Chapter 1 Economic Principles and Cycles 1

Chapter 1 Economic Principles and Cycles 1

I. Economics 2

Economics p Economics is primarily concerned with the efficient allocation of scarce resources p In economics, we are concerned with : 1. 2. 3. Production Distribution Consumption of goods and services 3

A. Real Estate Economics p Real estate economics is used to analyze national, regional, city and neighborhood trends in an effort to interpret what effect these trends will have on the real estate market National Trends State Trends County Trends City Trends Neighborhood Trends 4

B. Real Estate Economics p Real estate economics deals with the mechanisms that society creates to allocate different types of land among individuals. Real Estate Trends are interwoven and dependant on the other trends in the local economic situation as well as the national trends in economics. 5

C. Real Estate Economics p The value of real estate in any market is dependent on the four elements of value; 1. 2. 3. 4. Demand Utility Scarcity Transferability. 6

Demand 1. 2. 3. 4. Demand Utility Scarcity Transferability. 7

C. Real Estate Economics p The value of real estate in any market is dependent on the four elements of value; 1. 2. 3. 4. Demand Utility Scarcity Transferability. 8

C. Real Estate Economics p The value of real estate in any market is dependent on the four elements of value; 1. 2. 3. 4. Demand Utility Scarcity Transferability. 9

C. Real Estate Economics p The value of real estate in any market is dependent on the four elements of value; 1. 2. 3. 4. Demand Utility Scarcity Transferability. 10

C. Real Estate Economics p The value of real estate in any market is dependent on the four elements of value; 1. 2. 3. 4. Demand Utility Scarcity Transferability. 11

C. Purchasability p The value of real estate in any market is dependent on the four elements of value; 1. 2. 3. 4. Demand Utility Scarcity Transferability. 12

1. Pur. Why Study Real Estate Economics? p In economics, our goal is to determine how the market system prices and distributes goods and services throughout the economy. p REAL ESTATE ECONOMICS is the application of economic principles to the real estate marketplace. p In economics, we study what has happened in the past in order to explain and predict what will happen in the future. 13

B. Real Property p There are 2 types of property: n n p REAL PROPERTY (immovable) PERSONAL PROPERTY (movable) Real Property is the land buildings or improvements attached to the land. p p p Land Anything permanently attached to the land Anything incidental or appurtenant to the land That which is immovable by law Any property that is NOT real property is considered personal property 14

C. America’s Economic History p America’s early economic growth was fueled by an unlimited supply of free or low-cost land. p Early economic growth was stimulated by what the land could support p p p Crops Fur Game Domestic animals Mineral wealth 15

cont. p Gradually, after the industrial revolution, our nation’s economic base changed to manufacturing, technology, and service related industries. p The days of wide-open land are long gone. p The larger the population, the scarcer and more valuable the land becomes. 16

D. National and Local Economies p Local economies may be based upon an industry or even a single employer. p A local economy can be very different from regional or national economies. 17

E. Real Estate Economics p Real estate economics is inductive in nature. p It is a logical process that begins by looking at the neighborhood and the site itself. p The analysis looks at the economy on the following 4 levels: § § National Regional City Neighborhood 18

II. Supply and Demand 19

A. Law of Supply p Producers will increase production (supply) when prices rise in order to maximize their profits. p However, in a free market, the entry of additional suppliers creates an upward shift in the supply curve. p A SUPPLY CURVE indicates the number of units that will be available on the market at a given price p As supply increases, exceeding demand, prices start to decline p In real estate, when prices are high, more owners are willing to place their homes on the market for sale and developers will be encouraged to produce more units. 20

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B. Law of Demand p The amount consumers purchase varies inversely with price. p A DEMAND CURVE indicates the number of units consumers purchase or are willing to purchase at a given price. 22

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C. Equilibrium (Point and Price) p EQUILIBRIUM is the point where demand supply curves cross, establishing the market price p Since the marketplace is constantly changing with new sellers and buyers, the equilibrium point does NOT remain constant 24

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D. The Real Estate Market is an Imperfect Market p Real estate does NOT lend itself to perfect economic supply and demand models. p Demand is meaningless unless it is coupled with purchasing power and/or financing ability. p In a market system, items will NOT be produced if there is no market. If there is a demand, there will be production. 26

E. Elasticity of Supply and Demand p ELASTICITY is the size or magnitude of a reaction to a change in price. n ELASTIC SUPPLY means that a small change in price will greatly affect the quantity supplied. n INELASTIC SUPPY means that a change in price will have little effect on the quantity supplied. n ELASTIC DEMAND means that a small change in price will greatly affect the quantity demanded. n INELASTIC DEMAND means that a change in price will have little effect on the quantity demanded. 27

The demand for real estate is elastic because of: 1. Available alternatives. Where 2 similarly desirable houses are available, the lower priced house will lower the demand of the other. 2. Relative high price of real estate 3. Long time dimension of the purchase decision. 28

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F. Real Estate Supply & Demand in the Market p A neighborhood is the basic market unit of supply and demand in real estate. p From an economist’s point of view, the real estate market is primarily a local market. p SELLER’S MARKET exists when there are few sellers and many buyers who keep prices up p BUYER’S MARKET exists when there are many sellers but few buyers and prices go down. 30

