Table 16-10 explores the impact of leveraging the example property. Interest and points on the construction loan are developed in the same manner as in the simple return analysis (Table 16-1). Debt service and loan payoffs on the permanent loan are calculated by use of an annual constant (10.53%) and loan balance factor (0.909) taken from standard payment tables or through the use of a computer and are multiplied by the original amount of the mortgage. The cost of leveraging is then netted out in each year against the nonleveraged cash flow to arrive at the nominal leveraged cash flow. This then is deflated to produce the real leveraged cash flow. Investor Analysis Thus far we have been analyzing the position of the developer who retains ownership of the property throughout the holding period. Table 16-11 looks at the situation of the investor who acquires the property at the end of the leasing year, based on a 9.7 percent capitalization rate in the stabilized year of operations (year 1). All other assumptions through the holding period are the same as in the developer case. Internal Rate of Return A classic way to measure multiperiod returns of the project is by using the internal rate of return. The IRR represents the return rate at which the net present value of the above cash flow is equal to zero, or in other words, the present value of the future cash flow stream is equal to the initial investment of CF0: CF3 CFn CF1 CF2 NPV  CF0    . . . (1  IRR) (1  IRR) 2 (1  IRR)3 (1  IRR) n

11 At present, this approach is not widely used by industry analysts.

402 TA B L E

16-10

Leveraged Cash Flow (in dollars) Activity

Unleveraged Annual Cash Flow

Construction

Leasing

Year ⴚ2

Year ⴚ1

ⴚ14,427,846

ⴚ1,754,609

Operations Year 1

Year 2

Year 3

2,113,501

2,096,925

1,188,844

1,263,600

1,263,600

1,263,600

Year 4

Sale

Year 5

Year 6

Year 7

2,165,534

1,673,318

1,307,784

2,398,751

1,263,600

1,263,600

1,263,600

1,263,600

Year 8

Year 9

Year 10

2,386,972

1,327,616

26,619,740

1,263,600

1,263,600

Mortgage Construction

12,000,000

Points

240,000

Interest

720,000

1,440,000

Permanent Points

120,000

Debt Service Payoff

Leveraged Annual Cash Flow

1,263,600 10,908,000

ⴚ3,507,846

ⴚ3,194,609

849,901

833,325

ⴚ74,756

901,934

409,718

44,184

1,135,151

1,123,372

64,016

14,448,140

Deflation Factor

1.000

1.000

1.000

1.030

1.061

1.093

1.126

1.159

1.194

1.230

1.267

1.305

Real Leveraged Cash Flow

ⴚ3,507,846

ⴚ3,194,609

849,901

809,053

ⴚ70,458

825,191

363,870

38,123

950,713

913,311

50,526

11,071,372

Year 11

TA B L E

16-11

Investor Analysis (in dollars) Activity Construction Year ⴚ2

Leasing Year ⴚ1

Operations Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Sale Year 7

Year 8

Year 9

Year 10

Nonleveraged Cash Flow Nominal

ⴚ20,089,186 2,113,501

2,096,925

1,188,844

2,165,534

1,673,318

1,307,784

2,398,751

2,386,972

1,327,616

26,619,740

Real


20,089,186 2,113,501

2,035,850

1,120,494

1,981,275

1,486,073

1,128,373

2,009,004

1,940,628

1,047,842

20,398,268

Leveraged Cash Flow Nominal


8,089,186

849,901

833,325


74,756

901,934

409,718

44,184

1,135,151

1,123,372

64,016

14,448,140

Real


8,089,186

849,901

809,053


70,458

825,191

363,870

38,123

950,713

913,311

50,526

11,071,372

Year 11

403

404

Professional Property Development

The internal rate of return is a widely used measure of property returns partly because the information needed to calculate it is almost always available: initial investment, annual cash flows, and termination value (or value of property in the end of the period, which can be calculated using a desired cap rate). Table 16-12 summarizes the IRRs to both the developer and the investor, on a leveraged and nonleveraged basis. Note that the risk spread between the developer and investor is more accurately reflected than with the simple approach. Also, when flows over time are considered, leverage is positive to both the developer and the investor, rather than negative as indicated in the simple return analysis. Figure 16-4 illustrates graphically the IRR for both the developer and the investor. Note that a significant portion of the developer’s return comes from the two-year development period rather than the one year of operations. This helps to explain why developers often sell their projects upon completion rather than holding them as long-term investments, giving rise to the trend toward merchant building discussed in Chapter 3. Unbundling Investment Returns The IRR calculation can be unbundled to determine the source of the return. This is accomplished by discounting the cash flow and eleventh-year sale proceeds by the IRR for the developer and investor. The percentage from each source is then established and multiplied by the total IRR. Note that the investor is more dependent on appreciation than is the developer. Other unbundling variations are possible. As an example, the cash flow could be broken down by leases in place during the stabilized year versus those signed later. This gives some indication as to the risk inherent in lease turns.

TA B L E

16-12

Internal Rate of Return (IRR) Developer

Investor

Risk Spread

Nominal Returns Nonleveraged Leveraged

12.46% 13.34%

10.67% 11.54%

179 basis points 180 basis points

Real Returns Nonleveraged Leveraged

9.98% 10.67%

7.90% 8.71%

208 basis points 196 basis points

405

Measuring Real Estate Returns

FIGURE

16-4

Developer’s and investor’s internal rate of return. Total value EDP Unleveraged

tor Inves

Total value BDP

Value added through appreciation

IRR

R

Value added through development

er IR

Net future value or cost

elop Dev

Total cost

Leveraged Value added through appreciation

R tor IR Inves

Value added through development

R

er IR

elop Dev

2

1

Higher risk development period

1

2

3

4

5

6

7

8

9

10

Lower-risk holding period

If the tenant mix is known, the cash flow could be unbundled by national versus local credits, providing some measure of default exposure. In mixed-use projects, the cash flow could be unbundled by major land use to see which land use is most critical in producing the investment return. If debt is utilized, unbundling could establish how much of the return is from leverage. For the taxable investor, unbundling could determine the portion of the return that is from tax subsidy as opposed to the intrinsic economics of the project. Sensitivity Analysis Another useful tool in analyzing proposed development projects and investments is sensitivity analysis. Sensitivity is calculated in terms of the

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percentage change in the IRR as compared with the percentage change in the independent variable. Variables whose change produces a greater change in investment return are said to be sensitive; those producing less of a change are considered less sensitive. As an example, a 10 percent increase in market rent that produces a 15 percent increase in the IRR is highly sensitive. A 10 percent increase in land cost that produces a 2 percent decrease in the IRR is considerably less sensitive. Probability Theorem The degree of risk in a project can be considered through the use of a probability theorem. An overall probability rate can be ascribed to the cash flow for each year to arrive at an adjusted cash flow. This flow is then discounted, in the manner previously outlined, to arrive at the riskadjusted rate of return. The major concern with this approach is the manner in which the probabilities are established. Generally, it should be utilized only when the people developing the probability rates have extensive experience in the type of project envisioned and familiarity with the probability theorem process. Problems with IRR Analysis There has been considerable discussion about the problems of utilizing the IRR in discounted cash flow analysis.12 One problem is that the IRR calculation assumes that profit not recovered as cash before maturity is reinvested and earns at the same rate as the IRR. Another problem is that alternating negative and positive flows after the investment year can result in multiple IRRs. Several approaches have been suggested to resolve these problems. The modified internal rate of return discounts all negative cash flow back to the investment year and positive cash flows forward to the termination year.13 The adjusted rate of return approach offsets negative and positive flows, discounting the net result.14 The financial management rate of return discounts cash flows at a weighted average of the IRR consisting of

12 Paul E. Wendt and Alan R. Cerf, Real Estate Investment Analysis and Taxation, 2d ed. (New York: McGraw-Hill, 1979), chap. 3. 13 James H. Lorie and Leonard J. Savage, “Three Problems in Rationing Capital,” Journal of Business, October 1955. 14 Donald J. Valachi, “More on the Arithmetic of Multiple and Imaginary Rates of Return,” Real Estate Appraiser and Analyst, September–October 1980.

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a “safe” rate and a “reinvestment” rate.15 As of this writing, this approach has not been widely adopted by industry analysts. Unfortunately, each of these approaches has its own set of technical problems16 that when combined with the added complexity of the calculations, raise a serious question as to their usefulness. There is also some evidence that the impact of reinvestment assumptions has much less significance in reality than in theory.17 Rather than attempt to modify the IRR analysis, the most practical answer is to simply substitute the net present value approach in those situations in which the reinvestment rates are unrealistic or in which there are significant shifts in cash flow from positive to negative. Application to Other Land Uses This chapter has focused on analyzing investment returns from an office building. The same approach, with certain modifications, can be utilized for other investment properties. Apartment buildings must be adjusted for the fact that operating costs are absorbed by the landlord; retail and industrial projects, for the fact that tenants generally pay for most operating costs. Retail projects also should include revenue from percentage clauses, if such revenue is anticipated, and costs associated with common area maintenance (CAM). Hotel projects require the greatest adjustment, both in format and operation, to reflect the various sources of revenue and the characteristics of hotel operation. In analyzing sales-oriented projects such as single-family housing, condos, second homes, and land development projects, it is best to utilize a model that allows for the complexity inherent in these types of projects. Here, the use of the NPV is probably more useful than the IRR and may prevent some of the problems discussed above. A final note of caution: As with market analysis, sophisticated techniques in financial analysis are only as good as the accuracy of the numbers involved and the quality of the underlying assumptions. Too often, particularly when computers are involved, there is a tendency to view the output of the analysis as sacrosanct—possessed of

15 Stephen D. Messner and M. Chapman Findlay II, “Real Estate Investment Analysis: IRR versus FMRR,” Real Estate Appraiser, vol. 41, no. 4, July–August 1976. 16 Gaylon E. Greer and Michael D. Farrell, Investment Analysis for Real Estate Decisions (Chicago: Dryden Press, 1983), chap. 15. 17 C. Conrad Doenges, “The Reinvestment Problem, Practical Perspective,” Financial Management, spring 1972.

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some mystical quality in and of itself. It is critical for the developer or investor not to fall prey to this temptation. If the final result of the analysis doesn’t make sense, go back over the inputs and assumptions again. It should also be noted that the investment analysis is but one of the factors (albeit an important one) in the decision-making process. The results of the analysis must be weighed along with and against judgments as to economic conditions, market trends, political realities, and management skills and resources.

PA R T V

Building and Operating the Project

Copyright © 2007 by John McMahan. Click here for terms of use.

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C H A P T E R 17

Planning and Design

Sometimes, I think, the things we see Are shades of the things to be; That what we plan we build. Phoebe Cary American poet (1824 to 1871)

A

lthough market analysis and successful financing are critical, real estate development is essentially a physical process—improving land and constructing buildings. However, before construction can take place, the building must be planned and designed so that it will efficiently and functionally accommodate the proposed uses, fit on the land parcel, and meet legal requirements for the safety and welfare of the occupants and the community. This requires the talents of creative, trained professionals who, working as a team, evaluate various alternatives so that they ultimately arrive at a design solution that will be functional, economically sound, and aesthetically appropriate to its setting. Unfortunately, in a preponderance of real estate projects, too little inspiration and effort go into the planning and design phase. Budgets are restricted; allocated time is too short; and second-rate professionals are involved. Under these circumstances, the result at best is a mediocre design that fails to realize the project’s full potential; at worst, it is an unattractive and inefficient building(s) that ultimately may threaten the economic success of the project. 411 Copyright © 2007 by John McMahan. Click here for terms of use.

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To avoid these mistakes, the developer must thoroughly understand the planning and design process, evaluate and select the proper professional firms to undertake the effort, and orchestrate these firms so that they produce a satisfactory final project.

PLANNING AND DESIGN PROCESS The physical process of planning and designing a real estate project can be divided into four major phases of activity: (1) land planning, (2) site planning, (3) preliminary design, and (4) contract documents for construction. It should be noted that these are rather broad categories, and the phases may overlap considerably. Also, the importance of any one phase may vary, depending on the size and nature of the project. Land Planning Land planning is the allocation of parts of the subject site to various land uses.1 A portion of the site will be set aside for residential, commercial, or industrial building development, based on anticipated market demand and preliminary tests of financial feasibility. In the case of very large sites, additional land may be set aside for active recreation (for example, parks, lakes, or golf courses) and/or natural preserve areas (for example, forests, meadows, or mountain peaks). Figure 17-1 illustrates the evolution of a land use plan to be used as the Demonstration Project for this chapter. Several elements of the planning and design aspects of this proposed project will be discussed at various points in the chapter. Many factors must be considered in the land-planning process. One is the carrying capacity of the site with respect to the natural ecosystem, which influences both the development of the site and the surrounding natural environment. Important elements include geologic conditions, surface hydrology, soils, plants, wildlife, archeology, climate, sunlight, and the site’s susceptibility to such natural calamities as earthquakes, floods, and hurricanes as well as other problems such as hazardous waste deposits, polluted groundwater, and poor air quality. As a result of this analysis, the land planner may find several factors of the site’s relationship to natural features that could have an impact on 1 Land planning primarily applies to larger sites; smaller, single-use sites generally move directly into site planning.

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FIGURE

17-1

Evolution of land use plan.

Gentle Moderate Steep

Summer Sun

Winter Sun

Riparian Buffer Forestation Oak Pine Slope-Soil Constraint Promontory View Interchange Access

H C O MF TH SF R P

Hotel Commercial Office Multifamily Townhouse Single Family Tennis Club Park

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its suitability for development and how best to achieve the greatest economic benefit without environmental degradation. Generally, the land-planning process should emphasize providing the greatest exposure (views), accessibility to positive natural features, and the protection of buildings on the site from the adverse consequences of negative factors such as landslides, tidal action, winter winds, and geologic failures. In urban environments, shadow and wind problems created by new buildings must be considered as well. The topography of the site is also important: not only differences in elevation among various land formations to achieve views but also such factors as drainage, wind patterns, and gradients for vehicular and pedestrian movement. Natural features like cliff and rock outcroppings may be used to enhance the aesthetics of the site and reduce hazards to safety. Frequently there are topographical trade-offs. Steep terrain may provide excellent views but be more expensive and difficult to develop because of slide and erosion problems.2 Flat land may entail lower grading costs but higher sewage and storm drainage costs. Where excavation may be required, higher costs can be expected, especially if the foundations or basement construction is below the site’s water table. Soil conditions—the quality and nature of various soils found on the site—may affect the location of buildings, open space areas, and sewage and transportation systems. Soils also may influence water drainage patterns3 as well as the location of underground utilities. If extensive grading or excavation is contemplated, the degree to which changes in the water table or soil patterns will affect the location and foundation requirements of building construction must be known. Other factors also have to be considered: accessibility to major exogenous transportation systems, such as highways, rail lines, or waterways; the location and capacity of utility systems to handle water, electricity, waste disposal, and water runoff; proximity to institutional facilities, such as schools, parks, and government buildings; and proximity to private recreational facilities, such as golf courses, ski lifts, and marinas. Many people participate in the land-planning process. However, the overall responsibility generally is in the hands of the land planner. There is not a separate professional entity licensed to engage in land planning, nor does any one professional education concentrate on it as a specialized capability. However, it is beneficial to work with a planner who is

2 Site development costs increase considerably when slopes exceed a 10 percent gradient. Slopes in excess of 25 percent also may reduce options in building layout. 3 Gravel, sand, clay loam, or other porous soils generally provide the best drainage.

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certified by a recognized professional association such as the American Institute of Certified Planners (AICP). Land planning requires a combination of skills, and the planner must be professionally equipped to deal with the land, the natural environment, socioeconomic data, physical planning and design, and construction, as well as be involved in such matters as zoning and marketing strategy and have the vision to recognize new opportunities. The land planner may be an architect, a landscape architect, or a professional specializing exclusively in land planning. Several other disciplines may be involved in the team a land planner assembles. An ecologist may be involved to analyze the natural ecosystem of the site and the surrounding area in order to assess the impact of site development on this system. A geologist or soil engineer may be called in to analyze the loadbearing capacity, seismic behavior, and other physical characteristics of the soil, including any toxic waste problems from prior use of the site or adjoining areas. Traffic engineers help to develop the transportation system for the site. Civil engineers generally are responsible for laying out the utility systems, waste disposal, and drainage or flood control systems. Legal counsel may be required to interpret ordinances, variances, covenants, and other controls. With a thoroughly competent land planner leading a team of other professionals, the land-planning activity is a creative process that engages the developer and chosen specialists in market research, financial analysis, and project management. Ideas are proposed and tested against other alternatives until the best mix and fit are agreed upon. The result is a land development plan, sometimes referred to as a master plan, that indicates the location and magnitude of various land uses and a transportation and utility system to service these uses. If the site is large, the plan will identify the process for implementation by indicating the separate stages of a long-term development program that leads to a completed physical, social, and economic entity. The land use plan may be used to obtain public approval for zoning, for example, or commitments for public improvements. Usually, the plan is quite detailed in terms of the infrastructure and more general in terms of the building development. Specific areas are set aside for more detailed site planning as the development process proceeds. Site Planning Site planning is the detailed planning of a specific building site. This site may be part of a larger land plan, or—in more urban situations—involve

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a single parcel or combined parcels of land. If for a larger land plan, many parameters of building development will already have been established. Figure 17-2 is an illustrated site plan for the Demonstration Project.4 The major objective of site planning is to relate the specific building(s) to the characteristics of a given piece of property in the most aesthetic and economic manner possible. First, the specific indoor and outdoor space needs of the building(s) must be established so that a program of user relationships and requirements can be tabulated. This is to some degree influenced by the overall volume of the building(s). If the site planning is part of a broader land-planning effort, the volume may have been established by the land plan and by public controls through ordinances, height limits, or other regulations.

FIGURE

17-2

Illustrative site plan.

4 When a single parcel of land is involved, it usually will be necessary to undertake special studies of foundation conditions, soil quality, utility availability, traffic circulation, zoning, and building code regulations before definitive site planning can proceed. Updated market studies also may be needed to establish the demand for one or more land uses on the site.

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At this point, zoning must be considered, for it may not only limit the maximum volume of the building(s) on the site but also specify exactly what uses and densities are permitted. Zoning isn’t market demand; however, it represents the desired physical development of the community at one point in time, and it is a legal tool to enact public goals and guidelines. Just because a site is zoned for a particular use doesn’t necessarily mean that there’s market demand for that use. Therefore, zoning should be thought of as an opportunity or a constraint, not as a causative factor in successful development. The degree of constraint will depend on the flexibility in securing variances from the responsible public jurisdictions. Some jurisdictions, particularly those that work extensively with PUD ordinances, basically “negotiate” with the developer to create a plan that is economically profitable and yet benefits the community. The site planner should work with market demand estimates that are more refined than those used in land planning and also make a more detailed analysis of zoning constraints to come up with a work program that indicates the building volumes that are economically and legally possible. This work program includes the necessary support facilities, such as parking, loading, and utility requirements. The next problem is how to physically fit the building volume and support facilities indicated in the work program to the subject site. There may be certain zoning constraints, such as building and floor-to-area coverage ratios (FARs), setbacks, and open space maintenance areas, that will affect the location of the building(s) on the site and the overall mass (for example, high rise versus low rise or the number of stories). Once these constraints have been established, the site planner has a legal envelope within which to design the building(s)5 meeting the economic parameters established by the market research. Here, it’s usually a good idea to make some preliminary assumptions about building design, materials, and construction techniques. It is at this point that the site planner who is not an architect would collaborate with one, so that they could compare various alternative approaches to construction in order to understand the various trade-offs involved.6 Several alternative site plans and building forms should evolve in this search for the best solution. This process is sometimes described as the concept design stage.

5 This legal envelope shouldn’t necessarily be accepted as final if there are legitimate reasons for variances. 6 It also may be desirable to involve a contractor(s) at this point.

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The next step is to link the transportation and utility systems physically to the building envelope. In single-site projects, there may be only one choice: utility systems and vehicular access from a single street. However, larger projects may allow considerable flexibility in designing the transportation and utility support systems, and these factors should be weighed when establishing the location and magnitude of the building envelope. The participants in the site-planning process are similar to those in the land-planning process, except that the planning and design of the building take on a more important role. An architect experienced in this phase of the development process may be the site planner and would work closely with landscape architects and engineers. Both civil and structural engineering become more important as the planning grows more definitive and detailed studies are required to design and estimate the costs for major site work, utilities, and foundations. The traffic engineer is responsible for definitive parking and street design and may be required to make a detailed analysis of present and future traffic volumes and movement characteristics. The market analyst should continue to work with the site planner to react to ideas and problems during the site-planning process in order to maintain a continuous input of economic concerns. The output of the site-planning process is a definitive site plan within which a building can be designed and built. It shows the location of all buildings, roads, and utilities and includes a specific building envelope, which has been established to meet legal and economic criteria. As noted, the purpose of the preliminary evaluation is to ensure that the building(s) can be designed and built successfully within this envelope supported by the required transportation and utility support systems. Any element of the development project can now proceed to preliminary design. Preliminary Design The purpose of the preliminary design phase is to design a building within the building envelope that was established in the site-planning phase.7 Ideally, preliminary design will develop the building volume that was established in the work program in the most aesthetic and economical way possible. In reality, extensive trade-offs often occur between aesthetics and economics that must be resolved during the design process. Unfortunately, 7 The line between site planning and preliminary design is very fine. In most projects the phases proceed and interact simultaneously as the development proposal becomes more specific.

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these trade-offs may be exaggerated by both developers (“good design always costs more”) and architects (“cheap materials look cheap”). It’s best to have an open mind and resolve honest trade-offs by means of a thorough analysis of the project and the objectives of the parties involved. It even may be necessary to modify the work program and/or site plan to accommodate desirable building design objectives. In recent years, there has been a growing trend toward designing “smart” buildings with automated HVAC, lighting, communications, and other systems, usually controlled from a central location to optimize environmental comfort and energy efficiency. Architects and engineers also may propose environmentally friendly “green” building materials and products. There is growing acceptance by developers of sustainable building principles that, if effectively implemented, will achieve a Leadership in Energy and Environmental Design (LEED) certification.8 A LEED certification can be achieved in various levels: Silver, Gold, and Platinum. In most cases the first two levels have been found to be economically self-funding. It is anticipated that many communities will soon mandate LEED certification as part of the building permit requirements. At this point there should definitely be an architect taking major responsibility for the professional input to the project. The architect could possibly have been involved from the beginning or chosen at this stage because of particular experience with a certain building type or general professional competence as a designer concerned for the objectives of the client. The architect’s mechanical and electrical engineering consultants should also be involved at this point. The architect’s team starts by developing several schematic alternative building solutions in terms of space planning, structural systems, and building(s) massing within the allowable building envelope.9 These schematic designs will attempt to relate the various alternatives to the previously determined site plan and search for the appropriate aesthetic expression that fits the site and building type. As an example, Figure 17-3 is a section and elevation of a preliminary design for the hotel element in the Demonstration Project.

8 LEED certification is issued by the U.S. Green Building Council. The LEED applies a “wholebuilding” approach to evaluating the environmental sustainability of a project as projected in the planning and design processes. This certification is not only an important step in improving building energy efficiency but is increasingly an important selling point in attracting tenants. 9 If a concept design was previously prepared, the schematic design may proceed on a faster schedule because the major design options would have been studied previously.

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FIGURE

17-3

Section and elevation drawing of the preliminary design for the hotel component.

Front Yard Highway Corridor

Lobby

Frontage Road

Dining Terrace

Pool

Rooms Around Core

Convention Facilities

Park Arrival

Section Elevation : Hotel

It is at this stage that commitments determine what particular buildings will be like as a setting for effective use and quality environment. In an urban site, various design factors must be considered: view amenity; sun and wind conditions; building “mass” relationships to surrounding existing buildings and land uses; pedestrian movement patterns; relationship to public transportation; and other factors relating the proposed building(s) to the immediate physical and social environment. When one or more schematic designs appear desirable, the architect begins laying out building areas in an attempt to relate each alternative to very specific requirement of the work program. By testing the schematic designs against proposed use relationships in the work program, the architect may conclude that all of the requirements cannot be met and recommend certain modifications in the work program. The developer must then weigh these proposed modifications in light of the advantages of the design alternative. If the proposed design change will improve the project economically (for example, higher rental sales levels, higher occupancies, lower maintenance costs), the developer may decide to make the recommended modifications. Ultimately, the architect narrows the choice of alternative schematic designs to one or more that conform to the requirements of the work program and meet legal, functional, and aesthetic objectives. The testing and retesting of those design alternatives will result in one or two design schemes that meet the work program criteria (modified, if necessary) and successfully function within the overall site and land plans. A financial feasibility check and a sensitivity analysis are wise at this point in order to determine whether any particular schemes are more desirable than others. The process is similar to that described in Chapter 16. Any assumptions that, if modified, could have a major

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impact on investment return should be looked at particularly carefully. For instance, one scheme may call for a building material that is in short supply at the time of construction—thereby raising construction costs beyond economic limits. At this point the developer must select the scheme that best meets overall objectives. The architect then develops that design in greater detail so that all aspects of the building are investigated, including preliminary decisions on the structural and construction system, the mechanical system, materials, and equipment. All floor plans, elevations, and representative cross sections of the building are developed and shown in scaled drawings so that preliminary cost estimates can be made. It also may be desirable during the preliminary design phase to retest some of the market demand assumptions. For example, a particular design alternative may suggest a more expensive product that requires higher sales or rental levels. Or an entirely new product concept may be introduced that wasn’t contemplated when the original market research was undertaken. If additional market research is required, the market information to be sought should be defined as narrowly as possible. It also may help to test market specific design alternatives that are being considered.10 At this point the developer must weigh the incremental increases in the attractiveness of the design modifications against the additional costs and time involved. The key participant in the schematic and preliminary design process is the architect, who is supported by the original site-planning team— particularly the structural and civil engineers and the landscape architect. Input from specialized consultants (for example, interior designers, lighting specialists, acoustic experts, or life safety consultants) may be required, depending on the nature of the project and the specific problems involved. As noted earlier, advice from a contractor or other person currently involved in constructing the particular type of building proposed is also useful—especially when escalating construction costs can quickly invalidate an otherwise highly desirable design concept. The output of the preliminary design phase is one or more building designs that meet market, financial, and physical requirements. The designs should be illustrated graphically in two-dimensional (plan and elevation drawings) and three-dimensional (sketches) forms.

10 This can be accomplished through interviewing of potential consumers and users—or, more economically, through a consumer panel that would review various design concepts and comment on their advantages and disadvantages.

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A scale model or rendering of the project may help people visualize various design alternatives, and it also may be useful in explaining the project to public agencies, community groups, prospective tenants, and others. Once the preliminary design is completed, it’s possible to “take off” preliminary construction cost estimates. To do this, the architect must prepare an outline specification. Estimates are made from this specification, taking into consideration the building space involved, the materials specified, and the construction techniques envisioned. The site development costs that were formulated in the site-planning phase should be reexamined and modified if necessary. As Chapter 14 indicates, the preliminary design and cost estimates are an integral part of the loan package submitted for mortgage-financing purposes. In some cases they also may help to secure zoning or variances in existing zoning. At this point, the developer should be responsive to requests by lending institutions or government agencies for possible modifications in the preliminary design. To the greatest extent possible, any changes should be made before proceeding with contract documents. Computer-Aided Design For more than a decade, architects, engineers, and contractors have made use of computer-aided design (CAD) in the development process. These systems virtually eliminate the need for manual drafting, allowing for development of numerous design alternatives and modifications in a short time. The most sophisticated applications include generation of threedimensional and color images of the building components. CAD has greatly increased the productivity and creative capability of building designers by allowing them to test various alternatives much more quickly and efficiently than before. A recent innovation in CAD software consists of three-dimensional parametric modeling that integrates all building elements into an interactive database, a process known as building information modeling (BIM). This is predicted to become the industry standard for CAD-based design in the future. Approval Process As discussed in Chapter 2, the 1970s marked the beginning of an unpredictable and often unfavorable regulatory climate for real estate development. Developers found themselves dealing with a variety of regulatory agencies on several levels—federal, state, regional, county, and city—

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often with overlapping or contradictory requirements, many so vaguely drafted that they were subject to the interpretation (and whims) of the various agencies. Today’s developer must plan as carefully for securing project approval as for specific site and building design. In many projects, the approval process may require dealing with 25 or more regulatory agencies and, in the case of large projects, may cover a period of multiple years. There are several key areas that are generally subject to development regulation by government agencies. Perhaps the most critical is the overall environmental sensitivity of the project—plant and animal life indigenous to the development area and the impact of the proposed project on traffic, water resources, and pollution. If the proposed site includes a large amount of environmentally sensitive property, it likely will be very expensive and time-consuming to secure all of the necessary permits and approvals to proceed with the project. Before undertaking the project, the developer must understand the political climate of the area in which the development is to be built, including the politics of the local neighborhood. Including influential neighborhood groups (both proponents and opponents) in the early planning stages can help prevent costly delays as the project proceeds. The developer should plan in advance for the likelihood that the zoned density will be reduced (sometimes by more than half) in the course of the approval process. Water and sewer services must be provided for; as noted earlier, many states are restricting development on the basis of inadequate water supplies. If the project is to be developed in a wetlands area, the approval process may pose additional problems that are better dealt with early in the process. Because of the complex nature of the approval process, it may be desirable to retain professional consultants in order to secure the needed permits to proceed. The ability of these consultants to deal effectively with all of the governmental agencies involved in the permit process may make the difference between whether or not a project is approved. While consultant services can be expensive ($1 million or more for large projects), they can nevertheless save the developer time and money in the long run and, more importantly, increase the probability that the project will be approved. Because of the major expense involved in the planning and approval processes, it is also necessary that the developer have adequate financing to cover the cost of undertaking the preparation of marketing, environmental, and other studies required by governmental agencies at all levels. It is wise to plan for additional funds to handle the unforeseen problems that inevitably arise throughout the planning and approval processes.

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Contract Documents Once the developer has obtained satisfactory financial commitments and the necessary government approvals, it’s possible to proceed with contract documents: detailed drawings and materials specifications from which construction cost estimates are finalized and contracts are bid and awarded to construct the building. Figure 17-4 is a page from the contract documents for a residential element of the Demonstration Project. As a result, drawings must be exceedingly accurate and coordinated to avoid construction problems that may lead to delays or claims by the contractor for additional costs. The work is usually undertaken by an architect and several specialists working as a team to pull all the pieces together. The first step is to determine the structural elements of the building, with the team coordinating their efforts closely with the structural engineer who conducts final tests on the stresses that the structure will impose. Columns, beams, and other structural components are sized and related to various elements of the building. Specifications are prepared, indicating the type, quantity, and tolerances of the structural materials to be utilized. Once the structural elements have been determined, the nonstructural building elements must be finalized, such as the walls, partitions, floors, roofs, stairs, and windows. (In some projects these items may be part of the structural elements.) Detailed drawings and specifications are then developed regarding the type of materials to be utilized and the construction techniques to be employed. At the same time, the mechanical and electrical systems are finalized, including elevators, escalators, plumbing, fire protection, heating, air-conditioning, and waste disposal, as well as transformers, conduits, signal systems, and control panels. Plans detailing the location and design of each of these elements are prepared, as well as specifications indicating the type, capacity, and features of each system. All these elements will influence the architect’s work as detailed decisions on the building interface with the mechanical and structural systems. The preceding design services result in the core and shell of a commercial building. The next step is to design the interior standards for tenants, including ceilings, partitions, air-conditioning zones, electrical and telephone outlets, carpeting, draperies, and other elements of interior finish. Some of these items are designed on a minimum basis known as the tenant standards because tenants may wish to upgrade and otherwise modify their interiors according to their needs. The minimum systems therefore become the cost standard for preparation of the lease. Costs

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FIGURE

17-4

Contract documents.

Studding: Furnish and set all columns and studding of size, centers, and locations indicated on drawings. Unless noted otherwise, studding for furring and partitions shall be 2 x 4 stud set 16 inches on center. Plates on concrete floors shall be set until the concrete is finished. They shall be attached to the slab by anchor bolts or powder-driven fasteners where approved. Cripples shall be run to the floor plates. Headers shall be doubled over all openings and openings over 4 feet wide shall be trussed except as otherwise detailed. Studs against concrete shall be anchored as described above. Studding shall be bridged at half height with herringbone bridging, double-nailed at each end. Where studding or wall furring is over 12 feet high, there shall be two runs of bridging set in same. Joists shall be set with the crowning edge up. Where openings occur, headers and supporting joists shall be doubled or tripled, as the case may be, and headers and tail joists shall be hung on metal hangers. Joists abutting masonry shall be anchored as indicated on drawings. Framing system and sizes shall be shown. Solid blocking shall be at ends and over supports. Cross-bridging or solid blocking in spans shall not exceed 8 feet or as shown on drawings. Include furring or stripping, properly shimmed and leveled, where shown or required for ceiling finishes.

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allocated for the minimum standard are then applied against the total cost of interior finish. Finally, a full set of working drawings and specifications for all items of work are reproduced in a contract document form. These documents are now available for final review by governmental agencies, financial institution(s), and contractors bidding on the project. The drawings and specifications are also needed to obtain a building permit and are utilized in the field as the definitive description of all work to be performed. It should be noted, however, that no set of working drawings or specifications is absolutely final; changes and modifications will most likely be made as unanticipated problems come up or as possible design improvements become necessary. These are generally handled by change orders or, if the changes are significant, by revisions to the drawings. This work is a major responsibility of the architect who plays an important role in the final contract negotiations between the owner and contractor and continues to represent the owner by administering the construction through periodic visits to the site, approving the work as it proceeds, and authorizing incremental payments to the contractor. Regardless of the land uses involved, the planning and design phase efforts should be tested continually against the findings of the original market research and overall financial feasibility. It is this testing process that produces a sound plan and building design that are so essential to a successful project.

PLANNING AND DESIGN ASPECTS OF VARIOUS TYPES OF PROJECTS Since real estate projects are developed for a wide range of uses or, in some cases, a combination of uses, it is important to note the difference in planning and design between various land uses and building types. Residential Single-Family Homes The first step in planning and designing single-family residential projects is to develop the best possible plan for the particular site.11 This process is

11 This discussion applies to both detached and attached single-family developments, as well as to horizontal condominiums (that is, not high-rise condominium developments).

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essentially a “balancing act” between unit density, land development costs, site amenities, and unit sales price. Figure 17-5 is a plan for the single-family residence element of the Demonstration Project. It’s necessary to generate a certain minimum level of density on the site in order to make the project economically feasible. Too low a density can result in insufficient revenue to cover land and site development costs. Too high a density, however, may destroy site amenities (for example, trees) or create a claustrophobic feeling, either of which could reduce the sales price of the unit and/or projected absorption levels. The way to optimize the interaction of these forces is to prepare a series of land-planning alternatives and continually test their market and financial feasibility. If a particular alternative seems to create too much density, it should be reevaluated in light of market research, particularly the survey of competitive developments in the market area. If it appears that the project still can remain competitive because of superior location or other factors, the high density perhaps can be maintained. If competition is stiff or the subject site enjoys few location advantages, it may be necessary to lower the density to maintain the anticipated FIGURE

17-5

Single-family residential plan.

Single-Family Residential

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unit price levels or lower the price levels to reflect higher density. Again, the major objective is to maximize the overall ROI through the optimization of these forces. Density is not the only consideration in developing the singlefamily land plan. Arterial streets must be designed to allow through traffic with a minimum level of noise and danger. Local streets must be given good, safe access to arterials but designed so that they don’t become arterials themselves. Curvilinear street patterns, cul-de-sacs, and carefully designed intersections can help accomplish this objective. The pedestrian movement system should also be considered—not only from street to unit but also from unit to schools, shopping, recreational areas, and public transportation. Bikeways, horse trails, and cart paths also may affect the circulation element of the land plan. Design of the utility system should proceed concurrently with transportation planning since many of the utilities will use street rights-of-way and since linear costs often are the determining factor. Cluster design alternatives that reduce street and utility costs also should be considered. The desirability of placing utilities underground should be determined at this point. In some communities, undergrounding is required by law; where it is not, the developer must determine the incremental cost and the degree to which this cost can be recovered through higher unit prices. Generally, unless undergrounding is significantly higher, the incremental cost can be recovered.12 As the street and utility patterns take shape, the land planner can begin to finalize other public facilities. If a school is planned within the project, it should be located and related to the vehicular and pedestrian transportation systems. Parks and other recreational areas should likewise be located so that they utilize natural features wherever possible. If neighborhood shopping areas are to be included in the project, they should be planned so as to provide the best commercial site possible, without reducing residential values within the project.13 Basic landscaping, including street trees, also should be considered at this point. In evaluating various land-planning alternatives, the design of the individual unit also must be considered. Generally, three or four types of units should be offered, reflecting some combination of bedrooms and baths. 12 The competitive survey will provide some insight. If all competitive projects include underground utilities, the question is largely academic. If competitive projects have none, undergrounding may prove to be a competitive advantage. 13 Unless the residential project is quite large (that is, over 1,000 units), the commercial neighborhood will have to pull from other residential areas. The best location from which to accomplish this objective may conflict with residential development within the project.

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The preliminary mix of these units should come from data supplied by the market research. For example, if the market area consists predominantly of families with children, the unit mix should have more three- and four-bedroom units. If the elderly or young couples predominate, the mix would include some two-bedroom units. The exterior design of the units is largely a function of the architect’s creativity and of the receptivity of the marketplace. In some markets, consumer preference for traditional design is so strong that contemporary design solutions simply won’t work. In other markets, new design concepts should be considered if they make sense in terms of the particular site involved. If the project is sufficiently large, a variety of exterior designs can be developed to reach a broader range of consumer preferences. Within the units, there are several important design considerations. The perception of space is important, particularly if the rooms are small. A feeling of spaciousness often can be created through design features such as cathedral ceilings, atriums, balconies, skylights, and window and door placements. Since the kitchen-dining-living areas often are utilized functionally as a single unit, particularly for entertaining, they must relate well to one another and to the rest of the unit. Other important functional design relationships include the entryway-living room, bedroom-bathroom, garagekitchen, and kitchen-waste disposal areas. The designer should thoroughly think through these and other functional relationships, utilizing working models if necessary. Attention to such details as these in the design phase can often save construction costs later and also produce a product that is easier to merchandise. Multifamily Homes The planning and design phases of multifamily projects are considerably different from those of single-family designs. Individual unit design is very critical since the designer usually works with a smaller space envelope. Again, perception of space within the units is very important. Maximizing favorable views and ensuring privacy, including acoustic separation, are also major design considerations. Site planning must be carefully undertaken to minimize the feeling of higher density, with considerable attention given to pedestrian walkways, parking, and recreation areas. High-rise apartments, condominiums, and cooperatives may require greater attention to individual unit design, as the placement of columns and beams often constricts unit layouts.

