Real Estate Economics _ Notes

Table of Contents

LECTURE 1: INTRODUCTION......................................................................................................... 7

FOUR QUADRANT DIAGRAM: ONE OF THE MAIN MODELS IN COURSE................................................7

NORTHEAST QUADRANT:..........................................................................................................................8
SOUTHEAST QUADRANT:..........................................................................................................................8
NORTHWEST QUADRANT: Asset market valuation...............................................................................8
SOUTHWEST QUADRANT:..........................................................................................................................9
ELASTICITY OF SUPPLY:.........................................................................................................................9
REAL ESTATE AS ASSETS / INVESTMENTS:.............................................................................................9
REAL ESTATE ASSETS: STOCK..................................................................................................................9
REAL ESTATE INVESTMENTS: FLOW.......................................................................................................10
REAL ESTATE ASSETS:..........................................................................................................................10
REAL ESTATE INVESTMENTS:...............................................................................................................10
GROSS REAL ESTATE INVESTMENTS:......................................................................................................10
NET REAL ESTATE INVESTMENTS:..........................................................................................................10
VALUATING THE REAL ESTATE OF A NATION:....................................................................................10

LECTURE 2, PROPERTY AND CAPITAL MARKETS:.............................................................. 11

FOUR QUADRANT MODEL:....................................................................................................................11

ENDOGENOUS VARIABLES IN MODEL:....................................................................................................11
EXOGENOUS VARIABLES:.......................................................................................................................11
ASSET MARKET - DETERMINATION OF CONSTRUCTION:.........................................................................12
PROPERTY MARKET, RENT DETERMINATION:.........................................................................................13
ASSET & PROPERTY MARKET LINK:.......................................................................................................13
NORTHEAST QUADRANT, IN-DEPTH:.......................................................................................................15
NORTHWEST QUADRANT, IN-DEPTH:......................................................................................................16
SOUTHWEST QUADRANT, IN-DEPTH:.......................................................................................................17
SOUTHEAST QUADRANT, IN-DEPTH:.......................................................................................................18
POSITIVE ASSET DEMAND SHIFT:.........................................................................................................20
SHORT RUN, VS. LONG RUN:...................................................................................................................21
NEGATIVE SHOCK TO CONSTRUCTION COST: (INCREASED COST OF CONSTRUCTION)...........................21
ALGEBRAIC SOLUTION TO: FOUR QUADRANT MODEL:......................................................................22

LECTURE 3, OPERATION OF PROPERTY MARKETS (MICRO/MACRO APP.):..............25

DEFINING MARKETS:............................................................................................................................25
FIRST DIMENSION, PRODUCT TYDE:.......................................................................................................25
SECOND DIMENSION, GEOGRAPHICAL AREA:..........................................................................................25
PROPERTY MARKET DISTINKTION:.....................................................................................................26
PROS/CONS:............................................................................................................................................26
DEFINING AREAS:...................................................................................................................................26

LECTURE 4, MICRO AND MACRO APP. PART 2:..................................................................... 26

REAL ESTATE MACROECONOMICS:.....................................................................................................28

Real Estate Economics _ Notes

LECTURE 5, CHAPTER 3, URBAN LAND MARKET (LOCATION RENTS, AND PRICES:

............................................................................................................................................................... 28

BASIC MODEL OF MONOCENTRIC CITIES:...........................................................................................29

DETERMINING THE RADIUS OF THE CITY  CITY BOUNDARY:..............................................................29
RENT DETERMINATION AT ANY INTERIOR LOT IN CITY:.........................................................................29
RENT DETERMINATION AT CITY BORDER:..............................................................................................30
AGRICULTURAL RENT PER LOT:..........................................................................................................30
URBAN LAND RENT DETERMINATION: (EQ. 5)........................................................................................30
ILLUSTRATION OF HOUSING RENT:......................................................................................................31
ILLUSTRATION OF URBAN LAND RENT:...............................................................................................33
2ND APPROACH: COMPARATIVE STATIC ANALYSIS: CITY COMPARISON:.........................................33
NUMERICAL EXAMPLE: COMP. STATIC ANALYSIS:.............................................................................36

LECTURE 6, CHAP 3, PART 2, [URBAN LAND MARKET (RENTS AND PRICES)]:...........38

EQUATION 6: POPULATION GROWTH..................................................................................................38

EQUATION 7: BOUNDARY GROWTH RATE:..........................................................................................39
POPULATION GROWTH AND LOCATION RENT:....................................................................................39
EQUATION 9:.........................................................................................................................................39
SPATIAL CAPITALIZATION OF LOCATION RENT:.................................................................................40
EQUATION 10:.......................................................................................................................................40
EQUATION 11: URBAN LAND PRICES:..................................................................................................41
EQUATION 12:.......................................................................................................................................41
NUMERICAL EXAMPLE:........................................................................................................................42
EXT. NUMERICAL EXAMPLE: CALCULATING THE CAP. RATE:...............................................................43
EQUATION 13: GROWING COMMUTING COST:....................................................................................44
EQUATION 14: HOUSING RENT (EXISTING STRUCTURES) LOCATED AT (D) IN TIME (T):.................44
EQUATION 15: HOUSE PRICES:............................................................................................................45

LECTURE 7, CHAPTER 4, URBAN HOUSING MARKET: STRUCTURAL ATTRIBUTES

AND DENSITY:................................................................................................................................... 45

VARIATION IN POPULATION DENSITY WITH DISTANCE FROM CITY CENTER, REGRESSION TERM:. 46
DENSITY DEVELOPMENT (1970-1990):..................................................................................................46
HOUSING ATTRIBUTES AND HOUSEHOLD PREFERENCES:...................................................................47
ILLUSTRATION OF LAW OF DIMINISHING MARGINAL UTILITY TOWARDS HOUSEHOLD SIZE:..................48
HEDONIC PRICE EQUATION:....................................................................................................................49
THE ROSEN APPROACH:..........................................................................................................................50
LOG-LOG HEDONIC PRICE EQUATION: (MORE REALISTIC MODEL).........................................................52
NUMERICAL EXAMPLE: [EQ. 4.8]...........................................................................................................54
SEMI-LOG HOUSE PRICE MODEL:............................................................................................................54
SEMI-LOG HEDONIC MODEL EXAMPLE:..................................................................................................56
HOUSING ATTRIBUTES AND NEW CONSTRUCTION:.............................................................................57
RESIDENTIAL DENSITY, LAND VALUE, AND HIGHEST USE:................................................................58
DENSITY MEASURES: FAR.....................................................................................................................59
FAR IMPACT ON RENT:..........................................................................................................................60
FINDING THE VALUE OF F* THAT MAXIMIZE LAND PROFIT:...................................................................63
OPTIMAL FAR:.....................................................................................................................................64
BOSTON EXAMPLE: DENSITY:................................................................................................................64
URBAN RE-DEVELOPMENT:..................................................................................................................65
LAND USE COMP. BETWEEN GROUPS:.................................................................................................66
DETERMINING WTP FOR LAND BY EACH HOUSEHOLD (I). (OPTIMAL VALUES):.............................66
Real Estate Economics _ Notes

LECTURE 8, CHAP. 5, FIRM SITE SELECTION & EMPLOYMENT

DECENTRALIZATION:.................................................................................................................... 67

EMPLOYMENT DECENTRALIZATION:...................................................................................................68
MEASURING RELATIONSHIP BETWEEN EMPLOYMENT DENSITY AND DISTANCE:.............................68
EQUATION 5.1:.......................................................................................................................................68
LAND MARKETS WITH A CENTRAL BUSINESS DISTRICT:....................................................................69
STARTING ANALYSIS, 18-1900 CITIES AND TRANSPORTATION NEEDS:..................................................69
FIRM’S PROFIT FUNCTION (LECTURE):...............................................................................................70
ENHANCING THE MODEL:.....................................................................................................................71
MODEL OF CIRCULAR CITY WITH TWO USES OF LAND: RESIDENTIAL AND NON-RESIDENTIAL:.............72
SPATIAL LOCATION EQUILIBRIUM:.........................................................................................................72
MODEL OF LAND MARKETS IN A CITY WITH A CENTRAL BUSINESS DISTRICT:.......................................72
TECHNOLOGY AND THE DECENTRALIZATION OF MANUFACTURERS:................................................74
WAGES, THE LABOUR MARKET, AND OFFICE DECENTRALIZATION:..................................................75

LECTURE 9, NATIONAL ECONOMY AND REGIONAL ECONOMIC GROWTH:..............77

REGIONS:...............................................................................................................................................77
REAL ESTATE IN MACROECONOMICS:.................................................................................................78
AGGREGATE DEMAND FOR REAL ESTATE:..........................................................................................78
REGIONAL GROWTH:..............................................................................................................................78
WHAT DETERMINES INVESTMENT IN (SUPPLY) OF REAL ESTATE:.....................................................79
CORRELATION BETWEEN GDP AND REAL ESTATE RELATED GROWTH IN DENMARK:....................79
REGIONAL ECONOMIC GROWTH:.........................................................................................................80
THREE MODELS:...................................................................................................................................81
LABOUR MARKET MODEL:......................................................................................................................81
REAL ESTATE MARKET:..........................................................................................................................81
OUTPUT MARKET:...................................................................................................................................82
INVESTOR EXAMPLE:..............................................................................................................................82
MODEL OF REGIONAL ECONOMIC GROWTH. [THREE-SECTOR MODEL]:..........................................83
OUTPUT MARKET:...................................................................................................................................84
LABOUR MARKET:..................................................................................................................................85
REAL ESTATE MARKET:..........................................................................................................................86
EQUILIBRIUM:.........................................................................................................................................87
INCREASE IN QUANTITY OF GOODS SOLD: MODEL REACTION................................................................87
THREE-PART MODEL, [MORE INELASTIC LABOUR SUPPLY]:.............................................................89
DEMAND INDUCED GROWTH:...............................................................................................................93
CAUSES OF REGIONAL DEMAND SHIFTS:................................................................................................93
SUPPLY-INDUCED GROWTH:.................................................................................................................94
SUPPLY-INDUCED GROWTH, EFFECT ON OUTPUT MARKET:....................................................................95
SUPPLY-INDUCED GROWTH, EFFECT ON THE REAL ESTATE MARKET:....................................................96
SUPPLY-INDUCED GROWTH, INELASTIC PRODUCT DEMAND, [THREE-SECTOR MODEL MOVEMENTS]:...97
WHAT GENERATES REGIONAL SUPPLY SHIFTS:....................................................................................101
THE SYSTEM OF NATIONAL ACCOUNTS:............................................................................................102
ECONOMIC ACTIVITY MEASURES:.....................................................................................................103
PRODUCTION APPROACH: 1..................................................................................................................103
INCOME APPROACH: 2..........................................................................................................................103
EXPENDITURE APPROACH: 3.................................................................................................................103
SYSTEM OF NATIONAL ACCOUNTS, AND REAL ESTATE:.......................................................................104
HOW REAL ESTATE PRICE AFFECT THE ECONOMY: (CORRELATION /CAUSALITY):.............................106
([APPENDIX]), ([[HOUSING WEALTH]]):............................................................................................107
HOUSING WEALTH EFFECT:..................................................................................................................107
Real Estate Economics _ Notes

TRANSMISSION MECHANISM:................................................................................................................108

LECTURE 10, HOUSING MARKET, THE MORTGAGE MARKET AND TENURE

CHOICE:............................................................................................................................................ 109

THE ANALYSIS OF AGGREGATE HOUSING MARKETS:.......................................................................109

SUPPLY SIDE:........................................................................................................................................109
PROFIT MAXIMIZING FIRMS:.................................................................................................................110
LIST OF DETERMINANTS OF HOUSING DEMAND AND SUPPLY:..............................................................110
HOUSING CONSUMPTION AND INCOME:.............................................................................................110
TENURE CHOICE AS A DETERMINANT OF DEMAND FOR HOUSING:..................................................112
TENURE CHOICE, THE USER COST OF HOUSING:...............................................................................113
TAX CONSIDERATIONS OF TENURE CHOICE:.....................................................................................114
TENURE CHOICE, THE USER COST OF RENTAL HOUSING:................................................................115
TENURE CHOICE: MODELLING WITH REALISTIC DEPRECIATION:..................................................116
EFFECT OF INCREASED LANDLORD INCOME TAX RATE (λ) :............................................................117
DOWN-PAYMENT AND MORTGAGE DEFAULT:...................................................................................118
HOME EQUITY RULE:............................................................................................................................119
Delete definitions :TWO-PERIOD MODEL:........................................................................................120
NON-HOUSING CONSUMPTION IN PERIOD 0 AND 1:..............................................................................120
HOUSEHOLD INCOME:...........................................................................................................................120
RENTER, BUDGET CONSTRAINT:...........................................................................................................121
HOMEOWNER, BUDGET CONSTRAINT:..................................................................................................121
HOUSEHOLD INDIFFERENCE FUNCTION (OWNER/RENTER):.................................................................121
MODELLING OF HOUSING MARKET:..................................................................................................122
4-QUADRANT MODEL EXAMPLE:...........................................................................................................123
SIMPLE EXAMPLE:................................................................................................................................125
TRANSITIONAL DYNAMICS OF DIFFERENT POSITIVE DEMAND SHOCKS:.........................................126
THE LONG-RUN SUPPLY OF REAL ESTATE:........................................................................................127
THE ORIGIN OF THE SHOCK:..............................................................................................................127
RATIONAL EXPECTATIONS:...................................................................................................................128
HOUSING POLICIES: RENT CONTROL:...............................................................................................130
STOCK-FLOW MODEL (HOUSING POLICIES, RENT CONTROL):.............................................................130
RENT CONTROL AND MISALLOCATION:.............................................................................................132
JUSTIFICATIONS FOR RENT CONTROL:..................................................................................................133
HOMEOWNERSHIP FINANCING:..........................................................................................................134
MORTGAGE BUSINESS:.........................................................................................................................134
MORTGAGE CLASSIFICATION:...............................................................................................................135
FINANCING RISKS:................................................................................................................................136
REVERSE MORTGAGE CARRIES IMPORTANT RISKS FOR:.......................................................................137
HOME OWNERSHIP FINANCING:.........................................................................................................137
TYPES OF HEW:...................................................................................................................................138

LECTURE 11, NON-RESIDENTIAL PROPERTY MARKETS:................................................ 138

RESIDENTIAL / NON-RESIDENTIAL PROPERTIES:..............................................................................138

ANNUAL GROWTH INVESTMENT [AGI] CALCULATION:.......................................................................139
FLUCTUATIONS OVER TIME, ACROSS DIFFERENT PROPERTY MARKETS:........................................139
DEMAND FOR NON-RESIDENTIAL REAL ESTATE:..............................................................................142
ENDOGENOUS AND EXOGENOUS SHOCKS:............................................................................................142
DEMAND MEASURES [GROSS ABSORPTION, NET ABSORPTION]:..........................................................143
[WTE MODEL] WHEATON-TORTO-EVANS MODEL:.........................................................................144
FUERST (WHEATON-87) MODEL:..........................................................................................................145
Real Estate Economics _ Notes

COMMERCIAL PROPERTIES [SUPPLY SIDE]:......................................................................................146

SUPPLY OF NON-RESIDENTIAL REAL ESTATE:.......................................................................................146
WHEATON-TORTO-EVANS MODEL:...................................................................................................147
WTE MODEL EXAMPLE:.......................................................................................................................148
DISEQUILIBRIUM AND INEFFICIENCY IN MARKET FOR COMMERCIAL PROPERTIES:......................148
MARKET IMBALANCES:......................................................................................................................148
TRENDS IN CONSTRUCTION MINUS NET ABSORPTION:..........................................................................149
TRENDS IN DIFFERENCE BETWEEN NOMINAL AND NATURAL VACANCY:.............................................149
RENT-VACANCY ADJUSTMENTS: STOCK-FLOW MODEL:.......................................................................150
NVR DETERMINANTS AND EXPECTED EFFECTS:..................................................................................152
RENT ADJUSTMENT:............................................................................................................................153

LECTURE 12, CHAP: 13, LOCAL GOVERNMENTS, PROPERTY TAX, & REAL ESTATE
MARKETS:........................................................................................................................................ 154

LAND-PRICE GRADIENT (LOCAL JURISDICTIONS):...........................................................................154

US GOVERNMENT TAX DISTRIBUTION: (SERVICES AND TRANSFERS):............................................154
TAXES IN THE US AND DK:................................................................................................................155
DANISH PUBLIC INCOME:...................................................................................................................155
DANISH RESIDENTIAL PROPERTY TAXES:..........................................................................................155
COMMERCIAL PROPERTY TAXES IN DENMARK:...............................................................................156
PROPERTY VALUATION AND TAX REFORMS:.....................................................................................156
TOWN-BUDGET IDENTITY:..................................................................................................................157
TOWN EFFECTIVE TAX RATE:............................................................................................................158
DETERMINING PROPERTY VALUE:.....................................................................................................158
SOLVING FOR PRICE (P):.......................................................................................................................158
EXPENDITURE CHOICE:......................................................................................................................159
FISCAL INCENTIVES WITH DIFFERENT USES:....................................................................................159
FISCAL IMPACTS OF NEW DEVELOPMENTS:..........................................................................................160
FAR MODEL WITH DOWN-ZONING:...................................................................................................161
WELFARE COST OF COMMERCIAL USE:............................................................................................161
LAND-PRICE GRADIENT WITH LOCAL JURISDICTIONS:....................................................................162
TAX INCIDENCE:.................................................................................................................................163
INCIDENCE OF REAL ESTATE TAXES ON RENTAL PROPERTY:.......................................................164
TAX INCIDENCE, ALTERNATIVE OUTCOMES:....................................................................................164
FISCAL CAPITALIZATION CASE 1: G=T =tP ....................................................................................165
FISCAL CAPITALIZATION CASE 2: G>T =tP....................................................................................165
FISCAL CAPITALIZATION CASE 3: G<T =tP....................................................................................166
URBAN DECAY (PHILADELPHIA STORY):...........................................................................................166
DANISH LOCAL GOVERNMENT REFORM 2007:..................................................................................167
PROPERTY VALUE IN CASE OF LAND TAX:............................................................................................167
COMMUNITY STRATIFICATION IN SHORT RUN:.................................................................................168
COMMUNITY STRATIFICATION IN THE LONG RUN:...........................................................................170
MEASUREMENT OF RESIDENTIAL SEGREGATION:............................................................................172

LECTURE 13, CHAP, 14 - PUBLIC GOODS, EXTERNALITIES, DEVELOPMENT AND

REGULATIONS:............................................................................................................................... 173

PUBLIC GOODS:...................................................................................................................................173
PRIVATE VS. PUBLIC GOOD:...............................................................................................................174
PUBLIC GOODS, EXAMPLE:.................................................................................................................175
PUBLIC GOODS AND FREE-RIDING:....................................................................................................175
ENFORCEMENT PROBLEM:.................................................................................................................176
Real Estate Economics _ Notes

PUBLIC SPACE ACQUISITION IN CASE OF SINGLE DEVELOPER:........................................................177

COMMON PROPERTY RESOURCES:.....................................................................................................177
COMMON PROPERTY RESOURCE:.......................................................................................................178

LECTURE 14, CHAPTER 14, PUBLIC GOODS, EXTERNALITIES, DEVELOPMENTS AND

REGULATIONS:............................................................................................................................... 179

PUBLIC GOODS:...................................................................................................................................179
PRIVATE VS. PUBLIC GOOD:..................................................................................................................179
PUBLIC GOODS CONT.:........................................................................................................................180
FREE-RIDING PROBLEM:.......................................................................................................................180
ENFORCEMENT PROBLEM.....................................................................................................................181
PUBLIC SPACE ACQUISITION IN CASE OF A SINGLE DEVELOPER:....................................................182
COMMON PROPERTY RESOURCES:.....................................................................................................183
PUBLIC GOODS:..................................................................................................................................185
PUBLIC GOODS VS. EXTERNALITIES IN REAL ESTATE MARKETS:.........................................................185
EXTERNALITY DEFINITION:..................................................................................................................185
NASH STRATEGY:.................................................................................................................................187
Real Estate Economics _ Notes

Lecture 1: Introduction.

