Equilibrium

Real estate markets seek equilibrium. They spend so much time out of equilibrium that we lose sight that, eventually, equilibrium is what they seek. The economy grows. It makes demands for space to house whatever sector is growing. That space grows scarce, and, because of the time lag required to get more of it built, the price of what little is left shoots up. Later, the economy cools. The space is now over-supplied, and down comes its price. Real estate markets gyrate, in waves that can span decades. But the fact that their wave lengths may be long or that the rise or fall of a given wave may be steep does not mean that, over time, equilibrium is not what markets seek. 

Equilibrium is found at cost. Cost (the sum of the separate components of land, labor, materials, and profit) is more stable than price. Cost is a force that draws price toward it. Where price exceeds cost and price is not maintained by some artificial means (a building moratorium that prevents new construction; an extended boom that prevents supply from overtaking demand), price must fall. Where cost, instead, exceeds price, price must eventually rise, with the only exception those markets, like manufacturing shops, for which demand is gone for good. 

The Cost Approach is one of the tools of the appraiser. Cost Approach analysis has fallen out of favor, for teh simple reason that the thing appraisers seek to measure is value, and, at a given time, cost and value may be very different things. The Cost Approach is useful for the most part in the valuation of new and special-use buildings. But that is not to say that, for other buildings, cost analysis does not have its use. It is only to say that its use for older or non-special use buildings is not so much to accomplish the single purpose of estimating the value of that property today as it is to gauge the level of the market at some other date when the market is at equilibrium. 

In a market where prices are low and a thing is in over-supply, cost is a measure of how high a market may rise before a property faces competition from new construction. A frequent question in investor surveys is what is the relationship between current market prices and cost. To an investor, cost is a rough measure of the investment's "upside." In the opposite situation, an under-supplied market where construction is booming and prices are at historic highs, cost is a measure of the level to which the market is likely to return and, so, is a good gauge of how much money invested today stands to be lost. The Greater Boston suburban office market can produce an almost endless supply of space for rent at about $25.00 per square foot, because land is available and a rent of $25.00 per foot covers production costs, making new construction feasible. Cost is where prices are likely to settle once supply meets demand. 

We allow ourselves to be dazzled by markets' wild rides. We allow ourselves to be caught up with the complexity of buildings and the differences between them: wood or masonry, plain or ornamented, low-rise or tower-like, old or new. Real estate markets are less complex than they may seem. For all the differences of the buildings that comprise them, real estate markets are controlled by a very few forces. One is cost. Cost seldom is far from where prices return.

Eric T. Reenstierna, MAI