Chapter OneINTRODUCTION TO REAL ESTATE
Real estate is generally defined as land and all things that are permanently attached to it. These attachments include improvements made to add to the value of the land, such as irrigation systems, fence, roads, or buildings. When buyers purchase real estate, in addition to acquiring the physical land and its improvements, they acquire other specific rights related to that real estate. These rights include the right to control, exploit, develop, occupy, improve, pledge, lease, sell, or assign the real estate. These rights apply not only to the physical land and improvements but also to the ownership of all that are below and above the ground. These ownership rights normally can be separately leased or sold to interested parties; thus landowners can separately sell the space above a certain height on a particular piece of land. This space is normally called an air right. However, it is important to note that the use and transfer of air rights can be restricted or regulated by state and local laws.
TYPES OF REAL ESTATE ASSETS
Generally, a piece of land can be improved into different types of real estate assets. These improvements can be classified into seven different types of real estate:
1. Improved nonbuilt land
2. Residential properties
3. Commercial office properties
4. Industrial properties
5. Retail properties
7. Mixed use properties
Improved Nonbuilt Land
In economics and business, land is described as one of the four factors of production. (The other factors include labor, capital, and entrepreneurship.) The value of land is derived from the demand for land for production of goods and also for the demand for goods and services created from improvements made to land. For example, the demand for rice requires the cultivation of the seed in farmland to grow the rice. Likewise, the demand for cars requires the need to build factories to produce the cars, and land is needed to build these factories. Therefore, even an empty land is an asset with measurable and in many cases significant value. Thus, a vacant land can be improved through proper irrigation and access roads for farming or with structures for the production of goods and services.
Shelter is a basic necessity of life. In order to obtain it, residential properties must be constructed. The type of residential properties predominant in a particular area depends on factors such as availability of developable land, population and population growth, zoning laws, local government policies, and access to transportation, among others.
There are primarily four types of residential property:
1. Single-family and small multifamily properties
2. Garden apartment buildings
3. Mid-rise apartment buildings
4. High-rise apartment buildings
Single-Family and Small Multifamily Properties Single-family residential properties are found mostly in suburban areas and usually are occupied by one family. Such houses normally would have a living room, bedrooms, kitchen, bathroom(s), and maybe a family room. They are usually occupied by the property's owner or rented out to a tenant. This type of residential property is not usually found in a central business district (CBD) because it requires more land space per family living unit than other types of residential properties, and they are usually more affordable in a suburban area.
A small multifamily residential property is similar to a single-family residential property but with more than one unit. Because of the multiple-unit structure, each unit is rented out to different individuals or families. These small multifamily properties can be between two and four separate units. In some cases the owner occupies one of the units and rents the other units to tenants. This type of residential property is also predominant in suburban areas and sometimes is also found in urban areas. In some cases it can be found near CBDs.
Garden Apartment Buildings Garden apartment buildings usually are located in suburban areas and contain individual attached apartment units. They usually are built horizontally and normally are made up of three to four stories. In suburban areas, retirement homes and some condominiums and cooperative houses are built in this form. A typical garden apartment complex can have between 40 and 400 units. This type of residential property is more common in the suburbs because it requires significant land space due to the horizontal nature of the structures.
Mid-Rise Apartment Buildings Mid-rise apartment buildings are more commonly found in urban areas. They are usually higher than 5 stories and can be up to 10 stories. In cities, mid-rise apartment buildings can be structured as condominiums and cooperatives properties. Unlike garden apartment complexes but similar to high-rise apartment buildings, mid-rise apartment buildings require relatively small land space. But the cost of land, even relatively small parcels, often is very expensive.
High-Rise Apartment Buildings High-rise apartment buildings are usually towers built in urban areas. High-rise apartment buildings make effective use of the high cost of land in cities. High-rise buildings are usually taller than 11 stories. In major cities, such as London, New York, Tokyo, and Toronto, it is not uncommon to find 50-story high-rises. The construction costs of these towers are enormous. High-rises contain significant numbers of apartment units, certainly more than mid-rise apartment buildings.
