Real Estate Market Valuation and Analysis

JOSHUA KAHR

and

MICHAEL C. THOMSETT

John Wiley & Sons, Inc.

Real Estate

Market Valuation

and Analysis

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Real Estate

Market Valuation

and Analysis

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JOSHUA KAHR

and

MICHAEL C. THOMSETT

John Wiley & Sons, Inc.

Real Estate

Market Valuation

and Analysis

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Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Kahr, Joshua, 1974-

Real estate market valuation and analysis / Joshua Kahr and Michael C.

Thomsett.

p. cm—(Wiley ﬁnance series)

Includes bibliographical references.

ISBN-13: 978-0-471-65526-8 (cloth/cd-rom)

ISBN-10: 0-471-65526-0 (cloth/cd-rom)

1. Real property—Valuation. 2. Real estate investment. I. Thomsett,

Michael C. II. Title. III. Series.

HD1387.K3135 2005

333.33'2—dc22

2005012597

Printed in the United States of America.

10987654321

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Contents

Preface A

Practical

Approach vii

CHAPTER 1

The Essence of Analysis 1

CHAPTER 2

Using Analysis Effectively 29

CHAPTER 3

Valuation of Real Estate 47

CHAPTER 4

Single-Family Home and Condo Analysis 73

CHAPTER 5

Multi-Unit Rental Property Analysis 99

CHAPTER 6

Retail Real Estate Analysis 119

CHAPTER 7

Ofﬁce and Industrial Real Estate Analysis 145

CHAPTER 8

Lodging and Tourism Industry Real Estate 161

CHAPTER 9

Mixed-Use Real Estate Analysis 177

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Internet Sources for Further Study 195

Bibliography 207

Glossary 211

Using a GIS Tool in Real Estate Market Analysis 225

Notes 235

Index 241

vi CONTENTS

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Preface—A

Practical

Approach

ow much is it worth?”

Every investor begins with this question. The question of value is at

the core of the decision. It is the essence of the decision to buy one property

and to reject another.

Value is a complex topic because it is partly subjective and partly deter-

mined by outside forces. A particular piece of property—whether residen-

tial, commercial, or industrial—will be valued based on its location,

improvements, zoning, competition, local employment, and the availability

(or lack of availability) of other, similar properties. For the serious analyst,

the question should be, How is real estate value properly determined?

There are numerous methods and theories available, some scientiﬁc and

others utilizing inaccurate statistical bases or national (rather than regional

or local) trends. We propose the use of scientiﬁc methods and, at the same

time, an overlay of practical considerations regarding local markets, risk

tolerance, cash ﬂow, experience, tax beneﬁts, and real estate-focused funda-

mental analysis. Just as stock investors recognize the importance of the fun-

damental analytical tools in the selection of stock, the same approach can

and should be used in the analysis of real estate.

It is neither possible nor advisable to try to determine value based

merely on a visual inspection or other nonfundamental indicators. Such de-

cisions are better made based on comparative shopping and analysis and a

thorough comparative approach to the entire real estate market. Ironically,

some investors make a decision to purchase without careful and thorough

analysis and, in some cases, without even deﬁning the means for assigning

value. For some consumers, a property is worth whatever its listed price

may be, or whatever a real estate broker says. Considering that the same

consumers are likely to purchase automobiles with greater care, this is a

puzzling way to buy real estate. A car buyer will likely visit two or more

dealers and, at the very least, take cars out for a test drive. Why compari-

son shop for $20,000 cars but impulse-buy a $250,000 investment prop-

erty or residence?

The example of the impulse-buying real estate buyer is the extreme.

Most people are not that impulsive. However, real estate investors are faced

with the problem of how to analyze real estate values and, if they are to

vii

“

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succeed, they also need to develop the means for reliably analyzing the real

estate they are considering buying. What factors determine value? What

are the appropriate means for comparison between like-kind properties?

Why does a subtle difference in location make a vast difference in price?

These and similar questions are enormous challenges for the real estate

investor. We cannot shop for property based on a single criterion, and we

cannot limit our examination to the same criteria in all cases. For example,

it is not prudent to shop for commercial rental property using the same val-

uation methods as we use when buying residential property. We cannot

even make the same underlying assumptions about two similar properties

in different locations. The collective economic, demographic, and local fac-

tors affecting real estate values have to be studied and analyzed collectively

if we are to make an informed decision. Real estate analysis can be per-

formed by anyone; however, it is not enough to place trust in a broker or

seller, and we cannot pick real estate from classiﬁed advertising. Those me-

dia are starting points in the search; informed decisions rely on more de-

tailed analysis and study.

It is a mistake to rely on others to identify value without further study.

Even so, a vast number of investors do not ask the right questions or even

know what questions to ask. Those who do inquire usually limit their dia-

logue to one with a real estate broker, who may not even be conversant in

the art of real estate analysis. Most state tests for real estate licensing are

surprisingly easy and require little in the way of actual analytical knowl-

edge. Emphasis is usually placed on more mundane matters such as know-

ing how to ﬁll in the standard forms for real estate contracts; agent and

broker liability and how to prevent it; and knowing about buyer and seller

rights and duties. Few real estate agents can provide advice on estimating

cash ﬂow, analyzing relative value and investment potential, or the current

state of local supply and demand.

Even so, the buying public (including many mom-and-pop investors)

presumes that the real estate broker has the answers. The broker’s job is to

move property onto the market, and the more properties they close, the

more commission they earn. Emphasis is placed on bringing together a

willing seller and a willing buyer. But as many prospective buyers often

overlook, the broker usually works for the seller. Consequently, so the

process of real estate analysis—which is of greater interest to buyers than

to sellers—is not within the bundle of motivations that the broker has in

mind. Therefore, if you do not know how to critically analyze real estate

values and you depend on the assurances of a broker, you are on your own.

This book addresses the problems of analyzing real estate with several

possible readers in mind. A number of investors allocate a portion of their

capital to real estate through direct ownership, partnerships, or pooled in-

viii PREFACE: A PRACTICAL APPROACH

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vestments (mortgage pools, for example, operate much like mutual funds,

with portfolios consisting of mortgage debt rather than stocks or bonds).

Business and real estate students and professors will also ﬁnd this reference

to be valuable in developing—at the very least—an approach to issues of

valuation and investment in real estate.

The book has been organized to present material in a practical manner.

What does this mean? Many years ago, a workshop was held at a confer-

ence for stockbrokers. One of the audience members asked a panel, “How

can we do a better job helping our clients to make investment decisions?”

One of the panel members advised, “Pretend it’s real money.”

We are going to offer the same advice in this book. When we use the-

ory by itself, we can have all of the answers. However, to make theory

practical, we also need to provoke thought within ourselves. We ask basic

questions and try to provide answers that may surprise many readers.

Good rule-of-thumb advice, whether conceptual or practical, is valuable as

a starting point; but we want to go beyond, to help our readers to think of

money invested in the real estate market as real money, and not just as an

exercise in the theoretical process of investing.

We begin with three chapters that discuss real estate analysis overall.

These topics are essential for all investors, consumers, and students of real

estate topics. Chapters 4 through 6 discuss speciﬁc popular types of prop-

erty and isolate their unique features. The analysis of each type of real es-

tate rests largely with the features each type of property contains. Thus,

valuation of single-family residences (Chapter 4) will not be identical to the

process of analysis for multi-unit properties (Chapter 5) or retail properties

(Chapter 6). Chapters 7 through 9 examine valuation and means for analy-

sis of nonresidential investment properties: ofﬁce and industrial (Chapter

7), lodging and tourism (Chapter 8), and mixed-use real estate (Chapter 9).

Throughout the book, our goal has been to provide useful tools in the

form of statistical information, examples, charts and graphs, and case

studies. The organization and format of the book is intended to ensure that

the information can be absorbed and converted to practical applications.

Preface: A Practical Approach ix

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CHAPTER

The Essence of Analysis

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.

nowing the right questions to ask is a wise starting point in any inquisi-

tive task. Otherwise, we cannot identify the underlying assumptions nec-

essary to arrive at an informed conclusion. A market analysis may have

several different meanings, just as a real estate market is not necessarily go-

ing 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 character-

istics, 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 the broad function of market analysis.

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BASIC MARKET ANALYSIS CONCEPT—AN OVERVIEW

We view market analysis as a broad overview of supply and demand attrib-

utes 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 ﬁnan-

cial feasibility.

Investment Analysis: Evaluates a speciﬁc property as a potential in-

vestment. Usually incorporates speciﬁc ﬁnancing in the analysis,

and may evaluate alternative ﬁnancing options to select most ap-

propriate 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 be-

comes apparent. It is a study that tries to identify the market for a particu-

lar 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 ab-

sorbed in the market?

3. How might the project be planned or marketed to make it more com-

petitive in its market?

2 THE ESSENCE OF ANALYSIS

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In market analysis, three phases are involved: collection of data, analy-

sis, 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 announce-

ments and legal notices, or Census data. Secondary data has gone through

the analytical process by someone else, who tells the analyst what to con-

clude. 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 some-

thing of interest.

The value of direct interviews should not be forgotten in this informa-

tion-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 synthe-

size a complete picture.

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The data gathering process should be thought of as competitive intelli-

gence. Market analysis should be tied in with an understanding of the psy-

chology 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 busi-

ness, 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 pub-

lic 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 mar-

ket 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. Which-

ever 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

4 THE ESSENCE OF ANALYSIS

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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 de-

ﬁne how accurate the analyst’s work will be. For example, do you use geo-

graphic 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 com-

mercial clusters may more accurately deﬁne the trade area.

Following the gathering of data, the next step is to analyze. A site’s ad-

vantages and disadvantages can be studied and compared in terms of zon-

ing 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 lo-

cal 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 posi-

tion 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

Basic Market Analysis Concept—An Overview 5

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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 im-

practical, it needs to be modiﬁed so that questions relating to ﬁnancial fea-

sibility 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. Feasibil-

ity—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 invest-

ments to nonreal estate alternatives as well. The investor will, of course,

review ﬁnancing considerations as part of the analysis; however, ﬁnanc-

ing 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 deter-

mined 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 in-

volve a more detailed study. For someone requiring local approval or ex-

tensive 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 oc-

curring 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 con-

tinues 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 in-

terests being served.

6 THE ESSENCE OF ANALYSIS

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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. How-

ever, 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 re-

port.”

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 re-

search 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 de-

mand may go to price segmentation and coordination with mar-

ketability (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 devel-

opment 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 some-

what different form, that of supply and demand. We recognize three forms

Market Study and Feasibility Study: The Distinctions 7

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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? (Con-

sider 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 de-

mand? Can the design and concept of this development be improved,

and if so, how?

These ﬁve questions—involving questions of supply and demand—are

at the heart of the market study. In comparison, a feasibility study focuses

on ﬁnancial aspects of a proposed development or acquisition. While the ﬁ-

nancial aspects of market analysis and valuation may be viewed as coldly

factual, a lot of room for interpretation is likely to be found. The numbers

reﬂect varying forms of reality, but the whole question comes back to sup-

ply and demand and the marketability of a project concept. Expressing this

in market terms, “three possible courses of action . . . exist in real estate

feasibility: (1) a site in search of a use, (2) a use in search of a site, and (3)

an investor looking for a means of participation.”

What is the purpose of the feasibility study? If we view it simply as a

means for crunching numbers, then the value of the report will be limited.

In fact, number crunching can and should provide a developer, builder, or

potential investor with a far more important outcome: the determination

of whether the risks of proceeding are justiﬁed. A skeptical approach—as-

suming a project will not work—is often a smart approach. One business

consultant explained this aspect of feasibility:

The ﬁrst goal of a feasibility study or business plan should be

to determine whether or not the potential entrepreneur should

actually take the plunge . . . the default conclusion should be

that the [project] will not succeed. Thus, the plan must convince

potential investors [and] lenders . . . that the [project] will

succeed.

8 THE ESSENCE OF ANALYSIS

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Another expert has observed that the process of feasibility analysis

should relate more to what will work and less to what the costs will be, a

concept that often is forgotten in numbers-oriented feasibility work. That

expert observed that

. . . the steps necessary to evaluate the economic feasibility of a

project are frequently confused with a variety of other tasks. Of-

ten this confusion leads to the recital of various statistics dealing

with population size, growth rates, average income, median home

selling price, employment growth, unemployment listings, and the

like. Too often the result is that pure statistical information is sub-

stituted for the analytical process necessary to determine the eco-

nomic feasibility of a project. . . . Some believe the [analyst’s] role

should be limited to answering the question “what is it worth?”

and leaving the question “will it work?” to others.”

We can accurately deﬁne feasibility—at least in part—as the matching

between various elements of supply and demand, expressed in terms of

cost and beneﬁt. The kinds of questions you will ﬁnd in a feasibility study

are broader in scope because these various elements are complex; however,

the primary areas involved will include:

■

What is the target market for the proposed development? (In retail

projects, the target has two components: potential tenant stores, and

shoppers, so the target needs to be evaluated with both of these groups

in mind. In residential projects, the target may be either a home-buying

family or a renter, depending on the project and scope envisioned in

the development process. Mixed-use projects are especially complex

regarding target markets. For example, in urban areas such as Man-

hattan, some projects involve retail shopping areas and hotel, residen-

tial, and recreational features in a single complex.

■

What comparable properties are on the market, and how will competi-

tion affect pricing in our case? (If a lot of similar properties exist, does

it make sense to build another? If so, why?)

■

What is the performance level and market demand of the competition?

(This may include vacancy rates in multi-family complexes or sales in a

mall, for example.)

■

What level of ﬁnancial performance is projected? Speciﬁcally, the feasi-

bility study works like the well-known business plan model in its pro-

jection of cash ﬂow, intended to demonstrate that the proposed project

will remain solvent even with a reasonable assumption about vacancy

rates, market rental rates, and seasonal variation. Both investors and

Market Study and Feasibility Study: The Distinctions 9

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lenders will also be keenly interested in conclusions drawn concerning

the cash ﬂow impact of debt ﬁnancing and the impact—positive or

negative—of taxes.

■

What risks are faced in investing in this project (for equity partners) or

in lending money to ﬁnance this project (for lenders)? The range of

risks may involve negative cash ﬂow caused by high vacancies and

unanticipated expenses, changes in the local economic climate, and re-

versal of current demographic trends; the feasibility study should raise

all of these questions.

WHAT SHOULD A MARKET AND FEASIBILITY

STUDY CONTAIN?

While there is no set format for the study document, the typical market

analysis will contain the following items:

Cover page—The type of study, address of property, and names of the

team members.

Letter of transmittal—Major ﬁndings, conclusions, and recommen-

dations.

Table of contents—A list of all the sections.

Nature of the assignment—Description of the assignment, methodolo-

gies, and approaches used, and the scope of services undertaken.

Economic background—Establishes the market framework; discusses

the larger market areas ﬁrst (i.e., regions and/or cities) and the

smaller market areas last (i.e. neighborhoods). Analysts should be

sure to cover all the inﬂuences: physical, economic, governmental,

and sociological.

Description of the property and proposed development—A descrip-

tion of the site and improvements should be provided separately.

This section explains the physical and economic plan proposed

for the site.

Competitive developments—While the economic background will in-

clude market data on the competitive supply, this section should in-

clude details on the development’s most signiﬁcant competition

(existing, planned, and proposed). It should include rental rates and

sale prices, vacancy rates, size of projects, and other information.

Market potential—Here the analyst establishes how well the proposed

development will capture demand in light of the economic back-

10 THE ESSENCE OF ANALYSIS

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ground and compared to the competitive developments. This is the

place to quantify demand for the development. Where does the de-

mand come from for the proposed plan? How is your proposed

plan different or the same as the competition?

Conclusion of marketability—This section should not include any

new data. This is the part dedicated to pure analysis. Everything

included in the body of the report analysis so far is used to make

a case for how the proposed development will compete in the

marketplace.

A 10-year pro forma should be used, based on an assumed

sale of the property at the end of year 10. The pro forma will re-

quire certain assumptions about rental rates, vacancy rates, ab-

sorption rates, and operating expenses. If the proposal is for a

condominium development, the concept is the same, but an appro-

priately shorter holding period should be used.

Addendum—This section is used for any supporting documents such

as site plans, maps, and material supporting other sections of

the report.

Exhibits—In speciﬁc sections or as an appendix, include valuable addi-

tional items, including a map identifying the location of the sub-

ject, competitive developments, and the market area; photographs

of the subject property, its block front and the block facing it; and

schedules of competition (size, rent/sale price, and vacancy).

This format is meant only as a guideline. Actual format should be dic-

tated by materials needed to make the case; the unique attributes of the

proposal; and a mandate given to the analyst as part of the assignment.

The reporting format may include both market and feasibility study

features. The distinctions between the two types of studies demonstrate

that the range of requirements for thorough market analysis is comprehen-

sive. An important difference to remember is that the market study may re-

main relevant for a considerable period of time, whereas a feasibility study

is likely to evolve as ﬁnancial realities change, including employment, con-

struction and land costs, and other economic data (market rents for resi-

dential, lodging, ofﬁce, and industrial properties, for example). The

problem of reliability in a feasibility study in the lodging industry has been

expressed by a market expert:

Are feasibility studies accurate? They probably are at the time they

are performed. But hotel markets are highly dynamic, and unfore-

seen changes . . . can have a devastating effect on a hotel’s future

What Should a Market and Feasibility Study Contain? 11

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operating performance. With all these interrelated factors (positive

and negative) occurring in a highly random pattern, predicting the

future income and expense of a hotel is like determining the Dow

Jones average three years from now.

THE FIRST STEP IN THE MARKET STUDY:

MARKET AREA

The market study is usually the result of thorough market analysis; but

what form does this report take? In order to make this study useful to the

reader (whether approval-granting agencies, equity partners, or lenders),

the study should be organized in a logical manner, so that information pre-

sents a clear picture of the market in all of its meanings; so that important

information can be easily located; and so that decisions can be made.

As with all well-organized reports, the body of the report should be in

a narrative form, with supporting documentation within the report pro-

vided in graphic forms; and with detailed supporting documentation pro-

vided in appendix form. This format makes the report easy to read and

digest; it keeps the body of the report fairly short (even when the support-

ing back matter is voluminous); and it highlights and explains four key ar-

eas of evaluation: overall market area, location-speciﬁc factors, demand

factors, and supply of comparable properties.

These four aspects of the market analysis are designed to ask critical

questions. In other words, if we are able to demonstrate that the market

area, location, demand, and supply elements favor proceeding, then it

would make sense to others as well. Equally important, if in the process

of performing market analysis, we are unable to make a convincing case

for the project, then why would anyone else want to proceed? The pur-

pose to market analysis is to critically evaluate the underlying questions,

and to determine whether or not the market is situated so that the project

should proceed.

The starting point is a study of the market area. This is the range in

which supply and demand operates. Traditionally, market area has been

analyzed on the basis of studying the land physically. Today, however, new

technology has expanded the potential of market area analysis, explained

in one real estate book as being a new tool to assist market analysts in

many ways:

Although analysts have traditionally been forced to approximate

market areas by using census tracts, zip codes, or county bound-

aries because of data limitations, emerging geographic information

12 THE ESSENCE OF ANALYSIS

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systems (GIS) technology, or electronic mapping, is liberating real

estate decision makers from relying on arbitrary boundaries.

This new technology enables the analyst to look at geographical infor-

mation from a truly big picture view. Artiﬁcial boundaries do, indeed, ob-

scure the true market area in many instances. For example, a retail

shopping center would be designed to serve a speciﬁc population and geo-

graphical market area, which also makes it possible to estimate the reason-

able assumptions concerning trafﬁc volume and potential sales. However, a

careful study of the market area may point out that the results are not al-

ways as obvious as they may seem at ﬁrst glance.

Everyone will agree that market area is an important starting point.

You will want to identify the regional realities deﬁning the potential

The First Step in the Market Study: Market Area 13

CASE STUDY: BELLIS FAIR, WASHINGTON STATE

In the typical market area analysis for a retail shopping center, we

would study local population in order to determine whether a project

is supported by the market. This does not always work, however; you

also need to study the speciﬁc area to determine how market forces

work. In Bellingham, Washington, the regional mall called Bellis Fair

opened in 1988 on Interstate 5 in Whatcom County. At the time,

many people criticized the plan for this development, arguing that the

local population could not support the mall. Population at the time in

the largely rural county was only about 120,000 (as of 2004, What-

com County, Washington’s population is 157,477). However, Bellis

Fair has been a huge success.

Daily shopper trafﬁc exceeds 35,000 people. The mall has 150

stores, with anchors of Bon-Macy’s, J.C. Penney, Mervyn’s, Sears, and

Target. Overall, Bellis Fair has 768,906 square feet of leaseable store

area on its single level, and 4,730 parking spaces.

How is it possible? The location—Bellingham—is the largest city,

but its population is less than 70,000. The closest large city in Wash-

ington is Seattle, nearly two hours to the south. Bellis Fair is not a

destination from that distance, so where is this market coming from?

The answer: Canada. Bellis Fair is a mere 23 miles from the busiest

border crossing, known as the Peace Arch. Here, U.S. Interstate 5

(Continued)

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market itself. One modern tool worth using for the more complex mar-

ket area studies is Geographic Information Systems (GIS). These systems

may include any database with the ability to indicate a geographical lo-

cation or spatial dimension for the variables in the database....

Given

the case history of Bellis Fair, it is clear that such regional factors are not

always obvious. In any modern market area study, GIS would very likely

uncover valuable insights for similar project studies. Additional market

analyses may also be required beyond the geographic location of a per-

ceived market. Some guidelines:

■

Identify the region not only in geographical terms, but also in terms of

where the market exists.

■

The market area for tenants may be drawn from the immediate area as

well as from other areas. For example, with residential projects this

14 THE ESSENCE OF ANALYSIS

CASE STUDY: BELLIS FAIR, WASHINGTON STATE (Continued)

crosses into British Columbia. The metro Vancouver region (the area

encompassing the border, north to the suburbs of Vancouver itself)

has more than four million population. This is the dominant market

area for Bellis Fair. A majority of shoppers in Bellis Fair come from

Canada. The current exchange rate is 80 cents of Canadian to U.S.

dollars, so Canadian shoppers enjoy a 20 percent discount by taking a

short trip south. Given the added impact of high Canadian sales

taxes, shoppers have even greater incentive to shop south of the bor-

der. British Columbia sales tax is 7.5 percent (as of 2004), plus federal

taxes of 7.0 percent paid by all Canadians. So shopping at home costs

15.5 percent on top of the retail price, compared to a Washington

State tax rate of about 8 percent.

Conclusion: Any market area study must look realistically at the

effective market. The border between the United States and Canada

(or between any two states) is artiﬁcial in terms of market area. It

would be inaccurate for Kansas City, Kansas, to draw conclusions

limited only to Kansas residents; obviously, the larger Kansas City,

Missouri, market would dominate the market area. The same ratio-

nale applies in the case of Bellis Fair. The local population could not

support a larger retail mall (daily trafﬁc exceeds one-fourth of the

county’s population). The success of this mall has to be deﬁned in

terms of broader economic and demographic forces.

ccc_kahr_ch01_1-28.qxd 8/3/05 11:50 AM Page 14

could be related to the location of employment and ease of access to

transit lines.

■

Any project’s analysis should include consideration for how the new

project will affect existing projects. For example, meeting an assumed

demand for residential housing may lead to higher vacancy rates in ex-

isting multi-unit developments.

■

Be aware of the differences between artiﬁcial boundaries (county lines,

state borders, etc.) and built boundaries like freeways that cut through

neighbors, thus deﬁning or restricting a market area.

■

Be aware of historical patterns of development based on ethnic or cul-

tural ties. These boundaries change and evolve over time, but they are

remarkably persistent.

■

Be cautious in making undocumented assumptions concerning the ap-

propriate size of a development or the size of an existing market area.

Initial assumptions should be studied critically and conclusions should

be subjected to testing.

THE SECOND STEP IN MARKET ANALYSIS:

SITE EVALUATION

Studying the market area enables us to take a broad view of the region.

Clearly, the features of one area over another will vary considerably, and

the factors are not always obvious. The features within an area affect the

conclusions. For example, an interstate freeway, major border crossing, or

employment trends in one city or region are going to signiﬁcantly impact

your conclusions about the market area. This leads into the second step,

the more speciﬁc site evaluation.

A site evaluation should include comparative analysis—site to site—of

physical properties such as topography, shape of the land, surrounding

uses, and proximity to important features (such as transportation, for ex-

ample). Comparative analysis helps you to assess a particular property or

series of potential sites with features in mind. A shopping mall situated

near a freeway exit would, naturally, have greater potential than one out-

side the city limits and away from the visibility of potential shoppers, the

convenience of access via roads and transit stations, and the overall practi-

cality of siting a shopping mall on well traveled routes. For residential

property, local transit and access to conveniences such as schools and

shopping, also play an important role in comparative site evaluation.

While it may be obvious to some, it is important that the analyst walk the

The Second Step in Market Analysis: Site Evaluation 15

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site. Sound real estate analysis cannot be done thoroughly from a desk or,

for that matter, from behind the wheel of a car.

The question of zoning cannot be overlooked in site analysis, either.

We cannot simply assume that, given the acquisition of land for a speciﬁc

purpose, a rezone is automatically going to be granted. Lower-priced prop-

erty may be so priced due to its current zoning, and local authorities (not

to mention citizens living nearby) are likely to resist a rezone merely for the

convenience (and proﬁt) of development interests. On the other hand, in

some cases approval for rezoning is relatively easy to obtain if the new pro-

ject will beneﬁt the community and local government through increased

tax revenues. The potential problems of investing in land when zoning

problems may arise is one risk factor in the site evaluation. You may need

to compare overlooked but potentially proﬁtable land with more obvious

sites. The cost of already-zoned commercial land may be far higher, but the

risk of antigrowth movements among citizens, or denial of rezone applica-

tions by local governments, is largely removed when zoning issues are not

on the table.

The many questions that arise in site evaluation apply to every type of

land use. The questions include whether a particular site is appropriate for

the planned use; whether it is the best available property; whether there are

amenities close by (public recreation, shopping, schools, etc.); and the

larger question of whether citizens and local government would welcome

your planned use.

Potential resistance to your proposal may exist even when zoning is in

place. Those states that have enacted growth management legislation may

impose restrictive growth limitations.

For example, a common principle in growth management laws is that

a speciﬁcally identiﬁed urban growth area (UGA) should be in-ﬁlled be-

fore any new development is to be allowed outside its boundaries. While

intended as a means for preventing urban sprawl, the actual result may

be draconian density within the urban fringe with little or no growth on

the outside.

For the purpose of site evaluation, it is crucial that you also check state

16 THE ESSENCE OF ANALYSIS

Valuable Resource

A web site linked to many of the state growth management sites, and iden-

tifying additional useful publications on the topics, is http://www.realtor

.org/sg3.nsf/pages/landusezonegrowmgmt?OpenDocument

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and local laws beyond mere zoning. The zoning itself is meaningless if, due

to GMA legislation, you will not be able to gain approval for your project

because the site lies outside the UGA.

Growth management rules may further require that you prove the

need for the development you propose as a precondition for approval.

For example, you may need to evaluate a site within the context of a

county’s inventory of land sharing the same zoning. How much of that

land is developed and under operation? Can you establish a demand for

additional lands both zoned and developed in the same way? You may

discover that opponents will use GMA rules to prevent new development,

even when zoning is appropriate. While we may assume in most cases

that properly zoned land is implied approval for your development, it is

not necessarily so. You may win the point, but delays and legal fees could

make it less feasible. In comparing one site to another in GMA states,

you may need to limit your site evaluation to available land inside the ex-

isting urban fringe, or be prepared to prove the need for your develop-

ment outside that boundary.

