MARKET FACTORS AND MARKET RISK
Market factors affecting property investment can be divided into :
In this unit when we use the term global we are referring to factors of investment on the macro scale. The most relevant global factors in the context of this unit are measures of economic and population performance at state and regional levels.
Global factors can be considered as general factors underlying property investment and can be used to answer the initial question of which state or region to invest in. Useful historical information at state and regional (also local government) levels are available from the Australian Bureau of Statistics (ABS). ABS also has available “local snapshots” that summarizes the relevant information concerning a region or local government area. ABS allows a great deal of free data on it’s website:
Relevant data is usually available from local council particularly if they have a section encouraging local development or available from a regional library.
GROSS STATE PRODUCT AND GROSS REGIONAL PRODUCT
Gross State Product (GSP) is defined as the total value of goods and services produced within a state during a specified period, regardless of ownership. GSP differs from Gross National Product (GNP) in excluding inter-country income transfers, in effect attributing to a territory the product generated within it rather than the incomes received in it.
Gross Regional Product (GRP) is the same as GSP but at a regional or local government level. GSP and GRP are a useful statistics relating to state and regional economic performance. The following example shows the use of GSP in deciding which state to invest in.
EXAMPLE – WHICH STATE TO INVEST IN?
GROSS STATE PRODUCT (GSP)
The GSP for each state is available from the ABS:
GROSS STATE PRODUCT, Current prices VALUE S ($m)
|Tasmania||16 114||14 794||13 502||12 557||11 619|
|Western Australia||100 900||92 339||85 470||79 400||74 906|
|South Australia||59 819||56 737||53 635||50 834||47 388|
|Queensland||158 506||144 701||132 432||123 746||112294|
|222 022||212 243||197 266||185 583||173441|
|305 437||290 746||275 358||260 307||247208|
Source: ABS National Accounts 522.0
The above data shows an annual compound growth over the last 5 years of about:
Australia (GDP) 5.28
Australian Capital Territory 5.78
Northern Territory 3.76
Western Australia 6.14
South Australia 4.77
New South Wales 4.32
Based on GSP, the greatest economic growth has been in Queensland and Tasmania. NSW although with the greatest GSP (ie in absolute terms) has the lowest rate of growth. Therefore, for a property investor using GSP as the statistic of investment, the best two states for appreciation in value (capital gains) are Queensland and Tasmania.
Another important statistic that should be used to complement GSP is population growth. Prima facie, an investment in a state with rapidly increasing population will produce higher appreciation (capital gains) in the future compared to a state with lower rates of population growth.
ABS also provides state population data. From this data the following demographic factors emerge:
During the year ended December 2003 the Australian population grew by 1.3%. Excluding Other Territories, all states and territories had positive growth rates, the highest being for Queensland (2.3%) and the lowest for the Australian Capital Territory (0.1%).
ESTIMATED RESIDENT POPULATION AND GROWTH RATES(a)
Population at end of December Quarter
|no. 2002||no. 2003||Change
previous year no
|New South Wales||6,662,212||6,716,277||54,065||0.8|
(a) Data for December 2002 and December 2003 are preliminary and subject to revision.
(b) Comprised of Jervis Bay Territory, Christmas Island and the Cocos (Keeling) Islands.
Source ABS 311.1.55
Ranking states according to population growth results in a similar ranking to that obtained using the GSP. However, Western Australia becomes a better investment than Tasmania.
The expected appreciation or capital gains is not the only factor of investors when deciding where to invest. Another important variable is risk of investment.
Risk is expected fluctuations in value and income in the future. This is measured by historical data using standard deviation. Standard deviation of the GSP using indexed values are as follows:
Australian Capital Territory
New South Wales
This shows that the states of least risk are the Northern territory, NSW and South Australia.
A measure of risk is also made by private risk rating companies. Australia and New South Wales enjoy a triple-A credit ratings from both Standard and Poor’s and Moody’s. A top credit rating signifies an extremely strong capacity for an ‘obligator’ to meet its financial commitments and withstand changing economic circumstances.
According to Moody’s assessment of New South Wales in January 2005, its AAA credit rating is underpinned by “a favourable economic environment and prudent financial management”. A further factor was the State’s low debt burden compared with other Australian states and international counterparts. In the general government sector, the State’s net debt is projected to fall to A$2.4 billion by 2007, or just 0.7% of Gross State Product. Moody’s also reports that New South Wales’ strong financial position provides it with ample budgetary flexibility.
