LENDERS, LOOK OUT!
by Lim Lay Ying
Property Times, New Straits Times
30th October 2004

Finally, the key movers in the real estate industry recognize the benefits of conducting market assessment studies. With effect September 20, 2004, all financial institutions are compelled to commission independent market studies for any proposed commercial development they wish to fund. Bank Negara Malaysia hopes that with this ruling, another round of pileup of unsold properties can be avoided.

Industry players blamed the oversupply of office and commercial space following the 1997 Asian real estate market shake-out, on the absence of such studies. Market studies had all the while, been under-rated for their usefulness during the decision-making process, and viewed purely as an academic exercise to confirm what was assumed to be already obvious.

Most property developers largely relied on the back-of-the-envelope approach when determining the market viability of their projects. Market studies were frequently dismissed without hesitation, as an unnecessary expense and a pure waste of time. Besides, the financial institutions which provided the bridging finance seldom insisted on them before approving the facilities.

Now that it is mandatory for these studies to be conducted by independent consultants, lenders are advised to be aware that there are several issues which they may need to keep a lookout for.

Here are some of them:

1. Relationship between consultant and developer/owner

As lending institutions will henceforth be the ones initiating the studies, they will be able to play a more pivotal role in overseeing such studies. This would, hopefully, result in a more objective appraisal of the market situation and future trends.

Developers who are by nature optimistic risk-takers, may at times influence those conducting the market and feasibility studies if the onus to conduct the research exercise is left entirely to them.

2. Drive for profits

There are quite a number of consulting firms that offer a complete line of consultancy services, i.e. market studies, valuation, and brokerage. For these firms, the money-making centres are usually the brokerage or real estate agency services.

Thus if the same firm conducts the initial market and feasibility studies, they may invariably be biased. Although not a common practice (but possibilities do arise), those involved in the real estate industry, especially developers, investors, and loan officers, should be aware of them.

Thus to avoid instances of conflicting or vested interests, it would be advisable for these market and feasibility studies to be conducted by independent parties.

3. Incompetent personnel

The impact assessment analysis of real estate markets is still a relatively young and evolving field. The methodologies used are to a large extent borrowed from other disciplines, and to employ them properly requires knowledge that is as broad as it is deep.

Prior real estate experience and knowledge of the industry are crucial to ensure that market studies are executed with the highest level of professionalism.

They require a great deal of first-hand experience and involve field work, on-site analysis, interviews, data collection and analysis, business acumen, report writing, and brainstorming with clients.

4. Inaccurate data

One of the most pressing concerns is the unreliability of certain key pieces of data. More often the case, the data sources may have lagged in regular updates. Some types of key data may end up distorted because of this, and they include: population projections, new household formations, household size, effective demand, price range, retail expenditure, and the absorption rate or the percentage of the market that the project is expected to capture.

Every consumer of market and feasibility studies should be thoroughly aware of the data used, that if slightly exaggerated, could transform a non-feasible project to one that would appear to be potentially profitable.

5. Lack of relevant data

Too often, far too many reports are plagued by the general lack of relevant data. Market data are hard to come by. Most real estate transactions are not conducted in public, and the facts and figures relating to specific real estate developments are normally proprietary in nature.

In many cases, even with the most diligent efforts, this issue cannot be resolved. Hence, the over-dependence on assumptions and complex formulae to project future scenarios – both of which are likely to heighten investment risk.

6. Inadequate analyses

Inadequate analyses usually occur when the procedures used to collect and analyze data are not indepth methods. The end results are distorted projections and inappropriate recommendations.

To avoid using inadequate techniques of analysis, it is imperative that lenders (and developers) be thoroughly familiar with accepted and appropriate methods for conducting market and feasibility studies and begin insisting that high-quality research be the norm.

7. Lack of consumer surveys

Most real estate market analyses tend to lack consumer surveys, and depend largely on macroeconomic and microeconomic tools of analysis. While for the most part they are necessary and do provide essential information, it is however crucial that the question of consumer preferences be addressed. These preferences may relate to questions concerning specific types of dwelling units desired, size requirements, locational preferences, amenities desired, and ownership patterns.

Then again, the manner of asking these questions will determine the kind of answers given. Well-designed questionnaires can, and have proven, to yield powerful sets of data on consumer preferences.

8. “Best case” figures

One of the most common shortcomings is the widespread practice of using overly optimistic, or the “best case” figures when making future cash flow projections. The “best case” absorption rate, along with the highest estimated unit or sales price, are typically used in projections.

Many projects become over-leveraged due to inflated estimates of value, and possibly even underestimation of costs for both construction and operating expenses. Sometimes, land is overvalued because of overly optimistic sales and revenue projections owing to unrealistic estimates of absorption rates and potential appreciation.

An alternative to the “best case” projections may be to give a range of possibilities with advice given for the most likely situation. The range of projections could include the best, the worst possible, and the realistic scenarios.

9. Lack of sensitivity analysis

Potential changes in cash flow variables are quite often overlooked, hence leading to doubts in the profitability picture. For instance, the cost of utility systems, roads, lighting and other amenities are increasing at an unprecedented rate. Thus, without accounting for such changes, cash flow projections are likely to be extremely unreliable.

10. Post-planning follow-through

The common practice amongst developers and lenders is to discontinue the services of the consultant following the end of the market study and once bridging finance has been secured.

Changes in economic conditions and real estate markets should be monitored for their likely impact on the project. A continuous monitoring of external forces is essential to enable the developer to be on their guard in case of eventualities.