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Often, there is a trade-off between more merchandisable units and higher construction costs that must be thoroughly explored by both designer and engineer. The relationship between gross and net usable areas also is critical. Extensive design analysis is required to achieve the highest design efficiency ratio. Second Homes The planning and design of second homes involves most of the elements associated with primary homes. Exceptions usually are projects that involve relating units to specific natural and artificial recreational features such as lakes, rivers, or oceanfront properties. There also are specialized aspects of second home design and operation to take into consideration such as security and fire protection systems, owner storage areas, waste removal, and antifreezing measures. Consideration also should be given to developing greater sleeping capacity through the use of loft areas, bunk beds, specially designed furniture, and so forth. Retail Regional Centers The market research for a potential regional shopping center provides the initial work program for planning and design activities. The projected amount and type of gross leasable area (GLA) established by the market research is then refined and tested by preliminary leasing activities and discussions with leasing institutions. The role of the planner and designer is to translate the evolving work program into a center that functions smoothly in terms of parking, pedestrian movement, merchandise handling, and other physical aspects of building and operating a regional shopping center. The planner and designer also must create an aesthetically pleasing environment for shoppers and merchants alike. In fact, the hope is that the environment will be so outstanding that it will attract more shoppers than the market analysis indicates. The first step in the planning process is to roughly allocate land area among buildings, parking areas, access roads, landscaped areas, buffer areas, and land held for further expansion. The amount of land held for buildings is determined by adjusting the GLA to reflect common building areas, such as malls, corridors, rest rooms, elevators, loading areas, and storage and mechanical facilities.

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The gross building area is then divided by the number of floors to find the amount of land that will be required. Generally, retail buildings should have as few floors as possible to encourage maximum pedestrian exposure. If more than one or two floors are involved, it should be designed to facilitate pedestrian movement to the more remote levels. The amount of parking required will depend on the size and nature of the GLA and local zoning requirements. The amount of land needed for parking often is related to the amount of land needed for building in terms of a parking index stated in terms of the number of stalls per 1,000 square feet of GLA (for example, 3:1, 4:1, or 5:1). Fairly reliable parking indexes have been established for various types of stores, which should be applied to the recommended mix of uses proposed in the work program. Employee parking requirements should be determined at this time, as well as adjustments for shoppers arriving by public transportation. The total number of spaces should then be multiplied by the amount of space per parking stall to arrive at the amount of parking area that will be required.14 The amount of land area needed to handle the parking area will depend on whether multilevel parking structures are proposed. Higher land costs have forced many regional centers to utilize multilevel parking. The number of parking spaces should now be translated into traffic demand estimates, which are calculated at peak hours and should consider the average parking turnover that can be anticipated—that is, the number of times an individual space will be utilized during the peak hour period. Parking turnover generally is a function of the type of retail space in the center and local shopping patterns. For instance, large regional centers in smaller communities generally can expect a lower turnover ratio than smaller centers in urban areas. Projected peak traffic demand will establish the number of lanes of access roads required. The amount of land required for these roads can then be calculated on the basis of minimum requirements for each lane, which are established by local building codes. Land also should be allocated for other purposes. If the site is immediately adjacent to a residential area, a landscaped buffer to reduce noise and visual blight may be desirable. Other landscaped areas may fulfill aesthetic purposes or provide playgrounds for children to use while their

14 This space allocation should allow for internal vehicular circulation, turning, and storage. A rough guideline is 350 to 400 square feet per stall.

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parents are shopping. If land is to be held for future expansion and/or other land uses, it should be set aside at this time. This allocation process makes it possible to see how much land is required for the total center development. If there is sufficient land to meet the requirements of the work program, more definitive planning can proceed.15 If there is not sufficient land, building and parking structures must be reanalyzed. For example, a multistory building and/or parking may be physically necessary; the impact on construction costs and merchandising desirability must then be evaluated. If the impact is sufficiently negative, the amount of the GLA to be developed may have to be scaled down, thus forcing (1) a decision as to which types of merchandising activities are to be reduced and (2) the possible revamping of the work program. Once the allocation of land uses is complete, various location alternatives for the uses must be analyzed. Generally, anchor tenants should be located on that portion of the site where they will be as central to parking as possible, as well as most visible to passing vehicular traffic. The required parking area is then laid out around the buildings, with access roads planned to service the parking from the most convenient point of access. Traffic patterns on surrounding arterials should be evaluated to discover the impact of traffic generated by the center. Access roads for delivery vehicles also must be developed and linked to proposed loading facilities. Finally, landscaped areas and land held for future expansion should be identified. The building areas can now be refined, with emphasis on pedestrian movement between and within individual stores. The initial concern is where to locate the anchor tenants—usually department stores. The objective generally is to place the anchors at a comfortable walk’s distance from each other, linked by a shopping promenade lined with satellite shops. In some centers, anchors may include retail operations other than department stores, such as large drugstores, variety stores, or discount houses, and perhaps nonretail uses such as hotels, office buildings, theaters, or major restaurants. Once the location of anchor tenants has been determined, satellite stores can be located along the connecting axes. Complementary satellite stores are usually grouped together. Convenience stores, for example, are often clustered and given direct access to their own parking facilities.

15 See Chapter 9 for more information on the steps in the initial planning for a retail center.

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The degree to which impulse buying influences the success of the store also should be considered. Gift shops should be located where pedestrian traffic is most heavily concentrated. A travel agency, like other sought-out operations, can be located in less trafficked areas. If specific tenants are known in advance, additional factors become important, such as pricing policy, local reputation, compatibility with other retailers, and specific parking requirements. Now the plan can be finalized. Individual tenant areas are laid out in modular form to accommodate varying tenant space requirements. Pedestrian circulation elements, such as malls, plazas, rest rooms, drinking fountains, seating areas, and public assembly areas, are planned in detail. Parking and traffic circulation should be retested for accessibility to specific types of merchandising operations. Delivery and trash removal service should be retested in terms of individual store requirements. Landscaping and buffer areas should be finalized, as should the possible interim treatment of areas held for future expansion. Specifications for building materials, landscaping, street furniture, and center signs are developed. At this time, a policy regarding specifications for tenant signs also should be established. Community Centers The planning and design phases for community center developments are similar to those of regional centers, except the scale is smaller. Since community centers generally involve sites with less land area, efficient parking and traffic circulation must be considered in order to develop as many parking stalls as possible. If more than two anchors are used, they can function at both ends of the center, with “in-line” satellite stores in between. If there is only one anchor, the designer must be careful to maintain satellite store exposure. Neighborhood and Strip Centers The planning and design of neighborhood and strip centers focus largely on meeting the needs of the anchor tenants. Parking and traffic circulation probably will be the major concern, especially if the site is extremely tight. Providing exposure and parking for satellite stores may also pose a problem. Figure 17-6 is a parking plan for a neighborhood center in the Demonstration Project. Some centers resolve this by designing satellite stores as freestanding buildings (or pads), thus allowing independent identification as well as providing direct access for customers who are not utilizing the anchor

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FIGURE

17-6

Retail commercial plan.

stores. If pads are utilized, it is also important to be certain they do not significantly block exposure of the in-line stores from the arterial. Discount and Warehouse Stores The major challenge in designing discount and warehouse stores is how to provide sufficient capacity for their activities. Since these operations usually carry more merchandise in the selling areas than do other types of stores and since turnover is much higher, capacity must be designed for the delivery, storage, and management of a wide variety of goods. Capacity matters in the store itself too because shopper density often exceeds that of a department store. Parking and traffic-handling capacities also are important—particularly if the discount or warehouse store is located in an older industrial area. Specialty Centers The planning and design of a specialty center focus on the degree of ambience created in the pedestrian circulation areas. Visitors to the center should be able to move through spaces that interest and involve them. These spaces should be small and relatively intimate, planned to create surprise and delight as shoppers discover them, and they should allow for activities such as art exhibits, street musicians, and entertainers. If the center’s theme is based on a historic building or group of buildings, that feature should be the focal point with shops and restaurants located along several pedestrian movement spines, interlinked if possible. Parking should be on the extremities of or beneath the center, and vehicular traffic movement should be as unobtrusive as possible.

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Office Single-Tenant Buildings A single-tenant building requires a highly customized design geared to the specific requirements of the tenant. Future space needs, established during the planning phase, provide the basic work program. The location of specific activities within this program will depend on the type of space required for the activity. For example, computer rooms can utilize interior space; executive offices should be located on the periphery, if possible. The interface of a work activity with other activities also helps determine its location within the building. Since these activities often are dynamic and have continually changing space requirements, interior plans should be flexible. Space slated for future expansion also should be laid out as flexibly as possible in terms of future use by the dominant tenant as well as adaptability to other tenants in the future. The idea is to create a property that meets the needs of the original tenant but will retain its value if the tenant wishes to downsize its operation or moves out at the end of its lease. Multitenant Building Flexibility is even more critical in designing multitenant buildings, where specific tenant requirements may not be known in advance. Generally, the most critical factor is the dimension between the window and corridor wall. This space must be sufficient to allow for the reception and offices of the small user (for example, 500 to 1,000 square feet) and yet not so deep as to waste space for the larger user. The corridor itself should be carefully designed to provide access to as many tenants as possible with the least amount of space. The objective is to maximize design efficiency without sacrificing the space’s marketability. Flexibility also is important in providing lighting, telephone and electrical outlets, and air-conditioning zones. The leasing agent and interior designer should be allowed to tailor the space to the requirements of specific tenants as much as possible, recognizing the possible trade-off with higher construction costs. If possible, interior partitioning should be modular, which allows for modifications by the current tenant and by new tenants as leases expire. Elevators also are a critical design element. They must have sufficient capacity to handle peak loads without posing an undue construction or operating cost burden. Trade-offs between the number of elevators, their capacity, and the speed at which they operate are often necessary.

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Pedestrian movements elsewhere in the building—lobbies, garage access, connections to public transit, and so forth—also must be analyzed carefully. Retail space on the lower floors should, if possible, relate both to building tenants and to customers entering from the outside. Building security is an increasingly important consideration. Material specification plays an important role in office building design. Generally, the trade-off is between higher costs of construction and lower maintenance costs. Various materials and products should be tested thoroughly before they are finally specified. Energy conservation and other considerations must be weighed in selecting the materials to be used. One of the major problem areas in office building operation is the HVAC system. Planning and design should consider the various types of occupants and uses projected for the building. As an example, consideration should be given to off-hour HVAC operation, particularly in buildings directed at legal, accounting, engineering, and other tenants who are professionals. Office Parks The planning and design of an office park combines elements of the office building, shopping center, and industrial park. Vehicular and pedestrian circulation should be carefully planned to accommodate peak loads. Access to servicing facilities also must be provided. A certain degree of pedestrian ambience should be created through the use of malls, landscaping, and luncheon areas. Central facilities such as health clubs and day-care centers should be planned to serve the entire park as efficiently as possible, as well as business generated from other areas. Land parcels should be platted flexibly to accommodate various user requirements and yet provide flexibility in selling individual parcels. Finally, building standards, including signage, must be established to give the park an overall continuity once individual buildings have been completed. Figure 17-7 is an elevation of the office park proposed for the Demonstration Project. Medical Buildings Medical buildings are designed much like office buildings, but the efficient layout of doctors’ offices is emphasized. Flexibility is not as important here because office utilization is more standardized, with a doctor using the same office module in some cases throughout his or her career. Plumbing and mechanical systems are a major cost factor in medical buildings. If a pharmacy, radiology lab, or other medical service facility is provided, it should be in the most convenient location—generally in or near the building lobby.

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FIGURE

17-7

Section and elevation drawing for office and commercial component.

Parking requirements, particularly for the disabled, are greater for medical buildings and should be planned accordingly. Industrial Of the important factors in planning and designing industrial parks, site flexibility is perhaps the most critical. Available parcels should be platted in modules of 1/2 to 1 acre so that they can be combined in various ways to accommodate users’ needs without destroying the desirability of the remaining parcels. Streets should be designed to provide access to potential combinations of parcels and should be wide enough for large trucks to turn. If rail service is available, spurs to the various potential parcels should be provided, with a minimum loss of land. Utility lines should be readily available to all parcels, with sufficient capacity to handle peak requirements. Because of the diverse uses and the building types and sizes generally prevalent in an industrial park, it is important to have basic standards for all potential users. These standards usually involve the type of industrial operation, site coverage, building height and setback, minimum on-site parking requirements, and location and size of loading docks and vehicle storage areas. In R&D and other high-quality parks, additional standards may be required related to building materials, landscaping, sign control, and in some cases, approval of building design. Industrial park planning and design standards are generally enforced through legal covenants running with the ownership of the land.

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Transient Commercial Facilities Motels A motel presents a relatively straightforward planning and design problem. The buildings should be designed to conform to the size and configuration of the site. As with apartment buildings, acoustic separation between the units also is important. Parking should be as close to the rooms as possible, with direct access to the motel office. Motor Hotels Motor hotels are planned and designed in much the same way as motels, except that public space, such as restaurants, banquet rooms, and conference rooms, assumes greater importance. These facilities should be convenient to the lobby and away from guest rooms so that the guests are not disturbed by noise. Additional parking should be provided for public space facilities. If there is a restaurant, it should have its own identification through signs and, if possible, building design. Figure 17-8 is an elevation of the motor hotel element of the Demonstration Project. Hotels Hotel planning and design is more complex, particularly if a large convention hotel is involved. The findings of the market research in terms of the primary source of demand should determine the mix of rooms; the use of connecting rooms can provide flexibility in the mix. The rooms should look spacious and be designed in the most efficient manner possible. In some cases, this can be accomplished through balconies, high ceilings, and built-in furnishings. Baths should be “double stacked” to reduce plumbing costs.16 Walls should be insulated to prevent excessive noise transmission. A key element in hotel design is efficient servicing of guest rooms. Within the rooms, this can be accomplished by using furnishings that resist dirt and dust and allow carpets to be cleaned without having to move furniture. In public areas, a major goal is to minimize the number of steps taken by service personnel, which can be accomplished by properly locating service elevators, linen closets, and trash and soiled-linen chutes. The planning of public rooms also is important. The lobby should be spacious, and services (for example, registration, cashier, or bell captain) 16 Bathrooms in one unit are directly opposite facilities in an adjoining unit. Both utilize a single plumbing tree in the wall between the units.

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FIGURE

17-8

Section and elevation drawing for the hotel.

close together and as near as possible to the elevators. Restaurants and retail shops should be accessible both from the lobby and the street. Conference and meeting rooms should be designed on a flexible module to accommodate various conference sizes. Room acoustics must be excellent to limit interroom noise. Banquet rooms should lead directly to the kitchen. The kitchen itself should be immediately accessible to service elevators to ensure efficient room service. Vehicular and pedestrian traffic also must be handled efficiently. Vehicular access should be directly off major arterials. There should be sufficient capacity for short-term parking and loading. If possible, taxis should have independent areas for queuing; charter buses should have their own waiting and loading areas. There should be enough parking for room guests to handle peak requirements. If extensive public space is involved, additional parking must be provided for nonguest vehicles. Pedestrian connections to other buildings, public transportation, or recreational areas also may be desirable. Resort Hotels The requirements for planning and designing resort hotels are similar to other types of hotels, depending on the size and nature of the operation. However, there are several additional considerations. As with second homes, the land planning must relate closely to the natural or artificial recreational facility. This also applies to the public spaces, unifying the guests’ experiences. Since the stay is generally longer than in ordinary hotels, the guest rooms should be somewhat larger than rooms in urban hotels.

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Care also should be taken in planning the servicing of the rooms, especially if there are considerable distances between rooms and central service operations. If second homes are to be utilized as guest rooms under a coordinated hotel management, this should be considered when the units are planned and designed. Multiuse Multiuse Buildings In the design of multiuse buildings, the key element is location of the uses. Retail usually is on the ground floor in order to be exposed to pedestrian traffic. In general, residential uses should be on the upper floors, reflecting the rental value of good views and the lower costs of servicing (for example, fewer elevators, less frequent cleaning and maintenance). In a hotel-office complex, it may be desirable to put the hotel uses on the lower floors to facilitate room service operations and proximity to public facilities, but this objective may be thwarted by the placement of structural columns. Mixed-Use Projects The planning and design of MXD projects is very complex and closely related to market and financial analysis, particularly as the effects of synergistic demand are analyzed, as discussed in Chapter 13. Many plans and computer iterations will be required as various trade-offs are considered in arriving at the final design. More than with any other type of project, communication must exist between developer, architect, and contractor. An important factor is the location of buildings within the project. For example, it may be desirable to locate the apartment tower in that portion of the project that will afford the best views. If a hotel is involved, it should be located in that portion of the project providing the greatest proximity to public service (for example, convention center, taxis, or passenger loading and unloading). The pedestrian link between the various buildings is also critical. Ideally, it should be an area of great activity, during both daylight and evening hours. Retail is an excellent link, particularly if restaurants, bars, theaters, and other focal points of night activity are included. If a hotel is one of the uses, the lobby also can be a linking element. The general feeling should be one of free flow among uses, with activities at as many points as possible along the way. Well-conceived vertical transportation also is important, particularly in mixed-use buildings, as well as emergency exiting systems.

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Because of the great variations in electrical use by the individual components of the project, the base electrical system should provide for varying energy levels and tenant submetering. Fire protection systems become quite complex in MXDs and must be thought through well in advance. Parking design is critical because a portion of the parking resources will be set up based on the concept of shared parking between land uses. The peak parking demand for each use must be established and correlated with other uses. Major conflicts between uses in terms of parking demand may require modification in one or more of the uses in terms of size or location within the project. Consideration also should be given to vehicular access to the project from adjacent streets and freeways to avoid traffic bottlenecks as much as possible. Providing adequate access to shipping and receiving areas also is critical because of the intensity and possible overlapping of use by the various components of the project. Public spaces should be planned carefully in order to create as much pedestrian excitement as possible while providing a smoothly functioning movement system. Atria are often utilized in MXD projects to create drama, but they may produce other effects such as unbalanced HVAC circulation and increased security costs. Water and landscaping features also can add drama to public areas, but they must be carefully thought through in terms of installation, maintenance, and effect on air quality (humidity). Care must be taken that the public area of each use does not conflict with another use. As an example, residential lobbies require privacy and separate access from offices, retail, and other uses. Conference facilities in hotels should be near the hotel lobby and retail areas but separated sufficiently to allow meetings to proceed with a minimum of outside interference. Consideration also must be given to the project’s interface with surrounding land uses and the community at large. The days are past when an MXD project could turn its back on its neighborhoods (as many of the early inwardly facing projects were prone to do), but it is still possible for an MXD project to overwhelm a neighborhood if physical and psychological relationships are not carefully considered. Factors such as sunlight, wind, views, pedestrian entry points, and public facilities must be thoroughly evaluated by the development team. In terms of ongoing operations, the project design criteria should be attached to each lease, enabling the developer to control tenant material selection, image, and other elements of the design process. The objective is to achieve as much tenant individuality as possible, particularly in retail store fronts, within an overall framework of project design.

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New Towns The planning and design of new towns involves all the planning aspects that have been discussed thus far. Additional ingredients include the flexibility afforded by starting from scratch with a large site and the exciting challenge of creating a “total” community where people live, work, and play and where the process of town building will be continuous over several years. The major contribution of the planner of a new town is to establish a process which can respond to social and technological innovation but still have the conceptual strength that gives it direction as it grows. The phasing of the development plan also is critical, both in terms of costs and project marketability. A certain level of infrastructure must be developed during the first phase to provide a basis for various land uses and to demonstrate developer credibility. As each new land use is added to this infrastructure base, it should complement and support existing uses, as well as lay the groundwork for future uses. For example, the convenience goods phase of a new shopping center supports existing residential facilities and provides the base for expansion into shopper goods at a later date.

C H A P T E R 18

Construction

Three things are to be looked to in a building: that it stand on the right spot; that it be securely founded; that it be successfully executed. Goethe

Once the contract documents have been completed, permits obtained, contractor selected, and construction agreements finalized, the construction process can begin. Construction essentially amounts to marshaling materials, labor, subcontractors, and equipment on a specific site to produce one or more buildings. The building(s) may be constructed of any combination of materials and involve one or more building techniques. The developer may undertake the construction directly as an owner, on a contract basis with a general contractor, or as a joint venture partner with a general contractor. A successful developer doesn’t need to engage in construction but does need to understand the overall process in order to properly manage it and achieve the desired results. Even an investor who purchases a completed building should understand the general mechanics of its erection so that it can be operated and maintained properly and to ensure that the quality of the building is what the investor expected it to be.

TYPES OF CONSTRUCTION Construction generally is classified by the type of material used for structural support: wood, masonry, concrete, steel, or various combinations of 443 Copyright © 2007 by John McMahan. Click here for terms of use.

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these materials. In general, the larger the scale or higher the density and the more urban the context, the more fire resistant the construction materials should be. Building code types of construction are organized in descending order from Type I (noncombustible superstructure and primary elements) to Type V (combustible wood framing and sheathing). Wood Wood frame, the most common type of construction, is used extensively for residential buildings and small office buildings. Lumber creates a structural frame, which is then veneered on the exterior with one or more materials, including wood, stucco, rock, masonry, and metal (Figure 18-1). Wood frame is superior in terms of availability, lower cost, and ease of construction. Buildings framed with wood can usually be built more rapidly than buildings using other structural materials, using a less skilled workforce, and less technical procedures. The major disadvantages of wood are the inherent variation in material quality, susceptibility to fire, shrinkage, and limitation in height from two to four stories in most areas. FIGURE

18-1

Wood frame construction. Apartment building under construction in Tracy, California. (Marx/Okubo and Associates, Inc.)

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Several technological advances in wood frame construction have been made in recent years. Major components, like roof trusses, can be prefabricated in a factory and shipped directly to the site. The development of high-strength glues has led to the use of laminated woods for arches, beams, and other applications requiring heavy load–bearing qualities. As labor costs have outpaced materials costs and higher-quality raw lumber is less and less available, builders have increasingly moved to manufactured components (floor joists, panelized floors and walls, windows, doors, and frames) to improve on-site efficiencies. Masonry The structural elements in this type of construction include building materials such as brick, concrete block, hollow clay tile, stone, gypsum block, and glass block, typically held together with mortar joints. Walls are often internally reinforced with steel to provide additional strength. Masonry is used primarily in residential construction, but it is also used in small commercial and industrial buildings. Concrete or steel frame high-rise buildings also may be faced with masonry.1 Masonry construction is generally more durable and fire retardant than wood frame construction. Certain masonry products require no supplemental finish as do wood structures, and longer-term maintenance costs may be lower. The major disadvantages can be longer construction periods and slightly higher costs. Technological advances in masonry construction have occurred primarily in the forming and reinforcing techniques utilized in concrete and clay block construction. A spray-on method of binding masonry units speeds up the construction process as well as providing a fire- and waterresistant wall. Prefabricated masonry or block panels can reduce costs and building time. Special saws for fabricating or modifying masonry products on site also help to speed up the construction process. Concrete Concrete construction is utilized extensively for larger-scale residential, office, and industrial buildings where durability, fire resistance, and lower maintenance cost are desired (Figure 18-2). 1 Reinforced masonry–bearing wall construction has been used for multistory buildings in Europe for some years, and it is gaining greater acceptance in the United States.

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FIGURE

18-2

Concrete construction. Midrise office building under construction in San Francisco, California. (Marx/Okubo and Associates, Inc.)

Cast in Place The most common method is cast-in-place construction, in which concrete is poured into wooden, steel, or plastic forms at the building site and allowed to set. Concrete mixtures may be prepared in a temporary facility on site or prepared in a batch plant and mixed in transit. Concrete batching is a highly scientific process with specialized chemicals accelerating or retarding the hardening process. Finishes can vary using form liners, special aggregates, and color additives. There also has been considerable technological advance in the placement of concrete including the use of towers, cranes, hoists, conveyors, and high-pressure concrete pumps. New types of pumps on mobile trucks have been developed for pumping through small-diameter pipes, greatly extending this technique to smaller construction jobs. The placing boom, which resembles a hydraulic pump, can reduce the time spent pouring concrete by nearly two-thirds. Techniques also

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have been developed for protecting reinforced steel from corrosion in concrete bridge decks. In some cases, mixing fiberglass strands in concrete has reduced the need for steel reinforcing bars. Precast Concrete also may be precast at a manufacturing plant and transported to the site where it is assembled. Precasting generally involves such structural elements as columns, T beams, I beams, walls, planks, and slabs. In recent years, precasting has been adapted to specialized, nonstructural applications. The precast module is sent to a factory, where workers can assemble and complete, for example, an entire bathroom, painted and finished down to door handles and hooks. On large building projects, more than one method may be employed; for example, precast walls and joists may be used when columns and/or slabs are cast in place. Common Variations The problems and costs involved in breaking down and reassembling forms, particularly in high-rise construction, has led to the use of a relatively old technique—slip form—in which concrete for vertical walls is continually poured into a form that moves upward a small amount each day. The development of concrete pumps has advanced the slip-form technique. This is often accompanied by a system of flying forms where largescale prefabricated formwork systems are supported by the vertical concrete structure (columns and walls), reinforcements placed, and concrete floor slabs cast, after which the forms are pulled out and lifted into place above to start the process over again. Another method employed in high-rise buildings is the lift-slab method, in which each floor is poured on top of previously poured floor slabs and, after hardening, lifted into position by powerful jacks. One- and two-story industrial and commercial buildings often are built with tilt-up wall panels, which are site cast on the concrete slab and then tilted into place to form structural load-bearing exterior walls that have an architectural finish that can be painted. With supplemental exterior finishes (for example, tile, veneer brick, or rigid foam cornices and trim) and the addition of windows, the building appearance can be upgraded from industrial to office or retail. In recent years, several efforts have been directed at increasing the load-bearing qualities of concrete without proportionately increasing the bulk. Many of these have involved stressing techniques, in which the concrete is compressed, either before (pretension) or after (posttension) pouring. The structural efficiency and savings in concrete and reinforcement

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materials have contributed significantly to the use of concrete in structural element applications, where previously structural steel would have been used. Steel Steel frame construction is utilized in major high-rise buildings and in other structures where permanence and durability are required (Figure 18-3). Steel columns, beams, girders, joists, and floor decks are fabricated off site and welded or bolted together on site. Concrete is then poured into the steel decks to make a floor.2 Flooring also may be installed by “dry” systems of reinforced concrete deck slabs that are welded to the steel frame. FIGURE

18-3

Steel construction. Garden office building under construction in Emeryville, California. (Marx/Okubo and Associates, Inc.)

2 Pouring techniques involve composite action between the concrete, steel decking, and beams and girders. In essence, the molecular structure of concrete and steel are intertwined to provide greater strength.

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One major technological advance in steel construction has been the introduction of high-strength steel, which increases the allowable length of the beam span, thereby creating greater flexibility in the placement of columns. High-strength weathering steels that are resistant to corrosion also have been developed. New methods have perfected the continuous casting of steel into billets and slabs, speeding up the forming process. The handling of steel at the job site also has improved considerably, primarily because of high-capacity cranes. New bolting and welding techniques have simplified the erection of columns, beams, and girders. The high-strength structural bolt is a type of fastener that is stronger and safer, and because it is simpler to use, it increases the speed of construction. The use of steel in high-rise construction allows greater flexibility in designing building exteriors. Since walls do not provide major structural support, they function solely as exterior curtain walls; hence they can utilize glass, aluminum, lightweight steel, ceramics, and other lighter building materials.

CONTRACT CONSTRUCTION Many developers undertake all or portions of the construction process with their own staff. The vast majority of construction, however, is performed by individuals and firms that are in the business of building for others for a fee. Generally, these activities are performed under the terms and conditions of a contract between the owner and the general contractor, translating the architect’s working drawings into a definitive program to construct a building within a certain period of time and for a specified amount of money. Parties to the Contracts Owner The building owner is the developer or other entity that will own the building upon completion, utilizing the building for its own purposes or sell or lease it to another entity. In some cases, the owner uses an agent (project manager) who is responsible for dealing with the contractor during the construction period. Architects and engineers also play an important advisory role in construction administration by clarifying the owner’s objectives as part of the construction program. General Contractor The general contractor is an individual or firm responsible for producing one or more buildings that meet the specifications that were established in

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the contract documents. General contractors are licensed by state governments only after meeting certain requirements regarding their knowledge and experience in the construction business. Subcontractors The general contractor may undertake all of the functions required to complete the building or, more commonly, subcontract to firms specializing in one or more elements of the building process (for example, site preparation, concrete, steel erection, wood framing, masonry, electrical, air-conditioning, plumbing, carpentry, or painting). Some general contractors subcontract all elements of construction and act solely as coordinators or managers. The degree of subcontracting will depend on the proximity of the project to the general contractor’s normal base of operations, the project’s complexity or special technical requirements, the degree of involvement in other projects, the availability and costs of subcontractors, and the general contractor’s overall operating policy. Types of Contracts Construction contracting has many variations, although most contracts fall into one or more of the following categories. A lump-sum, or fixed-price, contract requires the contractor to complete the building for a specified amount of money, which often is established as a result of competitive bidding. If the actual cost of construction is less, the contractor keeps the additional profit; if it is more, the contractor absorbs the loss. A guaranteed-maximum-price contract is similar to a lump-sum contract, except that the owner pays only for actual costs incurred within the maximum price guarantee; the contractor generally shares in any resultant savings. A cost-plus-fixed-fee contract reimburses the contractor for actual costs incurred and sets a predetermined fixed fee. This type of contract often is desirable when time is important and/or the exact nature of the completed project is yet to be determined. Construction management contracts are utilized in large, complex projects in which the owner trusts a contractor to take over all phases of project development, including such items as budgeting and cost control, review and approval of subcontracting, analysis and approval of change orders, and preparation of financial reports in addition to construction. The emphasis in the construction management approach is to reduce the

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adversarial aspects of the working relationships by having the owner, architect, and contractor operate as a team to achieve project success. In the traditional arrangement, the construction manager (CM), including a general contractor acting as a CM, has responsibility for project coordination but has little financial responsibility or liability, being paid a fixed fee for its services. In most cases, each of the separate major subcontractor agreements is made directly with the owner, who takes on significantly more liability for performance. All forms of the construction contract have provisions for changes made during the course of construction. These typically include a construction change directive, a procedure for authorization of work for unexpected conditions encountered in the field during construction. This arrangement may also cover gaps in the construction documentation as well as owner-authorized changes to the original scope of work. These are then presented as a change order request to be included in a formal change order that modifies the contract sum and possibly the date of substantial completion. Estimating A critical element of all types of contracts (even cost-plus-fixed-fee contracts) is that the contractor must be able to properly estimate costs in advance. These estimates may be prepared by the project manager or by individuals who specialize in cost estimating. The first step is to break down the proposed project into its various components and establish which will be undertaken directly by the contractor’s own crews and which will be subcontracted. The estimator develops the cost estimate of the direct work, and the subcontractors being considered for the project develop the cost estimate of the work that is to be subcontracted. The technique of estimating is usually the same, whether it is done by the general contractor or the subcontractor. The physical quantity of each component (for example, square feet, cubic feet, linear feet, or hours) is established from the plans and specifications. These quantities are then extended by the cost per unit of the material or labor involved. Unit costs are developed based on experience with other, similar projects or from averages published by national services.3 In all cases, the 3 These include Dodge Digest of Building Costs and Specifications (New York: McGraw-Hill); R. S. Godfrey, Building Construction Cost Data (Duxbury, Massachusetts: Robert Snow Means Company); Richardson Estimating and Engineering Standards (Downey, California: Richardson Engineering Services); and Engineering News Record (ENR) (New York: McGraw-Hill).

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unit costs much be adjusted for projected materials prices, changes in labor contracts, the geographic location of the project, and the time of year when the building will be under construction. General requirements include field offices, supervision, cranes and hoisting, temporary utilities, builder’s insurance, taxes, travel expenses, and any indirect costs that are then added to the direct costs previously estimated. Depending on the type of contract involved, a fee is added for the contractor’s general overhead and profit. In large projects, the owner may retain an independent cost consultant to verify the contractor’s cost estimates. Bonding Owners may require a general contractor and/or subcontractors to get a construction bond from a surety company. These bonds are based on the general contractor’s experience, reputation, and financial strength. The bond obtained depends on the type of project, the method of contracting, and the degree of protection the owner desires. A performance bond guarantees the owner that the surety company will see the job through to completion, regardless of what happens to the general contractor. These bonds generally run 0.5 to 1.0 percent of the total construction costs. When competitive bidding is involved, the performance bond usually is supplemented by a bid bond, which compensates the owner for the difference between the low bid and the next lowest bid if the low bidder fails to enter into a contract. Subcontractor bonds protect the general contractor against nonperformance by the various subcontractors. A payment bond ensures that suppliers will be paid in accordance with the terms of the purchase agreement.4 Selecting the Contractor Several factors should be considered in selecting a contractor, regardless of whether the award is through competitive bidding, by negotiation, or through a joint venture arrangement.

4 James J. O’Brien and Robert G. Zilly, Contractor’s Management Handbook (New York: McGrawHill, 1971), pp. 1-12, 1-13.

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Project Experience Most important is the contractor’s experience in the type of project to be built on the subject site. Contrary to what many contractors maintain, there are substantial differences in the construction of various types of real estate projects: an apartment house differs from an office building; a shopping center differs from a hotel. Each type of project has its own learning curves, and the experience must be gained beforehand. The prospective contractor should be asked for a list of similar projects, the original cost estimate, and the final, actual costs. A field inspection of each referenced project should be made, preferably with the architect of the proposed project. Discussions with the owners and architects of the referenced projects should be held. If the prospective project is a rental building, the property manager and selected tenants should be interviewed as well. If the investigation yields consistently negative findings, the proposed contractor should be dropped from further consideration. Local Experience If possible, the contractor should have building experience in the local area where the proposed project is to be located. This is important because often there are significant differences in building codes, labor relations and practices, and materials purchasing practices in different local areas. A contractor who is not familiar with local practices also may have trouble once the project is underway. If the proposed contractor has local experience, reference checks should be made with officials of the building department of the local government, major trade unions, architects of previous projects, and building supply houses or supplier representatives. Again, consistently negative findings should rule out the use of a proposed contractor. Financial Strength The contractor who meets the first two tests then should be asked for a financial statement. The statement should show consistent profitability (indicating good cost control), a good liquidity ratio (indicating sufficient cash to handle day-to-day operations), and no excessive short-term debt (which may create problems once the project has begun). Discussions also should be held with the contractor’s bank and the proposed bonding company. Subcontractor Relations A general contractor is only as good as the subcontractors the firm uses. A list of major subcontractors to be employed on the proposed project

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should be obtained. Major subcontractors should be questioned about their working relationship with the proposed general contractor. A pattern of long-term working relationships, based on mutual trust and respect, is most desirable. If such relationships do not exist, problems may occur once the job is underway. Project Manager The project manager for the proposed project should be interviewed in depth. This individual should have at least 5 to 10 years’ experience, preferably in projects similar to the one being proposed, and should have a consistent record of good management. Other projects that will be the project manager’s responsibility during the construction period of the proposed project should be identified and reviewed for possible overextension. If the proposed project is a large one, the general contractor should be required to guarantee that the project manager and his or her assistants will work exclusively on the proposed project during the construction period. In some cases, a construction manager may be involved not only in the actual building process but may also be an integral part of the project team from its inception. In essence, the construction manager plays the traditional role of the general contractor on the project team. Since the major subcontractor agreements are directly with the owner in this case, however, the owner takes on significantly more responsibility for coordination and liability for performance. Price Only if the contactor meets all the above tests should price be considered. If two contractors appear equally qualified, the deciding factor should be the difference in price. However, if there are two contractors who both meet the basic criteria but one of them seems more highly qualified and is more expensive, it’s generally better to pay the higher price in order to get better quality and assurance of successful completion. It’s generally not a good idea to take the lowest bid just because it is the lowest bid.

DEALING WITH POTENTIAL PROBLEMS Regardless of the experience or reputation of the contractor chosen, problems may arise in the construction process, and it’s important for the developer or owner to recognize them and know how to effectively respond.