Using this and standard deviation, NSW is a comparatively low risk state to invest in.
Using the above global statistics, if the investor is a risk taker looking for appreciation or capital growth then Queensland or Tasmania are the best investment states. If the investor is averse to risk but still requires reasonable return on investment then NSW is the best investment state.
The above analysis can also be carried out at regional and local government levels. The local council is a good source of compiled information useful to the property investor. For example, the following is population projections compiled by Maitland Council:
POPULATION PROJECTIONS, Maitland, 2006 to 2021
(a) source: Community and Recreation Services, Maitland Community Profile, October 2003, Maitland City Council, viewed 12 November 2004 (www.maitland.nsw.gov.au/publications/).
(b) source: Non-official projections prepared by the ABS for the Commonwealth Department of Health and Ageing (DoHA) using assumptions agreed to by DoHA.
Regional population data shows most growth during 2003 to 2004 in the following local government areas:
Baulkham Hills 3.3%
Fairfield showed the greatest loss at -3.6%
Source: ABS 3218.0
OTHER LOCAL FACTORS
As well as the underlying economic and demographic factors described above the property investor in a town or city should also consider the following factors:
LOCAL GOVERNMENT CONTROLS ON LAND USE AND NEW DEVELOPMENTS. Are they stringent or flexible? For example, many country towns will encourage new land uses and development whereas a number of Sydney councils actively discourage it.
POTENTIAL INCOME. For example, will commercial future tenants before small private companies or government departments. The property investment may be a commercial office block designed to house government departments. Risk of investment is reduced if the departments enter into pre development agreements.
COMPETITION. Will a new investment property be subject to competition from comparable developments/ For example, a neighbourhood shopping centre may be endangered by a proposal to build a large regional shopping centre nearby. The valuer should check all development applications with council. Competition is also important for motel, hotel and service station investments.
COST OF BUILDING AND AVAILABILITY OF SKILLED PERSONNEL. If the investment is a proposed new development then the valuer will need to determine the cost of building in the locality. There may be a shortage of building expertise and equipment resulting in the need to import builders. This may add substantial cost to the investment.
AVAILABILITY OF SUITABLE LAND. Some localities are stifled in development because there is a shortage of available land zoned for the particular investment land use. Changing land use can be a costly and lengthy process.
The valuer will need to take into account all the above factors when assessing the feasibility of the investment or determining the market value of an existing investment building.
The proposed investment may be the existing land use or may require a change of land use. As mentioned above the economics of engaging in a change of land use will depend on the flexibility of council in agreeing to a change in zoning and there may also be state laws against a change in land use. Because of the uncertainty, expense and length of time required to change the land use, it would only be feasible for a large investment. For example, a shopping centre or a bulky goods store. The investment should be the highest and best use of the site.
HIGHEST AND BEST USE
The market value of an investment building will only equal its replacement cost new if it is new and represents the highest and best use of the land. Highest and best use is that use of the land which generates the highest land value commensurate with the risk of development. Generally, that is also the highest improved value (land and building value) as non highest and best will cause non adaptable building values to fall to demolition value only.
An investor is looking at buying an industrial site adjoining a medium density residential area. There are only 3 possible alternative uses:
CONVERSION TO FLATS
Council have indicated that they will allow this use as the site adjoins existing medium residential developments.
DEVELOPMENT INTO A "STANDARD" WAREHOUSE
A use equivalent to a number already developed and successful warehouses in the locality.
DEVELOPMENT INTO A MOTEL
A use based on a perceived market gap demand for motels within large industrial areas. However, none have yet been built in such a location. Therefore, this will be a pioneer use.
The required rates of return for the 3 alternative uses are:
10% pa. A risky land use, riskier than the conversion to flats in an established residential area.
8% pa. A proven land use and relatively safe because warehouses of the same proposed design have sold well in this area. Note that Council have allowed this use.
15% per annum. A pioneer land use and therefore, a high risk use as this is the first time a motel has been built within an industrial area in this city. Therefore, the investor requires a comparatively high return on investment as compensation for the higher risk.