Commercial Office Properties
Commercial office properties are properties constructed for commercial office activities. These properties can be found in both urban and suburban environments and are occupied by businesses for conducting business activities; however, they are predominantly found in CBDs. Office properties are usually classed either as A, B, or C. These classifications have no specific rules or criteria, and classifications in different cities vary; thus, what is classed as a Class A building in Dallas might have a different classification in Washington, D.C. However, some of the factors that affect a building's classification include amenities, type and condition of the elevator, lobby finishing, electrical and mechanical engineering efficiencies, adoption of modern energy concepts, design of the building, age, proximity to transportation, and tenant mix.
Generally, a Class A building is better in terms of the factors mentioned above than a Class B building in the same market. Class A buildings tend to be close to major transportation hubs; are new or relatively new, and have modern designs; have modern electrical and mechanical engineering systems; have modern heating, ventilation, and air-conditioning (HVAC) systems; and usually have major companies as tenants, among other attributes. Class B buildings tend to have fewer amenities than Class A buildings. They may have older electrical and mechanical systems and may be located farther away from main transportation hubs. Class B buildings also may have a mixture of major companies and less-known companies as tenants. Class C properties are much older buildings that have not undergone any major renovations for a long time. They also have older electrical and mechanical systems that lack current technological efficiencies. Most often Class C buildings are occupied by numerous, less-well-known companies with relatively small spaces rented to many tenants.
Industrial properties include manufacturing plants and warehouse facilities. These properties usually are built horizontally and are very large in size. Sometimes they are custom built to meet the specific needs of tenants due to the nature of the manufacturing process or the type of equipment used.
Industrial properties usually have simple structural designs with open space and very high ceilings. Some might have unique floor, wall, HVAC, or roofing specifications. The actual structure depends on the needs of the tenants. It is not unusual to find a manufacturing facility of up to 1 million square feet of horizontal space or a warehouse facility of the same size.
Industrial properties usually are located away from residential areas and urban cities. Due to amount of land required to construct these structures and also due to zoning restrictions, mostly they are located where land costs are relatively cheap. In some cases, the waste from these facilities can be unfit for normal living environments. In some areas, only certain locations far away from residential areas are zoned for industrial activities.
Retail properties in general are built near residential neighborhoods and commercial districts. There are different types of retail properties; the most common types are:
Neighborhood shopping centers
Community shopping centers
Regional shopping centers/malls
Superregional shopping centers/malls
Off-price outlets and discount centers/malls
The main differences among these types of retail properties are the size of the buildings and the nature and type of tenants. On one extreme are the convenience centers, which are usually less than 30,000 square feet; on the other extreme are the regional and superregional malls, which could be over 1 million square feet of shopping space. Exhibit 1.1 summarizes the attributes of each of these types of retail properties.
There are numerous types of hotel properties, and they are classified based on the level of service, amenities, and size of the property. The four most common classifications are:
1. Full-service hotels
2. Boutique hotels
3. Extended-stay hotels
Full-Service Hotels Full-service hotels provide guests with a variety of services, such as room service, restaurants on site, valet parking, spas, swimming pools, gymnastics centers, meeting rooms, and convention facilities. Some full-service hotels also have retail shopping and gift stores. Some examples of full-service hotels include Mandarin Oriental, Waldorf-Astoria, Marriott, and Hilton Hotels, among others. These hotels are usually big in size; some are 100,000 square feet or more. Many full-service hotels are well known due to their advertising budgets, services they provide, and amenities. In some cases these hotels are hotel franchises.
Boutique Hotels Boutique hotels provide limited service compared to full-service hotels. They are mostly small in size and do not offer services such as convention facilities, restaurants, or room service or other amenities found at full-service hotels. Boutique hotels usually are less known and usually have smaller advertising budgets than full-service hotels.
Extended-Stay Hotels Extended-stay hotels aim to be a home away from home. Each unit is designed with a larger room to feel homey, and they usually contain small kitchens complete with kitchen utensils. Customers often choose this type of hotel when they plan to stay for weeks or longer. Some examples include Hampton Inn & Suites, Embassy Suites, and Comfort Suites.