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Materials Materials generally constitute the major portion of the average construction contract, and their costs can significantly affect the degree to which a project can be completed within budget. A contractor may face several problems in trying to successfully control the materials cost element of the construction process. Availability The first problem is availability. Since shortages often occur in the construction industry, care must be taken to ensure that a specified material will be available when it is required. It may be desirable to purchase it before it is needed and warehouse it until it is required on site. It also helps to anticipate the use of “as-equal” substitute materials in case the specified material is unavailable. It should be noted that certain types of materials have inherently long delivery lead times (for example, elevators or specialized equipment), and they should be selected and ordered in a timely manner to avoid project delays. Price Once availability is ensured, the next concern is price. Naturally, the contractor wants to purchase the materials at the lowest possible price, consistent with the architect’s minimum quality standards. Tight specifications (often indicating a specific manufacturer or proprietary product) limit the contractor’s purchasing flexibility. One alternative is to sacrifice quality by purchasing lesser-quality materials. The near-term cost savings may be offset, however, by higher costs of operation or sooner replacement. Another possibility is to purchase in large quantities, thereby securing lower prices through quantity discounts. Unfortunately, cost savings may be eaten up through warehousing costs and/or the write-off of unused surplus material. Some materials suppliers provide extended storage for minimal additional cost in order to complete the sale. The best bet is to weigh each purchasing decision independently, considering price as only one factor. Site Delivery The purchased materials must be delivered to the site at the time when they are required. Often this presents a scheduling problem. If the materials are not on site when required, tradespeople may stand idle, thereby raising labor costs. If the materials arrive too early, they may take up

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valuable site storage space or be at the mercy of weather or vandals. The contractor therefore must schedule the delivery dates carefully. To be certain that the dates will be met, the materials suppliers should be contacted regularly. Site Storage The final problem is on-site storage. If the project involves a “tight” construction site, storage space may be at a premium, requiring even more careful scheduling of delivery dates. It even may be necessary to lease additional land or warehouse space for materials storage.5 If a material is affected by weather, it must be kept covered and protected from weather extremes. Another problem is theft and vandalism. The materials storage area must be adequately fenced, and around-the-clock security guards may be required. An inventory control system should be utilized to check out materials to the various trades not only to determine which supplies remain but also to discourage internal pilferage. Contractors are becoming more adept at performing constructability reviews and developing logistical plans to improve construction efficiency and spot potential schedule delays. The developer or project manager should carefully analyze these management tools to be sure they meet the architect’s specifications and owner’s objectives. Labor The second major element of the construction process is labor. This includes skilled labor such as carpenters, plumbers, masons, sheet-metal workers, welders, concrete finishers, equipment operators, and as many as 20 other skilled trades. Unskilled labor is also required on site for site preparation, construction, and site cleanup. In addition, certain types of labor are needed to service the site, such as truck drivers, warehouse workers, and security officers. The type and amount of labor depend upon the size of the project, the stage of the construction process, and the work productivity of the labor employed. Labor Availability The first problem facing the contractor is the availability of labor. In some areas of the country, construction is a sporadic activity, and skilled trades are periodically unavailable or in short supply. In other areas, where construction 5 Construction lenders may be reluctant to fund off-site stored materials; it’s important to check loan terms and conditions.

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takes place on a continuing basis, the availability of labor for a particular project may be in especially short supply if construction activity is strong. The seasonal nature of construction and the overall business cycle also affect availability. If labor in a particular category is unavailable locally, the contractor must either import labor from other areas or—if the project is large enough—engage in on-site job training. Union versus Nonunion Whether to employ union or nonunion trades must now be decided. The construction industry is heavily unionized, particularly in those trades involved in larger-scale projects, and in some areas there is no choice but to utilize a union workforce. If there is a choice, the question is largely one of how best to maximize productivity. It may be better to pay the higher costs of union labor to obtain greater experience, better-trained workers, and productivity, particularly if highly specialized trades are involved. The basic factor should be the cost per unit produced, not the labor rates that are charged. If union labor is employed, the contractor must be thoroughly familiar with the labor contracts governing the tradespeople hired. These contracts also are subject to national labor legislation adopted under the National Labor Relations Act of 1935, the Labor-Management Relations Acts of 1947 and 1959, and the Civil Rights Act of 1964. These acts cover items such as trade jurisdiction, work rules, work hours, grievances, and equal opportunity in employment. In addition, most union locals have negotiated specific contracts with contracting employers regarding wage rates and other localized labor-management provisions. It’s generally a good idea to request the contractor to provide a schedule of specific contract expirations or negotiations that might affect job progress and a contingency plan to avoid delays in completion of the project. Labor Scheduling The contractor must exercise great care to determine when certain skills will be required and to ensure that they will be available and on site at the scheduled time. If crews are unavailable when a particular activity is required, project completion may be delayed. If crews are available too early, they may stand idle, increasing overall labor costs. Site Working Conditions Once the project is underway, the contractor must be concerned with onsite working conditions. Areas must be set aside for cleanup, tool storage, rest rooms, and other facilities required for workers. If union labor is utilized, these items are probably covered by the union contract. If not, the

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contractor should take the initiative to assure workers that these facilities will be available. Safety also is a major concern both to workers and management, particularly in light of federal legislation such as the Occupational Safety and Health Act (OSHA) of 1970. Steps must be taken to avoid construction hazards, encourage safe work practices, and otherwise assure workers that they will be able to work in as safe an environment as possible. Labor Disputes Differences between management and labor inevitably arise in every construction project. These may involve jurisdictional disputes, work practices, or events concerning individual workers. Again, if union labor is employed, these areas are probably covered by the union contract. If not, the contractor should establish procedures that will resolve differences as fairly and expeditiously as possible. If disagreements cannot be resolved, the contractor must be prepared to handle work slowdowns or strikes. Equipment The third major element of the construction process is the equipment utilized on the job. With increasing labor costs and shortages of certain types of skilled trades, contractors have relied on more efficient equipment to offset rising production costs. Manufacturers have responded with more sophisticated, sometimes highly specialized equipment, often bearing considerably higher price tags (Figure 18-4). Equipment Selection The first problem is to determine what types of equipment to use on the project. In some cases, a certain piece of equipment will be specified to perform a particular task, forcing the contractor to choose between competitive manufacturers. In other situations, the contractor must decide if it’s desirable to use a particular type of equipment as a substitute for other costs, such as labor or project completion time. In either case, it’s important to establish the exact task to be undertaken and the costs of various types of equipment that might be employed. If the equipment is insufficient for the task, the project may be delayed; if the equipment has excess capacity, the cost of idle time may be too great. Utilization Costs In determining the cost of equipment utilization, the key factor is not the price of the equipment but the production per unit for the task involved.

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FIGURE

18-4

From transit truck to wheelbarrow to trowel, well-functioning equipment is vital to any job. (Marjorie Maxfield)

This may be expressed in terms of cubic yards of earth to be moved, board feet of lumber to be handled, or tons of steel to be erected. The equipment selected should handle the greatest volume of work at the lowest total cost. The best indicator of work capacity is prior experience on similar construction projects. If records haven’t been maintained or if similar experience is unavailable, the dealer’s or manufacturer’s representatives should be contacted for on-site demonstrations of the work capability of their equipment. The next step is to look at the total costs involved in utilizing the equipment. The original cost reflects the cost of purchasing or renting the equipment. Operating costs are operator wages, fuel, maintenance, parts, insurance, and the rate of depreciation. The source and availability of replacement parts also may be critical. Owning versus Renting In evaluating costs, the contractor often weighs rental versus purchase. Renting may be desirable if the equipment is very expensive, highly

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specialized, or to be utilized only for a short period—for example, a large crane used for lifting steel beams into place. Renting is also a means of testing equipment for subsequent purchase.6 Renting is expensive, however, and purchasing may make more sense if the equipment is to be used for a large project or several projects. In considering purchase, the contractor must decide between new and used equipment. Although new equipment is more expensive, it may require less maintenance and have a longer economic life. Used equipment is considerably cheaper and often makes more sense, particularly for noncritical construction tasks or as a backup for new equipment. If used equipment is purchased, it should be thoroughly inspected and, if possible, tested on site. Operation Once a piece of equipment has been rented or purchased, it must be operated properly on the job, minimizing downtime as much as possible. Also, it should not be applied to tasks for which it has not been designed or that are beyond its capacity. The best way to avoid equipment abuse is to thoroughly understand its capabilities and assign its use exclusively to individuals who are experienced in its operation. Proper maintenance also helps get the maximum service out of an individual piece of equipment. The day is long gone when a piece of equipment is repaired only when it breaks down. Today, the contractor must be concerned with preventive maintenance, the tune-up and adjusting necessary to keep equipment at peak operating efficiency. Maintenance agreements often are available from the equipment supplier. Minor problems must be corrected before they become major. A little preventive maintenance is better than long periods of downtime due to equipment failure. Preventive maintenance also requires continued inspection by persons operating the equipment and those responsible for its servicing.

SCHEDULING AND MONITORING PROGRESS A recurrent theme in this chapter has been the importance of materials, labor, and equipment arriving at the site in the required quantities, at the right time, and in the proper sequence in the construction process. Any item 6 Some equipment manufacturers have rental option plans under which the contractor may apply a portion of rental payments against purchase at a future date.

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that is out of sequence can cause delays or costly shortage or downtime problems. In essence, the contractor orchestrates a complex fabrication and assembly process in which all components must be coordinated if the final product is to be on time, within budget, and to design specifications. Preconstruction One key is preconstruction scheduling. A strategic plan of action is developed that clearly indicates the objectives to be accomplished, the logical sequence of events required for their accomplishment, and the methods that will be utilized. This plan should then be placed in a timeframe, based on contract deadlines, resource availability, and anticipated weather. Role of the Computer Early preconstruction scheduling was relatively crude—often no more than informal conversations between the contractor and suppliers, unions, and subcontractors. On large projects, contractors might have attempted to lay out the sequence of events, but they were often hampered by the need to handle great amounts of data. With the development of the computer in the mid-1950s, several systems evolved to schedule increasingly larger and complicated projects. In 1956, the E. I. du Pont de Nemours Company developed a logical network to explain the sequence of events encountered on its construction projects. This provided the basis for the development of the critical path method (CPM) of scheduling construction activity. A few years later, the Navy, in an attempt to control the costs and delivery dates of the Polaris missile program, added other statistical techniques and formulated the program evaluation and review technique (PERT). In subsequent years, the CPM and PERT have been so modified that both terms are used almost interchangeably to describe a logical-sequence system of project scheduling. Two considerations determine the sequence of events: (1) which events must occur before another one can proceed (for example, completion of the walls before a roof can be added) and (2) which events could proceed if desirable (for example, fabricating various elements requiring the use of common equipment). The latter is particularly important in optimizing the overall efficiency of the project. Today, PERT and other software programs are available for personal computers, greatly expanding the use of these planning techniques to smaller projects. Once a computerized project planning program is available, work schedules can be prepared for various elements of the project. A labor

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utilization schedule can be prepared, indicating the days on which specific trades will be required and the number of workers who will be involved. Materials purchasing schedules can be developed, indicating the types and quantities of materials that will be required on site and (utilizing delivery lead times) the days on which they should be ordered. Equipment scheduling documents also can be prepared, detailing the type of equipment that will be required on particular days and how long it will be utilized. Another key is timely feedback as to schedule status to improve the choices a project manager has to accommodate the inevitable variations that will occur. One important aspect of project scheduling programs is that they enable the project manager to assess alternate construction strategies, both as a proactive effort as well as a response to unforeseen changes in assumptions during the course of construction that require strategic modifications in the remaining course of activities. Newer programs allow tracking of both schedule and cost implications of alternative courses of action. Fast Tracking In recent years, the concept of fast tracking has become a popular, lowercost alternative for building construction planning. Traditionally, developers have waited until all documents and drawings for a proposed building were completed before putting them out to bid. Under the fast-tracking system, the bidding process is handled in phases, with preliminary construction—earthwork, foundations, steel, and concrete placement—proceeding while architectural drawings are being finalized. This can result in a significant reduction of time and costs on a large project. If such a system is utilized, it can be incorporated into the computerized planning process. Design-Build Another concept that has been growing in popularity is design-build. Traditionally, the designing and building functions have been performed by two different firms. Under the design-build concept, one firm provides both functions. This can result in lower costs because the design-build firm is responsible for keeping design costs in line with a total project budget that also includes the construction phase. It also can result in faster completion times because of the efficiencies of working with a single firm. Another advantage of the design-build concept is that a single firm is accountable for the project as a whole. As with any delegation of authority and responsibility, initial guidelines should establish clear expectations, and some form of periodic monitoring and assessment should be established and maintained.

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Value Engineering Still another concept that can be useful in managing the costs of a project or getting the best quality for the money spent is value engineering. The concept involves balancing functional elements of a project with quality and cost to come up with the highest overall value. As an example, an expensive HVAC system that operates more efficiently than a less-expensive system might be utilized in order to reduce overall system costs. A less-expensive curtain wall might replace the higher-priced one originally specified if it is determined that quality will not be significantly affected in any critical area as a result. Sometimes value engineering is employed when a project budget must be reduced by a certain amount in order for the project to move forward. Building components are reviewed one by one to determine where less expensive components or building methods can be substituted to reduce costs without significantly affecting quality or operation. For example, the architect may have specified heavy and costly stonework where a lighter-weight stone might work just as well and result in reduced costs for labor and materials. In other cases value engineering may simply involve finding the best-quality materials for a given budget. In this way the quality of the project is enhanced without incurring additional expense. Construction Progress Monitoring Systematically and consistently monitoring construction progress is critical to the success of any project. To ensure that such monitoring occurs, the development team should create a construction progress monitoring (CPM) plan at the start of the construction phase. In addition, because construction is a highly dynamic process, the CPM plan must be continually updated to maintain its effectiveness. The monitoring should be undertaken by someone who understands both the construction process and CPM networking. This person must analyze data produced on the job (for example, time reports, materials purchases, and equipment utilization) and compare the actual time expended with the time allocated in the CPM plan. The person assigned to monitoring should hold frequent discussions with the project superintendent, supervisors, subcontractors, and others regarding construction progress. He or she should also undertake field inspections frequently to verify reports of progress. If evidence exists that the actual time for a particular event will be greater than the time allocated, the CPM plan must be reexamined to

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determine the delay’s overall impact on project completion and the action necessary to bring the project back within the original schedule. The costs and benefits of these actions must be weighed against the costs of exceeding the contract deadline (for example, contract late penalties, loss of tenants, or client displeasure). If changes are made, the entire network should be run again and a revised CPM plan adopted. Progress Meetings The development and refinement of the CPM technique has given contractors a common-sense method of planning and executing a successful building project. CPM, however, is no substitute for selecting the best contractor and maintaining close coordination with the progress (or lack of progress) that is being made. A developer who fails to do this can expect major problems in the quality of the building that is finally constructed and, possibly, significantly higher costs than anticipated. The best method of maintaining close coordination is periodic meetings between the contractor, the architect, and the developer. At these meetings, the current status of construction can be reviewed and any modifications made to bring it more in conformance with the projected schedule. Changes in materials or construction techniques can be evaluated and firm action taken if a change appears desirable. Problems will inevitably arise in any construction project, and they can be better resolved if they are identified early to allow for a reasoned assessment rather than a survival reaction. In all cases, the developer must be prepared to respond quickly and knowledgeably to decisions that the contractor and architect need to make to keep the construction program moving smoothly. Dispute Resolution Unfortunately, even with today’s increasingly complex and sophisticated building processes, disputes may arise between the parties that, if not resolved, could lead to potential litigation. It is therefore essential that a method of dispute resolution, usually arbitration, be established in the contract documents. The mechanics of the arbitration process should be as simple and efficient as possible, while retaining a concept of equity that will prove acceptable to the parties as being preferable to lengthy and costly litigation. Building Completion At the completion of construction, it’s important to have a method established for “accepting” the building and making final payment to the

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contractor. The developer, or a representative, should spend the time necessary to inspect for any defects in the workmanship or the quality of the materials. Certain systems, such as elevators, air-conditioning, heating, plumbing, and electricity, should be in operation for a period of time before the building is accepted. It’s generally wise to withhold final payment to the contractor until these steps have been satisfactorily completed. The industry standard is to have a one-year general construction guaranty or warranty whereby the construction trades agree to correct material and functional problems that emerge in the building’s operations.

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C H A P T E R 19

Marketing

A salesman is got to dream, boy. It comes with the territory. Arthur Miller Death of a Salesman

T

he heart of the marketing program is a highly motivated, smoothly functioning sales or leasing force. Advertising and other promotional activities can interest people in the project, but interest is translated into an economic event only by means of a closed sale or lease. Successful closing requires contact with individual salespeople who properly interpret the needs of the purchaser or tenant, relate these needs to specific aspects of the project, and convince the prospect to enter into a purchase or lease agreement. The debate over whether to use an internal brokerage team or independent brokerage firm has continued for years and probably never will be satisfactorily resolved. A variety of factors enter into the decision to select one approach or the other.

INTERNAL BROKERAGE TEAM An internal brokerage team is most effective for marketing a large project requiring close coordination between planning, design, construction, and marketing—which, in many cases, can be provided only by individuals who are intimately acquainted with the day-to-day operations of the project team. 467 Copyright © 2007 by John McMahan. Click here for terms of use.

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A large project also requires continuity of top personnel in terms of dealing with the local business community and government officials as well as with prospective purchasers or tenants, who may make a final decision only after several encounters with the project’s marketing staff. An internal sales staff also may be a sensible approach if the developer wants to maintain a continuing sales program in which several small projects will come on stream in serial fashion. This is particularly true if the developer is trying to establish an image for a specific type of development (for example, congregate care facility, hybrid office building, or new town) requiring a learning curve on the part of the sales staff. The major problem with this approach is coordinating the staff’s efforts between the completion of old projects and initiation of new ones. There is also the potential problem that sales personnel from one project will not be compatible with another market area, regardless of the similarity of product.

INDEPENDENT BROKERAGE FIRM An independent brokerage firm1 offers the advantages of familiarity with the local market area, the ability to move ahead immediately, lower outof-pocket costs prior to sale, and no continuing financial commitment once the project has been sold or leased. In leasing situations, the firm also may be able to refer potential tenants from other buildings or, in the case of a regional or national brokerage firm, from other metropolitan areas.2 The independent broker also may provide other services, such as market analysis, appraisal, mortgage banking, and property management. Firm Selection There are several factors to consider when selecting an independent brokerage firm. The firm’s experience should be evaluated in relation to the target market for the proposed project. A shopping center broker would be a poor choice for a proposed office building; a residential sales broker

1 With a smaller project, the broker may be an individual or a few individuals rather than an established firm. 2 In marketing single-family homes, this may be an advantage where the brokerage firm is handling the sale of a home in the city from which the family is relocating.

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may not fully understand apartment leasing, even though the market area is the same. The broker’s experience also should be current. A good way of evaluating this is to interview other developers who have recently used the proposed brokerage firm for similar projects. The brokerage firm must believe in the proposed project. Prospective brokers should be thoroughly exposed to the planning and design of the project, construction to date, and the marketing advantages and disadvantages of the project vis-à-vis the competition. If the prospective broker can’t enthusiastically endorse the project, it’s better to seek out another than to accept a halfhearted commitment. It’s also important to be certain the brokerage firm is not involved in competitive projects that might create a conflict-of-interest situation. If a major conflict exists, it’s probably wise to drop the firm at this point or to at least reach agreement that no competing projects will be undertaken during the period of engagement. A more subtle, and potentially damaging, problem may be that the firm already represents too many clients to ensure sufficient attention to a new one. Managing Broker If the prospective brokerage firm meets the above tests, the next steps are to identify the individual who will be assigned as the managing broker on the project and to ascertain the degree of his or her commitment. The individual should be experienced in the type of project proposed, have an in-depth knowledge of the market area, and believe in the merits of the project. The managing broker’s personal image also should be consistent with the project’s image and prospective buyers (or tenants). The individual should be conscientious in sharing information about the project with other brokers and sales personnel who might provide referrals for sales or leases. Finally, the individual should be able to devote enough time to the subject project to result in a successful sales or leasing effort.

LISTING AGREEMENTS Regardless of whether an internal team or independent brokerage firm is utilized, the relationship usually is spelled out in a listing agreement, which covers such matters as the properties involved, the services to be provided, financial responsibilities for various marketing costs, the compensation to be received, and the duration of the relationship. Brokers are,

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in essence, agents of the developer, and the listing agreement defines the nature of the agency relationship. There are three basic types of agencies as illustrated in Figure 19-1. Open Listing In the open listing, the developer may employ many brokers and pays the commission to the broker who sells or leases the property. If the developer sells or leases the property directly, the broker does not receive a commission. Exclusive Agency In the exclusive agency listing, the developer employs one broker exclusively who receives the commission if the property is sold or leased by anyone other than the owner. Again, if the owner sells or leases the property, there is no commission. Exclusive Right to Sell The most common listing agreement in real estate is the exclusive right to sell contract, in which the developer employs one broker exclusively, who receives the commission regardless of who sells or leases the property, even if it’s the developer. Combinations There are also certain combinations of these forms of agency, such as the multiple listing, in which properties listed with one broker are open to other FIGURE

19-1

Types of listing agreements: (a) open listing, (b) exclusive agency listing, and (c) exclusive right to sell. Developer

Developer

Developer

LB

LB B

B

B

B B

LB

B

B

B

B

Buyer/lessor

Buyer/lessor

Buyer/lessor

(a)

(b)

(c)

Listing Broker

B

Other Brokers

B

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brokers participating in the multiple-listing arrangement. The listing broker who sells or leases the property keeps the full commission. If another broker sells the property, the commission is split on a predetermined basis. A referral fee is a flat fee paid by the listing broker to other brokers if they refer prospects who eventually purchase or lease the property. Increasingly, brokers are representing buyers and tenants as well as developers and owners. Buyer or tenant brokers not only provide market knowledge to their clients but may also participate in or handle the negotiations as well. The buyer or tenant broker’s fees or commissions may be paid by the client or, more commonly, by the developer or owner. It’s important that the buyer or tenant broker disclose early on in any contract with other parties the nature of his or her agency agreement and the principal(s) represented. In some states, this is mandated by law.

COMMISSIONS Both internal sales teams and independent brokers are generally compensated on a commission basis. Four questions usually arise regarding commissions: (1) How much should they be? (2) What should they cover? (3) To whom should they be paid? (4) When are they paid? The commission generally varies between sales and leasing transactions. Sales Commissions Commissions generated by a property sale are generally computed as a percentage of the total sales price. Although they vary considerably throughout the country, average commission rates on most real estate sales for various property types are as follows: Raw land: 5 to 10 percent Single-family houses: 5 to 6 percent ■ Multifamily dwellings: 2 to 5 percent ■ Shopping centers: 2 to 4 percent ■ Industrial buildings: 2 to 4 percent ■ Office buildings: 2 to 3 percent ■ Hotels: 2 to 3 percent ■ ■

It should be noted that commissions may vary with the dollar amount of the sale, usually decreasing as the size of the project increases.3

3 Large institutional properties and/or portfolios are sold based on lower fee schedules, depending on their size and the amount of effort to be expended. Lower fee schedules may include performance bonuses based on the final sale price achieved.

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Leasing Commissions Leasing commissions typically are based on a percentage of the total rental payments over the term of the lease. If the lease is for an extended term, the commission rate may scale down on annual intervals. Table 19-1 provides representative examples. These schedules should be viewed as guidelines to broker preferences. The actual commission paid is a matter of negotiation between the developer and the broker.4 The developer should strive to establish a commission schedule that provides the greatest motivation for the broker at the lowest total cost. This may not necessarily be the lowest commission rate. In some instances, it is better to pay a higher commission rate to achieve more rapid sales or leasing absorption. Sales momentum is also a factor. Not only does faster sales absorption reduce holding costs but it also establishes a positive sales tone for the project. A project that is moving rapidly creates enthusiasm on the part of the sales staff and pressure on prospective purchasers or tenants to make a buy or lease decision. To achieve greater momentum, it may be desirable to negotiate a commission schedule that pays higher commissions for early sales, scaling down as the project moves forward.5 The second critical question is what the commission should cover. In some listing agreements, the broker is responsible for all advertising costs and possibly even the costs of maintaining the sales office. In other situations, the advertising and other sales costs are split between the broker and the developer on a percentage basis (in practice, the split is usually 50–50 percent). However, many developers prefer to pay all the sales costs and TA B L E

19-1

Leasing Commissions Schedule Years

Shopping Center Office Building Industrial

1

2

3

4

5

6–10

10 or Over

6% 6% 5%

5% 5% 4%

4% 4% 3%

4% 4% 2%

3% 3% 1%

3% 3% 1%

3% 3% 1%

4 There is a growing trend away from declining commission rates and toward equal commission payments over the life of the lease. Leasing commissions also may be based on a fixed-dollar payment per square foot of space leased. 5 This approach may prove difficult if a sizable portion of the project is substantially less attractive: the good units or spaces move first, and there may not be sufficient commission left to motivate the sales force to move the unattractive units or spaces.

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negotiate a smaller sales commission to the broker, thus ensuring that sufficient advertising monies will be spent at the right time and giving the developer more control over the sales promotional efforts. The question of with whom the commission should be “split” is a topic of great concern to the brokerage community and one on which there is no consensus. Most firms split the commission between the individual broker and the brokerage firm. This split will vary, depending on the strength of the brokerage firm and the individual broker’s experience and sales ability. If more than one broker is involved in the sale, the formula may be more complex—the sales manager may receive a portion of each sale; the balance is then split between brokers establishing initial contact and those closing the sales or lease transaction. Formulas also may be established to compensate outside brokers who bring a prospective purchaser or tenant to the project.

PROJECT PROMOTION The purpose of project promotion is threefold: (1) to identify the project, (2) to inform prospective purchasers or tenants about the project, and (3) to create a sufficiently good impression to attract prospects into the sales or leasing compound. Advertising, public relations, and other promotional activities cannot close a sale or lease, but they can help generate the traffic and positive perceptions from which closings are possible. Without the traffic, there never will be a close. Advertising Advertising in newspapers, magazines, and other periodicals, as well as radio and TV markets, can be an important method of promoting real estate projects. The developer first must decide on the role that advertising is to play in the overall marketing effort. If it is primarily to identify the fact that the project exists, the campaign can be simple and less frequent. If it is to indicate the advantages of the project over competing projects, the advertising must be more descriptive and intensive. The advertising program itself should be well planned, consistent with the overall marketing program, and targeted to a specific market. Its effectiveness depends on the type of project, the nature of the target market, the project’s location, the degree of competition, the type of media and its cost, and the overall timing of the advertising program.

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Type of Project Advertising can assist in the marketing of virtually any type of real estate project. It is highly detailed in single-family, multifamily, and transient commercial projects where the location, size, and pricing of units is very important in helping define and attract the specific target market. For retail, office, and industrial projects, advertising is more general, attempting to establish a “theme” (for example, prestige, project features, or proximity to transportation) that invites a visit to the on-site sales compound for more detailed information. Generally, for advertising to be cost effective, the project should be relatively large. Smaller projects usually are better promoted through classified ads and on-site signage. Target Market The advertising campaign also should be highly targeted to those individuals and firms most likely to buy or rent in the project. As the target market broadens, advertising becomes more costly and less effective. Projects directed at large target markets, such as single-family housing, rely mostly on general media channels, such as daily newspapers, general-interest periodicals, and radio and television. Retail, office, and industrial projects may be more narrowly targeted through trade publications and prestigious metro magazines, as well as billboards and posters at airports, train stations, and other places with high public traffic. Advertising is most effective when the target market can be reached through clearly defined media channels—for instance, doctors for a medical complex through medical journals or industrial park prospects through industry publications. If the target market is relatively isolated, specific media channels can be readily ascertained. One way to narrow the field is to evaluate the geographic coverage of various media channels and concentrate on those that most closely correspond with the residence or place of business of prospective purchasers or tenants. Another approach is to select media channels that appeal to the income levels or lifestyles of sales or leasing prospects. Project Location The location of the project also may influence the type of advertising selected. Urban projects can use billboards located on site as well on highly traveled arterials and freeways. Projects located in relatively remote areas will require more expensive advertising, generally in magazines or through radio and television. If billboards are utilized, they are more likely to be placed on transportation corridors leading to or near the project.

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Competition Projects in intensely competitive markets also may require extensive advertising, if only to maintain market position. The advertising policies of competing projects should be carefully examined, with particular attention paid to the correlation between advertising programs and sales or leasing success. Type of Media The type of media may be a consideration. Radio and TV represent oneshot types of media: the message must be seen or heard on the spot or it is lost. For this reason, it is generally used as a “call to action,” referring the listener or viewer to other media or a “hotline” telephone number. Newspapers and magazines are read at the convenience of the reader, thereby extending the life of the advertising message. Magazines also have a relatively high degree of “second readership”—that is, more than one person may see the same message. Cost The cost of various types of media also can be important. Although TV and radio are expensive, they cover a broad market and the cost per person reached is often low. Newspapers and magazine advertising cost less but may have a higher cost per unit. A rough indication of media costs can be established by dividing the cost per message by the circulation or listening or viewing market of the media involved, expressed in cost per 1,000. If the target market can be separated from the general market, the figures for the target market should be used in the calculation.6 Timing Next, the timing of the advertising program should be established. Generally, advertising expenditures are greater in the early stages in order to establish project identity and generate sales momentum. This usually requires broader media coverage, larger ads, greater use of color, and more frequent insertions. If the project begins selling or leasing successfully, the number and frequency of advertising vehicles can be reduced. If sales are not proceeding, the advertising strategy should be reexamined and possibly revised. 6 Most media firms maintain fairly detailed figures on their circulation or listening or viewing audience. It is generally wise to take target audience statistics provided by the media with a grain of salt because they can be exaggerated in order to increase advertising sales.

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Advertising copy is generally prepared by advertising agencies that specialize in real estate. The entire series of ads should be designed at one time so that the overall sequence can be examined. For example, ads run in the early phases of a project may concentrate on identifying the location and features of the project, and later ads may reinforce its image. Ads keyed to special promotions also should be prepared in preliminary form, even if they are ultimately not used. The advertising budget should now be established. Once the final budget is established, a contingency of 30 to 40 percent should be added to allow for an extended advertising program if sales or leases do not materialize as anticipated. Public Relations Public relations (PR) activities also can be effective in promoting a real estate project and creating a favorable sales or leasing image, particularly if closely coordinated with the advertising program. A specific strategy should be adopted at the inception of the marketing program. This strategy should be established and executed by a firm specializing in real estate public relations, with enough muscle to ensure that the scheduled news stories have a reasonable chance of appearing. To be most effective, public relations activities require some form of event as a peg on which to hang a story.7 Unfortunately, there are few truly newsworthy events connected with most real estate ventures, but there are a few events that might interest the media: the announcement of the project, the groundbreaking, the “topping off” of a new high-rise building, the finalizing of major leases, high sales or leasing rates, and a short period remaining before close-out. If one of these events is used to stimulate publicity, each event should be viewed as an important opportunity to promote the project. Press releases should be prepared well in advance and keyed to release times that will ensure maximum exposure. If possible, the event can be enhanced by promotional activities such as speeches, cocktail parties, celebrity appearances, and anything else that will improve the newsworthiness of the release.8 Small, specialized publications should not be overlooked. Often, what is not considered newsworthy to major periodicals will interest publications

7 This excludes reciprocal PR by which a news story is run in consideration for display advertising expenditures. 8 Some developers now arrange to identify a project with a TV, movie, or sports personality, perhaps in exchange for a partial ownership position.

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geared to a specialized market, which may coincide with the target market for the project. Display advertising also may be very important to these publications, which would increase the opportunities for reciprocal PR. Public relations can take more subtle forms as well. Many developers, for example, sponsor cultural and athletic events in order to create goodwill in the community. One large developer built a child-care center in a California business park as a way of creating a positive link between the firm and the surrounding community. A greater public relations effort is generally required for projects in large cities where there is more competition for buyers’ or renters’ attention. In smaller communities, large projects are developed less frequently and thus are more of an “event”; as a result, there is greater opportunity for free publicity. The PR consultant also must be prepared to handle events that might have a negative impact on the project. Strikes, floods, fires, consumer complaints, and other events may damage the sales or leasing success of the project if they are not handled effectively. It’s wise to anticipate possible negative events and ways to counteract them. It’s better to be prepared to handle adverse publicity that doesn’t materialize than to have to respond quickly under pressure. Newsletters Periodic newsletters can help promote large real estate projects, particularly those, such as new towns, that require extended absorption periods. The newsletter can be prepared by the developer or a PR consultant. It should cover newsworthy events associated with the project or the area as well as interviews with satisfied purchasers or tenants and tips on making better use of the facilities offered. It should also attempt to head off negative events before they hit the local press. The timing of the newsletter is important. It’s best to anticipate anything newsworthy in the progress of the project and establish a schedule that keys every second or third issue to these events. Intervening newsletters can carry follow-up stories from the last news event and projected stories for the next one. Direct Mail Direct mail can be effective in certain types of situations, particularly when the target market is clearly defined. The direct-mail piece should be designed with a specific purpose in mind (for example, announcement of the project, special promotions, or response to a request for materials).

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The message should be hard-hitting and to the point; direct-mail pieces go into the wastebasket rather quickly. The message should conclude with a request for action on the reader’s part, such as coming to visit the project, calling or writing for information, or allowing a salesperson to call. The mailing list should be continually screened to be certain it hits the target market and is current. The timing of a mailing should be carefully planned to increase the likelihood it will be read. The costs of direct mail are high, but a well-planned and executed campaign can be effective. Promotional Pieces Several promotional pieces can be helpful in selling or leasing a project. A project brochure, explaining the advantages of the project, is generally always necessary; it should be designed and executed professionally and carefully aimed at the target market. Items subject to change, such as price schedules, should be printed separately. Reprints of ads and news articles also can be effective promotional tools, as can the project newsletter. Slides, Videos, Films, and the Internet Slides, video tapes, and films are increasingly used in marketing programs. The presentation may be mobile, allowing the salesperson to go to the potential buyer or tenant, or an integral part of a sales or leasing compound where every effort is made to give the prospect a “feeling” of the completed project. In some of the more elaborate leasing programs, the presentation may utilize a scale model for the filming so that the prospect can visualize how it would be to live, work, or shop in the completed project. In recent years, developers have used project Web sites very effectively in presenting one or more of their projects to potential buyers or tenants. This can be accomplished on the developer’s Web site or on a special one created for a single project (generally a large one). Through a registration process, the individual accessing the Web site can be identified and qualified for additional follow-up (through e-mail, mail, telephone, or personal sales call). Signage An effective signing program can be an important promotional tool for most real estate projects. There are three elements to a successful signing program: external, approach, and on site.

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External A typical external signing device is a billboard. It can be used to announce the existence of the project and to establish a positive image. Billboards also can be effective in cases in which the market strategy is to attract office or industrial tenants from one area into another. For example, a new suburban office building may benefit from a billboard in the downtown financial district. Apartment and single-family projects also may benefit from external signing. Approach Approach signing has a twofold purpose: it advertises the project to potential purchasers or tenants driving by, and it makes prospects aware of the directions for finding it. Approach signing can be particularly effective in diverting potential prospects from a competing project. Copy on the sign can be directed squarely at the advantages of the subject project over the competition, especially if it fulfills significant market voids. The best method of providing directions is a simplified map or a short phrase (for example, “first left after lake” or “across from Central School”). On Site The purpose of on-site signing is to announce arrival at the project and to provide directions for proceeding to the parking area and sales compound. The arrival announcement should be as simple as possible and large enough to be seen from a distance. No other message should be attempted, except for a descriptive phrase associated with the project name throughout the promotional program.9 Directions to the sales compound should be smaller and possibly interspersed with signs identifying the various features of the project. Use of Computers The development of computers has led to major changes in the way real estate projects are marketed. With a personal computer in the residential sales office, for example, sales personnel can qualify prospects, customize home designs in a matter of minutes, and present potential customers with detailed information about the costs and benefits of various models and custom features. Furthermore, detailed contact information about the

9 If the project is immediately adjacent to a freeway or other major transportation mode, the sign could carry other messages such as the phone number of the sales office, the name of the sales manager, major features of the development, and a changing section for special promotions.

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prospect can be entered into the computer, and follow-up letters can be automatically generated, depending on the level of interest expressed. Computers also can be used to superimpose a photo of an office building model on a picture of the site where it will be located as well as show the interior of model suites and the view potential of selected floors. Through the use of sophisticated CAD systems, developers can take prospective office tenants on a simulated “walk” through office lobbies or remove office walls to expose the building’s telecommunications, electrical, and air-conditioning systems. These tools can be used in residential, retail, and industrial projects as well. Sales Compounds or Leasing Offices A well-located, carefully staffed, and smoothly functioning sales compound or leasing office is essential to a successful marketing program. It’s important to spend sufficient time considering the atmosphere in which the purchase or lease agreement will be initiated and, it is hoped, consummated. Where the best location would be for the sales compound or leasing office depends on the type of project, its location, and its relationship to the target market. In single-family and apartment projects, the sales compound generally encompasses a cross section of units decorated as models, and the sales office is usually a room in one of the models, a temporarily converted garage, or a trailer. The leasing office for an office building project may initially be a trailer or nearby office building and then a typical office suite after construction has reached a certain point. In order to promote large office and residential projects, some developers are now building entire marketing centers, complete with large-scale models and multimedia presentation capabilities. Shopping center and industrial space generally is leased from an office located within the project. Since hotels usually involve a lease with a single operator, a leasing office may not be necessary. Although the sales compound or leasing office most frequently is located on site, there may be situations in which an off-site location is desirable. A large, single-family project that is not located on a freeway or major artery may wish to develop a sales compound, which would include a model of the units and be adjacent to the freeway to facilitate greater exposure.10 10 Land can be leased for a limited period and the models disassembled once the project has been sold.

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For an apartment or office building project, it may be desirable to develop model apartments or office space in a highly trafficked pedestrian area, such as a downtown retail district or within a shopping center. Resort projects sometimes have one sales compound on site and another in a major urban area. The relationship of the project to the target market also influences the location of the compound. If the project is directed at a recreationally oriented market, sales may be better if the compound is in the recreation or community building. If the target market consists of families with children, units could be placed near a playground so that children can be occupied while their parents are in the compound. Sales or Leasing Models Sales or leasing models are used in most residential and, increasingly, office building projects. Since the sales models play an important role in influencing the purchase or lease decision, the decorating scheme should be carefully chosen so as to appeal to the target market. Residential In residential projects, the furnishings should be of a slightly higher quality than the target market incomes might suggest. The furnishings should be in good taste, avoiding radical schemes, and be tailored to geographic preferences. Since tastes vary, it’s generally wise to have several different themes in each of the model units, provided they are consistent with the target market identified for the project. Office Office models are more difficult to decorate because the needs of office tenants vary considerably. If the target market is highly specialized (for example, financial services, attorneys, or doctors), it may be possible to decorate with specific functional needs and taste levels in mind. Office space directed at general occupancy, however, should be decorated as tastefully as possible and appeal to a broad cross section of potential tenants. It’s usually best to show both executive and open work areas, as well as their functional relationships. A model reception area and conference room may be desirable. Since office layouts often change over the period of the lease, flexibility should be demonstrated as much as possible.11 11 The development of movable partitions, modular furniture, and the use of interior “landscaping” has considerably enhanced flexibility in recent years.