The valuer determined the market value of the land based on the 3 different options. The land values determined are:
OPTION 1: $180 000
OPTION 2: $220 000
OPTION 3: $190 000
Therefore, the highest and best use of the site is as a warehouse because that use shows the highest land value of $220 000 when the appropriate return on investment (8%pa) is applied.
Quality assurance is the application of quality management principles to a valuation firm. Once a firm has established quality management principles they can apply for ISO900 quality assurance accreditation. The ISO 9000 standards for quality management systems are issued by the International Organization for Standardization (ISO) in Switzerland. A number of valuation firms have been accredited with this quality assurance standard.
There is no legal requirement for valuer to implement ISO 9000, and it is up to the valuation company to make this decision and to take the appropriate initiative and action for the implementation and certification of ISO 9001. However, in addition to the assurance that defined quality requirements are met, the valuation firm with an ISO 9000 quality management system has a competitive advantage over non certified competitors.
For information on ISO9000 see:
In some respects the need for quality assurance is more applicable to large valuation firms than for a sole operator or partnership. For example, good quality assurance requires efficient and speedy communication between participants (eg the writing of manual and procedures) but this is already part of the nature of single operator and a partnership.
Quality assurance for our purposes is part of the role of the valuer in the investment team. Therefore, quality assurance principles apply to how well the team performs against it’s investment targets and action plan. If quality management includes the input of all staff and employees then it is known as Total Quality Management (TQM). Because of the need for teamwork by both investors and consultants, the aim should be TQM.
We are unable to cover all the requirements for TQM in this unit but rather, illustrate its use with the following hypothetical case study. This case study will describe the components of quality management.
VALUATION FIRM CASE STUDY
To link Quality to Valuation by initiating a Quality Assurance program in the valuation firm.
The work described in this case study was undertaken in a young, rapidly expanding company in the valuation and investment advice sector with no previous experience with Total Quality Management (TQM). The quality project began with a two day introductory awareness program covering concepts, cases, implementation strategies and imperatives of TQM. The program was conducted for the senior management team of the company.
This program used interactive exercises and real life case studies to explain the concepts of TQM and to interest them in committing resources for a demonstration project.
The demonstration project, which used 7 steps of problem solving, was to show them how TQM concepts work in practice before they commit resources for a company wide program.
MAIN COMPONENTS OF TQM
TQM has 3 main components:
Just in Time (JIT). For a valuation firm this can be translated into the need to provide valuation advice quickly and when required by investors.
Total Quality Control (TQC)
Total Employee Involvement (TEI).
The relationship between the 3 legs of TQM is:
JIT exposes the cause of problems
TQC helps provide a solution to problems
Lastly, since the employees do all improvements; they need to be involved in the process of change. TEI helps elicits this involvement.
STEP 1. DEFINE THE PROBLEM
A meeting of the management of the valuation company was held. Brainstorming produced a list of more than 20 problems. The list was prioritized and then followed by a structured discussion to arrive at a consensus on the problem: “That valuation reports are taking too long and typically, 2-3 days later than required by the investors”.
Under the theme, "Reducing the time of preparation of valuation reports" was selected as the most obvious and urgent problem. Although the company was young it has produced a sufficient number of investment reports to determine reliable component times. The instructions to valuation report process affected a number of their most valued clients.
A group representing all staff and employees was set up to tackle this problem which can be defined as:
Problem = client desire – current status
What did the individual group members think the time for the preparation of investment reports is currently? As each member began thinking, questions came up. "What type of report are we addressing; formal or informal?". The latter takes much less time because it doesn’t need countersigning, is shorter and requires less research.
Perceptions varied, with each member thinking about the time taken for their involvement in the report. The key process stages were mapped.
After considerable debate it was agreed at first to consider turnaround between entry into the computer system (clerical section) and checking and redrafting in the valuers’ section as being the most critical part of the cycle. Later the entire cycle could be included. The perception of the length of time on the report by different members of the team was recorded.
Formal reports: 4.5 days
Informal reports 2 days
The members then used a time/activity sheet to determine their time actually spent on each valuation report.
What was the turnaround desired by the investor clients? Since a client survey was not available, individual group members were asked to think as clients; “imagine they had just provided instructions for an investment report to the company. When would they expect the report in hand?” From the client's point of view and their own knowledge from their experience with the clients they realized that they did not differentiate between formal and informal reports. Their perception averaged out 2-3 days for a useful report. A formal report would be required later by the investor to present to the lender but the investor initial decision making required only a short professional report.