THE THIRD STEP IN MARKET ANALYSIS:

DEMAND FACTORS

Closely related to the site evaluation and the practicality of developing a

speciﬁc piece of land is the question of demand. Demand may be a factor

of current zoning, inventory of lands zoned in that manner, and the bound-

aries of an urban area that has access to reasonably priced municipal ser-

vices. It may not be limited to the widely understood deﬁnition of market

demand.

Because demand does not necessarily mean the economic version of

demand, we need to be cautious in interpreting statements made by others.

For example, a local politician or antigrowth activist may state that “there

is no demand for a project like this” in the area. What does that mean? In

fact, it could mean that forces are at work to prevent such projects,

whether market demand exists.

Economic demand is a form of demand in which consumers need and

want more of a commodity or type of outlet (shopping center, apartments,

houses, etc.) or, when that demand would be likely to follow if and when

the development occurred. For example, a community may reside 60 miles

from the closest large-scale regional mall. The lack of such a mall right in

town does not prove that there is lack of demand; in fact, were such a de-

velopment to be built, it is logical that shoppers would arrive almost imme-

diately at that destination rather than traveling 60 miles.

The Third Step in Market Analysis: Demand Factors 17

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So a study of demand should include an understanding and study of

market forces and trends, but it is not necessarily so limited. We may face a

more political deﬁnition of demand as well. At times, the real agenda may

be to prevent change in any form; in that environment, appropriate zoning

and municipal code provisions may not be enough to gain approval for

your project. This is understandable; development is change, and change is

often resisted for no other reason than because it is perceived as negative

by some people. You may need to include as part of your demand analysis

the local political demand for development. In some jurisdictions, political

demand is at zero. From a development perspective, regardless of the eco-

nomic demand, the project may simply not be feasible because of politics.

This problem is prevalent in many areas, but the range of problems as-

sociated with antigrowth sentiment in residential development (and most

notably against low-income housing) is especially severe. As a matter of

public policy, slow growth policies may ultimately prove the point that

when government tries to control growth, it causes only badly planned

growth but cannot truly prevent it. This problem is aptly described in one

GMA-oriented web site, observing:

Jurisdictions are not accommodating growth because they either

refuse to comply with the law, need political cover from NIMBY

mentality, or lack the resources necessary to provide infrastructure,

amenities and low income housing. During times of high demand,

jurisdictions must do more to accommodate the need for housing.

While the private sector determines the market for housing, each ju-

risdiction determines the availability of land to develop through

comprehensive plans, zoning codes, permit requirements, fees, taxes,

and other costs that may serve to encourage or inhibit growth.

THE FOURTH STEP IN MARKET ANALYSIS:

EXISTING SUPPLY FACTORS

The concept of supply is as complex as that of demand in areas where leg-

islation has been drafted in an attempt to control or even to prevent

growth from occurring.

In an economic sense, supply is well understood. It is in reference to

the available properties designated for a speciﬁc use. When economic

supply is high, prices will soften because demand lags behind. When

supply is short and demand is greater, prices are driven up. This basic

economic concept is not complex, at least when viewed in its theoretical

deﬁnition.

18 THE ESSENCE OF ANALYSIS

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There are three speciﬁc kinds of real estate supply: already built, under

construction, and proposed. Each of these has a different level of reliabil-

ity, and the variables should be discounted by the analyst. For example, de-

velopers sometimes announce a project that they do not have tenants for,

only as a way to scare off other developers or to try to attract a potential

tenant in order to drive the development; most downtown ofﬁce buildings

cannot be built or ﬁnanced without a committed tenant. So it is a common

practice among developers to announce construction more as a marketing

ploy than as a statement of fact.

In a written market study, the questions of supply and demand may

be limited to a purely economic analysis. If a market study is undertaken

to convince lenders of the viability and cash ﬂow strength in a proposed

project, those economic analyses are quite appropriate. The same is true

when the study is designed to attract equity partners or to gain approval

for tax credits in low-income housing, for example. However, if the pur-

pose of a market study is to determine whether a project is viable both

economically and politically, we need to look beyond the economic ver-

sion of supply.

In residential developments, antigrowth conﬂict is often associated

with questions of supply. Antigrowth forces may argue that there is an ad-

equate supply of housing and it is not necessary to construct more. This ar-

gument is made even when economic demand is evident. However, the

antigrowth argument continues: If we build more houses, more people will

move here. That means more trafﬁc, higher crime, the need for improved

roads, larger schools, and other consequences of growth. So supply may

come to mean need rather than a purely economic study of whether there

are enough buyers available.

For commercial developments, the question of supply is equally com-

plex. A market study would review buying trends, trafﬁc patterns, logis-

tics, and site-speciﬁc questions in order to convince the reader of the study

that a mall, for example, would succeed at a speciﬁc site. Included in this

study would be commercial vacancies, affected by shifting trafﬁc and

shopping trends, local and regional competition, and typical rental rates

in the area.

Demand for either residential or commercial developments also needs

to include a study of the trend in net absorption or, in the case of single-

family homes, real estate sales trends in recent months.

Net absorption can be expressed as the square footage of available

space over time, modiﬁed by vacancy levels. More speciﬁcally:

Net absorption = space occupied – space vacated + space demolished

– construction of new space

The Fourth Step in Market Analysis: Existing Supply Factors 19

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For example, in a particular city, residential vacancies have consis-

tently run below 5 percent; however, in the past two years, several hundred

new apartments have been added to inventory and today, vacancies range

seasonally between 10 percent and 15 percent—a substantial increase. So

net absorption has diminished. The question next becomes, How long will

it take for the market to absorb the oversupply so that net absorption will

improve? This estimate would have to be based on economic and demo-

graphic trends in the area.

In the case of properties for sale, demand is judged based on several

forms of analysis. Checking with local lenders and Multiple Listing Service

(MLS) ofﬁces, we ﬁnd statistics concerning housing sales over the past one

to three years. What is the trend in the inventory of properties? (Inventory

is the number of homes available for sale, expressed in terms of the months

of demand. For example, if 200 homes are sold per month and there are

currently 600 homes on the market, then there is a three-month inventory.)

The trend in inventory levels reveals the demand. If the inventory level is

growing, then demand is falling. The trend reveals the health of the local

housing market.

A related test is the spread between the asked price and the ﬁnal sales

price for properties. The wider the spread, the softer the demand. In mar-

kets where demand is exceptionally high, spread tends to be low. So again

reviewing the trend, we would analyze demand in terms of whether the

spread is expanding or contracting.

The third important test is time on the market. How long does it take

properties to sell? In a high-demand market, well-priced properties sell

very quickly and, of course, when demand is soft, even bargain-priced

properties may remain on the market for many months. What is the trend?

The answer reveals the level of demand and, more revealing, the trend in

that demand.

Developers hiring outside ﬁrms to prepare market studies should en-

sure that the ﬁrm is qualiﬁed in the particular type of development being

studied. The study should also identify speciﬁc factors given the market in

question, rather than relying upon some generalized formula. For example,

many studies are prepared based on markets deﬁned via radius (three or

ﬁve miles are common markets in such studies). But this method is not ap-

plicable in most areas. A real market may consist of people living along a

highway as far out as 10 or 15 miles while few other potential buyers or

consumers will be found within a mile-based proximity. The underlying as-

sumptions of the study should be based on the geographical and local fea-

tures rather than on a formula that almost certainly does not apply. For

example, drive time is often a more reliable indicator of markets than ac-

tual physical distance.

20 THE ESSENCE OF ANALYSIS

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One expert has noted that one signiﬁcant error

is the failure to recognize that a new development will be able to

capture only a share of the market, rather than the entire market.

New projects do not necessarily create new demand. Many ana-

lysts incorrectly assume that if there is sufﬁcient demand in the

competitive market to absorb ﬁve lots per month, a new project

will automatically capture all this demand.

The same argument applies to economic modeling within the market

study. Broad-based assumptions should be rejected and the market study

based on the local realities and economic mix. This is essential if the study

is to truly identify the market in terms of supply and demand. Such eco-

nomic features cannot be formula-based because every region and munici-

pality is unique in terms of its demographic and economic mix. The market

study should analyze the area, rather than be designed to impose general-

ized assumptions on all areas. A competitive analysis within the market

study should be prepared along similar lines: The market study should in-

volve analysis of speciﬁc competitive forces rather than upon generalized

observations about the nature of competition.

How can you determine whether a particular consulting ﬁrm uses boiler-

plate assumptions or actually goes into the ﬁeld and studies the market? One

effective method is to ask to see copies of recent market studies and to com-

pare them. Since many such studies are publicly available and not proprietary

(such as studies prepared for government program clients), a consulting ﬁrm

should be willing and able to provide copies of recent market studies.

THE VALUE OF THE FEASIBILITY STUDY

The market study is intended to examine conditions of the local market

and to demonstrate, by way of compelling supply and demand factors, that

the development proposal is justiﬁed. In comparison, a feasibility study

questions the ﬁnancial aspects of the proposed development—tax features,

cash ﬂow, and likely proﬁt or loss—in order to show potential lenders (or

equity partners) that the numbers will work.

While the question of feasibility may be largely ﬁnancial, it is more than

an accounting exercise. The typical accounting revenue forecast, cost and ex-

pense budget, and cash ﬂow projection is limited to documenting possible

outcomes; the feasibility study, in fact, is far more. It is ﬁnancial in nature, but

it should be compelling beyond what the numbers reveal. A lender reviewing

a feasibility study should be able to conclude that the risk of ﬁnancing the

The Value of the Feasibility Study 21

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project is acceptable. Feasibility should not translate to an attempt to show

that there are no risks; a lender or potential equity partner would not accept

such a premise, and, under any standards, such a claim would not be sup-

portable. However, the question of risk is going to be on the minds of anyone

approached by developers for ﬁnancing or investment purposes.

Feasibility, in its most reasonable deﬁnition, is part budget and part

disclosure document. It is properly treated as part of a test of the ﬁnancial

potential, risk, and ﬁnancing required. All of this, which is part of the due

diligence process, is aimed at testing the assumptions underlying the pro-

ject. Part of that process—and a crucial part for the lender or the in-

vestor—is identifying risk. This risk may come not only in the most

obvious forms of net loss or negative cash ﬂow. In some instances, a far

more troubling risk may be the possibility that initial ﬁnancing will not be

adequate to complete the project.

The feasibility study presents a pro-forma version of what is expected

to occur during the acquisition, construction, completion, tenancy, and

eventual sale of the project. What happens if initial ﬁnancing or equity in-

vestment is not enough to complete these steps? Where will additional

funding be acquired? Of course, the fact that the study attempts to show

how currently known facts might look in the future—in other words, a

forecast—should be accepted as one of many possible outcomes. We

should be aware of an important distinction:

A forecast is not a prediction. Predictions require a leap in logic

and are not necessarily based on known or knowable current in-

formation. A prediction does not attempt to show how the future

relates to the present; it is stated as a fact, independent of and un-

related to what currently exists. A forecast, on the other hand, log-

ically links current information with events that are expected to

occur. In a forecast the future is not unrelated to the world as it

currently exists or will exist; rather, current and future events are

viewed as inexorably linked in some logical way.

The difference between these two is central to the theme. Consider, for

example, the point of view of the people who are asked to bring money to

the table—lenders or investors. Because the initial ﬁnancing is the basis for

identifying potential return to investors (or cash ﬂow to lenders), if that ﬁ-

nancing is inadequate, it presents a very serious dilemma. More ﬁnancing

will be necessary if the initial lender or investor is to proﬁt; however, the

assumptions all change if and when additional funding will be needed.

With this risk in mind, the feasibility study has to address the ﬁnancial risk

in very comprehensive terms.

22 THE ESSENCE OF ANALYSIS

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As a planning document, the feasibility study serves as a risk disclosure

summary within the due diligence process. It should follow the market

study. Clearly, disclosure has to be based on market assumptions, so a fea-

sibility study cannot precede a test of the market itself. In the market study,

the big question is, Does it make sense in this market to proceed, given site

attributes, supply and demand, and competitive realities? In comparison,

the feasibility study should ask the questions, Can we afford to build the

project as originally conceived, or do we need to examine costs with mar-

ket and ﬁnancial attributes in mind?

The market study indicates how the project should be completed in

terms of improvement size and scope (thus, cost). So the assumptions that

go into the feasibility study are based on the market study. That is the en-

tire assumption base, in fact, for studying risks and determining whether or

not a lender can reasonably expect timely payments or an investor can ex-

pect a return and, ultimately, a proﬁt.

If a developer prepares an in-house market study and feasibility study

and then goes forward to ﬁnd ﬁnancing, it would be normal for the picture

to be optimistic. And many development ﬁrms do, in fact, prepare their

market and business planning documents on their own. However, the real

test of feasibility is achieved when an outside, independent consultant

looks at the same questions objectively. As long as the developer pays the

bill, we may expect a degree of bias and that is unavoidable. However, an

outside consultant should adhere to certain standards and that is an impor-

tant feature of the independent feasibility study. An appraisal ﬁrm may of-

fer market and feasibility services but may lack the accounting skills to

prepare a comprehensive cash ﬂow analysis; their emphasis would likely be

restricted to cost/value questions. An appraisal ﬁrm with a qualiﬁed real es-

tate department that specializes in feasibility studies or a consulting ﬁrm

with demonstrated experience in preparing feasibility studies, may be the

best source for preparation of this feasibility study. A word of caution,

however, is offered by a principal in one such organization:

Once you have identiﬁed qualiﬁed feasibility consultants, there are

other factors that need to be weighed in making the selection. The

most important factor is whether or not the chemistry is right and

the match is a compatible one. This doesn’t mean hiring a ﬁrm that

will always agree with you. It means hiring people who have the in-

tegrity to tell the truth as they see it, and at the same time work

with the people in your organization in a team effort that is not ad-

versarial in nature. You must feel that you can trust the judgment

of the feasibility consultant that you hire, without feeling that you

can’t challenge their interpretation of the data gathered.

The Value of the Feasibility Study 23

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The feasibility study is most effective when it includes three key fea-

tures. First, the pro-forma number crunching has to be based on realistic

underlying assumptions about ﬁnancing, costs and rents, and these as-

sumptions have to be critically examined to ensure that they are fair and

accurate. Second, the assumptions used in the feasibility study must be an

outgrowth of the market study. Why? Because “recommendations re-

garding overall project size, unit sizes and mix will drive the overall pro-

ject cost as reﬂected in the development budget.”

Third, a feasibility

study should include a series of metrics so that the reader can better un-

derstand the cash ﬂow statement. This could include time value of money

calculations such as the Internal Rate of Return (IRR) or Present Value

calculations. Other metrics that examine return for both investor and

lender should be examined (such as cash-on-cash on both leveraged and

unleveraged bases; loan-to-value; and debt service coverage ratios). Fi-

nally, a competent analyst will include sensitivity analyses that show how

small changes in underlying variables (i.e., capitalization rate) may result

in large changes in project value.

Feasibility cannot be studied in a vacuum but should serve as an out-

growth of competitive analysis as well as an understanding of supply and

demand locally; if the market study shapes the development as it should,

then the feasibility study shapes the ﬁnancial questions in a meaningful

way, including risk assessment as well as acquisition and development cost

levels and cash ﬂow.

One possible outcome of the feasibility study is the conclusion that, in

fact, the project as originally conceived does not work out ﬁnancially. If the

investment cost is too high based on potential cash ﬂow, the conclusion

may be that the whole project will have to be scaled back. In the most ex-

treme case, the idea may have to be abandoned and the land used for other

projects (or if land has not yet been acquired, the whole project would be

abandoned). In those instances, it is far less expensive to pay the cost of a

market study and a feasibility study, than it would be to attempt to ﬁnance

the project. The cost of proceeding when the numbers do not work would

be far greater for all concerned.

WHO USES MARKET ANALYSIS?

Should market analysis be performed only as a means for obtaining ﬁnanc-

ing? The market study and feasibility study are essential for raising money

for a project, but is that the end of the process?

In fact, market analysis and the output obtained from it are valuable

24 THE ESSENCE OF ANALYSIS

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planning documents. These can and should be utilized throughout the

project by architect, engineer, and the project planning team. In develop-

ing the raw material, the individual or ﬁrm preparing a study considers

population, income, employment trends, commuting and trafﬁc patterns,

and more. But the market and feasibility studies should evolve beyond a

summary of raw data if they are to be effective. Many ineffective reports

end up gathering dust in the project manager’s ofﬁce, because they are not

designed as action tools. Thus, the cost and effort that go into market

analysis may be passively organized and presented, so that no meaningful

use will be made of it. As an alternative, the document may be designed to

provide vision and guidance to the many participants in making the pro-

ject a reality.

A lot of emphasis is placed on marketability analysis of a project, ei-

ther in terms of rental cash ﬂow or—if the developed property is to be

sold—how to maximize market value. But marketability analysis is only a

small part of the larger concept of market analysis. The latter is effective

when it includes the elements of the market study and feasibility study; but

it becomes exceptionally effective when the information and conclusions

are presented in a way that provides the project vision that is so important.

Elements of that vision include community involvement along with plan-

ning at the municipal level; innovative design; sensitivity to local concerns;

and the feasibility of the project in every way and not solely in terms of ﬁ-

nancial outcome.

The utilization of market analysis is so critical to a project’s acceptance

locally because no two projects are the same. Any attempt to use a cookie

cutter method of developing projects is certain to meet with resistance.

Variation in style, site planning, and price range should be based on a list

of local attributes. These include citizen involvement and/or resistance to

the development, local political mood, and the far more tangible site-spe-

ciﬁc attributes: topography, proximity to trafﬁc patterns, and surrounding

zoning, for example.

In considering the many diverse uses of market analysis, the most ef-

fective studies are those that meet the needs and answer the questions of

each of the interested parties: lenders or equity partners (capital forma-

tion), developers or contractors (project generation), architects and design-

ers (those responsible for creating aesthetic qualities as well as meeting

local code requirements within the site), marketing interests or users (buy-

ers or sellers, landowners and tenants, or consumers), and maintenance in-

terests (property managers).

It is useful to review the end-user on a matrix of objectives, as shown

in Table 1.1.

Who Uses Market Analysis? 25

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THE GOOD AND THE BAD ON STUDIES

The analyst needs to remember who usually commissions the market

study: the developer. Do not confuse the market study or feasibility

study with the more independent and objective appraisal, for example.

Some guidelines:

■

The analyst must remain objective. There is nothing wrong with a

study concluding that the site is not great and/or hard to build on.

26 THE ESSENCE OF ANALYSIS

TABLE 1.1 Market Analysis Users and Their Objectives

Lenders Developers Architects Buyers/ Property

Objectives Partners Builders Designers Sellers Managers

Promotion and initial x

marketing efforts.

Communication with x x

local politicians and

decision makers for

project approval;

outreach to land use

and community groups.

Employment and x x x

relocation of corporate

tenants/buyers.

Investment strategies or x x

ﬁnancing efforts.

Project planning and x x x

design, long-term.

Cash ﬂow projections x x x x

and ﬁnancial analysis

for investor proﬁtability

and lender risk

assessment.

Due diligence, multiple x x x x

levels of review.

Management of completed x

projects—tenant matters

and maintenance.

ccc_kahr_ch01_1-28.qxd 8/3/05 11:50 AM Page 26

■

Take caution if and when the developer’s objectives are not clearly de-

ﬁned. The analyst cannot be expected to know the purpose of the

study without a clear deﬁnition.

■

The drive for proﬁts by the consulting company blurs objectivity. Be

wary of the consultant that produces a glowing report promising high

proﬁts, but that glazes over the risk.

■

The study should be performed as a team. No one person should be

expected to produce an objective summary of all of the market and

feasibility issues. The team not only assigns work to members based on

expertise; it also provides a good checks and balances system ensuring

overall objectivity.

■

Many projects suffer from fragmented development planning. In all

too many instances, the planning phase is ﬁnished before anyone ﬁg-

ures out what the demand is. The process cannot be broken up and

performed piecemeal. It has to move forward in an intelligent way. As

the saying goes, Don’t put the cart of desired results before the horse of

as yet unknown demand.

■

Lack of strong personnel damages the process of market analysis. A

lot of damage can be done by a staff that is afraid to give the boss bad

news, lose a proﬁtable client, or fear sounding negative. Telling the

truth based on a well-researched report and fully documented ﬁndings

provides integrity to the process.

The analyst should also make note of 10 common weaknesses in the

market study process:

1. Inadequate analysis of indirect economic forces, such as environmen-

tal, social, and political. It may be possible to build the project, but

what is the community’s stance on development? Research the politi-

cal issues locally, in the early stages.

2. Using best-case numbers. It is far more valuable and realistic—from

marketing as well as ﬁscal points of view—to use a range of possible

outcomes: best, moderate, and worst-case.

3. Ignoring the importance of sensitivity analysis. Some numbers, if

tweaked a little bit, can dramatically change the projections. Cap rate

is a typical one. When dealing with highly sensitive numbers or ex-

ceptionally long-term projections, a sensitivity analysis is appropri-

ate—a good place to insert a worst-case analysis.

4. Underestimation of infrastructure cost. Among the more expensive

possible problems is the failure to realistically appraise the opera-

tional costs of the project. Remember, the devil is in the details. But

the details are expensive.

The Good and the Bad on Studies 27

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5. Inadequate analysis, particularly of cash ﬂow. To many analysts, cash

ﬂow is too elusive to fully document. This is an error. Carefully docu-

ment all of your assumptions, so that if and when the numbers start

to vary, you can go back and identify the cause. You will need to pin

down the variance speciﬁcally: as related to market data, tax calcula-

tions, debt service, for example.

6. Excessive use of statistics without any hard, realistic conclusions.

Numbers are great, but only to the extent that they lead you some-

where. Avoid the temptation to replace difﬁcult conclusions with con-

fusing numbers and test runs using estimates only.

7. Failure to edit data property. When reports depend on irrelevant

data, how do we ﬁnd the relevant parts? Market data is hard to get.

So when you have limited data, be honest about it. The dis-

closure of these limitations is far more valuable than the use of num-

bers that simply do not help. At least then, the reader can ascertain

what the situation is. A lack of clarity increases the risk; and if noth-

ing else, the analyst’s job is to highlight where those risks lie.

8. Conclusions drawn on numbers but lacking consumer surveys. Such

surveys may be expensive and time-consuming, but they are often in-

valuable in what they reveal.

9. Overvaluation of land. The method you use to set value of land ver-

sus improvements will affect all subsequent ratios and ﬁnancial

tests—for lenders and investors, not to mention potential tenants or

buyers. Depend on appraisal documents to set a fair value, and avoid

the temptation to alter the numbers.

10. A failure to critically assess management. Who is the development

team? What is their experience? Even the best market analysis is use-

less unless management knows how to make it work. This problem

may be more relevant to the developer than to the analyst, who has

no direct power to make changes. But as a part of the analysis, it does

not hurt to emphasize the importance of professional management as

a linchpin of a project’s success.

In Chapter 2, we take these concepts to the next step and provide you

with the means to put analysis to work to make the project succeed.

28 THE ESSENCE OF ANALYSIS

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CHAPTER

Using Analysis Effectively

We may analyze markets using theories alone; however, we make

these analyses powerful tools for decision-making only when we

are able to express our ﬁndings in practical terms. This chapter

provides an overview of the analytical process. It explains how

analysis becomes an integral part of your business plan and its

underlying assumptions; how the scientiﬁc method is applied to

the study of real estate markets; and how to employ facts in the

context of three distinct versions of real estate supply and

demand.

he theory of market analysis is a starting point in our quest for informa-

tion. However, once we have mastered the theories—meaning we at least

know what questions need to be asked—a more challenging concept is how

to make that information useful and practical.

How do we convert market analysis into forms of action?

FACTORS AFFECTING MARKET ANALYSIS—

BEYOND THE NUMBERS

The market study and feasibility study may represent typical documents

as reﬂections of a properly completed market analysis process. However,

the mere presentation of fact is not enough. Just as accountants may

present ﬁnancial statements as rows and columns of numbers, those

statements become most valuable when the accountant also explains

what those numbers reveal. In real estate analysis, the same rule applies.

There are several important differences, however, between speciﬁc real

ccc_kahr_ch02_29-46.qxd 8/3/05 11:50 AM Page 29

estate analysis and the more universal interpretation of ﬁnancial results,

including:

1. Local market variables. Real estate trends cannot be studied on a na-

tional or even regional basis. Local trends—those trends in the imme-

diate vicinity—are all that really matter. Unlike most other forms of

market and ﬁnancial analysis, real estate analysis is, indeed, highly lo-

cal in nature.

2. Site-speciﬁc attributes. The nature of a site itself also affects the meth-

ods you employ in translating market analysis. Two sites of identical

size located next to each other may have vastly different potential due

to attributes. For example, site A may be visible from an interstate,

have a ﬂat topography, and good drainage. Site B may be on a slope

with a tendency for partial ﬂooding and the need for improved

drainage, and be invisible from the interstate or other well-traveled

roads. Clearly, these two sites are not comparable in terms of market

potential.

3. Current market economic conditions. If your market analysis was

completed six months ago, the question of whether it remains accurate

today must be raised. This is a chronic and recurring problem in real

estate market analysis. Moving a development from concept to com-

pletion is a long-term venture, but current economic conditions will

change during that process. This is one of many risk elements that

have to be considered by developers and builders, lenders or investors,

and end-users. If a robust market disappears by the time the project is

completed, those anchor tenants who signed long-term leases, the

lenders and venture capital investors, and the developer and builder,

will all be faced with the unpleasant possibility that the project no

longer passes the basic test of demand in the current market. Thus, any

study of current market conditions needs not only to consider the cur-

rent snapshot, but also to attempt to judge the longer-term trend.

4. Ever-shifting demographics. What happens to a residential develop-

ment concept if the largest employer in town closes shop and moves

elsewhere? What happens if an area suffering high unemployment sud-

denly ﬁnds itself the site of a major new employer? Clearly, these

changes in employment would be among many possible factors that

would change local demographic factors. People relocate to follow em-

ployment, perhaps more so than they move to escape high-crime areas.

Today’s demographic trends may shift unexpectedly if and when other

factors—notably economic—change in signiﬁcant ways.

5. Developer/owner imposed restrictions. Often overlooked in the mar-

ket analysis is the developer’s own restrictions. Some developers have

30 USING ANALYSIS EFFECTIVELY

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realized that investing in exceptional design, working closely with lo-

cal citizens and government interests, and striving to improve local

conditions provide great ﬂexibility and creativity to the company or

individual preparing market and feasibility studies. However, some

other developers take a bare bones approach and are not willing to

spend more up-front capital than required minimally. Their design

tends to be ﬂat and unimaginative; communication locally is poor

and often leads to (and in some cases, creates) antidevelopment senti-

ment; and successful developers have to maintain at least an interest

in social and public policy, if for no other reason than that it can

boost proﬁts.

6. Financing limitations from lenders or equity partners. Few projects are

initiated with the mandate, “Money is no object.” Invariably, lenders

will not only specify a limited risk level they are willing to assume (and

that is almost always less than 100 percent of the project’s require-

ments). Lenders will also demand ongoing accountability in project

completion and scheduling. Equity partners will impose similar restric-

tions, concerned not only with project costs and scheduling, but

equally with cash ﬂow and proﬁtability after completion.

