Market Analysis: From Inferred Trends to Fundamental Forces

Chapter: Market Analysis: From Inferred Trends to Fundamental Forces

This chapter delves into the core principles of market analysis in real estate, differentiating between analyses based on inferred trends and those rooted in fundamental economic forces. Understanding these distinct approaches is crucial for conducting thorough and reliable real estate appraisals and investment decisions.

1. Levels of Market Analysis

The depth and scope of market analysis vary depending on the appraisal problem and the complexity of the subject property. The process mirrors determining the scope of work of an appraisal assignment. Market analysis can range from general market information❓ to property-specific analysis, incorporating marketability studies. A useful segmentation of these levels is:

• Level A: Inferred Demand Analysis
• Level B: Inferred Demand Analysis
• Level C: Fundamental Demand Analysis
• Level D: Fundamental Demand Analysis

The primary distinction between these levels lies in how demand is analyzed. inferred analysis❓❓ relies on historical data and broad market trends, while fundamental analysis❓❓ quantifies current and forecasted demand based on economic forces.

2. Inferred Demand Analysis (Trend Analysis)

Inferred analysis, often referred to as trend analysis, is a descriptive approach that projects future❓ demand based on historical data and prevailing market trends. It assumes that future trends will largely replicate past patterns. This type of analysis can be general, focusing on comparable properties representing the broader market, or more specific, incorporating area-wide market data.

• Key Characteristics:
  • Relies heavily on historical data.
  • Assumes continuation of existing trends.
  • Provides a general overview of market conditions.
  • Less resource-intensive compared to fundamental analysis.
• Applications:
  • Suitable for stable markets with predictable trends.
  • Appropriate for relatively simple and small properties within a market.
  • Useful for preliminary market assessments.

Limitations: Inferred analysis may not adequately capture shifts in market dynamics or the impact of underlying economic drivers. It is less reliable in volatile markets or for complex properties.

3. Fundamental Demand Analysis

Fundamental demand analysis involves a more in-depth investigation of the economic forces that drive demand for real estate. It requires segmenting demographic and economic data to analyze the subject property’s specific market. This approach focuses on identifying and quantifying the “fundamental forces of demand,” such as employment, population, and income.

• Key Characteristics:
  • Focuses on understanding the underlying economic drivers of demand.
  • Requires detailed data collection and analysis.
  • Quantifies current and forecasted demand for a specific property.
  • Provides a more comprehensive and robust analysis.
• Applications:
  • Necessary for complex properties or those in volatile markets.
  • Essential for evaluating large-scale development projects.
  • Crucial for understanding long-term market trends.

Indicators of Demand:

Indicators of demand are relevant in both inferred analysis and fundamental analysis.

• Competitive properties
  • Current and historical vacancy rates
  • Trends in current and historical rental rates
• Market area
  • Current and historical vacancy rates for existing competitive space
  • Trends in current and historical rental rates for existing competitive space
  • Construction activity—competitive space
  • Preleasing of planned space and space under construction
  • Current condition and historical changes in fundamental forces of demand (employment, population, and income)
• Macroeconomic area
  • Current and historical vacancy rates for existing property types
  • Trends in current and historical rental rates for existing property types
  • Construction activity—property type
  • Preleasing of planned space and space under construction
  • Current condition and historical changes in fundamental forces: Employment levels and foreclosure rates
  • Residential occupancy and foreclosure rates
  • Income levels and consumer spending

4. The Fundamental Forces of Demand: A Deeper Dive

The fundamental forces of demand are interlinked and influence each other in complex ways. Understanding these relationships is crucial for accurate market analysis.

4.1 Employment: The Engine of Demand

Employment is a primary driver of real estate demand. Growth in employment leads to increased demand for housing, office space, retail, and other property types.

• Basic vs. Non-Basic Employment: Distinguishing between basic (export-oriented) and non-basic (local service) industries is essential. Basic industries bring income into a community, driving overall economic growth.

• Economic Base Analysis: A survey of the industries and businesses that generate employment and income in a community as well as a study of functions of employment such as the rate of population growth and levels of income.

  • Location Quotient (LQ): A valuable tool for identifying basic industries. It compares the concentration of an industry in a local economy to its concentration in a larger reference economy (e.g., the nation).

    • Equation:
      • LQ = (E_local_i / E_local_total) / (E_national_i / E_national_total)
      • Where:
        • E_local_i = Employment in industry i in the local economy
        • E_local_total = Total employment in the local economy
        • E_national_i = Employment in industry i in the national economy
        • E_national_total = Total employment in the national economy
    • Interpretation: An LQ greater than 1 suggests that the industry is more concentrated in the local economy than in the nation as a whole, indicating a basic industry.
    • Economic Base Multiplier: The ratio of total employment to basic employment. This multiplier estimates the total employment created by each new basic job.

    Equation:
    * Economic Base Multiplier = Total Employment / Basic Employment
    * Practical Application: Suppose a city’s basic employment increases by 1,000 jobs. If the economic base multiplier is 2.5, the total employment in the city is expected to increase by 2,500 jobs.

4.2 Population: The Consumer Base

Population growth directly impacts demand for housing, retail, and community services.

• Demographic Analysis: Examining population trends, age distribution, household size, and migration patterns is crucial.
• Population Projections: Forecasts of future population growth are essential for long-term market analysis. Various methods can be used, including cohort-survival models and trend extrapolation.
• Practical application: Examining how a large increase in retirees in a certain area can determine the need to develop facilities specific to retirees (i.e., medical facilities and recreation centers).

4.3 Income: The Spending Power

Income levels determine the affordability of housing and the demand for various goods and services.

• Income Distribution: Analyzing income distribution (e.g., median income, income inequality) provides insights into the purchasing power of different segments of the population.
• Consumer Spending Patterns: Understanding how income is allocated across different consumption categories (e.g., housing, transportation, food) is important for forecasting demand for specific property types.

• Equation:

  • Disposable Income = Gross Income - Taxes
  • Discretionary Income = Disposable Income - Necessities (Housing, Food, Transportation)

• Practical application: In a wealthy area the price range that the majority of the inhabitants can afford is very high, which can determine the type of dwellings that are being developed in the area (i.e., luxury apartments).

5. Integrating Inferred and Fundamental Analysis

In practice, market analysis often involves a combination of both inferred and fundamental approaches. Inferred analysis can provide a starting point for understanding market trends, while fundamental analysis provides a deeper understanding of the underlying economic forces.

6. Determining the Appropriate Level of Market Analysis

The choice between inferred and fundamental analysis (and the specific level of analysis within each) depends on several factors:

• Market Stability: Stable markets may warrant inferred analysis, while volatile markets require fundamental analysis.
• Property Complexity: Complex or multi-use properties typically require fundamental analysis.
• Data Availability: The availability of reliable data can influence the feasibility of different analysis approaches.
• Client Needs: The client’s informational needs and risk tolerance should be considered.
• Scope of work: The level of market analysis appropriate to a specific appraisal assignment.

7. Cautions and Considerations

• Data Quality: The accuracy and reliability of data are paramount. Always verify data sources and be aware of potential biases.
• Assumptions: Be explicit about the assumptions underlying your analysis. Scenario analysis can be used to assess the sensitivity of your conclusions to different assumptions.
• Market Dynamics: Real estate markets are constantly evolving. Continuously monitor market conditions and update your analysis as needed.
• Pent-up demand: If the current market has inadequate supply or the supply does not have the real estate product with the features most desired by users of space, the amount that actual demand exceeds the amount of occupied space in that market can be called pent-up demand.