"Is this the average time or maximum time that you expect?" they were asked. "Maximum," they responded. It was clear therefore that the average must be less than 3 days.
The team decided that a report must be completed within 2 days. How can the company reduce the preparation time?
STEP 2. ANALYSIS OF THE PROBLEM
In a session the factors causing large turnaround times using the principles of JIT were explained. These were:
Input arrival patterns
Waiting times in process
- Batching of work
- Imbalanced allocation line
- Too many handovers
- Non-value added activities, etc.
Deployment of staff.
Typically it was found that once instructions were received, a period was lost waiting for a valuer to pick the instructions up.
Typical and actual procedures were timed and another where there was preparation without any waiting (ie immediate action by all staff). A 3/4 day difference was found.
It was found that the system could be streamlined by reducing the number of operations. This could be done by implementing a case management approach. That is, the person who receives the instructions manages the report and valuation process. Typically, the person who received the instructions processes the initial data into the computer system, carries out the initial research (sales, zoning and search on title) and then personally hands the instructions and research to an available valuer. This lead to a dramatic reduction in the number of operations, handovers, waiting and processing time.
The trial results amazed everyone and almost instantly the mindset of staff changed from doubt to desire: "Why can't we process all instructions this way?"
STEP 3. GENERATING IDEAS
In the introductory program of TQM during the JIT session the advantages of case management versus batch processing had been dramatically demonstrated using trials. Using that background a balanced flow line was designed where the receiver of the instructions became the “case manager” from receival through to the completed report.
Other ideas generated were to change to nd open office system so that communication and passing of hard data was immediate.
It was found that often the final report was held up because the senior valuer who cosigned all valuations was unavailable. This problem can be overcome by delegating. It was decide that the checking and cosigning of valuation reports could be carried out by other experienced valuers as well.
Finally since it was found that clients were just as happy with an informal report initially, clients would be issued an initial informal report quickly (1.5-2days) and a formal report would be prepared later when the client applied for a loan. For risk management purposes, the informal report would be clearly qualified as being “subject to a full valuation report”.
The new policy was sent to all existing clients and made available to new clients.
Changing the mindset of the staff and employees so they will accept and welcome change is critical to building a self sustaining culture of improvement. In this case, the line personnel were involved in a Quality Mindset Program so that they understood the reasons for change and the concepts behind them and are keen to experiment with new methods of working.
STEP 4. TESTING THE NEW SYSTEM
Testing in stages allows modification of ideas based upon practical experience and equally importantly, ensures acceptance of the new methods gradually by staff.
Run 5 reports through the new system and confirm results. The test produced the following results:
Average turnaround time: 1.5 - 2 days
In-house processing time: 1 day.
The success of the new system meant that staff and employees were now keen to push its full implementation.
It was agreed to run the new system for 3 weeks and compute the average time to measure the improvement. It was agreed that only in house processing was covered at this stage. The test results supported the trial results.
The goal of 2 days to prepare the report achieved.
STEP 5. IMPLEMENTING THE IDEAS
Once the new system has been implemented, TQM should still stay alive as an ongoing process. All staff should still attend regular TQM meetings and try to improve performance further.
This example of TQM was only applied to the office component of the valuation firm. It should eventually be applied to components of the firm.
STEP 6. CHECK THE RESULT
The process was run for 2 months with regular checks. The results obtained were marginally better than the trials which showed that staff were more comfortable with the idea and were implementing small improvements themselves.
The reputation of the firm s being quick and efficient increased through word of mouth. More investor clients dissatisfied with slow reports employed the firm.
STEP 7 FUTURE ACTIONS
A quality improvement story will be compiled by the project Leader for training and motivating all employees.
Once all functions have been through the TQM process the firm plans to obtain ISO9000 accreditation which will be used as in the advertising and promotion of the business.
Similar analysis of valuation staff roles and tasks
Client communication. For example, downloading the report immediately from the internet.
Data input. Source of sales and investment data used in investment reports.
“Paperless” office? New computer and communication systems.