7. Design elements and their inﬂuence on outcome. The marketability of

a project will depend to a signiﬁcant degree on the design itself. A

plain, minimally compliant design may pass government standards but

will not add to the ambient nature of the surrounding area. Excep-

tional design is more than how buildings and roads are placed; it im-

plies innovative architectural elements, heating and cooling systems,

and environmental decisions as well. Investment in exceptional design

can create dividends in future market value; thus, market analysis

should take into account the design philosophy of the developer and

architect. The key is to focus on architecture as not just making a

building pretty, but rather to focus on how design can boost the opera-

tional efﬁciency of a building on behalf of its tenants.

8. Local support of or opposition to a project. The question of local atti-

tudes toward new development cannot be ignored in the feasibility of a

project. Because ﬁnancial outcome depends on careful scheduling, it is

critical to be aware of the effects of local opposition and the potential

for project delays. Developers can take many steps to prevent or mini-

mize opposition through preemptive steps like early communication.

Most opposition movements thrive in information vacuums, so the key

to reducing opposition is to make contact and maintain it with citizen

groups, agencies, and elected ofﬁcials. Other developers choose to take

a silent approach and try to drive the process through quickly to mini-

mize dissent.

Factors Affecting Market Analysis—Beyond the Numbers 31

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THE ANALYTICAL PROCESS

There is an all too human tendency to begin with an assumed conclu-

sion, and then to seek out facts that support that conclusion. However,

this tendency can also serve as a trap. One possible way to view the ana-

lytical process is to seek the truth, even if the truth contradicts what we

expect to ﬁnd.

The scientiﬁc method is a process employed in analysis, with the

purpose of ﬁnding an accurate and unbiased answer to a question or to a

series of questions. The scientist, in testing an initial hypothesis, is satis-

ﬁed with results because, at the very least, a negative outcome eliminates

one possibility. When Thomas Edison stated that he had tried more than

2,000 ideas before ﬁnding a working carbonized ﬁlament for the light

bulb, he was asked, “Does that mean you failed 2,000 times?” He

replied, “No, it means that I found 2,000 ways to not make the light

bulb work.”

There are four speciﬁc steps to the scientiﬁc method, designed to not

only test ideas but also to reliably eliminate possible outcomes that do not

work. These steps are:

1. Observation. In the case of market analysis, an initial observation may

be an apparent growth in the demand for market-rate housing.

2. Hypothesis. The developer may begin with the belief that it will be

proﬁtable to acquire land, build houses, and sell them at a proﬁt.

3. Prediction. The developer hires experts to perform market and feasi-

bility studies.

4. Testing. Objective tests are performed to ensure the validity of the pre-

vious three steps. For example, cash ﬂow projections may prove that

the idea has merit; it might also prove that the idea as conceived will

not work.

32 USING ANALYSIS EFFECTIVELY

Valuable Resource

For information about the scientiﬁc method, check the following web

sites:

http://teacher.nsrl.rochester.edu/phy_labs/AppendixE/AppendixE.html

http://www.selu.edu/Academics/Education/EDF600/Mod3/

http://koning.ecsu.ctstateu.edu/Plants_Human/scimeth.html

ccc_kahr_ch02_29-46.qxd 8/3/05 11:50 AM Page 32

In the performance of these steps, it is all too easy to derail the scien-

tiﬁc method. If a developer views market analysis as a tool for obtaining

ﬁnancing—in other words, as a means to marketing the idea and nothing

else—then the validity of conclusions may be in jeopardy. If the mandate

given to the consultant is to prove a speciﬁc conclusion, then the outcome

has been predetermined and will not be accurate.

You need to ensure that the hypothesis is valid and that the right types

of tests are performed. Otherwise, the outcome will not be reliable. In the

example of a market study for real estate, possible ﬂaws in the hypothesis

may emerge from the study, including:

■

An inaccurate picture of demand. In a rental housing project such as

apartment buildings, developers may proceed based on an analysis of

waiting lists. However, these are not exclusively made up of people

who lack housing; these lists may include people currently residing in

other rental housing who desire to relocate. Thus, demand assump-

tions based on the existence of waiting lists could be highly inaccurate.

The construction of new rental housing units may serve to increase va-

cancies in existing housing. In fact, real market demand could be far

lower than the market study concludes. This is difﬁcult to know be-

cause many agencies, such as local housing authorities, keep their

waiting lists conﬁdential; and location services often inﬂate both sup-

ply and demand sides to create the illusion of more activity on the

market. Given these problems in quantifying the real level of supply

and demand, it is impossible to discover how many people on those

lists currently have housing and would simply move, versus the un-

known number of people who want to relocate in the area or section

of town, but cannot ﬁnd apartments.

■

A less than accurate picture of the market area. In the case of residen-

tial projects, the big question involves source of tenants. Where will

residents come from and where do they live now? If, in order to justify

the construction of additional units, the assumed market area is ex-

tended far from the site, it becomes increasingly unreliable.

■

Misunderstood employment statistics. A study of local employment

and trends in employment is easily misrepresented or misunder-

stood. For example, the major employer in an area may be down-

sizing, meaning that in the future there will be fewer jobs. So even

though this employer provides a lot of jobs locally, the level of

new jobs may be more dismal than an uninformed or biased study

would reveal. Another reality that may affect results is seasonal em-

ployment. If an area depends on tourism during warmer months,

what happens in the off-season? What may appear to be a robust

The Analytical Process 33

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economy with low unemployment may, in practice, be that way only

during half the year.

These possible areas affecting the reliability of the market study—and

possibly other conclusions as well—demonstrate that the scientiﬁc method

is a useful tool for avoiding inaccurate conclusions in the study of supply

and demand. On this topic, one writer has cautioned that

It is easy sometimes to focus on supply, because you go out and

count the trees—or homes or ofﬁce buildings. But how does the

supply of space in existence, under construction, planned, or oth-

erwise expected to come on line correlate with historical, current,

and forecast levels of demand? Are any apparent variables ex-

plainable? . . . it is easy to focus on supply. Demand is much more

difﬁcult to determine.

Assumptions or predictions based on artiﬁcial or misread demand for

rental units leads to exaggeration on the demand side—one of the great

problems in attempting to justify demand assumptions when, in fact, only

the supply side has been identiﬁed and, of course, it also may have been ex-

aggerated. Lacking strong assumptions on the demand side, it is all too

easy to also misread local indicators.

The testing phase will be ﬂawed if, in fact, the wrong data is tested.

The developer and/or the consultant preparing the market study may inter-

view the head of a housing authority for example, who conﬁrms the

premise that demand for new rental housing is high. Local politicians may

voice similar beliefs. Ultimately, though, the testing will be ﬂawed if supply

is adequate for the real level of demand, and demand itself is inﬂated

through (1) duplication of names on several lists, (2) names not removed

when people ﬁnd housing or move away, or (3) names on waiting lists of

people occupying units who are part of the current supply. In cases where

the developer wants a project to proceed, the incentive may be to maximize

the demand for a particular project. As long as the developer is in control

of how the market study is prepared and presented, the testing will be

questioned.

The same problems with methodology would extend to the feasibility

study. Any relatively skilled accountant can manipulate the numbers to

make assumptions work out to reﬂect future positive cash ﬂow. But again,

if the underlying assumptions are not accurate, the ﬁnancial projections

will not be accurate, either.

A developer approaching potential lenders or equity partners—not to

mention agencies granting tax credits, for example—may dispel suspicion

34 USING ANALYSIS EFFECTIVELY

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by subjecting their proposal to a completely neutral consultant. By allow-

ing a lender or equity partner to select a consulting ﬁrm that includes pro-

fessional accounting and appraisers, the opportunity to create a desired

outcome will be limited. While the majority of developers would be willing

to subject a sound marketing idea to independent analysis, everyone will

want to be aware that the minority may desire to use the system—includ-

ing local planners and citizens, tax incentive programs, and, of course,

lenders or investors—to create a desired outcome rather than to study the

initial assumptions objectively.

MARKET ANALYSIS AND BUSINESS PLANNING

In some respects, the combined market and feasibility studies serve the

same purpose as the more generalized business plan. However, there are

important differences as well, notably when real estate is involved.

A business plan usually combines detailed budgets and ﬁnancial as-

sumptions with an extended-period marketing plan. This normally is found

in business environments where the product or service is well-understood.

In real estate, the market and feasibility studies begin with the following

assumptions:

■

The market is well-understood. The business plan usually is aimed at

moving product or service to a well-understood market. A food man-

ufacturer sells to grocery store chains and identiﬁes the shopper as its

primary market. Financial service ﬁrms target families needing invest-

ment and insurance advice. In the case of real estate, the market may

be more elusive, but its elements remain constant. The end-user and

the all-important physical location of that end-user will directly im-

pact how a project is developed. We need to begin on an important

basic theme:

■

The product itself may also be a variable. If we begin with a project

concept, its very feasibility will be determined by the market study, fol-

lowed by a test of the ﬁnancial assumptions. We may discover, in fact,

that the original concept needs modiﬁcation, as a factor of market de-

Market Analysis and Business Planning 35

Assumption: In real estate, we know who constitutes our market,

and where that market is located.

ccc_kahr_ch02_29-46.qxd 8/3/05 11:50 AM Page 35

mand levels and costs. In the business plan, the product does not vary,

but the market does. In the real estate market analysis process, both

market and product have to be treated as potential variables. A second

theme emerges:

■

Market factors, either economic or demographic, may change. In the

business plan, a starting point often grows from a well-understood,

unchanging economic and demographic data set. For example, a com-

pany that runs theme parks understands the demographic it serves:

families with small children. It also knows that its own ﬁnancial pro-

jections have to be based on national economic conditions. In compar-

ison, the question of demographics is not speciﬁc in real estate

developments. That depends on other local factors such as employ-

ment trends and housing costs. Economics also shift, at times during

the project completion itself. Economic and demographic factors, by

deﬁnition, are cyclical and trend-based and are not stationary. This is

easily overlooked but an important distinction to keep in mind. The

third important theme to remember in market analysis is:

We cannot treat real estate market analysis in an identical manner as

the business plan. Another way to make the distinction is from the devel-

oper’s own perspective. The developer’s market analysis is speciﬁc to a pro-

ject and site, the local market and current trends, and the ﬁnancing

prospects and limitations. However, that developer’s own business plan en-

compasses the entire business and marketing theme, objectives and stan-

dards, and proﬁtability.

The business plan is an essential self-deﬁning document for the business

venture. The real estate marketing analysis refers to a speciﬁc project. The

36 USING ANALYSIS EFFECTIVELY

Assumption: Our concept of the real estate product is determined

not by the original idea as much as by the outcome of critical

market and ﬁnancial analysis.

Assumption: Market factors affecting both competitive and ﬁnan-

cial feasibility are always variables and have to be treated as cycli-

cal phenomena.

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business plan deﬁnes (among other matters) the owner’s objectives. For ex-

ample, a particular developer, architect, or builder specializing in upper-

income markets may establish a strong priority for creating projects of

innovative design and exceptional artistic quality. Another ﬁrm might not

even discuss the issue of quality, preferring to establish proﬁt goals only.

Low quality is acceptable if appropriate to a particular project. If a devel-

oper is building low-income housing units, the kitchens will not include

marble countertops. While we do not suggest that the importance of busi-

ness planning should be ignored, we emphasize that it is not the same as

market analysis. The consideration of a speciﬁc site and its market potential

is part of the speciﬁc job, just as a builder lays a foundation for a building,

and just as a writer outlines chapters for a book and deﬁnes the potential

reader as a starting point. Developers, architects, designers, builders, and

lenders or investors, all need the exact level of deﬁnition for both markets

and ﬁnancial projections that are derived from market analysis.

THE KEYS TO MARKET ANALYSIS:

SUPPLY AND DEMAND

At the heart of the business plan are budgets, goals, and market deﬁnitions.

This is a well-understood concept, and the process of preparing and ﬁnaliz-

ing a business plan may invigorate management and employees. At the

heart of market analysis is the dominant economic consideration: supply

and demand

While the premise of supply and demand in a free economy is well-

known as a basic premise, the application of these forces in real estate mar-

ket analysis is more complex. In fact, market analysis needs to consider

three different forms of supply and demand: These are in relation to the

obvious market form (supply and demand for real estate); the associated

rental supply and demand (tenant demand versus rental supply); and capi-

tal (ﬁnancing and associated interest rates or equity capital from investors).

Real Estate Supply and Demand

The most apparent and best-known form of supply and demand is reﬂected

in the market value of real estate. The theory is not complex. The higher the

supply of properties on the market of a speciﬁc type (single-family residen-

tial, retail, or industrial, for example), the softer the demand; and the higher

the number of buyers, the higher the demand. These factors and the trends

they follow determine market value. When properties are in short supply—

meaning there are more buyers than sellers—prices are forced upward. And

The Keys to Market Analysis: Supply and Demand 37

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when there are an excess of properties—meaning there are more sellers than

buyers—prices level out and may even fall.

While most people may be aware of real estate supply and demand ba-

sics, they may not appreciate the trends that underlie and are reﬂected by

these same forces. A lot of information is presented in the press and

through industry associations on a national level; but in fact, all real estate

trends are strictly local. We cannot judge the market in New York City by

the same standards as the market in Sioux Falls, South Dakota. Every as-

pect of the market, attributes, economic and demographic trends, and

competition are dissimilar so any attempt at comparison is invalid. How-

ever, if we review real estate supply and demand on a national level, we see

only an average; such averages do not reveal any meaningful information

about what is happening in a speciﬁc city or town or from one neighbor-

hood to another.

Some analysts make the mistake of assuming that real estate trends can

be tracked through a study of national averages, overlooking the local real-

ities of real estate prices; or of trying to associate real estate valuation with

inﬂation, as expressed by the Consumer Price Index (CPI). Housing, in

fact, is not included in the CPI. “Price level changes for items such as toma-

toes and video recorders have very little to do with changes in real estate

prices,” one analyst reminds us, and “price levels should not be viewed as

independent of a speciﬁc market.”

It is fair to observe that real estate trends vary from one location to an-

other, whether we are discussing towns, cities, counties, or metropolitan

areas. But the local nature of real estate is even more speciﬁc. The price of

a home on a busy street will differ from an identical home one block away

on a quieter street. The location of a regional mall near an exit on Inter-

state 35 just north of Austin, Texas, will have attributes far different from

those for a strip mall in the southern part of Sacramento, California. The

attributes, speciﬁc location, age and quality, and other competitive factors

make it impossible to compare two dissimilar properties when their areas

have nothing in common.

Supply and demand in real estate—to the extent that investment value

is affected—must be reviewed not on any national average basis, but on a

local basis. Even checking the housing trends on a regional basis are less

than revealing. For example, the Northeast encompasses areas including

rural Pennsylvania as well as Manhattan’s Upper East Side. The West in-

cludes the Yuma desert and downtown Phoenix, vastly dissimilar markets.

The reports on these regional markets are merely regional averages; to

judge your local market accurately, it is imperative that such averages not

be used; the local market forces are all that matter. National and regional

38 USING ANALYSIS EFFECTIVELY

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averages may be useful for comparative analysis between a speciﬁc site and

those averages; but regional and national averages are not the market in

any single city, town, county, or neighborhood.

Rental Supply and Demand

While the well-known market supply and demand dominates the attention

of most investors, an equally important variation is the market for rentals.

When the number of available rentals exceeds the number of renters, mar-

ket rents decline; and when the number of renters exceeds available rentals,

market rents rise.

This market is directly observed through trends in occupancy levels.

When occupancy is consistently high—97 percent or 98 percent, for exam-

ple—it indicates that the demand for rentals is high. When occupancy slips

and begins to trend downward, it indicates that an excess of rentals has oc-

curred. In some markets, these trends are seasonal and should be observed

as such. For example, if a large portion of the local population consists of

college students, of whom the majority are invariably renters, the supply

and demand should be expected to reﬂect changes tied directly to the

The Keys to Market Analysis: Supply and Demand 39

Valuable Resources

The National Association of Realtors (www.realtor.org) compiles and

publishes housing data based on regional studies. The regions as deﬁned

by the NAR include:

Northeast: Connecticut, Maine, Massachusetts, New Hampshire,

New Jersey, New York, Pennsylvania, Rhode Island, and

Vermont.

Midwest: Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota,

Missouri, Nebraska, North Dakota, Ohio, South Dakota, and

Wisconsin.

South: Alabama, Arkansas, Delaware, District of Columbia, Florida,

Georgia, Kentucky, Louisiana, Maryland, Mississippi, North

Carolina, Oklahoma, South Carolina, Tennessee, Texas, Virginia,

and West Virginia.

West: Alaska, Arizona, California, Colorado, Hawaii, Idaho,

Montana, Nevada, New Mexico, Oregon, Utah, Washington,

and Wyoming.

ccc_kahr_ch02_29-46.qxd 8/3/05 11:50 AM Page 39

school schedule. If the school does not offer a complete summer curricu-

lum, vacancies will rise and the market will see reduced demand for the

season. However, once school begins anew, that trend will immediately

turn around. As with all trend analysis, seasonal variation should be taken

into account to ensure that the conclusions drawn are accurate.

Cause and effect in rental occupancy rates reﬂects trends in develop-

ment. If the area experiences exceptionally high volume of apartment

construction, the supply and demand interaction will be affected as soon

as units become available. Historically, development tends to outpace de-

mand, so the market is continually moving back and forth between sup-

ply and demand. Short-term trends are chaotic and it is often difﬁcult to

spot trends without a broader view. However, from a landlord’s point of

view, whether involved with residential or commercial properties, the di-

rection of the trend often deﬁnes cash ﬂow success or failure. In the

course of market analysis, identifying the longer-term trend and antici-

pating the three- to ﬁve-year likely supply and demand realities is an im-

portant step.

It is also essential to recognize that real estate supply and demand (re-

ﬂected in the prices of properties, the time they remain on the market, and

comparisons between listed price and ﬁnal sales price) is not always the

same as the rental market’s supply and demand. Much depends on the

price level for properties and market rent levels. It is entirely possible that

some markets will experience strong market demand but weak rental de-

mand. For example, in a predominantly retirement-aged community, the

majority of people may own their homes but, due to the lack of jobs, few

younger individuals and families are likely to be found in the community.

Conversely, it is also possible to witness a market with very strong rental

demand and at the same time, a weakness in residential property prices.

This may occur in areas with large student populations but relatively few

jobs. Medium-sized cities in the Midwest may meet this deﬁnition. A large

student population means higher than average rental demand for the popu-

lation level, but at the same time there may be little requirement for owner-

occupied housing.

This disparity further demonstrates why it is essential to study every

local market individually. Formulas do not work everywhere. For example,

if a market analysis were to conclude that shopping trends represent a spe-

ciﬁc factor per capita, how might that conclusion be different in dissimilar

markets? A county located near the Canadian border may be inaccurately

gauged based solely on local population. A largely student population is

going to be vastly different from retirement-aged households. A city with

190,000 population in a primarily agricultural area of the country will not

share the same demographic attributes (thus, rental demand requirements)

40 USING ANALYSIS EFFECTIVELY

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as a city of the same size located within commute distance of a major met-

ropolitan region. Consider the following population examples:

City Population (2004)

Des Moines, IA 193,333

Lincoln, NE 192,722

Greensboro, NC 191,591

Montgomery, AL 190,831

Madison, WI 190,816

Grand Rapids, MI 189,673

Yonkers, NY 188,185

Residents of Yonkers, New York, may easily commute to Manhattan,

the largest city in the United States. However, those living in Lincoln, Ne-

braska, or Madison, Wisconsin, would experience far different employ-

ment prospects, not to mention property values, surrounding population

trends, and other important considerations. All of these cities share ap-

proximately the same population indicator, but that is where the similari-

ties end. We would further expect that the rental market supply and

demand for these cities would not be comparable; this points out the neces-

sity for reviewing a town or city individually, rather then employing for-

mula-based conclusions. Ratio analysis works in accounting, where

universally agreed upon standards apply. But in the rental market, there

are no universal standards for market rates, trends, or relative health

within the market.

Capital Supply and Demand

The third form of supply and demand is that for money, either debt or eq-

uity. Debt ﬁnancing—from a variety of potential conventional or private

lenders—is available at any time assuming that the developer is able and

willing to pay the going interest rate. And of course, rates—like all supply

and demand items—are cyclical. The span of these cycles may vary consid-

erably. For example, over an 11-year period from 1994 through 2004, the

prime rate changed only one percent (from 6.00 percent on January 1,

1994, to 5.00 percent on December 1, 2004). However, in the interim,

rates were as high as 9.50 percent and as low as 4.00 percent, a consider-

able range. While real estate rates are normally tied not to prime, but to

Treasury debt rates, we use this as an example. The prime rate tracks other

rates and reﬂects changes from federal funds rates to Treasury securities,

then to prime rate and above.

The Keys to Market Analysis: Supply and Demand 41

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Table 2.1 summarizes the prime rate during this period as of the ﬁrst

of each month. Note the December 1 rate, for example. By the end of

1994, and through to the end of 2000, the prime rate was supported for

the most part at about 8.00 percent and rose to 9.50 percent by 2000.

However, in 2001, a shift began in the second quarter, with rates falling

rapidly by the end of the year and remaining at about 5.00 percent for the

two years following.

The 11-year cycle using prime rates as of December 1 for each of these

years is summarized in Figure 2.1.

The concept that “money is always available” is only partially true. As

long as you are willing to pay a going rate for mortgages, which of course,

vary with changes in the long-term debt market such as U.S. Treasury

bonds, it is certainly possible to ﬁnd ﬁnancing for a project. A more reveal-

ing question, though, is whether the debt service on ﬁnancing is affordable.

If a project’s cash ﬂow is not adequate to cover the debt service, then in ef-

fect, the debt ﬁnancing is not available. If interest rates for mortgage ﬁ-

nancing rise, but market competitive forces do not, then cash ﬂow is

squeezed, perhaps to the point that the project is no longer feasible.

Within this same market—for capitalization—there may be equally

important but far more subtle supply and demand forces at work for eq-

uity ﬁnancing. Finding venture capital investors or limited partners de-

pends partially on other available real estate investments and partially on

tax beneﬁts or restrictions. Until 1986 investors were able to invest in lim-

ited partnerships and reduce taxes considerably. With top federal rates at

50 percent, tax incentives were attractive and many tax shelters were de-

signed to exploit the rules.

42 USING ANALYSIS EFFECTIVELY

TABLE 2.1 Prime Rate History

Date 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Jan 1 6.00% 8.50% 8.50% 8.25% 8.50% 7.75% 8.50% 8.50% 4.75% 4.25% 4.00%

Feb 1 6.00 9.00 8.25 8.25 8.50 7.75 8.50 8.50 4.75 4.25 4.00

Mar 1 6.00 9.00 8.25 8.25 8.50 7.75 8.75 8.50 4.75 4.25 4.00

Apr 1 6.25% 9.00% 8.25% 8.50% 8.50% 7.75% 9.00% 8.00% 4.75% 4.25% 4.00%

May 1 6.75 9.00 8.25 8.50 8.50 7.75 9.00 7.50 4.75 4.25 4.00

Jun 1 7.25 9.00 8.25 8.50 8.50 7.75 9.50 7.00 4.75 4.25 4.00

Jul 1 7.25% 9.00% 8.25% 8.50% 8.50% 8.00% 9.50% 6.75% 4.75% 4.00% 4.25%

Aug 1 7.25 8.75 8.25 8.50 8.50 8.00 9.50 6.75 4.75 4.00 4.25

Sep 1 7.75 8.75 8.25 8.50 8.50 8.25 9.50 6.50 4.75 4.00 4.50

Oct 1 7.75% 8.75% 8.25% 8.50% 8.25% 8.25% 9.50% 6.00% 4.75% 4.00% 4.75%

Nov 1 7.75 8.75 8.25 8.50 8.00 8.25 9.50 5.50 4.75 4.00 4.75

Dec 1 8.50 8.75 8.25 8.50 7.75 8.50 9.50 5.00 4.25 4.00 5.00

ccc_kahr_ch02_29-46.qxd 8/3/05 11:50 AM Page 42

For example, a ﬁve-to-one limited partnership allowed an investor to

claim deductions at ﬁve times the amount invested. So an individual pay-

ing taxes in the 50 percent bracket could invest $10,000 in a limited part-

nership and, by way of accelerated depreciation, claim a ﬁrst-year tax

loss of $50,000, or a loss equal to ﬁve times the amount invested. This

tax loss reduced the individual’s tax liability by $25,000 (in the 50 per-

cent bracket). So for an investment of $10,000, liabilities were reduced

by $25,000.

These shelter programs were closed down with the Tax Reform Act

of 1986 (known as TRA). Now, investor deductions are limited to at-risk

capital (investment plus recourse loans). Furthermore, in a passive invest-

ment such as a real estate limited partnership, while real estate profes-

sionals live with different rules, for most investors losses cannot be

deducted but have to be carried forward and applied against future pas-

sive proﬁts.

The current tax incentives for real estate investment are far less attrac-

tive than they were in the pretax reform days. However, equity investors

may still be interested in placing money into real estate developments when

the economic assumptions make sense. In the tax shelter days, the primary

concern was for immediate tax beneﬁts; now the numbers have to work in

order to attract equity partners.

The Keys to Market Analysis: Supply and Demand 43

FIGURE 2.1 Eleven-Year Summary, December 1 Prime Rate

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

December 1

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The competition for equity ﬁnancing—other developments or pools

such as real estate investment trusts (REITs) and mortgage pools, and simi-

lar programs—will appeal to investors as long as potential returns are

higher or risks are lower. So in the supply and demand for equity capital-

ization, it is invariably a competitive environment.

THE NATURE OF ECONOMIC CONDITIONS

In any review of the real estate market—and remembering the three dis-

tinct forms of supply and demand—we need to remind ourselves that eco-

nomic conditions are continually changing. This is easily overlooked. In

the stock market, where shares are traded moment to moment, the liquid-

ity is apparent. In real estate, where liquidity is completely lacking in most

product forms (exceptions being certain publicly listed conduit investments

like REITs), it is easy to forget that the condition of the market is in a state

of change.

The tendency to consider current status of supply or demand as more

or less permanent may be a fatal ﬂaw in market analysis. If you listen to

your local real estate broker, you will likely be told that this is the best time

to buy; if you are a seller, the same broker is likely to opine that this is the

best time to sell. When we work within a system where our experts are

compensated by commissions, we are unlikely to ever be told that the mar-

ket is weak. In fact, if we already know it is weak, the broker is likely to

counterargue that the trend is beginning to turn around!

So when we see today’s economic conditions as strong or as weak, we

also need to be aware of some related facts, including:

■

The market is in a continual cycle of change. Today’s situation will

not last forever; in fact, it may be different next month. Consider the

changes in prime rate as demonstrated in Table 2.1. Rates remained

at 8.25 percent for the 14 months from February 1, 1996, through

March 1, 1997; and at 8.50 percent for 18 months from April 1,

1997, through September 1, 1998. But from the beginning of 2001

to 12 months later, the rate fell 56 percent from 8.50 percent to 4.75

percent. So there is no predictable pattern in supply and demand.

The example has ramiﬁcations for the trend in Treasury bonds rate,

thus the market for ﬁnancing; but the same uncertainty applies

equally to the market and rental versions of supply and demand

as well.

44 USING ANALYSIS EFFECTIVELY

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■

Today’s condition is never unmoving. The tendency among investors

and market analysts is to look at today’s economic snapshot and to

assume that this condition is permanent. Whether we explicitly be-

lieve this or not, the tendency is to draw conclusions on that basis.