Four Quadrant diagram: One of the main models in course.

As described by compass designation:

The two quadrant the the left (Northwest, Southwest) = Asset market for the ownership of
real estate.

The two quadrants to the right (Northeast, Southeast) = Property market for the use of space.
Real Estate Economics _ Notes

Changes in the economy like an increase in the level of households will cause the demand-
curve to shift. In this case it will shift right, while a decrease in households will cause the
demand curve to shift left.

The same holds for the supply curve and number of supplying partners in the economy.

Northeast quadrant:

Comprised of Quantity: “Stock (SF)”, and Rent: ($ of rent).

Here we have the demand line, explaining “the higher the rent, the less demanded”.

Southeast quadrant:

Comprised of Stock (Quantity of buildings), and Construction: (How much is being built).

Adjustment to stock as supply change.

Northwest quadrant: Asset market valuation.

Comprised for Price: Cost of buying, and Rent: (Cost of renting).

This quadrant line “Asset Market: Valuation.” Can be explained as: What the market is
willing to pay in price, for a given level of rent.
Real Estate Economics _ Notes

If the yields required in the markets reduce, we are going to induce new supply.

Less steep asset market line:

- Price increase
- Construction increase
- Demand increase
- Rent decrease

If the yields required would be higher i.e. steeper asset market line, prices would go below
feasible construction point. Inducing no new supply.

Southwest quadrant:

Comprised of Price: ($ price), and Construction: (Supply / How much real estate is being
built).

Keynes supply curve, meaning, fixed in the short run, and then it is fairly elastic.

The line represents the break-even point of construction.

To the right of the line, construction is not feasible, as the price which the market is willing to
pay for the construction/building is below the cost of building it.

Above/ to the left of the line, it is feasible to build and there will be supply in the economy.

Elasticity of supply:

In case of complete elasticity of supply, supply curve will be horizontal.

In case of complete inelasticity of supply, supply curve will be vertical.

Real estate as assets / investments:

Real estate assets: Stock

Real estate = Buildings and land.

Real estate can be residential / corporate.
Real Estate Economics _ Notes

Real estate investments: Flow

Value of buildings. (As described by GDP, GFCF)

Real estate assets:

Viewing real estate as an asset, it is comprised as:

Real estate=Structures + Land

Structures = Private, public, and corporate.

Land = Used + Vacant.

Land is not part of GDP as we do not produce additional land, it is however part of the
overall level of wealth.

Real estate investments:

Gross real estate investments:

Yearly construction of new structures (GDP increase in new buildings)

That is a flow variable, measured in yearly movement.

Here we only look at the new structures, not land.

Net real estate investments:

Gross real estate−depreciation on existing real estate

Valuating the real estate of a nation:

Primarily difficult to measure because land must be valued.

Real estate is a durable good, allowing a small percentage of GDP to be allocated to

maintaining and building real estate.

Lecture 2, Property and capital markets:

Real Estate Economics _ Notes

Four quadrant model:

Movement counter clockwise around the diagram.

Endogenous variables in model:

Stock, per unit of space.

Rent, per unit of space.
Price, per unit of space.
Construction / Investment, per unit of space.

Exogenous variables:

Scenarios and changes to economy.

(Affects our endogenous variables, but our endogenous variables don’t affect them.)

In the short run: Asset market must determine asset price so demand to own real estate =
supply of real estate.

Asset market - determination of construction:

R
P=
I
Real Estate Economics _ Notes

Prices are determined by the level of rent ,relative ¿ interest rate .

Distinguish between asset-demand shifts (Top let quadrant) and property demand shifts (Top
right quadrant).

Supply of real estate  Construction / Investment.

Construction / Supply  Price of assets, relative to replacing/constructing them.

- How much will the asset be worth once build, relative to the cost of building it.

Line starts to the left of (0;0), because we at-least need FC to be covered.

- Slopes to the left to resemble the variable need for VC.

In the long run, asset market must determine construction so that prices = replacement cost +
cost of land.

Property market, rent determination:

D= ( R , Economy )=S

Demand depends onthe level of rent∧state of economy , demand should=Supply .

Real Estate Economics _ Notes

Demand  Occupiers of space. (Tenants, firms, households).

Firms: Space = Input factor  Level of activity.

Households: Space = Commodity  Income, costs, need.

Rent = Annual outlay to use commodity.

Asset market offers the supply to serve the demand of the property market.

Property market task = Align demand for space with supply of space.

Household increase  Demand for space increase  Rent increase (Given fixed prices).

Asset & Property market link:

Rent determined by property market, crucial for demand of assets.

Asset price determine level of new construction  Determines supply of stock in the future.
Real Estate Economics _ Notes

Rectangle, 90* angles all around = Joint Long-run equilibrium between all our four
endogenous variables.
Real Estate Economics _ Notes

Northeast quadrant, in-depth:

D0=¿ Relatively elastic demand function

D1=¿ Relatively inelastic demand function.

General change to economy will shift demand curve, not change slope.

D= ( R , E )=S

Small example:
Real Estate Economics _ Notes

E=Numer office emplyees

S
Assume D: E ( 400−10 R ) . Insert into eq . 1→ R=40−
10 E

D ( R , E )=S , Curve is sloping downward .

Northwest quadrant, in-depth:

§ 1st axis: Rent (per unit of space) denoted R

§ 2nd axis: Price (per unit of space) denoted P
§ The ray emanating from the origin represents the capitalization rate (Cap rate)
R
for real estate assets denoted i: the ratio of rent-to-price: i=
P
§ The lower the long-term interest rate, perceived risk of real estate, and more
generous tax treatment of depreciation of real estate, the lower the Cap rate
§ A lower Cap rate is represented by a counter-clockwise rotation
§ The Cap rate is taken as exogenous, based on the interest rates and returns in
the broader capital market for all assets (stocks, bonds, short-term deposits)
§ Thus, the purpose of the NW quadrant is to take the rent level, R , from the NE
quadrant and determine a price of real estate assets, P, using the Cap rate, i

Cap rate : i=i LR +risk rate+taxation of real estate

i LR  Real long term interest rate on a rf asset.

risk rate  Exp. Rate of depreciation of real estate asset.

Cap . rate  Rate of return on real estate inv.

R
NW quadrant equation: P=
I
Real Estate Economics _ Notes

R
If cap. Rate (i) decrease  Slope of P=  increase.
I

Southwest quadrant, in-depth:

§ 1st axis: Price (per unit of space) denoted P

§ 2nd axis: The annual flow of new construction (in units of space, e.g., square
feet) denoted C
§ The function f (C) represents the replacement cost of real estate (per unit of
space)
§ Assume f ' ( C )> 0, i.e., the cost of replacement through new construction
increases with greater building activity, i.e., VC>0
§ In long-run equilibrium in the asset market, P=f ( C ) g ( P )=C
§ Given P from the NW quadrant, a line down to the replacement cost curve and
then over to the C -axis determines the level of C where the replacement cost
equals the asset price (LR equilibrium)
§ The replacement cost curve is also called the long-run space supply curve
Real Estate Economics _ Notes

In case of changes to FC, curve shifts in parallel fashion.

NW quadrant equation: P=f (C )

P: Asset price per unit of space (e.g. square foot)

C : Level of new construction
f (C) represents the replacement cost of real estate
The P=f (C ) curve intersects the price axis at that minimum dollar value (per unit of
space) required to get some level of new development underway, FC
Assume f ' ( C )> 0

Read: Tobin’s Q, p. 62-63  other book.

Small example:

1
§ Assume f ( C )=200+ 5C . Insert it into Eq. 3 and isolate C ⇒ C= P−40.
5
1
§ Plot the curveC= P−40 in a (P , C) diagram!
5

Southeast quadrant, in-depth:

Real Estate Economics _ Notes

§ 1st axis: The annual flow of new construction (in units of space, e.g., sq. feet)
denoted C
§ 2nd axis: Stock of space (in units of space, e.g., square feet) denoted S
§ In this quadrant, the annual flow of new construction, C , is converted into the
long-run stock of real estate space, S
§ The ray emanating from the origin represents that level of stock (on the
horizontal axis in 4Q diagram) that requires an annual level of construction for
replacement just equal to that value on the vertical axis (in 4Q diagram). At
that level of stock and corresponding level of construction, the stock of space
will be constant over time, since depreciation will equal new completions.

C
SE quadrant equation: ∆ S=C−δS=0  S=
δ

δ=annual rate of depreciation

Small example:

§ Assume the depreciation rate is 1% annually, i.e., δ=0.01 .

C
§ Insert this value into the steady state version of Eq. 4 ⇒ S=
0.01

If δ increase (From 1% to 5%), then slope decrease.

Real Estate Economics _ Notes

4 Q diagram:
Eq. 1: D ( R , E )=S
R
Eq. 2: P=
i
Eq. 3: P=f (C )  C=g(P)
C
Eq. 4: ∆ S=C−δS=0  S=
δ
q Equations 1−4 is a simultaneous system of four equations with four unknown
variables: R , P ,C , S .
q This can be solved after assuming a particular functional form for D(R , E) in Eq. 1
and f ( C ) in Eq. 3 and relevant values for the exogenous variables i and E and the
parameter δ

Positive asset demand shift:

(
Increase (i). Interest rate.  P=
R
i)=Cap rate
Real Estate Economics _ Notes

Investments shift from government bonds to real estate investments.

R
As interest rate (i) increase  Slope of asset market valuation ( P= ), becomes steeper.
i

- In diagram ^ shows as less steep.

Short run, vs. long run:

Real Estate Economics _ Notes

Negative shock to Construction cost: (Increased cost of construction)

Initial change (Southwest quadrant)

Construction supply curve either shift outward due to increased FC, or rotate outwards due to
increased VC.

Then, Construction will be lower, causing stock to be lower.

This will cause rent to increase (Same demand less supply).

Causing Prices to increase.

Algebraic solution to: Four Quadrant model:

Model consist of following equations:

Real Estate Economics _ Notes

Equations are simultaneous equations with four unknown variables: (R, P, C, S).

We solve by considering a particular functional form of eq. 1 & 3, and values for our
exogenous variables.

Our equations therefore become:

Real Estate Economics _ Notes

Step by step:

Detailed approach:
Real Estate Economics _ Notes

Lecture 3, Operation of property markets (Micro/Macro app.):

Real Estate Economics _ Notes

Defining markets:

Defining markets for real estate use:

Two dimensions for a “Market”.

1. Product type
2. Geographic area

First dimension, Product tyde:

Products in same market:

Consumer perspective:

If products are Close substitutes, they are said to be in the same market.
- Close substitute  Cross-price elasticity of demand (CED) = Large and positive.

CED measures percentage change in Q demanded of one good when the other goods price
change by 1%.

Producer perspective:

If products are Close substitutes, they are said to be in the same market.
- Close substitute  Cross-price elasticity of demand (CES) = Large and negative.

CES measures percentage change in Q supplied of one good when the other goods price
change by 1%.

Second dimension, geographical area:

Two geographical areas belong to the same market if a price increase of a good in one
geographical area has a considerable impact on the price of the good in another geographical
area.
Real Estate Economics _ Notes

Property Market distinction:

Residential property markets

Non-residential property markets

Pros/Cons:

Pro’s

§ At the macroeconomic level,

o housing markets clearly behave differently from those of non-
residential property (no close movement in prices/rents and level of
construction) and
o housing markets are guided by different institutions from those of
commercial real estate markets (residential brokerage versus
industrial/office brokerage firms, residential mortgage market versus
commercial financing).
§ At the micro level, the behaviour of participants in the residential and non-
residential property markets is based on different economic theories and
motives.

Cons:

§ At the micro level, the distinction between residential and non-residential

property is not as clear; different uses compete for a common resource: land.
Therefore, at the micro level the price of commercial property is related to the
price of residential property and their locations are closely linked through the
commuting of workers and travel of shoppers.
§ The extensive government regulation of land in the two uses (e.g. through
zoning) has important impacts on both types of property markets.

Defining areas:

The geographic definition should encompass real estate parcels that are influenced by the
same economic conditions: national interest rate levels and employment and income which
vary widely across regions.

Lecture 4, Micro and Macro app. Part 2:

Real estate property markets are completely product differentiated.

Urban land markets follow several patterns.

Real Estate Economics _ Notes

Parents with high education  Earn more money  Can buy a more expensive house 
Children of intelligent parents are likely to also be more intelligent (High GPA scores).

§ Physical alteration of the structure

Real Estate Economics _ Notes

o Examples: Rehabilitation, renovation, expansion

§ Changes of characteristics of the neighbourhood
o Examples: New highway, new tram, lower neighbourhood crime,
higher school quality
§ Changes of consumer valuations of particular physical or locations attributes
o Examples: Sudden increase in gasoline prices => higher valuation of
sites with shorter commutes, demographic changes, changes of the
spatial distribution of jobs

Real estate Macroeconomics:

Market growth and dynamics:

§ Abstracts from the spatial dimension of real estate

§ Focuses on short-run movements and temporary disequilibrium
§ Averages or aggregate data for each (local labor) market
§ What are real estate cycles? Truly independent oscillations or just reactions to
the economy?
o Cycles vary with Property type: Residential vs. non-residential.
o Cycles are related to broader capital markets.
o Long-term trend: growth rates of the stock (construction) slow as
economy matures.
o Long-term trend: Prices adjusted for inflation rise over time?

Lecture 5, chapter 3, Urban land market (Location rents, and prices:

Markets for land and housing in urban labor market  Complete product differentiation.

Supply of land at each location is fixed. (Price inelastic)

Real Estate Economics _ Notes

Demand for particular lot is very price elastic.

Basic model of monocentric cities:

Assumptions:

Only one employment center. (Located at middle of circle).

Ricardian rent  Payments tenants are willing to pay for housing / Annual amount owner is
willing to pay for right of occupancy/ use.

Price is only determined by their relative distance to the city center. (Houses with same
distance to city center = Same rent/price).

Housing quality is fixed across locations and lot sizes.

Determining the radius of the city  City boundary:

Eq. 1:

Recall that the area of a circle=πr2.

The border is the radius of a circular city.
The land area of this circle is equal to πb2.
If the city is not fully circular, its area will equal Vπb2, where 0<V<1.

Rent determination at any interior lot in city:

Eq. 2

Determining annual house rent R per housing unit at any interior part of city  Location “d”,
we use following formula:

R ( d )=R ( b ) +k (b−d)
Where,
Real Estate Economics _ Notes

d : distance from the city centre (measured e.g. in miles), any “interior” location
b : most “marginal” or farthest location, i.e. the city border
d=0: “Best”, most central location
k : annual commuting cost (incl. time) per mile from “best” or central location

Rent determination at city border:

Eq. 3

Agricultural rent denotion: r a

Land generates an annual income of r a .

Rent at city border: R ( b ) =Ra +c

Where:
a
R =Agricultural rent per lot
c=Structural rent

Agricultural rent per lot:

Eq. 4
a a
R =r ·q
a
r =Agricultural rent per acre of land
q=lot ¿ ¿

Urban land rent determination: (eq. 5)

Determining the rent (per unit) of urban land: (Calculated as a residual of the
accumulated housing rent from the city, where structure rent d has been subtracted).

Eq 5.
R ( d )−c
r ( d )=
q
q=lot ¿ ¿
1
Urban residential density =
q
Real Estate Economics _ Notes

Determining urban land rent per acre:

Eq. 5’

k (b−d )
r ( d )=r a +
q
where
a
r : “Agricultural” rent (e.g. per acre)
1
1 acre is of a square mile and 40.47% of a hectare
640
1 hectare is equal to 10,000 m2. 1 square mile≈ 1.6 km2.

Illustration of housing rent:

Real Estate Economics _ Notes

Market (spatial) equilibrium:

Decreasing rents as one moves out from the city centre must exactly offset the increasing
commuting costs. Thus, in market equilibrium households no longer have incentive to move

Housing rent (City centre)

Housing rent at distance d from the city centre
found by inserting Eq. (3) into Eq. (2):
a
R ( d )=R + c+ k ( b−d )

R(d) is a linear function with intercept:

a
R + c+ kb
And,
∆R
Slope= =−k
∆d
Real Estate Economics _ Notes

Illustration of urban land rent:

Urban land rent at distance d from the city centre found by inserting the housing rent, R(d)
, into Eq .(5)⇒ Eq .(5' ):

R ( d )−c a k (b−d )
r (d)= =r +
q q

r (d) is a linear function with intercept:

a
r + kb
And,
∆ r −k
Slope= =
∆d q

2nd approach: Comparative static analysis: City comparison:

City Comparisons:
a) Larger number of households N implies higher R(d)
b) Denser cities have higher land rent r?
Real Estate Economics _ Notes

c) Transportation improvements: reductions in k

d) Transportation access: increases V (examples: Bombay, San Francisco,
Channel Tunnel, Øresund Bridge, Great Belt Link)
e) Other geographies [islands, coastlines]

Ad a) Housing rent gradient shifts upwards. Intuition: When b is farther from the center,
housing and land rent at interior locations is higher since at these locations there is a greater
savings in commuting costs.

Ad b) P. 40 in D&W: When the density 1/q increases,

1) the gradient for urban land rents r(d) will become steeper (since the slope is –k/q)
with higher rents at the city center relative to those near the edge (since more
households at location d save k(b-d) in commuting costs) and,
2) the edge is reduced from b0 to b1 since b=[Nq/πV]1/2.

Ad c) Slope of housing rent gradient changes from –k0 to –k1, where k1<k0 and intercept falls
from Ra+c+k0b to Ra+c+k1b.
Downward rotation of housing rent gradient. Intuition: When k falls, interior housing and
land rents will be lower relative to the edge rents, because the commuting cost savings at
interior locations are lower.

Larger number of households N implies higher R(d):

Ad a) Housing rent gradient shifts upwards. Intuition: When b is farther from the center,
housing and land rent at interior locations is higher since at these locations there is a greater
savings in commuting costs.
Denser cities have higher land rent r:
Real Estate Economics _ Notes

Ad b) P. 40 in D&W: When the density 1/q increases,

1) the gradient for urban land rents r(d) will become steeper (since the slope is –k/q)
with higher rents at the city center relative to those near the edge (since more
households at location d save k(b-d) in commuting costs) and,

2) the edge is reduced from b0 to b1 since b=[Nq/πV]1/2.

