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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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 T