Feasibility studies are a combination of a market study and financial analysis used to determine if it is financially feasible to develop a proposed property. They are also performed to evaluate the feasibility of renovating or upgrading an existing property. Feasibility studies determine whether a property is financially feasible and whether its complete and stabilized value are equal to or exceed (1) the total costs to build it, (2) entrepreneurial profit and (3) an adequate return for the capital invested to develop the property.
Following is a summary of the steps in performing a feasibility study:
Develop scope of work with client;
Gather data (rent comparables, properties under construction, proposed properties, market occupancy and absorption, submarket occupancy and absorption and data for economic drivers which impact future prosperity for the real estate market); and
Analyze data to develop opinions of market rent, stabilized occupancy and the time likely required for the proposed property to reach stabilized occupancy.
Most market studies focus upon the revenue portion of a profit and loss statement. They do not address operating expenses or the value of the property at stabilized occupancy. A feasibility study addresses the factors in a market study and also addresses operating expenses and the value as stabilized. Feasibility studies also address whether the indicated market value is sufficient for the property to be financially feasible.
A feasibility study involves two areas where seasoned judgment is necessary: 1) judgment regarding market rent, occupancy and absorption and 2) judgment regarding the amount of entrepreneurial profit and return for the equity investor necessary to make a property financially feasible.
Investors usually have a basic premise for making a particular investment. O'Connor and Associates terms this concept the "investment hypothesis". Evaluating the accuracy of the investment hypothesis early in the acquisition process allows the investor to increase their returns and reduce due diligence expenses.
Following are examples of typical investment hypotheses:
This property will yield an unleveraged 7% return based on its current revenues and expenses.
There is an existing tenant with a below-market rent for half the space in this office building. By either increasing their rent to market or replacing them with a tenant at a market rate rent when their lease expires in three years, this building will generate an 11% yield on total costs.
An existing apartment complex is 60% occupied and has substantial deferred maintenance. The investor believes by spending $6,000 per unit to cure deferred maintenance he can increase rents to $.70 per square foot and generate a 10% yield on total costs.
In many cases, the investment hypothesis is correct. However, in cases where the investment hypothesis is not correct, the investor can expend substantial time and due diligence costs before concluding the investment will not succeed. Alternatively, the investor could proceed with the investment and not realize until after capital expenditures have been completed that the investment hypothesis is not correct. In either case, the investor benefits from realizing as quickly as possible that the investment hypothesis is not correct.
Author Resource:
The appraisal division of O’Connor & Associates is a national provider of commercial real estate appraisal services including cost segregation studies, due diligence, insurance valuations, business purchase price allocation , feasibility studies, financial modeling, gift tax valuations, highest and best use analyses, casualty loss valuation and HUD map market studies.
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