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Analysis is an elusive process; whether investor, appraiser, or student, understanding the essential points to consider is itself a difficult process. In this chapter, we introduce the fundamental methodology as a starting point for deciding whether an investment makes sense. We examine the question, Who uses market analysis and why? Finally, we demonstrate how raising capital for investment purposes must be premised on a foundation of solid analysis.
Knowing the right questions to ask is a wise starting point in any inquisitive task. Otherwise, we cannot identify the underlying assumptions necessary to arrive at an informed conclusion. A market analysis may have several different meanings, just as a real estate market is not necessarily going to mean the same thing to different people. We recognize a definition of real estate market as
the interaction of individuals who exchange real property rights for other assets, such as money. Specific real estate markets are de-fined on the basis of property type, location, income-producing potential, typical investor characteristics, typical tenant characteristics, or other attributes recognized by those participating in the exchange of real property.
We also need to recognize that analysis may fall into several distinct and separate functions within thebroad function of market analysis.
BASIC MARKET ANALYSIS CONCEPT-AN OVERVIEW
We view market analysis as a broad overview of supply and demand attributes for property, including site-specific and local factors and current as well as emerging competition. To begin, we provide some basic definitions. Additional definitions may also be found in the book's Glossary. Studies that focus on the market include:
Analysis of local economies: Studies the fundamental determinants of the demand for all real estate in the market. Market analysis: Studies the demand for and supply of a particular property type in the market. Marketability analysis: Examines a specific development or property to assess its competitive position in the market. Studies that focus on individual decisions include: Feasibility analysis: Evaluates a specific project as to whether it is likely to be carried out successfully if pursued under a proposed program. May relate to developability. Most often related to financial feasibility. Investment Analysis: Evaluates a specific property as a potential investment. Usually incorporates specific financing in the analysis, and may evaluate alternative financing options to select most appropriate financing or consideration of income taxes. Emphasis is on risk and reward, sensitivity analysis, and internal rate of return.
With these definitions in mind, the value of the market analysis becomes apparent. It is a study that tries to identify the market for a particular real estate product. Why would we want to understand the market? Real estate markets are not efficient markets like the stock market, and pricing does not occur every day.
Whenever someone undertakes a real estate transaction, a market analysis must be performed. This could range from an informal process to a two-inch-thick book.
Three key questions should be answered by the study:
1. Will there be users to rent or buy the proposed product? 2. How quickly and at what rent or price will the proposed project be absorbed in the market? 3. How might the project be planned or marketed to make it more competitive in its market?
In market analysis, three phases are involved: collection of data, analysis, and recommendations. It all starts with data, which may be found in many places.
Primary, or raw data is unanalyzed, often collected in person by the analyst. It may include reading classified ads, new development announcements and legal notices, or Census data. Secondary data has gone through the analytical process by someone else, who tells the analyst what to conclude. Secondary data has bias.
The analyst needs to consider bias for all types of data. For example, even primary data may include unintentional bias. Even Census data may include undercounts of immigrants, as one example. Secondary data helps the analyst develop a sense of the market, but primary data is much more valuable and accurate.
Think of the data as coming from two sides-demand and supply-and in that order. Why? On the demand side, the analyst includes:
Population, number of households, and demographic characteristics. Income, affordability, and purchasing power. Employment, by industry or occupation. Migration and commuting patterns. Other factors.
On the supply side, the following are included:
Inventory of existing space or units. Vacancy rates and character of existing property inventory. Recent absorption of space, including types of tenants or buyers. Projects currently under construction and proposed. Market rents/sale prices and how they differ by location and quality. Features, functions, and advantages of existing and proposed projects. Terms and concessions.
Information sources are not limited, either. Analysts may include, among other sources newspapers, Census and private databases, tax rolls, advertisements, and maps-in other words, any source that reveals something of interest.
The value of direct interviews should not be forgotten in this information-gathering process. The analyst may interview brokers, owners, urban planners, local officials, and so on. Interviews provide guidance and open the analyst's eyes. The goal in the interview is to ask as many people as many questions needed to understand the marketplace in order to synthesize a complete picture.