This is a tendency worth resisting, because the assumption that an

economic condition is permanent may lead to errors in analytical

assumptions.

■

We must keep the three supply and demand variations in mind. Any

market analysis should be undertaken with independent considera-

tion given to the three forms of supply and demand: for market

prices, for rental units, and for ﬁnancing. If we ignore any of the

components of this overall economic analysis, the conclusions will

not be reliable. An analysis that ﬁnds all three conditions in agree-

ment as to the feasibility of a project is encouraging. The three may

act as conﬁrmation points in an economic forecast. However, any

opinion as to feasibility may be tempered when the three indicators

are not in conformity with one another. The market analysis will be

more reliable when the three different markets are critically ana-

lyzed together.

■

No one knows for certain the current cyclical direction or timing of

the market. In spite of what you may hear from experts, make a dis-

tinction between statements of fact and statements of opinion. Be-

cause opinion often is asserted as being factual, it is not always easy

to distinguish between the two. But any forward-looking, predictive

statement is only opinion. It may be based on experience, comprehen-

sive analysis, and a deep understanding of the many facets of real es-

tate economics; but even so, it is only an opinion. Just as you may rely

on opinion only as a means for justifying your own estimates (versus

attempting to prove that your estimates are correct), it is also impor-

tant that anyone preparing a market study or a feasibility study makes

clear distinctions between reporting between historical fact and pro-

jections. The factual record, including past ﬁnancial history and

trends, is most useful to support a premise included in a projection;

but it should be made clear where the discussion moves from fact to

opinion, if only because anyone reviewing the report may not make

that shift automatically.

■

No investment decisions should ever be made under pressure. If the

source of information is a seller or a seller’s broker, it is important to

be aware of the bias. It is never advisable to make decisions (or to rec-

ommend a course of action) until all of the data is gathered, sorted,

and studied; and until the analysis itself has been done.

The Nature of Economic Conditions 45

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■

In listening to advice or opinion, we should always consider the source.

Most sources of information have a bias. Anyone asking you to buy

property or to use services in the development or design of property,

has a self-interest in mind. This is human nature, and everyone is a

party to the interaction that is involved on the path from concept to

feasibility. However, let us not forget that, just as authors try to provide

value in order to sell books, the same is true of real estate brokers, de-

signers and architects, engineers, city planners, neighborhood groups,

and an inﬁnite line of experts we meet along the way.

46 USING ANALYSIS EFFECTIVELY

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CHAPTER

Valuation of Real Estate

What is a property worth, and why? This chapter presents the

principles of valuation that determine market value; basics of

appraisal science; and important economic and political trends

affecting valuation. Finally, we demonstrate how valuation needs

to be viewed on two levels: First, the basic principles of valuation

need to be mastered and second, we need to evaluate how an

investor actually enters the market with valuation questions in

mind.

arket analysis is a process of sensible observation. By being aware of

the factors that affect market value, it becomes possible to accurately

identify how those principles apply to a speciﬁc property; a group of prop-

erties; or to properties sharing similar attributes (location, size, age, zoning,

square feet, or neighborhood, for example).

Valuation is distinguished via attributes of properties and markets; fur-

ther clariﬁcations of value are based upon the priorities of the investor or

owner, including cash ﬂow and potential rental income tax beneﬁts or limi-

tations, and perceptions about future growth in market value. No one of

these valuation criteria are exclusive; they are part of a larger overall analy-

sis of a property’s value. As with all market, value itself consists partly of

what a property is worth today and partly what we believe it will be worth

in the future. One deﬁnition acknowledges the broad range of meanings,

but summarizes the meaning of value nicely:

The term “value” is often used inaccurately by non-qualiﬁed prac-

titioners. It is an abstract word with many meanings . . . In an eco-

nomic sense, market value has a speciﬁc deﬁnition—the present

worth of future beneﬁts realized from ownership.

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PRINCIPLES OF REAL ESTATE VALUATION

We begin with a summary of the major principles that govern valuation.

There are 10 primary concepts in this group:

1. Progression. This principle relates to one way in which market values

rise. Expressed as a statement, progression tells us, “A property’s

value may increase due to the existence of similar properties in simi-

lar locations, containing greater quality.” The idea that a rising tide

lifts all ships applies here. In fact, progression is also expressed by the

maxim that you proﬁt in real estate by buying the worst house on a

good block.

2. Regression. The opposite rule may work as well. A falling tide can

lower all ships or, as the regression principle reveals, “A property’s

value may decrease due to the existence of similar properties in simi-

lar locations, containing lower quality.” So an exceptional house may

not appreciate as one would expect if and when other houses—even

on the sale block—are outdated, obsolete, or poorly maintained. This

concept is closely related to the third principle in real estate valua-

tion, that of conformity.

3. Conformity. This concept is, “A property is most likely to appreciate

in value along with other, similar properties in the same neighbor-

hood.” So if an investor spends a lot of money to upgrade a house,

for example, conformity may limit the appreciation regardless of

how the work is performed. This relates to construction materials,

age of properties, number of rooms, and overall square footage and

style. If the neighborhood consists of 2,000 square feet, three-bed-

room, two-bath homes 10 years old, improving property above that

standard may not be proﬁtable. Converting a home by adding 500

square feet and changing the internal layout to four bedrooms and

three baths could be money poorly spent, based on the principle of

conformity.

4. Substitution. In real estate, comparison rules the way that valua-

tion trends become established. Thus, progression, regression, and

conformity are primary concepts. A variation on this theme is that

of substitution. This principle is, “A property’s greatest potential

market value is limited by the market value of other, similar prop-

erties.” Thus, it would not be realistic to judge market value in a

vacuum. Without considering the market value of similar proper-

ties located in similar areas, we cannot accurately analyze market

value of any property. This theory is easily observed. When two

48 VALUATION OF REAL ESTATE

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similar properties are for sale, the lower-priced one will tend to sell

ﬁrst and, as a result, the market value of the remaining property

may be lowered.

5. Change. This principle tells us, “No condition remains the same in-

deﬁnitely; change is part of the economic cycle.” Property values are

affected by change in several ways. These include local economic

and demographic trends, physical age and condition of the property

and surrounding properties, character of a neighborhood or city,

and natural events like disasters (hurricanes and earthquakes, for

example).

6. Anticipation. Real estate investors—like those in all markets—are

continually estimating the future value of properties. The principle of

anticipation may be stated as: “Market value often is affected by ex-

pectations about future events.” For example, if an investor believes

that a particular area is likely to experience growth in coming years,

that would mean property values would rise. The very expectation

actually increases demand, and valuation rises as a result. The cause

and effect can be more immediate than the time it takes for the cause

to occur. If a proposed rezone is in the works, properties in the af-

fected area could experience rise or fall in property value in anticipa-

tion of the change.

7. Contribution. This principle acknowledges a limitation on growth in

market value, notably in the case of improvements. The additional

market value one may expect from improving property is not equal to

cost, but to the contribution those changes make to actual market

value. Thus, in a low-demand market, an improvement may add only

$2,000 to market value even though actual cost was $5,000. In the

case of cosmetic repairs to properties in hot markets, the opposite ef-

fect may be seen as well. Contribution tells us, “Improvements add to

market value as a factor of current supply and demand, and not nec-

essarily on the basis of actual cost.” The principle of contribution can

also be deﬁned as being controlled both by increasing returns and by

diminishing returns. In other words, making improvements to prop-

erty will cause growth in market value to an extent (increasing re-

turns), but when improvements exceed that level, return on

investment begins to fall (diminishing returns).

8. Plottage. This principle observes that consistency in ownership of

land and zoning or usage, tends to maximize value. The principle

states that, “Land values tend to increase when adjacent lots are

combined into single ownership and put to a single zoning or use.”

This phenomenon is observed when a series of relatively small lots

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remain under-developed and are eventually purchased by one per-

son or company and subsequently developed. Each individual

would be unable to organize such a development when many own-

ers are involved.

9. Highest and best use. Closely related to plottage is the principle

that “Real estate valuation is maximized when land is utilized in

the best possible way.” Thus, rich farm land should be used to

grow crops and land located within sight of an interstate freeway is

best used for highway commercial zoning. The same observations

apply to all forms of zoning and usage. Real estate valuation is un-

usual in that sometimes 10 one-acre plots are worth more than one

10-acre plot. An analyst needs to compare land size to proposed

land use, and be prepared to adjust valuation based on a site’s vari-

ance from the idea.

This means looking at far more than just zoning and its obvious

attributes. Zoning is only one aspect, one expert has observed:

How many times have we seen statements in reports that con-

clude that the highest and best use of a property is as zoned?

Highest and best use, by deﬁnition, includes the legal, physi-

cal, and economic beneﬁts of ownership, plus social commit-

ments to a community at large.”

10. Competition. The last primary principle of valuation is directly re-

lated to the broader concept of supply and demand. The principle of

competition states, “Opportunities for proﬁtable investment lead to

competition.” This has ramiﬁcations for valuation of all properties. A

good idea is going to be imitated or duplicated. Thus, as long as de-

mand remains unchanged, the emergence of competing properties

will tend to dilute market value for all similar properties.

The 10 principles of valuation are summarized in Table 3.1.

MEASUREMENTS OF VALUATION

The principles of valuation are the guiding factors in market analysis; they

deﬁne how and why value rises or falls. They are fundamental. However,

an investment in real estate may be valued based on one of several different

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measurements in addition to price. Four speciﬁc measurements of valua-

tion are worth discussion. These are:

1. Proﬁtability. The increase in market value is, of course, the most ap-

parent method of measuring real estate value. In its basic form, real es-

tate value—the price at which buyers and sellers reach a meeting of the

minds—is at the core of this discussion. It is the primary means for dis-

tinguishing one property from another; from identifying the relative

real estate value growing from different zoning and land use; and for

spotting and quantifying trends in the market. Virtually everything

centers around price and, more speciﬁcally, the change in price over

time, or the price trend.

Just as stock market investors follow market price of stocks, real es-

tate investors also make a number of judgments concerning their market

positions based on the all-important price trend. But is that enough?

Perhaps emphasis on price alone is ﬂawed because it ignores the equally

important question of risk. In the stock market, a highly volatile stock

may grow in value quite rapidly but present an exceptionally high risk as

Measurements of Valuation 51

TABLE 3.1 The Ten Principles of Valuation

Progression. A property’s value may increase due to the existence of similar

properties in similar locations, containing greater quality.

Regression. A property’s value may decrease due to the existence of similar

properties in similar locations, containing lower quality.

Conformity. A property is most likely to appreciate in value along with other,

similar properties in the same neighborhood.

Substitution. A property’s greatest potential market value is limited by the market

value of other, similar properties.

Change. No condition remains the same indeﬁnitely; change is part of the

economic cycle.

Anticipation. Market value often is affected by expectations about future events.

Contribution. Improvements add to market value as a factor of current supply and

demand, and not necessarily on the basis of actual cost.

Plottage. Land values tend to increase when adjacent lots are combined into single

ownership and put to a single zoning or use.

Highest and best use. Real estate valuation is maximized when land is utilized in

the best possible way.

Competition. Opportunities for proﬁtable investment lead to competition.

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well. Investors saw this phenomenon—often too late—by investing in

the dot.com fad a few years ago. Those who put a lot of investment cap-

ital in Enron, WorldCom, Tyco, and many other corporations whose

bookkeeping practices were questionable, discovered the reality of risk

too late, and many lost large sums of money. Does the same caveat apply

to real estate?

The market prices of real estate cannot be observed day-to-day or

hour-to-hour as they can in the stock market. They can be observed di-

rectly only through sales prices and indirectly through asked prices.

Even so, the various risk factors unique to an area or a site should be

viewed along with price trends. If those trends are surprising in any

way, a skeptical interpretation of that may include a question of risk. If

land is exceptionally cheap today, might there not be a reason?

Example: A study of local classiﬁed ads reveals that as a general

rule, empty building lots average $75,000; however, a few ads offer

building lots for about $20,000. Why? Upon investigation, it is re-

vealed that the typical building lots have essential service hookups

nearby, but the lower-priced lots could not be developed unless the

owner were to pay to run those utilities. The cost of doing so would

add $50,000 to $60,000 to the advertised price of the lots. The lower-

priced land is not a bargain at all; to purchase land at the advertised

price would include the risk that utilities might never be run close to

the area.

Price is a good starting point in any market analysis. But valuation

contains many additional elements of risk and reward; the current

price of any real estate reﬂects a mix of factors, both advantageous and

disadvantageous. It is unlikely that an exceptional bargain can be

found without some offsetting factors.

2. Cash ﬂow. To many investors, cash ﬂow is more important than prof-

its, at least in the immediate future. A simple analysis may reveal that

even when growth trends are positive, cash ﬂow may negate the ad-

vantage itself. Consider the following summary:

Price of real estate $350,000

Down payment $ 70,000

Monthly payment, 6.5%, interest only payments $ 1,896

Rental income $ 3,700

Less: Operating expenses $ 2,800

Net operating income $ 900

Cash ﬂow after debt service and before taxes $ –996

Annual growth in property value (est.) 3%

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A basic analysis of this situation reveals that the overall invest-

ment will not be proﬁtable. If we accept the annual growth assumption

of 3 percent per year, the $350,000 investment will appreciate by

$10,500 in the ﬁrst year. However, cash ﬂow for the same full year will

be $–11,952 ($996 × 12). An argument may be made that an invest-

ment such as this is made for tax purposes. It is true that directly man-

aged real estate provides unique tax advantages. But the after-tax cash

ﬂow does not work out.

Referring back to the same numbers, even if we assume that the

entire monthly payment consists of interest and is deductible (ignoring

the fact that principal would not be deductible), do the numbers on an

after-tax basis continue to work? Let us also assume that depreciation

(a noncash deductible expense) is $10,909 per month. This is based on

a calculation involving residential property, which is depreciated over

27.5 years; and further, we assume that the land in this illustration is

worth $50,000, so the remaining $300,000 is subject to depreciation

(land cannot be depreciated). That would provide an annual deprecia-

tion allowance of $10,909 ($300,000 ÷ 27.5), or $909 per month.

Now the monthly numbers look like this:

Rental income $ 3,700

Less: Operating expenses –2,800

Net operating income $ 900

Interest –1,896

Depreciation –909

Taxable income $–1,905

If we assume that the effective total federal and state tax rate in this

situation is 40 percent (assuming 33 percent federal plus 7 percent state),

the monthly loss of $1,905 would create a reduction in income taxes of

$762 ($1,905 × 40 percent). (Incidentally, these calculations may be fur-

ther adjusted if and when the tax-based net loss exceeds the maximum

allowed per year.) Now how does the after-tax cash ﬂow look?

Net operating income $ 900

Less: debt service –1,896

Tax reduction + 762

Cash ﬂow after operating expenses and taxes $–234

We can conclude that this investment will produce after-tax nega-

tive cash ﬂow of $234 per month, or $2,808 per year. Returning to the

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original assumption that this property grows in value by 3 percent per

year, or $10,500, our cash ﬂow-based market analysis works out—but

this analysis is highly optimistic. It assumes that, in fact, the 3 percent

annual growth rate will continue to occur; that might not be accurate.

It also assumes that the rents will be collected every month without

any provision for vacancies. If growth estimates are correct, the com-

pounded effect of 3 percent per year will be far greater than the basic

$10,500 we have used. However, the point to be made here is that the

investor needs to be able to afford the monthly outﬂow for the invest-

ment to work.

The study of cash ﬂow as a method of valuation has two speciﬁc

components. First is the question of whether an investor can afford the

negative cash ﬂow. Even if the numbers are promising, one would need

to be able to continue spending more each month than was generated

from rents. If, in fact, those funds are not going to be available, then

the proposed investment simply lacks feasibility. The second compo-

nent involves investment assumptions. If we accept the premise that

the investor can afford the negative cash ﬂow, is the net after-tax cash

ﬂow higher or lower than the assumed growth rate of the property? If

that growth rate falls short of the after-tax negative cash ﬂow, we

again would conclude that the proposed investment lacks basic feasi-

bility. We cannot reasonably expect to proﬁt from investing funds, so

why proceed? In general, the concept of buying a property that loses

money year after year, but planning to make money in the long run

through price appreciation, is unwise.

3. Relative value of rental income. A third measurement of valuation is

related closely to the cash ﬂow issue, but it involves an additional in-

vestment component. Rental income varies based not only on trends in

demand for rental units, but also on the basis of location and property

condition. The owner of an apartment building may be unwilling to

perform routine maintenance, so conditions of the property are poor.

As a result, turnover is high and vacancies become a chronic problem.

This occurs even when demand is high, because the substandard condi-

tions make the site unappealing. Those who can afford to pay market

rates will prefer to do so, rather than live in a substandard apartment.

A buyer of such a property will recognize that the depreciated con-

dition also affects value. Income properties are normally appraised us-

ing the income method (discussed later in this chapter). Essentially,

value is derived from the income of the property. Clearly, an apartment

complex with higher than normal vacancies, drawing less than market-

rate rents, will appraise below market as well. The current owner may

not understand that maintaining such a property is, in fact, a wise in-

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vestment, or that the nominal savings accomplished by not spending

money to maintain the property creates far lower market value. So the

would-be buyer will recognize that the purchase price of such a prop-

erty would be a smart investment. By upgrading the property, the new

owner will be able to increase rents to market-rate levels, and also to

reduce vacancies. After that transition is complete, a new appraisal

would be likely to reﬂect a proﬁtable change in market value.

4. Tax incentives. Real estate investors have historically acknowledged

signiﬁcant valuation based on tax incentives. In the days prior to the

tax reforms enacted in 1986 (which effectively removed multiple

write-offs and instituted at-risk rules; restricted passive loss deduc-

tions; and reformed depreciation), real estate was a favorite haven for

tax avoidance, enabling those in top tax brackets to eliminate liabili-

ties. Since these reforms, those investing in passive forms of real estate

programs (limited partnerships, for example) can not claim loss deduc-

tions except to the extent that they offset passive gains. However, indi-

viduals who directly manage their rental income investments are

provided beneﬁts not available to other investors.

Those investors who are “actively involved” in management can

deduct up to $25,000 in annual losses on real estate. Meeting this test

is not difﬁcult; an owner must be tied to selection of tenants, decisions

to buy or sell properties, and maintenance. Even if a landlord hires a

management company, meeting this test is a matter of staying in touch

and putting in a minimum number of hours per month. To qualify, one

also must own at least 10 percent of the property.

An exception applies for what the IRS calls a “real estate person.”

This is anyone who generates more than half of his or her business ser-

vices in real estate; who performs more than 750 hours per year in real

estate business; who materially participates in real estate business

other than rental income; and who also materially participates in rental

income activity.

For the real estate person, real estate income is treated as nonpas-

sive, meaning that the level of annual loss deductions is not limited to

the $25,000 maximum otherwise allowed.

Even for those who are not real estate persons, the ability to write off

up to $25,000 per year is signiﬁcant. For many, the tax beneﬁt spells the

difference between positive and negative cash ﬂow, when calculated on

an after-tax basis. The deduction is restricted for those with adjusted

gross income (AGI) above $100,000; once that level is reached, the al-

lowable deduction is reduced by 50 cents for every dollar of adjusted

gross income. For example, if an individual’s AGI is $110,000, the allow-

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able maximum is reduced to $20,000 ($25,000 – 50 percent of $10,000).

Furthermore, the calculation of AGI for the purpose of this reduction is

modiﬁed from the AGI reported on an individual tax return. However,

for those with income below $100,000, the ability to reduce income by

up to $25,000 is an important feature in valuation; the beneﬁt—repre-

senting reduced overall tax liabilities—should be viewed as a tangible

beneﬁt of owning rental income.

Making this even more attractive, it is possible to have a positive cash

ﬂow from real estate investments and, at the same time, report a net loss

for tax purposes. This is possible because real estate investors can deduct

depreciation. This expense is a noncash expense, calculated based on the

value of the improvements (which is roughly the purchase price minus

value of land) and is allowed over a period of years (the recovery period).

Depreciation is a complex topic beyond the scope of this book; however, it

is an important feature in the calculation of cash ﬂow and proﬁts from real

estate, as well as a feature in determining valuation.

A key point is that while depreciation is often confused with the eco-

nomic life of an asset, it is not the same thing. Most real estate retains its

market value long after its depreciable basis has fallen to zero.

Investment Features Affecting Valuation

In determining a broad-based conclusion of valuation for real estate, we

must further consider the features of the investment. In any form of invest-

ment, it is not reliable to classify a particular selection as good or bad with-

out further analyzing these important features. They are liquidity, leverage,

risk, and marketability.

Liquidity A comparison between two or more investments is accurate and

reliable only when the attributes are comparative as well. Thus, comparing

a highly liquid purchase of publicly exchanged stock, to an illiquid long-

term real estate purchase, is not truly comparable. Thus, any calculation of

return on investment, risk, or other important features would be similarly

unreliable. We cannot judge real estate comparatively without being aware

of liquidity issues. Direct ownership of real estate is illiquid under three

distinct deﬁnitions.

Lack of Secondary Market Some forms of real estate are illiquid because

ownership cannot be easily transferred on an open, public exchange. The

stock market is a highly liquid market, but units of limited partnerships,

for example, can often be sold at a discount. The secondary market is

lacking, because used partnership units are not appealing to new investors,

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as a general rule. As the maxim goes, “Limited partnership units are not

bought, they are SOLD.”

Potential for Low Demand in Public Markets A second form of illiq-

uidity is found even when investors own real estate directly. If the mar-

ket is soft in terms of demand, the property is illiquid with one of two

consequences. First, it may take far longer to sell than the owner consid-

ers desirable. Second, it may be necessary to reduce the asked price in

order to compete with other sellers. Owners also have to pay capital

gains tax and tax on accumulated depreciation when they sell. This is a

huge disincentive to selling. It can be compensated for, however, through

the use of a 1031 exchange, also called a like-kind exchange. In that de-

vice, taxes on a current gains are deferred until a future sale of a replace-

ment property.

Cost of Buying and Selling For directly owned real estate, it is expensive

to buy and sell. Closing costs can easily absorb or even surpass a marginal

proﬁt, so in order to justify tying up capital, investors need to hold prop-

erty long enough for its market value to season. The only alternative in

dealing with this form of illiquidity is to reﬁnance to remove appreciated

equity, or to acquire a second mortgage or line of credit.

Leverage Most directly owned real estate is purchased with a down pay-

ment, often 30 percent or more for investment properties. The balance is ﬁ-

nanced. In this situation, an investor leverages the cash investment,

controlling 100 percent with only 30 percent down. While many consider

this a distinct advantage, notably when market values rise quickly, it is also

a higher risk. The investor depends on consistent cash ﬂow as a require-

ment for keeping up with debt service. A one-month vacancy may be seri-

ous, and a two- or three-month vacancy fatal if the investor has no cushion

to make it through extended vacancy periods.

Risk The concept of risk is easily underestimated, especially by real es-

tate investors. There is a tendency to dismiss risk on the argument that “it

is easy to make money on real estate.” However, a number of risks should

be kept in mind. These include the all-important cash ﬂow risk as well as

less obvious risks: a slow market in which market value does not rise or

even falls; catastrophic loss due to disasters not covered by insurance poli-

cies (including volcanic eruption, or earthquake, for example); the disas-

trous experience of having a tenant who does not pay rent and who

refuses to vacate, and perhaps even one who destroys the property; and of

course, the risk of a softening rental unit market. All of these risks should

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be understood as factors in real estate investing; for many, these risks re-

duce valuation to the point that it is not worthwhile.

Another form of risk involves spreading capital among markets with

dissimilar features. Popularly called diversiﬁcation or the avoidance of

losing all invested capital in a single investment choice, the risk here is

more accurately distinguished as asset allocation, or placing capital in en-

tirely different markets. Diversiﬁcation is best understood as placing

funds in several different stocks or investing in mutual funds to spread

risk; asset allocation is more closely associated with disparate market se-

lection, such as stocks, savings, and real estate. Because real estate re-

quires a large sum of investment capital, even in the form of a leveraged

down payment, it is easy to forget or ignore the importance of asset allo-

cation. Applying the concept of asset allocation is often difﬁcult for in-

vestors of moderate means; it is difﬁcult to diversify limited capital

within the real estate asset class. The risk remains, however; if most of an

individual’s capital is placed in real estate, the asset allocation risk is very

real. If real estate stagnates while stock market values become quite

strong, the missed opportunities from poor allocation and planning affect

overall proﬁts.

Marketability The last of the four investment features is marketability.

This is not the same as liquidity, although some of the same features apply.

By marketability, we mean the existence of a ready buyer when a current

owner wants to sell. Some real estate is going to lack marketability, for any

number of reasons. For example, an individual who buys property ﬁ-

nanced by the seller may not realize that the property cannot be ﬁnanced

through conventional channels. In some areas, houses with post and beam

foundations do not qualify for bank ﬁnancing; only those with permanent

foundations meet the criteria. So a seller-ﬁnanced home may be marketable

only through private ﬁnancing. It is often true that what seems an attrac-

tive deal—seller will carry the loan—is in reality a situation in which the

buyer takes on the seller’s problems. In terms of ﬁnancing, such a property

is not marketable.

Marketability is also affected by obsolescence, the expense of outdated

utilities, poor insulation, bad plumbing and electrical systems, or—in a

general sense—the need for repairs that exceed the equity in the property.

This last form of problem, one in which the property is essentially “to-

taled,” is especially troubling to the inexperienced real estate purchaser, the

individual who views the ﬁxer-upper or landlording market as a method of

building wealth in real estate. The concept of marketability refers to a

range of issues that are not always apparent, which make an investment a

poor choice.

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Appraisal Methods

The ﬁnal word on valuation is the appraisal. This is an analysis and report

prepared by a professional appraiser. An appraisal may be performed for a

lender as part of a loan application and review; by an attorney or escrow

company during the closing of a sale; or as part of a procedure to establish

current market value (closing of an estate, probate, or during a divorce, for

example).

While it may be generally assumed that a property has a single, true

value, reality demonstrates that this is not so. Based on the reason for the

appraisal and the motivation of the individual or company paying for it, a

range of reasonable estimates of current market value is possible. For ex-

ample, a lender who favors granting a loan based on strong credit of the

borrower needs primarily to ensure that the stated equity and value of

property are within reason. An attorney representing one side in a divorce

proceeding may be more interested in gaining veriﬁcation that property

value is lower than the adversary for the other side believes. While, in an

ideal world, all appraisals would be entirely unbiased, these realities cer-

tainly affect how appraisals are performed. But no matter what that moti-

vation, the appraiser is supposed to verify that the stated value is within

reason. State licensing boards also exist to ensure that if an appraiser

grossly abuses their position, they may have their license revoked.

Appraisers who work locally may be best qualiﬁed to render a solid

opinion because they are familiar with area trends and values. They know

where to locate comparable neighborhoods and properties; and they are

connected with local real estate and lending professionals.

Appraisers use one of three methods, and the applicable method de-

pends on the purpose of the appraisal as well as type of property. The three

methods are cost, market or sales comparison, and income. Many ap-

praisals of residential property compare the ﬁrst two methods and then ar-

rive at a reasonable estimate of current value based on that comparison.

Commercial appraisers tend to rely on the third method.

