developing investment strategy 

David Hornby PhD LlB FaPI

MARKET FACTORS AND MARKET RISK

Market factors affecting property investment can be divided into :



GLOBAL FACTORS

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 questionof 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 hasavailable “local snapshots” that summarizes the relevant informationconcerning a region or local

government area. ABS allows a great deal of free data on it’s website:

www.abs.gov.au

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 followingexample 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)


  0

2004–05
2003–04
2002–03




782 798
735 783
689340

Australian Capital
Territory 

18 306
17 309
16 091
14 707
13 819
Northern Territory
10 418
9 381
9 042
8 653
8 661
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

Victoria 

222 022  212 243  197 266  185 583  173441

New South Wales


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

Tasmania 6.76

Western Australia 6.14

South Australia 4.77

Queensland 7.14

Victoria 5.05

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 inabsolute terms) has the lowest rate of growth. Therefore, for a property investor using GSP as the statistic

ofinvestment, the besttwo states for appreciation in value (capital gains) are Queensland and Tasmania.


POPULATION

Another important statistic that should be used to complement GSP is population growth. Prima facie, an investment

in a statewith rapidly increasing population will produce higher appreciation (capital gains) in the future compared

to a state with lowerrates 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
over
previous year no		 %
New South Wales  6,662,212  6,716,277  54,065  0.8
Victoria  4,884,952  4,947,985  63,033  1.3
Queensland  3,754,154  3,840,111  85,957  2.3
South Australia  1,522,475  1,531,375  8,900  0.6
Western Australia  1,936,902  1,969,046  32,144  1.7
Tasmania  474,305  479,958  5,653  1.2
Northern Territory  198,075  198,700  625  0.3

Australian Capital
Territory

322,164  322,579  415  0.1

Other Territories(b)

2,657  2,646  -11  -0.4
Australia
19,757,896
20,008,677
250,78
11.3

(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


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:


Australia (GDP)

21

Australian Capital Territory

23



South Australia

19

Queensland

29

Victoria

20

New South Wales

17

This shows that the states of least risk are the Northern territory, NSW and South Australia.DEVELOPING INVESTMENT STRATEGY


CREDIT RATINGS

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.


CONCLUSION


Using the above global statistics, if the investor is a risk taker looking for appreciation or capital growth then

Queensland orasmania are the best investment states. If the investor is averse to risk but still requires reasonable

return oninvestment thenNSW is the best investment state.


LOCAL FACTORS/


The above analysis can also be carried out at regional and local government levels. The local council is a good source

of compiledinformation useful to the property investor. For example, the following is population projections compiled

by Maitland Council:


POPULATION PROJECTIONS, Maitland, 2006 to 2021


Organisation  2006  2011  2016  2021  Change
2006-2021 		% change

Department of Urban Affairs and Planning (a)

55300  56700  58200  59600  4300  7.8
DoHA(b)  57975  62456  67282  72482  14507  25.0

Hunter Valley
Research
Foundation (a)

 58468  63028  67467  71856  13388  22.9

(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) usingassumptions agreed to by DoHA.


Regional population data shows most growth during 2003 to 2004 in the following local government areas:

% GROWTH

Sydney 3.6%

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 alsoconsider the following factors:


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.


LAND USE

The proposed investment may be the existing land use or may require a change of land use. As mentioned above the

economics ofengaging in a change of land use will depend on the flexibility of council in agreeing to a change in

zoning and there may also bestate laws against a change in land use. Because of the uncertainty, expense and

length of time required to change the land use, itwould only be feasible for a large investment. For example, a

shopping centre or a bulky goods store. The investment should bethe 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 ofdevelopment. Generally, that is also the highest improved value (land and building

value) as non highest and best will cause nonadaptable building values to fall to demolition value only.


EXAMPLE


An investor is looking at buying an industrial site adjoining a medium density residential area. There are only 3

possible alternative

uses:

Council have indicated that they will allow this use as the site adjoins existing medium residential developments.

A use equivalent to a number already developed and successful warehouses in the locality.

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 anindustrial area in this city. Therefore, the investor requires a comparatively high return on investment

ascompensation for the higher risk.

The valuer determined the market value of the land based on the 3 different options. The land values determined

are:

Therefore, the highest and best use of the site is as a warehouse because that use shows the highest land value of

$220 000 whenthe appropriate return on investment (8%pa) is applied.


QUALITY ASSURANCE GOALS

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:  www.iso.org/iso/en/

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

AIM

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:


The relationship between the 3 legs of TQM is:


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


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.

It averaged:

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.


Client desire

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.

Processing times

Scheduling

Transport times

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.

Stage 1:

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 txqt stafd aNd employ%ec were now keen to pwsh its full implementition.

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