Motels Motels are usually small lodging properties whose doors face a parking lot and/or common area with small rooms, with free parking targeting business travelers and tourists looking to spend a few nights. Motels offer very limited services; their rates usually are cheaper than all types of hotel accommodations. Most motels are located close to major highways and attraction centers. Motels usually do not provide services such as convention centers, spas, room service, or restaurants.
Mixed Use Properties
Mixed use properties are innovative concepts in real estate development. They contain a combination of two or more of the different types of properties mentioned earlier. Such properties can be hedges during down cycles in a particular real estate market. A mixed use property may have a residential component, a retail component, and a hotel component all in one. Some mixed use properties contain an office component, a retail component, and a hotel component. A mixed use property could be made up of any combination of the different types of real estate that is appropriate for that particular market. Mixed use has been very popular recently, especially in urban areas such as London, New York, Chicago, and Washington, DC, and Tokyo.
COMMON INDUSTRY TERMS
As we move from this introductory chapter of the book, we will encounter numerous new terms that are mostly familiar to professionals in real estate. To facilitate easier understanding for folks new to the industry, it is prudent to offer definitions of some common terms used by professionals in the real estate industry. Obviously this list is not all inclusive, but it is a great start to become familiar with the industry.
Accounting The process of identifying, measuring, recording, classifying, summarizing, and communicating financial and economic transactions and events to enable users to make informed decisions.
Accounts Payable A type of liability arising from the purchase of goods and services from suppliers or vendors on credit.
Accounts Receivable A type of asset arising from the sale of goods and services to customers on credit.
Amortization An accounting term used to describe the periodic writing off of an asset over a certain timeframe or the periodic repayment of a loan over a specified timeframe. Example: A landlord incurred $60,000 of attorney fees for drafting a tenant lease with a lease term of 5 years. Accounting principles require that the amount should be capitalized and amortized into expense over the lease term; thus, the monthly amortization expense would be ($60,000/60 months) $1,000.
Appraisal An opinion about the market value of a property at a specific date. Appraisals usually are determined by licensed professionals.
Assets In general, "probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events." More simply, they can be thought of as properties and resources owned by an entity. Assets can be tangible such as land, buildings, furniture, and equipment or intangible such as acquired copyrights, trademarks, and patents. Assets are further classified as current or noncurrent depending on whether they can be converted into cash or used up within one year or one operating cycle, whichever is longer.
Balance Sheet A financial statement that shows an entity's financial position at a point in time, such as at the end of a month, quarter, or year. A balance sheet has three main parts: assets, liabilities, and owners' equity. The components of these three main parts are listed on the balance sheet based on their relative liquidity. For example, cash balances are listed before accounts receivable, and accounts receivable are listed before inventories.
Bankruptcy A term used to describe a party's inability to pay its liabilities as they become due. A bankruptcy is granted through a court proceeding and is filed under various bankruptcy codes, such as Chapters 7, 11, and 13. Each of these chapters has very different implications.
Budget A formal plan set by management for forecasted business activities in future periods against which actual business activities would be evaluated. It enables the actual operations of an entity to be compared to management objectives.
Capitalization Rate (Cap Rate) The rate at which future cash flows are converted to a present value amount. This amount is usually expressed in percent. This rate is sometimes used in the valuation of real estate. A cap rate is commonly calculated using the formula:
Cap Rate = Annual Net Operating Income=Cost Purchase Price
Central Business District (CBD) The central commercial and business center of a city. CBDs usually are where the major firms are located and are densely populated. CBDs usually are more accessible with better transportation systems than other parts of a city.
Condominium (Condo) A collection of individual home units in which the units are owned individually but there is joint ownership of common areas and facilities. A residential condominium can be viewed as an apartment that the resident owns instead of rents. Usually there is no structural difference between a condominium and an apartment. Thus, by looking at a building you can't differentiate whether it is a condominium or apartment. The key difference between them is mostly the legal structure that defines a condominium as a form of ownership. Note also there are nonresidential condominiums as well, such as hotels, industrials, commercial, and retail condominiums.