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In some projects, a well-decorated leased apartment or office also may assist the project sales effort, provided that the tenant is agreeable and that the tenant’s permission to show the unit is not abused. Traffic Flow Traffic flow through the sales compound or leasing office should be carefully thought out in advance and continuously monitored. The entrance should be clearly identified, and it should provide a warm, welcome feeling. Upon entering, the prospective purchaser or tenant should clearly understand where to proceed next. At this point, prospects could sign a record log, giving their name, address, phone number, and how they found out about the project.12 In apartment and office building projects, a salesperson should be assigned to take each prospect though the models. This makes for better traffic control and a more extended selling period; the salesperson can determine what features are most attractive to the prospect and counter negative comments as they arise. Within single-family models, it’s generally best to allow prospects to move about freely, looking at whatever interests them. The salesperson or leasing agent should be near enough to point out features and answer questions, but far enough away to avoid pressuring the prospect. If there is more than one model, movement between the models should be clearly identified. Ideally, traffic should be moved through smaller models into larger ones, thereby creating an expansive feeling that may encourage trading up to a more expensive unit. After having viewed the models, the sales prospect should end up in the sales office for a potential closing. This should be the case even if the prospect is being hosted by a salesperson or leasing agent. Here, the salesperson or leasing agent can decide which sales aids to give the prospect, or if sufficient interest has been generated, he or she can sit down for a serious discussion. Promotional Aids Promotional aids can be of considerable assistance to the sales force in successfully closing a sale or lease. Wall and freestanding graphics, such as photographs, ads, maps, renderings, site plans, and unit plans, as well 12 This information will be valuable later in analyzing the source of traffic and the effectiveness of promotional programs.

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as samples of the materials can be effective in establishing an overall sense of the project. A scale model of the project gives the purchaser or tenant a good perspective of the finished product and helps the developer identify sold or leased areas. Signs can be used to highlight specific features that make the project attractive. The sales compound also should contain sales brochures, reduced floor plans, direct-mail pieces, press releases, reprints of articles, and newsletters. Certain items, such as the sales brochure and floor plans, should be prominently displayed and have a sign that encourages the prospect to take copies home.

CLOSING THE DEAL Everything in the marketing program is geared to one goal: the closing of the purchase or lease agreement. No single event is more crucial to the success of the real estate project. Unfortunately, many developers don’t spend enough time thinking through a sound closing strategy but instead leave it to the individual salesperson. Many salespeople have developed their closing techniques over the years, and they often resent the developers’ or even the managing brokers’ involvement in the process. The task, therefore, is to develop a closing strategy that will complement the sales force’s skills rather than infringe on their territory. As all good salespeople know, a successful close will occur only after prospects have convinced themselves (both rationally and emotionally) that purchase or lease is the right decision. The mental checklist used to arrive at the decision varies with the general tightness of the market and the prospect’s individual preferences. A person responsible for leasing space for a retail chain, for example, probably gives much more thought to the decision than a couple who is purchasing a home on a two-day advance trip. In both cases, however, the ultimate decision must be a comfortable one, within the parameters of the marketplace and the amount of time available. The prospect goes through a mental checklist something like this: “Do I need it? Do I like it? Is it the best available? Is it a good value? Should I act now?” The psychology of a successful close is to anticipate each of these questions and continually reinforce a positive decision on the part of the prospect. The question of need generally is established by the mere fact that the prospect is in the sales compound or leasing office or has allowed a field call. In some cases, the need to make a decision will be so intense

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that no additional pressure will be required. In other situations, a prospect may fall back on the question of need in order to avoid a final decision. Some degree of need must have existed in the first place, and a good salesperson will have established the nature of that need early in the sales conversation (determining, for example, whether the prospect is being forced to move by circumstances or has outgrown his or her present accommodations or whether those accommodations are out of date). Later on, if the prospect appears to hesitate in closing the lease or sale, the salesperson can adroitly reestablish the reality of the need. In addition, comparing the prospect’s situation to that of other individuals or firms is often a productive method of moving closer to closing. The question of liking is more difficult because it involves individual tastes and preferences. Generally, a prospect must have a good visceral feeling toward a project before a successful close can be made. The problem facing the salesperson or leasing agent is how to identify the specific aspects of the project that the prospect likes best and subtly reinforce them at every possible point in the sales or leasing conversation (for example, location, view, design, price, or amenities), turning attention away from the features the prospect has reported to be less attractive to him or her. Unless it’s an extremely tight market, the prospect will compare the subject project with the competition. The salesperson has to sell against this competitor, often without knowing how extensively the prospect has looked at the competition or what the prospect found appealing about it. One way to resolve this problem is to ask the prospect early in the sales conversation which competing projects he or she has seen and then react accordingly. If the prospect has seen many competing projects, the salesperson can subtly sell against these projects by enumerating the more attractive features of the subject project; if the prospect hasn’t seen the competition, the salesperson should restrict the conversation to the subject project exclusively. In selling against the competition, the sales force must have in-depth information about these projects. A shopping service can document the advantages and disadvantages of the various projects, but sales personnel also should visit competing projects and be completely familiar with their advantages and disadvantages. The sales force must be absolutely honest about the advantages of the subject project over the competition; most prospects will see through unfair or unrealistic comparisons, and this lack of forthrightness can negatively affect a close. The prospect also will be weighing the price and terms of purchasing against budget amounts or available resources. It’s difficult to influence the latter, as resources are either available or not; and if they’re not,

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it’s probably better to avoid wasting valuable time. In terms of the competition, however, pricing policy is important. If the subject project is lower in price, this aspect should be emphasized as a major advantage (for example, greatest value or major opportunities for appreciation). If it is more expensive, the salesperson should shift the emphasis to other features of the project (for example, location, design, amenities, or prior tenants or buyers). If the price or rental rate is still an obstacle to closing, the salesperson should be flexible enough to make some adjustments. This is best accomplished by adding features within established company policy. For example, a salesperson in a single-family project might throw in more expensive carpeting or a washer-dryer, or in an apartment complex he or she could offer two months’ free rent. With business prospects, the opportunities for price concessions are even broader, including higher tenant finish allowances, purchase of an existing lease, rent moratoriums, more favorable lease terms, and so forth. Flexibility in pricing policy is important; however, pricing concessions should be considered closing tools, and they should not to be employed unless absolutely necessary. The final question on the prospect’s mental checklist is whether to act immediately. In some cases, necessity will force immediate action. In other situations, the salesperson or leasing agent must encourage a decision, and a variety of approaches often can be successful. If the project has developed sales or leasing momentum, fear of losing the unit or space to someone else can be exploited. Fear of external events, such as higher construction costs or higher interest rates, can also be effective in firming a close. The secret is to make certain that a prospect is sold on the property and then move decisively to elicit action. This action should always take the form of signing some type of agreement and accepting a monetary deposit from the prospect. If there is still some question on the prospect’s part, the deposit can be used to keep the space or unit off the market for a brief period until a final decision can be made. If this approach is taken, the salesperson must follow up firmly and conscientiously; otherwise, the prospect may have a change of heart.13 There also should be some type of follow-up after the close—a telephone call or personal note—thanking the purchaser or tenant for making the positive decision and extending a warm welcome to the project. 13 In some states, purchasers of residential units have a prescribed period (usually 48 to 72 hours) to rescind transactions.

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If the buyer or tenant is represented by a broker or agent, the exact nature of the agency relationship should be established early in the negotiation process, including the nature of his or her negotiating authority and the method and source of compensation. In some cases, however, the broker or agent will refuse to identify the principal,14 and the developer or owner must rely on the professional reputation of the individual or brokerage firm involved.

MONITORING PROGRESS The developer should establish a system to monitor the marketing program, which should be as simple as possible, generated frequently, and in the shortest possible turnaround time. Such a system has several elements: the first is the overall status of the marketing program versus original projections. Some examples of key quantitative measures are the exposure of the project (that is, traffic), the number of deposit receipts or lease deposits, the number of closings, and the number of move-ins. Procedures should be established to generate these data at their sources, preferably on a weekly basis. The data should be compared to original projections, and if actual experience is significantly under projections, action should be taken to discover the reasons and remedy any problems. The basic assumptions regarding the target market should be reevaluated continually. This can be accomplished by collecting data, again preferably on a weekly basis, on the composition of the sales or leasing traffic. The sales or leasing log will furnish part of the data (for example, geographic location of the purchaser or business affiliation of a new tenant). The sales force or leasing agents also can make notes after the prospect has left regarding age, family size, type of business, reasons for purchase or lease, features found attractive, and other pertinent observations. If the traffic generated differs significantly from the target market, and sales or leases are not meeting projections, it may be necessary to reevaluate the marketing program. It’s also important to know how well the promotional program is operating. The cost of the program should be monitored and compared with original budget estimates. Prospects should be queried, through the log or verbally by sales or leasing personnel, as to how they found out about the project. If a considerable portion of traffic is being generated by 14 This is often true with foreign investors and major corporate tenants who do not wish to disclose their activities to competitors prematurely.

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a particular form of promotion, it may be desirable to allocate more of the budget to this area. The competition also should be monitored periodically. This can be accomplished by a shopping service or visits to the competing projects by the sales force. It’s also advisable to maintain a continuing log of ads and other promotional devices used by the competition in order to detect changes in marketing policy or particularly successful promotional efforts. A follow-up monitoring after move-in is also desirable. The purchasers or tenant can be interviewed a few weeks after occupancy to see if any problems have been discovered with the space or unit, as well as to discover which features have been found particularly attractive.15 Positive interviews also may be employed for promotional purposes if they are approved by the purchaser or tenant. In monitoring the success of the marketing program, the impact of external forces must be realistically assessed. If the economy has moved into a recession or high interest rates are being used to slow inflation, the entire market for the project may be affected. If these changes appear to have long-term consequences, it may be necessary to revise the original absorption projections and/or modify the marketing strategy.

15 In rental projects, this interview should be conducted by the property manager.

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C H A P T E R 20

Property Management

I cleaned the windows and I swept the floor And I polished up the handle of the big front door. Gilbert and Sullivan H.M.S. Pinafore

When construction is complete, the project is ready for occupancy. In a for-sale or build-to-suit project, such as single-family homes and tenantowned industrial buildings, the developer’s role is largely over; maintaining the facilities is primarily the responsibility of the new owners. In leased projects such as apartments, shopping centers, and office buildings, however, the developer may retain ownership of the facilities, sell the project to investors, or enter into a limited partnership or other joint ownership vehicle. In these situations, the developer and/or investor owners must have a systematic method of managing the property: keeping it in good repair, paying operating costs, answering tenant complaints, securing new tenants as vacancies occur, and generally doing whatever is possible to enhance the value of the property.

IMPORTANCE OF GOOD PROPERTY MANAGEMENT Many developers who are intensely involved in the planning, design, construction, and marketing aspects of real estate projects often prefer not to get involved in property management, although many of the same talents 489 Copyright © 2007 by John McMahan. Click here for terms of use.

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might make the difference between a successful and an unsuccessful project over the longer term. There are several reasons many developers avoid property management roles. Many developers are not long-term investors, preferring to cash out after they have successfully built and leased a project. Even developers who don’t cash out are often impatient with the operating problems of a completed project and prefer to leave property management to others. And yet probably no other area of real estate has a more pronounced and continuing impact on the success of a building project over the holding period. As an example, a 10 percent reduction in operating costs can improve cash flow by as much as 25 percent. In addition, a properly managed building can help secure a higher level of lease renewals, thereby reducing turnover, vacancy, and leasing costs. A well-maintained building also will prolong the physical life of its components, thereby reducing repair costs and replacement frequency. Finally, a well-maintained building generally will command a higher price when the building is sold, all other factors being equal.

TENANT RELATIONS One of the major changes in property management best practices over the last several years has been an evolving view of the tenant (legal term) from being a user of real estate “space” to being a “customer” (business term) of real estate “services.” This is much more than merely semantics—it represents a change in attitude on the part of the industry toward recognizing tenants as being the major source of income and cash flow over the holding period and fundamental to the ultimate financial success of an investment property. This shift in perspective was accelerated by the dot-com and telecom recession that began in mid-2000 and the reaction of building owners to the events of September 11, 2001. In addition, the continuing consolidation of ownership in the industry has placed greater emphasis on the use of branding to build strong customer allegiance, which can often make a difference in tenant retention during economic downturns. This makes common sense because real estate is the “residual” of other business activities. If the building is not serving the specific needs of tenants, ultimately those tenants will be lost to competing projects. As an example, the editor of Rent & Retain magazine maintains that roughly two-thirds of tenants are lost through a lack of personal contact.1

1 Journal of Property Management, September 1, 2002.

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As a result, more and more property owners are focusing on tenant relations as a way to enhance the bottom line. During the lease term, the manager should maintain contact on a regular basis, generally no less frequently than weekly for larger tenants and monthly for smaller ones. Special billings, promotional or advertising programs, and other such activities are best discussed in person to gain the support and understanding of the tenant. Retail projects frequently have tenant committees for advertising and promotion, and these meetings should be attended by the property manager. During this period, an important step in better understanding the tenant is to acquire a thorough knowledge of the customer’s business. Key questions that need to be addressed include the following: What is the customer’s core business(es)? What are the firm’s major products and/or services? ■ Who are its major competitors? ■ How are they organized? ■ Who are the key members of management? ■ What is the tenant’s financial status? ■ ■

In response to the last point, many landlords check a tenant’s financial status only when the original lease is negotiated, at the time of subsequent renegotiations, or when rent is in default. Unfortunately, problems may arise in the intervening period that may lead the tenant to look elsewhere for new space when the lease renewal comes up or, worse, declares bankruptcy along the way. By keeping in touch with tenants on a regular basis, the property manager will have a better idea of the current financial health of the tenant.2 Important information to keep track of includes the following: Revenue growth trends Expense trends ■ Overall profitability ■ Receivables aging ■ Quick ratios ■ Vendor credit experience ■ Credit ratings (if any) ■ Available cash resources ■ ■

It is also helpful to understand how susceptible the tenant’s business is to cyclical and/or seasonal change.

2 Many leases have covenants requiring the submission of periodic financial statements, but they are not always enforced.

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The effective property manager understands the relationship between good tenant relations and net operating income. Consistency, frequency, and quality of service are critical to the successful management of a real estate project.

LEASES The foundation of an effective property management program is a soundly conceived, equitable lease between landlord and tenant. This legal document, and the atmosphere in which it is negotiated, establishes the original contact between the parties and the basic framework for their continuing relationship. It also provides the final statement of rights should there be a dispute. In most cases, a well-drafted lease will encompass most of the rights and obligations of the parties. However, there is a wide range of judicial and statutory law that may limit permissible terms, aid in interpretation, or provide for given results in those cases in which a lease fails to deal with an issue. The relationship with the tenant begins during lease negotiations as he or she tours the physical premises. Upon occupancy, the manager should inspect the premises with the tenant to be sure that all tenant improvements have been provided as stated in the lease agreement. At this point, it’s a good idea to have the tenant sign a formal acceptance of premises notice stating that all terms of the lease are satisfactory or identify any that are not, so they can be remedied. Methods of Calculating Rent The amount of rent and the method of payment are important ingredients in any lease. There are several methods of calculating rent. Gross Leases Most apartment and office leases are gross leases, in which the landlord is responsible for most costs. The rent paid by the tenant may be a flat rate for the period of the lease, or it may step up or step down at a particular time during the lease term. In office leases, the gross lease has been modified to shift part of the costs to the tenant. An expense stop or base year is established with the tenant paying its proportionate share of increases in all or individually designated operating expenses. Generally, these costs are billed to the tenants monthly on an estimated basis and reconciled on an annual basis.

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Net Leases In a net lease, which is the type of lease generally utilized with retail and industrial properties, most of the operating costs are shifted to the tenant. The landlord may pay the operating costs and be reimbursed in full by the tenant, or the tenant may be directly responsible for paying taxes, insurance, maintenance, repairs, and improvements. Net leases most often are for relatively long periods of time with many tenants usually possessing strong credit ratings. The amount of rent also may be established as a percentage of the value of land and improvements. Percentage Clauses Many shopping center and hotel leases contain percentage rent clauses that gear the amount of rent paid to the operating success of the commercial venture. These clauses may be based on a percentage of the gross receipts, gross margin, or net profits. With hotel leases, the rent may be based on the level of room occupancy. The amount of rent is fixed on the basis of operating results for a specific period, generally a quarter or a year. The landlord usually has the right to inspect the tenant’s records and, if necessary, to audit operating results. Many leases provide for a base rental to be paid until such time as the percentage rent is greater. In essence, the base rental is absorbed into the percentage rent. The amount by which the percentage rent exceeds the base rental is known as overage. Escalation Clauses The double-digit inflation of the mid-1970s tended to decrease the real yield on leases, leading many landlords at that time to begin insisting on cost escalation clauses. An escalation clause adjusts the amount of rent paid by an indicator of change in monetary value. The most common indicators used for this purpose are the consumer price index and the wholesale commodity index, both maintained by the Department of Labor. Formulas for adjusting the rent are established in the lease; changes in the indicator are related to a base period, usually the first year of the lease. Reappraisal Clauses If the rent has been calculated on the basis of a percentage of property value, a clause may be inserted to adjust the property value at periodic intervals through reappraisal. One approach is for the tenant and landlord each to appoint an appraiser to determine a new property value; if they can’t agree, the appraisers appoint a third appraiser. Although the

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discussion may be acrimonious and the approach cumbersome, the clause protects the landlord, to some extent, against inflation.3 Lease Terms Types of Tenancies The duration of a lease is influenced by the type of tenancy. Generally, there are three basic types of leasehold tenancies, classified in terms of their manner of termination: Tenancies for a fixed or definitive term Tenancies for an indefinite term, subject to termination upon notice (tenancy “from month to month” or “from year to year”) ■ Tenancies for an indefinite period, subject to termination without notice (tenancy at will or tenancy by sufferance) ■ ■

If the tenant remains in the premises at the end of a fixed-term lease, a holdover tenancy situation is created. Holdover conditions generally are established in the lease or, if not, by statutory or common law. Generally, the landlord has the right to renew the lease or dispossess the tenant through specific means.4 If a considerable amount of time passes in which the landlord does not take action, the lease may be assumed to be renewed.5 In the case of tenancies for an indefinite term that are subject to termination, notice should be given early enough to allow the tenant to leave the premises in an orderly manner. Sufficient time generally is considered to be the period of tenancy: one week in a week-to-week tenancy, one month in a month-to-month tenancy. But in the case of year-to-year tenancy, the period is usually three to six months. Tenancies at will are not common; generally they arise when a lease does not conform to statutory law. A tenancy by sufferance occurs when the tenant’s original rights to occupancy have expired, as in the case of the holdover tenancy. Lease Renewals Lease renewal discussions are generally initiated between the tenant and property manager prior to the scheduled expiration date of the lease. The

3 This approach is more common in Europe, particularly the United Kingdom. 4 Most states provide an accelerated, or “summary,” procedure for removing tenants at the expiration of the term or in the event of a default. 5 The tenant’s position is considerably enhanced if the landlord has accepted rent from the tenant during the holdover period.

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tenant’s satisfaction with the service provided during the lease term can have a substantial impact on the decision to renew. Even if the owner directs negotiations through someone other than the property manager, the manager should participate in the negotiations. Figure 20-1 is a lease profile of a typical office building indicating lease turns for each tenant space over the following 10 years as well as whether it represents an original lease or a renewal option. Blank areas indicate space that is not leased. Renewal Options A fixed-term lease will expire at the end of the lease unless the parties have included a renewal clause. This clause generally gives the tenant the option to renew the lease, provided that the tenant has not been in default during the lease term and gives the landlord written notice within a prescribed period of time prior to termination. To be binding, a renewal clause should provide a formula for determining rent under the renewed lease. Option to Purchase Leases also may contain an option for the tenant to purchase the building during or at the end of the lease period. If it is to be enforced, the option price and purchase terms should be clearly spelled out in the lease or a specific method—such as appraisal—established to arrive at such terms. The tenant normally exercises the option by notifying the landlord in writing and placing the down payment in a purchase escrow.

FIGURE

20-1

Office building lease profile. 10 9 8

Leasable area Original lease Renewal options

7 Years

6 5 4 3 2 1 0 Square footage

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Right of First Refusal The lease also may give the tenant the right to match a purchase or lease offer received from a third party. The offer must be a bona fide offer and indicate price and purchase or lease terms. The tenant then has a period of time in which to match or refuse the offer. However, the landlord is not required to sell or lease to anyone. Tenants’ Rights and Obligations Possession When a lease is executed, a tenant has the right of possession to the property unless other arrangements have been mutually agreed upon. If, for some reason, the landlord prevents the tenant from gaining access to the property, the tenant may have the right to withhold rent and, in some situations, collect damages. Once the tenant secures possession, the landlord cannot occupy the premises or give the right to anyone else. Use of Property Unless the lease otherwise specifies, the tenant has full use of the property, subject to the terms of the lease, applicable zoning ordinances, and general provisions regarding nuisance and unlawful acts. Lease terms regarding use generally restrict the tenant to activities in line with the purpose for which it has been rented (for example, residential, retail business, or office commercial).6 The tenant, however, is usually prohibited from making major alterations to the property that will “injure or diminish the value of the landlord’s interest.” For example, a tenant cannot alter a building structurally or cut down shade trees without securing the landlord’s permission. Covenant of Quiet Enjoyment Most leases contain a provision that a tenant who pays rent and otherwise lives up to the terms of the lease will not have his or her possession disturbed by the landlord. The covenant normally also extends to claims by mortgagees and lien holders. If a tenant who meets the terms of the lease is evicted by the landlord, the tenant has a right to recover damages. If the tenant is evicted by a third party, however, the landlord is not responsible.

6 Over the years, use provisions in most leases have grown more restrictive.

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Repairs The tenant is generally required to “keep the premises in good repair.” Some leases require only that the tenant not damage the premises. Other leases specify that the tenant will make “all repairs not involving structural changes.” In the most common arrangements, the landlord makes “ordinary repairs,” and the tenant repairs flaws resulting from his or her neglect or misuse of the property (ordinary wear and tear excluded). If the tenant fails to make the required repairs, the landlord usually has the right to enter the property, make the repairs, and bill the tenant for the costs involved. In some situations, the landlord may also have the right to terminate the lease if the tenant fails to make the necessary repairs. Fixtures Equipment, machinery, partitions, shelves, and other fixtures usually can be removed by the tenant at the end of the lease. This provision is particularly true in the case of fixtures installed for the purpose of conducting a trade or business. If the tenant fails to remove the fixtures after giving up possession, the fixtures usually are deemed the property of the landlord. This also is true if the removal of the fixtures would substantially reduce the value of the property. Some leases provide that the tenant is obligated to remove certain fixtures if they are of little potential value to the next tenant. Dangerous Conditions Generally, a lease will place liability for dangerous or defective conditions on the party who is in possession and control of the property. In most cases, the tenant is this party, unless the landlord continues to control part of the property. If the condition existed prior to possession and is not brought to the tenant’s attention, the landlord may continue to be responsible. However, if the condition is pointed out to the tenant and no corrective action is taken, the tenant may be liable with no recourse against the landlord. If the landlord is responsible for making repairs to the property and fails to do so, the landlord may become liable to the tenant and any others injured. If the landlord makes repairs (whether required or not) in an improper or negligent manner, the landlord also may become liable. If a public nuisance is created on the property, both tenant and landlord may be liable. This is increasingly true regarding toxic or hazardous substances where lawsuits may be filed against all parties involved, particularly those deemed to have “deep pockets.”

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Assignment Some leases provide that a tenant can assign, or transfer, leasehold interests to a third party.7 In such cases, the lease will usually require that the assignee assume the full rights and obligations of the lease for the unexpired term and be directly liable to the original landlord. The original tenant, or assignor, also continues to be liable for performance under the lease, unless the landlord has signed a release. Subletting Leases also may allow the tenant to sublet all or part of the property to another tenant. A sublease differs from an assignment in that the original tenant becomes the landlord with regard to the space subleased and the subtenant becomes the lessee. As the sublessor, the original tenant has the right to reenter the property prior to expiration of the original lease. The sublessee has no more rights than those that were granted the sublessor in the original lease. The sublessee pays rent directly to the sublessor, who, in turn, pays the lessor. If the sublessee defaults, the sublessor can exercise all rights open to a landlord to collect the unpaid rent and/or legal damages. If the sublessor defaults, the lessor can evict both the sublessor and the sublessee. Security Deposits It’s customary in most leasing situations to require a security deposit; the amount generally is equivalent to 1 to 2 months’ rent on short-term leases and as much as a year’s rent on long-term leases. The deposit may be held by the landlord or placed in trust, with interest accruing to the tenant. If the tenant meets all the obligations under the lease, the deposit is returned at the expiration of the lease period. If default occurs, the landlord may use the deposit to cover any damages. In highly competitive leasing situations, tenants with strong credit may negotiate a waiver of the security deposit. Sale of Property If the leased property is sold, the tenant retains all rights existing under the lease. The tenant simply begins making payments to the new landlord and otherwise continues to possess and utilize the property.

7 Since assignment can materially change the creditworthiness of the lease, most landlords require written approval of the new assignee.

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RENTAL INCOME As noted in Figure 20-1, after paying for building operating costs, an average of 70 percent of the gross revenue flows to the owner of the property to cover debt service and equity return. The control and enhancement of rental income is therefore a major key in the success of the typical income property.

Scheduled Rental Income Chapter 19 discussed many aspects of marketing rental space. One of property management’s continuing functions is to maintain an up-to-date gross rental schedule indicating the asking price for the units of space. This gross rental schedule should be based on the original rental projections, adjusted for changes in market conditions, increases owing to escalation clauses, and changes in marketing policy. As much as possible, variations in rent between units or space should reflect reasonable differences in value: unit or space configuration, location within the building, space or unit amenities, and the presence or absence of views. Maintaining a gross rental schedule, even in buildings with longterm leases, provides a current view of the scheduled income that the building should produce. In buildings with tenant turnover, the gross rental schedule provides an up-to-date pricing list for marketing purposes. Lease terms should be examined continually to be certain the maximum amount of rent possible under the lease is being billed.

Effective Rental Income Schedule The property manager should also maintain an effective rental schedule with the gross rental schedule adjusted for any tenant concessions that have been made. The effective rental schedule should explain the nature of the concession, who extended it, and its date of expiration. This schedule should be considered a confidential document that is not for outside view. It should be updated as frequently as the gross rental schedule. The effective rental schedule can help the property manager assess leasing performance. The overall strategy should be to reduce or eliminate concessions in new leases as the building nears 100 percent occupancy. The degree to which this is accomplished is indicated to some extent by the percentage spread between gross scheduled income and effective income for the space leased to date. If this gap is not narrowing, it may

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mean that leasing personnel are still extending concessions that may no longer be necessary. The nature of the concession should be continually reviewed in light of its effectiveness in leasing space. Billing and Collections The first step in collecting rents is to send the tenant a prompt, accurate billing. The billing should be based on the effective rental schedule, including all concessions, expense prorations, and escalation adjustments. Keeping these items absolutely current not only improves cash flow but also helps maintain good tenant relations. It can be exasperating for a tenant to be billed for an expense that occurred several months earlier. Most tenants will pay their bills promptly, making further action unnecessary. Some will not, however, and the manner in which a property manager handles extended collections may be critical in securing the monies owed while retaining tenant goodwill. A follow-up reminder should be sent if the bill is not paid within 5 days. If the bill is not paid within 10 days, a telephone call or, preferably, personal visit should be made to the tenant, inquiring whether there are any problems with the payment. This personal touch, expensive as it may seem, will pay large dividends in terms of good tenant relations. If the tenant’s reason for delay is valid and the past record has been good, an extension to a firm date in the near future should be granted. If the manager has had little prior experience with the tenant’s payment record, the manager must assess the tenant’s overall creditworthiness and the probability of payment within an extension period. If the payment extension date arrives and the rent still hasn’t been paid, a follow-up phone call should be made. If the check doesn’t arrive within 24 hours after this phone call, future extensions should not be considered unless there are highly extenuating circumstances. At this point, unfortunately, informal persuasion may have proven ineffective, and stronger action is required. A letter should be sent immediately, indicating the amount due and the legal steps that will be taken if the amount is not paid right away.8 If a security deposit is involved, reference should be made to the fact that the deposit will be debited for the amount owed and that a replacement deposit will be required. If the letter does not bring immediate results, it’s time to turn the account over to an attorney or collection agency. If the tenant has a record 8 It’s often wise to send a copy of this letter to legal counsel, with a notation to this effect.

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of collection problems in the past, it may be best to proceed with eviction. Recurring collection problems can only dissipate management time and resources, and unless the market is extremely soft, it may be better to evict the problem tenant. The collection procedure outlined above is based on three premises: A punctual, accurate billing system An informal but firm procedure of handling delayed payments ■ Immediate legal action if the informal procedures are not successful ■ ■

Some property managers immediately move to threats of legal action, but these often prove hollow, destroying the credibility of the collection system. It’s much better to work with the tenants if they have problems and only move to strong collection procedures after all else has failed. Once the move has been made, however, it should be swift and final.

OPERATING EXPENSES Figure 20-2 summarizes the various operating expenses associated with a typical office building that, in most cases, amount to approximately 30 percent of total revenue. It’s important to note that, while some of these expenses may vary with occupancy, for all practical purposes they are relatively “fixed” when the building is largely occupied. This means that there is much less flexibility in reducing expenses than there is in other types of business operations. This also implies that, given a finite amount of management time, it may be more productive to focus on attracting new tenants and other forms of revenue enhancement than cost reduction in order to increase overall building income.

FIGURE

20-2

Breakdown of building operating costs.

Revenue

Trash Security Replacement Repair & maintenance Landscaping

Real estate Utilities Insurance Janitorial Property management

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In the following pages, each category of operating expense is discussed in roughly the order of the percent of total expenses it represents. The focus is on the ability of the building owner and property manager to control each cost category. Real Estate Taxes Real estate tax generally is the largest item of the operating expenses and unfortunately the least controllable. However, the property manager can do a few, limited things to try to keep taxes as low as possible. The manager should support lobbying efforts against property tax rate increases. Unless faced with a strong property lobby, local governmental jurisdictions will probably not seek other methods of raising public revenue. Another possible action is to protest any assessment increases. Many property owners believe that assessments are established in a uniform, systematic manner. This is not always the case; often, significant differences exist between similar pieces of property. If the property owner has a strong case against an assessment increase, direct relief may be possible. Even if the case is not strong, sustained resistance by property owners will tend to keep the assessments lower and more in line with actual property values. If all or a portion of property taxes are to be passed on to tenants, the amount should be billed concurrently with the receipt of the tax bill. This at least tends to reduce the cash drain created by the property tax payment. It’s also desirable to notify tenants in advance of any anticipated increase in property taxes and if possible, secure their support in trying to head off the increase. Utilities Certain utility costs are incurred regardless of the occupancy level of the building. Lighting must be maintained; power must be available to operate elevators, air-conditioning condensers and fans, and other service facilities; water is necessary for plumbing, irrigation, and maintenance of common areas; and removal of refuse from common areas is also a basic requirement. It is hard to control the costs of basic utilities because they are usually provided by monopolistic enterprises whose rates are established by public regulatory agencies. In some cases, however, preferential rates based on usage are available and should be explored.

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Energy-saving lighting fixtures and improvements to the HVAC system should be investigated to determine if energy consumption can be reduced. With office and industrial buildings, consideration also should be given to shutting off basic utilities at certain times, such as the late evening and weekends. Care must be taken, however, that the overall level of service is not affected, as the cost of tenant dissatisfaction may more than offset any possible utility savings. Landlord-Paid Utilities In buildings where the landlord pays for tenant utilities, steps should be taken to minimize their use whenever possible. It may help, for example, to make the cleaning crews responsible for turning out lights in tenant areas after they’re finished. It may be possible to turn off heat and airconditioning at certain times when the tenant space isn’t occupied. This, of course, has to be weighed against the start-up costs of heating or cooling the space when it is reoccupied. Tenant-Paid Utilities In buildings where utilities are paid by the tenant, the specific utility should be submetered wherever possible; this reduces the possibility of misunderstandings between manager and tenant. If submetering is not possible, a method of cost allocation should be established in the lease, based on some rational standard (for example, square footage, lighting and power outlets, or air-conditioning zones). If this was not provided for in the original lease, a memorandum of understanding should be prepared and circulated among the tenants.

Insurance Several types of insurance should be maintained as an integral part of managing a building. Property Insurance The most common type of insurance is fire and casualty coverage on the building, generally required in an amount equal to 80 percent of the replacement cost of the building. Many owners, however, now carry insurance at full replacement cost because reconstruction may occur under more stringent building codes and/or involve higher building costs. An annual review of the amount of property insurance carried is wise in order to be certain that it is sufficient.

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Rental Income Insurance It also is common to carry loss of rental income insurance to cover the period during which rental income abates because of destruction of or damage to a building located in areas where specific hazards exist (for example, floods, tornadoes, or earthquakes). Public Liability Insurance This type of insurance is also usually considered to be required for most buildings. The coverage should be reviewed periodically to be certain that major risks are covered and that the amount is commensurate with recent court rulings. It also may be wise to insure against liability claims from the failure of specific components in the building; examples of such coverage are plate glass insurance as well as boiler and machinery insurance. Theft and Vandalism Insurance This type of insurance is usually considered a good idea if the building is located in an area with a high incidence of crime. A collection agent, if used, should be bonded. Insurance costs should be kept as low as possible. One way to do this is to remove or modify any hazards connected with the building that might affect insurance ratings. If costs are involved in making these modifications, they must be weighed against resultant premium reductions. Another way is to shop around for insurance coverage. Property managers often get locked into one insurance agent or company, unaware that they may be paying higher premiums than necessary or getting improper coverage. The insurance agent should be asked to submit the insurance program to several companies each time it comes up for renewal.9 If the agent refuses, a new one should be considered. Janitorial Expenses The most frequent janitorial work involves vacuuming carpets; washing floors and windows; cleaning around waste receptacle areas; and hosing off exterior walkways, driveways, and parking areas. In larger properties, some or all of these activities may be performed by building employees or by a mix of employees and custodial contractors. In medium and smaller buildings, the work is done mostly by contractors who specialize in one or more functional areas. Some large maintenance companies provide all or most of the necessary services. 9 This is a lot easier to accomplish if the program is handled by an independent agent.

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Cleaning of Tenant Areas The cost of cleaning tenant areas under a new lease should be based on an equitable proration, generally the square footage involved. With gross leases, cleaning costs can be controlled by scheduling the day and hour of cleaning to follow the period of most intensive tenant usage. In office buildings, for instance, this most often is in the evening, at midweek, and possibly on weekends. With retail facilities, it may be on Sunday or after evening shopping. Whether to use an internal staff or to contract for outside janitorial services depends on the size of project, potential utilization of the staff on other projects, and the frequency of cleaning required. In most cases, a detailed specification of duties to be performed and the frequency of performance is a must. Generally, these decisions are made by the property manager whose on-site knowledge of the building, its tenants, and continuing relationship with local market contractors is essential to a successful, yet cost-conscious operation. The frequency of janitorial work is usually a decision of the property manager and is often a balancing act between costs and tenant complaints. A building owner doesn’t want to invite tenant complaints but also is aware that custodial maintenance can be costly and is one of the few operating costs that can be reduced through less frequent use. Generally, it takes some time and experimentation to discover the right balance.10 Trash Removal Removal of tenant-generated trash should be undertaken periodically, preferably from a central trash collection area. Tenants should be informed when trash will be collected and where it should be placed for removal. Services for special situations, such as move-ins, move-outs, and parties, should be available. Property Management Building Office Expenses Certain fixed costs are associated with maintaining an office of the building. These usually consist of salaries for a building manager or

10 Building maintenance is also a highly competitive industry in which vendors fight to obtain and keep the business. Contract bidding can be a very effective tool in reducing operating costs, provided quality of services is not severely compromised.