G. Supply Side Economics p SUPPLY SIDE ECONOMICS is the economic theory that the most effective way to stimulate growth is to provide incentives for people who produce or supply the goods by lowering taxes and reducing governmental regulations 31

III. Inflation and Deflation 32

A. Deflation and Inflation in Real Estate p In a deflationary period, the dollar buys more. p A DEFLATIONARY ECONOMY exists when there are more goods than there is purchasing power. p The dollar buys less in an inflationary period. 33

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B. Stagflation p STAGFLATION is the name given to the phenomenon of inflation during a recessionary or no-growth period. p During a recession, the increase in unemployment should reduce the purchasing power for goods and stem inflation. 35

IV. Basic Real Estate Economic Theories and Principles 36

A. Leverage p LEVERAGE is obtained by using other people’s money to purchase real estate. p The advantage of leverage is that, for relatively low capital outlay, a person can control real estate of high value. 37

B. Multiplier Effects p A MULTIPLIER EFFECT measures the outcome of an economic event as a multiple of the amount of the initial change. p A large change in a variable results from only a small initial change in another variable. 1. 2. Manufacturing and Service Dollar Multiplier 38

C. Marginal Propensity To Save p The marginal propensity to save is affected by expectations p If a person has negative expectations of the future, he might save more money p If the future is expected to be good, savings could be reduced 39

D. Marginal Propensity to Consume p Increases in the propensity to consume will mean less money saved and a greater demand for goods p This increase in demand could be inflationary 40

E. Theory of Filtering Down p FILTERING DOWN is the principle by which housing tends to be passed on to lower economic groups p People tend to “move up” leaving more marginal housing units available for people on the lower economic scale p This process can be halted or even reversed by GENTRIFICATION, the return of the affluent into neighborhoods that had become home to lower income households 41

F. Economies of Scale p ECONOMIES OF SCALE are obtained by producing more and spreading fixed costs over a larger number of units, and results in savings to the producer 42

G. Law of Diminishing Returns p The LAW OF DIMINISHING RETURNS states that at some point, as production is increased, additional units will result in increasing costs, so that as units are added, profits may decrease. 43

H. Economics of Subdividing p There are more buyers for smaller parcels than there are large parcels. p Lower prices for smaller parcels make smaller properties more affordable. p The increased demand an economy of scale allow a subdivider to make more money on individual, subdivided parcels than on larger parcels. 44

I. Economics of Assemblage p ASSEMBLAGE is the concept of assembling a group of smaller lots to form one large lot, which can net a larger profit. p The shortage of larger parcels within a highly developed area allows an owner or assembler to get a higher price for the group of properties than the total value of each of the individual properties. n PLOTTAGE INCREMENT 45

J. Economic Obsolescence and Economic Life p More buildings are torn down than wear out. p ECONOMIC or EXTERNAL OBSOLESCENCE occurs when the value of a property decreases because of negative factors affecting the neighborhood. n n Economic Life Highest and Best Use 46

K. Principle of First Choice p PRINCIPLE OF FIRST CHOICE states that a business that needs a particular type of location for a specific use will pay the most. 47

L. Principle of Competition p PRINCIPLE OF COMPETITION states that when extraordinary profits are made in a field, then competition will enter the field and profits will decline. 48

M. Principle of Substitution p This appraisal principle is also a basic economic principle. p The PRINCIPLE OF SUBSTITUTION affirms that the maximum value of a property tends to be set by the cost of acquiring an equally desirable alternative property. 49

N. Principle of Change p Property is NOT static; it is always changing. p The PRINCIPLE OF CHANGE states that real estate values do not remain constant but are always in a state of flux. 50

O. Principle of Real Estate Cycles p Development stage (Integration) p Maturity (Equilibrium Stage) p Decline (Disintegration) 51

P. Business Cycles p There are recurring patterns or business cycles in the economy p Cycles are not precise, but vary in length and intensity p Cycles are waves that have a high point or peak and a bottom point with a trough 52

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Q. Forecasting Real Estate Cycles p The downward swing of the real estate cycle tends to lead a general business recession p A real estate recovery tends to lag behind a general business recovery p Sales of family housing are generally strongest in the spring until September, when the market slows down 55

R. Recessions and Depressions p RECESSION is defined as a minimum of two quarters in which the growth of real Gross Domestic Product (GDP) is negative p A DEPRESSION is nothing more than a severe recession, during which the economy shrinks considerably. 56

S. Government and Cycles p Government fiscal policy affects the business cycle. p FISCAL POLICY is the responsibility of our federal government to tax its citizens and wisely spend our money to benefit the nation. p The Federal Reserve controls the money supply and usually short-term interest rates through monetary policy. 57

Chapter Summary p Economics n n n Real Estate Economics Real Property America’s Economic History p Basic Theories & Principles n n p Supply and Demand n n n p Law of Supply Law of Demand Equilibrium Elasticity Real Estate Supply & Demand in the Market Inflation and Deflation n Stagflation n n n Leverage Multiplier Effects Marginal Propensity to Save Marginal Propensity to Consume Theory of Filtering Down Economies of Scale Law of Diminishing Return Economics of Subdividing Economic Obsolescence and Economic Life Principle of First Choice Principle of Competition Principle of Substitution Principle of Change Principle of Real Estate Cycles Business Cycles Forecasting Real Estate Cycles Recessions and Depressions Government and Cycles 58