Measurements of Valuation 59

Valuable Resources

To ﬁnd a local appraiser, check qualiﬁcations, or to learn more about the

science of appraisal, check the following web sites:

http://www.appraisalinstitute.org/

http://www.appraisalfoundation.org/

http://www.american-appraisal.com/

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Cost Method The cost method, or cost approach to appraisal calculates

what it would cost to duplicate the existing improvements in today’s dol-

lars. A distinction has to be made between cost and replacement, espe-

cially for older structures with exceptional architectural or handwork

features. A replacement of such attributes would be more expensive than

merely replacing a structure of the same square footage and other inter-

nal features.

The cost method includes a calculation of construction costs, minus an

estimate of depreciation and special site features, such as view, topography,

or lot shape. The concept of depreciation for appraisal purposes is quite

different from depreciation as deﬁned for tax purposes. Tax-based depreci-

ation involves writing off the value of improvements over a recovery pe-

riod. Appraisal-based depreciation is an estimate of the difference between

new construction (cost or replacement) and the current condition of prop-

erty. So a run-down property will be given a higher allowance for deprecia-

tion than one that is newer and in better condition. A formula for arriving

at value using the cost approach is:

Cost of construction – allowance for depreciation

+ added value based on site attributes = estimated value

The basic calculation using the cost value involves ﬁrst ﬁguring out the

square feet and area of the building or buildings; and then multiplying the

total feet by applicable cost ﬁgures (these vary by region). A useful sum-

mary of how to calculate cost factors is found at http://architecture.about

.com/cs/buildyourhouse/a/costs.htm. However, the ﬁrst step will be to com-

pare local land and improvement values, based on data from a reputable

and authoritative source.

Calculating a depreciation allowance to adjust for age and condition

of the home is a process devised to deﬁne the economic life of a property,

or a comparison between improvements and their contribution to overall

value. An age/life method for calculating depreciation involves dividing

100 by the economic life to arrive at annual depreciation. For example, if

the appraiser believes that the economic life of a property is 40 years, the

depreciation calculation would begin with:

100 ÷ 40 = 2.5% depreciation per year

Next, the appraiser calculates the effective age of a property, which is

the age of the property based on current condition of improvements (and

not necessarily the true age). For example, if we assume that the appraiser

believes a property’s effective age is 15 years, the annual depreciation rate

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of 2.5 percent (in the preceding example) would be multiplied by ﬁve

years:

2.5% × 5 years = 12.5%

The appraiser’s estimate of cost to replace improvements would next

be reduced by the depreciation factor. For example, if the current cost

value of property is estimated at $300,000, the calculation would be:

Cost value of property $300,000

Less depreciation, 12.5% – 37,500

Net cost value $262,500

Finally, the appraiser adds value for advantageous site features. By

comparing the subject site to other sites in the area, the appraiser adds a

factor to compensate for differences. For example, if the site is larger than

other lots, the appraiser may add a percentage to the net cost value. In re-

viewing comparable lots, the appraiser may determine that it is reasonable

to add 5 percent to the value of the property for site value:

Net cost value $262,500

Plus: site value, 5% + 13,125

Adjusted value $275,625

Applying these criteria to a subject property and three or more compa-

rable properties, the appraiser is likely to make speciﬁc adjustments to ar-

rive at fair market value; or to take an average among comparable

properties to arrive at a base for calculations under the cost approach.

A cautionary note concerning the use of the cost method: When ap-

praisal is performed for developers on larger-scale projects, selection of

costs has to also take into account the practical marketing aspects, and not

simply the cost of land and materials. It has been observed that

these costs are a function of the overall design of the project and

the needs and desires of likely buyers of the ﬁnished lots. In fore-

casting site development costs, care should be taken to ensure that

the forecast properly reﬂects not only the actual expenses, but also

the timing of the expenditures. Often an appraiser is supplied with

a cost estimate by the developer. The cost estimate should be cross-

checked against the actual development costs of similar subdivi-

sions and perhaps against cost service estimates.

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The cost method is also often used for valuation of industrial proper-

ties that may have specialized equipment and do not have an easily ob-

served rental market. As such, the cost method is more applicable than the

income approach.

Market or Sales Comparison Method The second method is an exercise in

comparison between the subject property and other, similar properties that

were sold recently. These comparable sales are most valid if they occurred

in the recent past. Thus, properties sold in the past three months would be

more relevant than those that sold nine months ago. Recent sales reveal

current market value and make a convincing argument in support of this

appraisal method.

Adjustments are made to the comparable property sales totals to arrive

at a true basis for comparison. For example, an appraiser may deduct a

percentage of value from a comparable property because it was built a few

years before the subject property. Or some value may be added to a com-

parable property with more square footage or a somewhat larger lot. So

condition, lot size, square footage of improvements, and condition will all

play a role in adjusting comparable sales so that, in the appraiser’s opinion,

the related sales are truly as comparable as possible.

The appraiser makes a judgment about how to equate comparable

sales (after adjustments) to the subject property. However, more weight

may be given to a property requiring the least amount of adjustment; or to

a property whose neighborhood is most similar to the subject neighbor-

hood. Is the decision about how to make an adjustment to be based on

subjective or objective criteria? This appraisal approach is described by

one expert as a paradox. He explains that some textbooks

refer to the adjustment and ﬁnal estimate of value process as more

of an art form than one of mathematics. The appraiser is sup-

posed to draw on his or her experience to aid in the adjustment

process and rigid mathematical calculations should not dictate the

amount of the adjustment. In actual fact, the opposite should oc-

cur. The valuation of any given piece of real estate should not be

left to a process that relies on an artist’s acuity, particularly when

the outcome of value is deemed to have some type of mathemati-

cal signiﬁcance.

Income Method The third and most complex method for appraising prop-

erty is based on rental income derived from properties. This method is used

for both residential single-family or multi-unit buildings and for commer-

cial properties.

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For single-family properties appraised under the income method, a

gross rent multiplier (GRM) often is used. This is a factor developed from

a study of comparable sales prices of property and the monthly or annual

income those properties generated.

For example, consider the case of ﬁve properties sold during the past

six months. To compute the GRM on a monthly rent basis, the formula is:

sales price ÷ gross monthly income = GRM

Some typical numbers based on this formula for single-family residences:

Monthly

Sales Price Income GRM

$125,000 ÷ $ 950 = 131.58

132,500 ÷ 1,050 = 126.19

134,000 ÷ 1,000 = 134.00

141,500 ÷ 1,100 = 128.64

145,000 ÷ 1,125 = 128.89

Average = 129.86

The same calculation can be made using annual rents:

Annual

Sales Price Income GRM

$125,000 ÷ $11,400 = 10.96

132,500 ÷ 12,600 = 10.52

134,000 ÷ 12,000 = 11.17

141,500 ÷ 13,200 = 10.72

145,000 ÷ 13,500 = 10.74

Average = 10.82

An appraiser would conclude from this analysis of GRM for compara-

ble properties, that a reliable estimate can be applied to be the subject

property. More weight may be given to properties most comparable, so

even these averages could be altered to make the appraiser’s conclusions

more accurate. For example if the appraiser uses the annual GRM method,

it may be that the second and fourth properties are most comparable to the

subject property. As a result, the appraiser may apply a factor of 10.62 (an

average between GRM of 10.52 and 10.72) rather than the higher overall

average.

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Next, the appraiser would analyze annual rent derived from the sub-

ject property. If we assume, for example, that a single-family home has

been rented out in recent years and currently generates gross rent of

$12,000 per year, the annual GRM is used to estimate appraised value:

10.62 × $12,000 = $127,440

Under this method, the appraiser would conclude that the property is

worth $127,440. Factors affecting the selection of a GRM and making ad-

justments to comparable properties may include neighborhood condition,

age and condition of the property, lot size and other amenities, and any

other attributes the appraiser believes are signiﬁcant (view, proximity to

transportation or shopping, noise levels, topography, etc.).

For multi-unit properties, an appraiser uses a factor known as capital-

ization rate, or cap rate. The calculation of cap rate involves calculation of

annual income and a comparison between the subject property and cap

rates on comparable properties in the same area or similar areas. For ex-

ample, in appraising an apartment complex with net operating income

(rents less vacancy factor, taxes, insurance, management fees, repairs and

utilities) of $52,800 per year, the current value of the complex can be cal-

culated by comparison with other apartment complexes with a similar

number of units, same or similar neighborhood, and similar condition and

age. For example, checking ﬁve other properties, the appraiser may dis-

cover the following:

Net Operating Sales Cap

Income Price Rate

$58,000 ÷ $565,300 = 10.3

52,500 ÷ 522,800 = 10.0

57,000 ÷ 566,000 = 10.1

61,500 ÷ 605,400 = 10.2

55,000 ÷ 545,000 = 10.1

Average = 10.1

The cap rates in these comparable sales are very close, so an ap-

praiser may conclude that the 10.1 is a reasonable local rate. Thus, ap-

plying this rate against net operating income, market value may be

appraised as:

$52,800 ÷ 10.1 = $522,772 (rounded to $522,800)

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This method, also called direct capitalization of the subject property, is

convincing when it conforms to market rates in comparable sales, when

rents are at market rates, and when the properties are stabilized. Alterna-

tive calculations may be based on assumed available return on investment

from other uses of capital, and the calculations are far more complex. For

complex properties, such as ofﬁce buildings or rehab properties with long-

term lease tenants, the appraiser may ﬁnd that rents are signiﬁcantly above

or below market rates. In these situations, appraisers will use a discounted

cash ﬂow over the entire life span of the investment by valuing earlier cash

ﬂow as worth more than future cash ﬂow. The goal in this approach is to

reduce the future value to present value or, put as a question, “What

should you pay today for the future stream of cash ﬂows?” Most apprais-

ers will use specialized ﬁnancial software tools such as ARGUS (www.ar-

gussoftware.com) to help with these calculations. This approach is

complex and beyond the scope of this book.

The alternative cap rate calculations are troubling because comparisons

between dissimilar investments are not always valid. Given different risk

factors, return on investment is not as exact as market sales comparisons.

In appraising rental income property, appraisers may adjust their ﬁnd-

ings based on other factors, especially cash ﬂow. The strength or weakness

in projections of likely future cash ﬂow is, perhaps, of more immediate

concern to investors than proﬁtability over the long term. As a question of

feasibility, investors need to base valuation on the relative strength of cash

ﬂow adjustments. Three useful tests are used in appraisals for this purpose:

debt coverage ratio, expense ratio, and loan-to-value ratio.

The appraiser may begin by questioning whether current net operating

income will be strong enough to cover debt service on a mortgage loan. To

determine this, the debt coverage ratio is used. To calculate, net operating

income is divided by the amount of debt service to calculate the ratio. For

example, when net operating income is $52,800 and annual debt service is

$37,896, the debt coverage ratio is:

$52,800 ÷ $37,896 = 1.39 to 1

This ratio provides a view of the net cash ﬂow after expenses and debt

service have been paid. How this compares to similar properties may reveal

the relative strength of that cash ﬂow and could affect the appraiser’s con-

clusions concerning value.

A closely related calculation is a study of the expense ratio for an in-

come property. In this calculation, operating expenses are divided by effec-

tive gross income (maximum rental income minus vacancy rate). For

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example, if effective gross income is $52,800 and annual operating ex-

penses average $21,500, the expense ratio is:

$21,500 ÷ $52,800 = .41

This operating ratio is next compared to the operating ratio for similar

properties to draw conclusions about whether cash ﬂow conditions are

strong or weak, in comparison.

A third calculation involving cash ﬂow is the loan-to-value ratio. In

this calculation, the mortgage amount is divided by the value of property.

An investor purchasing a property for an assumed value of $522,800 may

seek a loan of $400,000. In this example, the loan-to-value ratio will be:

$400,000 ÷ $522,800 = 76.5%

These three ratios are most effectively used in comparative form, be-

tween alternative potential properties and between a subject property and

comparable sales. Valuation is normally involved with identifying a rea-

sonable sales/purchase price for buyers, sellers, lenders and investors; the

three forms of cash ﬂow analysis further identify valuation of properties

based on comparative return, which may be of more immediate interest to

buyers as well as to lenders. The question of affordability relates more to

cash ﬂow than to economic rent.

That being said, potential income value is also calculated based on a

study of economic rent. This is an analysis of rent on the basis of rent per

unit, per room, or per square feet (or all three). For example, if gross an-

nual rent is being compared for ﬁve comparable properties, an economic

rent analysis may reveal the following:

Property Property Property Property Property

#1 #2 #3 #4 #5

Annual rent $11,400 $12,600 $12,600 $12,000 $13,500

Units 10 12 15 13 15

Rooms 32 37 48 41 45

Square feet 4,450 4,900 6,200 4,400 5,950

Annual rent per:

unit $1,140 $1,050 $840 $923 $900

room $356 $341 $263 $293 $300

sq. feet $2.56 $2.57 $2.03 $2.73 $2.27

These factors, like other appraisal steps, enable comparisons between

comparable properties and the subject property, and may allow both ap-

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praiser and investors to draw conclusions about the efﬁciency, cash ﬂow,

return on investment, and other important questions. As a means for com-

paring the feasibility between two or more properties, the comparative

analysis that is derived from appraisals is an integral part of market analy-

sis and the overall study of property valuation.

Legislative Policy and Valuation

We have concentrated on market forces for the majority of our discussion

on land valuation. However, we also need to be cognizant of how artiﬁcial

forces may also affect land values. These forces—speciﬁcally consisting of

local zoning, growth management and other legislative controls, and the

government’s right to exercise eminent domain—may signiﬁcantly affect

land values as well as the ability of the market to respond to forces of eco-

nomic supply and demand.

The ﬁrst U.S. zoning ordinance was passed in 1916 in New York

City. It deﬁned height and setback limitations on buildings and restricted

incompatible land uses. The original purpose was to prevent industrial

uses from moving gradually into Manhattan’s ofﬁce and shopping dis-

tricts. Today, the three most common major land use divisions are resi-

dential, commercial, and industrial, with many potential subcategories

as well.

Local zoning is designed to control, limit, and regulate land use. One

premise underlying zoning itself is to protect public health, safety, and wel-

fare. The basis for this starting point is found in the Fifth Amendment to

the U.S. Constitution, which reads in part, “. . . nor shall private property

be taken for public use, without just compensation.” An important land-

mark case heard before the Supreme Court clariﬁed this principle with a

ruling that zoning designed to protect the public health, safety, and welfare

is Constitutional, but that when zoning is set for other purposes, it may be

challenged.

However, the issue of how and why municipalities enact speciﬁc zones

may be challenged in some circumstances, notably when it can be shown

that the purpose of zoning is to prevent certain types of development from

occurring. This so-called exclusionary zoning is used improperly to keep

out newcomers and to prevent growth, rather than to serve a legitimate

purpose.

The city or county may employ zoning to provide exceptional design,

encouraging developers to use innovative features such as cluster develop-

ment, mixed use, and landscaping to add visual effects while also providing

amenities (public areas, trails, sight and wind buffers, privacy, and com-

mon areas for residents, for example). A Planned Unit Development (PUD)

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is one device used by cities and counties to provide developers with excep-

tions to general zoning laws in exchange for innovative design.

The idea that a government can take land from citizens through zoning

laws does not necessarily mean actually acquiring ownership of the prop-

erty. A taking of land can be accomplished by reducing a property owner’s

rights to use of that land. So valuation of property can be determined by a

change in zoning, for example.

Two U.S. Supreme Court cases set the rule that local governments can

impose restrictions on land use only if there is what the Court called an

“essential nexus” between conditions and regulatory objectives. The Court

also ruled in these cases that there must be a balance between considera-

tion of the public burden resulting from development, and a requirement

placed upon a developer to fund the cost of infrastructure projects.

So takings may be deﬁned as limitations on development activity,

changes in zoning that prevent an owner from using land as intended or

desired, or the requirement by a city or county that in order to gain ap-

proval, a developer must pay for additional beneﬁts or donate land. Of

course, such requirements can be imposed, but they have to be measurable

against the impact to the public of new development, and there must be

what the Court called a “rough proportionality” between such conditions

and the public burden caused by development.

The ability of a government to take property grows out of another

concept, called eminent domain. This is a legal power granted to the gov-

ernment and found in the Fifth Amendment. It provides that the govern-

ment (federal, state, or local) has the power to take private property for

public use; upon exercise of that right, the landowner must be given ade-

quate compensation (the proper or just value of property taken under emi-

nent domain, usually market value). The exercise of eminent domain is

most often called a condemnation or expropriation—nicer terms meaning

the same thing as a taking of land.

Takings are allowed under law for the “public good.” This means that

when a freeway has to go through, or hospitals, jails, utility plants, and

other essential public facilities, the government can override the private

property rights of the current owner and buy the land, even when the

owner does not want to sell.

68 VALUATION OF REAL ESTATE

Valuable Resource

To study current trends in takings legislation and zoning policy, check

http://www.law.georgetown.edu/gelpi/takings/courts/.

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Recent trends have demonstrated that in some cases, governments

have used eminent domain to control development or to force through

land uses that cannot be truly classiﬁed as belonging in the realm of the

“public good.” Condemning land so a new sports arena can be built might

be advantageous to the community, but does it ﬁt the deﬁnition of “public

good” and does such a facility constitute an “essential public facility”? The

controversy is ongoing. In other cases, governments have misused eminent

domain as a way to prevent development from occurring, as a sort of insti-

tutionalized antigrowth movement, sanctioned by the local government.

One possible risk associated with development, as exercise of eminent do-

main, would limit potential improvement in land values.

The trend in the courts shows that while some attempts have been

made to abuse the power of eminent domain, those decisions are likely to

be overturned. In two recent cases, state courts ruled that taking private

property in order to resell it to other private owners was not legal.

Real estate valuation may certainly be adversely affected by takings on

the part of government. However, these occurrences are not common. In

comparison, those states that have enacted so-called “growth manage-

ment” laws have experienced a mix of outcomes, not all positive. Several

states and some municipalities have enacted growth management legisla-

tion. Among the most controversial have been Virginia, California, Ore-

gon, Florida, and Washington states. About one-fourth of Washington and

Florida state increases in housing prices from 1995 to 2000 were due to re-

strictive terms in state growth management laws. Ironically, one stated pur-

pose in growth legislation is to promote affordable housing. The record

demonstrates that trying to artiﬁcially control market valuation through

legislative tinkering is ineffective and, in fact, expensive.

In such states, recent history has shown that the stated intention of

Growth Management Act (GMA) types of laws has not worked and in the

long-term, such plans will not be effective. In many states, notably the

State of Washington, the GMA has been very controversial. Many of the

decisions made by the Washington GMA boards have been overturned by

the state’s courts, fueling the debate. Growth management is intended to

provide a means for public participation without needing attorneys; but in

Measurements of Valuation 69

Valuable Resource

To view recent court cases involving eminent domain, check the web site

http://home.hiwaay.net/~becraft/recentcases.htm.

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some GMA states, there has been an increased level of land-use litigation

relating to GMA rules.

Methods of Entering the Market

The ramiﬁcations of growth management and other artiﬁcial imposi-

tions on market-based real estate valuation are serious for all real estate

investors, lenders, and homeowners. However, the concern goes beyond

the three most common forms of entry to the market: home ownership,

single-family housing rental investments, and the ﬁxer-upper (property

ﬂip) market.

These are the most common starting points for most people. However,

questions of valuation are also on the minds of those who enter the market

through other means. These include:

Individual Secondary Mortgage Lending Individuals can assume debt posi-

tions (lending money) as well as equity (owning property). These posi-

tions can involve signiﬁcant risk as well. Granting individual second

mortgages to property owners creates an income stream and higher than

average interest rates. However, if and when such second mortgages are

defaulted, the lender is entitled to get their principal returned only after

the ﬁrst mortgage has been paid. In cases where owners overborrow, sec-

ond mortgage investors could be left with losses. The way to reduce risk

is through careful screening and selection of borrowers with plenty of

equity in their homes. Some companies specialize in placing money in

second mortgages, notably through self-directed retirement plans or ﬁ-

nancial planning programs.

Mortgage Pools A relatively safe method of investing in debt is through

what is called the secondary market for debt. Most conventional lenders

sell their loans to one of the big government-sponsored programs, which

include the Federal National Mortgage Association, or FNMA

(http://www.fanniemae.com/index.jhtml) and the Government National

Mortgage Association, or GNMA (http://www.ginniemae.gov). These or-

ganizations create mortgage pools of real estate loans and sell shares to in-

vestors. They are just like mutual funds, but portfolios consist of real estate

loans instead of stocks and bonds. Investors can also enter into these posi-

tions indirectly by purchasing shares in mutual funds that in turn buy

shares in mortgage pools.

REITs The Real Estate Investment Trust, or REIT, is a practical venue for

acquiring equity in real estate. The big advantage of buying REIT shares is

70 VALUATION OF REAL ESTATE

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that they are traded on public exchanges, just like stocks. This liquidity

makes the REIT a desirable and practical way to diversify an equity portfo-

lio. The most popular type of REIT is called the equity REIT, in which in-

vestors buy shares of ownership in properties. Two other types are the

mortgage REIT, in which invested funds are loaned out to builders and de-

velopers, current real estate project owners, or mortgage backed securities;

and the hybrid REIT, which combines both equity and mortgage features.

About 96 percent of all REITs are classiﬁed as equity. About 1.6 per-

cent are mortgage REITS, and just over 2 percent are hybrid. The REIT

market is also interesting in terms of the types of property these programs

select. The most popular choice (33.1%) is industrial and ofﬁce; next are

residential (21.0%); and retails (20.1%). These three classiﬁcations add up

to about three-fourths of all REIT-based investments. The remaining equity

goes to no real estate representing more than 10 percent of the total.

Limited Partnerships Investors can also buy units in limited partnership

programs. In the past, such programs were popularly called “tax shelters”

because they were set up to provide big write-offs for investors, often ex-

ceeding the amount invested. Changes in tax laws essentially closed down

the tax shelter industry. As part of the change, limited partnerships were

classiﬁed as passive investments. This means that losses can only be de-

ducted to the extent that they offset other passive gains. No longer can in-

vestors in limited partnerships claim large write-offs; and investors can

never deduct more than the amount at risk (this is deﬁned as the total of

cash paid into the program plus recourse loans, or loans that must be re-

paid). One major problem with limited partnerships is their illiquidity.

ETFs A ﬁnal category is also the newest. The Exchange Traded Fund, or

ETF, is a type of mutual fund that is highly liquid. Shares are bought and

sold on public exchanges rather directly through fund management com-

panies. Traditional mutual funds were set up to emphasize a particular

investment policy, such as “aggressive growth,” “current income,” or

“conservative growth.” In comparison, the ETF is set up to select a spe-

ciﬁc portfolio, such as stocks in an index or market average; stocks of a

Measurements of Valuation 71

Valuable Resources

A useful overview of REIT basics can be found at ReitnetOnline (http://

www.reitnet.com/reits101) as well as at the National Association of Real

Estate Investment Trusts (http://www.nareit.org).

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particular country or those that specialize in a precious metal; or funds

with stocks in a speciﬁc industry or sector. An ETF may invest in real estate

sector stocks, REITs, or both. Because the ETF portfolio is identiﬁed in ad-

vance, management fees are far lower than those for the old-style mutual

fund. Finally, ETF owners often have the ability to break out segments of

the fund, or to buy and sell options based on the ETF and its bundle of

stocks. The ETF market is growing rapidly.

72 VALUATION OF REAL ESTATE

Valuable Resource

The market for ETFs changes often as more investors discover the beneﬁts

and advantages of these funds. As of the writing of this book, four ETFs

specializing in real estate were identiﬁed. While we do not endorse any of

these funds, they are useful as a starting point to learn more about the ETF

market:

Name Trading Symbol

iShares Dow Jones US Real Estate IYR

iShares Cohen & Steers Realty Majors ICF

Vanguard REIT Index VIPERs VNQ

street TRACKS Wilshire REIT fund RWR

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CHAPTER

Single-Family Home

and Condo Analysis

Most people are familiar with residential real estate; however, this

is itself a complex investment form. There are many different

types of residential properties and analysis should be broken out

and separated based on (1) location, (2) size, (3) local trends, and

(4) other, special considerations (i.e., subsidies, rent controls, or

tax credit incentives). We introduce these important issues in this

chapter and also study the antidevelopment movement known as

NIMBY (Not In My Back Yard), demonstrating how analysis in

real estate is not merely economic; it may be political as well.

o particular property is necessarily easy to analyze. Some relatively in-

experienced individual investors believe they understand the market val-

uation attributes of single-family homes because—like a majority of real

estate investors—they own and live in a home themselves. This is a mistake.

The investment attributes of residential property are not the same as

the features of owner-occupied homes, in four ways:

1. The underlying premise for ownership is not the same. An individual

purchases a home partially as an investment, but also out of necessity.

If that person does not own a home and make payments on a mort-

gage, the same money (in some instances, more money) has to be paid

for rent, without the tax savings and long-term appreciation derived

from home ownership. The premise for investing in rental property is

entirely separate from the premise for buying a home. For anyone not

yet a homeowner, the idea of ownership is the deﬁnition of the Ameri-

can Dream.

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2. Cash ﬂow analysis is not the same thing as homeowner mortgage af-

fordability. It is not accurate to compare investment cash ﬂow to the

entirely separate question of a primary residence’s affordability. Cash

ﬂow analysis is a study of risk as well as of affordability; many market

and economic factors come into play when you are analyzing the feasi-

bility of a particular property and given a speciﬁc market. The type of

home an individual can afford is determined by income, down pay-

ment, and current interest rates. While an investor can simply decide

to not proceed because the feasibility study is not encouraging, a

would-be homeowner has more limited choices when the numbers do

not work: Continue to pay rent or look for a home that does not cost

as much. The homeowner seeks affordability, and the investor views

cash ﬂow issues as aspects of feasibility; these are not the same issue.

3. Lenders have a far different risk proﬁle for each type of real estate. In-

dividual real estate investors discover quickly that lenders are far more

risk-conscious in the case of ﬁnancing investment real estate than they

are in the case of owner-occupied properties. When an individual ﬁ-

nances a home, good credit may lead to low-rate, low-down (or no

down) ﬁnancing, and fast approval. But investors traditionally are re-

quired to commit 30 percent or more to a down payment, and also

may have to pay higher interest rates than homeowners.

4. Tax beneﬁts are vastly different. Homeowners enjoy speciﬁc tax bene-

ﬁts, but these are also quite limited. They are allowed to deduct mort-

gage interest and property taxes on their primary residences, but

nothing else that recurs from year to year. When a primary residence is

sold, gains up to $500,000 are tax-free. This may be a good or a bad

tax rule. If a married couple wants to move from their current home to

a smaller one and their gain is less than $500,000 (and they qualify in

every other way), the tax-free proﬁt is a substantial beneﬁt. However,

in some regions of the country, properties purchased 20 years ago for

less than $50,000 may be worth $1.2 million today. A sale may pro-

duce a proﬁt of $1 million or more in these markets, and the maxi-

mum tax-free proﬁt is $500,000. In the past, gains could be deferred

by buying another home, but under the tax-free rule, any excess more

than the maximum of $500,000 for a married couple is taxed.

Investors are allowed to deduct as investment expenses their interest

and taxes, as well as other operating expenses: insurance, utilities, adver-

tising, management fees, and auto or truck expenses, for example. Most

signiﬁcantly, however, they can also deduct depreciation, which is a sub-

stantial beneﬁt. Investors who actively participate in managing their own

properties can deduct up to $25,000 per year in tax losses. Upon sale of

74 SINGLE-FAMILY HOME AND CONDO ANALYSIS

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investment properties, investors pay capital gains tax on the net differ-

ence between sales price and original purchase. They also have to pay

taxes on the total of depreciation claimed over the period the property

was owned.