Transportation improvements: reductions in k:

Real Estate Economics _ Notes

Ad c) Slope of housing rent gradient changes from –k0 to –k1, where k1<k0 and intercept falls
from Ra+c+k0b to Ra+c+k1b.

Downward rotation of housing rent gradient. Intuition: When k falls, interior housing and
land rents will be lower relative to the edge rents, because the commuting cost savings at
interior locations are lower.

d)

Improvements on transportation will increase V . (New areas are considered part of the city,
because they have easier access to central Business centre.)

Example:

Numerical example: Comp. static analysis:

Real Estate Economics _ Notes

Parameters:

N=2mil
q=0 , 25 acre
k =$ 200/mile (commuting cost)
c=$ 7.000
a
r =$ 1.000 / year
V =0 ,6

Since V<1, it is a semi-circular city.

Since 1 acre=1/640 of a square mile, q=1/4 acre => q=(1/4*1/640) square mile=q=(*1/2560)
square mile, i.e. 2560 households per square mile = 0.0004 square mile
1 square mile≈2.6 square km.

We need this info. to calculate the edge b in miles using Eq. (1):

b=[Nq/πV]1/2=[2,000,000*0.0004/π0.6]1/2=20.36 miles.

According to Eq. (2), R ( d )=R ( b ) +k (b−d)

To calculate R(0), first calculate R(b) given by Eq. (3) by inserting the parameter values and
b=20 into Eq. (3):

a a 1000∗1
R ( b ) =R +c=r q+c ⇒ R ( 20 )=$ acre+ $ 7000=$ 7,250 per lot
4

Now find R(0) using Eq. (2):

R ( 0 ) =R ( b ) +k ( b−0 ) =R ( b ) +kb ⇒ R ( 0 )=$ 7,250+ $ 200∗20 miles=$ 7,250+ $ 4000=$ 11,250 per lot .

Note that the difference between R(0) and R(b) is the commuting cost savings from living in
the city center instead of at the city edge: $200*20 miles=$ 4000.
Use Eq. (5’) to calculate r(d) for d=0 and d=b. It is easiest to first calculate r(b) and then
r(0).

Eq. (5’):
Real Estate Economics _ Notes

k (b−d )
r ( d )=r a +
q
k (b−b) a
r ( b )=r a + =r
q

Insert the value of ra into r(b)=>r(20)=$1000.

Now insert d=0 into Eq. (5’):

200 (20−0)
r ( 0 ) =1000+ =$ 1000+ $ 16,000=$ 17,000 per acre.
1/4

Note that the difference between r(0) and r(b) is the commuting cost savings for all four
households from living on the acre of land in the city center instead of at the city border:
4*$200*20 miles=$16,000.
Real Estate Economics _ Notes

Lecture 6, Chap 3, part 2, [Urban land market (Rents and prices)]:

Equation 6: Population growth

Population growth at rate 2g:

2>¿ ¿
nt =n 0 e

In the basic model we assumed g=0, meaning, No population growth.

Equation 7: Boundary growth rate:

Boundary (b) growth rate of g:

¿
b t=b 0 e

Since city is a circle, then if city growth is at factor 2g, then boundary growth rate will be g.

[ ]
1
n0 q 2
boundary growth=
πV

Equation 8: Housing rent (existing structures), at location d, time t:

a
Rt ( d )=r q+ c+ k ( bt −d ) , d ≤b t

Population growth and location rent:

Real Estate Economics _ Notes

Equation 9:

Existing structure price at (d) at time 0 is PDV of future rent. (Using discount rate i):

Spatial capitalization of location rent:

Real estate cap. Rate:

R0 ( d )
Cap . rate=
P0 ( d )

Price-ratio = Opposite of Cap. Rate.

Equation 10:

Price / rent ratio (multiplier) today (t=0) for existing structure:

1 P0 (d ) 1 k b0 g
= = + , d ≤ b0
Cap. rate R0 (d) i i ( i−g ) R0 (d)

With no growth (g=0), the multiplier is the inverse of the discount rate (i) / interest rate. For
all locations.

Note that the second term on the r.h.s. of Eq. (10) is positive => The price/rent ratio exceeds
1/i  the cap rate is below i.
Real Estate Economics _ Notes

The price-rent ratio in Eq. (10) can be thought of as comparable to a price-earnings ratio for
equity shares or common stocks (P/E). Since the P/E is the inverse of the capitalization rate,
assets with growing income streams always have higher P/Es than assets with fixed or
declining income streams.

When the city is expected to grow, the price-rent ratio exceeds 1/i (the capitalization rate is
less than i).

The second term is the value of future growth in location rent/R0(d)>0.

At sites closer to the urban border R0(d) is lower => the second term is larger.
Within an urban area, the price-rent ratio will be somewhat greater (capitalization rate lower)
at the edge of the city, where, in this model, rents increase the fastest.

Equation 11: Urban land prices:

Equation 12:

For d > b 0 the value of land has two components:

- Discounted value of agricultural rent (until development)
- Location value (when developed) - discounted to PV.
Real Estate Economics _ Notes

Numerical example:

Parameters:

N=2mil
2
q=0 , 25 acre(0.0004 mile s )
Real Estate Economics _ Notes

k =$ 200/mile (commuting cost)

c=$ 7.000
a
r =$ 1.000 / year
V =0 ,6

Recall the solution for g=0 from earlier (numerical example in slides on first part of Ch. 3).
If g=0.02 and i=0.07 , then:

To find P(b) and P(0):

R 0 (d ) k b0 g
Plug into Eq. (9): P0 ( d )= ∫ 0 ∞ R t (d)e-it dt= +
i i ( i−g )

d=b=20=>
R (20) k 20 g 7,250 200∗20∗0.02
P0 ( 20 )= 0 + = + ≈103,547 +22,857 ≈ $ 127,000
i i ( i−g ) 0.07 0.07(0.07−0.02)

R0 (0) k 20 g 11,250 200∗20∗0.02

d=0=> P0 ( 0 )= + = + ≈ 184,000
i i ( i−g ) 0.07 0.07(0.07−0.02)

[ ]
c 1 r k (bt −d ) k bt g
a
Plug into Eq. 11: pt ( d ) = Pt ( d )− = + + , d≤bt
i q i qi qi(i−g)

+ 200∗20∗0.02
r
a
k b0 g 1000
For d=b=20 and t=0: p0(20)= +
i qi(i−g) 0.07
= + 1
4 ()
0.07∗0.05
= $14,286+

$91,429≈$105,000
r k ( b0 ) k b0 g
a
1000 200∗20 200∗20∗0.02
p0 ( d ) = + + = + + ≈ $ 14,286+¿
For d=0 and t=0: i qi qi ( i−g ) 0.07 1
4 ()
0.07
1
4 ()
0.07∗0.05
Real Estate Economics _ Notes

$ 228,571+$ 91,429 ≈$334,000

Ext. numerical example: Calculating the Cap. Rate:

Using same parameters.

Calculate Capitalization rate for housing rent at b and d=0.

q Solution:

§ Recall that if g=0, then:

o b=20 miles (approximate)
o R ( 0 ) =$ 11,250 , R ( b ) =$ 7250
o r ( 0 ) =$ 17,000 per acre, r ( b )=$ 1000 per acre
§ If g=0.02 and i=0.07 , then:
o P ( b ) =$ 127,000 , P ( 0 )=$ 184,000
o p(b)=$ 105,000 per acre, p ( 0 )=$ 334,000 per acre

q Calculate the cap rate for housing rent at b and 0. Solution:

Cap. rate of housing rent≡R0(d)/P0(d):

For d=b=20 : cap. rate of housing rent = R0(20)/P0(20)=$7,250/$127,000≈0.057 (i.e.

5.7%).

For d=0: cap. rate=R0(0)/P0(0)=$11,250/$184,000≈0.061 (i.e. 6.1%).

Note that at both locations the cap. rate of housing rent < i=0.07 .

In this model the rents increase the fastest near the city border => higher cap. rate in
the city center. See Eq. (10).

Equation 13: growing commuting cost:

Population growth = 0, Growth in k instead at rate g. (Increased price of gas /worse

transportation systems).
¿
k t=k 0 e
Real Estate Economics _ Notes

Equation 14: Housing rent (existing structures) located at (d) in time (t):
a
Rt ( d )=r q+ c+ k t ( b−d ), for d ≤ b

Equation 15: House prices:

r q c k t (b−d )
a
Pt ( d ) = + + , i> g
i i i−g
Real Estate Economics _ Notes

Lecture 7, Chapter 4, Urban Housing Market: Structural attributes and

density:
In the earlier, simpler model, we assumed all houses to be homogeneous together with a fixed
density across the entire city.

In the real world however, density tends to be higher towards the center of a city and in
specific areas. This is due to several reasons.

Also, structural attributes, both to buildings for private and company-use, together with land
is a very important factor.

Variation in population density with distance from city center, regression term:

Density gradient expression: (Eq. 4.1)

Two-variable regression model:

- Population density = Dependent variable.
- Distance = Independent variable.
−αd
D ( d )=D0 e

D ( d ) : Population density at distance (d)-miles from city center, D(d). Depends on two
components:

D0=¿ Model estimate of density at city center.

α =¿ Model estimate of the coefficient of distance. (Represents percentage reduction in

density with each unit increase in distance (Mile/KM), from city center.)

Statistical estimation of Eq. 4.1:

Requires us to transform expression into linear terms, by taking natural log of both sides of
the equation:

Eq. 4.2:

log ( D ( d ) ) =log ( D0 )−αd

Eq. 4.2 is estimated using least squares reg. across town-obs.

Dependent variable: log of town density

Independent variable: towns distance.
Real Estate Economics _ Notes

When model is statistically significant, implies that there is a relationship between city
density and distance moved away from city center.

Coefficient = -0,09 means:

Each (unit) of distance moved away from city center, relates to a 9% decrease in density.

(Simple model explains 53% of variation in city density) (For the Boston book example).

Density development (1970-1990):

Densely populated cities saw in the period determined, a decrease in population density at the
city center.

These towns conversely saw an increase in density further away from city center, while the
ground between remained fairly the same. Density-wise.

This varies across cities, of-course, but the same trend is true for a large number of cities
across the world. Recently a growing number of people are seeking to live further away from
the city center.

Housing attributes and household preferences:

Real Estate Economics _ Notes

Houses bought at the same purchase price (Housing expenditure) does not imply that two
identical houses have been bought.

One might be very small, but house a lot a important attributes, while the other may be very
large but lack attributes.

Housing is a heterogeneous commodity.

- Differ in structure, size, attributes, location, etc.

Other heterogeneous goods:

- Cars, Employees,…,

It is important to distinguish between:

- housing expenditures (What people purchase a property for)

and,
- Actual price / True market price.

Market price is defined in a fixed term of unit. (A pound of meat)

Where the expenditure is the market price X amount purchased.

In the housing market, we generally use expenditure as the measure in question, not price
per housing quantity / quality.
The principle of optimal utility, irrespective of housing location will still hold in this, more
developed model.

(When we move from city center, city becomes less densely populated, and the increased
transportation cost, for some consumers may be offset by increased privacy or a cheaper
housing unit.)

We expect that the implicit valuation of individual attributes, (bedrooms, bathrooms, pool,
etc.) follow the law of diminishing marginal utility. (Added value of additional
consumption of a commodity drops, as consumption increase).

(Is it double as good to have 6 instead of 3 bathrooms, as a four-person family) - probably

not.

Illustration of Law of diminishing marginal utility towards household size:

Real Estate Economics _ Notes

We see that as the house increase in size, people are willing to pay more, but the line is a
downward sloping, concave slope, meaning, that we at some proportionately want to pay a
diminishing sum of money, for increased size of housing.

We can measure the exact implications of this on consumer spending, using a multiple
regression analysis. Here we estimate the hedonic price equation.

Hedonic price equation:

Hedonic equations used for:

Standard hedonic price function:

P=f (S , T )
Real Estate Economics _ Notes

P = Market price paid for a house.

P is a function of the levels of all observable characteristics of that house: X i Where,

i=1 , n .

S = Vector of structural characteristics, (Bathrooms, bedrooms, etc.)

T = Vector of spatial and neighborhood characteristics, (Location, good/bad
neighborhood, etc.)

Dependent variable: Housing price / rent.

- Developed by tracking actual sales / rent data. / Surveying actual tenants or house
owners.

Independent variables:
- Characteristic variables
o Continuous independent variables: Sq. meters,
o Integer independent variables: Bathrooms, Bedrooms, Kitchens
o Discrete independent variables: Garage or swimming pool (Yes / No)

Qualitative data also used by homeowners as to the state of the house, maintenance, etc.

Simple, linear Hedonic price equation: Eq. 4.3:

β 1 is a estimated coefficient on the housing characteristics.

- Estimate of how much house owners are willing to pay for an additional unit of some
attribute. (Extra bathroom).

Linear hedonic price equation assumptions:

Constant price
Price does not depend on how much of an attribute a housing unit has.
(All square feet of the property, add equal amount of value to the house).

The Rosen approach:

Estimate hedonic regression and differentiate the results to find the implicit / Hedonic
price:
Real Estate Economics _ Notes

∂ p(z)
= pi, for each amenity, z i.
∂ zi

Linear hedonic price regression example:

n=1.648 owner-occupied, single family housing units.

X i =¿ Described in table 4.2 above.

All the independent (attribute) variables, combined, provides an neighborhood-quality

variable.
- Takes value [1] if neighborhood is fair. Else [0], = Poor.
Real Estate Economics _ Notes

Linear hedonic regression is as such:

Attached houses = House that is attached to another house by a common wall. (Rækkehus).

t-statistics attached in parenthesis below the variables.

Additional bathrooms, bedrooms, and a garage all increase the property value.

If the unit is of poor quality, attached, located in a bad neighborhood the price of the property
will decrease.

Price also decreases if located in central city. (Quite significantly), this is the opposite
reaction than we estimated in the Monocentric model. (Closer to the city center = Higher
property value/price).

If we use these figures produced by the linear hedonic price regression and sum the terms
using the statistics from figure 4.2, we get a house price, for a house with these
characteristics, values at $199.738, almost exactly the average house price.

Each variable in the model, is described using its incremental value (1 additional unit).

An add. Bathroom is most valuable, next garage.

Log-log hedonic price equation: (More realistic model)

Linear hedonic equations are frequently used but are unrealistic in their assumption of
constant additional benefit from adding units of attributes.

To account for diminishing marginal utility, we can express the model as:

To statistically estimate this, we transform it into linear terms:

log P=log α + β i log X 2 + β 2 log X 2+ …+ β n log X n (4.6)

Dependent variable is the natural log of price.
Real Estate Economics _ Notes

Independent variable is natural log of original attribute measures.

Not X i which is the constant value of increased unit attributes.

Coefficients of Eq. 4.6, express the elasticity of price with respect to increased number of
attributes.

Log-log Hedonic equation:

Interpretations:

Discrete variables:

Garage:

Encoded to be value 1, if no garage. Or value 2, if there is a garage.

Thereby, if there is a garage, we see that this adds. (20,145 ) = 1,106 = 10,6% price increase.

Undesirable neighborhood:

House value will be reduced by: 2−0,103 = 0,931  (0,931 - 1) = -6,9%

House price estimation:

Real Estate Economics _ Notes

We predict the price of a house by inserting values for each att. In Eq. 4.5, using coefficients
estimated in Eq. 4.7 as exponents in Eq. 4.5, and then multiplying all of the terms.

Numerical Example: [Eq. 4.8]

Single-family, detached house, 27 years old, 3 bedrooms, 2 bathrooms, garage, in good

shape, and located in good neighborhood:

Equation 4.5 coefficient order:

Bedroom [ Integer ] , bathroom [ Integer ] , Garage [ Bin ] , Age [ Integer ] ,

SFA [ Continuous ] , Quality [ Bin ] , Area [ Bin ] ,Central city [ Bin ] .

11 ,71 0,165 0,473 0,145 −0,004 −0,001 −0,122 −0,103 −0,015

P=e 3 2 2 27 1 1 1 1

¿ $ 221.118

Then, altering the number of bathrooms from 2 to 1, we see that an house with the exact same
attributes, but only 1 bathroom will be priced at: $159.308. Increasing to 2 bathrooms thus
has a $61.810 price change / (38,8%) increase in price.

Increasing number of bathrooms from 2 to 3, in an otherwise identical house, will increase

the price to $267.865, that’s now only a $46.747, or 21,1% increase in price.

Thus, our model now does take into consideration the law of diminishing marginal utility.

In contrast, Eq. 4.4 added a constant value of $50.678 price increase per additional bathroom.

Semi-log house price model:

Real Estate Economics _ Notes

β is the estimated effect of a one-unit change in z on the rate of change in the property price.
β >0: A “good” and consumers have increasing MWTP
β <0: A “bad” and consumers have diminishing MWTP
For dummy variables: For large β -estimates, the following formula is a good approximation
of the marginal effect of a dummy variable on the house price P:

marginal effect=( exp( β)−1 )∗100 %

Real Estate Economics _ Notes

Semi-log hedonic model example:

Interpretation of coefficients:
Real Estate Economics _ Notes

Housing attributes and new construction:

Consumer preference largely dictate what housing is build, in the long run.
Consumer preferences is as such, very profitable to know, when constructing new buildings.

If we assume construction cost per sq. ft. space to be roughly constant. (Sq. ft. cost = C)
Then, constructing house with SIZE sq. ft. costs: (C * SIZE)

However, housing should follow the law of diminishing utility.

Using our Hedonic equation and adding SIZE as P(SIZE).

Construction cost will be a linear ray, moving northeast from the origin.
The difference however in house price and value, is the law of diminishing utility.
Real Estate Economics _ Notes

C(SIZE) = Construction cost. (Fixed pr. Sq. ft.).

P(SIZE) = Value / Utility, (Diminishing as SIZE increase).

The point where P(SIZE) and C(SIZE) intersect is where the difference between house
price/value and construction cost is maximized.

Units of houses added/constructed each year, represents the consumer preferences and
construction technology prevailing at that current time.

Thus, the aggregation of houses at any point in time, is the sum of all units constructed over
time, with the specific preferences and technological solutions at the time of construction.
(Changing preferences most likely cause (Property age) to be negative).

(Older homes may not be “disliked” because they are old, but because people preferred
smaller/bigger homes 30 years ago), or not having a garage because cars were expensive back
in the days… something.
Real Estate Economics _ Notes

Residential density, Land value, and Highest use:

New land development often mostly characterized by its density.

Higher density is normally associated with lower housing price as green areas, privacy, and
general space decrease.

However, more density implies more rent that can be collected.

Landowners who want to construct housing, wants to maximize residual profits after
construction costs.

Thus, density decrease housing value / rent which can be collected but increase number of
houses that can be sold / rent to be collected.

It is as such, a tradeoff, and the developer must balance these two, opposite moving forces.

Density measures: FAR

Real Estate Economics _ Notes

Two methods to review density:

- The ratio of housing units to total land area of the property

- The ratio of total housing floor area to total land area (FAR  floor area ratio)

We will use FAR for now denoting it as: F.

We expect people to want to pay less for units in taller / denser buildings/areas.

Using the Hedonic equations like previously, we construct an equation for the price / Sq.
ft. of floor area, (P) in a housing unit:

P=α −βF

α =¿ collective value of all other locational and housing attributes that can affect price / sq. ft.
area of a house.