COMMUNICATION OF PERFORMANCE STRATEGY
Ongoing, regular and extraordinary meetings and other forms of communication are part and parcel of the valuer’s role with investors. The crucial communication stages for a typical investment are as follows:
RECEIVING AND CLARIFYING INSTRUCTIONS.
It is common for the valuer to have to clarify instructions received from the investor. The following matters should be discussed and clarified:
If the investment is concerned with buying an existing investment property then the valuer needs to know whether or not the valuation is subject to existing tenancies or subject to vacant possession. Does the investor require a market value or special value to the investor? Does the investor have a building inspection report or do they intent to have one carried out?
If the investment proposal is for a new development then the valuer will require details of the proposal so that they can carry out a hypothetical development to determine land value. Does the client have council approval? Has an architect prepared concept or preliminary sketch plans of the proposal?
These issues are best discussed face to face as in that way the valuer can ascertain how well the investor understands the proposal and particularly, how well they understand the role of the valuer. It is a good opportunity to explain the valuation system in their project.
The initial meeting is also an opportunity for the investor to hand over hard copies of information that the valuer may need. For example, building reports and council approvals. The investor will also know any extra information they may have to supply the valuer.
The valuation may also be required to be part of a business plan. This will be required by the investor when approaching a lender for finance.
PRESENTING AND DISCUSSING THE PURCHASE REPORT
Once the valuer has clarified and obtained all necessary information about the investment then they can carry out the required valuations. Once the valuations are complete, the valuer should arrange another meeting with the investor to not only hand over the reports but also discuss and explain the reports’ contents.
Again, a face to face meeting is the best way of doing this as it allows immediate response to questions and will save a great deal of time in the future. It is time saving as it will pre empt a number of future queries from the investor.
ONGOING MEETINGS DURING THE INVESTMENT PERIOD. EG RENT REVIEWS.
After the investment property has been bought, the investor will require a formal report of the starting values of depreciable items for taxation purposes. This is provided to the investor’s accountant who will use this report to start a depreciation schedule in the investor’s tax return for the first year.
After the investment property has been bought or built the valuer still plays an important role during the investment period. The valuer and investor should meet on a regular basis (eg monthly) to discuss the status of the investment. These meeting will not require a formal report from the valuer and most probably, verbal advice will be sufficient.
For example, advice that the investor should advertise now for a new tenant or negotiate with an existing tenant because the lease is due next month. The meeting will also be a useful vehicle for the investor to remind the valuer that rent reviews will soon be necessary. The valuer can then start their research into market rental evidence in time for the formal rent review report. Therefore, regular face to face meetings can save both parties a great deal of time.
EXTRAORDINARY MEETINGS TO OVERCOME PROBLEMS THAT HAVE ARISEN.
These are occasional meetings that arise when some problem arises with the investment building. For example, if the lifts break down or the air conditioning needs replacing. The valuer can play either an informal role with verbal advice or they may be required to prepare a formal report on the best option; to repair the existing system or to buy a new system.
The investor will also require reports during the investment period if they wish to refinance the investment. To enable this, the valuer can carry out a forma valuation for mortgage purposes.
FINAL MEETING. RECOMMENDATION AND FINAL VALUATION AT THE END OF THE INVESTMENT PERIOD.
At the end of the investment period the valuer will provide an up to date market valuation of the property which will help the investor decide whether or not it is better to sell now, keep the property (with or without renovation) or sell at a later date. This will be by way of a formal report after receiving instructions from the investor. To enable better decision making the valuer should also provide a land value of the property and costs of redevelopment.
As with the initial valuation, the valuer should discuss this report with the investor.
MANAGEMENT SOFTWARE PROGRAMS
The investor will have the use of dedicated management software programs to enable and evaluate the investment during the investment period. The program will most likely be run by the investor themselves or the property manager. Alternatively, the investor can construct their own spreadsheet programs to evaluate the investment against time. The evaluation will include a return on investment (as IRR or capitalisation rate) so that the manager of the program or spreadsheet will require the valuer’s input of market value during the investment period to enable the calculation of return on investment.
The value would only need to provide a short informal valuation for this purpose. This can be by way of a letter to the investor or property manager.
Communication between the valuer and investor consists of a complex mix of regular and extraordinary meetings, formal and informal valuation reports and face to face or non face to face communications. Each method and system should complement each other to enable the most efficient reporting and communication system.