If we move even further beyond the mere understanding associated

with investment value, we begin to understand that for residential proper-

ties, analysis requires a comprehensive survey of market factors beyond

value itself. One real estate book involving the necessity of the differences

between ﬁnancial and lifestyle (among other) issues affecting decisions peo-

ple make, explains that:

much of the analysis for residential development must rely on a

qualitative understanding of the market and its dynamics. Both

the product and the consumer must be understood in terms of

choices people make, evolving lifestyles, personal tastes, and many

other considerations that cannot be quantiﬁed. Focus groups,

buyer surveys, and other qualitative techniques augment the hard

data of the market study. Understanding the lifestyles and other

qualitative characteristics of consumers can help to appropriately

deﬁne a residential product.

Therefore, it is wise to consider the nature of the end-user (home-

owner) in an analysis of residential property and to accept the reality that

those who buy homes may have a different series of assumptions, desires,

and motivations from those who purchase warehouses and ofﬁce build-

ings. Everyone is interested in value and cost. But homeowners are differ-

ent enough and in signiﬁcant ways that, in fact, when you attempt to

identify valuation factors of residential properties—even using primarily ﬁ-

nancial and economic data—it is wise to also remember that the residen-

tial, homeowning consumer is unique and different from the commercial

customer, the developer, or even the residential property investor.

HOME OR CONDO?

We make a distinction in this chapter between a single-family home and a

condominium, and for good reason: The analytical and market attributes

of each may be vastly different.

A single-family home is a stand-alone building and includes full own-

ership of the land and improvements. There are no shared common areas

or expenses with other owners, except in those areas where covenants

mandate—as part of the purchase agreement—that each property owner

Home or Condo? 75

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carries a responsibility for common ownership and liabilities of speciﬁc ar-

eas (such as park areas, trails, club house, sports facilities, exercise rooms,

and meeting room areas, for example).

A multi-family directly owned unit is studied in the next chapter. How-

ever, its classiﬁcation may properly belong here with single-family housing,

as opposed to rentals as seen in apartments. Thus, duplex, triplex, and

fourplex units are multiple units within a single building. They usually

have separate entrances or access to units through a shared common area

such as a lobby or hallway. Owners in multiple-unit buildings operate un-

der the terms of an agreement for common-area maintenance, insurance,

and ownership.

A condominium may come into existence in one of two ways. A devel-

opment may be designed to create owner-occupied condo units, or an ex-

isting apartment building may “go condo,” be converted to condominium

ownership, in which case the purchaser buys an apartment. At the same

time, the purchaser, together with the other unit owners, buys an “undi-

vided interest” in the common elements of the building or development.

Common elements generally include the land on which the building stands,

the lobby, public halls, driveways, access roads and parking areas; and the

electrical, mechanical, heating, and air-conditioning systems that service

the building.

In a similar arrangement, the cooperative, or “co-op,” a corporation

is formed to take ownership of an entire project or building, and individ-

ual owners buy shares. In the condo, rather than owning shares in a co-

operative, buyers own their individual units outright and receive deeds

for them. Each of the unit owners is responsible for paying a proportion-

ate share of the building’s fuel costs, building employee salaries, and

other expenses of operation. These are known as common charges. Addi-

tionally, each condominium owner pays real estate taxes, separately as-

sessed against each unit, and the cost of any mortgage obtained to

ﬁnance the original purchase. The condominium owner may deduct these

tax payments and the payments of interest (but not principal) on the

mortgage, from taxable income.

The condominium is governed by a board of managers elected by the

unit owners. The board’s authority to operate the building is explained in

detail in the condominium declaration and bylaws, a copy of which is in-

cluded in the offering plan. These provide rules and procedures for con-

ducting the affairs of the condominium, and deﬁne the rights and

obligations of unit owners. For example, the bylaws may restrict the right

of unit owners to make certain kinds of alterations to their units or to lease

or mortgage them.

In studying speciﬁc valuation factors, these distinctions should be kept

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in mind. The attributes of each ownership format may affect value. For ex-

ample, the cost of a mortgage on a single-family home is not directly com-

parable to a mortgage on a condominium. Because condominium owners

are obligated for additional fees, their relative cost-versus-beneﬁt analysis

should be made on the basis of total payment obligations.

Example: You are comparing the ownership of a three-bedroom,

single-family home to a variety of condo units. The typical condo unit

sells for $200,000 and on average additional monthly fees are $400.

What is the equivalent cost to purchase a single-family home? Using an

assumed mortgage rate of 6 percent and a 30-year term, the cost to the

condo owner will be:

Mortgage payment, $150,000 mortgage $ 899

Common area and other fees $ 400

Total monthly obligation $1,299

In looking at a book of mortgage amortization, a $1,299 monthly payment

would apply on a $200,000 mortgage. So in theory (and assuming the

same down payment) the monthly obligation for a $200,000 condominium

would be the equivalent to the outright purchase of a $250,000 home.

This analysis is not entirely reliable. Some of the services provided

within the monthly condo payments include expenses the homeowner

would have to bear or pay separately—or pay for features the homeowner

might not have. But even so, the brief example makes the point that in

comparing costs, the analyst should consider not only the mortgage pay-

ment, but the condo (or co-op) contractual obligations as well.

VALUATION FACTORS UNIQUE TO

RESIDENTIAL PROPERTY

In judging the market value of single-family homes, we need ﬁrst to study

the basic market characteristics and next to consider the supply and de-

mand features for the property as well as site-speciﬁc attributes. The valua-

tion factors should be broken down into three speciﬁc classiﬁcations.

Market Conditions in the Local Area

The “local area” in the case of single-family homes is, of course, both the

immediate neighborhood and the city or town in which it is located. So we

have to consider two versions of the local market in the analysis of a

house. If the neighborhood is in transition, which way is it heading? As

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older owners move or pass away, younger families replace them and, as a

general rule, tend to ﬁx up outdated properties, adding value to the neigh-

borhood. However, due to outside factors like high unemployment, some

neighborhoods experience deterioration, high vacancies, increased crime,

and other factors that reduce property values. While houses in such areas

may be cheaper than market rates elsewhere in the same region, the nega-

tive transition is not a positive indicator.

Certain larger market areas—speciﬁcally towns, cities, or counties—

also experience transitions. Growth is caused by factors such as employ-

ment, tourism, proximity to outside work centers, and other external

inﬂuences. For example, if a city within a one-hour commute has a boom-

ing employment market, a relatively remote town could experience a rapid

increase in demand as workers seek suburban “bedroom communities”

nearby. Growth may also be artiﬁcially contained, controlled, or deferred

through antigrowth sentiment locally or even through legislation. Growth

management trends have demonstrated that attempts to slow down growth

have resulted only in higher real estate prices (see the previous chapter).

Such trends are anything but economic, and, time has shown, devices such

as growth management, local building moratoria, and impact fees not only

add to the cost of housing, they also do immediate damage to commercial

and retail trends locally and may even cause growth rates to fall below de-

sirable levels, and below levels required to sustain local jobs and trade. In

one instance in North Carolina’s Research Triangle area (Raleigh,

Durham, and Cary) the consequences of impact fees included negative con-

sequences. A 2003 story explains that

leaders in Cary . . . began to rethink their stratospheric impact fees

after the town’s growth rate plummeted below the goal of 4 per-

cent to only 1.7 percent last year. Cary’s impact fees are as much

as four times higher than those in the city of Durham and six times

higher than those in Raleigh.

Attempts to artiﬁcially control or prevent growth, or even schemes de-

signed to create added revenues through impact or permit fees, invariably

bring unintended consequences: unacceptably low growth rates, soaring

real estate prices, and what can only be described as poor planning policy.

Such artiﬁcial growth policies relate more to housing than to other types of

property. A widespread belief that rapid growth in housing stock leads to

higher crime, more trafﬁc congestion, and deterioration in the quality of life

may be based on some evidence, but the point remains that, in spite of ef-

forts to the contrary, growth occurs in response to economic realities. It

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cannot be created where there is no demand, and it cannot be prevented

when demand is high.

In fact, in spite of evidence that attempting to artiﬁcially control the

market through imposition of growth management legislation has

largely failed, many states continue to pursue the agenda of trying to de-

termine what types of growth occur, both where and when, based on the

notion that, somehow, such controls are good for the market. These so-

called “planning intervention regimes” have universally had the oppo-

site effect to the stated goals. As explained in one article, it has been

demonstrated that:

local governments are unusually ineffective in achieving such over-

arching public interest goals as preserving natural resources, con-

taining urban sprawl, and mitigating losses from hazardous

events. The reason is basic to decision making: individual, devel-

opers and local governments will act in their own self-interest.

The classic observation of how people act and react begs the question. In

an economic sense, the theory of the “tragedy of the commons” prevails

and motivates people, and this reality cannot be avoided.

Economic Trends and Supply and Demand

A more ordered factor in the valuation of single-family housing is the col-

lective basket of economic factors. Generally, this refers to supply and de-

mand; however, there is more to the equation. Supply and demand markets

may exist on several tiers (for housing, rental units, and ﬁnancing), and the

trends in those tiers of markets do not always move in the same direction.

Economic trends, of course, continue to rule, but the landscape itself

has changed over history. The development of the automobile and mass

transit have drastically changed not only how people work, but also where

they live. We remain in the middle of a long-term trend of population

movement away from traditional big cities and into suburbia. This new

population center, dubbed Edge City by author Joel Garreau, is deﬁned as

a major change in U.S. demographic trends:

These new hearths of our civilization—in which the majority of

metropolitan Americans now work and around which they live—

look not at all like our old downtowns. . . . their landmark struc-

ture is the celebrated detached dwelling, the suburban home. . . . I

have come to call these new urban centers Edge Cities.

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80 SINGLE-FAMILY HOME AND CONDO ANALYSIS

CASE STUDY: ANTHEM, PHOENIX, AZ

One of the fastest-growing regions in the United States is the central

Arizona Phoenix metro area. Much of the development is aimed at re-

tirement or semiretirement age groups; one exception is the Anthem

project, which began selling in 1999 and is planned for completion in

2007.

Developer Del Webb is well-known in the Southwest for its

“lifestyle communities”—often gated, guarded neighborhoods. The Del

Webb Corporation has built more than 100,000 homes since 1928 and

is best known for its Sun City retirement communities. Anthem is the

company’s ﬁrst nonage-restricted housing development and is described

on its promotional web site—www.anthemarizona.com—as containing

two sections. Anthem Country Club consists of “gate-guarded, resort-

style living with two . . . 18-hole championship golf courses.” The tar-

get resident market is described as professionals aged 40 to 60,

preretirees and empty nesters. Anthem Parkside offers “real neighbor-

hood living with activities and amenities tailored to ﬁt the way your

family lives, works and plays.” This section markets to people aged 25

to 40 with children.

This self-contained approach to master-planning community de-

sign is typical of the Edge City trend. These are not small, either. By

the time the project is completed, it will contain 12,000 homes—the

size of a small city on its own. In fact, the project includes features

one would expect to ﬁnd in such a city: shops, restaurants, parks,

open space, schools, commercial, industrial, and ofﬁce space, and mu-

nicipal services, for example. Because the area involved is both large

and remote (5,760 acres 35 miles north of Phoenix) virtually all trips

require the use of an automobile. And because the development is so

large, it is also diverse, offering something for many different markets

within the development itself. Even the recreational facilities are de-

signed to appeal to all age groups.

A 43,000-square-foot community center is the hub of the com-

munity. It is next to the community park where the ﬁrst K-8 school is

also sited. The center includes after-school activities, a complete ﬁt-

ness center, tennis courts, dance studio, and a Big Splash Water Park.

The Golf and Country Club, one of the few private clubs in Arizona,

includes two full championship courses as well as swimming pools,

tennis courts, ﬁtness center, and a dining room.

The complex includes a 128,000-square-foot retail center called

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Valuation Factors Unique to Residential Property 81

CASE STUDY: ANTHEM, PHOENIX, AZ (Continued)

Anthem Marketplace. Included within are a Safeway store, drugstore,

dry cleaner, restaurants, and a DVD rental store, among others. Busi-

ness outlets are also located strategically at major intersections within

the complex so that, conceivably, residents would never need to travel

outside the immediate community. All of their schools, shops, and

recreational facilities are available close by. Even a complete medical

facility is planned in the near future.

What makes this large-scale project unique is that it is designed to

respond to many different markets—semiretirement through families

with young children. In many of the gated communities in the area,

the predominant market is retirement-aged. In one of the dozens of

communities in Chandler, Arizona, for example, a common complaint

is lack of adequate healthcare facilities within the immediate area.

The residents refer to the frequently heard EMS vans and ambulances

as the “taxis to the hospital.”

Anthem’s design includes 36 percent of the total land area for

open space and recreational use. This is a major selling point, espe-

cially for the younger age-group residents and their children. The site’s

design—the land was originally a remote rural desert setting—incor-

porated the natural terrain and desert vegetation into the community.

Cacti that had to be removed for streets and houses were replanted,

and an extensive system of trails provide for horse and foot trafﬁc.

The Webb Corporation performed an extensive market analysis

and, in the case of Anthem, this phase was more extensive than usual.

The company spent $5 million on marketing before the project design

was started. Research included a detailed survey of baby boomers and

retirees. The Anthem design was based on the research, which included

not only the survey, but also focus groups and interviews with potential

buyers. Further research was conducted on existing residential commu-

nities in the area. The goal was to avoid mistakes and to develop a

large-scale community that met the needs of the target markets.

The research paid off. More than 7,000 people attended a pre-

view of the ﬁrst phase and about 300 homes sold in the ﬁrst week.

With an estimated total cost at build-out of $1.7 billion, the mixed

market approach may set a trend for large Edge City-type planned

communities in the future. Rather than focusing on a single market,

Anthem demonstrates that it is possible to appeal to a variety of dif-

ferent demographic groups.

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The very concept of Edge City implies order and predictability, but

when we consider the inefﬁciencies of the model, including the requirement

that residents must drive virtually everywhere, we soon realize that as a

planning device, the newly evolved Edge City, while part of a modern

trend, may be as “unintelligible as in any dream.”

While Edge City-style planned communities represent an important

trend, notably in areas like Phoenix, a parallel trend continues away

from urban living to outlying suburbs. In some areas, this trend has been

reversed as city centers go through renovation, but the widespread ap-

peal of suburban living—whether in a planned community or an easy

train ride to downtown—is undeniably continuing to occur. Additional

economic forces, all of which affect supply and demand itself, include

the following.

Local Development Trends Some areas experience exceptionally high vol-

ume of growth in new houses, even when demand does not appear to

support such trends. As a general observation, development does tend to

perform in excess of demand and we see housing construction continue

even as the supply and demand cycle peaks; just because the cycle turns,

does not mean a slowdown in immediate construction. Construction

takes time to ﬁnish; it is invariably better to ﬁnish and sell than to merely

stop work.

The cause of the cyclical turn may also be attributable to ﬁnancing

incentives (cheap money and cheap land, for example), enabling builders

to continue working and keep employees busy, due more to seasonal

preferences than to actual demand for more homes. Of course, the

whole cycle is driven by demand, but construction trends may rely

equally on tax incentives (for affordable housing), ﬁnancing, and favor-

able local growth policies.

The Local Job Market As employers move into an area, people follow to

obtain jobs. This tendency has characterized real estate and demo-

graphic trends since the post-Civil War era. Today, an equally important

factor is that of proximity. People do not need to live where they work

and, in fact, may ﬁnd urban living far less desirable than buying a home

in the suburbs. The emergence of this trend—purchasing homes outside

of the city and commuting to work—is a dominant theme in residential

real estate.

Local Amenities beyond Housing We witness the growth of many areas

based on economic factors beyond local job markets. For example, recre-

ational amenities often create growth directly. When Six Flags Marine

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World

opened its 136-acre park in Vallejo, California, years ago, the

town was relatively small. While many factors have contributed to

growth in the San Francisco Bay Area, Marine World’s facility con-

tributed signiﬁcantly. Since 1970, the city’s population has grown 70 per-

cent and Marine World was the third largest employer in 2004, with

1,660 jobs (behind Kaiser Permanente Hospital and the local school dis-

trict). Housing prices have followed suit; Vallejo made the CNN list of

“hottest zip codes” for ﬁve-year growth in housing prices as of 2004; and

the Vallejo/Fairﬁeld metro area was in the top 10 regions on the Housing

Price Index (HPI) that same year, showing a 21.8 percent increase in av-

erage home prices.

Local Quality of Life Issues and Perceptions Economic trends are also re-

ﬂective of (and affected by) trends in other realities, such as safety, trafﬁc,

and crime levels. Every year, various cities and towns are rated in terms of

the desirability or quality of life. Factors include jobs, housing prices, crime

statistics, recreational amenities, climate, honesty or friendliness of resi-

dents (subjective to be sure, but an important test of quality of life), and

similar perceptions about a city or region.

Attributes of the Site

Finally, we want to consider site-speciﬁc attributes. These are many and

varied and include obvious as well as subtle features. For example, it has

been observed that a house on a busy street will not experience increases

in market value as much as an identical house on a quiet street—even

when they are in the same neighborhood. Factors such as ongoing mainte-

nance, age of the property, proximity to schools, shops and malls, recre-

ation, and other desirable destinations, will also affect a property’s value.

A recreational facility, for example, may initially draw residents and lead

to more housing construction due to new job creation, but ultimately the

trafﬁc congestion and higher prices may have a reverse effect on an area’s

quality of life. So the attributes of the site itself may be extremely negative

or positive. The speciﬁc site has greater inﬂuence on market value than on

the house’s speciﬁc features. Thus, a property located at the end of a ma-

jor airport’s runway, for example, is unlikely to have as much market

value as the same house on a quiet suburban hillside with a spectacular

view of the bay.

Equally important in this comparison is a range of environmental is-

sues. Among the greatest impacts is noise. While problems like ﬂooding

caused by poor grading can be mitigated, noise often cannot. It is more

likely that measures will have to be taken to change the environment or

Valuation Factors Unique to Residential Property 83

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accept lowered property values due to noise. The solution to noise prob-

lems can be summarized:

There are only three ways to mitigate noise: (1) quiet the source,

(2) put more distance between the source of the noise and the re-

ceptor, and (3) build or create a barrier to the noise. It is often in-

feasible for homeowners to have control over quieting the source

. . . and it is equally impractical to move the house . . .

Noise levels certainly affect property value and have to be considered

in market analysis as well as feasibility phases. Some analysts believe that

noise simply lowers property values and that eventually, current owners

have to accept this and sell for less. However, if noise is severe enough,

this may not be true. An “enticed population”—those willing to live in

heavily impacted areas such as airport ﬂight corridors—does so in ex-

change for property value discounts. However, the damage caused by

noise and similar undesirable features of a property or area may make the

potential buyer market so small that it must be discounted altogether. One

appraiser explained:

While some real estate analysts may initially believe that any po-

tential buyer will purchase a damaged property if discounted

enough, this is simply not true. To illustrate, consider a run down

house in the middle of a heavy industrial area. Certainly a signiﬁ-

cant portion of the typical residential market will simply not pur-

chase the property at any discount, as they simply will not live in

such an area under any conditions and have no interest in buying,

renting, or reselling such properties.

TRADE AREA ANALYSIS

The analyst assesses trade area by determining the source of potential ten-

ants, factors that determine the location, and the degree to which the study

is merely blunt judgment. One worthy goal is to identify ways that analyti-

cal judgment can be made more accurate and objective.

Begin by looking at existing projects. The analysts will need to esti-

mate how many people are here today, and how many will be there when

the project opens. Then, calculate how many of those households can af-

ford the subject project. Using census data for what you deﬁne as your

trade area is key, whether based on tract number or by zip code.

On the supply side, begin by studying how many housing units are

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available now. Include a count of new competing projects that will be

coming on line. There are more technical ways to establish trade area.

For example, one author (Thrall) tells a case of determining the need for

student housing. The analyst identiﬁed the address database for all

45,000 students and mapped it. The trade area was deﬁned to be 80 per-

cent of the students whose resident addresses were local. Next, supply

was mapped by taking all apartments from lease guides for the county

and building permit information.

Absorption predictions were made from looking at the way students

would advance through the school, with the understanding that upper-

class students would be more likely to live off campus.

The conclusion drew together all of the assumptions.

MARKET CHARACTERISTICS OF

RESIDENTIAL PROPERTY

There is a tendency in some local real estate markets to consider market

value in isolation, or based on outdated information. For example, if

property values were rising quickly and houses were selling as soon as

they were placed on the market last year, some market observers think

those conditions are permanent. But since no economic cycles remain un-

changed for long, in residential real estate, it is not realistic to base as-

sumptions on past market conditions or on what is claimed by a real

estate salesperson.

As with all other markets, residential real estate market value depends

on many factors, both direct and indirect. The most apparent and best un-

derstood factors are demographic trends—the numbers of local residents

and the growth in population in recent months and years. The market is

easily observed in hindsight by examining the time properties that remain

on the market; the differences between asked price and ﬁnal sales price;

and the local inventory of homes for sale. This is the number of properties

on the market, compared to the monthly absorption on the market (aver-

age sales per month). For example, if a town experiences sales of 15 prop-

erties per month and there are currently 75 homes for sale, there is a

ﬁve-month inventory.

These indicators are useful for spotting trends. However, today’s sta-

tistics are not as revealing as they are as the latest entry in local trends.

So if you see a spread between asked and sales prices shrinking, ever-

lessening time on the market, and a shrinking inventory, these all are re-

liable indicators of a strong demand market. Because you are reviewing

three speciﬁc indicators, when they all point in the same direction, they

Market Characteristics of Residential Property 85

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86 SINGLE-FAMILY HOME AND CONDO ANALYSIS

CASE STUDY: SONOMA VILLERO, BOTHELL, WA

One might assume that siting a 240-unit development of condomini-

ums near Microsoft Redmond, Washington headquarters would ﬁnd

a strong demand market, especially for affordably priced units. The

high employment in the area is attributed to software development,

Boeing, and the Bothell campus of the University of Washington.

However, competition can cause a developer to change the entire

strategy.

When the 160th Street Association developed Sonoma Villero

in 1997, the need for ﬂexible marketing became apparent immedi-

ately. Because a similar development was underway at the same

time close by, the developer decided to rent out units initially, with

the ability to convert to ownership later on. The fact that a 209-

unit condo development was being built literally across the street

led to community opposition to Sonoma Villero. Partly to deal with

competition and partly to respond to the NIMBY sentiment, the de-

veloper literally shifted markets, at least initially. Instead of com-

peting head-to-head for sales of condos, the developer changed

original plans and went after a rental market. Demand for rentals

was strong in the area, and market rate rents averaged $1,325 per

month. Upon conversion to ownership, the condo units were af-

fordable, especially by Seattle metro standards. One-bedroom units

were about $120,000 and three-bedroom units were about

$200,000.

With development costs through the year 2000 at just under $33

million, the developer learned from the experience that local opposi-

tion delayed the approval process, and the local market was affected

by a directly competing project. The decision to shift to the rental

market and gradually transition into sales was wise, given conditions

at the time. However, the change in marketing strategies also made it

difﬁcult to decide which amenities should be included. For example,

interior amenities and ﬁnishes (i.e., plumbing for washers and dryers)

were excluded because of lack of demand in the leasing/rental market.

However, including such amenities would have helped in the condo

sales market when units were converted.

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are reliable conﬁrmation of the trend. Therefore, it is far less reliable to

look at only one trend to draw a conclusion about the current health of

the residential market.

The problems of changing markets during the development process

aside, the need to shift due to competition in the immediate area was ap-

parent to the developer in the case of Sonoma Villero. In analyzing the

market for a condo, versus the market for rentals, this is one of many fac-

tors to bear in mind: The need to shift due to competition may change the

entire development strategy. Because the analyst’s point of view has to be

based on a market-response strategy rather than that of a would-be buyer,

the entire process is quite different. If analysis is premised on what an indi-

vidual has experienced in purchasing a residence as owner-occupied hous-

ing, it is unreliable. There are vast differences in market characteristics

between a residence and an investment property. We must consider mort-

gage affordability and adequacy of a home as well as location, type of

neighborhood, and proximity to schools and shopping. But for rental

properties, we also need to calculate after-tax cash ﬂow, potential for

growth in market value, and the supply and demand features of the local

rental market, that is, occupancy rates.

When we expand beyond a single investment, the question of market

characteristics has to be viewed with a broader perspective. When we

look at only one property, cash ﬂow requirements can be easily narrowed

down and we can estimate the likely return on investment based solely on

local rental market conditions. However, when we perform market

analysis for subdivisions—especially those in highly specialized markets

such as low-income housing—we also have to look at a larger supply and

demand market.

In larger subdivision developments, we consider the same factors as

those for solitary home purchases: household demographics, employment,

and transitional trends locally. However, economic factors such as the

number of people living below the poverty level also have to be considered

when low-income housing developments are the subject of study. Because

so many of these developments are constructed with taxpayer subsidies

(via tax credits), there is a tendency to gloss over the realities of market de-

mand, or to make assumptions in market and feasibility studies that are

simply false.

The most serious among these is to believe that the entire perceived lo-

cal demand will be absorbed entirely by the new development. Ignoring the

realities of the competition is a mistake, but one that is made commonly.

This is even more subtle than the obvious comparison: If two developers

are building apartment buildings in the same market, it is not realistic for

Market Characteristics of Residential Property 87

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either to assume that the entire local demand will come to their project. A

realistic view may consider market share. However, a more subtle competi-

tive view is required. A local planner, for example, who understands the

market may further realize that local demand is not waiting only for newly

developed housing. A portion—perhaps a majority—of those would-be

tenants currently live in existing units, either other single-family homes be-

ing rented, or in other apartments. The latter tenant may want to move

into a rented home because it is more desirable than remaining in an apart-

ment. This reality indicates the real competitive condition in the market. In

88 SINGLE-FAMILY HOME AND CONDO ANALYSIS

CASE STUDY: EAST LAKE COMMONS, DECATUR, GA

Some developments are designed to appeal to speciﬁc, narrowly fo-

cused demographic markets. East Lake Commons is a high-density

development of 67 townhouses near downtown Atlanta. It is a “co-

housing” project.

Co-housing means just that: a sharing of responsibilities among

residents. The market for this project included a diverse mixture of

single people, retirees, families, and gay/lesbian couples. Residents

work cooperatively through committees to manage affairs such as

kitchen scheduling, ﬁnancing, and neighborhood outreach programs.

Meals are prepared and offered by community volunteers several

times per week in the project’s community building, and residents

participate on a volunteer basis. No one is required to give time.

The developer originally purchased the 17-acre site to develop

HUD Section 8 affordable housing. However, local civic leaders ad-

vised the developer that they preferred market-rate housing targeting

working professionals on the site. The developer, Jack Morse, recog-

nized a marketing opportunity and identiﬁed pent-up demand in the

area for a residential development offering community-based ameni-

ties. This led to a revision of the original plan and, ultimately, to the

design of East Lake Commons.

To help get the project moving, the developer presold 17 units to

a group interested in setting up a co-housing community. The sale

helped move the project forward, generating further interest in it. At a

total cost of nearly $9.7 million, the project was completed in Sep-

tember 2000. It is an example of how design combines desirable fea-

tures of urban living in a suburban setting.

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fact, new construction may create an oversupply and lead to higher than

current level vacancies. In that case, the entire market (counting current as

well as new real estate) will experience overall higher vacancies.

