Real estate feasibility study is a must before moving ahead with a real estate project. A preliminary feasibility study should be done at the idea stage and should be validated once concept design is done. It can be validated again once the design is complete, you have all the costs in place and market research team has provided the rental/sales data.
Everyone makes mistake and a real estate development analyst is no exception. We should always follow the best practices of building a real estate feasibility study model and should avoid the top 10 mistakes at all costs listed below:
1. Not optimizing the product mix / tenant mix
The first step of a real estate feasibility study should be the product mix optimization for a mixed-use development; or tenant mix optimization for a single asset class project. I have seen most of the analyst missing this first step. Unless you optimize your product mix / tenant mix, there are very little chances that the project is going to work.
2. Not conducting basic market research
Many a times we are tempted to assume things and call it conservative assumption. This is very bad and makes a project look feasible on paper; however, the reality might be exactly opposite. It is a good practice to conduct a basic market research on rental, sales price, competition and construction cost. Chances are that there might some generic real estate research report available for purchase online at a minimal cost, which should be good enough at this stage of real estate feasibility study.
3. Mixing assumptions and calculations
It is more of excel modeling stuff. The assumptions and calculations should not be mixed at any cost. You should have all you assumptions on a separate sheet. If you identify the variables at this stage it will be much easier to do the sensitivity analysis later.
4. Not getting the areas right
This is another area where you need to focus. How is the areas measured, what methodology is being followed – RICS or BOMA or something else? What is the market practice, on what area the tenants are charged?
From the start of the project, you should be clear on the area measurement methodology and should have a separate sheet in the real estate feasibility study model for area schedule.
5. Ignoring absorption rate
Many analysts tend to ignore absorption rate completely; and this significantly impacts the return metrics. You should have sound assumptions for absorption and vacancy rate. It is always a good practice to build absorption rate in the real estate feasibility study model.
6. Not including financing cash flow
Ok, you do not need to forecast the financing cash flow for calculating the project IRR / NPV. If the project capital structure involves mix of debt and equity, you have to calculate returns for the equity holders. It is always a good practice to forecast the financing cash flow and see its impact on net cash flow.
7. Focusing too much on calculating WACC
I have seen some analysts wasting too much time calculating weighted average cost of capital. They want to achieve some kind of perfection in calculating the cost of equity. My experience is that it is not worth the time and research. Just use capital asset pricing model and find the beta from Bloomberg for similar listed companies in your region. Keep is simple; few basis point difference in WACC is not going to make the project unviable.
8. No including sensitivity analysis
You should always include the sensitivity analysis in your real estate feasibility study report. It helps the management to think clearly. For doing the sensitivity analysis first you need to identify the variables, it might be construction cost or rental rates or cost of capital.
9. Using complex formulas
Don’t use complex formulas when things can be achieved by simple formulas. Complex formulas make it difficult for audit; and even for us it becomes difficult if we want to modify the real estate feasibility study model after some period of time.
10. Not focusing on the things you can control
Many analysts, and some senior management staff, focus on the things which are beyond their control. Why should I waste my time doing research to calculate cost of equity? It doesn’t matter. You should focus on increasing building efficiency, optimizing product/tenant mix and see how the project cost can be controlled.
Hope you enjoyed this post on mistakes to avoid when conducting real estate feasibility study. What do you think, use the comment section below.