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superintendent, bookkeeper, secretary, receptionist, as well as incidental expenses such as office furniture, telephone, and office supplies. These costs should be analyzed and controlled on a case-by-case basis, depending on the size and image of the project, the ability to spread costs across several projects, and the strength of the rental market. Legal and Accounting Expenses Most buildings have some continuing legal and accounting expenses. Legal services may be required for lease preparation and review, rent collection, and litigation Accountants are involved in preparing and reviewing operating statements, tax returns, and specialized analytical functions. The best way to control these services is to establish a minimum retainer amount to handle day-to-day items as they arise, providing more extensive services only on approval of the property manager. Public Relations Expenses A continuing budget for public relations may be advantageous, especially if the project is large and has an extended absorption period (Figure 20-3). Such a program should emphasize the overall image of the project, for instance through newspaper and magazine articles

FIGURE

20-3

Many developers, such as the Irvine Company, financially assist merchant tenants with their advertising programs. (The Irvine Company)

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related to testimonials by satisfied tenants, description of special promotions, and announcements of new building services or features. A newsletter also can be effective in this regard. Maintenance Regular Maintenance The proper maintenance of an investment property is probably the most important ongoing concern to tenants and the most common complaint that they have about their building environment. This applies not only to the space they lease but to common areas such as hallways and building lobbies as well as exterior facilities such as parking structures, pathways, recreational facilities, and landscaped areas. This is particularly true with retail tenants because their lifeblood— shoppers—may be the first to complain about a center’s appearance. Or worse yet, they may simply not return. Maintenance concerns range from routine custodial maintenance to longer-term preventive maintenance to facilitate operations and avoid costly repairs. Tenant Maintenance Maintenance of tenant areas may involve a wide variety of services: plumbing, electricity, air-conditioning, heating, painting, and repairs. Again, it’s important to determine which calls will be handled internally and which will be contracted on the outside. Generally, it’s best if the building superintendent makes this decision only after responding to a tenant’s call. Many maintenance items are minor and can be handled by the superintendent or internal maintenance personnel. Outside contractors are expensive and should be called only if their services are absolutely necessary. When using outside contractors, a single contractor in each trade should be responsible for each type of repair. Thus, the contractor becomes familiar with the building, which reduces the service time and resultant costs. Common Area Maintenance (CAM) The common areas of the building should be kept in a presentable condition, regardless of occupancy.11 The lobby and corridors must be cleaned, landscaped and parking areas maintained, windows washed, and elevators

11 This applies most commonly to shopping centers.

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and air-conditioning serviced. Maintenance expenses for common areas can be controlled only by careful, continual analysis of the nature of the service and how it should be provided. A key question is whether to hire internal personnel to perform the service or to use outside contractors. This generally depends on the size of the project and the frequency of the maintenance service. For example, a project with extensive landscaping may require a full-time gardener; a large office building may call for a full-time janitor. Preventative Maintenance Under the heading of “ounce of prevention” management best practices is the scheduling of periodic maintenance surveys of all properties. The objective is to extend the operating life of the building components and equipment as well as avoid the higher costs of nonscheduled, often emergency maintenance. Preventative maintenance may involve the shutting down of equipment while it is being tested or, at a minimum, turning off power for a period of time. For these reasons, preventative maintenance should be scheduled with tenants as far in advance as possible. Corrective Maintenance Although many maintenance problems can be avoided through systematic custodial and preventative maintenance programs, there always will be situations in which tenants complain about a maintenance problem. It’s important that the property manager responds quickly and effectively to these requests. The traditional way that property managers have responded to corrective maintenance requests has been through telephones, pagers, and answering machines. In recent years, however, technology has dramatically improved response time. The first technology that contributed to this improvement was e-mail, which has allowed property managers to respond systematically to service requests without being interrupted by a ringing phone (which they may not have time to answer). Tenants also like e-mail because it enables them to send out messages at times other than business hours, which is helpful because emergencies can occur at any time including weekends, as many offices have evolved into a 24/7 work routine. More recently, some property owners and managers, particularly those with larger properties or portfolios, have begun to utilize the Internet to solve the tenant-manager communication problem. One building owner

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found that the time needed to submit a service request over the Internet was one-third the time it took to make such requests by telephone or in person.12 This building owner also found that there were fewer mistakes and misunderstandings when the tenants described the problems in e-mail versus in telephone conversations. Perhaps the most powerful benefit of the Internet handling of service requests, however, has been the “connecting” of the customer directly to the person who completes and satisfies the service request, thereby reducing the number of “information handlers.” One of the reasons for this benefit is that the system creates a mutual information dependency between the tenant and the person who performs the work. Because tenants have direct access to the completion information, there is a heightened accountability among employees of the property management company. Overall, the use of the Internet appears to have empowered tenants and employees while reducing dependency on others to support the information flow. Procurement of Building Supplies Generally contractors providing maintenance services take responsibility for supplies they use, so the property manager is responsible only for purchasing and storing other maintenance supplies or equipment that might be required. The property manager has considerable influence, however, over the quality of supplies selected by the contractor, and this usually is a part of the periodic contract negotiation between the parties. Marketing These costs are associated with leasing the building and keeping it occupied. Examples include leasing commissions, advertising, and promotions. Commissions Most brokerage agreements also cover commissions for leasing activities after the building is in operation. These activities include securing new tenants for unoccupied space, subleasing by existing tenants, and lease renewals. Commissions for subleases and renewals generally are at a lower rate than new leases. In cases in which a broker is serving as property

12 Reported experience of Boston Properties over three-year period ending April 29, 2002.

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manager, there may be no commissions—the owner pays a single fee for both marketing and management. Since commissions are paid only upon performance, there is little need to worry about controlling costs once the brokerage or property management contract has been negotiated. The funding of commissions, however, may be important in securing better broker performance and improving cash flow. Generally, in commercial leasing agreements, one-half of the commission is due when the lease is executed and the balance when the tenant takes occupancy and accepts the premises. Another method that is sometimes used is to prorate the brokerage commission over the term of the lease, paying only if the lessee makes rental payments satisfactorily. This is used in situations in which the credit of the tenant is questionable and default a possibility. Another approach, less harsh on the broker, withholds a percentage of the commission (usually 20 to 50 percent), which is distributed each year as lease performance is realized. This approach works particularly well if the brokerage firm is also the property manager. Advertising The advertising budget for a building is generally higher during the leaseup period and drops to a maintenance budget once a satisfactory level of occupancy has been attained. In some situations, particularly those involving long-term leases, it may be possible to drop the advertising budget altogether. Another approach is to shift the emphasis of the advertising from leasing space to maintaining the image of the building. This may help to secure higher rents upon renewal and possibly a higher price, if the building is sold. In the case of retail and transient commercial facilities, the building owner may help tenants carry the costs of their business advertising. This is particularly true with shopping centers, where as much as 20 to 30 percent of the tenant’s advertising costs may be paid by the center owner. Generally, arrangements such as these are established in the lease or by operating memorandum. In some cases, the center owner may advertise independently in order to increase overall patronage. Promotions Special promotions may be used to supplement or, in come cases, replace advertising once a building project has been substantially leased. These promotions may range from pen sets and other mementos to art shows and musical entertainment. Some shopping centers have set aside space for meetings, exhibitions, dances, and other community events.

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Special promotions also may be employed in fixed-lease projects, such as apartments and office buildings, to maintain good tenant relations. Examples include free theater tickets, discount on travel, and holiday parties. Security Since the events of September 11, 2001, billions of dollars and manhours have been invested in trying to prevent another terrorist attack or at least enable us to deal with the aftermath more effectively should another attack occur. As of this writing, the United States hasn’t had another attack within our own shores, so as a result of those efforts, we have perhaps made some progress in deterring terrorists from striking us again on our own soil. However, the indications are that although we are better prepared should another attack occur, we are not yet fully prepared. In fact, the 2005 hurricane disasters in the Gulf of Mexico region have led to some concerns that we’re not even well prepared for a catastrophe for which we’ve had some advance warning. There has, however, been some progress. Today, there is better information sharing among governmental agencies and the private sector, particularly in the real estate community because, after the loss of human life, property value is the next major casualty in any catastrophic loss. For property managers, the security and protection of buildings and their occupants is a vital and growing part of their direct management responsibilities.

CAPITAL IMPROVEMENTS Periodic allocations should be made from the revenue stream to a replacement reserve account to cover capital improvements that will be required as various parts of the building wear out. Examples include the following: Exterior repainting: 3 to 5 years New carpeting: 7 to 10 years ■ Replacement of boiler or air-conditioning condenser: 12 to 15 years ■ Replacement of elevators: 17 to 20 years ■ ■

These costs are over and above normal maintenance and parts replacement and may require heavy outlays of capital. In theory, capital improvements of this nature should be covered by charges to building depreciation. The problem is that depreciation has been so distorted by tax policy that it no longer applies to funding capital improvements. Furthermore, many building owners consider depreciation

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as an important ingredient in cash flow, often spending or reinvesting it as it is generated. It’s necessary, therefore, to set aside an amount each period as a reserve against future capital expenditures. The amount of this replacement reserve can be determined by estimating the physical life of various building components, establishing a cost of replacement (adjusted for anticipated inflation), and prorating the replacement cost over the physical life. These allowances should be funded in an interest-bearing account as they are generated, and they should not be used for other purposes. Continuing maintenance is extremely important in order to avoid capital replacement earlier than necessary. Unfortunately, many property managers postpone maintenance and parts replacement so as to show better near-term operating profits. This can pose serious problems, especially if the problem is compounded by insufficient replacement reserves. Therefore, the owner must be certain that good maintenance practices are followed, even though they may depress current operating results.

CONSTRUCTION MANAGEMENT Tenant Space Repairs The property manager generally has responsibility for tenant space repairs and improvements. The property manager is also involved in answering questions posed by tenants regarding scope of the project, current status, and anticipated completion date. Tenant Space Build-Outs The property manager also takes a major role in customer space build-outs because he or she is responsible for making sure that new tenants’ needs are successfully fulfilled. This may include attending meetings with the space planner, engaging in ongoing discussions with the tenants, and maintaining a current knowledge of the progress of the project, including any negative budget variances. New Construction The property manager also may be responsible for new construction such as freestanding pads, additions to in-line shops, new signage, landscaping or parking improvements, and on- and off-site utilities. This may include hiring and supervising the project designer and contractor(s), subject to the owner’s approval. Larger construction projects may be handled by a staff construction manager or an outside contractor or architect.

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SECURITY-RELATED IMPROVEMENTS While there is usually some advance warning about natural disasters, there is little or no warning about a spectrum of security issues ranging from petty crime to a terrorist attack. The major response, therefore, is prevention—often referred to as hardening the site. Prevention can take many forms. For new buildings (and those that can be redesigned), architects and engineers are working on ways to design buildings and building features to withstand terrorist attacks and other disasters. As an example, some new high-rise buildings (particularly in Asia) are designed with special intermittent floors as assembly evacuation areas to protect victims from fire and smoke inhalation until help can arrive. For most buildings, however, the property manager must deal with existing conditions and try to modify the building in the following areas. Property Line At the property line, fences and gates should be designed and installed so as to withstand a breach when the building is not occupied or if the system is breached, to set off an alarm that alerts security personnel. Landscaping Landscaping should be designed to provide a full field of vision for human as well as remote camera surveillance. It also is important that the landscape plan avoids creating areas that might shelter a potential intruder. Lighting can be utilized to not only provide illumination but also eliminate dark areas where someone might hide. Protection for tenants or visitors is also a major concern, particularly along pedestrian walkways and in parking lots and structures. This is of particular concern in shopping centers, industrial parks, and multifamily projects. Exterior of the Building The next line of defense consists of the walls and roof of the building as well as areas of potential human penetration such as windows and doors. While the defenses at the property line are meant to be as unobtrusive as possible, on the building’s exterior they are expected to be obvious, in the hope that they will become additional deterrents to criminal behavior. As an example, walls and roofs can be designed not only to better withstand natural disasters but also to deter intruders who are intent upon entering the building by cutting or jack-hammering the building surface.

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More likely is unapproved entry through skylights, windows, and doors. Skylights and other penetrations in the roof can be secured by locks, making certain that they can be opened from within to permit exiting in times of emergency.13 Unauthorized entry through windows can be deterred by reinforcing window frames, installing shatterproof glass, and utilizing window locks. There are several ways to “harden” doors against unauthorized entry. Locks should be a dead-bolt type to make them difficult to pick. Hollow core doors should be replaced with metal or solid wood doors with attached metal plates. Door frames can be reinforced with metal. Interior of the Building Despite defenses at the property line and the exterior of the building, the working assumption should be that these can be penetrated and that there should be a level of protection inside the building as well. Here, the objective is to detect the intruder or, failing this, at least to prevent her or him from having access to anything of great value. Detection is accomplished by the use of motion or infrared detectors, which alert security personnel or activate a closed-circuit television recorder. Access to sensitive material is thwarted by dead-bolt locks on doors. In open office areas, desks and files should have pick-proof locks. Mail Delivery The use of the mails for terrorist activity was seen a few years ago when anthrax was delivered to congressional and other office buildings. More recently, mailrooms and mail refuse areas have been the focus of efforts to steal monetary and corporate secrets. To some extent, mailrooms can be secured by having an access control system (both doors and windows) that restricts access to approved personnel and provides detection capabilities during periods when the mailroom is unattended. Undelivered, certified, or registered mail, as well as money, should be stored in locked cabinets when the mailroom is unattended. Suspicious packages are of particular concern and can be identified by being different from other packages in terms of weight, shape, size, or smell. Unfortunately, today’s bomb makers are more sophisticated and can disguise bombs to fit into smaller packages or even envelopes to be 13 Unfortunately, in the September 11th terrorist attack on the World Trade Center, access to the roof was blocked to those trying to exit to the roof.

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triggered remotely by electronic devices in the package. More than ever, vigilance is the watchword in mailrooms and throughout the building and its grounds.

DISASTER PLANNING Prior to the Oklahoma City bombings, September 11, and Hurricane Katrina, property managers were primarily concerned with day-to-day management and maintenance of properties under their control. While this accountability is still in place, the primary focus of protection efforts has shifted from protecting physical property to protecting tenants and customers in the building. As a result, property managers face new, more demanding responsibilities in preserving the human lives of those working, shopping, or living in their buildings. Fortunately, there are several major lessons that we have learned from the natural and manmade disasters that have befallen our country in the last five years. Building Owner’s Responsibilities The recent experience with hurricanes in the Gulf of Mexico has driven home the fact that building owners and managers have an inescapable responsibility for the personal safety of their tenants as well as the protection of the physical assets under their management. If property owners don’t do the planning necessary to deal with a disaster, the properties and tenants under their care will suffer and the property owners may be responsible, if not legally at least morally, for a sizeable portion of adverse consequences. This means that it is necessary to internalize this fact of life and then move on to develop an emergency response plan before the next disaster strikes.14 Multiple Contingencies One of the emerging lessons of recent catastrophes is that we are a highly interdependent society and a breakdown in one area can quickly lead to a

14 Not having a disaster plan also probably increases the chances of being on the receiving end of adverse litigation.

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breakdown in another. This means that every conceivable major adverse event must be identified and planned for in advance. As an example, who could have anticipated that there would be looting after Hurricane Katrina or that Americans would shoot at helicopters coming to the rescue of their fellow countrymen? Or that the New York firefighter’s response of running up the stairway of a burning World Trade Center (as they had been trained to do) would conflict with civilians trying to escape down the same stairway? The old adage of “whatever can go wrong, will” is certainly true in a disaster setting, but it is compounded by the breakdown of life safety systems that have traditionally been relied upon. Owners and property managers have to rethink the planning process, continually questioning traditional response theories and asking over and over, “What if this breaks down or fails to materialize?” Proceed Independently There is no question that public agencies at all levels of government and responsible parties in the private sector have learned a lot from recent disasters about how to respond quickly and effectively and also how to avoid many of the mistakes of the past. It is incumbent upon, and in the self-interest of, property owners to support these efforts, both financially and in terms of time and political support. Building emergency plans should tie into and work with public agencies in this effort, but it is also wise to have contingency plans in the event that there is a breakdown in the public response process. Practice Makes Perfect One of the emerging lessons of recent disasters is that “stuff happens” in the chaos that occurs during and after a disaster that is difficult to anticipate and it’s better to expect the worst and plan for it than to experience it and discover you are not prepared. This means drills and more drills in anticipation of not having to use the experience of any of them but gaining a little more knowledge from each of them. (Again, the time to ask the what-if questions is before the disaster, not after.) Insurance Coverage It’s not clear at this writing how insurance claims from recent disasters will be handled or, if necessary, adjudicated by the courts. Suffice it to say,

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it’s time for property owners to have sufficient insurance to cover major property and liability risks and be prepared to self-insure for major deficiencies. In selecting an insurance carrier, it’s also important to take a look at the company’s existing risk exposure profile and experience in paying claims fairly and expeditiously. A good test is the size and experience of the internal team the company has established to respond to a large number of simultaneous claims. If the company doesn’t have such a team, it might be wise to consider moving the policy to a firm that does. In the case of a large building or a portfolio of buildings, it may be wise to spread insurance coverage over several carriers, in order to minimize the risk of loss exposure to any one carrier. This is particularly true if the portfolio is located in one or a few geographical areas where the risk of loss is concentrated. In the case of national or regional building portfolios, the risk of loss is geographically diversified, and a large carrier may be the best alternative both in terms of risk coverage and premium expense. Newly acquired properties also can be added to the portfolio without having to review risk issues with each acquisition. Self-insurance also is an option not only due to necessity but also as a measure to reduce insurance premiums. It’s also desirable to have analytical programs that continually weigh the trade-off between making and buying insurance coverage.

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APPENDIX

The Appraisal Process

DEFINITION OF APPRAISAL The major U.S. appraisal professional organization, the Appraisal Institute, has defined an appraisal in the following way: A professional appraiser’s opinion of value. The preparation of an appraisal involves research into appropriate market areas; the assembly and analysis of information pertinent to a property; and the knowledge, experience and professional judgment of the appraiser.1

DEFINITION OF MARKET VALUE Appraisers are usually called upon to estimate “market value.” Unfortunately, there is no uniform definition of market value as applied to real estate. Sometimes, other “values” such as insurable value, investment value, assessed value, and so on are provided by appraisers. Some economists believe that the value of a property is synonymous with market price, assuming that the price was reached under competitive conditions. Other economists feel that a property has an “intrinsic value” that may vary from the current meaning of value. Still other observers qualify the motives of the buyer and the seller. This approach stresses that a property’s value may vary depending on whether it is to be sold quickly, held for speculation, or developed. The Uniform Standards of Professional Appraisal Practice (USPAP) is the generally accepted standard for professional appraisal practice in 1 Appraisal Institute Web site, January 2007, www.appraisalinstitute.org. 519 Copyright © 2007 by John McMahan. Click here for terms of use.

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North America. USPAP contains standards for all types of appraisals including real estate, personal property, business, and mass appraisals. In 1989, recognizing the wide variety of definitions of market value, Congress passed the Financial Institutions Reform, Recovery and Enforcement Act, which recognizes USPAP as the generally accepted appraisal standard and requires USPAP compliance for appraisals related to real property appraisal, real property appraisal consulting, mass appraisal, personal property appraisal, and business and intangible property appraisal. This requirement applies to federal transactions; State Appraiser Certification and Licensing Boards; and federal, state, and local agencies. Appraisal trade associations also require compliance with USPAP. The USPAP and the Appraisal Process were developed by the Appraisal Foundation to aid appraisers, students, regulators, and others seeking to understand the relationship between the requirements of the USPAP and the appraisal process. The report summarizes the development and reporting requirements for each of the disciplines and assignment types covered by the standards. In its report, the Appraisal Foundation defines market value as follows: The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.

Implicit in this definition are the consummation of the sale as of a specified date and the passing of title from seller to buyer under the following conditions: 1. Buyer and seller are motivated. 2. Both parties are well informed or well advised, and acting in what they consider their own best interests. 3. A reasonable time is allowed for exposure in the open market. 4. Payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.2 2 Office of the Comptroller of the Currency, 12 CFR Part 34, Subpart C, 34.42(f), August 24, 1990. This definition is compatible with the definition of market value contained in the Dictionary of Real Estate Appraisal, 2d ed., and the Uniform Standards of Professional Appraisal Practice, 1992 ed., adopted by the Appraisal Standards Board of the Appraisal Foundation. This definition is also compatible with the Office of Thrift Supervision (OTS), Resolution Trust Corporation (RTC), Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the Board of Governors of the Federal Reserve System definitions of market value.

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The purpose of this Appendix is not to add further definitions of value but rather to inform the reader briefly about how professional appraisers estimate value, to point out certain problems and weaknesses with the traditional approach, and to discuss several techniques that offer promise in resolving these problems.

THE TRADITIONAL APPROACH It’s important to understand at the outset that an appraisal is not an exact determination of value but an estimate, derived from a logical evaluation of observable facts, of the probable value of property. This logical evaluation traditionally involves at least seven major steps: 1. 2. 3. 4. 5. 6. 7.

Identification of the property Establishment of the purpose and intended use of the appraisal Formulation of a plan to attack the problem Collection and preliminary analysis of the data Highest-and-best-use analysis Estimate of land value, independent of any improvements Application of the appropriate valuation approaches to estimating the value of both land and improvements

Based on information developed from these seven steps, the appraiser arrives at a single estimate of value. Each of these steps is discussed below. Identification of the Property and Definition of the Problem The first step in the traditional appraisal process is to define the problem. The subject property must be identified as to address location, assessor’s parcel number (APN), size, configuration, topography, and any other distinguishing characteristics, including when necessary for clarity, a metes and bounds (legal) description of the land. The “bundle of legal rights” to the property must also be specified. These rights might include fee simple ownership of both land and improvements, but if they do not, the structures and land might need to be dealt with separately. Zoning and other development controls affecting the subject property also should be identified. Because both physical and economic factors change with time and affect the value of the property, the effective date of the appraisal also should be identified.

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Since the appraisal establishes a “benchmark” of value for a particular decision, the appraiser must know and clearly understand the reason that the client wants the appraisal prepared. This objective will determine the definition of the value to be appraised—usually market value but possibly insurable, loan, rental, or merger value. These questions must be resolved at the beginning of the process because the nature of the problem or the value to be estimated dictates the methodology to be used. Purpose and Use of the Appraisal The purpose and use of the appraisal should be stated. The purpose is generally to estimate market value. There can be a variety of uses for the appraisal such as a sale, gift of interests, taxation, purchase, or mortgage financing. As stated above, the intended use of the appraisal is absolutely key in guiding an appraiser in determining the scope of the appraisal. Formulation of the Plan Next, the appraiser develops a plan to attack the provision of the value defined for the use articulated (referred to as the scope of the appraisal), outlining the procedures to be followed and the content of the report. The type of property and the use of the appraisal determine the data that will be required and, usually, the sources of those data. Data Collection and Analysis Data collection and analysis make up a very important part of the appraisal process. The output, or the appraised value of a property, can be only as good as the input. General data concerning the market area as well as economic levels and trends are collected. Specific data concerning the subject property and comparative properties are also required. Only data that bear on the value of the property to be appraised should be considered. Highest-and-Best-Use Analysis As noted in Chapter 7, a parcel of land is at its highest and best use when it is used for purposes that have the highest comparative advantage or least comparative disadvantage in relation to possible alternative uses. By undertaking a highest-and-best-use analysis, the appraiser considers the various market forces that affect a property and identifies the use on which the market value estimate is to be based.

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In identifying the highest and best use, the appraiser considers two situations: ■ ■

The use of the land as though the parcel were vacant The use of the property as improved

In some situations, the use under these scenarios is different, reflecting the fact that the property is under- or overimproved. The highest-and-best-use analysis of the land as vacant assists the appraiser in identifying and selecting comparable land parcels that have recently been sold in the marketplace. Land parcels that do not meet the use test are eliminated at this point. The analysis also will prove helpful in deriving a land value estimate for use in the cost approach to value as well as in determining if unimproved land value is greater than value as improved. The analysis of the use of the property as improved also helps in selecting comparable properties, as well as in determining whether the improvements should be retained, rehabilitated, or demolished. Land Value Estimate Once a parcel’s highest and best use has been established, a separate valuation of the land parcel may prove useful, particularly if the cost approach is to be utilized. The land value can be established through a comparison to comparable land sales, a separation of value between land and improvements through income capitalization techniques, or, in the case of subdivision development, by subtracting the costs of development and discounting the net income over the absorption period. Three Approaches to Estimating Value In arriving at a final value estimate, the appraiser has traditionally considered three approaches to value: 1. The sales comparison approach, in which the value is indicated by the recent selling prices of comparable properties 2. The income approach, in which the value is determined by capitalizing project income or performing a discount cash flow (DCF) analysis to arrive at an investment value 3. The cost approach, in which the value is derived by estimating the cost to reproduce the building and then adjusting this estimate for appropriate depreciation and adding land value This threefold approach to determining value has traditionally been used to reflect the various ways in which properties compete with each

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other and as an internal check on the valuation process. Furthermore, market data supporting all three approaches may not be readily available. Contrary to popular belief, however, USPAP does not require the use of all three approaches but rather suggests that the appraiser be responsible for selecting the one or more approaches most relevant to the definition of value (that is, market value), provided that the reason for the elimination of any approach or approaches is fully disclosed. Sales Comparison Approach The sales comparison approach compares the subject property with other similar properties that have been sold recently, as well as with current asking prices and offers. The first step is to collect data regarding sales of reasonably comparable properties. Such data should include the location and size of the property (both physically and in terms of its economic potential); legal restrictions such as zoning, deed restrictions, and easements; and any other pertinent information that would influence its market value. The sales data then are adjusted to make them as comparable as possible to the subject property. This adjustment may be made judgmentally by evaluating all the factors that influence the value of the comparable sale and then making a reasoned lump-sum or aggregate adjustment reflecting the differences between the comparable sale and the subject property. For example, an appraiser might conclude that, on the basis of the comparable sale at $15 million, the subject property would have sold at $17 million. No distinction is made for the individual elements of difference between the two properties, although such distinction is inherent in the judgmental process. A refinement of the lump-sum approach is the component approach, in which each of the individual elements comprising the value (for example, the location, the quality of the buildings, the economic productivity, or the terms of sale) is broken down and evaluated independently. Positive or negative values are ascribed to each component to reflect differences between the comparable sales and the subject property. These values may be expressed in either dollar or percentage terms. An example of this approach utilizing dollar adjustments would be the following:

Comparable Sale

Location

Terms of Sale

Indicated Value of Subject Property

$15,000,000

$3,000,000


$1,000,000

$17,000,000

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This process then can be repeated for each of the comparable sales collected. Another approach to adjustment is the index method, also called factor analysis or the grid system, in which differences in value are expressed in terms of percentages instead of dollars, with the comparable property representing 100 percent. An example would be the following:

Comparable Sale

Location

Terms of Sale

Index of Indicated Value of Comparability Subject Property

$15,000,000

120%

93.33%

113.33%

$17,000,000

The comparable sales price is then adjusted by the index of comparability to arrive at the value of the subject property. Adjustments also may be made through the use of percentages directly, without transforming them into an index. In some cases, the percentages are summed to arrive at an overall adjustment percentage. When this is done, it is important that the appraiser follow a consistent sequential pattern in arriving at the overall percentage adjustment. The sequence recommended by the Appraisal Institute is given below:3 1. 2. 3. 4. 5. 6. 7.

Adjustment for property rights conveyed Adjustment for financing terms Adjustment for conditions of sale Adjustment for market conditions Adjustment for location Adjustment for physical characteristics Adjustment for quality and quantity of income (in investment properties) when appropriate

In this manner, the appraiser arrives at intermediate prices and applies subsequent adjustments to each previously adjusted price. Once the comparable sales data have been adjusted to the subject property, the timing of comparable sales is considered in order to determine the overall trend of value in the marketplace up to the time of the appraisal. In reaching a final determination of value, the most recent sales are usually assigned the greatest value. If a significant amount of time has

3 Appraisal Institute Web site, January 2007.

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passed since sales have occurred, the appraiser may be forced to depend more on the income or cost approach. Income Approach This approach, primarily utilized with investment properties (for example, apartments, office buildings, shopping centers, or industrial properties), considers the income that the subject property can generate over its economic life and compares this income stream to other comparable properties in the marketplace, as well as other forms of investment. The future income stream is determined in a manner similar to that outlined in Chapter 16. Existing leases are evaluated, or if no leases exist, the most probable gross income that can be obtained is estimated, based on an evaluation of comparable properties. The first step is a rental survey to determine the market rent for the subject property—that is, the rent that it could achieve if it were vacant and available for lease. It is critical to compare unit factors, such as rent per unit or rent per square foot, that are derived on the same basis. For example, a single-tenant office building might be leased on a gross area basis; most mid- and high-rise multitenant office buildings in suburban locations are leased on the basis of usable, or “net,” area. Rental rates that appear different may, in fact, be expressed relative to different measurable areas. Similarly, rental rates may vary because they cover different expenses. Again, an office lease might be gross, with the landlord paying all expenses (at least for the base year), or net, with the tenant paying all expenses. Once all of the comparables have been expressed using a common unit of comparison, such as monthly gross rent per square foot of net rentable area, the rentals can be adjusted to provide an indication for the subject property. The process is essentially the same as that in the sales comparison approach. Adjustments are first made for any rental concessions, then for time, and next for location and physical characteristics. The result is an indication of market rent. If the appraiser has been engaged to appraise the fee simple estate, the market rent per square foot will be multiplied by the appropriate area to reach an estimate for potential gross income per year. If, however, the appraiser has been requested to value the leased fee estate, he or she also will have to reflect the contract rent payable under any existing leases. The value contribution of these leases is based on whether the contract rent, less expenses, is greater or less than the market rent, less expenses.

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The margin between the net market and net contract rent affects value only for the duration of each lease. Therefore, the value of the contract is usually considered separately and after a conclusion has been reached for the value of the property as if leased at market rents. The contract rent may then be used to develop potential gross income. The potential gross income is converted to effective gross income by deducting the vacancy and collection loss that can reasonably be expected over the life of the building. Any short-term vacancy higher or lower than the stabilized rate should be treated separately by discounting it over the expected period of duration. The gross income generated is then reduced by the expenses that are consistent with the rent estimate. For example, if the market rent conclusion has been reached as a net rent per square foot, the only expenses will be vacancy and collection loss, management, and reserves. Additional expenses incurred if the lease is gross include property taxes, insurance, and general operating expenses (for example, utilities, air-conditioning, trash removal, or repairs and maintenance), property management costs, and miscellaneous expenses such as licenses, advertising, supplies, and telephone. Janitorial and security services may or may not be provided under a gross office lease. Also, it should be noted that market rent may be net, but an existing lease may obligate the landlord to pay certain expenses. The pro rata share of these expenses attributable to the space occupied under the old lease is property expense until the leases expire. The projected expenses associated with the subject property are deducted from the gross income to arrive at net operating income. The appraiser then analyzes the income and expense projections to determine whether any of the projections are inconsistent with comparable properties in the area. If significant inconsistencies exist, the appraiser may stabilize income or adjust expenses to arrive at a more realistic level of net operating income. Projected net operating income is then translated into a capital value through the capitalization process. The first step in this process is to determine the capitalization rate, or “cap rate,” which reflects the relationship between the net income stream and the value of the property. The capitalization rate includes both (1) the interest rate, which is the rate of return on the investment and (2) the recapture rate, which is the rate of return of the investment. Capitalization rates are determined by the direct capitalization method and the yield approach. In the direct capitalization method, a single year’s net operating income is divided by the capitalization rate to

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arrive at the value of the property. The capitalization rate is either an overall capitalization rate that includes land and improvements or a split rate that separates them for independent analysis. The overall capitalization rate is established through a variety of techniques. The market method, also called the comparative method, is based on the ratio between the sales price of comparable properties and the income from these properties. For example, a property that sold for $20 million and had an annual net operating income of $2 million would have an overall capitalization rate of 10 percent. It’s important in comparing properties that operating expenses, financing terms, and market expectations are similar to the subject site. If this type of information is not available, it may be necessary to utilize a gross income multiplier approach in which the gross income of the property is compared with the sales price. Since the comparability of the properties is not known, this is generally a less desirable approach. The band of investment method, also called the synthetic rate method, considers the debt financing on the subject property and the rate of equity return on the amount of equity funds required. This approach requires a current knowledge of both mortgage rates and the yield expected by equity investors. Such information can be gained by examining comparable projects in the market area or by broad rules of thumb based on current market conditions. The equity capitalization rate represents the first year’s pretax cash return anticipated by an investor. The debt capitalization rate is the mortgage constant. Both debt and equity rates are multiplied by the percentage of the investment that they constitute in order to arrive at a weighted capitalization rate. For example, a property valued at $20 million with a mortgage of $18 million at 9 percent for 30 years would have the following overall capitalization rate:

Mortgage Equity Total

$18,000,000

90%

0.1009%

9.1%

$2,000,000

10%

0.0900%

0.9%

$20,000,000

100%

10.0%

Today, most appraisers use this approach as a check on capitalization rates derived from market comparables. Another traditional method, now used primarily as a check on marketderived data, is the component rate method. This approach attempts to

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identify the various elements affecting the investment, assigns a rate to each, and then sums the rate to arrive at an overall capitalization rate. Generally, a “safe rate of return” is established as a base, reflecting the rate of return on investments having the greatest liquidity and safety (for example, long-term U.S. government bonds). To this base are added judgmental assessments of various rates, reflecting factors such as the degree of risk inherent in the land uses that generate the net income stream, the costs of managing the investment, and a penalty for the nonliquidity of the investment. Again, the “recapture” rate is the return of the investment. For example, a property might have the following component rates: Safe rate: 3.0 percent Risk rate: 2.0 percent Burden of management: 1.0 percent Penalty for nonliquidity: 0.5 percent Recapture of investment: 3.5 percent Total rate: 10.0 percent The exact component will vary with each property being appraised (the risk rate generally will decrease as the quality of the income improves). In addition to the overall capitalization rate, split rates are utilized, in which the land and buildings are capitalized at different rates (the rates of the land generally are lower, reflecting greater permanence and less risk). The rate is split to arrive at a separate value for land or buildings through a technique known as the residual approach, which is used when the building value is known and the appraiser wishes to determine the value of the land (land residual) or when the land value is known and the building value is being sought (building residual). The two values are then summed to arrive at a total value for the subject property. In recent years, with the expanded use of computers, the direct capitalization approach has been augmented and, in some cases, replaced by the yield capitalization approach. This method is similar to the discounted cash flow analysis discussed in Chapter 16, except that a current market value is derived rather than a yield. The yield, or discount rate, is determined by the appraiser based on capital market considerations and the hurdle rates required by knowledgeable investors operating in the marketplace for similar types of property. In situations involving leverage, a separate yield rate may be used for mortgage and equity components. Capitalization and yield (discount) rates may also be obtained from published information from the Appraisal Institute and/or national

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investor surveys such as the Korpacz Real Estate Investor Survey, published quarterly by PricewaterhouseCoopers. Once the capitalization rate has been established, the market value of the subject property can be determined. If an overall rate is used, it is divided into the net income developed from market rent.4 Any short-term positive or negative rental margins from existing leases are discounted over the remaining term of each lease, generally using the factor for the present worth of $1 per period. The present worth of the leases is then totaled and added to, or subtracted from, the value based on market rent. If a yield rate is used, it is applied to a series of cash flows over a holding period. The property is assumed to sell at the end of this holding period, and the net sale proceeds are discounted back to the date of value and added to the present worth of the cash flows. Using this method, each lease is typically entered at the contract rate, rolling over to today’s market rent increased by an inflation factor when the lease expires. Application of the yield rate to the cash flows generated by this revenue stream results directly in the leased fee value, without the need to value the fee simple estate as an interim step. This valuation utilizing the income approach is then compared to the valuation achieved through the market approach. If there are major divergences in the two approaches, the appraiser generally reviews the assumptions utilized in the income approach because they are subject to greater distortion by the capitalization process. Unless the income stream is highly predictable and capitalization rates are well established in the marketplace, the appraiser usually will place greater emphasis on the valuation obtained through the market approach. Cost Approach The third approach is the cost approach, in which the appraiser estimates the cost of reproducing the improvements “as built” or replacing them with a building of like size and function. From those costs are subtracted the accrued depreciation to date, plus a separate value for the land. This approach generally is used as a check on valuations that have been estimated through the market or income approach or for specialpurpose properties for which comparable market data are unavailable or the income approach is not applicable.

4 It may be divided into contract rent only if the contract is 10 years or longer and the sales from which the overall rate was derived were similarly leased.

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The reproduction or replacement cost of the building is determined through one or more estimating techniques. One of the most common is simply to update the original construction costs by a relative cost index that compares current costs of reproduction with previous periods. This method is used primarily by assessors in appraising large numbers of properties. A more accurate, although time-consuming, method is to calculate the square footage area, cubic foot volume, number of rooms, or some other physical unit and multiply this by a current estimate of unit costs for the type of construction involved. This is known as the comparison cost method, and it is often used by construction lenders and the Federal Home Loan Bank Board. The most accurate, and most time-consuming, method is the unit-inplace method, in which the appraiser actually performs a modified quantity takeoff, much the same as a building contractor. A quantity takeoff is based on detailed plans and specifications; the building is broken into its various components, and unit costs are developed for each component, based on local labor market conditions, materials prices, overhead rates, and other applicable costs. The appraiser does not use building specifications but breaks the building down into various structural elements (for example, the foundation, walls, floors, and roof) and estimates the costs of materials, labor, and overhead for each element. The cost of the architect’s fees, contractor’s profit, financing, property taxes, insurance during construction, and other costs of project development then are added. Once the cost of reproducing the building has been determined through one or more of these techniques, the next step is to estimate the amount of accrued depreciation, or the loss of value that has occurred in the building since it was originally built. This loss is a function of physical deterioration, functional obsolescence, and economic obsolescence. Physical deterioration is the reduced value of the structural elements of the building through decay, cracking, settling, or just wear and tear. The amount of depreciation resulting from physical deterioration is calculated by comparing the effective remaining physical life of the building with what it would be if it were new. For example, the depreciation charge for a building with 20 years’ remaining physical life, which, if built new, would have a physical life of 50 years, would be 60 percent if a straight-line method were used. If the depreciation curve published by the Marshall Valuation Service were used, the depreciation would be only 34 percent. The depreciation is about one-half that using the straight-line method because the

532

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curve reflects the fact that depreciation accrues slowly through a building’s midlife and accelerates rapidly toward the end. Functional obsolescence is reduced value owing to poor original design or to improvements in design that have made certain elements of the building obsolete. Examples include poorly placed columns, inadequate elevators, or lack of air-conditioning. Depreciation charges for these are calculated on the basis of repairing or replacing the components of functional obsolescence, less the proportion of physical deterioration already charged. In the example above, if the cost of a new elevator were $300,000, the depreciation charge would be $120,000 ($300,000 less 60 percent). If the problem is incurable, the obsolescence is measured by capitalizing the rent loss. Economic obsolescence occurs as a result of external forces, such as poor site location, deterioration of the neighborhood, or changes in tax or lending policies. A depreciation charge reflecting economic obsolescence can be calculated by comparing the rental value of the subject property with a similar type of improvement on a good site in a good location and adjusting for additional expenses associated with an “ideal” location. This lowered income stream is then capitalized to arrive at a depreciation charge that reflects economic obsolescence. For example, if the subject site generates $10,000 less annually than it would in the ideal location, the annual net loss is $6,000. Capitalized at 10 percent, this would indicate a depreciation charge of $60,000. The charge also can be estimated by determining the present value of the rental loss at a predetermined discount rate. The final step in the cost approach is to determine land value. This is usually based on a comparison of the land associated with the subject property with other similar property in the area, adjusting for differences such as size, location, or accessibility. A unit cost is developed for the adjusted value of the comparable properties and then multiplied by the square footage, acreage, or other physical units associated with the subject property. The value of the land estimated in this manner is then added to the cost of the improvements, less applicable charges for depreciation, to arrive at the total value derived through the cost approach. Reconciliation of the Three Approaches Traditional appraisal theory held that it was wise to use all three approaches when valuing a property. This usually would result in different values. At this point, a more definitive value estimate would be required, involving a judgmental reconciliation of the approaches used.

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533

This would entail some estimation as to which approach was most applicable and the relative strengths of the underlying assumptions. Current standards do not require the use of all three approaches. In the appraisal of single-family homes, for instance, the greatest reliance is usually placed on the value estimated through the market (sales comparison) approach. In situations involving investment properties, value is based on the sales comparison approach, as adjusted, which should correlate with the value obtained through the income approach. The value obtained through the cost approach generally is employed only as a check on the other methods; except in the case of “insurable value” and/or unless the subject property is of a special-purpose nature and insufficient market data are available. The final value is then expressed in terms of a singlevalue estimate, or if there is considerable uncertainty, a range of values.