Judging the current supply and demand in single-family housing is not

always a simple matter of studying occupancy/vacancy rates in rental prop-

erty. Nor can the entire competitive condition of the market be judged

based on market statistics for owner-occupied housing. The demographic

and income mix of a region determines the subtle shifts in supply and de-

mand. In evaluating the true competitive status of today’s market, an ana-

lyst has to consider:

■

The obvious supply and demand attributes. The obvious interpretation

of supply and demand in the rental market is expressed in the study of

occupancy and vacancy rates as well as trends. However, confusion

may arise when we mix market analysis between the two major types

of single-family residential property: owner-occupied and rental prop-

erty. The local mix of population will determine whether newly con-

structed homes are likely to be put to use as owner-occupied or as

investment properties. Thus, an analysis should include a study of lo-

cal owner-occupied rates by neighborhood, the mix of population (for

example, is the population aging or is it dominated by college stu-

dents?), and income levels. All of these affect—and in fact, create—the

type of demand locally.

■

The level of demand that currently has other housing. Most important

in a local study of supply and demand is the realistic analysis of the

market. Whether you are dealing with subsidized housing or market-

rate developments, the level of supply has to be understood properly.

For example, if a developer plans to construct 100 market-rate homes,

where will the buyers come from? If there is little available on today’s

housing market but the population is growing, then the demand is gen-

erated as additional demand above and beyond the current popula-

tion. However, if buyers come from the existing homeowner

population, this has ramiﬁcations for the competitive marketability of

the homes. As current owners sell their homes to move into the newly

built homes, the inventory on the local market remains unchanged

(one home is exchanged for another). There is no real new demand, so

prices are likely to ﬂatten out or even fall. Performing a feasibility

analysis of the new development raises the question of whether the es-

timated pricing of properties is correct. If the basic assumption is that

there is a demand for housing (based on local sales trends), the indica-

tor is false if, in practice, people will simply replace one home with an-

other. In addition, the population is often distinguished by levels of

Market Characteristics of Residential Property 89

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income in this type of analysis. It is one thing to say the population is

growing, but in which economic levels?

■

The correlation between current population trends and existing real

estate. Is the local population growing above or below the rate of new

housing construction? This basic indicator is often overlooked in favor

of more myopic analyses. For example, if you were to consider

statewide trends rather than local trends, the result is an average of a

series of dissimilar markets rather than an indication of what is going

on in town. Market demand is strong only when the local population

of homebuyers is growing. This does not include college students or

transient population groups such as migrant workers; it also does not

include existing homeowners. If analysis includes any of these groups,

then the real nature of competition on the market will be inﬂated be-

yond the real demand levels.

■

The inﬂuence of nearby markets in terms of rental demand, employ-

ment, and price. Even though real estate trends are always local, it is

essential that an analysis considers the scope of the local market realis-

tically. For example, one small town may be largely rural in character

and be more than 200 miles from the closest city. Another city of the

same size in terms of population may be within 30 minutes commute

time of a large city. These differences vastly change the supply and de-

mand factors. The difference will be seen in the price of real estate,

population trends, and basic supply and demand for new housing. So

it is not realistic to base a market analysis on universal assumptions us-

ing ratios between population and market demand. These are mean-

ingless. You need to study the actual nature and mix of supply and

demand based on where people work, and on how the home-buying

population is growing in response to local economic change.

■

The speciﬁc property design potential buyers seek. Over time, desir-

ability of interior design has to change as well. In the post-World War

II era, families were happy with very small houses: small bedrooms

and kitchens and, if any areas were expansive, it would likely have

been the living room. This may have been based on how the young

married person of 1945 grew up, with family activities focused around

listening to the radio together. Today, the television generation has dis-

covered that family size is smaller than in the past, orientation around

family life has declined, and people do not necessarily gather together.

As a result, couples prefer adult amenities. As fewer Americans are ori-

ented toward cooking, for example, demand for larger kitchens is not

as strong today. Most afﬂuent Americans would rather have a wine

cellar than a fourth bedroom, especially if they have only one child—

or no children.

90 SINGLE-FAMILY HOME AND CONDO ANALYSIS

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CASH FLOW ANALYSIS OF RESIDENTIAL PROPERTIES

The development of a cash ﬂow analysis is the essential part of a feasibility

study. If the numbers do not work out, then the longer-term proﬁtability

estimates of a project are of no value. The question, however, has to be re-

viewed in terms of the speciﬁc type of project, inﬂuenced by many market

and competitive factors, and studied in terms of all three supply and de-

mand markets (for purchase of property, rentals, and ﬁnancing).

We need to consider the cash ﬂow question on several potential tiers of

the residential market. These include:

■

Single-family homes, as solitary investment possibilities for individuals.

■

A development of many single-family homes at market rate or below

market rate.

■

A speculative investment in one or more homes, as ﬁxer-upper properties.

■

Investment in vacation homes or second homes.

Cash ﬂow analysis in these different types of single-family home markets is

going to be vastly different, so we need to approach the issue carefully.

There is no single, universal rule for how cash ﬂow analysis is to be per-

formed. We analyze each of these markets separately.

Single Family Homes

The most popular entry into real estate investing is the purchase of single-

family houses to be used for rentals. The concept is simple: Rents are sup-

posed to cover the mortgage payment, insurance, taxes, utilities, repairs,

and other expenses. In practice, the strength of cash ﬂow depends on:

■

Dollar amount of down payment and, as a direct result, level of mort-

gage payment. The higher the individual down payment, the lower the

monthly payment on the ﬁnanced portion of the purchase. The interest

rate you pay also affects the mortgage aspect of cash ﬂow. Real estate

investors may be required to put 30 percent or more down payment

Cash Flow Analysis of Residential Properties 91

Valuable Resource

To get an idea of desirability in different housing features, check the matrix

chart at http://www.davisandpartners.com/newsite/ammen.html.

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into a property and may have to pay more to make the lender’s cash

ﬂow analysis work.

■

Level of market rates compared to mortgage obligation. The very basic

ﬁrst question individual investors have to ask is whether the known

level of mortgage payment can be covered by market rates. This as-

sumes full occupancy and no surprises such as unplanned-for repairs

or maintenance. If the difference between rent and mortgage payment

is marginal or negative, the cash ﬂow will not work. Even when tax

advantages are considered, the investor has to also plan for other ex-

penses involved as well as with the prospect of vacancies.

■

Current occupancy rates and trend. The health of the rental market

should dictate the timing of real estate investments. The widespread

belief that it is smart to invest in rental property should be questioned;

if the current market demonstrates soft demand, that means higher

than average vacancies and the possibility that rental income levels will

trend downward from today’s market rates.

■

Deferred and ongoing maintenance on the property. If investors buy

“bargain” properties—usually meaning those that have not been main-

tained—this also means it will be necessary to perform repairs. It may

be that the demand for such repairs could offset any discount gained

from seeking out bargain-priced properties, perhaps even making the

feasibility negative as well.

■

Tax advantages involved. An after-tax cash ﬂow is the most reliable

method for analyzing cash ﬂow on individually purchased property.

However, each individual is limited to annual deductions of $25,000

or less in losses from real estate, so as a tax shelter this offers value,

but limited value. An exception: The real estate professional as deﬁned

by the tax rules is not limited to $25,000 in annual losses. But the

point to remember for many ﬁrst-time investors is that tax beneﬁts

may deﬁne the difference between feasible and nonfeasible investing,

so these beneﬁts cannot be ignored. The method used to value land in-

ﬂuences the tax calculation, perhaps signiﬁcantly. Land cannot be de-

preciated, so the value assigned to land also affects the annual

depreciation deduction. An investor may prefer more depreciation to

maximize tax beneﬁts, or less depreciation because losses are limited

and that extra deduction provides no annual beneﬁt.

Allocation of value between improvements and land for the purpose of

calculating depreciation is done in several ways. These include prorating

on the basis of assessed value, insurance-based value, and appraisal-based

value. All of these calculations have merit, but if an individual purchases

more than one rental property, the same basis should be used in each case.

92 SINGLE-FAMILY HOME AND CONDO ANALYSIS

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Developments of Single-Family Homes

Cash ﬂow calculations for developments are, of course, far more complex

than for single home investments. A developer has to consider design and

engineering costs, approval and the possibility of legal fees involved in a

challenge to the development, and construction costs of a project. These

costs may include constructing new utilities, streets and sidewalks, land-

scaping, street lighting, trafﬁc mitigation costs, environmental impact miti-

gation, and a range of other possible costs, all in addition to basic

construction of new homes. The cash ﬂow analysis for a development is

complex because it involves so many possible levels of cost; furthermore,

the ﬁnancing of a development varies based on the type of property.

Cash Flow for Market-Rate Housing The feasibility study for development

of market-rate housing is often aimed at satisfying lender’s questions. The

lender must be convinced that the developer will be able to sell homes at

an adequate proﬁt to cover the mortgage obligation at the very least. A

cushion of proﬁts ensures that the development will be feasible, given the

possibility that additional costs will arise beyond the known, estimated

cost levels. When a developer runs out of money before completion, this

presents a special problem for the lender. Refusing to loan more funds

means that less will be recovered; however, giving the developer more

money when the initial estimates were inaccurate could present even

greater risks. So cash ﬂow analysis for market-rate development has to

include a demonstrated market demand, experience on the part of the de-

veloper in successfully completing similar projects, and the timing of com-

pletion that will ensure repayment of the construction loan before interest

expenses absorb proﬁts.

Cash Flow for Subsidized Housing The cash ﬂow analysis for low-income

housing includes the same range of questions. However, a lender may be

involved only in a limited way. Developers are more likely to use one of the

many taxpayer-supported subsidized programs, with the idea of funding

the large capital portions of the project (running new utilities, streets and

sideways, street lighting, trafﬁc signals) through selling of tax credits to in-

vestors. Approval of subsidized programs requires that housing be kept as

low-income for many years, but developers rarely retain projects and man-

age them; they are more likely to sell off the properties as soon as ﬁnal ap-

proval has been achieved. So among the possible costs of a subsidized

housing development may be performance bonds a municipality will re-

quire with the likelihood that the developer will not be around during re-

curring maintenance cycles; the cost of ﬁnding likely buyers for projects;

Cash Flow Analysis of Residential Properties 93

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and the possibility of having to absorb vacancies for a period of time if the

local demand market is not strong enough to keep all units ﬁlled—an un-

likely event, but still a possibility. (The developer in this situation may

make a convincing case in the market study to show that demand is high,

but when it comes time to rent out housing, the market realities may result

in chronically high vacancy levels. This affects cash ﬂow and the ability to

sell the project for top dollar on the market.)

Fixer-Upper Properties

An interesting variation on single-family property investing is the purchase

of run-down properties. The idea is to use sweat equity—the work per-

formed in completing repairs—to bring the property’s value up to market

rates. This concept works when the cost of repairs is less than the appreci-

ation in market value. Thus, cosmetic repairs—including painting and

landscaping, for example—are easily completed at minimal cost but with

the greatest potential for creating increased value.

The problem with the ﬁxer-upper market is cash ﬂow. If an investor

holds onto a property for six months, the cash ﬂow calculation is not lim-

ited to only the difference between discounted purchase price and market

value, offset by the cost of repairs. The calculation also has to consider the

six months’ mortgage payment. When margins are thin or, when the im-

proved property does not sell quickly enough, a minimal proﬁt is easily

wiped out.

Two alternatives many investors have tried are rental conversion and

living in the property. In the rental conversion plan, repairs are done as

quickly as possible after closing the deal, often in one month or less. The

property is then rented out and held as a long-term investment. Because the

property was purchased below market rates, the idea here is that cash ﬂow

will be healthy. Because the new owner charges market rates for rent, cash

ﬂow is positive and allows a cushion that would not otherwise be avail-

able. So the cash ﬂow calculation in this instance is made as modiﬁed

rental investment. The assumption here is that the repairs can be com-

pleted in a reasonable amount of time. Renovation projects are more prone

to cost overruns than new construction.

The calculation is even easier when the investor moves into the prop-

erty during a period of repairs. Because the individual has to pay either

rent or a mortgage payment, this eliminates the duplication of negative

cash ﬂow. After repairs are completed, the house is sold or converted to a

rental and the investor moves on. While this idea has merit on paper, it

may prove stressful for other family members. Not only is a family ex-

pected to live in the middle of the chaos of repairs, they are also required to

94 SINGLE-FAMILY HOME AND CONDO ANALYSIS

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move frequently, as one project is completed and another begun. The idea

solves the cash ﬂow problem, but may not be practical for other reasons.

Vacation or Second Homes

A ﬁnal type of investment requiring cash ﬂow analysis is the second home.

Many people purchase a cabin by the lake, a timeshare, or a house in a dif-

ferent clime. All of these ideas appeal to those who want to spend time on

vacation, but the question of cost has to be considered as well.

A second home—deﬁned as a part-year primary residence, for tax pur-

poses—is partially subsidized through tax beneﬁts. Individuals can deduct

interest expenses and property taxes as itemized deductions on both their

primary residence and a second home. This reduces the after-tax cash bur-

den, but not entirely. The individual is still left with ongoing mortgage pay-

ments as well as taxes, insurance, and maintenance. One possible solution

is to rent out a second home for that portion of the year it is not used as a

second home. This provides a prorated tax beneﬁt, because the property

can be depreciated for the part of the year it serves as a rental. The owner

can also deduct utilities, interest, insurance, taxes, and other expenses as

investment expenses. So it is possible to create rental income to cover the

costs of owning the second home for part of the year, and also to create a

partial tax beneﬁt at the same time. The problem with this plan is often

one of timing. If the owner wants to vacation at the same time as everyone

else, there is a good chance that the off-season will see low demand. One

solution is to vacation at the second home during the off-season and get

higher market-rate rents when everyone else wants to be at the beach, in

the mountains, or at the Mexican resort.

LOCAL OPPOSITION AS A MARKET FACTOR

The phenomenon of organized land use opposition adds to the cost of de-

velopment, often considerably. It is even possible that a group of local citi-

zens can prevent certain types of development from taking place.

The Not In My Back Yard (NIMBY) movement has to be considered

as a possible cost factor, notably for single-family housing aimed at low-

income renters or buyers. Also called Locally Unwanted Land Use (LULU),

Build Absolutely Nothing Anywhere, Not Anytime (BANANA), and Citi-

zens Against Virtually Everything (CAVE), antigrowth forces often present

ridiculous arguments against development. While such groups may oppose

any form of development, rezone, or change in local land use policies,

trends in recent years have been toward a focus on low-income housing. As

Local Opposition as a Market Factor 95

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one of the more important forms of development risk, organized NIMBY

movements should not be overlooked. A survey of developers revealed that

in terms of risk, “three common refrains were meeting governmental and

utility regulations, dealing with neighbor complaints, and correcting un-

foreseen environmental problems.”

All of these risks can and should be anticipated and mitigated in ad-

vance. The NIMBY problem should not take a developer by surprise if the

market survey is completed thoroughly—even when a project has real or

perceived social impacts. The NIMBY movement has come about largely

due to the increase in development trends aided by major changes in the

tax law in the Tax Reform Act of 1986 (TRA), and through the creation of

Low Income Housing Tax Credits (LIHTC). The greatest argument

NIMBY groups make is that low-income housing reduces property values

for surrounding properties. This argument has great appeal to local resi-

dents, and often leads to petition drives, letters to the editor and to the lo-

cal public hearing ﬁle, and direct testimony. In some instances, local

political approval may move the entire question to the courts, adding cost

and delay to any development process.

96 SINGLE-FAMILY HOME AND CONDO ANALYSIS

Valuable Resource

Several studies support the argument that low-income housing does not ad-

versely affect property values of nearby homes. Some examples can be

found at:

www.fhfund.org/educational_materials_reports.asp—A Study of the

Relationship Between Affordable Family Housing and Home

Values in the Twin Cities, Maxﬁeld Research report.

www.enterprisefoundation.org/—Affordable Housing and Property

Values, The Enterprise Foundation.

www.abag.ca.gov—Myths and Facts About Affordable and High-

Density Housing, California Planning Roundtable.

www.habitat.org Why Affordable Housing Does Not Lower Property

Values, Center for Common Concerns.

http://www.mcaws.gov.bc.ca/housing/housing.htm—The Effects of

Subsidized and Affordable Housing on Property Values: A Survey

of Research, State of California.

www.uic.edu/aa/cdc Affordable Housing Design Advisor, University of

Chicago.

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As effective as the arguments are for protection of local property val-

ues, the facts reveal that low-income housing development does not reduce

property values nearby. In fact, numerous studies have concluded that

property values rise or, at the very least, remain unaffected, when low-in-

come housing development occurs.

The concerns among NIMBY groups also go to increased trafﬁc or

crime, noise, loss of trees, and other amenities. In other words, NIMBY

opposition grows from change. Such movements gain a lot of momentum

from poorly designed development, from situations in which developers’

actions do have adverse impacts locally, and when local planners do not

enforce zoning laws, comprehensive plans, and other regulations.

The best way to deal with antidevelopment sentiment is by acting in a

preemptive manner. The vast majority of momentum NIMBY groups

achieve derives from lack of information. However, withholding plans from

citizens is illogical. A developer’s plans will be known soon enough, but if in-

formation is not available, all sorts of worrisome rumors ﬁnd their way to

neighborhood meetings. In one situation, plans for a large 200+ acre site

were to build a truck-to-train intermodal facility. A well-organized local op-

position group formed with limited initial success. However, when the

group’s leaders began spreading a rumor that developers planned to site a

landﬁll on the property, the antidevelopment sentiment picked up speed, and

ﬁnancing. In that situation, the developer needed to get the land rezoned,

and the rumor was based on a reading of the local code which, among other

uses, allowed light industrial zoning, which included landﬁlls.

Developers who announce their lands in advance defuse much of the

opposition that is likely to center around a project, especially in the envi-

ronment where dependable information is not available.

Local Opposition as a Market Factor 97

CASE STUDY: SNOW HILL CITIZENS FOR DECENT HOUSING

In Worchester County, Maryland, this organization originally pro-

posed a low-income housing project in 1995. It was defeated in a lo-

cal referendum. In 2000, the group tried again, but ﬁrst took steps to

provide information about the proposed 24-unit housing plan.

The effort included brochures that were mailed out to residents;

ads in the paper; and canvassing, both door-to-door and via tele-

phone. The group also made the convincing argument that 42 percent

of residents in the city of Snow Hill would qualify to live in the units

based on income levels.

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Similar outcomes have been achieved in other places, largely due to an

effort by developers or by organizations sponsoring low-income projects,

to educate the public in advance or to hold community meetings to explain

development plans. This is especially effective if people are invited to make

suggestions to improve a project’s amenities or design. In 2002, a nonproﬁt

organization met virtually no opposition to building a 400-person home-

less shelter in downtown Minneapolis. This was the result of community

meetings early on and before the process began, in which a citizen sugges-

tion for a design change in the building’s façade was accepted.

Rather than accept the alternative of extended battles, often involving

expensive lawsuits and years of delay, including the possibility of rejection of

plans for development, it makes far more sense to prevent such problems as

an organized NIMBY movement, before it begins. Developers and market

analysts also should keep in mind that even a ludicrous argument may pre-

vail in a land use dispute. In one instance in Florida, opponents to allowing a

homeless “safe zone” on 14 city parcels argued that allowing homeless peo-

ple to have a safe zone would negatively impact sea life! The city’s attempt to

elicit comments from local residents included sending out 840 invitations to

a public meeting concerning the issue. City ofﬁcials were confronted by a

hostile group they described as Not On My Island (NOMIs).

It is also essential to test the mood politically in a community before

coming forward with plans for a low-income housing project, or for that

matter, any new project. That includes not only elected ofﬁcials, but the

heads of agencies, politically active citizens, and the person in charge of the

planning department. All of these groups have an interest in planning and

in land use issues. Advice to developers and builders worth heeding in-

cludes the observation that

while NIMBY opposition to affordable housing projects may be

traditional, it isn’t inevitable. Project sponsors can reduce or even

avoid community resistance to affordable housing by taking a

strategic, proactive approach to community relations.

Single-family housing is best-known to most people because they ei-

ther own homes, or because they would like to buy a home one day. Those

individuals who analyze investment properties—either solitary home in-

vestments or more complex subdivisions—need to realize that investment

properties and developments have numerous market attributes that make

this property vastly different from the market for owner-occupied homes.

98 SINGLE-FAMILY HOME AND CONDO ANALYSIS

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CHAPTER

Multi-Unit Rental

Property Analysis

Multi-unit developments compete not only with other

developments, but also internally between units. Competition is

driven by the amenities that a project offers, the size of the units,

and the project’s distance from retail, recreation, health care

services, and places of work. In addition, there are specialty

residential projects such as senior, disability, and low-income

housing that compete both in the larger market and in their

specialty submarkets. This chapter examines these complex issues

and provides a context for analysis based on area-speciﬁc and

developmental factors.

nalysis of multi-unit residential real estate is more complex than analysis

for detached, single-family housing. The reasons for this include the

variable of the demand market for apartments and similar multi-family

units; and the complexity of analyzing actual demand locally, given the

competitive market conditions and trends.

The market for apartments and other multi-unit projects is huge. The

overall value of property (excluding single-family houses) in the United

States, in 2004 was $5.275 trillion, of which 44 percent consisted of apart-

ments.

The breakdown among apartments and other types of property is

summarized in Figure 5.1.

There is a tendency to view the market inaccurately, in many ways. For

example, it is popularly believed outside of New York City that virtually all

apartments in the city are rent controlled. This myth is fostered in many

venues, including a recurring gag line in TV sitcoms. Someone dies and, upon

being informed, a friend’s ﬁrst question is, “Who is getting his apartment?”

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The truth is not as extreme, however. With more than 2 million rental units

in New York, only 2.8 percent are rent controlled.

In fact, rent controls at

any level are very rare outside of New York City.

Inaccuracies abound about many other urban markets. For speciﬁc

projects, the analyst should remember that conclusions about market de-

mand may be inaccurate, and it is a common error to base demand as-

sumptions on the idea that a project will receive 100 percent of the current

demand. Neither of these assumptions are accurate.

Current demand is the sum of all potential tenants currently seeking

rentals in apartments or similar multi-family units (two, three, or fourplex

projects, for example). One easy way to identify demand is by checking lo-

cal waiting lists among existing apartments and housing agencies (Housing

Authority, HUD Section 8 ofﬁces, and other agencies set up to seek and

provide housing, especially for those individuals and families whose in-

come is below local averages).

100 MULTI-UNIT RENTAL PROPERTY ANALYSIS

FIGURE 5.1 Real Estate by Property Type, 2004

Source: Society of Industrial and Ofﬁce Realtors.

Apartment

44%

Retail

23%

Office

15%

Industrial

10%

Hotel

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The problem with using such lists to identify demand is that any con-

clusions will be exaggerated. Many people on waiting lists currently oc-

cupy apartments locally. So this is not actual demand but would result in a

shift between local units. This variety of demand results in additional va-

cancies somewhere in the same local market. Newer units are likely to gen-

erate interest especially if existing units cost about the same market rates;

people like to move to newer units with better amenities. However, in

larger perspective, demand identiﬁed from waiting lists is not reliable.

A more accurate measurement of demand forecasting should be based

on local population trends, in comparison with new unit construction. For

example, if the population has been growing by 5 percent per year and new

apartment and housing starts have matched that increased demand, the

market generates new demand that is easily quantiﬁed—assuming the ana-

lyst is also able to perform this study based not only on population growth,

but also on growth by income levels. However, population alone does not

necessarily justify an argument that a particular project is in demand, be-

cause we also have to understand that demand in the context of competing

projects. How many competing apartment and housing projects are under-

way, and when will they be completed?

Market share is the degree of new demand a project will be likely to ab-

sorb. The tendency to assume that a new project will meet all of the new de-

mand is simply unrealistic. If a study of recent population growth is

supported by a healthy job market, we may identify a demand next year for

200 additional apartment units. However, if we build those 200 units, we

cannot reasonably expect that all new demand will come to that project. If

other builders are currently building 150 units, it may be reasonable to make

an argument that our project will be justiﬁed by 25 percent of the demand

(50 out of 200 new tenants, based on trends and forecast tenant growth).

A study of current demand and market share may not be entirely reli-

able, again based on the speciﬁc attributes of an area. It may be possible,

through location selection, amenities, and design, to expand the local mar-

ket and to attract tenants from outside of the apparent market area, that is,

the geographical market.

THE LOW INCOME HOUSING MARKET

One important market in the rental industry is low-income housing. Con-

gress, recognizing the importance of providing incentives to developers to

include low-income units in larger programs or to willingly devote entire

projects to this specialized market, enacted a Low Income Housing Tax

Credit (LIHTC) program as part of the Tax Reform Act of 1986 (TRA).

The Low Income Housing Market 101

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102 MULTI-UNIT RENTAL PROPERTY ANALYSIS

CASE STUDY: THE YARDS, PORTLAND, OREGON

The riddle we answer here is: How do you attract markets from out-

side the area? In other words, why should someone move to a speciﬁc

city or town and occupy units in a newly developed building?

The Yards is a community of about 600 affordable and market-

rate apartments in the River District near Portland, Oregon’s down-

town. Portland is unique in the sense that speciﬁc neighborhoods

retain their individual characteristics even though a part of a larger

city. The River District is just north of downtown and—before rede-

velopment—was characterized by empty lots, vacant warehouses, and

industrial sites like the large postal distribution center two blocks up

from the water.

Complicating redevelopment, the site was contaminated with

diesel and petroleum products as well as hydrocarbons, lead, and ar-

senic. Some of this contamination was found as deep as 10 feet. A to-

tal of 100,000 cubic yards of contaminated soil had to be treated or

removed. Development was aided through a low-interest loan by the

Portland Development Commission, augmented by the sale of tax-

exempt bonds to provide construction and permanent debt. Further

tax incentives are provided for the low-income aspect of the develop-

ment through low-income housing tax credits (LIHTCs).

Fortunately, the neighboring Pearl District, which once was a pri-

marily industrial area, also went through a transformation. Today

this area includes art galleries, restaurants, and small boutiques as

well as several developments of luxury condominiums. Demand in

this and other areas of Portland with close proximity to downtown,

has been high during recent years. Most of the project (four out of

ﬁve phases) was ﬁnished by December 2002 and occupancy has re-

mained steady at about 95 percent.

This project has demonstrated that proximity to a downtown

area, consisting of affordable housing, can and does attract new mar-

ket share from outside of the immediate and obvious existing market.

Many people have relocated to The Yards, both from California and

the Seattle areas to either semiretire or to change location while con-

tinuing to work. In this example, the combination of attractive loca-

tion and price redeﬁned the market. It enabled the developer to

achieve a high occupancy rate by appealing to tenants beyond the im-

mediate area.

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As of 2004, this program has assisted in development of 1.6 million af-

fordable apartment units to qualiﬁed families. Incentives for developers

usually are provided in the form of tax credits, direct reductions in tax lia-

bilities. Tax credits are transferable and can be used to ﬁnance the infra-

structure of low-income housing projects, thus serving as a type of

ﬁnancing. On average, these tax credits ﬁnance 40 percent of total develop-

ment costs.

The incentive has worked. Today, 40 percent of all multi-family devel-

opments include some level of qualiﬁed LIHTC units. The rules require one

of two standards: Either 20 percent or more of apartments in a develop-

ment must be occupied by tenants with incomes below 50 percent of me-

dian income; or at least 40 percent of units must be occupied by those

whose incomes are at or below 60 percent.

