Picture yourself looking down at some shimmery water from atop a cliff. Before you jump off the cliff, it’s probably a good idea to know that the water you’re jumping into is deep enough so that you don’t hit the bottom. It’s also important to know if there are any rocks hidden underneath the surface that would hurt you. Furthermore, it would be pretty smart to check for any sharks or other not-so-friendly creatures.
You get the point, planning is pretty darn important before jumping into a real estate deal worth millions of dollars.
Our friends at Investopedia define the Feasibility Study as being:
“an analysis of how successfully a project can be completed, accounting for factors that affect it such as economic, technological, legal and scheduling factors.”
The first step in the feasibility study is to look at municipal bylaws and zoning regulations. For example, you may be thinking that you’d like to build a residential tower with 17 floors of micro-condos on a piece of property, however perhaps the land isn’t zoned for such a high-density project. Maybe the land isn’t even zoned for multi family residential construction at all, and light industrial facilities are called for in the zoning regulations. The bottom line is that you’ve got to know what you’re allowed to build before you research any further.
Next, after determining what can be legally built on a piece of land, we must ask a very important question: What, according to the market, are the best options?
So you know which options are legally viable on a piece of land, but how do you choose where to go from there? Well, the best place to go for guidance at this point is straight to the market to figure out where there is unmet need. You’ve got to invest some time and resources to ensure that you’re going to build something that the market needs and wants.
Let’s say you have a piece of land that’s zoned for detached homes. How do you choose what kind of homes you might build? Well, after researching the market via studies of current market data, perhaps you determine that Victoria needs detached homes for downsizing empty nesters as well as homes for young families who are looking to purchase their first homes.
If those are two of your options (maybe you have 4 or 5 different options!), then you would want to look at what kinds of costs each one of them would entail. For example, empty nesters would likely have more wealth than young families and might therefore demand a higher quality house with more “creature comforts”. The homes would be more expensive to build, but would sell at a higher price point. These are the kinds of details that are necessary to analyze in the feasibility study.
So you might be wondering:
“Once you’ve determined your building options based on zoning and market demand, what comes next in the feasibility study?”
Today, let’s talk about two major areas that your feasibility study should look at: Market/Project Absorption Rates, and Cash Flow.
1. Market/Project Absorption Rates:
Scenario: You decided to build 50 single-family homes on a 10-acre lot! The only problem is, it’s been a year since completion and 20 of them are still sitting unsold. This costs the owner extra money in unpredicted carrying costs…
Well, this is precisely what we are trying to avoid when we look at absorption rates. The market absorption rate is:
“the rate at which available [units] are sold in a specific real estate market during a given time period. It is calculated by dividing the total number of available [units] by the average number of sales per month.”
(shout out to Investopedia for the awesome definition!)
So, what does market absorption rate mean to you? You need to tailor your building schedule to the market absorption rate. You don’t want to build faster than you can sell.
Ideally, you want to build at a rate to ensure that whatever you build is sold at or before completion. Whether you build warehouses, storage units, condominiums or rental units, well-timed absorption carries many interrelated advantages. These advantages include maximizing revenue, improving cash flow, and reducing carrying costs.
Luckily, there are a few ways to accelerate your sales and complete the project at a faster rate. This is where the idea of project absorption rate comes into play.
Market absorption rates are external, meaning we aren’t in control of them. Your project absorption rate, however, can actually outpace the market absorption rate if your project offers better-than-average value through intelligent design and desirable features. These valuable qualities positively impact project absorption rate because they increase buyer demand.
The 2 largest items that impact project absorption rates are:
1. Pricing: The lower you price, the faster you will sell. Conversely, higher-than-market prices will slow down your sales (i.e. lower your project absorption rate). A lower project absorption rate will increase your carrying costs and eventually force you to drop your prices (potentially even lower than market value!) as consumers shy away from your “high market age” listings. The goal is to sell at the highest price with the shortest sales cycle.
2. Marketing and Sales: Commonly referred to synonymously, these terms actually represent two completely different processes. How do these processes impact your project absorption rate? Well, poor marketing efforts will fail to target and attract enough of the correct buyers. Poor sales teams, on the other hand, will close out less of the prospects generated by your marketing. Both of these issues will result in a longer sales cycle, and a lower absorption rate. See our blog on Marketing and Sales for more information!
Bottom line, the idea is to build at approximately the rate the market will absorb the units while actively trying to beat the market absorption rates by using intelligent designs, desirable features, competitive pricing, and great marketing and sales.
When conducting a property development feasibility study, you want it to address market absorption rates for every option in consideration.
A cash flow analysis starts by asking two questions:
1.How much money do I need?
2.At what stages (when) do I need it?
A deal may look like a slam-dunk in a lot of different areas like profit, return on investment (ROI), and general awesomeness (hey, it’s pretty cool to look at your land and imagine what your project will look like when it’s complete!)…but that doesn’t necessarily mean that the bills are going to be paid each month. Often times, financing will come in phases that are contingent on the completion of a number of prerequisite tasks.
In order to set a project up for success, it is paramount to conduct a cash flow analysis well before starting any construction. You need to forecast available funds and expenses each month, and plan out your project’s monthly bottom line to always be in black ink.
Financing is frequently subject to completion of different phases of a project. In other words, funding is made available after something has been built. On the other hand, some sub trades, service providers and suppliers require payment before completing work. This can create cash flow issues, and these issues need to be planned for in advance to avoid stalling a project.
When planning out the project’s monthly cash flow, you may find that in the next quarter, you’ll have a big bill for pouring concrete. How are you going to ensure that you can cover this expense? Well, you may have to start a contingency fund a few months in advance, or plan for a certain investment to mature and become liquid so that you don’t have to borrow short-term funds at a high interest rate.
The end result of completing a cash flow analysis is that everybody gets paid on time, short-term borrowing is kept out of the picture, long term financing is used efficiently, and your profits are maximized. Smiles all around!
Reducing risks and maximizing profits are the name of the game in any investment. Completing a feasibility study will ensure that you can do both of these things, and a lot more. Furthermore, the study will help you obtain financing at better rates, and more favourable terms for you. Lenders will be confident that you really know what you’re doing, and they’ll be assured that you’ll create a successful and profitable project. Everyone wins, and we all want to be on a winning team!
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