PROBLEMS WITH THE TRADITIONAL APPROACH The traditional approach to estimating value has several problems and limitations that have concerned the real estate appraisal profession. The criticism focuses on two areas: Attacks on the problems within each of the three approaches to value ■ Criticism of the entire three-approach process5 ■

Most criticisms of the market approach relate to the adjustment process by which various properties are compared to the subject site. No one property is exactly like another, nor are the expectations of buyer and seller entirely similar in all transactions. In the traditional process, the appraiser attempts to make these adjustments quantitatively, either numerically or in percentage terms, based on professional judgment. Even the best appraisers, however, have difficulty in assigning quantitative values to these differences, particularly if the transactions are spread over an extended period of time. In addition, appraisers’ professional abilities vary considerably, often leading to significant differences of opinion within the same procedural framework.

5 An early critic of the traditional approach was Professor Richard U. Ratcliff of the University of Wisconsin. His and the thoughts of others were crystallized in the 1984 Real Estate Valuation Colloquium edited by Professor William Kinnard of the University of Connecticut and published by the Lincoln Institute.

534

Appendix

Problems also are inherent in the income approach to value. Since every piece of property is different and usually serves a different purpose, the future economic life is very hard to project, even in the most stable of economic conditions. Unless the property is leased on a net-net-net basis, the income stream is hard to forecast with any degree of reliability. Even among experienced appraisers there can be wide differences of opinion, sometimes resulting in varying estimates of value. Another problem with the income approach is the method of calculating the direct capitalization rate. Using the traditional approach, the cap rate is selected judgmentally, based on the appraiser’s experience and exposure to the marketplace as well as a review of investor surveys and sales data. The application of the direct capitalization rate to the stabilized income stream also poses mechanical problems. The traditional process of dividing the capitalization rate into the income stream does not consider the future value of money or the anticipated sale of the project to another investor. These problems are largely overcome by using discounted cash flow (DCF) analytical techniques, and an increasing number of appraisers are adopting this approach rather than the direct capitalization method. However, a DCF analysis is most appropriate in multitenant properties where there are a large number of lease expiration dates and/or substantial vacancies to be filled before the property income is stabilized. The cost approach has even more severe limitations. Traditionally, it has been assumed that the cost approach places an upper limit on market value. It was reasoned that a prudent person would not pay more for a building than what it would cost to buy the land and construct a similar building. But this reasoning ignores the synergistic combination of land and building that creates market value and, in many situations, is greater than its replacement cost. The inputs into the cost approach also can pose problems. Cost estimation of a new structure is very difficult, as most contractors can readily attest. Manuals used to estimate costs are limited, labor requirements vary from area to area and from contractor to contractor, and the measurement of depreciation often is tenuous. It is virtually impossible to measure accrued depreciation independently by arbitrary or conventional methods. In addition to criticism of each of the three approaches, there is also growing skepticism as to the validity of the three-approach process itself. Tradition encouraged the use of all three approaches in almost every appraisal when, in fact, only one or at most two methods may be appropriate. It now recognized to be more meaningful to concentrate on the approach that is most relevant to the appraisal at hand.

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The correlation process by which the results of the three approaches are reconciled into a single value also is under fire. With many properties, the three approaches may lead to quite different results, often for logical reasons. To arrive at a single value, the appraiser must provide a well-reasoned conclusion based on the approach to value that he or she used and relied on.

FUTURE DIRECTIONS In light of these criticisms, many appraisers suggest that the income and cost methods be dropped altogether and that the market approach be the only determination of value. Others recommend that all three approaches be retained but that only the approach best suited for a particular situation be used. The concept of investment value also has emerged: the price that a specific investor would pay for a property, depending on that individual’s particular tax situation, available financing, and minimum acceptable return. The debate over appraisal theory has been sharpened by the availability of the computer and the emergence of several new mathematical techniques that may ultimately have a profound impact on the appraisal profession. New software programs enable appraisers to apply more sophisticated mathematical techniques to the analytic process, quickly and efficiently. The debate within the appraisal profession is being intensified, however, by governmental regulatory pressure, increased client involvement, and the emergence of new competitors. As a result of a series of scandals in the appraisal of single-family homes, the Federal Home Loan Bank Board has adopted very rigorous standards that are raising the complexity and cost of home appraisals. Clients also are taking a greater interest in establishing appraisal standards. The Rouse Company pioneered the use of appraisals to value its investment portfolio and provide investors with a better indication of market value than was possible previously through the exclusive use of accounting standards. Investment advisory firms also have developed model engagement letters in an effort to standardize appraisal assumptions and provide consistency in valuation methodology between various markets represented in the investment portfolio. Concerned about variations in investment performance reporting, the Real Estate Standards Council (REIS) in company with the National

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Council of Real Estate Investment Fiduciaries (NCREIF) published Property Valuation Standards, effective November 15, 2006,6 to guide the investment valuation process for institutional real estate investments. In addition to increasing regulation and client involvement, appraisers are now facing competition for the first time. Public accounting firms have established appraisal staffs in an effort to link auditing and appraisal activities into a single professional engagement. Credit rating agencies, such as Moody’s and Standard & Poor’s, now rate properties for securitized issues in a manner similar to the appraisal process. It is hoped that, as a result of these events, the appraisal profession will ultimately evolve a sound policy that will strengthen the credibility of the appraisal process and provide investors and other concerned parties with accurate and meaningful indications of asset value.

6 NCREIF Web site, January 19, 2007, www.ncreif.com.

GLOSSARY

abstract of title A written summary of all of the publicly recorded documents and proceedings that affect title to a property. accelerated depreciation A method of calculating depreciation in which greater amounts of depreciation are charged off in the earlier years than in the later years of the asset’s economic life. See also straight-line depreciation. adjustable-rate mortgage (ARM) A form of the variable-rate mortgage with a cap on the interest that can be charged to the borrower. See also variable-rate mortgage and convertible adjustable-rate mortgage. air rights The rights to use, control, or occupy the airspace above a real property. all-inclusive mortgage See wraparound mortgage. American Institute of Certified Planners (AICP) American Planning Association’s professional institute, providing recognized leadership nationwide in the certification of professional planners, ethics, professional development, planning education, and the standards of planning practice. American Land Title Association (ALTA) A national trade association of title insurance companies, abstracters, and title insurance agents. American Law Institute (ALI) Founded in 1923 to address the uncertain and complex nature of early-twentieth-century American law. Since then the institute has focused on a wide variety of legal areas in need of reform. anchor tenant Main (and usually largest) tenant in a shopping center; attracts customers and other tenants to the center. Also called magnet tenant and puller tenant. Sometimes used to describe the dominant lessee in an office building. See also generative business. appraisal “A professional appraiser’s opinion of value. The preparation of an appraisal involves research into appropriate market areas; the assembly and analysis of information pertinent to a property; and the knowledge, experience and professional judgment of the appraiser.”1

1 Appraisal Institute Web site, January 2007, www.appraisalinstitute.org. 537 Copyright © 2007 by John McMahan. Click here for terms of use.

538

Glossary

appreciation An increase in value. arbitration A binding out-of-court dispute resolution technique in which disputes are referred to one or more outside arbiters whose decision the disputing parties agree to accept as final. assignment The transfer of any right or interest, present or future, in real or personal property from one party to another. attornment and recognition agreement A tenant’s formal agreement to be a tenant of a new landlord.2 axial theory, 1932 Urban growth theory propounded by F. M. Babcock. Modifies the concentric urban growth theory to consider accessibility to the central business district (CBD). Maintains that land uses tend to develop along the various axes to the CBD in terms of their time-cost relationships. baby boomers Generation born in the period of 1946 to 1964 (presently aged 43 to 61). The largest generation in American history; influenced by the Vietnam War, Watergate, TV, and The Pill. balloon payment The last installment payment terminating a debt, the amount of which is substantially larger than prior installments. band of investment method Also called synthetic rate method. A method of establishing the overall capitalization rate that considers the debt financing on the subject property and the rate of equity return on the amount of equity funds required. Requires knowledge of both mortgage rates and the yield expected by equity investors. benchmark A measurement that forms the standard for comparison; used to measure management best practices of individual firms. In property surveys, physical permanent mark that establishes elevation of a property. beneficiary See mortgagee. best available control technology (BACT) A standard set by the Clean Air Act Amendment of 1990 for reduction in the amount of air toxins. best practices Establishment of industry benchmarks (standards) against which the management of an individual firm is measured. Generally, the benchmarks reflect what the “best” firms are doing. bid bond A bond that compensates the owner for the difference between the low bid and the next lowest bid if the low bidder fails to enter into a contract. bid-rent theory, 1961 Utilizes the basic concepts of microeconomics to explain the use of land throughout an urban area. The price of land (rent) depends on the value it represents for different sectors of the urban economy: office, manufacturing, residential, and so on. Whichever sector is willing to pay the most for a particular plot of land determines the use of that land. binder See deposit receipt. birth dearth Falling fertility rate. blanket mortgage See wraparound mortgage. building information modeling (BIM) A model-based technology linked with a database of project information. Provides three-dimensional parametric modeling that integrates all building elements into an interactive database.

2 Jack P. Friedman, Jack C. Harris, and J. Bruce Lindeman, Dictionary of Real Estate Term, 5th ed., Barron’s Real Estate Guides (Hauppauge, New York: Barron’s Educational Series, 2000).

Glossary

539

building residual See residual approach. building standard finish See tenant standards. build to suit Agreement to construct a building according to a future tenant’s specifications. California Coastal Zone Conservation Act of 1972 State legislation that formed a permanent state commission and six regional commissions to develop and execute a longterm plan for managing the California coastline. capitalization process The process by which the value of a property is established by dividing the annual earnings of the property by an actual or desired capitalization rate. capitalization rate The rate that is considered a reasonable return on and of investment (on the basis of the risk of the investment as measured against alternative investment opportunities). Often used to determine the value of real property through the capitalization process. Also called free-and-clear return. See also capitalization process. carrying capacity Maximum amount of development of the site with respect to the natural ecosystem. cash flow Cash received during a certain time period from an investment after all cash operating expenses, debt service, and an allowance for income taxes have been deducted from the gross income. See also real cash flow. cash-on-cash return See simple return. cash yield Annual cash return on funds invested. cast-in-place construction The most common method of concrete construction in which concrete is poured into wooden, steel, or plastic forms at the building site and allowed to set. category killers Major “in-depth” (usually discount) retailers, specializing in bulk foods, health aids, toys, home furnishings, sporting goods, consumer electronics, computers, office supplies, and home improvement goods and services. See also power center. central business district (CBD) Traditional center of a city’s principal retail, office, service, and government functions. Often called downtown. change order A written agreement, executed by all parties to a construction contract, changing building or utility design or other requirements of the contract. Specifies adjustments in compensation and/or completion date (if any) resulting from the change. Circular A-95 of 1969 Federal law bringing state governments into the council of government (COG) review process. City Beautiful A planning movement of the late 1890s–early 1900s; explored concept of improving inner city through “beautification”; popularized through Daniel Burnham’s plan for Chicago’s 1893 World Columbian Exposition. city-county consolidation A formal joining of a city (or cities) with a county government. Civil Rights Act of 1964 Legislation that, for the first time, outlawed discrimination based on race, color, religion, sex, or national origin. The law outlawed racial discrimination in public places, and it required employers to provide equal employment opportunities. Clean Air Act of 1970 Legislation that required states to show how they intended to ensure maintenance of ambient air quality standards once the standards had been achieved. Clean Air Act Amendment of 1977 Legislation that invalidated the review procedures extended to cover indirect sources of air pollution. Clean Air Act Amendment of 1990 Legislation that targeted acid rain, urban air pollution, and toxic air emissions. Called for a national permit system and a better enforcement system.

540

Glossary

closed-end fund A real estate investment fund with a fixed number of units issued to investors (primarily pension funds). Also characterized by a limited fund life (usually 10 years) and cash distributions at fund termination or upon property sale or refinancing. closing statement An accounting of funds involved in a real estate transaction. Also called settlement statement. cluster housing Land use planning concept aimed to reduce public service costs and allow development of additional usable open space by clustering housing units together while maintaining density levels of traditional single-family subdivisions. collateralized mortgage obligation (CMO) Security backed by a pool of mortgage loans; often separated into various classes with varying maturities. commercial real estate Real estate owned and operated with the objective of receiving rental income from tenants. Traditional forms of commercial real estate include office buildings, shopping centers, industrial buildings, apartments, and hotels. commission schedule A schedule of sales or leasing commission rates. The objective is to provide the greatest motivation for the broker at the lowest total cost. See also sales commission and leasing commission. commodity markets Markets where real estate is viewed largely as a factor of production. Public policy is to keep land costs and building rents low in order to appeal to new firms and remain attractive to existing firms. Implemented by maintaining low barriers to new development and an expedited entitlement process. Believed to create environment more favorable to developers and tenants than to long-term investors. common area Land or improvements in a development project that are held in common by, or are for the use of, all property owners. In residential projects, used for recreational facilities as open space, with the title held usually by a neighborhood association. Also used in shopping centers for parking lots and mall areas. common area maintenance (CAM) Maintenance associated with common areas such as parking lots, internal roads, public rest rooms, and pedestrian malls. See also common area. community center Shopping center serving customers within a market radius of approximately 30 minutes’ driving time. In addition to providing the same goods and services as neighborhood centers, features tenants selling hard goods such as appliances and hardware and tenants selling soft goods such as apparel. Sizes range from 100,000 to 500,000 square feet or even larger. See also neighborhood center. community development block grants (CDBGs) Grants awarded by the U.S. Department of Housing and Urban Development (HUD), through a federal program begun in 1974, to communities to provide them with resources to address a wide range of community needs. Communities receive these grants based on population, extent of poverty, and housing overpopulation. community development corporations (CDC) Nonprofit organizations that combine private and public resources in order to promote the development of disadvantaged areas. Their focus is on providing affordable housing, health clinics, job training and placement, child care, and many other community services. Community Reinvestment Act (CRA) of 1977 Legislation that intended to encourage depository institutions to help meet credit needs of communities in which they operate, including low- and moderate-income neighborhoods.

Glossary

541

comparison cost method A variation of the cost approach in the appraisal process whereby the square footage, cubic foot volume, number of rooms, or other physical unit measure is calculated and multiplied by a current estimate of unit cost for the type of construction involved. competitive area The geographic area surrounding the market area that may be competitive with the market area. competitive properties survey Survey of properties in a market area directly competing with a potential or existing property in an investment portfolio. component rate method Method of establishing a capitalization rate that attempts to identify the various elements affecting the investment, assigns a rate to each, and then sums the rate to arrive at an overall capitalization rate. computer-aided design (CAD) The use of a wide range of computer-based tools to assist with project design activities. concentric theory, 1925 Based on studies of the development of Chicago by Ernest W. Burgess, an urban growth theory that concludes that land uses tend to develop in concentric circles out from a central point. Five zones of land are identified: (1) central business district, (2) transition zone of mixed commercial and industrial uses, (3) low-income housing zone, (4) middle-income housing zone, and (5) commuting zone. concept design state The process of developing alternative site plans and building forms in order to understand the various trade-offs involved in alternative approaches to site development. condominium A multifamily property development in which each unit is separately owned in fee simple but in which the common areas such as elevators, hallways, landscaping, and land are owned jointly by the individual unit owners. Each unit is separately financed and pays its own taxes and pro rata share of insurance and common area maintenance. constrained markets Markets where the supply of real estate is restricted as an integral part of public land use policy. New projects usually undergo a rigorous approval process including compliance with environmental, economic, social, and construction quality standards. Many building users, particularly those involved in technology and other highgrowth industries, are attracted to constrained markets because the area’s “quality of life” helps attract and retain high-value employees. Many real estate investors target these markets because it is believed that buildings are built to higher standards and that a constrained supply allows rents to increase over time, ultimately resulting in greater appreciation in real property values. construction change directive A procedure for authorization of work for unexpected conditions encountered in the field during construction. construction loan A form of interim financing usually disbursed in installments; used to finance construction of improvements upon a piece of land. Usually made for a period of one to three years. construction management contract Authorizes a contractor to take over all phases of project development, including such items as budgeting and cost control, review and approval of subcontractor selection and work, analysis and approval of change orders, and preparation of financial reports in addition to construction. construction manager A manager appointed to coordinate a project but assigned little financial responsibility or liability. Usually paid a fixed fee.

542

Glossary

consumer behavior technique A method of analyzing retail demand based on developing potential customer profiles to use in calculating demand in a market area. contingent interest mortgage A mortgage for which a portion of the interest payable is tied to the economic performance of the property (for example, the percentage of sales, hotel room receipts, or gross rentals). See also shared appreciation mortgage. contract documents Working drawings and materials specifications from which construction cost estimates are finalized and contracts are bid and awarded to construct a building. contract of sale See purchase agreement. convenience center Shopping center anchored by a store providing personal or convenience services, such as a minimarket; usually contains a minimum of three stores and does not exceed 30,000 square feet. Often anchored by “quick stop” markets such as 7-Eleven and Stop-n-Go. convenience goods Retail items usually bought at the most convenient place available without comparison shopping. These goods vary little from store to store and are purchased relatively frequently. Examples include food, over-the-counter medicines, liquor, and hardware. See also shopper goods. convertible adjustable rate mortgage Adjustable-rate mortgage that gives the borrower an option to convert from a variable- to a fixed-rate payment schedule when rates are more favorable. convertible mortgage A mortgage that gives the mortgagee an option that can be utilized at a future date (generally 5 to 10 years) to convert to full or partial ownership of the property. cooperative Corporate form of real estate ownership in which each member owns common stock in a corporation and receives a lease from the corporation giving the member the right to occupy an individual living unit. The costs of ownership and operation of the structure are divided among the members in proportion to a set formula. Tenant stockholders are allowed to deduct interest and property taxes paid to the corporation. core The central area of a building that contains elevator banks, restrooms, stairwells, electrical services, janitorial closets, and so on. cornerstone land use Major land use for a multiuse project. corporation An artificial entity created under state enabling legislation. A corporation may acquire, develop, and dispose of real property as well as engage in any other legitimate business activity. cost approach One of three appraisal approaches to value. Value is derived by estimating the cost to reproduce the building and then adjusting the estimate for appropriate depreciation and added land value. cost of friction The cost of the disutility of moving goods or people along a linkage; consists of transportation costs, travel time, personal aggravation, and parking rates. cost-plus-fixed-fee contract A contract that stipulates reimbursement to the contractor for actual costs incurred and sets a predetermined fixed fee. council of government (COG) A loosely organized confederation of local jurisdictions. Council on Environmental Quality (CEQ) Established by Congress as part of the National Environmental Policy Act (NEPA) of 1969. Coordinates federal environmental efforts and works closely with agencies and other White House offices in the development of environmental policies and initiatives.

Glossary

543

County of London Plan Plan for rebuilding London after World War II; prepared by the London County Council in 1943. covenant Promise to do or not to do something or an agreement that something does or does not exist. Covenants are included in deeds and other written legal instruments. covenant of quiet enjoyment A lease provision assuring a tenant who pays rent and otherwise lives up to the terms of the lease that his or her possession will not be “disturbed” by the landlord. credit crunch Deficiency of funds experienced by thrift institutions as a result of disintermediation. critical path method (CPM) A management tool for scheduling and monitoring construction activity based on the step-by-step breakdown of a job into its component parts, the plotting of sequential relationships, and the time and lead time required for all operations. debt capitalization rate Mortgage constant. Calculated as a percentage ratio between the annual debt service and loan principal. debt service Periodic payments consisting of principal and interest required to amortize a loan. debt service coverage ratio (DSCR) Ratio of the net operating income (NOI) to annual debt service (ADS) measuring the times the debt service is covered by the NOI. Used as underwriting criteria for income property mortgage loans. Inverse of loan-to–value (LTV) ratio, which is expressed as a percentage. deed A written instrument that, when it has been properly executed and delivered, transfers the title to real property. deed of trust See trust deed. default Failure to perform an act or meet an obligation as required by a contract or agreement. default clause A clause in a mortgage, lease, or other written agreement that defines the rights and remedies of the parties upon the default of either party. defeasance clause A clause contained in a mortgage or trust deed that terminates the security interest of the mortgage or trust deed once the secured debt is paid in full. See also mortgage and trust deed. deficiency judgment A personal judgment against a debtor made when, upon foreclosure, the collateral provided as security does not satisfy the debt. definitive term tenancy Tenancy scheduled to terminate at a definite point in time. Also called fixed term tenancy. deposit receipt A standard form instrument that is used to submit an offer to purchase real property and that serves as a receipt for any money used as a deposit or down payment. When it has been accepted by the seller, it also serves as a binding agreement of sale. Also called binder or offer to buy. depreciation In real terms, a loss in the usefulness, and therefore value, of an asset over time. See also straight-line depreciation and accelerated depreciation. derivative securities Securities in which investors invest in “tranches” of mortgage principal repayment rather than a pro rata share of the whole pool. Allows investors to better match individual pools with their risk profile. design-build The concept under which one institution provides both design and construction.

544

Glossary

design efficiency ratio Ratio between net and gross areas of a building; the higher the ratio, the more efficient the design. developing countries A term generally used to refer to low- or middle-income economies, which generally have lower per capita income, widespread poverty, and low capital formation. development credits A system of rewards given to developers who devise ways to promote environmentally sensitive development by, for example, increasing building densities, reducing traffic congestion, or preserving open space areas. development impact fees Fees charged commercial real estate developers to offset direct and indirect costs associated with their projects. digging for gold Conrad Hilton’s development program aimed at converting unused space to profitable use. direct capitalization method A method of determining capitalization rates where a single year’s net operating income is divided by the capitalization rate to arrive at the value of the property. discounted cash flow (DCF) analysis A method of analyzing investment opportunities in which future annual cash flows are discounted and cumulated to arrive at their net present value (NPV) or internal rate of return (IRR). See also net present value (NPV) and internal rate of return (IRR). discount rate See yield. disintermediation The removal of funds by savers from financial intermediaries (savings and loan associations, banks, and so on) for direct investment in financial instruments (government and corporate bonds); occurs when the interest rates available on direct investments are significantly higher than the return offered by the financial intermediaries. disutility A negative cost or inconvenience associated with performing an action. downtown See central business district (CBD). due diligence In prospective property acquisitions, the concerted effort to verify previously disclosed information and to uncover additional problems that may adversely affect property ownership. If problems are uncovered, due diligence involves renegotiation to establish the seller’s legal and monetary responsibility and/or the development of a mitigation plan for the buyer’s resolution following the close of the transaction. If the renegotiation is unsuccessful, the buyer has the right to cancel the transaction and have any deposit he or she has made be returned to him or her. earnest money deposit (EMD) A deposit placed in escrow by the buyer of a property to demonstrate his or her intention to complete the transaction. easement A right or privilege to enter or use real property that is owned by another party. echo boomers See generation Y. economic obsolescence Degeneration that occurs as a result of external forces such as poor site location, deterioration in the neighborhood, or changes in tax or lending policies. Economic Recovery Tax Act (ERTA) of 1981 Legislation that reduced marginal tax rates by 25 percent over three years; indexed for inflation. Also known as the Kemp-Roth Tax Cut. effective gross income See effective gross revenue. effective gross revenue (EGR) The actual rental receipts that a project receives. In pro forma statements, the amount of gross revenue after deducting an allowance for anticipated vacancy. See also gross revenue and vacancy allowance.

Glossary

545

effective rental schedule Gross rental schedule adjusted for any tenant concessions that have been made. See also gross rental schedule. eminent domain The right of government or a public utility to acquire property without the owner’s consent for necessary public use through condemnation proceeding and with the payment of just compensation. Employment Retirement Income Security Act (ERISA) of 1974 Legislation establishing tough new fiduciary standards for the management of pension plans including personal, criminal liability for proven violations. Directed primarily at preventing a repeat of pension abuses related to corporate bankruptcy (Studebaker) and union graft and corruption (Teamsters’ Union). encroachment The intrusion of a structure on another person’s property. endogenous growth An economic growth theory that incorporates human capital as an input into economic growth. environment influence area Environment surrounding a site that may affect potential users’ desire or ability to visit the area. environmental impact report (EIR) Environmental impact study that assesses the environmental health impact, risk to ecological health, and changes to nature’s services that a project may have. equity capitalization rate The first year’s pretax cash return anticipated by an investor. escalation clause A clause in a lease or note that provides for an increase or decrease in rent or interest under specified conditions, such as changes in certain price or interest rate indexes. See also lease. escrow A legal arrangement, often connected with the sale of real property, whereby all funds, contracts, mortgages, and deeds are deposited by the buyer and the seller with a third party (escrow holder). When all conditions have been met, the escrow holder will pay out all funds and deliver all papers as directed by the terms of the escrow agreement. exclusive agency A listing agreement in which the owner employs one broker exclusively who receives the commission if the property is sold or leased by anyone other than the owner. If the owner sells or leases the property, there is no commission. See also listing agreement, sales commission, and leasing commission. exclusive right to sell A listing agreement in which the developer employs one broker exclusively, who receives the commission regardless of who sells or leases the property, even if it’s the developer. See also listing agreement, sales commission, and leasing commission. expanded community New town involving expansion of an existing smaller community. See also new town. expense stop A lease provision establishing a maximum level of operating expenses to be paid by the landlord; expenses beyond this level are reimbursed by the tenant. export base theory Urban growth theory that holds that export industries (generally manufacturing and those exploiting natural resources) that produce goods sold outside the region usually support a certain number of local services industries. extended first mortgage See wraparound mortgage. Fannie Mae See Federal National Mortgage Association (FNMA). fast tracking A lower-cost alternative to the traditional construction process. The bidding process is handled in phases, with some of the preliminary key elements of

546

Glossary

construction—for example, earthwork, foundations, or steel and concrete placement— proceeding while architectural drawings are being finalized. Federal Deposit Insurance Corporation (FDIC) The federal agency created to insure deposits in federally chartered and state-chartered banks. Federal Home Loan Bank System (FHLBS) Organization established by the Federal Home Loan Bank Act of 1932 to restore confidence in financial institutions and provide a reliable source of financing to real estate lenders. Now focuses primarily on increasing available funds for low-income and community development projects. Federal Home Loan Mortgage Corporation (FHLMC) A corporation established by the Federal Home Loan Bank to issue mortgage-backed securities. Nicknamed “Freddie Mac.” Federal Housing Administration (FHA) Organization created under the National Housing Act of 1934 to stabilize the mortgage market, improve housing standards, and provide mortgage insurance systems. Federal National Mortgage Association (FNMA) Organization established in 1938 to provide secondary market for securities backed by pools of FHA-insured mortgages. Nicknamed “Fannie Mae.” Federal Savings and Loan Insurance Corporation (FSLIC) Federal agency created to insure deposits in federally chartered and state-chartered savings and loan associations. fertility rate The average number of children that would be born to a woman over her lifetime if she were to experience the current age-specific fertility rates throughout her lifetime. festival center Tourist-oriented shopping center, usually developed around a special theme, often through use of existing, often historic structures or, more recently, from scratch with the theme created through planning and architecture. fiduciary A person in a position of confidence or trust, such as an agent, trustee, administrator, or attorney-in-fact (includes a firm or individual investing pension plan assets governed by ERISA). final underwriting Following due diligence, the final recommendation made by the developer’s management team about whether or not to acquire a property and, if so, a strategy for its ownership and operation, future sale, anticipated investor returns, and remediation of any postclosing problems identified in due diligence. Provides the foundation for approval by the investment committee. Financial Institutions Reform, Recovery and Enforcement Act of 1989 Federal law that recognized the Uniform Standards of Professional Appraisal Practice (USPAP) as the generally accepted appraisal standard and required USPAP compliance for appraisals related to property appraisal, personal property appraisal, and business and intangible property appraisal. financing memorandum A document used by lenders for reviewing potential acquisitions. Usually includes property description, pro forma operating statement, market analysis, and lease comparables. fixed operating expenses Operating expenses that do not vary with occupancy, such as property taxes and insurance. See also operating expenses and variable operating expenses. fixed price contract See lump-sum contract. fixed term tenancy See definitive term tenancy. fixture An improvement to land or structures, often immovable, that becomes a part of real property.

Glossary

547

flat mortgage See straight-term mortgage. floor-to-area ratio (FAR) The ratio of the gross area of a building to the land on which it is situated. Calculated by dividing the total square footage in the building by the square footage of land area. For example, a 500,000-square-foot building on a 50,000-square-foot land parcel would have an FAR of 10. Often used by public agencies in regulating building development. Florida Environmental Land and Water Management Act of 1972 One of four major land use laws passed after the 1971 drought in Florida. Established state control over land use decisions having an impact outside local areas. Florida Growth Management Act of 1986 State legislation that requires that all local growth plans be approved by the state planning agency. Florida State Comprehensive Plan Act of 1986 State legislation that established a statewide growth plan in response to the rapid expansion of Florida’s population. flying forms Large-scale prefabricated formwork systems that are supported by the vertical concrete structure (columns and walls). In using these construction systems, first reinforcements are placed, then concrete floor slabs are cast, and then the flying forms are pulled out and lifted into place on a higher floor to start the process over again. Flying forms are often used in conjunction with slip-form construction. footloose firms Industrial firms not oriented toward any particular factor; these firms tend to locate in certain areas on the basis of style and image. foreclosure A legal procedure whereby, in the event of default, property securing an obligation is sold to pay the obligation. Freddie Mac See Federal Home Loan Mortgage Corporation (FHLMC). free-and-clear return See capitalization rate. freehold Legal concept giving a property owner legal title of the land and exclusive right to its possession. Freehold rights may be of unlimited duration (fee simple) or for the life of a specific person (life estate). freestanding store Store not located in shopping centers or districts. French flats Luxury apartments with central location and most services and facilities on site; popular in the late 1800s to early 1920s. frictional vacancy (FV) Vacancy that occurs when a tenant moves out of the space at the expiration of a lease and is replaced by another tenant. Measured as the time required to find a new tenant. Friends of Mammoth v. Mono County California Supreme Court case in which the court extended the state law requirement that private developers prepare environmental impact reports on private-sector projects. fully amortized mortgage Mortgage calling for constant periodic payments (usually monthly, quarterly, or annually) of principal and interest, such that the principal is fully amortized over the term of the mortgage. Interest constitutes the major portion of the payments in the early years; principal dominates the later stages. See also straight-term mortgage and partially amortized mortgage. functional obsolescence Reduced value owing to poor original design or to improvements in design that have made certain elements of the building obsolete. garden apartment An apartment located in a low-rise housing complex that provides direct tenant access to grounds and recreational facilities.

548

Glossary

general construction guaranty An agreement, generally for one year, whereby the construction trades agree to correct materials and functional problems that emerge in the building operation. general contractor One who supervises the construction of a structure under terms specified by the owner. The construction may be carried out by the general contractor’s employees, or it may be subcontracted. general partnership See partnership. general warranty deed A deed in which the grantor agrees to protect the grantee from any other claim to title of the property. generation X Generation born in the period of 1965 to 1980 (presently aged 27 to 42). First generation growing up with both parents’ working full time. Xers seek to integrate family life into career; they often embrace entrepreneurial opportunities, and they treasure independence above organizational structure. generation Y Generation born in the period of 1981 to 2000 (presently under 27 years old as of 2007). The major influences on this group have included the first Gulf War, the stock market boom-bust of the late 1990s, the attacks on September 11, the War on Terror, and the Iraq War. Also known as echo boomers. generative business Business activity generated by a retail operation through its own efforts, historical reputation, advertising, or promotional gimmicks (for example, a major department store). Usually, this type of retailer looks for a location easily accessible to large numbers of shoppers to maximize its merchandising efforts. GI Bill The Servicemembers’ Readjustment Act of 1944 (“GI Bill of Rights”) that provided federal aid to returning World War II veterans to assist them in readjusting to civilian life. Guaranteed opportunities for education, job training, home loans, and unemployment pay. Ginnie Mae See Government National Mortgage Association. globalization Worldwide economic expansion. Applied to real estate to describe the movement of development and investment firms, institutional investors, real estate operating companies, and real estate services firms from operating within the national market to operating within the global market. Golden v. Ramapo, 1972 U.S. Supreme Court case that upheld comprehensive local growth management plan for Ramapo, New York. Government National Mortgage Association (GNMA) The agency within the U.S. Department of Housing and Urban Development (HUD) that purchases obligations of the federal government (such as FHA-insured mortgages) in order to provide a secondary market for these securities. Nicknamed “Ginnie Mae.” graduated payment mortgage A mortgage that permits the borrower to make smaller payments in the early years of the mortgage and to make increasingly larger payments in later years. Attractive to first-time home buyers. grant deed A form of deed in which the grantor warrants that he or she is the legal owner in fee simple, that the title has not been previously conveyed to another, and that there are no encumbrances or liens against the property that have not been revealed. Gray Areas Program A national program launched in 1960 by the Ford Foundation to promote revitalization and redevelopment of communities in minority areas. gross building area The total area of an office building or a combination of buildings; expressed in square feet.

Glossary

549

gross income See gross revenue. gross income multiplier approach Method of calculating the overall capitalization rate whereby the gross income of the sales price of the property is divided by the gross income. gross leasable area (GLA) The total area of a building on which the tenant pays rent. Measured from the face of outside walls and the center of joint walls; expressed in square feet. Used primarily in connection with shopping centers. gross lease A lease agreement in which the lessor (landlord) pays all maintenance costs, taxes, utilities, and so on. See also lessor and net lease. gross rental schedule Schedule of expected gross rent based on the original rental projections and adjusted for changes in market conditions, increases due to escalation clauses, and changes in marketing policy. See also effective rental schedule. gross revenue The total rental receipts that would be collected at scheduled rental rates and 100 percent occupancy. Also called gross income. ground lease A lease used for a form of real estate financing in which the developer obtains use of the land in return for periodic rent payments over an extended period of time (in essence, the developer “borrows” from the landlord the value of the land). The period of time is generally long enough to permit financing of the improvements and permit the developer to recover its investment costs, plus earn a return on its investment. growing equity mortgage (GEM) A mortgage in which the payment is increased by a specific amount each year with the additional payment amount applied to the principal. growth corridor Localized geographical area where existing or anticipated public infrastructure will tend to induce economic growth (for example, new transportation systems, sewer lines, or urban renewal projects). Influences the path of urban growth over the medium term and may create greater opportunities for appreciation in real estate values. Growth Management Planning Council of King County Planning council formed by King County in the state of Washington. The council estimated growth targets and employment targets for each city in the county, which were incorporated into local development plans. guaranteed investment contract (GIC) Investment instrument sold by life insurance companies that guarantees investment principal and offers withdrawal flexibility. guaranteed maximum price contract A contract similar to a lump-sum contract, except that the owner pays only for actual costs incurred within the maximum price guarantee. Gulf Opportunity Zone Act of 2005 Provides tax incentives to areas affected by Hurricanes Katrina, Rita, and Wilma. Temporarily expands low-income housing credits, increases rehabilitation tax credit, and allows 50 percent bonus depreciation for business owners within the zone. hardening the site The practice of preventing potential security problems by securing areas of potential intrusion. highest and best use The use of property that will produce the highest economic returns over time. Also defined as the purpose that has the highest comparative advantage or least comparative disadvantage in relation to possible alternative uses. holdover tenancy The continued occupancy of a property with the consent of the landlord by a tenant whose lease has expired. Home Mortgage Disclosure Act (HMDA) of 1975 Legislation passed by Congress in 1975 and implemented by the Federal Reserve Board Regulations. Requires financial

550

Glossary

institutions to disclose data about mortgage applications, applicants, and application resolution. The data are distributed annually and made available to the public. hotel Lodging facility providing full range of services, including rooms, a restaurant and bar, and room service. May also include retail services such as a barber shop and a beauty salon. Generally located in major nodes of activity such as downtowns, airports, and major uptown centers. hoteling Concept for the use of office space such that employees do not have personal offices but rather “lockers” in which they store their personal effects and are then assigned a workspace for as long as they are in that location. Hoteling is used primarily by accounting and other professional firms with multioffice locations. Housing Act of 1949 Legislation that created the Urban Redevelopment Agency citing the need for “a decent home and a suitable living environment for every American family.” Housing Act of 1954 Legislation that amended the Housing Act of 1949 to emphasize rehabilitation of existing structures and the conservation of neighborhoods. Offered funds to guarantee bank loans for these purposes and emphasized commercial and industrial uses over residential. Housing Act of 1961 Most comprehensive housing legislation since 1949. Objectives included low- and moderate-income housing improvements, reduction of urban congestion, and stimulation of building activity. Housing Act of 1968 Also called the “Fair Housing Act.” Legislation that was part of Civil Rights Act of 1968 and that prohibited rental and housing sale discrimination on the basis of race. HUD See U.S. Department of Housing and Urban Development. hybrid mortgage Combines features of both fixed-rate and adjustable-rate mortgages. The interest rate remains fixed for a period of time then converts to an adjustable-rate mortgage. Provides a lender with a measure of equity participation. income capitalization approach One of three appraisal approaches to estimating value. Value is determined by capitalizing project income to arrive at an investment value. indefinite term tenancy Tenancy subject to termination on notice (for example, tenancy “from month to month” or from “year to year”). industrial district (park) Planned development set aside for industrial land uses. inflation hedge An investment that increases in value roughly consistent with inflation. in-line tenant In a shopping center, a merchant who occupies space in a single multitenant building. input-output analysis The application of the urban growth theory that involves developing a matrix consisting of regional industries and an export category. The matrix shows how one additional or marginal dollar spent in a particular industry affects sales in each of the other industries in the matrix. installment land contract Method of financing in which the title remains with the seller until the buyer has made a predetermined number of periodic payments or until the last installment has been paid. Institute of Real Estate Management (IREM) A professional and trade association of real property managers. Affiliated with the National Association of Realtors. Designations include CPM, Certified Property Manager (individuals), and AMO, Accredited Management Organization (firms).