The cost (measured in reduced tax revenues) is approximately

$6 billion per year. Current issues being debated are one provision

allowing states to allocate LIHTC resources to areas where they are

most needed, and basing eligibility on statewide standards rather than

on those standards in one area within the state. Objections to this pro-

posal include concerns that states would possibly use LIHTC provisions

to control where low-income housing could or would be built. Even so,

the proposal is supported by many advocacy groups throughout the

country.

LIHTC incentives can induce developers to construct housing for low-

income families while also helping cities and counties to encourage resi-

dents to move to new areas where affordable rental units are available,

even in major metropolitan areas.

FACTORS AFFECTING MULTI-UNIT MARKET ANALYSIS

In studying the local market for multi-unit housing, the question of de-

mand is central to identifying feasibility. How many units will be needed

by the entire market? What portion of that demand should we expect to

absorb? And when is that demand apparent in the local market?

These questions identify aspects of the absorption analysis process.

Within market analysis, absorption refers to all forms of real estate;

however, for multi-family housing in particular, absorption should in-

volve a study of demand aspects. The most important among these is the

expectation of occupancy level and timing. When do we expect to

achieve maximum occupancy? This question should further take into

Factors Affecting Multi-Unit Market Analysis 103

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mind the issue of where the market exists. So a market area study should

include a realistic analysis of the real supply and demand market. Using

strictly geographical miles-based arbitrary assumptions is not reliable.

This analysis should include a study of trafﬁc patterns relating to com-

mute, location of regional and local jobs, transportation issues (public

as well as auto-based transportation patterns), and the proximity from

the site to schools, shopping, and other local amenities. So to simply

identify the market area as existing in a ring of ﬁve miles from a site is

rarely accurate. The shape of the market is not likely to be round, but is

more likely to follow development and roadway factors, location of

jobs, and the competitive factors—existence of competing or planned

apartments within that realistic market area.

Absorption is an estimate of not only the occupancy level, but the tim-

ing as well. Certain events that delay completion of a project will direct af-

fect the estimates, including complications in local approval of permits;

labor strikes and other work-related problems; or unforeseen events that

no one could possibly predict. In such instances, developers may need to

ﬁnd ways to give incentives to tenants through reduced rents, for example.

One striking example of this was the ﬁrst new development completed in

lower Manhattan following the September 11, 2001, attacks on the World

Trade Center.

104 MULTI-UNIT RENTAL PROPERTY ANALYSIS

CASE STUDY: THE SOLAIRE, NEW YORK

This development includes 293 apartments and contains 383,000

square feet in 27 stories. Total development costs were $120 million.

Completed in 2003, this is the ﬁrst “green” residential high-rise and

the ﬁrst project completed in the post-911 Zone I section of lower

Manhattan, also called Battery Park City. The project is called

“green” due to its innovative design incorporating energy-savings and

environmental state-of-the-art features, marketed with the invitation

to “live healthy, live green.” Design and engineering translate to 35

percent less energy use and 67 percent reduction in electricity during

the hottest summer months.

The unforeseen events of September 11 naturally lead to the ques-

tion of whether the original feasibility assumptions concerning occu-

pancy of these residential units remain valid. The site is only two

blocks from the site of the World Trade Center. However, even with

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Factors Affecting Multi-Unit Market Analysis 105

CASE STUDY: THE SOLAIRE, NEW YORK (Continued)

this in mind, the complex is 90 percent occupied as of the end of

2004. Original projected rents were higher than the current levels be-

tween $2,200 and $6,700 per month. High occupancy was aided by

grants provided by the Lower Manhattan Development Corporation,

reducing rents by up to $12,000 (payable in increments of $500 per

month) as incentive to sign leases by May 31, 2003. In spite of predic-

tions concerning lowered market rents and high vacancies in lower

Manhattan following the 2001 attacks, Solaire reports annual rents

of $47 per square foot.

The developer, the Albanese Organization, Inc.—http://www

.albaneseorg.com—is located in Garden City, New York. As part of

the design, the building’s tenants have access to an exercise room, aer-

obics room, children’s playroom, a rooftop garden, and a green roof

system to help insulate the building. Also provided: storage for up to

150 bicycles.

Recalling that this project’s feasibility predated September

2001, it is not surprising that following the attacks, the lead

construction lender withdrew from the project and new sources

of ﬁnancing were required. This was achieved in February 2002,

when Congress approved the issue of tax-exempt Liberty Bonds.

Developer Albanese was the ﬁrst to receive funds through this

program, in the amount of $120 million. The September 2001 dis-

aster and changes in the ﬁnancing structure of the project caused

a nine-month delay in construction, adding $9 million to the

total cost.

This project was completed successfully as measured by occu-

pancy and rental rates. This has occurred in spite of the September 11

disaster and the building’s proximity to Ground Zero. The combina-

tion of replacement ﬁnancing and lease incentives offset the original

concerns. Superior design certainly supports rental levels, which are

not surprising by Manhattan standards; the incentives provided for

signing leases further aided in completing the initial absorption for

this property. Developers were faced with several initial problems:

proximity to the World Trade Center, loss of original ﬁnancing, and

expensive delays in completion. Even so, they were able to revise their

plans and create ﬁnancing and lease incentives to offset what had

been lost.

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Any projections concerning occupancy in a project are going to be un-

certain. The unknown elements in an extreme case—as we saw with The

Solaire in New York—are certainly not typical. But even if a project is not

sited two blocks from the World Trade Center, market analysts must ex-

pect some surprises.

One would use as a starting point the analysis of current supply. In be-

ginning to approach the analysis of supply, be aware that there are speciﬁc

kinds of supply: existing, under construction, and proposed (permitted). It

is not adequate to merely count existing units in an area, because it may be

that under construction and proposed units will drastically alter the supply,

thus affecting the feasibility of the proposed new project. A skilled analyst

should know how to weigh each of these as part of the study.

A realistic evaluation of the overall supply makes sense because, clearly,

a comparison between existing supply and perceived demand, should reveal

whether the project is feasible and whether occupancy assumptions are sup-

ported. However, it is equally important to remember that the issue of occu-

pancy is not based solely on existing supply. Today’s supply is a snapshot in

time, but it will look far different when a project has been completed. We

point once again to the extreme example of The Solaire to make this point.

To some degree, it is important to allow for changes in the supply element.

So if we are studying the feasibility for a project to be completed in one

year, the completion issue will be far different from the same issue for a pro-

ject planned for completion three years from now.

The ability to forecast supply and demand in three years is elusive in

comparison to a one-year time frame. So the further away the estimated

completion date, the less reliable the occupancy estimates. A one-year fore-

cast period—at least for purposes of identifying emerging competition for

the same market share—should not be difﬁcult. However, because supply

is more easily pinned down than demand, there is a tendency to place em-

phasis—perhaps too much emphasis—on the supply side, even in the short

term. To elaborate:

In the short term, new supply is not (or should not be) a surprise.

Even in cities with limited local construction, the quantity of new

apartment completions in the next 12 to 18 months can be esti-

mated closely enough to make informed decisions. And supply risk

is tangible, readily visible just from driving by construction sites.

Instead, the stealth forces—the factors that sneak up and sur-

prise—lie on the demand side of the market equation.

While estimates should be as broadly inclusive as possible, the analysis

should consider supply and demand with equal weight. Furthermore, it

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makes no sense to limit the analysis to only the obvious tenant market. For

example, will a particular apartment complex be aimed at a market-rate

tenant only? Or will some units be set aside for low-income, handicapped,

or specialized markets? In urban centers, for example, many buildings gen-

erally geared toward family tenants also serve the growing corporate

apartment market. The size of this business is considerable, according to

the experts:

Corporate apartments [were] a $2.2 billion dollar industry in the

United States in 2000. . . . This emerging segment is particularly

interesting to multi-family housing owners and operators because

76 percent of corporate apartments are leased inside traditional

multi-family complexes.

The need to accurately forecast is a basic problem in all forms of

budgeting and forecasting. However, considering the maximum potential

market area range is also crucial to accuracy in the forecast. Estimating

future occupancy is easiest when we are looking at a short period of time

and becomes increasingly unreliable as we look further into the future. At

some point, the variables make the process little more than guesswork.

So a market area with its economic and demographic trends is rarely ex-

clusively reliable. We need to depend on a collection of many data to

draw a reasonable conclusion concerning occupancy in the distant future.

These include the trends in population, job market, transportation pat-

terns, housing and rental prices, and other local statistics. While the de-

mand for owner-occupied housing is entirely different from the demand

for apartment units, the trends in housing may serve as a useful indicator

in estimating future occupancy. If prices are ﬂat and a large inventory of

homes are for sale, we may assume that rental demand is also likely to be

affected. As owners ﬁnd they cannot get a desired price on the market,

they may decide to wait until those market conditions change. In this sit-

uation, many of today’s owner-occupied houses may be converted to

rentals. And as an increased number of houses become available at mar-

ket rates, there is an effect on apartment rentals as well. The overall mar-

ket (for housing and, as an effect, for apartments as well) is affected more

by current interest rates than by almost anything else. The various effects

are not always indirect or obvious, because the demographic is not the

same between ownership and rental markets, and neither are market

rates. Many people living in apartments simply cannot afford to buy or

rent a house; however, there is a segment of the market that is willing and

able to afford to rent a house (or duplex, triplex, or fourplex unit) and

prefers that over apartment living. As the volume of housing rentals

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increases, some level of demand for apartment units is reduced. Thus, ab-

sorption may require more time and occupancy levels may be lower as

well. The timing, level, and net rental demand of the market ultimately

determine and deﬁne feasibility in terms of occupancy levels one should

expect. Net rental demand

means balancing the growth of rental households against the ex-

pansion of the rental stock. Although new rental communities may

derive renters from existing communities through turnover, inter-

preting those moves as demand can lead to high vacancies in the

overall market, which eventually will affect the subject project as

well as the rest of the rental stock.

In attempting to identify likely occupancy timing and level, this is one

of many factors worthy of consideration. It makes sense to include a reduc-

tion of total occupancy levels to allow for the competition from other

apartments, multi-unit housing, and single-family housing.

Another factor making it difﬁcult to project occupancy into the distant

future is the unknown of competing apartment projects. Even in a market

with very strong demand, competing developments are likely to be built to

meet that demand. And units ﬁnished earlier than the subject project will

get a share of the then-current demand, leaving less for later-completed

projects. It is more likely that occupancy estimates will be made when a de-

veloper has a speciﬁc target date in mind. Supply analysis as well as de-

mand analysis is usually limited to a one-year period, with the unknown

quantities beyond 12 months a determining factor in how (and why) ex-

tended analysis is of little practical value—especially if the analysis is to be

used to obtain current ﬁnancing, determine appropriate design, and most

importantly, to decide how many units to construct.

Some types of real estate can analyze supply and demand more easily

because they are able to presell occupancy. Retail projects, notably malls,

begin with long-term lease commitments from anchor tenants, and, once

those commitments are in place, gaining additional leases is far easier. It is

likely that lease commitments will be well in hand indicating at or near 100

percent occupancy, even before a developer closes the deal with lenders or

investors. Thus, other aspects of the analysis, speciﬁcally cash ﬂow, are

more easily and more conﬁdently estimated, even years in advance. The

same beneﬁt is not always possible in single-family residential real estate. It

is unlikely that a future tenant will be willing to commit to a long-term

lease a year in advance. It is unlikely that a majority of tenants will be able

to make such commitments even a few months before move-in date; the

majority of interested tenants will want to move into units as soon as pos-

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sible. In comparison, both houses and condo units are often presold based

on viewing models or other existing units.

CASH FLOW ANALYSIS FOR MULTI-UNIT HOUSING

Cash ﬂow analysis depends upon occupancy assumptions, and this is

where the uncertainty lies. The initial market and feasibility study—often

performed at the planning stage—are based on current market conditions

such as occupancy rates, market rent levels, and the current job market.

We go forward assuming that those initial assumptions will be valid in the

future; however, conditions may change. Once a project’s completion is to

occur within one year, cash ﬂow analysis is far easier and more accurate.

It may be that neighboring markets will be built in response to devel-

opment closer to city and town centers. As a result, today’s potential tenant

may ﬁnd better prices further out, which also affects the market analysis.

One writer has observed that this

important intermarket relationship is often overlooked; the

changes in market occur because of changes in the extent to which

neighboring markets are built out. As a local market area gets an

increase in units approaching the holding capacity . . . the price

tends to rise, and buyers shift to the next outlying area.

This predictable tendency—the movement of competitively priced

units into ever-farther out locations—may lead an analyst to an inaccurate

conclusion. Upon realizing that local rental rates have gone up, the analyst

may conclude that this is good news in terms of cash ﬂow analysis; in other

words, more revenue will be earned. However, the ﬂaw in this conclusion

is that the initial analysis used a particular occupancy rate and presumed

time for absorption, neither of which remains accurate. In addition to rates

rising as tenants move farther out, a related trend occurs: the tendency to-

ward lower overall occupancy, as a factor of competing market rates in

other neighborhoods, where rents are lower.

Cash ﬂow analysis has to consider issues beyond the initial assump-

tions concerning occupancy. Because the analysis involves dynamic rental

markets, the analyst needs to not only anticipate the trend and its ramiﬁ-

cations for the subject proposal, but also to identify the likely steps

needed in response. These may include lower market rental rates, more at-

tractive lease terms, or the addition of amenities that tenants will ﬁnd de-

sirable—all designed to bolster the occupancy rate to compete within the

current trend.

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While the identical market analysis problems apply to subdivisions,

the apartment market is more subtle, because two different supply and

demand markets are involved (market value and rental demand). In the

typical cash ﬂow analysis for subdivision housing, a form of “risk diver-

siﬁcation” occurs because, upon completion, units can be sold individu-

ally on the market, or even presold when demand is high. Thus, a

subdivision development is often able to ﬁnance its own cash ﬂow with-

out the need for gap ﬁnancing. Presales usually pay off existing con-

struction loans, and later sales are available for the developer’s use. This

eliminates the common risk of scheduling delays, causing higher interest

expenses and debt service. In the case of apartments, which are rental

units rather than buy-and-sell products, such advantages are not avail-

able in either case. They cannot be prerented, and there is no available

after-market generated from sales (the exception, of course, is when a

developer is able to presell an apartment development, which eliminates

the typical interim cash ﬂow risk). Some developers also have proﬁtable

relationships with REIT managers and other institutional investors who

do not want to develop their own projects, but who have a voracious ap-

petite for newly built projects.

The analysis should not be limited to rental gross income and occu-

pancy, either. Basic real estate investment value is an important part of fea-

sibility. Are land values reasonable today and, based on a study, what types

of growth are likely to occur if the subject land is utilized for multi-unit de-

velopment? Some analysts and appraisers assume that desirable location

automatically translates to advantageous land proﬁts when development

occurs; this is not always the case. It may be ﬂawed to merely assume that

appropriate zoning (or a rezone) creates an automatic investment advan-

tage. For example:

Zoning, as it translates to highest and best use, is the area where

we see some of the major errors made by appraisers. When you

have a diminishing asset (i.e., the availability of direct oceanfront

properties), having a “multifamily” zoning designation may not

translate automatically into the development at allowable density

as the highest and best use.

Since both land values (and increases in such values) and rental income

affect future appraised value, both have to be considered during the initial

feasibility phase. With potentially higher than expected vacancies, disap-

pointing changes in land values, or a longer absorption period in play, the

cash ﬂow issue becomes not only more complex but also more difﬁcult to

quantify. Thus, the analyst needs to manage the analysis by tracking the

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market during the development phase. If the cash ﬂow assumption has

been based upon market and feasibility studies, a concern develops on two

fronts: the potential that the market has changed, as well as the potential

that assumptions in the initial studies were ﬂawed.

A changed market is likely if and when completion of the project runs

over the initial schedule or if the market itself is moving through a rental

demand cycle rapidly. We have provided one example, when rents in the

immediate area rise due to scarcity, so the tenant market moves to adjoin-

ing locales, eliminating demand. It is ironic, in fact, that one motivating

factor may be rising demand in the immediate area of the proposed apart-

ment complex to be developed. In performing the cash ﬂow analysis, it is

important to be aware of how a predictable tenant base will act. The rising

rents, in fact, are not positive indicators for cash ﬂow; but there is a limit

to its effect. Some tenants will not passively remain in the area and pay

higher rents, but will move to more affordable markets. These may be only

a few miles removed from the project site, but the market forces behind the

migration are easily tracked: Higher rents lead to softened demand.

Flawed basic assumptions include a belief that the subject project is

going to absorb all identiﬁed demand; that the demand is itself unchang-

ing; and that the demand exists when it may not. These potential ﬂaws

in assumptions have been explained previously. However, putting to-

gether these three assumption-based problems may lead to a serious cash

ﬂow shortage. We may cast these three elements (inclusion of all de-

mand, a static demand assumption, and softness in real demand itself) in

another light, identifying three cause-and-effect aspects to the causes of

ﬂawed assumptions:

1. Failure to understand the components of demand. The market analyst

who simply seeks out statistics in support of a premise that “there is a

need” for a project, misses the point. Demand certainly may exist, but

so does competition. In real estate, everyone gets the same good idea at

the same time. If analysts cannot identify any potential competition,

they are not looking hard enough . . . or it is not a good idea.

2. Lack of recognition of the dynamic nature of supply and demand cy-

cles. When we say that a market is “cyclical,” this means that it moves.

More to the point, the market changes elusively. We cannot identify

the timing by which a cycle strengthens or weakens, or reverses the

current trend. While this is a troubling aspect of forecasting, it is also

the most interesting. The key to effective cash ﬂow management is be-

ing able to provide for “worst-case” outcomes in recognition of the

uncertainties in cyclical timing, and at the same time devise a practical

forecast that is useful to developer as well as to lender or investor.

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3. Failure to recognize that demand, in fact, does not really exist. The

most drastic error in the basic supply and demand analysis is to docu-

ment the wrong factor. It is easy to prove that various apartment com-

plexes, housing agencies, and governmental advocacy groups have

waiting lists for housing. It may even be possible to document issues

such as local homelessness, transient populations, or families living be-

low the poverty level. None of this data is useful, however, in identify-

ing the current level of demand. Because the population of potential

tenants is itself complex, we cannot ﬁnd it easily. When concert tickets

go on sale, we can see a line disappearing around the corner, so we

know that the concert will be sold out. When property is listed for sale

and three offers are received on the ﬁrst day, we know that demand is

very high in that price range. However, we cannot assign the same vis-

ibility to demand for apartment units.

The fact that many people on waiting lists (1) live elsewhere, (2)

have found living accommodations since adding their names to a list,

or (3) have moved away complicates this entire question and makes

list-watching the most unreliable method for deﬁning current demand

(not to mention identifying what demand may be a year from now).

In recognizing that the list-watching method is not reliable, the astute

market analyst will turn to recent housing and apartment starts, job

creation, changes in population, and similar statistical data to esti-

mate demand. Interest rates are valuable, too, as a tracking device.

High interest rates mean more rental demand. As rates rise, more peo-

ple substitute rental housing for owner-occupied housing. So a list

alone does not tell the whole story; we also need to discover why a list

is growing or shrinking. While lists are easier to ﬁnd, we must also

recognize that they are not reliable as indicators of actual demand.

The combination of high occupancy in existing complexes, coupled

with ever-present lists is one strong indicator of continuing demand;

but that alone does not reveal the trend adequately to serve as a reli-

able, ﬁnal answer.

Because the cash ﬂow projection relies on the accuracy of a future

occupancy level and absorption time, we need to utilize the local eco-

nomic and demographic trend data, in addition to occupancy levels

(and waiting lists). Clearly, if local apartment complexes have weak

occupancy rates, no waiting lists, and declining markets for prospec-

tive tenants, there is no way to justify the feasibility of building more

apartments. However, all this reveals is that low-demand markets are

more easily recognizable than are high-demand markets.

Even when we know that demand exists, we cannot easily quan-

tify the level of demand, the strength of the trend, or the level of com-

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petition; to discover the scope of these factors, our cash ﬂow analysis

has to be more inclusive of all the supply and demand factors at work

in the existing market as well as within the trend.

THE OCCUPANCY ISSUE IN MULTI-UNIT

CASH FLOW ANALYSIS

Cash ﬂow and all of the assumptions that go into it rely upon accurate

readings of the local real estate market. The analysis of cash ﬂow and de-

veloping estimates of likely future occupancy levels is no easy matter. The

chief economist of the National Multi Housing Council (Washington, DC)

has observed that

knowing how a local economy is performing does not necessarily

give a good indication of how the local apartment market, or any

other property market, is performing. Differences in apartment-

speciﬁc demand and supply conditions can weaken the link be-

tween the local economy and the local property market.

This observation has profound ramiﬁcations for the real estate analyst.

If there is no direct connection (necessarily) between the local economy in

general, and the local property market, how is a cash ﬂow projection to be

developed? What data can be used reliably to make the projection realistic,

and to support that projection with rational assumptions?

In fact, estimating near-future occupancy and vacancy trends is more

accurately done using performance data—indicating trends in market rent

levels as well as in occupancy within a speciﬁc market. A correlation be-

tween these two trends—rent increases and vacancy rates—may provide

the most reliable trend in estimating cash ﬂow for an apartment project.

Such information is useful only if applied within the same region as the

project itself; because every region’s trends are unique to that region, it

makes no sense to use average rates involving the entire country or many

regions. For example, an article in a Las Vegas newspaper compared one-

year changes in average market rates and concluded that in many regions

in Nevada and California, rates dropped (in California’s San Francisco,

Riverside, and San Bernardino counties, for example).

While such regional data is of limited value and often outdated by time

of publication, other local sources are useful for obtaining up-to-date in-

formation—not only on average rental rates, but also on occupancy trends.

For estimating cash ﬂow, the most reliable and meaningful analysis is a

comparison between market rate trends and occupancy trends.

The Occupancy Issue in Multi-Unit Cash Flow Analysis 113

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The two indicators do not necessarily conﬁrm each other. In fact, rent

increases and trends in occupancy/vacancy provide dissimilar types of mar-

ket indicators. A popular theory states that in a strong demand market, we

are likely to witness a combination of low vacancies and rising rental rates.

This seems logical; however, long-term studies indicate that the pattern

does not always come out according to this theory concerning the dynam-

ics of supply and demand. In some cases, the highest average vacancy rates

also report higher than average rent increases.

Furthermore, the analyst should be sensitive to the likely correlation

between the range of apartment costs and vacancy rates. There is a ten-

dency for vacancies to increase as rental levels grow. For example, a trend

in New York City demonstrates the consistency of this phenomenon. The

lower the rent, the lower the vacancy rate, as shown in Figure 5.2.

The indicators causing rent increases are limited not only to response

to local occupancy trends. While occupancy is one of the factors in-

volved—recognizing that when demand exceeds supply, rates tend to rise—

there are many others as well. For example, even a very localized study of a

single metropolitan area may involve numerous dissimilar markets, based

on income, rental levels, and amenities. We have already observed that as

rents rise in the immediate area, tenants may move farther away. In the

case of a large city, this move may consist of an additional bus or subway

stop, an adjoining neighborhood, or the next suburb over, only two or

114 MULTI-UNIT RENTAL PROPERTY ANALYSIS

FIGURE 5.2 More Affordability = Lower Vacancy Rates

Source: New York City Housing and Vacancy Survey, 2002.

00224466881010 1212

10.05%

9.25%

4.36%

3.66%

2.61%

1.42%

1.54%

$2,000 – up

$1,750 – up

$1,000 – $1,749

$800 – $999

$700 – $799

$500 – $699

Less than $500

ccc_kahr_ch05_99-118.qxd 8/3/05 11:52 AM Page 114

three miles away. In urban areas, the population is likely to be more depen-

dent on public transportation than in more rural areas, so availability of

transit sites may be more of a factor when residents use such amenities.

A study documented by Jack Goodman showed two large cities, Hous-

ton and Philadelphia, reporting high vacancy rates, but also reporting

higher than average rent increases in the same markets.

This type of long-

term data is valuable, as it includes information on both rent increases and

vacancy rates. However, such studies also tend to be outdated by the time

the analyst discovers them; and again, the data does not provide clear an-

swers to the question of how cash ﬂow estimates can be supported with

current information.

More likely sources for current, local data would include regional

landlord associations, lenders, real estate brokerage ﬁrms, and Multiple

Listing Service (MLS) ofﬁces.

Amenities will also act as incentives in certain types of properties. This

is especially true in the planned gated communities popular around

Phoenix, Arizona, such as Scottsdale and Chandler; and in central Florida.

Today’s tenant is willing to trade living space for speciﬁc and desir-

able amenities, such as nearby or on-site recreational outlets. While many

The Occupancy Issue in Multi-Unit Cash Flow Analysis 115

CASE STUDY: THE VILLAGES, FLORIDA

This central Florida development takes up 5.2 square miles. While the

latest reported population was 11,828 (2000 Census), approximately

45,000 people live in the immediate area in owner-occupied or rented

housing and multi-unit retirement and senior accommodations. This

development combines gated communities with recreational facilities,

notably a series of golf courses. However, with additional develop-

ment near the villages, trafﬁc congestion and travel distance to the

courses are becoming a problem. The popularity of the closest golf

(Continued)

Valuable Resource

To ﬁnd links to local information concerning MLS ofﬁces, occupancy rates

in a particular area, and market rent trends, check http://www.mls.org/.

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116 MULTI-UNIT RENTAL PROPERTY ANALYSIS

CASE STUDY: THE VILLAGES, FLORIDA (Continued)

course has made getting a tee time quite difﬁcult, so additional

courses are developed periodically, each one farther away than the

last. It appears to the visitor that the majority of local residents use

gas-powered golf carts rather than automobiles, to travel to and from

the attractive central shopping area.

A visitor to The Villages notices at once the confusing array of ap-

parently endless gated communities, acting as satellites around various

golf courses. Because the courses cross roadways and local residents

seem permanently attached to their gas-powered golf carts, this is a

world apart from the more urban settings so familiar to most other

Americans. In fact, there is a tendency among golf-playing residents to

forget that some people continue to use the automobile. It is a common

occurrence for golf carts to dart across roadways with their drivers

oblivious to the danger afoot even in a 25-mile zone. Accidents are not

uncommon, including car-to-cart as well as cart-to-cart mishaps.

The planned community continues to expand, even though road

and golf course congestion have worsened over time. Located only 50

miles from Orlando and 75 miles from Tampa, The Villages is located

in the very middle of Florida. Besides golf and local shopping, residents

are within an easy drive of The Villages Regional Hospital and at least

two medical centers, all within 20 miles. It is also about 50 miles to the

Orlando or Gainesville airports. Web site: http://www.thevillages.com/

Described by a local travel guide site—http://www.city-data

.com/city/The-Villages-Florida.html—as an “active 55+ adult commu-

nity,” recreational emphasis includes golf and other physical sports,

health and ﬁtness, and even bowling. The immediate area also boasts

a staggering 153 Red Hat Society groups within The Villages (chap-

ters of ladies aged 50 and over who meet monthly to plan events, web

site http://www.redhatsociety.com/), which may be a record for a sin-

gle area. This serves as a good indicator of semiretirement aged trends

in this and similar planned communities.

The key feature of The Villages is the connection between active

retirement and recreation. The median house value (as of 2000) was a

relatively low $136,000, with median household income $42,542.

This is an afﬂuent mostly white (97.2%) population able to choose

recreational amenities as close as possible to home, and that deﬁnes

the development. One visitor observed that residents of The Villages

were typically “a bunch of stressed-out senior citizens breaking their

necks in pursuit of leisure.”

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