At The Danter Company, we are a real estate research company specializing in market feasibility research. One of the misconceptions that we battle most often is that a market feasibility study is the same thing as an appraisal, or that an appraisal is really all you need to ensure that your project achieves success.
Asking Different Questions
Appraisals and market feasibility studies are designed to answer different questions:
The question answered by a market feasibility study is “If I build it, will they come?”
The appraisal is designed to answer the question, “What will it be worth?” The appraisal is an estimate of the value of a property as of a certain date, while a market feasibility study measures expected market response. Because they measure different aspects of the market, each type of study needs a different methodology.
How Does an Appraisal Work?
First, an appraiser, in conjunction with the client, will determine the purpose of the appraisal, which is expressed in a statement of purpose.
The purpose of most appraisals is to determine “market value” for the purpose of buying, selling, improving, or financing a project. As defined by the American Institute of Real Estate Appraisers in Appraisal Terminology and Handbook, market value is “the price at which a willing seller would sell and a willing buyer would buy, neither being under abnormal pressure.”
Besides market value, an appraisal may also be undertaken to identify insurable value, condemnation value, liquidation value, or assessed value.
An appraiser generally uses three approaches to help determine the appropriate value, according to The Appraisal of Real Estate by the American Institute of Real Estate Appraisers: the cost approach, the income approach, and the market approach. Most appraisals will determine a value of a property using all three approaches and then establish a final value by carefully considering the purposes of the appraisal and the limitations inherent in each of the approaches:
- The cost approach involves identifying the replacement cost of a project minus depreciation.
- The income approach identifies the value which a property’s net earning power will support.
- The market data approach is based on the sales of comparable properties. Each transaction selected is studied for its sales/asking price, the conditions influencing the sale, and the differences between the properties involved that would influence the value of the property being appraised.
An appraiser goes through considerable training to make these value judgments, and appraisers who are members of the American Institute of Real Estate Appraisers (or other appraisal organizations) are held to a professional code of ethics and standards.
Appraisals are important in the development process because they set value within the financing and acquisition process. No real estate transaction should take place without an appraisal to set appropriate values.
How Does a Market Feasibility Study Work?
A market feasibility study determines the depth and condition of a particular real estate market and its ability to support a particular development.
The key concern of a market feasibility study for multifamily development is a project’s ultimate marketability. Therefore, the market feasibility study must determine the following:
- What is the current condition of the market?
- How will the market respond to the proposed project?
Determining Market Condition
The first step is defining the extent of the market area, because not all market areas are alike. Several basic methods exist for determining the appropriate market area.
One common method is radial analysis. In this method, a series of concentric circles is drawn around the site at, for example, distances of 3, 5, and 10 miles. The areas within these circles are then analyzed. This method is usually employed for one reason—it is easy.
A second method, particularly common in studies for governmental bodies, is to base market areas on boundaries between governmental units. In such a method, county, township or city boundaries might become the boundaries of the market area. This, too, is an easy solution since most secondary data are reported by political delineations.
A third methodology, developed by the Danter Company, is the Effective Market Area. The EMA is defined as the smallest geographical area from which a project can expect to generate 60% to 70% of its support. It is not as easy, but we think it gives us a better reading of the true market area for a project.
When we determine an EMA for a project, we look at several factors, including geography, demographic analysis, mobility patterns, and area perceptions.
Geographical factors—rivers, railroads, freeways, hills, and major arteries often define neighborhood boundaries. Such geographical factors, which can play a big part in where people move, are ignored in radial analyses. In addition, geographical factors can often be more important than governmental boundaries, as market areas often cross county, township, or city borders.
Demographic factors--population and household trends, housing and income characteristics, differences in socioeconomic makeup of individual neighborhoods, and growth figures all are analyzed to help identify the EMA. Radial analyses cannot take all these characteristics into account, and often can skew a report by including neighborhoods of vastly differing socioeconomic makeup, as can analyses based on governmental boundaries.
Mobility factors—interviews with area real estate professional and civic officials are combined with our past experience in determining mobility patterns. Mobility patterns within an area are predictable, and while individuals occasionally act counter to prevailing trends, mobility analysis can help pinpoint where the majority of tenants for a particular project are the most likely to come from. Radial analyses cannot make these distinctions.