Glossary

551

interest-only mortgage See straight-term mortgage. interest rate A percentage of a sum of money, paid or charged for its use; usually expressed for a one-year period. In appraisal, the interest rate represents the rate of return on the investment. Intergovernmental Cooperation Act of 1968 Legislation that broadened the areas subject to the Council of Government’s (COG) review to include virtually all federal grants-in-aid. interim financing Short-term financing, usually used during construction, that is paid off with the proceeds from permanent financing when the building is completed and in operation. internal rate of return (IRR) calculation A discounted cash flow technique in which investment outlays and future cash flows are discounted by a series of present value factors, in a trial-and-error process, to arrive at that discount rate (internal rate) that most nearly reduces the current value of future cash flows to zero. Also called the yield capitalization approach. Investment Advisors Act of 1940 Legislation that established a system and standards for governing investment advisors who are managing security investments; this law now applies to real estate investments as well. Enforced and interpreted by the Securities and Exchange Commission (SEC). investment manager Registered investment advisor, manager of real estate investment trusts (REITs), general partner, and any other individual or firm that serves as a fiduciary to security or real estate investors. investment value The price that a specific investor would pay for a property, depending on that individual’s particular tax situation, available financing, and minimum acceptable return. joint tenancy Ownership of a partial interest in property in which each participant is personally liable for all expenses associated with the property and in which each has individual legal rights and rights of survivorship. See also tenancy in common. joint venture Entity established between two or more parties to undertake a single project or a group of projects. May involve individuals, partnerships, corporations, or REITs. Kemp-Roth Tax Cut See Economic Recovery Tax Act (ERTA) of 1981. kickout clause A clause found in retail leases that allows the tenant to get out of a lease if he or she doesn’t reach certain volume levels or a competitor is allowed into the shopping center. knowledge employee Employee who works primarily with information or who develops and uses knowledge in the workplace. labor force participation rate Ratio of the size of the labor force to the overall size of their cohort (national population of the same age range). Labor-Management Relations Act of 1947 Also known as the Taft-Hartley Act. Legislation that outlawed closed-shop practices, instituted an 80-day cooling-off period for strikes threatening the nation’s health or safety, prohibited unions from using union monies for national elections, allowed suits for breach of contract against unions, and defined unfair labor practices of unions. labor-oriented firms Industrial firms primarily concerned with availability and cost of labor. These firms tend to concentrate in areas where labor is plentiful at relatively low cost.

552

Glossary

land development plan Development plan, sometimes referred to as a master plan, that indicates the location and magnitude of various land uses and a transportation and utility system to service these uses. May identify the process for implementation by indicating the separate stages of a long-term development program. landlord Owner of land or building who leases space to an individual, partnership, corporation, nonprofit organization, or other entity. Also called lessor. land planning The process of analyzing and planning a large parcel of land in terms of both its potential uses and its relationship with surrounding land parcels, environmental resources, and the region. land residual See residual approach. land sale leaseback with a leasehold mortgage Transaction in which land and improvements are separated; the land is sold and a mortgage is obtained on the improvements. Land Sales Full Disclosure Act of 1968 Required land developers to register subdivisions of 100 or more nonexempt lots with HUD and provide each purchaser with a disclosure document. See also property report. land warrants Issued to War of 1812 veterans as an entitlement to a certain number of acres located in one of several land districts. Could be used to apply for land patents that granted them ownership of the land. law of retail gravitation Also known as Reilly’s law, developed by William J. Reilly of the University of Texas. Postulates that under normal conditions two cities draw retail trade from a smaller intermediate city or town in direct proportion to some power of the population of these two larger cities and in inverse proportion to some power of distance of each of the cities from the smaller intermediate city. Leadership in Energy and Environmental Design (LEED) The nationally accepted benchmark for the design, construction, and operation of high-performance green buildings. Developed by the U.S. Green Building Council (USGBC), provides a list of standards for environmentally sustainable construction. lease An agreement whereby an owner (lessor) grants possession and use of real property to a tenant (lessee) under certain specified conditions for a limited period of time. leasehold Legal concept that conveys the right to use and/or improve the land for specified periods of time (the term). leasehold mortgage Mortgage placed on a lessee’s interest in a property. leasing commission Commission generated by a property lease, computed as a percentage of the total rental payments over the term of the lease. least-cost theory Theory of industrial location that claims that industrial firms tend to choose a location that minimizes their costs, including labor, transportation, and raw materials. Le Plan de Paris City plan published by Le Corbusier in 1937 illustrating how Paris could be rebuilt without losing its historical monuments. lessee See tenant. lessor See landlord. letter of credit (LOC) An instrument, usually issued by a bank, authorizing a named person or firm to draw a specified amount of money on the issuer bank. letter of intent (LOI) A nonlegal (that is, unenforceable) document that sets forth certain basic business parameters regarding a potential property acquisition. Often used by a potential buyer to make an offer to purchase a property.

Glossary

553

leverage The use of another’s money (usually a financial institution) for a portion of the costs of purchasing or developing a real estate investment. Use may increase equity return. lien theory Theory and practice by which the title and right of possession remain with the mortgagor. The mortgagee has a lien on the property, as security for the loan, which is extinguished when the loan is repaid. See also mortgagee and mortgagor. lifestyle center A shopping center that targets high-income shoppers and that is usually anchored by a specialty store in addition to having shops that carry fashion merchandise. lift-slab method A method of construction used in high-rise buildings in which each floor is poured on top of a previously poured floor and, after hardening, is lifted into position with powerful jacks. limited liability corporation (LLC) A type of business ownership in which features of both partnerships and corporations are combined. limited partnership Form of partnership with a general partner and one or more limited partners. The general partner has liability beyond that established for the limited partner(s) and is responsible for managing activities of the partnership. The limited partner has liability up to the amount of its investment but does not have a voice in managing the day-today affairs of the partnership. linkage The ability to move goods, services, and/or people between two points; requires a transportation system and accessibility to the transportation system. listing agreement A formal contract appointing a broker as the agent with the right to market a property on behalf of a property owner. loan constant The annual payment required to amortize a loan in a given period of time at a given rate. Includes both principal and interest; expressed as a percentage of the total loan value. For example, the constant required to amortize an 8 percent 30-year loan is 8.81. loan origination The process of making a new loan from marketing to closing. loan-to-value (LTV) ratio The percentage a loan represents of the cost or value of a property. logistics Management of product inventory between the time it is produced to when it is finally in the hands of the consumer. Includes procurement, shipment, and storage of raw materials utilized in the manufacture of the product. long-term loan See permanent loan. lump-sum contract Also called fixed-price contract. Requires the contractor to complete the building for a specific amount of money, which often is established as a result of competitive bidding. market analysis A forecast of future demand for potential land uses on a site, along with recommendations as to quantity to be sold or leased, prices to be charged, project phasing, and, in some cases, merchandising recommendations for the potential market identified. Also called a market demand estimate. market area The geographic area surrounding a site from which it will draw the major portion of demand for various land uses; usually applies to residential or retail uses. market capture Anticipated percentage of market demand in the trade or market area that a certain project is expected to capture. market demand estimate See market analysis. market method Method of establishing an overall capitalization rate based on the ratio between the sales price of comparable properties and the income from these properties.

554

Glossary

market-oriented firms Industrial firms oriented toward a specific market for their final product; includes consumer industries and firms that produce for other industries. market timing Investment strategy based on the real estate cycle, whereby the investor buys or sells shortly before the trough or peak of the cycle. market value “The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.”3 Maryland Economic Growth, Resource Protection and Planning Act of 1992 Legislation that established procedures for review of capital improvement projects in compliance with the state growth policy. Maryland Smart Growth Area Act of 1997 Legislation that channels development funding to smart growth areas already developed or designated for future growth. Massachusetts Coastal Wetlands Protection Act of 1963 Legislation that places permanent restrictions on private coastal wetlands provided that the owners consent to those restrictions. Massachusetts Community Preservation Act of 2000 Legislation that allows local governments to establish up to a 3 percent tax surcharge to be used for preserving open space, historic resources, and recreational land and for the development of affordable housing. master limited partnership Large partnership that is publicly registered and whose shares are freely traded. median age Midpoint age of the population, at which half of the population is older and half is younger. metes and bounds A legal description in which the boundary lines are described by landmarks, terminal points, directions, distances, and angles. metropolitan statistical area (MSA) One or more counties having a combined population of at least 50,000, as designated by the U.S. Census Bureau. microanalysis technique Method of analyzing retail demand in which the trade area is divided into a series of small units (for example, blocks or neighborhoods); the potential business from each of these units is then calculated and distributed judgmentally among the various stores in the trade area. Any potential business not distributed is assumed to be available to the proposed store or center. mineral rights See subsurface rights. miniperm loan A loan that requires payment of interest only during the construction and lease-up period (usually three to five years), then converts to a fully amortizing permanent loan when project cash flow reaches sufficient levels. mixed-use development Multiuse development characterized by three distinct features: (1) the project has at least three significant revenue-producing uses, (2) there is significant physical and functional integration of the various uses, and (3) development is carried out according to a coherent plan. See also multiuse building. modal split between forms of transportation The percentage of travelers who take one form of transportation over another (for example, automobile versus public transportation). 3 Uniform Standards of Professional Appraisal Practice (USPAP), 1997 edition (Washington, D.C.: Appraisal Foundation).

Glossary

555

Model Cities Program Program created under the Demonstration Cities and Metropolitan Development Act of 1966 to provide coordination of existing urban programs and provide additional funds for local plans. Emphasized comprehensive planning and rehabilitation. modular housing Standardized mass-produced construction component prefabricated at a factory and assembled on site. monocentric city model, 1964 A theory to explain urban growth that assumes that there is a single core around which all economic activity is concentrated and a single mode of transportation utilized by businesses and residents. Firms and residents compete for land closest to employment. mortgage Placement of a lien or an encumbrance on a property to secure repayment of a debt. mortgage-backed securities Securities representing an investment in a pool of mortgages held by the issuer of the securities in which the actual yield on the mortgages is “passed through” to the investor, less a service charge by the issuing institution. Foreclosure losses are passed through as well, although these are generally insured through private mortgage insurance. mortgage constant See debt capitalization rate. mortgagee The lender of funds secured by a mortgage or trust deed. Also called beneficiary. See also mortgage and trust deed. mortgage takeback See purchase money mortgage. mortgagor Borrower of funds secured by a mortgage or trust deed. Also called trustor. See also mortgage and trust deed. motel Lodging facility without a restaurant or other hotel types of services. Generally, overnight guests arrive by car and drive directly to their rooms upon checking in. motor hotel Lodging facility with certain hotel types of services and facilities (on-site restaurant, bar, small banquet rooms, and so on). multifamily REIT A real estate investment trust that invests primarily in apartment properties. multiple nuclei theory, 1945 An urban growth theory which holds that there is more than one focal point of economic activity in any urban area and that land use patterns will evolve in relation to the type of centers and proximity of land to these centers. Developed by C. D. Harris and E. L. Ullman. multitenant building Building, office, or other facility occupied by more than one tenant; may be anchored by one or more major tenants. multiuse building Building combining several uses in a single structure. multiuse project Project including more than one land use. National Association of Real Estate Investment Managers (NAREIM) Founded in 1990, a professional association of real estate investment managers. Members represent both domestic and foreign capital and include real estate advisors, financial institutions, REITs, opportunity funds, and private investors. In aggregate, NAREIM members manage over $300 billion in real estate assets. National Association of Real Estate Investment Trusts (NAREIT) A trade association of real estate investment trusts (REITs) and other publicly traded real estate firms as well as corporations, partnerships, or individuals who advise, study, or service these businesses.

556

Glossary

National Council of Real Estate Investment Fiduciaries (NCREIF) Nonpartisan organization that collects, processes, validates, and publishes historical data on real estate performance. Publishes the NCREIF Property Index (NPI). National Environmental Policy Act (NEPA) of 1969 Legislation enacted to require federal agencies to file an environmental impact report (EIR) with the Council on Environmental Quality (CEQ). National Historic Preservation Act of 1966 and the National Register of Historic Places Legislation authorized as part of a national program to coordinate and support public and private efforts to identify, evaluate, and protect the nation’s historic and archeological resources. Administered by the National Park Service, Department of the Interior. National Labor Relations Act of 1935 Legislation that established the National Labor Relations Board with the power to investigate and decide on charges of unfair labor practices and to conduct elections in which workers would have the opportunity to decide whether they wanted to be represented by a union. National Planning Board Organization established in 1933 to coordinate planning activities throughout the nation. Renamed National Resources Board in 1934. National Resources Board Originally National Planning Board, an organization established to coordinate planning activities throughout the nation. needy elderly Population age group of 75 to 84 years old, often surviving-spouse households that tend to have low income levels and are dependent on the assistance of family or social institutions. negative leverage A situation in which the simple return on an investment is less with the use of debt financing than it would be on a free-and-clear basis. In real estate, this generally occurs when a loan constant is higher than the capitalization rate. See also leverage and positive leverage. neighborhood centers Shopping centers usually located within 15 minutes’ driving time from the majority of its shoppers. Provides necessities such as food, over-the-counter medicines, and personal services primarily through large food and drugstore chains. Sizes range from 30,000 to 100,000 square feet of gross leasable area. neighborhood revitalization programs Programs aimed at revitalizing and restoring deteriorating neighborhoods. net lease A lease agreement in which the lessee pays certain costs associated with a leased property, including property taxes, insurance premiums, and the cost of repairs, utilities, and maintenance, in addition to rent. See also lessee and gross lease. net occupied area Amount of space actually occupied by tenants. See also net rented area. net operating income (NOI) The effective gross revenue from a real estate project, less operating costs and an allowance for anticipated vacancy. net present value (NPV) A discounted cash flow formula by which investment outlays and future cash flows are discounted by a predetermined discount rate to arrive at a property’s present value. The present value factor may reflect a “riskless” rate of return (government bonds), the cost of internal capital (opportunity rate), or a “target” or “hurdle” rate that incorporates some assessment of risk. net rentable area (NRA) Amount of space in a building or buildings available for rent to prospective tenants, measured in square feet. Generally excludes elevator shafts, duct shafts,

Glossary

557

stairways, and smoke towers and includes restrooms and janitorial equipment, telephone equipment, and electrical ducts, or a pro rata share of such space for tenants on multitenant floors. Used primarily in connection with office buildings. net rented area Amount of space in the building(s) under legal lease to tenants, whether the space is utilized or not. See also net occupied area. new economy warehouse Type of warehouse that separates incoming and outgoing functions; usually at opposite sides of the buildings with a central “staging area” to unpackage and repackage stored goods, generally from larger packages to smaller ones. New Jersey State Development and Redevelopment Act of 1992 State legislation that defined a comprehensive strategy to achieve goals enumerated in the New Jersey State Planning Act of 1985. New Jersey State Planning Act of 1985 Legislation that created New Jersey State Planning Commission and the Office of State Planning. Established statewide planning system to “conserve natural resources, revitalize urban centers, protect the quality of environment, and provide needed housing and adequate public services at a reasonable cost.” new town A self-contained new community, planned and built from the ground up, with all the facilities, including jobs, to make it an independent environment. new town in town A totally planned city within an existing urban area; designed to make a major economic and environmental impact on the surrounding, and, usually, deteriorated neighborhood. new urbanism Urban design concept emphasizing traditional neighborhood planning; emphasizes environmental responsibility, historic preservation, pedestrian-friendly neighborhoods, and integration of local ecosystems and open space into the culture of living. node Concentration of real estate and other economic activity. nonanchor tenants In a shopping center, smaller, local merchants who generally do not have strong credit ratings and often require a lot of TLC from a property management standpoint. See also anchor tenant. nonsystematic risk Statistical measure of the variance in expected investment return due to underlying risks of a particular asset or asset class. See also systematic risk. North American Free Trade Agreement (NAFTA) of 1994 Agreement between Canada, the United States, and Mexico, forming the world’s largest free-trade area. offering memorandum (OM) A formal description of a property being offered for sale and the terms of the prospective transaction. Most commonly used in a competitive bidding situation. offer to buy See deposit receipt. office park A node of office structures, usually in an outlying area, having a single development management firm that oversees landscaping and other site maintenance services. off-price center Shopping center that sells out-of-season, surplus, or discounted items, all at discounted price. offshoring A business practice of outsourcing a portion or all of the production and/or service activities to countries where market conditions are perceived to be more favorable. off-site infrastructure The infrastructure in the community in which the development project is located. Includes libraries, parking facilities, schools, storm drainage systems, and other objects in proximity to and often affected by a development project.

558

Glossary

one-child policy Policy adopted in China in 1979 to limit population growth. Enforces a policy of allowing families in urban areas to have only one child. It allows families in rural areas and some minorities to have two children without facing economic or other penalties. open-end fund A real estate investment fund with a varying number of investors (primarily pension funds), who share income based on their pro rata share of funds invested. Investors can leave the fund at certain intervals based on their pro rata share of the appraised value of all of the properties in the portfolio. open listing A listing agreement given a broker on a nonexclusive basis; that is, the same listing can be given to other brokers at the same time. See also listing agreement. operating expenses Expenses of maintaining a property including property taxes, utilities, and insurance. Does not include financing and depreciation. Operation Breakthrough Program, 1969 A program initiated by the federal government to promote the concept of modular housing. option The agreement that gives a right to purchase or lease a property upon specified terms within a specified period. option to purchase A right to purchase a leased property during or at the end of the lease period at a specified price. Oregon Land Use Act of 1973 (Senate Bill 100) State legislation that required the state’s cities and counties to adopt comprehensive plans consistent with state goals. outlet center Shopping center with brand-name retailers who sell merchandise at discounted prices; usually has no anchor tenant. Center may be regional in scope and located on a major highway, often near a popular tourist area. Trade area is regional, with strong customer base of tourists. overall capitalization rate The percentage relationship of net operating income divided by the purchase price of the property. Includes land and land improvements. partially amortized mortgage Mortgage that requires periodic payments of principal at selected points during its term, with the balance due at the end of the term (balloon payment). See also straight-term mortgage and fully amortized mortgage. participating-convertible mortgage A mortgage that combines the features of a participating and a convertible mortgage, allowing the mortgagee to participate in cash flow and providing an option to convert to full or partial ownership of the property. participating mortgage A mortgage contract in which the mortgagee does not have an equity interest in the property but has the contractual right to participate in cash flow beyond a certain point and, in some cases, in sales or refinancing proceeds beyond a certain value. partnership An association between two or more persons who agree to combine part or all of their capital, property, labor, and/or skills in the pursuit of some lawful goal or business and to divide their profits or losses in some predetermined manner. Each partner has full personal liability for all the debts of the partnership. Also called general partnership. payback period The amount of time in years required for the total net operating income from the investment to equal the equity investment. payment bond A bond that ensures that persons or entities furnishing labor or materials will be paid for their services or materials up to the amount of the bond. percentage lease A lease of property in which the rental is calculated as a percentage of sales; the lessor is usually protected by the provision for a minimum rent if sales are below a certain level.

Glossary

559

performance bond A bond guaranteeing the owner that the bonding company will complete construction if the contractor defaults; the cost is usually 0.5 to 1 percent of the total construction cost. permanent loan Long-term financing on projects that have been completed and are in operation. personal services Services provided on a relatively frequent basis, generally at the most convenient locations. Includes laundries, dry cleaners, barber and beauty shops, nail salons, video stores, fast-food restaurants, and quick serve coffee shops. See also specialized services. Petaluma Plan, 1972, Petaluma, California Local environmental design plan enacting strict criteria for evaluating new development; upheld by the U.S. Supreme Court in 1976. physical deterioration The reduced value of the structural elements of a building through decay, cracking, settling, or wear and tear. pioneer new town New town that is a completely independent community of more than 250,000 people, located a considerable distance from existing urban centers. See also new town. planned unit development (PUD) Model zoning ordinance allowing large-scale land development of compatible land uses such as housing, industrial, and commercial parks and recreation. polycentric city theory, 1982 An urban growth theory based on the assumption that a benefit from interaction of two firms is a negative exponential function of the distance between them. This assumption results in an exponential increase of transportation costs as distance from the city center increases and allows formation of multiple business districts and multiple equilibriums of land use patterns. Developed by Fujita and Ogawa in 1982. population growth rate A function of the number of births (fertility), deaths (mortality), and net international migration. In essence, population increases when the number of people born or immigrating is ultimately greater than the number dying or emigrating. positive leverage A situation that exists when the simple return on a real estate investment is higher with the use of debt financing than it would be on a free-and-clear basis. Occurs when the loan constant is lower than the capitalization rate. power center Shopping center consisting of a collection of big-box buildings containing at least 20,000 square feet each and leased to major (mostly discount) retailers specializing in bulk foods, health aids, toys, home furnishings, home improvement supplies, and so on. Usually requires at least four of these retailers to provide critical mass. In some situations, anchors may occupy 80 to 90 percent of the total center. precast construction A method of construction in which concrete is poured at an offsite location and then transported to the site, where it is assembled. preconstruction scheduling A strategic plan of action that clearly indicates the objectives to be accomplished, the logical sequence of events required for their accomplishment, and the methods that will be utilized. preliminary design A step in the project planning and design process during which specific dimensions and volumes are established in the form of hard-line drawings. preliminary underwriting In the investment process, preliminary analysis of investment potential of a property; usually in preparation for submittal to an investment committee for approval.

560

Glossary

prestressing Technique for increasing the load-bearing qualities of concrete without proportionately increasing the bulk; concrete is compressed either before (pretension) or after (posttension) pouring. preventive maintenance The tune-up and adjusting necessary to keep construction equipment at peak operating efficiency. profit maximization theory Theory of industrial location that cites profit maximization as a primary determinant of firm location. See also least-cost theory. pro forma cash flow analysis (pro forma statement) A projection of the annual income, expenses, and resulting cash flows expected from the operation of an investment. program evaluation and review technique (PERT) A computerized management tool for planning and scheduling. promissory note Legal instrument representing a debt and normally setting forth the principal amount of the debt, the rate of interest, the schedule of payments of interest and principal, and the date when the loan is due. propensity to consume (marginal propensity to consume) Ratio of the change in consumption to the change in income. Reflects the increase in personal consumer spending (consumption) that occurs with an increase in disposable income (income after taxes and transfers). property management Day-to-day management of individual properties, generally involving responsibility for on-site tenant relations, custodial services, maintenance, supply procurement, security, and disaster plan execution. Services may be provided internally or by contract with one or more independent firms. property report A report mandated by the Land Sales Full Disclosure Act of 1968; contains relevant information about the subdivision and must be delivered to each purchaser before the signing of the contract or agreement. Proposition M of 1986, San Francisco, California A referendum and subsequent law that have incorporated citywide growth limits and impose restrictions on real estate development. Limited new commercial development to 475,000 square feet a year until 1998. purchase agreement A written document in which the seller and the purchaser set forth their agreement to the terms and conditions of sale. Also called purchase and sale agreement, contract of sale, or agreement of sale. purchase money mortgage A mortgage given to the seller of a property by the purchaser, making the seller the lender and the purchaser the borrower. Also called mortgage takeback. qualified plan asset manager (QPAM) (1980) A pension fund trustee. Also the legislation clarifying ERISA standards for hiring of real estate agents. Establishes the role of a QPAM whose use allows plan sponsors to escape direct liability for the management of real estate assets in their portfolios. quasi-equity mortgage See hybrid mortgage. quitclaim deed A written instrument that transfers whatever interest in real property is held by the transferor, without warranty that the transferor has any specific interest. railroad apartment buildings Developed in 1879 in New York City, the first buildings that allowed several families to occupy a single site. rational nexus A formula used to determine the maximum fee communities can charge developers for off-site infrastructure. Under this concept, developers can be charged only for the portion of municipal capital facilities that serve their development.

Glossary

561

real cash flow Cash flow deflated by the assumed or actual inflation rate. See also cash flow. real estate investment trust (REIT) An unincorporated trust or association managed by one or more trustees, with beneficial ownership by 100 or more people. Provided 90 percent of annual income is distributed to beneficial owners, the income is taxed directly to the owners and not the trust. real estate mortgage investment conduit (REMIC) Standard tool for investment in derivative securities. Holds a fixed pool of mortgages and issues interest in itself to investors. May be in a form of a partnership, corporation, trust, or separate pool of assets. Real Estate Roundtable (RER) Formerly known as the National Realty Committee. The RER is a real estate lobby organization currently focusing on protecting interests of the real estate industry. Real Estate Transparency Index (RETI) Developed by Jones Lang LaSalle Management in 1999, an index that measures the level of real estate investment transparency of various countries. Criteria include accurate market and financial information; reliable performance benchmarks; enforceable contracts and property rights; clarity regarding taxation and regulation of real estate; fair treatment in the transaction process; and ethical standards among professionals hired to transact business. reappraisal clause A clause in a reappraisal lease that provides for adjustment of the property value at periodic intervals through reappraisal. Both landlord and tenant have the right to appoint their own appraiser. reappraisal lease A lease in which the rent is adjusted periodically based on a percentage of the value of the property. recapture rate Rate of return of the investment. (See the appendix for further explanation.) rectangular survey system A governmental land survey system that establishes a series of north-south lines (meridian lines) and east-west lines (base lines) and that divides the nation into townships, sections, and acres. Red Cars Nickname used for the Pacific Electric Railway trains that connected small towns in the Los Angeles area. These trains made up the largest private interurban transportation system in the world in 1910. redlining Practice of refusal by home lenders and insurance companies to provide financing or insurance policies for homes located in certain low-income inner city neighborhoods. reduction-option mortgage A mortgage that allows the borrower to reduce the interest rate (on a one-time basis) between the second and fifth year of the mortgage, provided that rates drop at least 2 percentage points in a single year. referral fee A flat fee paid by the listing broker to other brokers if they refer prospects who eventually purchase or lease the property. regional center Shopping center serving a market area of up to 45 minutes’ driving time; usually used for big-purchase needs such as appliances, furniture, or apparel. Regional centers range in size from 250,000 to over 900,000 square feet. Most regional centers are anchored by one or two major department stores. They also may have tenants such as travel agencies, home services, entertainment facilities, banks, and other personal and business services. Reilly’s law See law of retail gravitation. reinstatement The act of curing all defaults by a borrower; the act of restoring a loan to its current status by paying all arrearages.

562

Glossary

reinvestment rate The interest rate an investor is assumed to be able to earn on intermediate cash flow in the projection of a terminal value. relative location value The value of a parcel of land computed as the combination of its spatial proximity to other parcels and the linkage between them. renegotiable mortgage See rollover mortgage. renewal clause A clause in the lease giving the tenant an option to renew the lease provided that the tenant has not been in default during the lease term and that the tenant gives the landlord written notice within a prescribed period of time prior to expiration. rental income insurance Insurance to cover the loss of rental income over the period during which rental income abates because of destruction of or damage to a building located in areas where specific hazards exist (for example, floods, tornadoes, or earthquakes). replacement real estate market A market with a contracting labor force in which demand for new properties comes primarily from replacing obsolete buildings and/or geographical shifts in demand between metropolitan areas. replacement reserve Reserve account intended to cover capital improvements that will be required as various parts of the building wear out. Report of the Royal Commission on Distribution of Industrial Population (1939) Analysis of the distribution of the industrial population in Great Britain; established many of the concepts of English new towns. residential market area The geographic area within which most or all dwelling units are linked together in a chain of substitution. residual approach Approach used in appraisal to determine the value of one component when the value of the other is known. For example, when the land value is known and the appraiser wishes to determine a building value (building residual), or when the building value is known and the appraiser wishes to determine the value of the land (land residual). Resolution Trust Corporation (RTC) (1989) An organization created by the federal government to liquidate the assets of insolvent S&Ls. resort hotel Lodging facility directed primarily at the pleasure traveler, although it may cater to group businesses in the off-peak seasons. Generally provides all hotel services, as well as extensive recreational facilities. resource-oriented firms Industrial firms oriented toward resources required for production. reversionary right A property owner’s right to property whereby at the end of a ground lease the land and improvements revert to him or her as the owner of the land. Rhode Island Comprehensive Planning Act of 1988 Legislation that required each city and town to adopt a comprehensive master plan addressing elements specified in the act (for example, housing, land use, economic development, or environmental impact). right of first refusal The right of a party to be given an opportunity to buy or lease property by matching the terms of a contract being proposed by another party. right of survivorship Under the joint tenancy form of ownership, the automatic succession by a surviving owner to the deceased owner’s interest. risk-adjusted rate of return The rate of return calculated for an investment using discounted cash flow analysis when the projected cash flows have been arrived at by assigning probabilities based on risk. rollover mortgage A short-term mortgage with interest rates fixed for a specific time period (usually one to three years), then renegotiated based on prevailing market rates.

Glossary

563

safe rate of return Rate of return on investments having the greatest liquidity and safety, such as long-term U.S. government bonds. sale leaseback transaction Process whereby the owner sells the property and leases it back over a period of years. sales commission Cash remuneration generated by a property sale, generally computed as a percentage of the total sales price. sales comparison approach One of three appraisal approaches to estimating value. With a sales comparison approach, value is indicated by the prices of comparable properties recently sold. San Francisco Bay Area Conservation and Development Commission (BCDC) (1965) Local commission formed to regulate land and water use around San Francisco Bay. San Francisco Downtown Plan (1985) An ordinance passed in San Francisco that requires developers to pay for public costs arising from the adverse impact of development projects on housing and transportation. satellite new town New town created within a framework of an existing metropolitan region—close enough to draw upon the employment and cultural base of the urban center, yet removed enough to create a new environmental setting. satellite store Retailer that is dependent on being near a larger retail store that generates business. See also generative business and shared business. savings and loan association (S&L) A depository institution specializing in origination, service, and holding of mortgage loans, primarily on owner-occupied residential property.4 Seattle Comprehensive Plan (1994) Seattle’s growth and development plan that revised its 1956 land use plan. The 1994 revision included a two-tier incentive approach to encourage higher-density commercial developments. Updated in 2004 to accommodate projections up to 2024. sector theory, 1939 Proposed by Homer Hoyt, a theory that modified the axial theory on urban growth to consider attractiveness of one transportation corridor over another. A transportation corridor that is established early or is more accessible will tend to attract more development than one that develops later or is less efficient. security deposit A cash payment required by a landlord to be held during the term of a lease to offset damages incurred due to actions of the tenant. Usually the landlord is required to return the deposit within a certain period upon expiration of the lease. sensitivity analysis A method of analysis that evaluates several different outcomes critical to a project’s success and then tests the impact of each outcome on the overall rate of return. settlement statement See closing statement. shared appreciation mortgage A form of contingent interest mortgage, allowing for lower interest rates in exchange for a future sharing of equity by the lender. See also contingent interest mortgage. shared business Business activity dependent on customers who are attracted by the pulling power of a nearby generative business; attempts to be as close as possible to generative operations, accounting for the satellite store designation.

4 Jack P. Friedman, Jack C. Harris, and J. Bruce Lindeman, Dictionary of Real Estate Term, 5th ed., Barron’s Real Estate Guides (Hauppauge, New York: Barron’s Educational Series, 2000).

564

Glossary

shell The frame of a building. shift-share theory Urban growth theory that involves looking at two measures of industry in relation to the national economy. For each industry a ratio is developed that compares the percentage of the region’s jobs in that industry to the percentage of the nation’s jobs in that industry. This theory maintains that a regional economy will grow if this ratio is greater than 1 for those industries that are also growing on a nationwide basis. shopper goods Items purchased after some degree of deliberation or shopping around. Generally differentiated through brand identification, retailer image, and/or shopping area ambience. Purchases are made less often, and the products usually cost more and last longer. Examples of shopper goods include apparel, general merchandise, household furnishings, home improvement products, and specialty items like jewelry, cameras, and books. See also convenience goods. shopping center A group of commercial establishments planned, developed, owned, and managed as a unit; related in location and types of shops to the trade area it serves, per Urban Land Institute definition. silent generation Generation that, as of 2007, included people born in the period of 1925 to 1945 (presently aged 62 to 82). Heavily influenced by the Great Depression and World War II, resulting in respect for security and centralized authority. simple return A method of evaluating real estate investment opportunities in which annual debt service is deducted from net operating income (NOI) to arrive at the amount of spendable income. This number is then divided by the amount of equity investment to arrive at the simple return. Also called cash-on-cash return. See also net operating income (NOI) and spendable income. single-family housing Property developed so that there is only one residential dwelling unit on a site, and it does not share plumbing and heating equipment with any other dwellings. single-tenant building Building, office, or other property occupied by a single tenant. site planning The detailed planning of a specific building site, often within a larger land plan. skills-oriented firms Industrial firms that rely on their workforces having particular sets of skills. Such firms locate in proximity to a skilled labor force (for example, electronics firms within proximity to universities and technical schools). slip-form construction A construction method by which concrete for vertical walls is continually poured into a form that moves upward a small amount each day. smart growth Development concept identifying a set of policies for transportation and land use planning aimed at preserving the environment and limiting urban sprawl. soil conditions The quality and nature of various soils found on a site. sole proprietorship The simplest form of equity ownership involving the direct ownership of the equity fee. Sole proprietors completely control the development, management, and disposition of a property. They receive all of the investment return, but they bear the financing obligations as well as unlimited liability. spatial proximity An influence of relative location value described as nearness in space to some other feature. Examples include nearness to physical features (such as water, mountains, or floodplains), markets (such as shopping centers, offices, or industrial facilities), or public services (such as water, sewers, or electricity). specialized services Services provided on a less frequent basis. As with shopper goods, the purchaser often has to shop around before deciding on a particular service provider.

Glossary

565

Typical services include banks, insurance companies, real estate brokers, and travel agencies. See also personal services. specialty center Shopping center ranging in size from 40,000 to over 300,000 square feet; generally has no major anchor stores. Tenants are usually small (400 to 2,000 square feet) and specialize primarily in apparel, household, and specialty goods. Tenants’ emphasis is on merchandising depth rather than breadth. spendable income The amount of pretax cash accruing to equity investors. Calculated by subtracting monthly or annual debt service from net operating income for a similar period. See also net operating income (NOI). split capitalization rate Method of establishing a different capitalization rate for land and buildings involved in the project. spot zoning The act of assigning zoning status to a property that is different from the prevailing status of surrounding properties. spread financing Financing strategy that attempts to match income with maturity of assets and liabilities as well as various levels of risk. The profits are made on the spread between the return of the asset and the cost of the liability. Staggers Act of 1980 Federal legislation passed in 1980 that resulted in a 60 percent reduction in rail shipping rates between 1981 and 2001. Standard City Planning Enabling Act (SPEA) 1928 Legislation that outlined a “master plan” for communities, which would be prepared under the direction of a “planning commission,” advising the local elected governmental agency; discussed provisions for approval of all public improvements, procedures of subdividing land, and participation of the local jurisdiction in the regional plan. standard industrial classification (SIC) codes Codes that identify industries by the category of products they produce. A method of classifying industries in accordance with the structure and composition of the economy; used for comparability of statistics. Standard State Zoning Enabling Act (SZEA) of 1922 Legislation that enabled local governments to control the height, area, bulk, location, and use of buildings. Also allowed local jurisdictions to divide land into zones or districts with varying regulations (for example, residential, commercial, or industrial), as long as the properties within the districts were treated uniformly. straight-line depreciation A method of calculating annual depreciation by which equal amounts of depreciation are charged off each year (for example, an asset with a five-year life would have one-fifth of its depreciable value charged off each year). See also accelerated depreciation. straight-term mortgage Mortgage requiring no principal payments during its term. A balloon payment is required at termination to pay off the principal. Also called interestonly mortgage and flat mortgage. See also fully amortized mortgage and partially amortized mortgage. strip center Shopping center with 6 to 12 shops with parking in front. Tenants include small, quick-serve restaurants as well as coffee chains such as Starbucks. Subchapter S A section of the Internal Revenue Code that allows a corporation to pay no corporate income tax on its income and, instead, to have the income taxed directly to the shareholders even though it may not be distributed to them; requires unanimous consent of shareholders. subcontractor An individual or organization that contracts with either an owner or a general contractor to perform specific work on a project basis. Commonly, the general

566

Glossary

contractor makes arrangements with separate subcontractors for different parts of construction such as plumbing or electrical wiring. subcontractor bond A bond that protects the general contractor from nonperformance by the various subcontractors. subdivision A tract of land that has been divided into smaller legal parcels for the purpose of selling or leasing them. The disposition of the parcels may occur immediately or at some later time. The property may be improved or unimproved. subleasing See subletting. subletting The lease of a space by a tenant to another tenant. Also called subleasing. subsurface rights The rights of gaining income from the sale of any natural resources found under the land. Also known as mineral rights. subtenant An individual, partnership, corporation, nonprofit organization, or other entity that leases space in a building in accordance with a written legal sublease agreement, provided that approval of landlord has been granted. suburban shopping district Shopping area developed largely on an unplanned basis in older suburbs. Often emerged as strip commercial areas around a major arterial connecting with downtown or evolved around a major department store with an uptown branch. Also, may represent downtowns of small rural communities swallowed up in the spread of suburbia. superregional center Largest of all shopping centers, a type of shopping center that provides a similar merchandize mix as a regional center but in greater quantity and diversity. Anchored by three or more department stores, ranges in size from 500,000 to 1,500,000 square feet and serves a market of up to 60 minutes’ driving time. May also have an office employment center and entertainment complex on or adjacent to its site. More similar to a central business district than to any other type of shopping center. supply chain management Process of planning, implementing, and controlling the supply chain in order to satisfy customer requirements as efficiently as possible. surface rights The rights to use and modify the surface area of a real property. suscipient business Business activity generated by people coming for a purpose other than shopping. Examples include newsstands in airports, subways, train stations, and downtown retailers that exist to serve office workers in the immediate area. synergy The interaction of two or more parts of a system such that the combined effect is greater than the sum of the parts. In business, describes a hoped-for or real effect resulting from different individuals, departments, or companies working together and stimulating new ideas that result in greater productivity. synthetic rate method See band of investment method. systematic risk In an investment portfolio, overall market risk that cannot be diversified. Taft-Hartley Act See Labor-Management Relations Act of 1947. Tahoe Regional Planning Agency (TRPA) (1969) Regional commission formed to deal with lake pollution, landfill, and other land development problems. takings issue A civic issue concerning zoning laws and regulations as they pertain to property rights. The debate on takings centers on which government provisions and actions constitute a taking of private property and thus require the government to compensate owners under the Fifth Amendment of the Constitution.