β=¿ marginal reduction in value as house lot is reduced and density / FAR increase.

We also expect construction cost to vary with FAR of the residual development. We expect
construction cost to increase with FAR (Increased foundational work, structural support,
elevators, etc.)

Floor area
Floor area ratio [ FAR ]=  Residual structure density * unit floor area.
Land area

FAR
% of lot open / not constructed on ¿ 1− , for stories > FAR.
Stories

FAR impact on rent:

Real Estate Economics _ Notes

Cost of construction abbreviated to:

C=μ+ τF

μ=¿ basic cost of construction/sq. ft. housing. μ>0.

τ =¿ incremental additional cost. (Linear), as density increase. τ > 0.

Profit:

Profit of constructing house unit / sq.ft.: P−C

Price−construction cost

Profit at (d) (Where construction cost and price intersect = 0. And negative to the right. (The
Construction cost of additional density exceed the price people are willing to pay).

Equation summary:

Eq.1:
P=d−βF
- P, Price per sqft. Floor area.

Eq. 2:
C=μ−τF
- C, Construction cost/ sqft. Floor area

Eq. 3:
p=F ( P−C )
- Residual land profit /Sqft of developed land.
Real Estate Economics _ Notes

Top panel depicts profit in terms of price to construction costs.

Bottom panel depicts the residual value of land.

Residual value of land must be 0 at the origin as F = 0. (No housing)

Residual value of land must also be 0 at point (d), where P = C, as no one want to purchase.

At F*, residual value of land is maximized.

We can see what price this correlate to at P*.

The expressions for F* and P* are shown as:

Eq. 4.9

· [α −μ]
F=
2[ β+ τ ]
Real Estate Economics _ Notes

2
·[α −μ] [ α −μ ]
P= , F=
2 4 [ β+ τ ]

Maximum land profit / sq.ft. is in principle an equilibrium value for what land is worth.

Finding the value of F* that maximize land profit:

We substitute the expressions for floor area price and construction cost:

In order to truly maximize profits, the residential development must both be build with the
equilibrium FAR and the value-maximizing construction. (Is residential the most valuable
construction-type for this location?)

Equation 3 derivation:
Real Estate Economics _ Notes

Equation 4 derivation:

Optimal FAR:

Boston example: Density:

Real Estate Economics _ Notes

n=578 condominium sales transactions

Price unit = per sq.ft:

P=222−1.48 F
Construction cost/sqft:

C=100+2 F

Optimal FAR:

[α −μ] (222−100)
F ¿= = =17.5
2[ β+ τ ] 2(1.48+ 2)

Max. land price:

¿
[α −μ ] [ α −μ ] F [ 222−100 ]∗17.5
2
¿
p= = = =$ 1,068 per sqft .
4 [β +τ ] 2 2

Urban Re-development:

Large sunk cost associated with redevelopment.

We rarely see incremental FAR increases.

FAR typically increase in waves. (Buildings torn down for redevelopment).

α 0 : Hedonic value of existinghousing capital on the site .

F 0 : FAR of existing use .

Redevelopment can only occur if:

·
p − p0 >δ F 0 (7)
Real Estate Economics _ Notes

δ : Demolition cost per sqft.

Implies:

F ¿ ( α −β F ¿ ) −F 0 ( α 0−β F 0 ) > δ F 0+ F ¿ (μ+ τ F¿ )

Increase in value of land and capital > demolition plus development cost

Land use comp. Between groups:

Residential segregation of households of type 1 at relative central locations and households of

type 2 father away.

As city redevelops, at what FAR-value will land be developed, and for whom will it be
developed?

Determining WTP for land by each household (i). (Optimal values):

Real Estate Economics _ Notes

The maximum value for any given site can be determined only by considering the optimal
FAR that should be developed for each potential group of occupants or type of land use and
then compare the potential residual land values across types or uses.

Equation 9 derivation:
Real Estate Economics _ Notes

Lecture 8, chap. 5, Firm site selection & employment

decentralization:

In this chapter we look at the reasons why the simple model, that assumes employment to be
located at a single, central location in a city, no longer holds in modern society.

Employment decentralization:

Employment has followed where people live. Retail stores, service central etc. want to be
close to people’s homes, for convenience and to be the obvious choice.

People in recent years have sub-urbanized at greater extend, therefore employment is no

longer, solely at the centre of a city, but dispersed throughout the city.

Manufacturing and retail stores today need more physical space than in early days. Therefore,
firms seek land which is cheaper. (Outskirts / City border).

The modern multicentred city is the outcome of competing forces. The benefit of
decentralization vs. the benefits from concentration.

Measuring relationship between employment density and distance:

We can measure this using the negative exponential specification defined in Eq. (4.1) and
(4.2)

We statistically estimate the density gradient using ln (Employment density) as dependent

variable, and distance as the independent variable.

Equation 5.1:

log [ D ( d ) ] =8 , 05−0 , 10 d
8 , 1 −11, 15

2
R =0 , 46
N=146

D( d) = Density of employment at distance (d)

- Negative coefficient (-0,10d), indicates how employment is assumed to decrease by
10% for each mile distance from city centre we move away.
Real Estate Economics _ Notes

Model will predict an employment density in Boston of 3.134 jobs/sqml.

Far below the actual number of 11.104 jobs /sqml.

However, model predicts 46% of variation in employment densities.

Land markets with a central business district:

For this type of scenario to hold, firms must value central locations, more than homeowners.

In a competitive, unregulated land market, CBD can exist only if the land rent from these
non-residential land uses exceeds land rent derived from housing.

Starting analysis, 18-1900 cities and transportation needs:

Assumptions:

City has a single port / transportation terminal. Firms brings goods for exports, and receive
raw materials / input from other cities. Imported consumers goods arrive.

In the city, transportation of goods costs: s $ per unit, per mile.

Distance from transportation centre is denoted d .

Firms produce an identical product using the same production process.

- Unit production for each firm is fixed at Q .

No factor substitution. Both lot size f and structure capital used by each firm is fixed.
- Rent for structure used by firms is C .
- Firm’s residual land rent per acre varies with location, r c (d).
- With fixed land and structure, output per acre is fixed.

Input/Output markets are perfectly competitive.

- Free entry into the industry
- Each firm takes pieces as given and economic profit is 0.

Land is allocated or rented to that use and to those plants or offices that yield greatest rent.

How will firm profits vary with location:

Firm sells Q units of goods at price p.

- Firm total revenue: pQ
Real Estate Economics _ Notes

Variable cost includes wages and material production costs per unit, and transport or
shipping costs to market per unit sd .

Fixed costs include rent for the building, C, and land rent per acre, r c (d) times the number of
acres used by the firm, f.

Profits, π :

π=Q ( p− A−sd )−C−r c ( d ) f Equation 5.2

Competition between firms ensures profits of 0, land rent per acre, r c ( d ), can be determined
as a residual:

Q ( p− A−sd ) −C
r c ( d )= Equation 5.3
f

Assuming (p, Q, A, and C) to be fixed across all locations, land rent will exactly compensate
firms for the increased transportation costs.

Land rent gradient for firms is:

sQ(m−d )
r c ( d )=r ( m ) + Equation 5.4
f

Firm’s profit function (Lecture):

Intermediate microeconomics course:

Firm profit function:

π ( Q )=TR ( Q )−TC (Q)

Where:
Q: Units of output per acre of land
TR: Total revenue
TC: Total cost of production

If we assume perfect competition we get:

TR ( Q )=S·Q

Where:
S: Sales price per unit.

Firm profit function, re-written:

Real Estate Economics _ Notes

π ( Q )=TR ( Q )−TC (Q )=¿ S·Q−AC·Q=¿ ( S−AC ) Q

Where:
AC: average cost of production (Wages, capital costs, raw materials).

Enhancing the model:

Relaxing assumption about identical production process and identical use of land.

Instead, we assume there will be a systematic location pattern by type of firm.

Type of commercial uses: denoted i .

All firms within a given type, can output Q i, utilize land: f i, and have shipping cost per mile:
si.

Firms who produce a lot of products to be shipped, or ship heavy/expensive products, will
have a high si Qi f i ratio.

Contrarily, goods that are easy to ship, or firms with lower output, will have a lower si Qi f i
ratio.

Firm profit function under perfect competition, including shipping cost and firm rent per
acre of land:

π ( Q, d ) =TR (Q )−TC ( Q )−s ∙ d ∙Q−r f ( d )

¿ S ∙Q−AC ∙ Q−s ∙ d ∙Q−r f ( d )
¿ ( S− AC −s ∙ d ) Q−r f ( d )
Real Estate Economics _ Notes

Model of circular city with two uses of land: Residential and non-residential:

Profit per unit of output:

r f (d )
π=( S−AC −sd )−
Q
Where:

S: Sales price per unit

AC: Average cost of production (Wages, capital costs, raw materials)
s: shipping cost to port per unit of product, per mile of distance shipped.
d : distance to port (in miles)
r f (d ): Firm rent per acre of land
Q: units of output per acre of land

With competition between firms, ensuring 0-profits in the long run, land rent can be
determined as a residual:

r f ( d )=( S− AC −sd ) Q

Where land rent compensates firms for increased transportation / shipping.

Slope of firm rent function:

∂ rf
=−sQ
∂d

Spatial location equilibrium:

To make worker indifferent between locations within the commuting area, land rents must be
determined as:

a k
r ( d )=r + (b−d)
q

Location equilibrium involves:

1. Giving all the best locations to that use which values it highest.
2. That each household occupies one house
3. That the city exactly fits the number of households with a lot size q and workers given
the floor space per worker f, (Assumed fixed across locations).

Model of land markets in a city with a central business district:

Two conditions for location (spatial) equilibrium:

Real Estate Economics _ Notes

r f ( m )=r (m)
r ( b )=r a

Assume that:

k
sQ>
q

In location equilibrium:

k (b−m)
r ( m )=r ( b )+
q

r f ( d )=r ( m ) +sQ (m−d )

Determining b , m depends on the number of workers N ,the lot size q , and the floor space per
worker f .

[ ]
1/ 2
Nf
m=
πV
Real Estate Economics _ Notes

[ ]
1 /2
Nf + Nq
b= Equation 5.
πV

Technology and the decentralization of manufacturers:

The first firms to decentralize from the CBD was industrial firms. (Firms who need large
space but does not necessarily need to be located next to their consumers.)

The empirical reasoning is that industrial firms rent gradient became relatively flatter due to
technological advances. Thus, industrial firms became more observant about the rent of a
piece of land.

Two reasons for this is:

- Evolution of transportation systems.

o Railway, highways.

- Better methods for industrial production and storage technology.

o Increased the amount of land used per unit of output by industrial firms.
 Thus, industrial firms needed more land at roughly same price. 
Decentralization.

Horizontal assembly lines (Henry Ford), Ford Motors. Greatly increased firm need for
space.
Real Estate Economics _ Notes

Therefore, rent gradient of industrial firms became quite flat, wrt. To distance from CBD.

Industrial firms therefore choose locations at city border or at undesirable locations for most
other uses like locations next to large highways or airports or water-cleaning facilities.

Wages, the labour market, and office decentralization:

Historically, office and service firms have remained much tighter located to the CBD than
industrial firms.
Real Estate Economics _ Notes

Since 1990, there has however been an increasing trend of office building development
outside CBD’s.

Office firms do not need physical input like raw materials quite like industrial firms.
Therefore, office buildings have no need for being specifically close to the CBD
(transportation port).

Office firms are conversely highly dependent on labour as a central input-factor for the output
produced by these firms.

Bump in rent gradient between d 4 and d 5 is due to employees bidding up house prices near
firm located between d 2 and d 3.
Real Estate Economics _ Notes

Lecture 9, National economy and regional economic growth:

Focus of real estate [Macroeconomics]:

Real estate macroeconomics focus more on the time dimension and studies short-run
movements in real estate related activities as well as temporary disequilibrium in the
market.

Also interested in long-run trends in real estate markets.

We primarily focus on aggregate variables, (Averages of aggregations of data, measured at

different locations, markets, and points in time).

One of the main objectives of macroeconomics is to understand and explain the movement in
property prices or rents.

Regions:

Normally regions are small open economies that do not have separate currencies, so no
possibility of running their own monetary policy.

No expand (contract) money supply to stimulate (slow down) economic growth

No currency devaluation to reduce imports and stimulate exports
Local wages and employment absorb the impact of economic shocks
Intensive trade among regions of the same country: leads to (1) specialization and (2)
”insurance” so that a slow-growing region (economic, or population) saving more than it
invests passes the excess to a fast-growing region
Real Estate Economics _ Notes

Real estate in macroeconomics:

Macroeconomics can be used to study these phenomena by either:

- Analysing the determinants of demand and supply in individual real estate markets

- Analysing the relation between real estate markets with the overall national business
cycle.

Also, macroeconomic analysis may provide insights to:

- Economic growth of metropolitan areas (determined by movements in national

economics and area’s industrial mix, and competitiveness) Here (long-run)
demographic changes and preferences play a huge role.

- Real estate market in a given area, moved closely with that areas general economic
growth. (Economic growth is influenced by supply and prices of real estate).

- Metropolitan areas usually adjust slowly to economic changes.

 Resources are relatively immobile between markets
 Slow adaptability of the supply of labour, relative to the demand of labour.

Aggregate demand for real estate:

Regional growth:

The most important source of increase in aggregate demand for commercial space and
housing.

- Increased local employment levels will push up the agg. Demand for office spaces /
housing units.

Thorough analysis of metropolitan growth at macroeconomic level is the initial step to

conduct a detailed study of specific property markets.

- Seek to understand the different patterns of regional growth, what causes the growth,
it’s mechanisms, and its implications for real estate market analsis.
Real Estate Economics _ Notes

What determines investment in (supply) of real estate:

1. Utility driven investment: (Demand oriented)

Whenever the investor’s marginal utility of one additional unit of real estate exceeds the
market price, demand for real estate structures will rise, pushing up the need for new
construction.

2. Tobin’s q (Supply oriented):

Market price of housing unit

q=
Construction cost + Land cost for new housing

- When q > 1, construction will increase. (Because of unexploited profits available in

the market.

3. Macroeconomic fundamentals:

Economic growth, interest rates, demographics and institutional environment defines

aggregate demand for real estate, which ultimately will determine construction.

4. Government tax income and their ability to borrow:

Particularly relevant for public investment.

Correlation between GDP and real estate related growth in Denmark:

Real Estate Economics _ Notes

(a): This graph depicts real estate activity growth on the y-axis and output growth on the x-
axis, in Denmark. The implied correlation is very high (0.87), the two growth rates are almost
the same.

(b): Output and real estate activities are positively correlated (0.80) at the regional level, the
numbers are quite similar to the DK graph. Almost 1:1 relationship.

For midtjylland, output and real estate activities are positively correlated (0,86)
For Nordjylland, Output and real estate activities are also positively correlated (0,88)
Almost 1:1, for both these regions, compared to DK overall.

Regional economic growth:

Regional economic growth refers to one of three possible types of change:

- Physical growth: population, employment, and capital stock growth.

- Wealth growth: regional income and wage growth.
- Output growth: increased volume of goods and services produced within a region.

Can there be demand for additional space at specific locations within a region, even with zero
growth in regional income or employment? YES.

It can come from either:

- Location shifts, due to changing preferences or substantial rent differentials across
sub-markets.
Real Estate Economics _ Notes

- Replacement demand, generated because of the depreciation and obsolescence of a

percentage of existing stock.

Three models:

Labour market model:

Demand for labour, perfectly inelastic.

Real estate market:

Real Estate Economics _ Notes

Output market:

Price, (P), is the weighted average of w and r, where the weights are (α L , α K ).

Investor example:

Considering investment in high-end housing in one of the following, candidate regions:

Region A: The area is experiencing and is likely to continue experiencing amentity induced
immigration of employable population.

Region B: The area is experiencing and is likely to continue experiencing immigration of

non-employable population (retirees).

Region C: The area is, and is likely to continue experience shifts (Increases) in demand for
exportable goods it produce.

We must understand what type of growth is occuring at each place. And which is likely to
experience significant income growth (Crucial driver for high-end housing.)
Real Estate Economics _ Notes

To do this, we develop the three-sector model: [Output, labour, real estate], with two
potential sources of economic growth process, (Shocks):

Demand-induced growth, is driven by shifts in demand for a region’s main products, goods
and services.

Supply-induced growth, is driven most often by shifts in the region’s supply of labour.

Model of regional economic growth. [Three-sector model]:

Main assumptions:

No substitution between real estate and labour market inputs in the production process.

In other words, there will always be a fixed amount of these inputs required (demand), to
produce each unit of output.

Implication: cost of production is going to be the sum of the cost of the two fixed amounts of
inputs required to produce Q: so C=aKr + aLw (does not depend on quantity, AC=MC) and the
demands for each input will be L=aLQ and K=aKQ – this means that the demand for each
input depends on output quantity and not on their price.

It’s a simplification of course (technology might allow us to get rid of those two workers and
use the space for a big server fx), but one that doesn’t bother us so far.
Real Estate Economics _ Notes

Output market:

Demand:

Driven by internal demand and by exports, which depend (inversely) on the price of the
product (relative to the price of similar product in other regions), i.e., X ( p).

Therefore, total demand for output of a region will also be a negative function of relative
prices, Qd (p) .

Supply:

Determined by the cost of production, where we assume:

1. Average cost = marginal cost (No fixed cost)

2. Intermediate inputs are irrelevant since their prices are similar across regions.

Labour and real estate prices differ among regions and affect production costs.

Average cost of production: C=α L W +α K r

A nearly VERTICAL demand curve suggests that demand for the region’s export is very
INELASTIC with respect to price.
Real Estate Economics _ Notes

A nearly HORIZONTAL demand curve suggests that the region’s export is very ELASTIC with
respect to price  Exportable products of the region are sold in very COMPETATIVE national
market.

P is the weighted average of r (for RE) and w (for Labor).

Labour market:

Demand:

Completely inelastic demand for labour (Ld ), given the assumption of no substitution
between inputs, meaning: Demand does not respond to changes in the effective wage rate.

w
The effective wage is ,meaning: the region’s nominal wage relative to the price of the
p
goods and services produced in the region.

Demand for labour entirely determined by production levels. Therefore: Ld =α L Q

Vertical demand for labor: with the assumption that there is no substitution between RE and
Labor (two production factors), the demand for each factor depends only on OUTPUT (Q),
not the price of that factor  Demand only SHIFTS with the level of output.

Supply:

Is an upward sloping curve, Ls , which suggests what the effective wage rate must be, to attain
a given size of the labour force into the region.
Real Estate Economics _ Notes

Horizontal axis: The size of the region’s labor force.

Vertical axis: Region’s wage rate divided by the price level of output (vertical axis in the
Output Market)
Labor force MIGRATION into the region occurs due to increase in the effective wages
(ENDOGENOUS) represents MOVEMENTS ALONG the labor supply curve.

Labor force MIGRATION into a region that occurs because of events in other regions
(EXOGENOUS, such as foreign immigration, regional demographic forces, changes in
lifestyle preferences) represents a SHIFT in the labor supply curve.