The data gathering process should be thought of as competitive intelligence. Market analysis should be tied in with an understanding of the psychology of the different players. In order to understand whether a proposed project is real, we need to understand the game of business. It is not enough to just say what is going on; we need to understand the players involved. Going even further, it is not just enough to know the players. The analyst also needs to know the local government. In the real estate business, government is your largest partner. If you want to do a project, you need to understand how the political framework either supports or hinders you based on the desires of elected officials.
Market analysis is generated by virtually everyone in real estate:
Private Sources of Analysis Appraisers. Brokers (leasing and sales). Developers. Investors. Asset managers. Lenders.
Public Sources of Analysis Urban planners. Economic development consultants. Public agencies.
It is interesting to determine-and to study-whether private and public analyses mesh or even agree in their conclusions. There are certain ways that the two sides may be specifically biased. In the private sector, market analysis is used to maximize profits (and to reduce losses by reducing market risks). However, the goals of the public sector are often quite different, including a context of impacts beyond profitability or feasibility, such as density, traffic, or design.
Is there such a thing as an unbiased analysis? The answer: Yes. Whichever one you are doing.
The serious analyst-absence of bias aside-should be keenly aware that the process itself invites bias. The analyst cannot fall in love with a project and remain objective.
One effective method for identifying market analysis is by taking note of which group or groups use the analysis. These may include developers/builders, investors and lenders, designers, marketing managers, local governments, appraisers, assessors, tenants and occupants, sellers, purchasers, landowners, and property managers. Within the context of identifying the end-user, it also is important to note that the market analysis data feeds into the process of feasibility analysis. The two phases-market and feasibility-are directly affected by the analyst's conclusions about market area.
Defining the market area can be broken down into attributes of the question, What location and physical space make up the market area? This includes natural features, constructed barriers, population density, political boundaries, neighborhood boundaries, type and scope of development, and location of the competition. This level of analysis next leads to a study of primary and secondary trade areas. Some important considerations define how accurate the analyst's work will be. For example, do you use geographic rings to define the trade area? Putting it another way, is the trade area a circle? In practice, trade areas are actually formed by travel time and other market factors, and true trade areas are rarely suitable to explain with the use of perfect circles. For example, residential zoning and commercial clusters may more accurately define the trade area.
Following the gathering of data, the next step is to analyze. A site's advantages and disadvantages can be studied and compared in terms of zoning and comparisons to the competition: location/linkage to other services and properties, rent or purchase price, unit sizes, occupancy costs, parking ratios, building/project amenities, technology, security, and maintenance (current expense level and any deferred maintenance).
In performing the range of analytical tasks, one aspect of real estate valuation within the broader scope is the more concentrated analysis of local economics. This study of supply and demand is viewed as specific to a narrowly focused region or city. Furthermore, whereas market analysis tends to be associated with the economic conditions affecting valuation of a particular property or property type, analysis of local economics applies to all real estate within a region.
We also want to make a clear distinction between market analysis and marketability analysis. The latter is a study of the relative competitive position of a project within the existing market and anticipated market trends in the near future.
While studies such as these (market analysis, local economics, and marketability) tend to be broad-view market studies, two additional types of analyses are more specific to a particular project. First is the process of feasibility analysis, which is intended as a study of whether the numbers work, given the current perception about how a project should proceed, what it will cost, and who will buy or rent the property. The range of analysis includes a feasibility study, which we examine later in this chapter. However, the analysis is a larger process focused on financial questions but intended as a critical review. If the financial aspects of the project are impractical, it needs to be modified so that questions relating to financial feasibility produce more favorable answers.
A related process is called investment analysis, and it looks at the same financial questions but from the investor's point of view. Feasibility-usually associated with developers and project management-is a part of the developer's market analysis, whereas investment analysis takes the same issues and examines them with a different set of choices. A developer may tend to compare various projects, sites, and real estate markets; an investor is likely to compare potential real estate investments to nonreal estate alternatives as well. The investor will, of course, review financing considerations as part of the analysis; however, financing is not isolated to investors alone. Lenders and potential lenders will perform a variation of investment analysis to analyze risk and to identify the most appropriate type of project financing. Overall, investment analysis, whether performed on behalf of equity investors or potential lenders, will want to include an analysis of cash flow, tax benefits and costs, and comparative return analysis.