Glossary

567

Tax Reform Act of 1986 Legislation that introduced several homeownership tax incentives (such as increasing the home mortgage interest deduction) while phasing out certain incentives for rental housing. tenancy at will Tenancy subject to termination at any time without notice. Generally arises when a lease does not conform to statutory law. tenancy by sufferance The legal status of tenancy that occurs when a tenant’s original rights to occupancy have expired but the tenant keeps the subject property with the implied consent of the owner. tenancy in common (TIC) Ownership or a partial interest in property without individual legal title or rights of survivorship. See also joint tenancy. tenant An individual, partnership, corporation, nonprofit organization, or other entity that leases space in a building in accordance with a written legal lease agreement. Also called lessee. tenant estoppel certificate A written statement by a tenant identifying that a lease is in effect and certifying that no rent has been prepaid and that there are no outstanding defaults by the landlord, except as specified; relied upon by a prospective lender or purchaser. tenant standards The minimum basic standards for designing interior space of a building, including ceilings, partitions, air-conditioning zones, electrical and telephone outlets, carpeting, and so on. Tenants may select to upgrade from this basis or modify interiors according to their own needs and desires. Also called building standard finish. tennis ranch Tennis-themed destination resort where guests enjoy access to tennis and other recreational facilities; gained popularity in the 1970s. tilt-up method A method of concrete construction in which wall panels are cast on the ground and then tilted into place to form structural load-bearing exterior walls that have an architectural finish that may be painted. timesharing A method of ownership of condominiums or other real estate in which an undivided interest is sold to two or more parties as tenants in common, with the deed indicating the specific time of the year when the property can be utilized by the purchaser; used primarily for resort and hotel properties. title insurance Insurance written by a title insurance company to protect and indemnify the owner for any loss due to imperfections or defects in the title other than as disclosed in the policy of title insurance. title search A complete examination of the records of the county recorder to determine the legal status of title to a property. title theory Theory and practice by which a lender holds legal title to a property covered by a mortgage, as opposed to having a lien on the property. The borrower retains physical possession, but only at the sufferance of the lender. topography The state of the surface of the land including differences in elevation, drainage, wind patterns, gradient, and other natural features. town center Community shopping center that includes two or more pedestrian streets with street-front retail and, in some case, residential above. See also community center. town jobbing Practice employed by private land companies in early 1800s to facilitate land sales. Entire cities were laid out and sold to potential investors. Examples include Cleveland, Cincinnati, Toledo, and many smaller Ohio cities. transitional neighborhoods Neighborhoods going through a revitalization process.

568

Glossary

transportation-oriented firms Industrial firms oriented toward the type of transportation that best serves their needs. trust deed A security instrument that transfers title to real property to a third party (trustee) as collateral for the repayment of a debt owed a lender (beneficiary) by the borrower (trustor); used in some states in place of a mortgage. Also called deed of trust. trustee See mortgagee. trustor See mortgagor. Uniform Standards of Professional Appraisal Practice (USPAP) The generally accepted standards for appraisal practice in North America. Contains standards for all types of appraisal including real estate, personal property, business, and mass appraisal. unit-in-place method A variation of the cost approach in appraisal by which the appraiser performs a modified quantity takeoff based on detailed plans and specifications and then multiplies physical measures of various building components by their respective unit costs. unsystematic risk Risk that can be reduced through portfolio diversification. uptown Area close to downtown located along a major arterial that provides access to the suburbs. Often a popular site for office development. See also downtown. urban development action grants (UDAGs) Grants awarded by a federal program started in 1977 and administered by the Department of Housing and Urban Development. The grants provide funds for residential and nonresidential uses to distressed communities. urban growth Increase in the intensity of land resource uses in an urban area; may or may not entail an increase in population. Usually includes higher capital investment per unit of land employed and increased productivity associated with urban economic processes. urban growth boundary (UGB) Tightly regulated zoning boundary around a city; intended to promote development within city, thereby limiting urban sprawl. Urban Land Institute (ULI) A nonprofit organization dedicated to providing information on development and use of land resources and building operations. urban renewal The redevelopment of a deteriorated urban area in which one or more governmental agencies assume a leadership role in organizing and implementing the process. Usually includes restructuring of land ownership parcels; oversight of physical planning activities; financing, construction, and operation of public improvements; and oversight of development and operation of private development within the project area. U.S. Demonstration Cities and Metropolitan Development Act of 1966 Legislation that requires local governments that have applied for certain types of federal grants-in-aid be subject to review by “an areawide agency designated to perform metropolitan or regional planning for the area within which the assistance is to be used.” U.S. Department of Housing and Urban Development (HUD) The Cabinet-level department of the federal government responsible for housing and urban affairs. Includes the Federal Housing Administration. use capacity The relative ability of a land parcel to generate a surplus of returns and/or satisfaction over its costs of utilization. VA See Veterans Administration. vacancy allowance The amount of gross revenue lost because of vacant units and/or unleased space; an allowance item on pro forma income statements, usually calculated as a percentage of gross revenue.

Glossary

569

vacuum technique Method of calculating sales potential for a new retail store or center in a given trade area by subtracting the existing sales volume from the total sales potential in the trade area. valuation An estimate of value of a property by means of an appraisal. value engineering Engineering practices that result in the balancing of the functional elements of a project with their quality and cost so as to come up with the highest overall value. variable operating expenses Operating expenses that vary with occupancy, such as utilities. See also operating expenses and fixed operating expenses. variable-rate mortgage A mortgage in which the interest rate and/or payment schedule may vary over the life of the mortgage. The interest rate is usually tied to some predetermined index (for example, Treasury bonds or the thrift industry cost-of-funds index) that reflects changes in the cost of capital. See also adjustable-rate mortgage. Vermont Act 250 State land use development plan enacted in 1970. Established state environmental board to regulate development. Developers are required to prove that projects will not (1) generate undue environmental problems, (2) place too great a burden on public services, or (3) adversely affect the aesthetics in the area. Veterans Administration (VA) As of 2007 named the U.S. Department of Veterans Affairs. An independent agency under the president responsible for administering laws providing benefits to veterans and their dependents and beneficiaries. Voting Rights Act of 1965 Legislation that outlawed the use of literacy tests as a requirement for voter registration. walk-ups Buildings with two to three floors that do not utilize elevators for employee or resident transportation between floors. Washington Growth Management Act of 1990 Legislation enacted to channel urban growth into cities and protect agricultural land and rural areas from suburban sprawl. weighted capitalization rate Capitalization rate that includes debt and equity capitalization rates multiplied by the percentage of the investment that they constitute. Williamson Act of 1965 Legislation that authorized counties to designate special agricultural preserves. Owners of farms of over 100 acres within these preserves received favorable property tax treatment, provided that they maintained the land in a “use not incompatible with agriculture” for at least 10 years. wraparound mortgage A mortgage that places a new junior loan on a property without removing existing loans. The new loan generally exceeds the remaining balance on the existing loans, thereby releasing new funds and/or facilitating the sale of the property. Usually written for a longer term than the existing mortgage and has a higher overall interest rate. The new mortgagee then makes payment to the first lender who holds the existing mortgage. Also referred to as a blanket mortgage, an extended first mortgage, or all-inclusive mortgage. yield Also called discount rate. The effective return on an investment based on the stated interest rate and the actual amount of investment; also the ratio of the annual project income from a property to its cost. yield capitalization approach See internal rate of return. yuppie elderly People presently in the population age group of 65 to 74 years old who are in relatively good health and generally have high disposable incomes. zoning Government process by which the character and use of real property is regulated and controlled. Also defined as the application of the police power of the government to the use of land and improvements.

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Index

Abstract of title, 186 Accelerated depreciation, 361 Accounting expenses, 506 Adjustable-rate mortgages (ARMs), 328 Advertising, 473–476, 510 Africa, 120–123 Aggregate adjustment, 524 All-inclusive mortgages, 329 Anchor tenants, 229 Apartment buildings, 10 Apartments, 193 cooperative, 193 garden, 194 high-rise, 194 loans for, 343 Appraisal, 519–536 cost approach for, 523, 530–532 definition of, 519 future directions for, 535–536 income approach for, 523, 526–530 land value estimate and, 523 market value and, 519–521 purpose and use of, 522 sales comparison approach for, 523, 524–526 traditional approach to, 521–535 Appreciation, 357–358 Approach signing, 479 Approval process, 422–423 Architectural and engineering (A&E) fees, 379 Attornment and recognition agreements, 326 Australia, 115–116 Automobile, suburbs and, 13–14 Axial theory of land use development, 164, 165 Baby boomers, 214, 245–246 Balloon payments, 327 Band of investment method, 528 Banks, real estate lending by, 333–334 Best available control technology (BACT), 60 Bid bonds, 452 Bid-rent theory of land use development, 166, 167 Binders, 187 Blanket first mortgages, 329 Boating facilities, 33

Bonding, 452 Brazil, 119–120 Brokerage firms, independent, 468–469 Brokerage teams, internal, 467–468 Building inventories, 162 Building office expenses, 505–507 Buildings: industrial, 273–274 multiuse, 305–306, 311–312 Building supplies, procurement of, 509 Business cycle, 149–150 Business firms: demographic changes and, 248–249 in U.S., 144–145 Business travelers, 288–289, 295–296 California, 8 Canada, 116–120 Canadian investors, 79–81 Canals, 6 Capital, U.S. supply of, 148–149 Capital gains, 361 Capital improvements, 511–512 Capitalization process, 527–528 Capital structure, in simple return analysis, 382–383 Carrying capacity, 412 Cash flow, in discounted cash flow analysis, 395–401 Cash return, 359 Cast-in-place construction, 446–447 Category killers, 224 Ceiling prices, 181–182 Change orders, 426 China, 107, 109–111 Cities: economic growth of, 154–156 historical growth of, 152–154 19th-century growth of, 8–13 revitalization of, 20–26 City Beautiful movement, 40 City planning, 38–43 broadening of geographic planning unit and, 55–56 City Beautiful movement and, 40 industrialization and, 38–39 571

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572

City planning (Cont.): regional and local, 42–43 zoning and, 40–42 Closing deals, 189, 483–486 Cluster concept, 27 Collateralized mortgage obligations (CMOs), 338 Commercial banks, real estate lending by, 333–334 Commissions, 471–473, 509–510 Commodity markets, equity financing and, 353 Common area maintenance (CAM), 507–508 Community development corporations (CDCs), 21 Community renewal programs (CRPs), 21 Community shopping centers, 223–224, 433 Comparative method for capitalization, 528 Comparison cost method, 531 Competitive surveys: for industrial development, 281, 282 in market demand analysis, 235–236, 237 for office space, 260–261, 262–263 for ownership housing, 204–206 for rental ownership housing, 216 for transient commercial facilities, 296–298 Component rate method, 528–529 Computer-aided design (CAD), 422 Computers, in marketing programs, 479–480 Concentric theory of land use development, 164 Concept design stage, 417 Concrete construction, 445–448 Condominiums, 27–28, 193, 211–212 Constrained markets, equity financing and, 353–354 Construction, 443–465 contract, 449–454 potential problems with, 454–460 scheduling and progress monitoring for, 460–465 types of, 443–449 Construction change directives, 451 Construction costs, 377–379 Construction equipment, 458–460 Construction loans, 342 Construction management, 512 Construction management contracts, 450–451 Construction managers, 454 Construction materials, 455–456 local supply of, 162 U.S. supply of, 147–148 Construction progress monitoring, 463–465 Consumer behavior theory analysis, 232 Consumer surveys, in market demand analysis, 236, 238–239 Contingent interest mortgages, 328

Index

Contract documents, 424–426 Contractors, selecting, 452–454 Contracts: for construction, 449–454 of sale, 187–188 Convenience shopping centers, 225 Conventioneers, 289 demand for facilities related to, 291–295 Convertible ARMs, 328 Convertible mortgages, 328 Cooperative apartments, 193 Corporations, 371–372 Corrective maintenance, 508–509 Cost approach to appraisal, 523, 530–532 Cost of friction, 175 Cost-plus-fixed-fee contracts, 450 Costs: construction, 377–379 of housing, attempts to lower, 64–66 of land, 377 leasing, 379 soft (interim), 379–380 Councils of government (COGs), 55 Covenants, 186 Coverage ratio, 383 Dangerous conditions, 497 Debt capitalization rate, 528 Deeds, 186–187 of trust, 326 Demographics, 66–67 labor force and, 92 ownership housing demand and, 197–198 of U.S. population, 131–139 of workplace, 244–249 Department stores, 10–11 Deposit receipts, 187 Depreciation, 361, 531–532 Deregulation, financing and, 69–70 Derivative securities, 338 Design (see Planning and design) Design efficiency ratio, 257, 379 Development credits, 54 Development impact fees, 52, 54–55 Direct mail, 477–478 Disaster planning, 515–517 Discount and warehouse stores, planning and design for, 434 Discounted cash flow analysis, 384–408 application to other land uses, 407–408 cash flow and, 395–401 internal rate of return and, 401, 404, 405–407 investor analysis and, 401, 403 leveraged analysis and, 401, 402

573

Index

Discounted cash flow analysis (Cont.): net operating income and, 389, 391–395 probability theorem and, 406 sensitivity analysis and, 405–406 space analysis and, 389, 390 time value of money and, 385–388 unbundling investment returns and, 404–405 Discount rate, 529–530 Disintermediation, 70 Downtowns, 228, 252 Due diligence, 188–189 Easements, 185, 186 Echo boomers, 67, 214–215, 247–248 Economic decline, 363 Economic growth: of cities, 154–156 globalization of real estate investment and, 90–91 Economic projections, ownership housing demand and, 200–201 Effective rental schedule, 499–500 Eminent domain, 186 Employment: ownership housing demand and, 197 in United States, 139–145 Endogenous growth theory, 155–156 Entrepreneurship, local supply of, 163 Environmental impact legislation, 56–58, 59–60 Environmental movement, 43–61 exactions and development impact fees and, 52, 54–55 federal legislation and, 56–58, 59–60 geographic planning unit and, 55–56 local growth management and, 49–52 problems with traditional land ownership/use management and, 43 regional growth management and, 48–49 smart growth movement and new urbanism and, 58–59 state laws affecting, 44–47 takings issue and, 60–61 Environment influence area, 178 Equity capitalization rate, 528 Equity investment, 347–373 attractions of real estate as investment and, 357–361 development process risk and, 348 individual property risks and, 361–364 location and value and, 351–355 market timing and, 356 portfolio diversification and, 364–368 property management and, 356–357 synergy’s role in creating value and, 348–351 vehicles for, 368–373

Escalation clauses, in leases, 493 Escrow, 189 Estimating, for construction, 451–452 Ethnicity, of U.S. population, 137–139 Europe, 99–107 Exactions, 52, 54–55 Exclusive agency listings, 470 Exclusive right to sell, 470 Expanded communities, 310 Export base theory of economic growth, 154–155 Extended first mortgages, 329 External signing, 479 Factor analysis, in sales comparison approach to appraisal, 525 Federal Home Loan Mortgage Corporation (FHLMC), 337 Films, in marketing programs, 478 Financing, 68–83 equity investment for (see Equity investment) leaseback, 330 local supply of capital and, 162–163 mortgage (see Mortgages) pension funds and, 72–75 structural changes in lending and, 69–72 traditional real estate capital markets and, 68 U.S. real estate capital supply and, 148–149 Firm orientation, industrial site location and, 269–270 Fixed expenses, net operating income and, 381–382 Fixed-price contracts, 450 Fixtures, tenants' responsibilities for, 497 Flat mortgages, 326 Floor prices, 181–182 Florida, 8 Flying form construction, 447 Foreclosure process, 325 Foreign investors, 79–82 France, 103–104 Freehold estates, 185 Free rent, 394 Freestanding stores, 228 French flats, 10 Frictional vacancy, 394 Fully amortized mortgages, 326 Functional obsolescence, 532 Garden apartments, 194 General partnerships, 370 General warranty deeds, 186–187 Generation X, 246–247 Generative business, 220

574

Germany, 102 Globalization of real estate investment, 82–83, 87–126 forces underlying, 88–99 potential investment markets and, 123–126 regional and country characteristics and, 99–123 Golf courses, 32–33 Goods and services, offered by retailers, 219–220 Government National Mortgage Association (GNMA), 337 Government policy, changes in, 363 Graduated payment mortgages, 328 Gray Areas program, 21 Great Depression, 11–13 Grid system, in sales comparison approach to appraisal, 525 Gross building area, 257 Gross income multiplier approach, 528 Gross leases, 492 Gross rental schedule, 499 Gross revenue, in discounted cash flow analysis, 391 Ground leases, 6, 329–330 Growing equity mortgages, 328 Guaranteed investment contracts (GICs), 71 Guaranteed-maximum-price contracts, 450 Hardening the site, 513 Headquarters hotels, 293 Health and fitness resorts, 34 High-rise apartments, 194 Historic preservation, 24–25 Holdover tenancies, 494 Hoteling, 249 Hotels, 31, 287 headquarters, 293 in mixed-use developments, 314–315 planning and design for, 438–439 Housing costs, attempts to lower, 64–66 Housing expenditures, in United States, 143 Hybrid mortgages, 328 Hybrid projects, matching sites with user’s needs and, 276 Immigration: globalization of real estate investment and, 93 U.S. population growth and, 130–131 Impact fees, 52, 54–55 Income approach to appraisal, 523, 526–530 Index method, in sales comparison approach to appraisal, 525 India, 111–113

Index

Individual parcels of land, 171–190 highest and best use concept and, 171–172 location of, 172–178 purchase transactions and, 183–190 real estate market and, 178–183 Industrial buildings, loans for, 344 Industrial demand, market demand analysis for, 279–284 Industrial facilities, planning and design for, 437 Industrialization, city planning and, 38–39 Industrial parks, 17–18 Industrial sites, 267–284 building design and construction and, 273–274 location of, 268–270 matching with user’s needs, 275–276 site selection process for, 276–279 supply chain management and, 270–271, 272 transportation and, 271–273 Inflation: financing and, 69 real estate as hedge against, 358 Infrastructure, 54 Input-output analysis of economic growth, 155 Installment land contracts, 329 Insurance, 503–504, 516–517 Interest-only mortgages, 326 Interim costs, 379–380 Internal rate of return (IRR), in discounted cash flow analysis, 401, 404, 405–407 Internet, in marketing programs, 478 Investment property submarket, 181 Investor analysis, discounted cash flow analysis and, 401, 403 Italy, 105–106 Janitorial expenses, 504–505 Japan, 113 Japanese investors, 81 Joint tenancy, 370 Joint ventures, 373 Junior mortgages, 326 Labor, 456–458 Labor force: globalization of real estate investment and, 91–93 in United States, 139–141, 146–147 Labor supply, local, 162 Land: cost of, 377 local supply of, 160–162 U.S. supply of, 145–146

575

Index

Land companies, 4, 5 Land contracts, installment, 329 Land development, 19th-century, 6 Land grants, 4 Land leases, 6 Land planning, 412–415 Landscaping, security and, 513 Land speculation, second home sales and, 35–36 Land use development pattern theories, 163–169 Land warrants, 4 Law of retail gravitation, 230–231 Leadership in Energy and Environmental Design (LEED) certification, 419 Leaseback financing, 330 Leasehold estates, 185 Leasehold mortgages, 330 Leases, 492–498 assignment of, 498 ground, 329–330 relationship to mortgages, 325–326 renewal of, 494–495 rent calculation methods and, 492–494 tenants’ rights and obligations under, 496–498 terms of, 494–496 Leasing commissions, 472–473 Leasing costs, 379 Leasing models, 481–482 Leasing offices, 480–481 Least-cost concept, industrial site location and, 268 Legal description of property, 183–185 Legal expenses, 506 Leisure time, changing patterns of, 30–36 Letters of intent, 187 Leverage, 360 Leveraged analysis, discounted cash flow analysis and, 401, 402 Lien theory, 325 Life insurance companies, real estate lending by, 335–336 Lifestyle centers, 226 Lifestyle changes, 66–67 Lift-slab construction, 447 Limited partnerships, 370–371 Liquidity, 362 Listing agreements, 469–471 Location, 172–178 cost of friction and, 175 equity financing and, 351–355 future expectations and, 178 industrial, 268–270

Location (Cont.): relative locational value and, 173–175, 176–177 of retail centers, 229–232 site exposure and, 178 surrounding environment and, 178 trip frequency and, 175 value trade-offs and, 175, 178 Lodging facilities (see Transient commercial facilities; specific types of facilities) Logistics, industrial sites and, 271 Lump-sum adjustment, in sales comparison approach to appraisal, 524 Lump-sum contracts, 450 Mail delivery, security and, 514–515 Maintenance, 507–509 Malaysia, 115 Managing brokers, 469 Manufactured housing, 212 Manufacturing firms, matching sites with user's needs and, 275 Marinas, 33 Market building rent, in discounted cash flow analysis, 389 Market capture, estimating, 263, 265 Market demand analysis: for industrial development, 279–284 for multiuse projects, 311–316 for new towns, 317–319 for office space market, 256–265 of retail market, 232–242 for transient commercial facilities, 290–301 Marketing, 467–487, 509–511 advertising and, 510 closing deals and, 483–486 commissions and, 471–473, 509–510 independent brokerage firms and, 468–469 internal brokerage team and, 467–468 listing agreements and, 469–471 monitoring of, 486–487 project promotion and, 473–483 promotions and, 510–511 Marketing strategy, for ownership housing, 207, 209–211 Market method for capitalization, 528 Market prices, 182–183 Market synergy, multiuse developments and, 316–317 Market timing, equity financing and, 356 Market transparency, globalization of real estate investment and, 96–99 Market value, definition of, 519–521 Masonry construction, 445

576

Master limited partnerships (MLP), 371 Master plan, 415 Medical buildings: planning and design for, 436–437 tenancy of, 254–256 Metro areas, 95–96 demand for office space in, 247–249, 262 growth of, equity financing and, 351–352 selecting for business firms, 277–279 Mexico, 118–119 Microanalysis, of retail market, 231–232 Middle Eastern investors, 81 Miniperm loans, 344 Mixed-use developments (MXDs), 18, 228–229 characteristics of, 306–310 market demand analysis for, 312–316 planning and design for, 440–441 Model Cities program, 21 Monocentric city theory of land use development, 166–167, 168 Mortgage-backed securities, 72, 337–338 Mortgages, 323–346 deeds of trust and, 326 foreclosure process and, 325 ground leases and, 329–330 junior, 326 leaseback financing and, 330 leasehold, 330 lending process for, 338–341 primary mortgage market and, 330–336 property types and, 342–346 rationale supporting real estate debt and, 323–324 relationship to leases, 325–326 repayment terms of, 326–329 secondary mortgage market and, 336–338 theories of title and, 325 Motels, 31–32, 286, 438 Motor hotels, 31–32, 286–287, 438, 439 Multifamily homes, planning and design for, 429–430 Multiple listings, 470–471 Multiple nuclei theory of land use development, 164, 165–166 Multiplier effect, 154 Multiuse buildings: characteristics of, 305–306 market demand analysis for, 311–312 planning and design for, 440 Multiuse projects, 303–319 characteristics of, 305–311 loans for, 345–346 market analysis for new towns and, 317–319 market demand analysis for, 311–316

Index

Multiuse projects (Cont.): market synergy and, 316–317 planning and design for, 440–442 reasons for, 304–305 Negative leverage, 360 Neighborhood shopping centers, 224–225, 433–434 Net leases, 493 Net occupied area, 257 Net operating income, 527 in discounted cash flow analysis, 389, 391–395 in simple return analysis, 380–382 Net present value (NPV), 386 Net rentable area (NRA), 257 Net rented area, 257 New construction, 512 New economy warehouses, 273–274 Newsletters, 477 New towns, 28–30, 310–311 market demand analysis for, 317–319 planning and design for, 442 in towns, 311 Offer to buy, 187 Office buildings, 243–265 activity nodes and, 251–253 demographic changes and, 244–249 loans for, 343–344 location changes and, 250–251 market demand analysis and, 256–265 in mixed-use developments, 312–314 physical workplace changes and, 249–250 planning and design for, 435–437 sales or leasing models for, 481–482 tenancy types and, 253–256 Office parks, 18, 19 as office activity node, 252 planning and design for, 436, 437 tenancy of, 254, 255 Off-price centers, 226 Offshoring: globalization of real estate investment and, 93 U.S. employment and, 141–142 Off-site infrastructure, 54 On-site signing, 479 Open listings, 470 Operating expenses, 395, 501–511 Operating income, net, in simple return analysis, 380–382 Option agreements, 189–190 Option to purchase, 495 Outlet centers, 226–227

577

Index

Overage, 493 Ownership, loss of, 362 Ownership housing, 194–213 competitive surveys of, 204–206 condominiums and, 211–212 demand for, 198–204 manufactured housing and, 212 market area for, 195–196 marketing strategy for, 208, 209–211 project plans for, 207, 208 rental housing versus, 213–215 second homes and (see Second homes) socioeconomic influences on, 197–198 Partially amortized mortgages, 327 Participating-convertible mortgages, 328 Partnerships, 370–371 Payment extension date, 500 Pension funds, 72–75 Percentage clauses, in leases, 493 Performance bonds, 452 Physical destruction, 364 Physical deterioration, 531 Pioneer new towns, 310 Planned unit developments (PUDs), 28, 217 Planning and design, 411–442 approval process and, 422–423 computer-aided design and, 422 contract documents and, 424–426 for industrial facilities, 437 land planning and, 412–415 for multiuse projects, 440–442 for office buildings, 435–437 preliminary design and, 418–422 for residential projects, 426–430 for retail centers, 430–434 site planning and, 415–418 for transient commercial facilities, 438–440 Pleasure travelers, 287–288, 296 Polycentric city theory of land use development, 167–169 Population growth: globalization of real estate investment and, 88–90 in United States, 128–131 Population migration, 156–160 Portfolio diversification, 364–368 Positive leverage, 360 Possession, right of, 496 Power shopping centers, 224 Precast concrete construction, 447 Preconstruction scheduling, 461–463 Preliminary design, 418–422 Preventive maintenance, 508

Pricing, ownership housing demand and, 201, 203–204 Pricing mechanisms, 181–183 Primary homes, 193, 342 Probability theorem, discounted cash flow analysis and, 406 Product distribution, industrial sites and, 270–276 Production portfolio, 368 Profit maximization, industrial site location and, 269 Project managers, 454 Project plans, for ownership housing, 207, 208 Promotional aids, 482–483 Promotional pieces, 478 Promotions, 510–511 Property insurance, 503 Property management, 489–517 capital improvements and, 511–512 construction management and, 512 disaster planning and, 515–517 equity financing and, 356–357 expenses of, 505–507 importance of, 489–490 leases and, 492–498 operating expenses and, 501–511 rental income and, 499–501 security-related improvements and, 513–515 tenant relations and, 490–492 Proprietorships, 370 Public liability insurance, 504 Public lodging industry, growth of, 31–32 Public relations, 476–477, 506–507 Public sector, in U.S., 145 Public space demand, 300–301 Purchase agreements, 187–188 Purchase money mortgages, 329 Purchase transactions, 183–190 legal description and, 182–185 title and, 185–187 Purchasing power, loss of, 362–363 Quasi-equity mortgages, 328 Quiet enjoyment, covenant of, 496 Quitclaim deeds, 187 Railroad apartment buildings, 9 Railroads, 6–7, 11 Raw land submarket, 180 Real estate demand, at local level, 151–160 Real estate investment, 76–77, 82–83 Real Estate Investment Trusts (REITs), 77–79, 80, 372 Real estate market: characteristics of, 179

578

Real estate market (Cont.): local, 178–183 pricing mechanism and, 181–183 submarkets and, 179–181 Real estate mortgage investment conduit (REMIC), 338 Real estate supply, at local level, 160–163 Real estate taxes, 502 Reappraisal clauses, in leases, 493–494 Redlining, 23 Reduction-option mortgages, 328 Referral fees, 471 Regional shopping centers, 222–223, 430–433 Regions, selecting for business firms, 276–277 Relative locational value, 173–175, 176–177 Renegotiable mortgages, 328 Rental housing, 193–194, 213–217 market analysis for, 215–217 ownership housing versus, 213–215 Rental income, 499–501 Rental income insurance, 504 Repairs: to tenant space, 512 tenants’ responsibilities for, 497 Repayment terms, for mortgages, 326–329 Replacement real estate markets, 92 Replacement reserve, 398–399, 511 Research and development firms, matching sites with user’s needs and, 276 Residential demand, 193–217 for ownership housing, 194–213 for planned unit developments, 217 for rental housing, 213–217 Residential facilities, in mixed-use developments, 315 Residential market areas, 195–196 Residential projects: planning and design for, 426–430 sales or leasing models for, 481 suburban, 15–17, 26–28 Residual approach, 529 Resolution Trust Corporation (RTC), 70 Resorts, 287 health and fitness, 34 planning and design for, 439–440 ski, 33 Retail demand, 219–242 analyzing, 232–242 goods and services and, 219–220 location and, 229–232 potential, 220–221 projecting, 241–242 tenants and, 229 venues and, 221–229 Retail expenditures, projecting, 239–240

Index

Retail facilities: in mixed-use developments, 31 planning and design for, 430–434 Returns, 375–408 internal rate of, 401, 404, 405–407 unbundling, in discounted cash flow analysis, 404–405 (See also Discounted cash flow analysis; Simple return analysis) Revenue: gross, in discounted cash flow analysis, 391 net operating income and, 380–381 Reversionary rights, 329 Right of first refusal, 190, 496 Rights-of-way, 186 Rollover mortgages, 328 Room night demand, 299–300 Russia, 99, 101–102 Sale-leaseback transactions, 330 Sale of property, tenants’ rights and, 498 Sales commissions, 471 Sales comparison approach to appraisal, 523, 524–526 Sales compounds, 480–481 Sales models, 481–482 Satellite new towns, 310–311 Saudi Arabia, 122–123 Savings institutions, real estate lending by, 334–335 Scheduling, of construction, 460–465 Secondary market, 72 Second homes, 193, 212–213 loans for, 342 planning and design for, 430 postwar boom in, 34–36 Sector theory of land use development, 164, 165 Securitized real estate, globalization of, 82–83 Security, 511 Security deposits, 498 Security-related improvements, 513–515 Sensitivity analysis, discounted cash flow analysis and, 405–406 Shared appreciation mortgages, 328 Shared business, 220 Shift-share analysis of economic growth, 155 Shopping centers, 16–17, 221–227 community, 223–224, 433 convenience, 225 loans for, 343 neighborhood, 224–225, 433–434 as office activity node, 252–253 power, 224 regional, 222–223, 430–433 specialty, 225–227, 434

579

Index

Shopping centers (Cont.): superregional, 221–222 Signage, 478–479 Silent generation, 244–245 Simple return analysis, 375–384 capital structure and, 382–383 net operating income and, 380–382 problems with, 383–384 return calculation and, 383, 384 total investment and, 377–380 Single-family housing, 193, 194–195, 426–429 Site planning, 415–418 Site selection, for business firms, 276–279 Ski resorts, 33 Skyscrapers, emergence of, 9–10 Slides, in marketing programs, 478 Slip-form construction, 447 Smart growth movement, 58–59 Soft costs, 379–380 Sole proprietorships, 370 South Africa, 120–121 Space analysis, in discounted cash flow analysis, 389, 390 Spain, 106–107 Specialty shopping centers, 225–227, 434 Special warranty deeds, 186–187 Sports facilities, 32–34 Spread financing, 70–71 Steel frame construction, 448–449 Straight-line depreciation, 361 Straight-term mortgages, 326 Strip centers, 228 Strip shopping centers, 433–434 Subcontractor bonds, 452 Subdivisions, 194 Subletting, 498 Submarket location factors, equity financing and, 354–355 Suburban shopping districts, 228 Suburbs, 11 postwar development of, 13–19 residential developments in, 15–17, 26–28 Superregional shopping centers, 221–222 Supply chain management, industrial sites and, 270–271, 272 Suscipient business, 220–221 Synergy, value created by, 348–351 Synthetic rate method, 528 Systematic risk, reduction of, 359–360 Takings, 60–61 Taxes: depreciation and, 361 financing and, 71–72 real estate, 502

Technology, outdated, 363–364 Tenancy: in common, 370 joint, 370 of office buildings, 253–256 by sufferance, 494 at will, 494 Tenant default, 394–395 Tenant maintenance, 507 Tenant relations, 490–492 Tenants: retail, 229 rights and obligations of, 496–498 Tenant space build-outs, 512 Tenant standards, 424 Tennis clubs, 33 Tennis ranches, 33 Theft and vandalism insurance, 504 Timesharing, 34–35 Time value of money, 385–388 Title: to land parcels, 185–187 transfer of, 189–190 Title insurance, 186 Title searches, 186 Title theory, 325 Total investment, in simple return analysis, 377–380 Tour groups, 289 Tourist market orientation, 226, 227 Town jobbing, 4, 6 Trade area, in market demand analysis, 234–235 Traffic flow, through sales compound/leasing office, 482 Tranches, 338 Transient commercial facilities, 285–301 characteristics differentiating, 285–286 loans for, 344–345 market demand analysis for, 290–301 planning and design for, 438–440 sources of lodging demand and, 287–290 types of, 286–287 Transportation, industrial sites and, 271–273 Trash removal, 505 Trust deeds, 326 Turkey, 121–122 Turning costs, 397–398 Unemployment, in United States, 141 United Kingdom, 104–105 United States: business cycle and, 149–150 national demand patterns in, 128–145 national supply patterns in, 145–149

580

Unit-in-place method, 531 Uptowns, as office activity node, 252 Urbanization, globalization of real estate investment and, 93–96 Urban renewal, 20–26 historic preservation and, 24–25 public and private partnerships for, 23–24 Use capacity, 171–172 User property submarket, 180–181 Utilities, 502–503 Vacancy: frictional, 394 net operating income and, 381 Vacancy allowance, in discounted cash flow analysis, 391, 394–395 Vacuum technique, 231 Variable expenses, net operating income and, 381–382

Index

Variable-rate mortgages, 328 Videos, in marketing programs, 478 Vietnam, 114 Volatility, of cash return, 359 Walkup facilities, 249 Warehouse and distribution firms, matching sites with user’s needs and, 275–276 Web fulfillment centers, 274 Weighted capitalization rate, 528 Wood frame construction, 444–445 World War II, 13 Wraparound mortgages, 329 Yield, 362, 529–530 Yield capitalization approach, 529 Zoning, 40–42

About

the

Author

J

ohn McMahan has enjoyed a professional career in real estate as a consultant, investment manager, public board member, educator and writer, and industry and community leader. Real Estate Consultant: In1961, John served as Director of Feasibility Studies for Charles Luckman Associates, a major architectural firm involved in designing and supervising the construction of several major U.S. real estate projects. In 1963, he cofounded Development Research Associates (DRA), a market research, financial analysis, and appraisal firm that became one of the nation’s major real estate consulting firms. In 1970, DRA was acquired by Booze, Allen & Hamilton, with John heading DRA as well as being the Vice President, Real Estate, for the parent firm. Investment Manager: In 1973, he established John McMahan Associates (JMA), which acquired several hundred million dollars worth of U.S. properties for foreign investors. In 1980, JMA became McMahan Real Estate Advisors, a Registered Investment Advisor, shifting its focus to investing pension capital in real estate. In 1990, the firm merged with a subsidiary of Mellon Bank to form Mellon/ McMahan Real Estate Advisors, with John as CEO. By 1994, Mellon/McMahan was managing $2.2 billion in assets and was the nation’s sixteenth largest pension real estate advisory firm. Public Board Member: As part of the Mellon relationship, John assumed responsibility for turning around Mellon Participating Mortgage Trust, Inc., a troubled mortgage REIT. In 1996, he left Mellon/McMahan to become Chairman of BRE Properties, Inc., and led its restructuring, out of which it became one of the leading apartment REITs in the nation. He also has served as chairman of two additional public REITs and as a board member of a public REIT and three private corporations. He is presently Chairman of Home Option Capital Corporation, a new REIT formed to invest in single-family homes. Educator: Throughout his career, John has been involved in real estate education. For 17 years he taught “Managing the Real Estate Enterprise” as a Senior Lecturer at the Stanford Graduate School of Business. He subsequently taught “Institutional Real Estate Investment” at the Haas School of Business, University of California, Berkeley. 581 Copyright © 2007 by John McMahan. Click here for terms of use.

582

About the Author

In 2000 he established the Center for Real Estate Enterprise Management (Centerprise), a nonprofit organization focusing on management training for the real estate industry. In 2006, John received an award from Harvard University for Lifetime Achievement in Real Estate Education. Previously he received the Louise L. and Y. T. Lum Award for Excellence in Teaching and the William S. Ballard Award for writing. Writer: John has written five previous books about real estate. Property Development was published in 1976 (and 1989) by McGraw-Hill, and the McGraw-Hill Real Estate Pocket Guide was published in 1979. Cases in Commercial Real Estate Investing was published in July 2005 by McMahan Real Estate Services (San Francisco), and The Handbook of Commercial Real Estate Investing was published in June 2006 by McGraw-Hill. He also has written over 40 professional articles and 20 case studies on real estate management and served as an expert witness in several major cases involving real estate fiduciary duties and responsibilities. Industry and Community Service: John has served in leadership roles with the National Association of Real Estate Investment Managers (Chairman), Urban Land Institute (Council Chairman), Association of Foreign Investors in U.S. Real Estate (Secretary General), San Francisco Architectural Heritage (President), Lambda Alpha International (Chapter President), Counselors of Real Estate (Board Member), and the Trust for Public Land (Advisory Board). He has received Certificates of Commendation from the California Assembly and the Los Angeles City Council. He is also a member of the Aspen Group, the Real Estate Round Table, the Anglo-American Real Property Institute, and the Commonwealth Club of San Francisco. John is a Registered Investment Advisor and a California licensed real estate broker. A graduate of the University of Southern California and the Harvard Business School, he has four grown children—Cathy, Jason, Justin, and Vanessa—and lives in San Francisco with his wife, Jacqueline.