From Inferred Demand to Fundamental Analysis

Chapter: From Inferred Demand to Fundamental Analysis

Introduction

Real estate market analysis involves understanding the forces that drive demand for property. This chapter explores two distinct approaches to demand analysis: inferred demand analysis and fundamental analysis. Both aim to project future demand, but they differ significantly in their methodology and depth. Inferred demand relies on historical trends and general market data, while fundamental analysis delves into the underlying economic drivers to quantify and forecast demand. Understanding the nuances of each approach is crucial for selecting the appropriate level❓ of market analysis to support appraisal and investment decisions.

1. Understanding Demand in Real Estate

Demand in the real estate market is derived demand. This means that it stems from the need for space to conduct economic activities (e.g., office space for businesses, retail space for shops, residential space for households) and is thus closely linked to broader economic forces.

• Long-Term Drivers: These reflect fundamental shifts in the economy, including:

  • Changes in employment levels and structure.
  • Population growth and demographic shifts (age, household size, etc.).
  • Income levels and distribution.
  • Evolving consumer preferences and lifestyle trends.

• Short-Term Drivers: These are influenced by cyclical economic conditions and financial market dynamics:

  • Availability and cost of credit (interest rates).
  • Overall economic growth (GDP).
  • Investor sentiment and market psychology.

The interaction of these long-term and short-term factors creates the complex demand patterns observed in the real estate market.

2. Inferred Demand Analysis

Inferred demand analysis, sometimes called trend analysis, is a descriptive approach that uses historical data and current market conditions to infer future demand. It’s based on the assumption that past trends❓ will continue, at least in the near term.

• Methodology:
  • Examines historical vacancy rates, rental rates, and absorption rates in the market.
  • Analyzes past trends in employment, population, and income.
  • Compares the subject property to similar properties in the market.
  • Extrapolates historical trends into the future to project demand.

• Assumptions:

  • Future trends will mirror historical and current trends.
  • The market is relatively stable, with no major disruptions expected.
  • Current conditions are a reliable indicator of future conditions.

• Limitations:

  • May not accurately predict demand in volatile markets or when significant economic shifts occur.
  • Limited ability to identify and quantify pent-up demand or artificially induced demand.
  • Can be unreliable when examining a geographic area or property type that is significantly different from the subject.

• Practical Application: A simple example might involve projecting future apartment demand based on the average annual growth in population and the historical average vacancy rate in the area.

• Mathematical Representation (Simple Trend Extrapolation):

  Let:

  • D_t = Demand in year t
  • D₀ = Current demand
  • g = Average annual growth rate of demand (expressed as a decimal)
  • t = Number of years in the future

  Then:

  D_t = D₀ * (1 + g)^t

3. Fundamental Analysis

Fundamental analysis provides a more in-depth and quantitative assessment of demand. It focuses on the underlying economic forces that drive demand for specific property types in specific locations.

• Methodology:
  • Segments the market into specific user groups based on their needs and characteristics.
  • Analyzes demographic and economic data to identify the factors that drive demand for each segment.
  • Forecasts future demand based on projected changes in these factors.
  • Considers the supply of competing properties and potential future development.
• Focus: Economic drivers of demand (employment, population, income) and how they relate to the specific property being appraised. Understanding the relationships between these factors is key.
• Advantages:
  • More accurate demand forecasts, especially in volatile markets or when significant economic shifts are expected.
  • Ability to identify and quantify pent-up demand or artificially induced demand.
  • Provides a deeper understanding of the forces that drive demand, enabling better-informed investment decisions.
• Disadvantages:
  • More complex and time-consuming than inferred demand analysis.
  • Requires access to detailed demographic and economic data.
  • Relies on forecasts of economic and demographic variables, which may be subject to error.

• Practical Application:

  • Example: Analyzing the demand for new office space in a city by examining the projected growth in specific industries (e.g., technology, finance) and the number of employees they are expected to add.
  • Example: Determining the demand for senior housing by analyzing the projected growth in the elderly population and their income levels.

• Mathematical Representation (Cohort-Survival Method for Population Projection):

  This method is often used in fundamental analysis to project future population.

  Let:

  • P_t+1,a+1 = Population in age group (a+1) at time (t+1)
  • P_t,a = Population in age group (a) at time (t)
  • S_a = Survival rate for age group (a)

  Then:

  P_t+1,a+1 = P_t,a * S_a

  This formula is applied sequentially to each age group to project the entire population forward in time. These population projections can then be used to estimate the demand for housing and other types of real estate.

