Average Asking Price

Why it’s important

The average asking price for a comparable property type should provide a loose guideline for the feasibility of a proposed project. If you are able to achieve your target revenue with projected prices that are in line with average asking prices, your project has passed an important test and may be viable.

Strengths/Weaknesses

This does not take costs into consideration, so has only limited utility on its own. Ideally, one is able to achieve their target return by combining this figure with a conservative expense budget. There is also the risk of comparing asking prices with properties that have underlying difference. For instance, a condominium may be a near perfect match physically, but one association may be in a much worse financial situation than the other and can expect substantially higher HOA fees. An additional risk worth stating is that there may be a lack of substitutable inventory. This lack of data may lead to unrealistic projections.

Resources

The multiple listing service and an experienced broker will generally understand the local market dynamics. If feasible, a boots on the ground approach allow you to identify competing product and interact with tenants in the area. Ideally you are in a position to cherry pick the most desirable aspects for your own projects.

Historical Sale Price Trends

Why it’s important

In order to forecast appreciation rates, it is helpful to understand historical trends. While momentum is not a guarantee of future performance, it can help you identify markets which may be overheated and which markets may be undervalued.

Strengths/Weaknesses

Black swan events are not captured with historic data. Over-reliance on historic trends can lead to undue risk for a project.

Resources

While the multiple listing service is a solid resource for residential properties, commercial transactions tend to be more opaque. The county recorder or local property tax office generally keeps a copy of the deed, as well as any mortgage notes on file. This information is often available online direct to the public or through third party data aggregation services.

Cap Rates

Why it’s important

Cap rates can indicate a number important characteristics about a project. A cap rate is calculated dividing the net operating income by the purchase price of the asset. One key use of cap rates is price setting. Knowledge of cap rates on comparable projects can help you to project the value of your project, given a projected net income. In general, a lower the cap rate should indicate a less risky cash flow projection. Projects with inherent challenges, should produce a higher cap rate. These challenges can include high vacancy rates, high crime and lack of investor demand.

Strengths/Weaknesses

Cap rates can be analyzed with and without leverage. Because each loan has unique terms and characteristics, a levered cap rate can distort the underlying nature of the project. However, unlevered cap rates do not reflect the unique impact debt service can have on a particular project. Since cap rate data can often be difficult or impossible to come by, one can alternatively look to the gross rent multiplier (GRM). This figure is derived by dividing the purchase price by the gross rents. This obviously has less value in one’s analysis due to the lack of expense figures. Other issues with cap rates include lack of knowledge of non-property inclusions in the sale and the use of projected vs. historic income.

Resources

The authoritative source for cap rates has been the Korpacz Real Estate Investor Survey. Knowledgeable local brokers are usually your best alternative to costly data subscriptions like Korpacz.

Competing Supply

Why it’s important

Knowledge of alternatives or substitutes for your product are key to understanding the local market dynamics of supply and demand. This understanding will aide you in setting pricing, incentive offerings, and whether a market can support the project you have planned.

Strengths/Weaknesses

Real estate is known for being a heterogeneous asset type. You will never find a perfect substitute, as each plot of land is unique in its precise location. In addition, you will find differences in the age of various components, layouts, styles, construction materials and more. One must compensate for this by adjusting for differences when comparing.

Resources

The multiple listing service and an experienced broker will generally understand the local market dynamics. If feasible, a boots on the ground approach allow you to identify competing product and interact with tenants in the area. Ideally you are in a position to cherry pick the most desirable aspects for your own projects.

Wages, Labor costs & Job Markets

Why it’s important

When conducting due diligence and creating your project proforma, wages, labor costs and the job market can weigh heavily on your expected returns.

On the revenue side of your income statement, changes in these markets can impact your rent inflator, bad debt rates and vacancy rates. To cite one of the more dramatic recent examples, have a look at the building boom in North Dakota, fueled by high oil prices and the requisite demand for labor. With the decline in oil demand, the result is a glut of homes on the market, shuttering businesses and over-leveraged local governments. Not a recipe for a healthy real estate market.

On the expense side, labor costs commonly make up a disproportionate amount of real estate development costs. Typically 45-50% for of the budget for commercial projects, with unionized labor, costs can be 20 to 25% higher.