A more HORIZONTAL (elastic) labor supply curve indicates that labor EASILY MOVE
into the region in response to a higher effective wage.

A more VERTICAL (inelastic) labor supply curve suggests that the region has
DIFFICULTY in ATTRACTING labor.

Real estate market:

Demand:

Completely inelastic demand for real estate, ( K d ), given the assumption of no substitution
between inputs, meaning demand does not respond to changes in rents for real estate.

The rent, r, is determined by both structures and land.

Demand for stock of real estate entirely determined by production level. Hence, K d =α K Q
Real Estate Economics _ Notes

Supply:

Is an upward sloping curve, (K s) which indicates what rent-level is necessary to bring

actualize a given level of real estate stock. (In order to expand, a region-area must develop
more land, which in turn, necessitates higher real estate rents.

Horizontal axis: Is the stock of real estate in the region

Vertical axis: Is the rent for real estate in that region.

A more vertical (Inelastic) RE supply curve suggests that the region has difficulty in
construction of new properties due to: topographic constraints, building restrictions, and other
impediments to development.

Equilibrium:
Real Estate Economics _ Notes

In equilibrium there is no growth. Growth is present as a comparative static shift, here we

talk about a static model.

But even if the model is static, you can already notice that the equilibrium requires time to get
there. However, we do not talk about duration of moving from an equilibrium to another
equilibrium.

Increase in quantity of goods sold: model reaction.

P=C=α L ·W +α K · r

Where:

W → Increase
r → Increase

Causing:

C → Increase

∆ Q → Positive
∆ L → Positive
Real Estate Economics _ Notes

∆ K → Positive

Where,

Change in Q = Output growth.

And

Change in L and K = Physical growth.

Also:

∆ P → Positive

∆ ( WP ) → Positive
∆ r → Positive

w
=effective wages
p

Effective wages increase if: ∆ W >∆ P, conversely, Effective wages decrease if ∆ W <∆ P .

Three-part model, [More inelastic labour supply]:

Real Estate Economics _ Notes

Note: The two regions are the same (i.e., in equilibrium and in both regions, the amount of
output (Q0) demanded labor force (L0) and demanded real estate (K0), price levels (P0),
effective wage (w0/p0), and rents (r0) are exactly the same) with only one exception: in the
second region the labor supply is more inelastic (steeper).

The idea is to see what would happen to Q, L, K, P, w/p, and r after an exogenous positive
demand side shock when we have more inelastic labor supply. Therefore, we can compare the
equilibrium points after the shock in two regions by knowing the equilibrium points before
the shock were initially the same.
Real Estate Economics _ Notes

Movement 1: An exogenous positive demand-side shock happens, which shifts the demand
curve in the output market outward. Therefore, the amount of output increases from Q0 to
Q1. (Note: increase in output from Q0 to Q1 is a kind of overshooting in outputs, and little by
little, the 3 markets react to such overshooting and the magnitude of increase in output
declines. But the output in new equilibrium should ALWAYS be in between Q0 and Q1, as
we will see in the next movements. Otherwise, we will not have a steady state and internally
consistent equilibrium after the demand side shock, which means the markets will never
converge to a new equilibrium. We will study more about that later, when I introduce Capital
Stock Adjustment Model (CSAM)). The increase in output from Q0 to Q1 in both regions is
the same (i.e., Q1 in the first region is the same as Q1 in the second region), because we
assumed the magnitude of outward shift in both regions are the same, and the cost curves in
both regions have the same situation/magnitude. In addition, the slopes of output demand
curves are the same.

Movement 2: Due to increase in Q from Q0 to Q1, demand for labor and real estate will
increase, which are shown by outward shifts in demand for labor and real state from L0 and
K0 to L1 and K1, respectively. As a result, the effective wages increase from w0/p0 to w1/p1
and rents increase from r0 to r1:

• The magnitude of increase in rents in both regions are the same (why? Because Q1 in
both regions is the same, and the magnitude of shift in K is the same (from K0 to K1)
and labor supplies have the same slope/elasticity).
Real Estate Economics _ Notes

• However, the magnitude of change in effective wage is the second region with more
inelastic labor supply is higher (just compare difference between w0/p0 and w1/p1 in
both markets). (Why? Due to more inelastic labor supply).

• Since both effective wages and rents have increased, we expect to see increase in
production cost. Nevertheless, the magnitude of increase in production cost in region
with more inelastic labor supply is higher, because the increase in effective wage in
this region is higher. Look at the next slide.

Movement 3: As mentioned in previous slide, due to increase in w/p and r, production cost
will increase, and increase in production cost should be higher in the second region with more
inelastic labor supply (increase in effective wage is higher). Therefore, upward shift in cost
curve (in the output market) takes place. As it is shown, the upward shift in the second region
is greater than the first market.

Due to upward shift in the cost curve, production declines from Q1 to Q2. The magnitude of
decline in the second region with more inelastic labor supply is higher because the upward
shift in cost curve is higher in this region.

As a result, the output declined from Q1 to Q2, and now the demand for labor and real estate
should decline (inward shift). The inward shifts in demand for labor and real estate in the
second region with more inelastic labor supply are greater, because Q2 in the second region is
smaller than Q2 in the first region. These movements are mentioned in the next slide.
Real Estate Economics _ Notes

Movement 4: Due to decline in output, the demand for labor and real estate will decline,
which are shown by backward/inward shifts in the demand curves from L1 and K1 to L2 and
K2, respectively. As mentioned in previous slide, inward/backward shift in the demand for
labor and real estate in the second region should be greater than the first region. This is the
reason for greater backward shifts of L2 and K2 in the second region.
Equilibrium: Such corrections in 3 markets happen for several times, until the markets reach
to a new steady-state equilibrium points, which are internally consistent. Actually, we can
show these adjustments for several times, but it is enough to show them in 4-5 movements, as
I described here.

The red lines are showing the status of demand and supply curves in the new steady state
equilibriums, which are internally consistent. At the end, as we expected, output (Q),
demanded labor and real estate (L and K) increase. At the same time, prices (P), effective
wage(w/p), and rents ( r ) increase, as well. Please note that in the second region with more
inelastic labor supply:

• Increases in output, as well as demand for labor force and real estate are smaller
(compare Q2, L2, and K2 in two regions)  Lower physical growth.

• Increases in prices and effective wages in the region with more inelastic labor supply
is higher  Higher wealth growth.

• Increase in rents in the second region is lower (due to smaller amount of increase in
output, and hence, increase in demand).
Real Estate Economics _ Notes

Demand induced growth:

Causes of regional demand shifts:

National business cycle:

cyclical upswings of the national economy associated with changes in consumer and producer
expenditure, especially on durable goods, may have effects on local metropolitan markets
depending on each of the market's industrial structure. For example, increases in export
demand for American cars may generate a demand-induced growth in Detroit, but not in San
Jose, while increases in demand for computer-related products may generate demand-induced
growth in the latter, but not in the former.

Comparative advantage:

increases on comparative advantages in production of similar products across regions might

increase locally produced export goods. For example, increase in prices of competitive
products elsewhere (due to higher production costs) might lead to demand-induced growth.
Non-wage production cost differences across regions might be due to:

 Productivity-enhancing amenities (Tax / other incentives, educated labour,

infrastructure quality, etc.)

 Industrial agglomeration: industrial clustering may foster innovation and

induce productivity increases and production cost savings. Clustering
might be especially important during the early stages of product cycles, as
it might facilitate labor market economies, economies of scale and more
types of positive externalities.

Population growth:

Government consumption:
Real Estate Economics _ Notes

Supply-induced growth:

Shifts in supply, [Endogenous vs. Exogenous shocks]:

Endogenous shock: Movement along supply curve.

Exogenous shock: Shift in supply curve.

Exogenous shock to labour market curve. (Immigration of employable population), causes

curve to shift, increased labour force.

∆ L → Positive

W
Which, causes →decrease.
P
Real Estate Economics _ Notes

Labour demand will however increase as output increase, causing effective wages to settle at
a point in between the old point, and the short-term point.

Supply-induced growth, effect on output market:

Real Estate Economics _ Notes

Supply-induced growth, effect on the real estate market:

Real Estate Economics _ Notes

Supply-induced growth, inelastic product demand, [Three-sector model movements]:

The two regions are the same (i.e., in equilibrium and in both regions, the amount of output
(Q0) demanded labor force (L0) and demanded real estate (K0), price levels (P0), effective
wage (w0/p0), and rents (r0) are exactly the same) with only one exception: in the second
region the product demand is more inelastic (steeper).

The idea is to see what would happen to Q, L, K, P, w/p, and r after an exogenous positive
supply side shock when we have more inelastic product demand. Therefore, we can compare
the equilibrium points after the shock in two regions by knowing the equilibrium points
before the shock were initially the same.
Real Estate Economics _ Notes

Movement 1: An exogenous positive supply-side shock happens, which shifts the labor
supply curve in the labor market outward. Therefore, the effective wages decline from w0/p0
to w1/p1. (Note: The magnitude of decline in both regions is the same, as we assumed the
location of the initial labor demand (L0) and the slope/elasticity of labor supply are the same
in both regions).

Movement 2: By decline in effective wages, production costs in both regions decline, which
are shown by downward shifts in cost curves. Note that the magnitude of decline in
production cost in both regions is the same (Why? Because decline in effective wages in both
regions is the same).

By decline in production costs, the output increases from Q0 to Q1. Note that the magnitude
of increase in output in the second region with more inelastic output demand is smaller (Just
compare Q1 in both regions).

By increase in production from Q0 to Q1, the demand for labor and real estate increase.
Therefore, demand curves for labor and real estate shift outward (movement 3 in the next
slide). However, since the increase in output in the second region with more inelastic labor
supply is smaller, we expect smaller outward shift in L0 and K0 in this region.
Real Estate Economics _ Notes

Movement 3: As described in previous slide, due to increase in output from Q0 to Q1, L0 and
K0 shift outward to L1 and K1 in both regions. And we know the magnitude of shift in L0
and K0 in the second region with more inelastic product demand is smaller. By outward shift
in demand for labor and real estate (i.e., L1 and K1), effective wage increase from w1/p1 to
w2/p2 and rent increases from r0 to r1. Note that the magnitude of increase in effective wages
and rent in the second region with more inelastic product demand is smaller (why? Because
the outward shifts in L and K in this region is smaller).

Consequently, the production costs shift upward (increase), but with smaller upward shift in
the second region (why? Because increases in effective wages and rents are smaller in this
region). The upward shifts in the production costs are described in the next slide (movement
4).
Real Estate Economics _ Notes

Movement 4: Due to increases in effective wages and rents (i.e., w2/p2 and r1) , production
costs increase, which means production costs shift upward. As mentioned, upward shift in the
production costs is smaller in the second region. Hence, production declines from Q1 to Q2.
The magnitude of decline in production in the second region is smaller because of 2 reasons:
(1) There is a smaller upward shift in the production costs in the second region, and (2) the
product demand curve in the second region is steeper/more inelastic.

Movement 5: By decrease in output to Q2, the demand for labor and real estate decline.
Therefore, we expect to have a backward shifts in demands (i.e., shifts from L1 and K1 to L2
and K2, respectively). Nevertheless, backward shift in the second region is smaller (why?
Because decline in output from Q1 to Q2 in this region is smaller).

Due to backward shifts in L2 and K2, effective wages decline from w2/p2 to w3/p3 and rent
decline from r1 to r2 in both markets.

Equilibrium: Such corrections in 3 markets happen for several times, until the markets reach
to a new steady-state equilibrium points, which are internally consistent. Actually, we can
show these adjustments for several times, but it is enough to show them in 4-5 movements, as
I described here.

The red lines are showing the status of demand and supply curves in the new steady state
equilibriums, which are internally consistent. At the end, as we expected, output (Q) increase
from Q0 (in the initial equilibrium) to Q2, and demanded labor and real estate (L and K)
increase from L0 and K0 (in initial equilibrium) to L2 and K2, respectively. At the same
time, prices (P) declines from P0 to P2, and effective wages (w/p) decline from w0/p0 to
Real Estate Economics _ Notes

w3/p3, whereas rents ( r ) increase from r0 to r2. Please note that in the second region with
more inelastic product demand:

• Increases in output, as well as demand for labor force and real estate are smaller
(compare Q2, L2, and K2 in two regions)  Lower physical growth.
• Decrease in prices are larger (just compare p2 in two regions).
• Decrease in effective wages is larger Higher negative wealth growth.
• Increase in rents is smaller (due to smaller amount of increase in output, and hence,
increase in demand).

What generates regional supply shifts:

Real Estate Economics _ Notes

The system of national accounts:

We know how the real estate market operates within the regions of a particular country.
- How does real estate-related activities contribute to the both national GDP and
employment?

 How strong is the effect of construction investment on GDP?

 How does the effect of construction compare with the effect of other kinds
of investments?
 Is there a difference in the strength of the effect of construction between
developed and developing countries?

And, employment… How much employment does real estate-related activities create in
comparison to other activities?

We use the system of national accounts, to answer such questions:

SNA is n international standard set of recommendations on how to compile measures of

economic activity

Developed by the united nations’ statistics division (UNSD)

However, not all countries follow strictly the same standards (US, France, China)

SNA describes a coherent, consistent and integrated set of macroeconomic accounts, based
on a set of internationally agreed concepts, definitions, classifications, and accounting rules.

Can be seen as a formal representation of the traditional circular flow chart and hence, the
SNA is one of the building blocks of macroeconomic statistics, forming a basis for economic
analysis and policy formulation.

Economic activity measures:

Real Estate Economics _ Notes

Production approach: 1

The amount of output produced in the economy:

GDP=∑ Qi−∑ C I i=∑ V Ai

(1): GDP = sum of output – input cost (if inputs produced in the country THEN are part of Q)

Income approach: 2

The income generated by production:

GDP=W + Π

(2) GDP = wages + profits

Expenditure approach: 3

The amount of spending by purchasers:

GDP=C+ I +G+( X−M )

(3): GDP = consumption + investment + government consumption + (exports – imports)

Imagine SNA as a big family where parent bake a strawberry cake and give a piece to each of
their five children. How much cake is there:

The production approach says: Go to the kitchen, measure what ingredients the parents
used to bake the cake. (Flour, Sugar, Cream, Eggs, and strawberries).

The income approach says: Check how much cake each family member received. How big
were the pieces?

The Expenditure approach says: Measure how much they ate.

Real Estate Economics _ Notes

System of national accounts, and real estate:

1. Value added by new construction and renovation (Incl. demolitions, and disposals of
waste materials).

2. Value added by industries and firms (Incl. outsources ones), supplying building, and
renovating materials and equipment.

3. Value added by facilitating transactions in real estate, resolving disputes, and

managing properties.

4. Value added through the generation of “shelter” services by dwellings.

However, information is often only available for (1), and sometimes partially for (4).
Real Estate Economics _ Notes

Wages appear in the income account but not all of it is separated: it’s difficult to round up the
exact RE contributions, as many of these jobs are not necessarily RE related in theory, i.e. RE
activities appear also in financial intermediation (but we have not a measure of – for example
– how much time of a bank clerk is spending doing mortgages versus opening bank accounts)
VA contribution of construction is higher than the income contribution (same for RE
activities and financial and insurance): under income approach we only have the
compensation of employees working in those sectors, but not profit, earned rents and interest
Gross fixed capital formation from construction (i.e. investment in buildings) in the
expenditure approach is 163.9 bl dkk (79.8+84.1), in production approach construction is
77.2 bl dkk. The difference is due to 2 main reasons:
1. GVA approach GDP=gross output-input cost (intermediate consumption). The
investment is calculated as gross. (in production approach the intermediate inputs are
accounted with their value added, while in investment they are counted all together in
the final destination).
2. In production approach every output is classified under its primary productive
activity, i.e. construction activity done by a mining company would add to GVA of
mining. GFCF is recorded as total irrespective to the originating industry.
Real Estate Economics _ Notes

How Real Estate price affect the economy: (Correlation /Causality):

Does construction pull GDP or is it the other way around?

Evidence is not clear on this respect.

Some studies find that higher GDP tends to explain higher construction, but some other
studies find the opposite.

What is clear is that their correlation is strong, and understanding real estate activities helps
us understand economic growth.

1. Consumption channel:

Changes in real estate prices affect the wealth of households. (Housing wealth effect), who
adjust their consumption levels to reflect those changes.

2. Investment channel:

Changes in real estate prices could lead to new construction instead of purchasing the existing
structures. It could also lead to a better financial position of firms, resulting in more credit
available to the business sector.

3. Financial sector channel:

Changes in real estate prices could mean that the assets of financial institutions (banks,
insurance companies), will improve their balance sheets, which increase their ability to take
home more business, (Because of capital adequate conditions).

Besides, it will affect the positions of their clients by decreasing both non-performing loans,
(A loan that is in default or close to being defaulted) and insurance cancelation.)
Real Estate Economics _ Notes

4. Inflation channel:

Changes in real estate prices will affect inflation through:

a) The housing component of the CPI
b) The effect on prices induced by movements in the aggregate demand
c) Changes in the expectations of future prices

5. Fiscal channel:

Changes in real estate prices affect the revenue of governments from property taxes, hence
affecting the budget position of governments.

([Appendix]), ([[Housing Wealth]]):

Housing wealth effect:

In Denmark’s, (As in most countries in the world), private consumption accounts for around
half of domestic demand and has a strong impact on the business cycle.
Consequently, it is important to have good insight into the determinants of private
consumption.

The HWE measures the change in consumption that may happen as a result of changes in
house prices. The size of such effect demands on the share of housing wealth from
households’ total wealth.
Real Estate Economics _ Notes

Transmission mechanism:

1. Home-equity adjustment:

As response to increase in house prices, households can either sell their dwellings or take a
mortgage loan on the strength of the value of their home, thereby turning part of the home
equity into cash (Home equity withdrawal). The adjustment is asymmetric as it depends on
the direction of the house price change.

2. Permanent income and life cycle adjustment:

Changes in house prices lead to adjustment in the relative proportions of non-housing

consumption and savings into income.

- Permanent income: People adjust their consumptions spending on the basis of their
permanent, rather than current income.
- Life cycle: Accumulations of assets allows individuals to smooth out their
consumption pattern over their entire lives, including retirement.
- Therefore, expectation about the whole or part of the rise on house prices to be
permanent is enough to affect consumption behavior of households.

3. Consumer credit adjustment:

House price changes alter the amount of consumption credit demanded by household,
because they expect higher house prices in the future, which will cushion them from any risk
involved in a large debt burden.
Real Estate Economics _ Notes

Lecture 10, Housing market, the mortgage market and tenure choice:
In this chapter, we are interested in the behavior of housing markets when aggregated across
space: (Municipals, regions, national markets.)

How can we compare a regional level of a housing market, with a national level of the
housing market?

We can make the analysis with two types of housing markets:

 Market for housing units

- Demand and supply of dwelling units.
- Single-family detached homes, row houses, apartments, summer houses, etc.
- No measure of quality, amenities, location.

 Market for housing services

- Capital goods (houses) are valued because of the flow of utility or services they
provide for their users.
- Total quantity and quality of housing consumed
- Differentiate units: Size of structure and lot, amenities, location.