4. Indicators of Demand

Whether using inferred or fundamental analysis, certain indicators are crucial for understanding demand:

• Occupancy Rates: The percentage of occupied space in existing properties. High occupancy rates generally indicate strong demand.
• Vacancy Rates: The percentage of unoccupied space in existing properties. Low vacancy rates generally indicate strong demand.
• Rental Rates: The price paid to occupy space. Rising rental rates generally indicate increasing demand.
• Net Absorption: The amount of new or vacant space that is occupied over a specific period. Positive net absorption indicates increasing demand.
• Construction Activity: The amount of new construction underway. High construction activity can indicate strong demand, but it can also lead to oversupply.
• Pre-leasing of Planned Space: The percentage of space in planned or under-construction projects that has been leased. High pre-leasing rates indicate strong anticipated demand.
• Employment Levels: Growth in employment generally leads to increased demand for office, retail, and residential space.
• Income Levels: Higher income levels generally lead to increased demand for higher-quality housing and retail goods and services.
• Foreclosure Rates: High foreclosure rates can depress demand for housing and other types of real estate.
• Consumer Spending: Increased consumer spending generally leads to increased demand for retail space.

These indicators are relevant to both inferred and fundamental analysis, but they are used in different ways. In inferred analysis, they are primarily used to identify past trends. In fundamental analysis, they are used to understand the underlying drivers of demand and to forecast future demand.

5. Levels of Market Analysis

The depth and complexity of market analysis can be classified into different levels. The Appraisal Institute typically uses four levels (A, B, C, and D), each requiring different data, methods, and expertise.

• Level A❓: Typically involves inferred demand analysis using readily available data. Suitable for simple properties in stable markets.
• Level B: Still primarily inferred demand, but incorporates more property-specific and area-wide data.
• Level C: Moves into fundamental demand analysis, quantifying subject attributes and locational determinants. Includes an economic base analysis.
• Level D: The most detailed and labor-intensive, focusing on the individuals behind the economic and demographic characteristics. Involves direct attitudinal surveys of the target market.

The appropriate level of market analysis depends on:

• Market Conditions: More volatile markets require a higher level of analysis.
• Complexity of the Property: Larger or more complex properties require a higher level of analysis.
• Future Expectations: Greater uncertainty about the future requires a higher level of analysis.
• Client Needs: A client’s informational needs and risk tolerance may influence the desired level of analysis.

6. Economic Base Analysis

Economic base analysis is a critical component of fundamental demand analysis, particularly for Level C and D studies. It involves identifying the industries and businesses that drive economic activity in a community.

• Basic Industries: These industries generate income from markets outside the community, bringing money into the local economy (e.g., manufacturing, exporting agricultural products, tourism).
• Non-Basic Industries: These industries provide services for workers in the basic employment sector, and the income generated remains within the community’s borders (e.g., retail, restaurants, local services).

Economic base analysis helps to understand:

• The structure of the local economy.
• The relationship between basic and non-basic employment.
• The potential for future economic growth.

• The impact of economic changes on real estate demand.

• Techniques for Identifying Basic Industries:

  • Judgment Approach: Based on expert knowledge of the local economy.
  • Direct Survey Approach: Surveys of local businesses to determine the origin of their revenue.

  • Location Quotient (LQ) Approach: Compares the concentration of an industry in the local economy to its concentration in the national economy.

    • Formula:

      LQ = (Local Employment in Industry / Total Local Employment) / (National Employment in Industry / Total National Employment)

      An LQ greater than 1 suggests that the industry is a basic industry in the local economy.

  • Minimum Requirements Approach: Identifies the minimum amount of employment required for each industry to support the local population.

• Economic Base Multiplier: This multiplier estimates the total impact of a change in basic employment on the local economy. It reflects the fact that each new basic job creates additional non-basic jobs.

Conclusion

Choosing between inferred and fundamental demand analysis is a crucial decision in real estate market analysis. Inferred analysis offers a simplified approach for stable markets, while fundamental analysis provides a more comprehensive understanding of demand drivers in complex and volatile environments. The appropriate level of analysis depends on the specific property, the market conditions, and the client’s needs. By mastering both inferred and fundamental analysis techniques, practitioners can provide accurate and insightful market assessments, supporting informed investment and appraisal decisions.