Feasibility study is a critical part of a new development project. The purpose of the feasibility study is to determine whether the development is technically and financially feasible to move forward with.
In the previous post I have discussed about the mistakes to avoid when doing real estate feasibility study. And in this post I will be discussing some other factors to consider while doing feasibility study for real estate development projects.
1. Limited market research is a dangerous thing: Many a time we are tempted to assume things and feasibility study is no exception. It should be noted that we couldn’t complete the feasibility study without assuming certain project variables. But a through market research is always advisable; it makes the assumptions more realistic and reduces the chances of overstating the project returns.
2. Making too many assumptions ahead of time is even more dangerous: Feasibility study involves projecting various project variables like rental, occupancy etc. into future. Many a time I have seen analysts projecting rental growth at the rate of inflation or some other factor. They tend to completely ignore the supply and demand of the given property type. A solid forecasting methodology should be used for the demand, supply and market equilibrium forecasting.
3. Bigger is not always better: We live in the age of social media and public relation. Top real estate consultants use various methods of public relation to win a space in our thought process. For larger development projects, companies tend to hire self-proclaimed “top-four” external consultants to do the feasibility study. I have worked with all of them and feed sad to see the quality of their work. From time to time these consultants also issue market research report (paid or free). I call it is a good PR exercise. I strongly feel that these consultants should use Google more often than depending on their own “proprietary” research. If you are wondering why I’m so critical of these consultants, you should see this post.
4. Operating expenses are difficult to forecast: Operating expenses are difficult to forecast, no matter how experienced you are. Real estate analysts or any other consultant is not an industry expert. If you are doing a feasibility study for a restaurant, you should go and talk to the guy who is running a restaurant. I have seen analysts and consultants under-estimating the operating expenses. It is always better to consult industry expert rather than generic consultants or assuming things.
5. Liquidly can disappear more quickly than you can imagine: Be careful how you are forecasting the exit. Timing and price of actual sale may vary widely than what you have assumed. I have see situations where companies developing a very promising, branded real estate project in a hot market, going bankrupt. Liquidity can disappear more quickly than you can imagine.
6. Construction delay is the norm: Also remember that the projected investment return is almost impossible to achieve. Construction delay is the norm of the industry. You must develop various scenarios and do sensitivity analysis as part of the feasibility study report. The management must be well informed in advance about the impact of the construction delay on the project return.
7. Cost overrun should not surprise you: I have seen projects with cost overrun in the range of 100%, although it may an extreme case. However, you must develop various scenarios and do sensitivity analysis to see the impact of cost overrun.
8. Actual rentable area may be much lower than assumed: This is another factor many analysts tend to ignore. Very rarely it happens that the actual revenue generating area is more that what had been assumed in the feasibility study.
9. Define KPI and be clear how you will be tracking financial health of the development: You must be very clear about what is your performance indicator and how you are going to track it. What are the red-flag items and what is your risk mitigation strategy.
10. Always consider margin of safety: The term, margin of safety, was popularized by Benjamin Graham and Warren Buffett. Consider a stock is valued at $10, buying it at $7.50 will give you a margin of safety in case your analysis turns out to be incorrect and the stock is really only worth $8.
The same concept should be applied while doing feasibility study for a real estate development project.
However, margin of safety doesn't guarantee a successful investment, but it does provide room for error in an analyst's judgment. Margin of safety provides a cushion against errors in calculation.
Hope you enjoyed this post on feasibility study. What do you think, use the comment section below.