The analysis of aggregate housing markets:

Assuming housing as a homogeneous good, economic theory suggest a demand function for
housing unit like this:
d d
St =α 1 Pt + V t

Where:

α <0 , S t is the stock of housing at time t, Pt is the price of a housing unit at time t and V dt is a
vector of other determinants of the demand for housing.

Supply side:

It is important to recognize the slow adjustment process implicit in durable goods. (Time to
build). Hence, it is intuitive to assume that the current stock of housing available to a
household is:

St =St −1+C t −δ St −1

C t=S t−( 1−δ ) St −1

Real Estate Economics _ Notes

Where, δ is the depreciation rate, and C t is the number of newly constructed units.
Profit maximizing firms:

Will operate using the following Supply of new housing:

s
C t=α 2 Pt−V t

Where, α 2> 0 ,∧V ts is a vector of cost variables.

If we then substitute in the supply equation for the stock of housing:

s s s
St =α 2 Pt + (1−δ ) St −1−V t

List of determinants of housing demand and supply:

Housing consumption and income:

The basic microeconomic model suggests that the demand for a particular good (housing) can
be represented by:
β θ
H=α p Y

Where:

P = Price per unit of housing

H = housing consumption
Y = household’s income
β <0 , θ> 0: Measure the price and income elasticities of demand.
Real Estate Economics _ Notes

General explanation:
When we think about demand for housing, we think about two things: whether to buy or rent,
and how much to buy or rent: the size of the housing (but also the quality, the location…)

Let’s write it down mathematically. Housing consumption (call it H) can be measured with a
single number that can be thought of as simply squared meters but also quality, floor plan,
number of rooms, number of bathrooms, windows, light, floor, whether it is an apartment or a
single-family house, etc. All of the components that affect demand for housing, and our
choice between renting or buying one home instead of another. Normally we would think
about them as discrete (choice between two options), but we can abstract them and write
them down as one number H.

Which home we get is then going to depend on the price (P) and on our income (Y).

More technical explanation:

The standard demand model gives us the elasticities of demand to income and price.
However, there are other attributes that affect our choice of housing (that we put in H), and
we might be interested in the effect of those attributes on demand. So, define “con” as base
consumption of non-housing goods, utility function would not just be u(con, H), but u(con,
h1, h2, h3, …) where the h1, h2, … are the levels of various housing attributes.
To get the impact of the various housing attributes, we estimate a hedonic price function that
relates the selling price of a house to the levels of the other various attributes.
Data: actual selling price of house, property characteristics data maybe from real estate agents
(Zillow data…) or housing registers and transactions in Denmark (BBR, EJSA, …).
The coefficients out of this estimation are the “implicit prices” of the attributes. From a 1974
estimation done in the US for example, a second bathroom is worth extra 800 dollars in price,
a fireplace 830, a garage adds 790 dollars to the price and so on…
Having these estimates, we can derive the demand for housing by re-introducing the
household attributes.

How do we gauge at the income and price elasticity of demand, if we do not observe the
actual consumption of housing?
(β +1) θ
E=P× H ❑ E=α P Y
⇒

❑ log ( E )=log ⁡¿ )+( β +1)log(P)+ θlog(Y)

⇒

The new equation does not require physical measurement of housing consumption.

% ∆∈housing consumption
Elasticity of demand=
% ∆∈housing price

∂ E P ∂ log ( E )
× ≈ =¿ (β +1)
∂ P E ∂ log ( P )
Real Estate Economics _ Notes

Tenure choice as a determinant of demand for housing:

When households are formed, they must decide whether to rent or own. (Tenure choice).

Such a decision is sometimes considered a determinant of the demand for different types of
housing units. (Rental vs. owner occupied).

Tenure choice most often based on following user costs:

Real Estate Economics _ Notes

Tenure choice, the user cost of housing:

In deciding whether to own or rent, the household will choose the cheaper tenure mode:
Compare the cost of owning vs. the cost of renting.

The cost of owning a household is not straight forward to estimate. The annual cost should
reflect:

For simplicity lets assume:

The buyer takes 100% mortgage loan. (No down payment) D = 0

Mortgage is interest-only type loan.

Annual cost of homeowner:

( i+h+d −g ) V

Or: Annual homeowner cost per m2:

( i+h+d −g ) v
Real Estate Economics _ Notes

Tax considerations of tenure choice:

Real Estate Economics _ Notes

Tenure choice, the user cost of rental housing:

The, the landlord’s profit per m2 is:

Annual ( after tax ) profit=(1−λ)( p−( i+ h+d−g ) v)

Competition in the housing market drives profits to zero. Therefore, the rental price is related
to the purchase value of the unit according to:

Annual (After tax) costs for rental housing = p = ( i+h+d −g ) v

Real Estate Economics _ Notes

Tenure choice: Modelling with realistic depreciation:

Real Estate Economics _ Notes

Households are indifferent between owning and renting when:

λe
τ^ =
(1− λ)(i+ h)

τ < τ^ :withlower τ , renting is cheaper than owning for households

τ > τ^ : With higher τ , Owning is cheaper than renting for households.

Taxation is usually progressive. (Income increase  Tax rate increase), τ rise with income.

- Low income households will be renters.

- High income households will be owners.

Effect of increased landlord income tax rate (λ):

Real Estate Economics _ Notes

Renters user cost line will decrease.

∂ Renter user cost −ev

Downward shift due to: = <0
∂λ ( 1−λ )2

Down-payment and mortgage default:

Real Estate Economics _ Notes

Home equity: HE=V ⋆−M

⋆
HE=V −(V −D)
HE=( V ⋆−V ) + D

Home equity rule:

Default:

When: HE ←C → Default → ( V ⋆−V ) + D←C

When home equity is lower than the default costs.

Pay:

When HE >−C → Pay → ( V ⋆ −V ) + D>−C

When home equity is bigger than the default costs.
Real Estate Economics _ Notes

Therefore, default condition becomes:

( V ⋆−V ) + D←C

Pay Default

D=0 D=0
C=0 C=0

⋆ ⋆
V =2.200 .00 V =1.800 .000
V =2.000.000 V =2.000.000

HE=( 2.200 .000−2.000 .000 ) +0 HE=( 1.800 .000−2.000.000 )+ 0

HE=200.000 HE=−200.000

Pay / Default Pay / Default

HE >C HE <C

HE >0 HE <0

Pay Default
Real Estate Economics _ Notes

Two-period model:

Assumptions:

Non-housing consumption in period 0 and 1:

u=c 0+ β c 1
β : the discount factor: 0< β <1

High β indicates a patient household, (High value of the second period consumption (C 1)).

All households are renters in periods 0.

To become owners in period 1, households must acc. A down payment amount.

Household income:

y 0 , y 1 should denote households’ income in the two periods.

τ 0 , τ 1 should denote the associated income tax rates for those periods.
Real Estate Economics _ Notes

Renter, budget constraint:

Period 0:
R
C 0 =( 1−τ 0 ) y 0− p

Period 1:
R
C 0 =( 1−τ 1 ) y 1− p

P = renter in period.

Homeowner, budget constraint:

Period 0:
H
C 0 =( 1−τ 0 ) y 0 −p−D

D = Collection of down-payment amount, to become home-owner in period 1.

Period 1:
H
C 1 =( 1−τ 1 ) y 1−( 1−τ 1 ) i ( v−D ) + D

( ( 1−τ 1 ) i ( v−D ) )  Mortgage payment after deduction

D  At end of period 1, Household receive down-payment.

Household indifference function (Owner/Renter):

Modelling of housing market:

Real Estate Economics _ Notes

4-quadrant model example:

Real Estate Economics _ Notes
Real Estate Economics _ Notes

In the CSAM version of the model, an exogenous upward demand shift leads to:

- Increase in prices (rent) from Pe 1 to P2 at the original housing stock Qe 1.

- Higher prices, P2, make profitable the additions to the housing stock, in particular q 2
units are added.

- The addition in the stock increases the short-run supply rightwards from S sr1 to S sr2

- Higher supply brings prices down, leading to less net construction.

- As long as ∆S > 0, the increase in space will continue until, at price level Pe 2, there is
once again an equilibrium, meaning Demand = Supply.

At the new point (C), equilibrium has been re-established:

- At a higher equilibrium price Pe 2> P e1

- At a higher quantity of space Qe 2> Qe1

- Net construction is 0 (All construction is intended to replace exclusively depreciated

stock (∆S = 0).

Simple example:

A DPW world where the economic relations in each of the markets is given by:

Rt =a+ b S t

−1
Pt =Rt · k
Real Estate Economics _ Notes

C t=g+ h P t−1

∆ S t=C t −δ St −1

Where a > 0, b < 0, k > 0, g < 0, h > 0, and δ > 0, are constants.

h shows the speed of construction reaction to change in price (Pt −1).

We then let ( P⋆ , S⋆ ) denote the price and housing stock that clear the markets and generate
just enough construction to keep the stock of housing constant. (∆ St = 0).

A pair like that, is called Stable Steady State.

P⋆ =( a+ b S ⋆ ) k −1
⋆ −1 ⋆
S =δ ( g+h P )
¿
⋆ ( g +ha k −1) δ −1
S= −1 −1
1−hb k δ

We use the following parameter values to analyze the effect of a demand shock on the steady
state levels of prices and housing stock:

( a=110 ) , ( b=−0 , 08 ) , ( k=10 % ) , ( g=−5 ) , ( h=0 , 05 ) ,(δ=2.67 % )

Solving for steady state value we find:

⋆
P =500
⋆
S =750
If we suppose the demand curve shifts upwards with the new intercept being a new =130

If we solve again for steady state price and quantity, we find:

⋆⋆
P =580
⋆⋆
S =900

Transitional dynamics of different positive demand shocks:

Real Estate Economics _ Notes

The long-run supply of real estate:

Calculating the supply curve is not straight forward, due to potential nonlinearities among the
variables.

However, we would consider a linear approximation by using simple techniques from

calculus.

We know two points in the (P, S) space. In particular, the initial, and final equilibrium state
prices and quantities.
Real Estate Economics _ Notes

Long run supply of real estate therefore is: P=99.5+0.534 S

We also know demand equations before and after the shock:

P=1,100−0.8 S , P=1,300−0.8 S

As we can see from the numbers, only (P) change, which is the intercept of demand. No
change in the slope is recorded. Therefore, we have an upward shift (from 1,100 to 1,300) in
demand.

The origin of the shock:

The disturbances to the real estate market could come from:

- The nationwide business cycle

- The influence of macroeconomic factors specific to housing, like demographics
- Factors specific to the real estate market

To see this, we could re-formulate the DPW model and define demand for housing as:

Dt =H t (α 0 −α 1 U t )

Where:

U t =Pt ( ( 1−τ t ) ( i t +h t ) +d t −gt )

Where:

H t = the current number of households

U t = Annual cost of owning a house
- U t depends on:
o the current price of the house ( Pt )
o After tax mortgage rate (1−τ ¿i .
o Property tax (h )
o Economic depreciation (d )
o Capital gain ( g).
In equilibrium, house prices should adjust, so that demand for housing equates the available
current stock of units, St .

Dt =S t

H t { α 0−α 1 Pt [ ( 1−τ t ) ( it +ht ) +d t −g t ] }=S t

If we solve for current house prices:

Real Estate Economics _ Notes

Pt =[ ( 1−τ t ) ( i t + ht ) + d t−g t ]
⏟⏟ −1
¿k t
−1

[ 1
α1
St
(α 0− )
Ht]
¿ Rt
Hence, in every period:

∂ Pt ∂ Pt ∂ Pt ∂ Pt ∂ Pt ∂ Pt
<0 , <0, <0 , <0, >0 , >0
St ∂i t ∂ ht ∂ dt ∂ gt ∂ τt
∂( )
Ht

What is the role of price expectations in the real estate cycles?

In our extended version of the DPW model, expectations on future house prices play an
important role as measured by capital gains. (gt ). These expectations could be:

Exogenous , i.e., formed outside the model,

Myopic/Backward looking
Rational/ Forward looking

Rational expectations:

Consumers’ expectations may be wrong, but they are correct on average over time. In other
words, although the future is not fully predictable, their expectations are assumed not to be
systematically biased given that they use all relevant information in forming expectations of
economic variables.
Real Estate Economics _ Notes

Due to rational expectations:

 After the shock, prices overshoot the new steady state but by less than in
the exogenous / Myopic expectation case.

 This is explained by the fact that consumers know that future supply will
be forthcoming and hence, prices will decrease.

 Therefore, a smaller house-price deflation is expected in order to reach the

new equilibrium point.

 The anticipated reaction to what is expected in the future (Forward

looking) stabilizes the otherwise higher demand for housing, and hence,
explains the lower prices relative to the exogenous/ Myopic case.

With rational expectations, a market shock does not trigger a recurrent cycle, there is only
one price overshoot and a single resulting construction boom.

A fully informed, rational market will exhibit a cyclical behavior only if the exogenous
macroeconomic variables have recurrent cycles.
Real Estate Economics _ Notes

Housing policies: Rent control:

In Denmark we have four different rent control systems:

All types of rented dwellings in Denmark are, as a rule subject to rent regulation. Of the four
types of rent regulation, market rent is the only one which actually relates to market forces
and therefore (Supply and Demand).

The system is based on that landlords should not be able to profit of renters. Landlords are
only allowed to pass on costs, property taxes excepted, incurred in the day-to-day operation
of the property, and a proscribed charge to cover maintenance costs. They can also pass on a
capital charge, (7% - 14%).

Rent control has some negative effects, making them unpopular amongst economists:

Stock-Flow model (Housing policies, Rent control):

To understand the motivation for rent control and its effects, we consider a stock-flow model
in equilibrium:
Real Estate Economics _ Notes

We assume the economy to be hit by a demand shock (Increase in population), which pushes
the demand for housing upwards:

At current housing stock, demand shock pushes prices up from Pe 1to Pe 2, as a result of the
space scarcity. The larger population must now fit in the same total square meterage as before
the shock.

In response to increased prices, new construction starts, (Gross addition to stock of: q 2
units).
Further adjustments follow a path as discussed earlier until the price falls again to Pe 1and the
stock of housing increases to Qe 2.

In this transition, existing residents suffer from higher housing costs, the price surges to P2
before falling again to Pe 1 and hence, they are unhappy with the excess cost burden.
Real Estate Economics _ Notes

Anticipating what is going to happen in the absence of government intervention, the residents
persuade the authorities to impose rent control on the rents to limit price increases.

¿
The government introduce a loft (maximum) for rents equal to Pe 1< P P 2, and that new
construction is not exempted from the law.

Rent control and misallocation:

Real Estate Economics _ Notes

In the stock-flow model, misallocation occurs due to the excess demand for housing, which
¿
arise during the rent-control period. (Period where Q<Q )
¿
Immediately after the shock when P=P , the stock of housing is ´Qe 1. While the quantity
demand at that price is Q¿. Therefore, the excess demand is Q−Q e1.

Under conditions of excess demand, a commodity usually ends up being allocated among
consumers in an erratic fashion, with those valuing the good the most, not necessarily getting
it.

Rent control prevents the proper scarcity signal from being transmitted.

Those who end up with disproportionate amounts of space are better off with rent control, but
the outcome is not the right one for the society.

Rent control is thus a government policy that benefits particular interests at the expense of the
society as a whole.

Justifications for rent control:

Real Estate Economics _ Notes

Homeownership financing:

To become homeowners, people usually need to borrow money. Credit-availability enables

people to buy housing, at the expense of non-housing consumption. Taking a loan is a
decision which depend on:

- Household income and preferences

- Interest rates & loan conditions.

In the real estate market, these loans are most often mortgage loans. (Property serves as
collateral).

- If the borrower defaults on their loan/payments, the lender has the right to repossess
the property (Foreclose on the loan).

Mortgage business:

Made up of a primary and a secondary market.

- Primary market: Financial institutions grant mortgage loans for the purchase of
property (Remortgaging).

- Secondary market: investors buy existing mortgages (More generally, mortgage

back securities, MBS) from financial institutions that issued them.

Market participants:

Borrowers: Owner of the real property who commits to pay back the debt according to a
payment schedule.

Lender: (Mortgage Ordinator), Financial institution that has the right to foreclose the loan
and seize the property.

Investor: Fund provider in the secondary capital market, usually with a long-term investment
strategy. (Pension funds, insurance companies, etc.)

Lenders usually assess the property-value and borrowers creditworthiness. (Usually regulated
by governments).

- Loan to value ratio (LTV)

- Payment to income ratio (PTI)
- FICO score (in the US)
Real Estate Economics _ Notes

Mortgage classification:
Mortgages can be classified based on following characteristics:

1. Credit:
- Prime loan: If the borrower has high credit quality, the mortgage is said to be a prime
loan.

- Subprime loan: If he has low credit quality, the mortgage is a subprime loan.

- In Alt-A loan: In between and due to the lack of documentation or uncertainty about
the creditworthiness of the borrower, the mortgage can be an alt-A loan.

2. Interest rate:
- Fixed rate mortgage (FRM): The nominal interest rate of a mortgage can be fixed
for the entire maturity of the loan (Fixed rate mortgage, FRM)

- Adjustable-rate mortgage (ARM): The nominal interest rate of a mortgage can be

adjustable according to some conditions. Those conditions include adjusting the rate
regularly following the market trends or placing caps on the maximum of the contract
rate.

3. Amortization:
Paying off a loan with regular payments.

- Annuity loan: When the sum of the interest payment and the principal repayment is
the same for all payment dates, the mortgage is an annuity loan. That is, periodically
the loan is settled and because the loan is being reduced, the interest will, equally
become smaller, and the principal payment equally higher.
Real Estate Economics _ Notes

- Interest-only loan: If the borrower is not obliged to make any repayment of debt in a
given lockout period (only paying interest payment), then the mortgage is an interest-
only loan.

- Negative amortization loans: There can be negative amortization loans in certain

initial periods in which there is no repayment of debt, and the total scheduled payment
is smaller than the interest payment. Since payment is lower than interest payment,
the remaining amount of the interest payment is added to the loan’s principal, which
ultimately cause the borrower owe more money.

Financing risks:

With any mortgage investments there are two types of risk:

- Default risk: If the borrower fails to meet interests and principal payments (Generally
the bank takes this risk)

- Interest rate risk: If the mortgage originator’s assets (Mortgage loans) and liabilities
(deposits) have different interest rate structures.

- Prepayment risk: If the borrower decides to pay the mortgage back partially or
completely before maturity.
Real Estate Economics _ Notes

Reverse mortgage carries important risks for:

Financial institutions:

Borrowers:

Home ownership financing:

Home equity withdrawal: (HEW):

Occurs when a person already owns fully (or mostly) a property and wants to obtain a loan on
the strength of the property’s value.

The difference between the market value of the property and the outstanding balance of any
financial obligations that use the property as collateral is called home equity.
Real Estate Economics _ Notes

Types of HEW:

Cash-out refinancing:

Substitute an old mortgage for a new one and getting on top some extra cash (based on the
current equity) to spend as one please.

Home equity loans, (HELOAN):

The household borrows against the home equity. Lomp sum transfer. Any existing mortgage
is not replaced, and a new mortgage is added on the existing one. In other words, he gets a
second mortgage. More likely with a higher interest rate since the new mortgage has second
order priority in case of default.