To what extent should analysis go? Is it expensive, formal, and time-consuming in all situations, or should the extent of the process be determined by the project? For an experienced speculator, for example, who is familiar with local conditions and trends, an analysis may include a quick and informal study of a specific property. For an outsider, analysis may involve a more detailed study. For someone requiring local approval or extensive financing, that analysis may be a thorough research on many levels.
An expanded definition explains how analysis continues to work after initial decisions have been made concerning where, when, and how to build a project. Market analysis and research are not isolated functions occurring only at the very front processes of the project but are best utilized throughout:
Market analysis is a crucial part of the initial feasibility study for a real estate project, but it does not end there. Market research continues to play an important role in shaping the project throughout its development and management phases. Market analysts are commonly consulted for repositioning strategies after a project is up and running and the developer realizes that absorption does not meet projections. As many types of market analysis exist as variations in development projects, stages of development, and interests being served.
In its final form, analysis may be published as a market study or a feasibility study. In some cases, these are one and the same. However, we make a clear distinction. Market analysis, as a collective process, includes an identification of the timing for demand; the direct relationship between demand and supply (the analysis of which should consider the role of competition), and calculations of investment rates of return.
MARKET STUDY AND FEASIBILITY STUDY: THE DISTINCTIONS
A market study should always begin by answering specific questions that may be raised by lenders or equity partners, or by investors themselves. The document has added value as well. For example, regarding subdivision developments, a survey among developers and bankers concluded "that a well-documented market survey was a key component of the appraiser's report." Such a survey often is mandatory in defining the market area itself. That definition phase should be the first step, according to a real estate research company's president, who also advises that "all market analysis should focus on three basic areas of evaluation: the site, the demand for the product, and the supply of comparable products.
The issues of site plus supply and demand analysis lead us to a series of critical questions:
1. Is there adequate demand for the improvements existing or proposed, so that assumed vacancies will be low? This should include analysis of population demographics, income, employment, and growth forecasts. Additional market components beyond the analysis of supply and demand may go to price segmentation and coordination with marketability (development concept in the context of the market, current available sites versus what end-users want, and market absorption analysis, for example).
2. Is there a market demand for such improvements and how readily will the development be sold on the market? How will the proposed development impact on current supply in the immediate area (local market) and the broader market (regional)?
3. How will the development be paid for, and what is the source of funds?
These three questions will be expressed in the next chapter in a somewhat different form, that of supply and demand. We recognize three forms of supply and demand, involving tenants, real estate acquisition/sale, and financing. For now, we want to review these important questions and even expand upon them in defining the scope of a market study. To continue, a market study will also include the following questions, concerned with marketability rather than with the conditions of the market:
4. What competitive developments exist and how should this project be designed, planned, and marketed to effectively compete? In other words, what is the specific development concept in terms of site plan, architecture, design, and the proposed market itself (tenant, shopper, user)? 5. What relevant factors affect our determination of the market? (Consider the effects of local employment trends, population mix, and even the existence or lack of similar properties.) What is needed in the market today, and how does this development address that demand? Can the design and concept of this development be improved, and if so, how?
Excerpted from Real Estate Market Valuation and Analysis by Joshua Kahr Excerpted by permission.
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|Preface : a practical approach|
|Ch. 1||The essence of analysis||1|
|Ch. 2||Using analysis effectively||29|
|Ch. 3||Valuation of real estate||47|
|Ch. 4||Single-family home and condo analysis||73|
|Ch. 5||Multi-unit rental property analysis||99|
|Ch. 6||Retail real state analysis||119|
|Ch. 7||Office and industrial real estate analysis||145|
|Ch. 8||Lodging and tourism industry real estate||181|
|Ch. 9||Mixed-use real estate analysis||177|
|Using a GIS tool in real estate market analysis|
Posted February 11, 2006