OSPAR: Real Estate / Mortgage : MARKET STUDIES
Market studies can be performed on all major property types for cities in Canada and the United States. The material below is excerpted from an article by Ian Marcil, principal of OSPAR Consulting Ltd., and deals with the office market. The research was begun in Dallas and Houston, Texas, in the early 1980's and found to be completely transferable to other markets. The article explains how the absorption model forewarns investors of market corrections, and in this example the subject is the Toronto office market.
.... The second warning signal relies on brokerage house office market statistics.
Brokerage houses collect data on the existing office stock, occupancy, projects underway, projects being planned, and completion dates, all of which provide valuable input on the supply of space.
Information on historical demand (space absorption) can also be gleaned from the brokerage reports. However, the raw data do not provide information regarding the reasons for market movements, and more importantly, nor what movement can be expected in the future.
Even though the data do not explain the underlying reasons for the movement in supply and demand, the data can be used for a "quick and dirty" market forecast by comparing the projected supply to the historical demand for space.
In order to use such trend analysis with any degree of certainty, the data history must be sufficiently long to account for the natural waxing and waning within each cycle. With a reasonably long data history, a "base case" demand can be assumed, but this base case must be adjusted to account for the "season" within the current cycle.
"Chart 2 - Toronto Office Market, CMA 1989", below, shows that over the nine year period from 1980 to 1988 the average yearly absorption of space was 5.0 million square feet (msf). It also shows that at the end of 1988, 26.9 msf of new office space were anticipated for delivery over the next three years, or an average supply of 9 msf per year. As there were already 7.0 msf of vacant space, that meant there would be approximately 33.9 msf available over the next three years, or an average availability of 11.3 msf per year.
With a nine year annual average absorption of only 5.0 msf, this meant the future available space would be more than twice the long term average demand. Given that Toronto had just experienced a record absorption of 26.9 msf over the prior four years, it was extremely unlikely that strong demand could be sustained.
This rough measure of the balance between supply and demand was already sending warning signals by late 1987 and early 1988. By mid-year 1988 the problem was undeniable. Unfortunately, the real estate industry was focused on the trend line and not the underlying demand variables.
While forecasting with historical averages provides a quick and easy estimate of the balance between supply and demand, it is not accurate.
Improvements to historical averaging techniques are possible with more accurate models which do not simply inject the average historical demand but rather produce a forecast of the demand.
The supply side of the office market is the physical office space. As explained previously, this data is provided by brokerage houses. The demand side of the market is the people who use the space, office workers.
Having determined the components of supply and demand, producing an office market forecast would appear an easy task. However, determining future office employment is complicated by the fact a statistical model must be created for each metropolitan market.
Once the statistical relationships are established, a forecast of office employment is produced and married to the supply information to create the market forecast.
"Chart 3 - Comparison of Model Forecast to Previous Demand, Anticipated Supply, & Actual Absorption", below, of the Toronto office market, compares three model-based absorption forecasts developed by Ian Marcil, principal of OSPAR Consulting Ltd., to historical absorption, the "market call", and the actual absorption. The forecasts were made at the beginning of three successive years, 1989, 1990 and 1991. Each of the forecasts covered a three year forecast period. For example the 1989 forecast included market activity for 1989, '90 and '91. Similarly, the 1990 forecast included 1990, '91 and '92 while the 1991 forecast included 1991, '92 and '93.
The first column (blue) of each forecast year shows the absorption of office space for the prior three year period (the historical incremental demand). For the 1989 forecast, that represents the aggregate demand of approximately 22 msf for 1986, '87, and '88.
The second column (red) of each forecast year shows the amount of office space which would be coming on stream for the following three years (the future incremental supply). It represents buildings under construction or committed for completion in that time period. In essence this is the "market call" made by real estate industry management of the amount of space that would be absorbed by the market. In early 1989 the anticipated supply coming on stream in 1989, '90, and '91 was approximately 26.9 msf (the actual deliveries were approximately 28 msf).
The third column (green) of each forecast year shows the model-based three year forecast for absorption. In 1989, the model-based absorption forecast for the next three years was less than 14 msf. In other words, in 1989 the model forecast that demand for the coming three years (1989, '90, and '91) was going to be only one half of the supply that was expected to be delivered during that time period. This absorption forecast was also significantly less the 22 million square feet which had been absorbed by the market in the preceding three year period.
The fourth column (yellow) of each forecast year shows in retrospect the amount of space that was actually absorbed during each three year forecast period. During the first forecast period, 1989-91, approximately 11.5 msf of office space was absorbed.
The actual absorption during the period 1989-91 equaled only one half of the previous three year's absorption. In retrospect, the industry's "market call" of 28 msf was unrealistically optimistic, and over-supplied the market with 240% of what it could absorb. By comparison, the model-based forecast was within 2 msf of the eventual absorption.
By year-end 1991, real estate managers were faced with 24 msf of vacant space in the Toronto CMA office market . . . and were about to deliver an additional 5 msf . . . real estate values dropped by 40 to 60%. Few investors had received advice to leave the market before the downturn, and the resulting losses have still not been recovered.
The above excerpt demonstrates that investing in real-estate-related-assets does not necessarily mean that one must accept extreme volatility. With appropriate research, both systematic and non-systematic risk can be greatly reduced.
The value of the model's 1989 forecast to investors was exceptional. The validity of the research was reaffirmed by the subsequent Toronto market forecasts in 1990 and 1991 as well as forecasts for other markets. Such risk management tools are necessary for successful investment decision making, and allow investors to take advantage of real estate investment opportunities rather than simply riding the market cycle up, only to ride it back down again.
The office market research described above is an example of what can be done for residential, retail, industrial, and hotel property types. The difficulty is not so much in designing, developing, and producing appropriate research. The true difficulty is believing the statistically validated forecasts rather than trusting in "instincts" and "expertise". For those who prefer to invest using a rational, empirical approach, unbiased advice can be obtained through independent research such as provided by OSPAR Consulting Ltd..
The cost/benefit of research provides very profitable returns. The real estate related losses to owners, investors and pensioners from the crash of the late eighties is in the billions of dollars. The cost of research services which would prevent or mitigate those losses is less than the amount of the dollar rounding on financial statements. You work hard to create value - - invest a fraction of the amount that is spent creating value on the research necessary to secure and preserve that value.
Do you have a real estate related question about market studies that requires independent consulting? Please contact us.
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