Home equity line of credit, (HELOC):

Instead of giving fixed amount of cash (Lump sum), the household is granted a credit line
with specified maximum amount within the agreed period. The collateral in HELOC is home
equity. HELOC differs from HELOAN, because in HELOAN there is a one-time lump sum
loan instead of credit line.

Lecture 11, Non-residential property markets:

Residential / Non-residential properties:

Non-residential property: Commercial property. (Buildings or land) with intent of

generating profit, (capital gains / rental income).

Non-residential property categories:

Category Examples
Leisure h o tels, p u b lic h o u ses, restau ran ts, cafes, sp o rt facilities
Retail retail sto res, sh o p p in g m alls, sh o p s
Office o ffice b u ild in gs, serviced o ffices
Industrial in d u strial p ro p erty, w areh o u ses, garages, d istr. cen ters
Healthcare m ed ical cen ters, h o sp itals, n u rsin g h o m es
Real Estate Economics _ Notes

Financing is also different for the two property categories. (LTV & Down-payment
requirements differ), liquidity in secondary market is also different.

(MBS / Covered bonds)  Traded higher for residential mortgages, than for non-residential.

Rent in the non-residential property market often settled for 5-10 years.

Non-residential property market does not react as quickly to changes in supply/demand as

residential property market.

Annual growth investment [AGI] calculation:

Completions of buildings
AGI=
Stock of buildings

Fluctuations over time, across different property markets:

Real Estate Economics _ Notes

Real estate does not reach uniformly to changes in the economic situation, across all its
different categories.

(Apartments / Industrial) does not have their own intrinsic cycle, but react to notianal /
regional economic shocks.

Other property types (Office /retail) seem to behave in another way, where their oscillation is
longer.
Real Estate Economics _ Notes
Real Estate Economics _ Notes

Demand for Non-residential real estate:

Three relevant concepts for the demand for non-residential markets:

Endogenous and exogenous shocks:

Demand for commercial space depends on prices and other exogenous factors:
Real Estate Economics _ Notes

Demand measures [Gross absorption, Net absorption]:

Gross absorption:

The total amount of space involved in all leases signed in a particular period.
- Physical occupancy of the space, in a particular lease contract might be deferred by
several months.

Net absorption:

Measures changes in aggregate demand for space.

Real Estate Economics _ Notes

WHAT DETERMIN ES N ET ABSORPTION ?

Effect
Prices/ Rents -
Changes in market size (e.g., population, employment) +
Changes in income/ wealth +
Expectations for changes in prices or employment +

Increase in price  Negative demand shock

Change in market size, Change in income, and Expected change in prices or employment 
Positive demand shock.

[WTE model] Wheaton-Torto-Evans model:

WTE model assumptions:

Market demand = Office worker X Office space per worker that firm desires to occupy

Desired amount of space=f (recent rent for space)

Recent rent for space = Observed rent

Real Estate Economics _ Notes

Fuerst (Wheaton-87) model:

Real Estate Economics _ Notes

Commercial properties [Supply side]:

Construction of new property is the most important factor of the supply side of real estate.

Acc. To stock-flow model, market total space is determined at any given point in time by:

St =( 1−δ ) S t−1 +C t
Where:

St →Stock of space at time t.

δ → Physical depreciation rate.
C t → refers to new construction at time t.

“New construction” refers to completion or otherwise the total square footage in all new
buildings with a occupancy certificate.

Supply of non-residential real estate:

Project completion represents the last of three major stages of the development process.
These steps lie in the “Pipeline effect”.
Real Estate Economics _ Notes

New construction follows the law of supply: Higher property prices lead to higher quantity of
new space supplied.

The major motivation for development of a speculative commercial real estate project is
profit. Hence, the major determinants of new construction are factors that determine any
project profitability and the uncertainty associated with profitability of that project.

- Availability and cost of production factors: These include capital, labor, land, and
building materials. Their costs negatively affect the amount of new space developed.
Higher costs reduce profits, and hence, the motivation to develop.

- Expectations regarding future demand and prices: Higher growth and price
expectations have a positive effect on new construction.

- Perceived market risk: By increasing risk, the requested returns by investors will
also increase. Risk and uncertainty have negative effect on new construction.

Wheaton-Torto-Evans model:

Construction of (Office) space is similar to investment in new capital (Tobin´s q theory)

Hence, it should depend on the asset price of office space, relative to its replacement cost.
The former should depend on current effective net rental income (Considering vacancy) and a
capitalization rate.

asset price of office space f ( current effective net rentalincome , capitalization rate )
q= =
Replacement cost construction cost +land cost

Therefore, new construction can be modelled as:

C t=β 0 + β 1 R t + β 2 V t + β 3 I t + β 4 R Ct

Where:
Real Estate Economics _ Notes

WTE model example:

Disequilibrium and inefficiency in market for commercial properties:

At any point in time, the commercial markets may not be at a demand-supply equilibrium
because of frequent exogenous shocks and a number of inefficiencies that precent demand,
supply, and rents to adjust quickly. These include:

- Lack of information:
Real estate is heterogeneous in terms of quality and location attributes. Thus, timely market
and project specific information required for evaluation of specific transactions is rarely
available and its collection is costly and time consuming. The lack of information forces
tenants and buyers to engage in legthy searches and prevent quick adjustment of demand to
price changes.

- Construction lags:
When they last for several months or years, they prevent speedy adjustment of supply to
demand and price changes.

- Long-term leases:
Real Estate Economics _ Notes

Those with terms ranging from 3 to 10 years, prevent speedy adjustment of existing rents to
changes in supply and demand, and hamper timely adjustments of space consumption to
changes in the market rents.

Market imbalances:

Disequilibrium refers to the state of the market characterized by supply-demand imbalances,

or alternatively, by excess supply or demand.

There are two ways to assess the extent of market imbalances:

Trends in construction minus net absorption

Trends in difference between nominal and natural vacancy

Trends in construction minus net absorption:

We know:

ABt=OS t−OSt −1
OSt =S t ( 1−V t )
St =( 1−δ ) S t−1 +C t ❑ C t + S t−1−St =δ S t−1
⇒

Therefore:

Trends in difference between nominal and natural vacancy:

The nominal vacancy rate is simply defined as the ratio of vacant stock to total stock. But
what is the neutral vacancy rate (NVR or V*)?

The NVR can be thought of as that portion of the stock of space that is desirable to remain
vacant for any of the following reasons:
Real Estate Economics _ Notes

Frictional vacancy: It usually takes time to find a new tenant either between two lettings or a
first tenant for newly built spaces. It also takes time to find the right tenant. Hence, it is
optimal to have some space vacant to facilitate tenant search.

Market imbalances cont.

Rent-vacancy adjustments: Stock-flow model:

Real Estate Economics _ Notes

Assume that we have an exogenous increase in demand for space.

- Immediately, vacancy rate decreases.

- The effect of a decrease in vacancy rate on rents can be positive or negative
o Rents increase when nominal vacancy rate is smaller that natural vacancy rate
(V<V*)

o Rents decrease when nominal vacancy rate is greater than netural vacancy rate
(V>V*)

Here we assume that the economy was in equilibrium before the exogenous shock
(V=V*). Therefore, vacancy rate decreases to below V*.

- Rents start increasing at an increasing rate.

- New construction responds to these rent increase and the vacancy rate reaches a
minimum and starts increasing.

- As the vacancy rate (V t ) increase but still is below its equilibrium level (V ⋆ ), rents
will continue to increase, but at a slower rate.
- Rents reach their maximum level as the nominal vacancy rate rise back to its
equilibrium level.
- As the vacancy rate (V t ) continues to increase above its equilibrium level (V ⋆ ), most
likely because of over-shooting of construction - rents are declining at an increasing
rate.
Real Estate Economics _ Notes

- As rents start declining, construction starts declining too. As a result, the vacancy rate
(V t ) reaches a maximum and starts decreasing. However, as land as it is still above its
equilibrium level. (V ⋆), rents continue to decrease, but at a decreasing rate.

Rent-vacancy adjustments:

This vacancy rate adjustment process is described by a standard rent adjustment equation:
⋆
∆ R t=α 0 (V −V t )

Where

∆ R t is percent change in rental rates

α 0 shows speed of adjustment

With this idea in mind, a standard approach to estimate the NVR is to use time-series data on
rent changes and vacancy rates and estimate the following equation:
Real Estate Economics _ Notes

∆ R t=α− β V t + ϵ t

Hence, if the vacancy rate is such that the changes in rents is zero, then the vacancy rate must
be equal to the NVR and therefore:

⋆ ^⋆= α^
V =V t when , ∆ Rt =0 → V
^β

An important question is whether the NVR is constant or changes over time. The answer will
depend on whether the determinants of the NVR are constant or changes over time.

NVR determinants and expected effects:

Structural vacancy influences Effect

L an d lo rd ’s p e rs p e c tive
Expectations for demand and rental growth +
Cost of holding vacant space -
a. Forgone rent, R -
b . Forgone interests on forgone rent, i × R -

T e n an t’s p e rs p e c tive
Length of the search +
a. Idiosyncratictenant tastes / tenant diversity +
b . Stock heterogeneity +
c. Spatial heterogeneity/ dispersion +
d . Information inefficiencies +
Cost of search -

Rent adjustment:
Real Estate Economics _ Notes

Equilibrium rent influences Effect

Expectations for demand and rental growth +
Idiosyncratic tenant tastes / tenant diversity -
Stock heterogeneity -/ +
Spatial heterogeneity / dispersion -/ +
In fo rm atio n in efficien cies -/ +
Real Estate Economics _ Notes

Lecture 12, chap: 13, Local governments, Property tax, & Real estate
markets:
Land-price gradient (Local jurisdictions):

US Government tax distribution: (Services and transfers):

Taxes in the US and DK:

Real Estate Economics _ Notes

Income from taxes, dues, and rates fall into four categories:

 Income taxes
 Social contributions
 Taxes on consumption
 Wealth/Property taxes

The US vs. DK tax structure:

§ In the US in 2009, income taxes constituted around 42%, social contributions around
28%, taxes on consumption around 16% and wealth/property taxes around 14%.

§ In Denmark in 2009, income taxes constituted around 62%, social contributions

around 2%, taxes on consumption around 21% and wealth/property taxes around 3%.

Danish public income:

Consists of:

- Taxes
- Rates
- Duties imposed on different types of income.
- Consumption

Tax burden = Sum of public income (in %)

Tax burden is roughly 50% in Denmark. (Corresponds to public expenditure burden).

Danish residential property taxes:

Two types of residential property tax:

1. Municipal land value tax

- Promille of total value of land.

2. Property value tax:

o “Ejendomsværdiskat”

§ Calculated as 1% of that part of the property value which does not exceed
DKK 3,040,000 and 3% of the property value above that threshold.
§ The property value is an estimate of the cash price of the property in a
potential sale. The property value is the sum of the estimated value of the land
Real Estate Economics _ Notes

and the structure which considers the maintenance, location, etc. of the
property.

§ Progressive

Commercial property taxes in Denmark:

1. Municipal land value tax

Promille of total land value (min. 16, max 34)

2. Kommunale dækningsafgift

§ Before 2022, tax on the difference between the property value and land value
(“forskelsværdien”), i.e. the structure value, that municipalities can levy on
commercial properties and publicly owned properties
(www.statbank.dk/EJDSK2)
§ In 2021, for commercial properties it ranged between 0 (the majority of
municipalities including Frederikssund) and 10 per mille (in Tårnby,
Albertslund, Ballerup, Gentofte, Herlev, Hvidovre, Lyngby-Tårbæk,
Rødovre, Hørsholm, Rudersdal)
§ Does not exist after 1st of Jan. 2022, because of no public property assessments
of commercial properties until at least 2024

Property valuation and tax reforms:

Town-budget identity:
Real Estate Economics _ Notes

Where:

t : town residential effective tax rate (assuming same property tax rate on residential and
commercial property)

G : total town expenditure/household

A : state aid received/household.

P: average market value of houses and commercial properties in town

N : Town number of properties

N r : Number of residential properties

Town effective tax rate:

Real Estate Economics _ Notes

Determining property value:

R
p= (In the four-quadrant model)
i

Now we introduce local government spending G, which is financed by property taxes t p.

The property value is the Present discounted value (PDV) of the annual value of housing
services R, and local public spending G, net of property taxes: t p.

Solving for price (p):

Combining Eq. 1 and 2:

Real Estate Economics _ Notes

With an increase in either one, taxes drops, causing prices to rise, which cause taxes to
further drop.

Expenditure choice:

Expenditure decision: What level of G maximizes the value of household assets?

 In the hedonic eq. 2, each dollar of spending increases p by 1/i dollars.

 Considering the budget identity (Combining eq. 1 & 2) the cost of

spending is less that 1/i because of C , A, etc. Solution therefore always
encourages additional spending.

 More realistically, there is diminishing marginal utility from increased

school spending and hence as G rises its impact on P becomes less than 1/i
.

Fiscal incentives with different uses:

Town budget identity with 2 property uses: (Replacing eq. 1)

Property tax rate, t:

Where:
Real Estate Economics _ Notes

U i : Service usage by a property of use i (Housing vs. commercial use of high vs. low-income
households)

N i : Number of “properties” of each use.

Pi : Average price of each property in use i .

AT : Total state aid received.

Fiscal impacts of new developments:

Who pays and who does not?

The unpleasant, but real incentives that towns face: U i vs. t Pi .

Real Estate Economics _ Notes

FAR model with down-zoning:

Welfare cost of commercial use:

Beneficial to the town (Negative net cost) if t high and V low.

Adverse (Positive net cost) if t low and V high.

But what towns would like does not equal what they can get.
Real Estate Economics _ Notes

Land-price gradient with local jurisdictions:

Frequently, there are established affluent communities adjacent to central cities, incorporated
many years ago to provide their own services and escape the financial burdens of the city.
Moving further out, there are numerous other suburbs for which land prices also vary in
response to zoning regulation, taxes, and the quality of services. The net result is that better
services are frequently found in communities located at greater distance from the city centre.
This can overwrite the effect of commuting, leading to a price or rent gradient that resembles
the solid line rather than the dashed line.
Real Estate Economics _ Notes

Tax incidence:

The current owners of land bear the full burden of a tax on the land value.
S
E
Share of tax burden borne by buyers = S D
=0 . Meaning, inelastic supply.
E +|.| E
Real Estate Economics _ Notes

Incidence of Real Estate Taxes on Rental Property:

Tax incidence, alternative outcomes:

Formula for the share of the tax borne by renters:

Where E S denotes elasticity of supply and E D denotes elasticity of demand

- Elastic demand, inelastic supply implies that R1 is not much higher than R0 
Landlord absorbs the impact.

- Inelastic demand and elastic supply imply that R1 is much higher than R0  tenant
absorbs the impact.

Tax incidence in the long run:

Only if supply is elastic (Which it will not even be in the long-run), while demand is
inelastic, then capitalization will be incomplete, and the owner can pass a significant portion
of the tax to the tenant.

The demand curve for the rent for space is likely to be highly elastic in the long run, in which
case
Real Estate Economics _ Notes

- The long-run incidence of the tax increase lies with the landowners, not tenants. This
is consistent with the view in Chapter 3 that eventually, the land market fully
capitalizes locational advantage.
Fiscal capitalization case 1: G=T =tP
Balanced budget:

q With a highly elastic long-run demand curve, the rent for space in one community
will always reflect only the valuation (by tenants) of the services they receive. It is the
price of land that will eventually absorb the cost of providing those services. If the
cost of provision and the value of the benefits received move with each other dollar
for dollar (i.e. when G=tP ), then tenants will pay for the services they receive. See
Figure 7.
q It is when the cost and value move differently (due to state aid or commercial
property taxes) that landlords may receive a windfall gain or loss
q If two towns have identical public services, but one receives significantly more state
aid or has a sizable base of taxable commercial property, then its lower taxes will be
reflected in higher land prices. Housing rents, however, will be the same in the two
communities. See Figures 7 and 8.

Fiscal capitalization case 2: G>T =tP

Due to transfers from richer municipalities:
Real Estate Economics _ Notes

Fiscal capitalization case 3: G<T =tP

Due to transfers to poorer municipalities:

Urban decay (Philadelphia story):

Real Estate Economics _ Notes

Danish local government reform 2007:

Real Estate Economics _ Notes

Property value in case of land tax:

R+G−tp
P=
i

Where:

P : Real re-sale price of house

p : Real land value (of lot)
R : Pre-tax rental value of house
G : Household local public services
Tax Bill
t : Effective tax rate =
True market value of land
Real Estate Economics _ Notes

Community stratification in short run:

Now assume for simplicity that the annual value of the housing characteristics R is equal to
zero.

Assuming perfect capitalization, house price bids pk of each household type are given as:

Rk G−t P k
Pk = Eq .7
i

Where:

k =¿ L,M,H income
Rk = Marginal willingness to pay for town services by households of each income level.
Real Estate Economics _ Notes

Short term “residential income sorting”, (Also referred to as tiebout sorting)

This is a realistic assumption since demand for normal goods is income elastic

If towns with higher levels of public service are those with greater income (Which, all else
being equal, they should be).

Then households will self-sort by income  Community stratification by income, implying

high levels of residential income segregation.

R L < R M < R H means that high-income groups have higher marginal willingness to pay for
local public services. A realistic assumption since demand for normal goods is income
elastic.
Real Estate Economics _ Notes

House price indifference curves of each household type k =L , M , H .

This price of housing Pk would make that type of household (k), equally well off across
towns with different public expenditure levels.

Community stratification in the long run:

New land is developed for the use k, that yields the highest land price Pk .
Real Estate Economics _ Notes

Long term residential income sorting if:

If the marginal willingness to pay for local public services per square foot of land area
increases with household income. If the lot size increases substantially with household
income, this assumption may not hold, in which ccase there will be land succession in the
long run.

Towns that offer high levels of local public service will in that case not be able to keep its
character as a high-income town because it is more profitable for land owners to develop land
in such towns for lower income households.
However, the local government can prevent this through regulation, requiring a minimum lot
size (MLS) equal to q H . Such regulation is also called down-zoning and maximum floor-
area-ratio (FAR).
Real Estate Economics _ Notes

Measurement of residential segregation:

Xi/X: Share of minority population in the city that live in neighborhood i

(ti-xi)/(T-X): Share of majority population in the city that live in neighborhood i.
Damm, Schultz-Nielsen and Tranæs (2006), p. 44: ”Tolkning af formlen er, at man for hvert
boligområde i beregner forskellen imellem hvor stor en andel af henholdsvis majoritets- og
minoritetsbefolkningen, som bor i området. Efterfølgende lægges disse (numeriske) forskelle
sammen for samtlige boligområder og deles med to, da enhver overrepræsentation af
minoritetsgruppen i et boligområde, jo må modsvares af en underrepræsentation et andet sted.
Da det her er forskellen i den relative fordeling af de
to befolkningsgrupper, der beregnes, har det ikke indflydelse på dissimilationindekset, om der
bor mange eller få minoritetsgruppemedlemmer i byen som helhed.”
D-indekset afhænger imidlertid også af, hvor store boligområderne er. Jo mindre byområder,
jo større D-værdier, jf. Cutler m.fl . (2005).
Real Estate Economics _ Notes

Lecture 13, Chap, 14 - Public goods, Externalities, Development and

regulations:

Public goods:

Goods fall into four categories, depending on whether it is rival and excludable.