Area perceptions—we conduct interviews with area officials and real estate professionals to determine area perceptions and how they relate to the previous factors. Area perceptions are important in helping determine mobility patterns, a key component of any market feasibility study.
Our research indicates tenants already living in an apartment within the EMA are the largest single component of support for an apartment project. Typically, an apartment project can expect between 45% and 50% of its tenants from other apartments within the EMA. Add support from within the EMA from new household formation, current home owners, or other rental properties, and the total EMA support increases to 60% to 70%, depending on the demographics of the EMA.
As a result, our EMA is a Supportive EMA and not a Competitive EMA. A Competitive EMA would consist of the projects most likely to compete with a proposed project for support. Therefore, a Competitive EMA is likely to include projects with a similar price point or amenity level to the proposed project, or perhaps even projects from outside the Supportive EMA. However, since the Competitive EMA includes only similar projects, it is only a subset of the Supportive EMA. Analyses using a Competitive EMA only examine a portion of the market at one pricing level, and then perhaps not all similar projects.
Our solution is the 100% database. In order to determine the depth of support for new development, it is crucial to identify support at all levels. We have found that in most markets a continuum of housing exists, starting with entry-level units, and moving to upscale units as units include more amenities and higher rents. Tenants tend to move up the continuum as their financial status increases, or as their space needs change through marriage, children, or other status changes.
Therefore, our field surveys identify all modern apartment developments within the EMA to determine the depth of the market at all levels. Each project is surveyed to determine rents, vacancies, amenity level and curbside appeal. Because the EMA is supportive, the field survey details the existing market conditions experienced by those tenants most likely to move into the proposed project.
Once the field survey is complete, we can then determine the condition of the market and historical trends. Our analysis identifies the number of market-rate and government subsidized units in the market and the vacancy rates by unit type (i.e., studio, one-bedroom). We also identify historic construction trends by tracking the year of construction for each modern apartment development, and the vacancy rates by year of construction. As a result, we can identify whether vacancies in the market are related to the age of the product.
Determining Market Response
Once we have determined the condition of the market, we can then determine how the market will respond to the proposed project. In order to do that, we combine the full market data provided by our field study with our experience studying a variety of markets.
The key result of any market feasibility study is the absorption rate. The absorption rate is the measure of how many apartments we think the project will be able to lease after opening on a monthly basis. To determine the absorption rate, we look at many factors, the most critical of which are step-up and step-down support and a rent/value analysis.
As explained earlier, our research has indicated that the largest component of support for new modern apartment development comes from existing apartment development. Our 100% database allows us to quantify this support using an analysis of step-up and step-down support.
Our research indicates that apartment tenants are willing to pay more, or “step up” their rents, for an apartment that they consider to be a value. The level of step-up support varies with different markets and the amenity level of the development. Tenants at the high end of the market may step up their monthly rent as much as $150, but most tenants are only willing to step up their rent up to $60 (for shared housing, $60 per bedroom). We identify the number of units in the market with rents up to $60 below the proposed rents for the subject site. This enables us to determine the depth of the step-up support. Then, we compare the number of proposed units to the units of step-up support, and express this as a percentage. If this percentage is low (a small number of proposed units and a large number of units in the step-up support base), then this is reflected in a higher expected absorption rate. Naturally, an analysis of the competition’s level of step-up support is also critical.
Comparable Market Rent
A second important consideration in determining the projected absorption rate is the comparable market rent The regression analysis (see example) is used to determine the market-driven rent for a project at any amenity level. Using this graph, we are able to determine the relative value of the proposed units. The relative value of the project is then reflected in our projected absorption rate.
Often, based on the comparable market rent analysis, the step-up support analysis, an examination of competitive projects, and our own experience, we recommend changes in a project that will make it more responsive to the market (and thus more profitable, increasing rent and absorption and decreasing turnover).
For example, we sometimes recommend rent adjustments to make a project more of a value, or to place it within a market niche experiencing less competition. We also review amenity packages and suggest ways the amenity package can be fine-tuned to respond to the market and give a project competitive advantage. Also, we often review site plans to help identify premiums for which a renter will pay more (i.e., views, end-units, fireplaces, garages, carports).
We believe that the market study should be one of the most important steps in the development process. A market feasibility study not only predicts the absorption rate, but can also present methods of fine-tuning the product to achieve greater success in the market. In addition, our policy of continued consulting until project finalization ensures that the market impact of all changes is fully evaluated and documented.