Strengths/Weaknesses

Labor and wage indicators are an important component of market research, but should be taken in context. What would it look like if we saw a geographic area with a sudden increase in U6 (underemployment)? Is this a sign of a weakening economy or an aging population working fewer hours?

Resources

Source Name	Link
Bureau of Labor Statistics	Regional Data. NYC.

Construction Material Costs

Why it’s important

After acquisition and labor costs, your next largest development project cost is likely to be construction materials. Various factors can influence these costs, luckily, the Bureau of Labor Statistics compiles this information on a regular basis. In a large project, small changes can have a big impact.

Strengths/Weaknesses

To the extent a project relies on a volatile commodity component, the developer can purchase insurance in the form of futures contracts for that good. Additionally, when considering which materials to use, a developer should consider the risk of functional obsolescence. Functional obsolescence accelerates the effective depreciation of your building components as the result of a more desirable substitute good. This can be caused by technological innovation in energy efficiency, fire safety or a number of other building features in high demand. The result could be higher than expected vacancy rates at your project.

Resources

The Bureau of Labor Statistics collects and publishes data on the producer price index (PPI). This includes regional PPI data which is further separated into various construction industry components. There is also census related data available at: https://www.census.gov/construction/.

Absorption rate

Why it’s important

Carrying costs can push out your project’s break even point substantially. The market absorption rate offers a window into how substantial your carrying costs will be for your project. The absorption rate is calculated by dividing the total available space or available housing units by the average number of sales or space leased per month. In addition, absorption rates should also compensate for new construction and removal of existing space from the market, often due to physical depreciation. Absorption rates can also be used as a key indicator for developers considering new projects in an area.

Strengths/Weaknesses

Calculating residential inventory is an easier task than calculating commercial inventory. This creates more inherent risk in a commercial project. Due to less centralized records, absorption rate calculations can also overlook pre-sold homes and destruction of existing stock. In the event of a natural disaster, one’s knowledge of local conditions would enable a more thorough understanding of the impact on absorption rates. Absorption rates may also differ across different sub-geographies and price segments of the market. Therefore, it is critical to understand how substitute product may differ from the broader market absorption trends.

Resources

Your local multiple listing service will generally capture enough of the market to provide a clear view of absorption trends in the residential market. Various appraisal and brokerage firms also publish absorption rates online.

Total Inventory

Why it’s important

The number of housing units or square feet is a critical component in the supply and demand picture of a market. When combined with population, we get a good barometer of the supply/demand equilibrium or lack thereof.

Strengths/Weaknesses

Total inventory does provide a picture of deteriorating inventory or the pipeline of new inventory. It’s simply a snapshot of what’s in service today. The real value of this data is unlocked when used in tandem with population data; specifically projected changes in population. Any differential between these numbers can be compared with additions and subtractions from the total inventory to determine whether the future conditions will drive up prices due to undersupply or will drive prices down due to oversupply.

Resources

The US census conducts a study every other year called the American Housing Survey. It provides an estimate of total housing inventory, plus many other valuable data points for the professional real estate researcher.

Vacancy Rates

Why it’s important

Your vacancy rate will determine how long a space is empty between occupancies. Your effective vacancy rate will be determined by a number of factors, including: market conditions, pricing strategy, management policies and physical characteristics of the space. Key considerations during due diligence should include identifying the price at which rent revenue is maximized and degree to which the space is in demand for transient tenants. A transient tenant means more turnover and is generally less desirable.

Strengths/Weaknesses

While all properties have a “natural vacancy rate” (i.e. unoccupied time due to turnover), many of these factors are under control of the owner/manager. It’s important to understand which factors you have control over through effective management techniques and which must be acceptable as a condition of ownership. In fact, a high vacancy rate due to under-management can be a desirable characteristic to an investor, as that would indicate potential cash flow upside once they are able to apply their superior management acumen.

Resources

In addition to US census’ American Housing Survey, vacancy rates can be assessed by speaking with other owners and brokers in the area, as well as conducting research through the local MLS. Much can be uncovered about the vacancy rate for a particular property through the due diligence period.