Types of goods:

Public goods are commodities with benefits that are impossible to deny from some
consumers. (Non-excludable). Also, public goods are inherently public as consumption of
one unit of the good, does not preclude its consumption by another agent. (Non-rival).

Property values and public amenities (Assuming market is in spatial equilibrium)

- Higher prices to make buyers indifferent.

Private provision of public goods generates a special type of externality. If one individual
provides a unit of a public good, all individuals benefit.

Free-riding problems can occur.

Real Estate Economics _ Notes

Private vs. Public good:

Private good:

Market demand Dt is derived by horizontal addition of individuals demand, Q1∧Q2 , at a

2
given price P :Q ( P )=∑ Qi ( P ).
i=1

Public good:

Due to the non.rival characteristic public goods, market demand Dt is derived by vertical
addition of individual demand curves D1 and D2 at any given quantity Q:
2
M Bt ( Q ) = ∑ M Bi ( Q )
i=1

Socially efficient level is the level of Q at which M Bt ( Q )=MC (P), Denoted Q⋆ .

Private provision of public goods:

House owner 2 will buy Q2 units of the public good, because M B2 ( Q )=MC ( P ) , at Q2.
House owner 1 will free-ride. Under provision of public goods (Q ¿ ¿ 2<Q ⋆) ¿.
Real Estate Economics _ Notes

Public goods, example:

A number of (n) neighbours contemplate purchasing a vacant lot in their midst.

 Model Assumptions:

n property owners in a neighbourhood.

All lots are identical.

MV : The increase in house value to each of the n property owners of adjacent open slot.

One underdeveloped lot. Open space increases the value of other lots.

p : Price of a lot

p
MV > ,but MV < p
n

Public goods and free-riding:

The Free-Rider problem:

No individual owner will unilaterally purchase the lot for use as open space, because MV < p .

p
If the group were to agree to purchase the lot jointly, with individual owners contributing ,
n
each owner could seek to abandon the group, allowing the others to purchase and split the
cost, that is each owner has economic incentive to free-ride.
Real Estate Economics _ Notes

Enforcement problem:

Further assumptions:

- Assume that we have an enforcement mechanism.

- Assume owners have different preferences for open space.
- A: Acres of open space.
- p :Marginal Cost.
- n1 <n have high valuation of open space.
- n2 =n−n1 have lower valuation of open space.

Collective interest of all highest when MB = MC.

The level of open space acquisition that each type of household would like to undertake:

p p
M V 1 ( A 1 ) = ; M V 2 ( A2 )=
⋆ ⋆
n n
Real Estate Economics _ Notes

Public space acquisition in case of single developer:

q The problem of open space acquisition would be far easier to handle by an original
single developer-owner of the lots.
q As long as the aggregate value of the n lots owned by the developer can be increased
by more than the cost of acquiring and preserving adjacent land, then the acquisition
is in the developer’s self-interest.
q This criterion is simply the same as Eq. 1 for the optimal amount of open space (A*):
n1 MV 1 ( A ¿ ) + n2 MV 2 ( A¿ )= p

Common property resources:

Common property recourses are commodities that are non-excludable like public goods, but
are rival, so that the marginal value to one user depends on how many other people use the
commodity.

Common property resource, Examples: (Fishing, hunting, grazing, parcs).

Suppose benefits of open space demand on the number of users n :

MV ( n ) : Valuation of the park by each (As a function of how many are sharing it), if not
excludable, how many will use it?

MV (n0 ) = 0

n 0=∞ ( Potentially )
Real Estate Economics _ Notes

Common property resource:

Total value of usage to group: nMV ( n ) :

Optimal number of users:

n ∂ MV
MV ( n )+ =0
∂n
⋆
−n ∂ MV
MV ( n )=
⋆ ⋆
> 0 ,i . e . n < n0
∂n
Real Estate Economics _ Notes

Lecture 14, Chapter 14, Public goods, externalities, developments and

regulations:
Goods fall into different categories depending on their level of rivalry and inclusiveness’:

Public goods:

The private provision of a public good generates a special type of externality: if one
individual provides a unit of a public good, all individuals benefit.

Free-riding problem.

As a result, private provision of a public good is typically inefficient.

How is it inefficient?

Private vs. public good:

House owner 1 will buy 0 units of the public good, because MB1(Q)<MC(=P) at all levels of
Q.
Real Estate Economics _ Notes

House owner 2 will buy Q2 units of the public good, because MB2(Q)=MC(=P) at Q2.
Once house owner 2 has bought Q2, house owner 1 can free-ride.
The socially efficient level of the public good is at the level of Q at which MBt(Q)=MC(=P),
that is at Q*.
Private good:
Market demand Dt
is derived by horizontal addition.
of individual demand Q1 and Q2
at a given price P:
2
Q ( P )=∑ Qi (P).
i=1

Public good:
Due to the non-rival characteristic
public goods, market demand Dt is derived by vertical addition of
individual demand curves D1 and D2 at any given quantity Q , i.e.
2
MB t ( Q )=∑ MB i (Q) .
i=1
Socially efficient level is the level of Q at which MB t ( Q )=MC (¿ P), denoted Q¿.

Private provision of public goods:

House owner 2 will buy Q2 units of the public good, because MB 2 ( Q )=MC (¿ P) at Q2.
House owner 1 will free-ride.
¿
Under-provision of public goods (Q2 <Q ¿ .

Public goods cont.:

A number (n) of neighbours contemplate purchasing a vacant lot in their midst

Model assumptions:

n property owners in a neighbourhood.

All lots are identical.

MV : the increase in house value to each of the n property owners of adjacent open slot
One undeveloped lot. Open space increases the value of other lots.

p: Price of a lot.

p
MV > , but MV < p .
n
Real Estate Economics _ Notes

Free-riding problem:

No individual owner will unilaterally purchase the lot for use as open space, because MV < p .

p
If the group were to agree to purchase the lot jointly, with individual owners contributing ,
n
each owner could seek to abandon the group, allowing the others to purchase and split the
cost, that is each owner has economic incentive to free-ride.

Free-riding

- Solution: Voting?

Suppose all owners of the n lots were part of a majority-rule government (e.g. community
association or “grundejerforening”) that could propose only a “take it or leave it” vote with
all owners required to pay p/n if the acquisition passed.

Given the values of MV and p (p>MV) and the homogeneity of open space valuations, the
vote would be unanimous in favour of acquisition.

However, each owner hopes to free ride on others. Without mandatory participation, it is
difficult, if not impossible, to get the n members to participate in the common effort.

Enforcement problem
Further assumptions:

Assume that we have an enforcement mechanism

Assume owners have different preferences for open space

A : Acres of open space

p: Marginal cost

n1 <n have high valuation of open space

n2 =n−n1 have lower valuation of open space

Collective interest of all highest when MB=MC

n1 MV 1 ( A ¿ ) + n2 MV 2 ( A¿ )= p or (1)

n1 n2 p
MV 1 ( A )+ MV 2 ( A ) =
¿ ¿
(1’)
n n n
Real Estate Economics _ Notes

The level of open space acquisition that each type of household would like to undertake:
¿ p ¿ p
MV 1 ( A1 ) = ; MV 2 ( A 2 )=
n n

Since the first household type values open space more than the second house, its marginal
benefit curve, MV_1(A), is above the second household-type’s curve, MV_2(A).

Hence, the preferred outcome for group 1, A_1*, is greater than A_2*. We have defined the
optimal amount of open space as A*, a point at which the weighted average of the benefit
curves for the two household types intersects the cost line (p/n).

If the collectively optimal level of open space is somehow selected, each group of households
would still prefer a different outcome. The 2s would want less and the 1s more.

Public space acquisition in case of a single developer:

Real Estate Economics _ Notes

Common property resources:

Common property resources are commodity goods that are non-excludable like public goods,
but they are rival, so that the marginal value to each user depends on how many other people
use the commodity.

Examples: Fishing, hunting, grazing, parcs.

Suppose benefits of open space demand on the number of users (n):

M V n : Valuation of the parc by each (as a function of how many are sharing it) if not
excludable, how many will use it?

M V n =¿ 0
0

n 0=∞ , potentially.
Real Estate Economics _ Notes

Because of the rival nature of common property resources, market demand Dt is derived by
horizontal addition of individual demand Q1 and Q2 at a given price p:
2
Q ( p )=∑ Q i ( p )
i=1
We think of D1 as the demand curve by group 1 consumers who have a lower MV than group
2 consumers.

Similarly, think of D2 as the demand curve by group 2 consumers.

External marginal cost: The cost imposed on a third party when an additional unit of good is
produced or consumed.

External marginal benefit: The benefit conferred on a third party when an additional unit of a
good is produced or consumed. Social cost: The cost of an economic transaction to society.

Total value of usage to group:

nMV ( n )

Optimal number of users:

⋆
n 0−n : degree of “over grazing, fishing…”

If it is possible to make parc excludable, it can be privatized. The entrance fee should be:
Real Estate Economics _ Notes

To find the optimal number of users, total differentiate nMV (n) with respect to n and set
equal to zero => First equation.

The entrance fee should be equal to the external marginal costs at the optimal level n*:
−n ∂ MV
EMC ( n ) =
⋆
⋆
∂n

The entrance fee would force users to pay the full costs of their use of the parc by
internalizing the externality that arises from their use of the parc.

Public Goods:

Public goods vs. Externalities in real estate markets:

Public goods: a collective impact on many parcels whose origination is not one specific other
parcel.

Externalities: Impact of what happens on one parcel to adjoining ones.

Externality definition:

Definition of externality: A cost or benefit that affects a third party not directly involved in an
economic transaction.
Negative externality: A cost imposed on a third party not directly involved in an economic
transaction.
Positive externality: A benefit conferred on a third party not directly involved in an economic
transaction.
Real Estate Economics _ Notes

Now we introduce external effects into the chapter 4 model: (Optimal density):

Price pr/sq. foot housing:

P=α −βF− yf

Construction costs:

C=μ+ τF

A developer will take f as given and choose the FAR that maximizes the residual profit
per square foot of land.

p= [ ( α −μ )−( τ+ β ) F− yf ] F

Ad Eq. 1: Extend the equation for the price per square foot of housing in Ch. 4: P=α −βF
with an additional term that captures the marginal impact of neighbour FAR on the property
price => Eq. 1.
Real Estate Economics _ Notes

γ : Marginal impact of neighbour FAR or the incremental loss (to each house) with increased
density of adjacent property.
Ad Eq. 2: Same as in Ch. 4.
Ad Eq. 3: Recall from chapter 4 that p=[P-C]F. Next, insert Eq. 1 at P’s place and Eq. 2 at
C’s place and collect terms => Eq. 3.

Nash Strategy:

A strategy which the individual has no incentive for unilateral deviation from the strategy.

Nash solution:

max p w . r . t . F given f
Real Estate Economics _ Notes

Cooperative solution by choosing a common FAR  Max using f = F:

Introducing externalities across developments:

Real Estate Economics _ Notes

The annual value that households place on each mile of separation will be γ .
Note: works in both directions with the absolute value function | |.
- When residents live beyond industries, the two forces of commuting and proximity to
industries act in opposite directions: greater distance from the center reduces residential land
rents because of commuting and increases them as distance generates greater separation =>
the residential land rent gradient has a slope of −¿).
- When residents live closer to the center than industries, their rents decrease with
distance to the center due to two forces: commuting to the center and proximity to the
industries. In this case the slope of the residential land rent gradient is −( k H + γ ) .
m: separation point between the two uses of land.
Last assumption: Assume γ large. γ > [ k H −k I ] k I >k H −γ =>In the first spatial equilibrium,
industries outbid residents for land at central sites.

Additional examples of public goods:

Real Estate Economics _ Notes

Sidewalks, roads, waterways

Historical districts
- Designation provides control against adverse design/ use
- Loss of individual development options

Additional examples of externalities

- Office building height, (views vs. view blockage)
- Good architecture
- Comprehensive development design: Is the style of your development an
externality?
- Adjacent retail stores, shopping centres
- Adjacent hospitals, medical “zones”
Real Estate Economics _ Notes

Lecture 15, Chap 14, Public goods, Externalities, Development and

regulations: Part 2:
Solving public goods and externalities:

1. Private bargaining
2. Larger scale developments
3. Government policy
- Public regulation/planning
- Economic incentives

Under certain circumstances it is possible to reach the efficient market outcome through
private negotiation.

The Coase theorem:

No matter who has the property right, the market participants can negotiate and reach the
efficient market outcome, if negotiation is costless and outcomes can be monitored.

Private bargaining (Coase theorem) In presence of externalities

- Conditions: Trade is possible, no transactions costs, property rights well-defined,

market is transparent.
- The allocation will be efficient.
- Possible criticism?

Coase theorem:

External marginal cost: The cost imposed on a third party when an additional unit of good
is produced or consumed.

External marginal benefit: The benefit conferred on a third party when an additional unit of
a good is produced or consumed.
Real Estate Economics _ Notes

Social cost: The cost of an economic transaction to society, equal to the private cost plus the
external cost.

Social benefit: The benefit of an economic transaction to society, equal to the private benefit
plus the external benefit.

Bidding for uses:

Assume each town can negotiate with the firm at no cost.

- If town has location “rights”: Firm pays town environmental costs if it locates there
(“Compensation”)

- If firm has location “rights”: Town pays environmental costs for firm not to locate
there (“Exclusion”)

What if environmental impacts spread beyond boundaries?

- If towns have location “rights”, then the firm must compensate all towns for possible
location.

- The best location is the location where the sum of production costs plus all
compensation payments is lowest.

Explanation:

The private marginal cost are assumed to be constant and equal to:
- 15, if the firm produces in town A,
- 10 if the firm produces in Town B.
The external marginal cost are assumed to be constant and equal to:
- 10 in town A
- 20 in town B
So the social marginal cost (SMC) will be equal to
- MC+EMC=15+10=25=SMC in town A
- MC+EMC=10+20=30=SMC in town B
Since SMCA<SMCB, the efficient (or socially optimal) location of the firm is town A.
Assume that each town can negotiate with the firm at no cost.
1) If town has location “rights”, or right to clean natural resources, the firm has to
compensate the town for the environmental costs.
Real Estate Economics _ Notes

- So the firm will choose to locate in Town A, because the sum of “production costs” and
“compensation” is the smaller in Town A. This firm location is socially optimal since SMC is
smaller in Town A.
2) If the firm has location “rights”, that is the right to pollute, the town has to pay the firm for
not to locate there:
- Town A is willing to pay the firm up to 10 (thousand dollars per year) for not locating
there
- Town B is willing to pay the firm up to 20 (thousand dollars per year) for not locating
there
The firm will locate in Town A because MCA-exclusion payment from Town B is lower than
MCB-exclusion payment from Town A 
15-20<10-10  -5<0.
Therefore, the firm will choose the socially optimal location (Town A), no matter who owns
the right to pollute/clean natural resources.

Government policy:

Public regulation / Planning:

Careful public regulations (Like subdivision regulations and zoning laws) and master-
planning could maximize aggregate value (Like: Town architects in Europe)

Economic incentives:

Taxation of FAR level above the FAR level chosen by neighbourhood, tax credits to
encourage developments that create a positive externality (Like: Restoring properties of
historic importance).

Congestion externalities:

Monocentric city model:

Assumptions:

- Linear city with some width: Interior land is located at d , where d w < d < d e

- Households work in the centre (d 0 )

- Live at a constant residential density 1/q (q is lot size in acres of land)

East side:

- East side (d > d 0 ) use cars

- Travel cost: k e (d e ) per mile, per year.

Real Estate Economics _ Notes

−k e ( d e )
- Land rent gradient declines from the centre d 0 over distance with slope
q

- Border: d e

West side:

- West side (d < d e ), use public transportation.

- Travel cost: k w, per mile, per year.

−k w
- Land rent gradient declines from the centre d 0 over distance with slope
q

- Border: d w

Interior land is located at distance d, where d w < d< d e .

East side:
Ad “Travel cost: “k e (d e ) per mile”: Due to increased congestion as the Eastern part of the
city grows and the number of commuters to the city center increases. Thus, the cost per mile
of travel will not be constant. Transportation costs per mile will depend on the amount of
development there, which means that k eis a function of d e .
Ad “Land rent gradient: -k e ( d e )/q .” For households to be in locational equilibrium, land on
the east side of the city will have a rent gradient that declines from the centre d 0 over distance
with a slope of -k e (d e )/q .
West side:
Ad “Travel cost: “k w per mile”: Assume that the subway system has considerable excess
capacity. As a result, any number of commuters can travel at a fixed cost of kw per mile per
year.
Ad “Land rent gradient: -k w /q.” For households to be in locational equilibrium, land on the
west side of the city will have a rent gradient that declines from the centre d 0 over distance
with a slope of -k w /q.
Due to the difference in transportation technologies on the east and west sides and the
resulting differences in commuting costs per mile, we expect that in location equilibrium the
land rent gradient on the east side will have a different slope than the land rent gradient to the
west. Let’s explore this further (next slide).
Note: If you think of d0 =0, then distances to the west of d0 take negative values, while
distances to the east of d0 take positive values.
Real Estate Economics _ Notes
Real Estate Economics _ Notes

Ad “Land rents”:
The spatial equilibrium is reached with individual commuters considering only their own
commuting costs, not the costs that they impose on other commuters by being on the road.
Ad “Land rent at the borders are the same”:
Beyond the borders de and dw, land is devoted to agricultural use that yields a land rent ra.
Therefore, re(de)=rw(dw)=ra, so the second term vanishes in the equilibrium land rent equations
above.
Ad “Land rents in the city centre are the same:” If land rents in the city centre were not the
same, then a household could be made better off by making a slight move to the east or west
where rents are lower.
In the equilibrium land rent equations, land rents are equal at the centre (d0) only if total
commuting expenses on the east and west side are equal. If the per-mile commuting costs
vary because of differences in the transportation systems on the two sides of the city, total
transportation costs can only be the same if east and west borders of the city are at different
distances from the centre.
Figure 14.3 (next slide) illustrates this asymmetric land market in which rents are equal at the
centre, and the eastern border is a greater distance from the centre than the western border,
yielding a flatter gradient in the east.
Ad “What happens when development occurs?”:
Or, more precisely, how do the east and west land rent gradients change with population
growth? Explain using Figure 14.3.
If the city is small, and, hence, the distance to both borders (dw,de) is short, the slope of the
east-side rent gradient would be quite flat since use of the road system would not be sufficient
to cause congestion. In this case, the city would extend to the east much farther than to the
west. As the city expands from population growth, the west-side rent gradient shifts
proportionately outward and dw increases (just as we have seen in Chapter 3). In the east,
however, more development increases road use, congestion sets in, travel speeds fall, and the
slope of the land rent gradient begins to steepen as auto commuting costs rise. As a result, the
expansion of the east side of the city begins to slow.
As de expands and extra vehicles are added to the road system, the expense of commuting at
any given closer location d, ke(de)(de-d), increases. As one more person develops land to the
east, the commuting cost per mile for all other east-side residents is made worse. On the west
Real Estate Economics _ Notes

side, where kw is fixed, this is not the case. Growth on the west side imposes no costs on
existing west-side residents, that is has no negative externality!
Real Estate Economics _ Notes