RSM483 Lecture 1 + 2

How is real estate different from other markets?

• Real estate is immobile and durable

• Real estate markets are highly regulated and have heavy government involvement

  • Rules about mortgage terms and tax treatment

• Real estate markets are dominated by amateur investors

relationship between interest rates and real estate returns?

• As interest rates rise, returns on real estate increase

Correlation does not equal Causation

• Just running a regression does not give you a home price → gives price on average

  • There may be other variables that impact home price

Real estate is difficult to value because

• It is heterogeneous in terms of location and attributes

  • Views, crime, school quality

• There are a lot of unobserved or poorly measured attributes

• It is not heavily traded in the market

  • Not a ton of observations.

What are the 3 approaches to value real estate

1) Cost Approach

2) Income Approach

3) Comparables Approach

Cost Approach

• Sum up all the costs to build it

  • If old home– thing about the cost of building an old-quality building today. 

• Add up the cost of acquiring all components of a replacement property

• Why is it important that markets are competitive?

  • In competitive markets, economic profits = 0, cost = close to final price

When is Cost approach used best?

• Most commonly used for new development of standardized properties in competitive markets

• Works best in areas where land values and the cost of all attributes are easily observed and standard

Income Approach

• Most commonly used for investment properties

• Simple version: the sum of discounted cash flows associated with renting out the property forever

• • If net income is constant = (Net Income)/r

• Implies r = “Cap Rate”= (Net Income) / (Purchase Price)

• The simple version ignores risk and expected capital gains/losses

• Good when considering use/productivity of asset – especially if hard to sell/no comparables. 

• Sensitive to interest rate used. 

  • Certain businesses might use higher r’s because their value of future rental streams is lower, leading to lower valuations by income approac

• Mostly good for commercial real estate – not homes.

Comparables Approach

• Most commonly used for home appraisals and by realtors

• Look at recent sales of comparable homes nearby and then use adjustments as needed to the average for differences in home characteristics. 

Good when lots of comparable properties and data

• Repeat sales approach: when same building is selling again

  • Use last sale price and apply a home price index to update the price to current time period

    • Ex: old price x 15% growth in index = current price

Hedonic Pricing – 

• A more data-driven way to value any house based on any theoretical set of characteristics

• Goal here is to find an efficient way to adjust the price of observed sales to account for differences in attributes of houses we hope to value

  • 1) Determine the price of various housing attributes

  • 2) Apply these prices to the house we are trying to value.

What did Rosen Agrue?

• Rosen argued that housing price or rent differences must capitalize differences in a and α across homes, such that identical individuals are indifferent across homes. 

  • Prices adjust for different characteristics such that people are indifferent between living in either house.

Hedonic Price Methology

Using Log in Hedonics

• Helps put everything in percents or percent changes

• If P(a) = 0.07, a home with 1 more unit of a is has a price that is 7% higher, on average, holding other factors fixed. 

Difficulties with Hedonic Pricing

• Data may not include some a and α (marble countertops, nice view, surly neighbour, barking dog, etc.)

• These could be correlated with attributes and amenities that are observed (coefficients estimated incorrectly: correlation # causation!)

• Information is on the marginal value of attributes, and may not apply to large changes in attributes

  • Example: shadow price of 1 garage may not be same as 10 garage. 

•  But the hedonic approach tells us the price of various things we care about

• Schools; demographic attributes of neighbours

• Which is useful for real estate valuation and for making better public policy!