Consulting Tools and Techniques for Decision Making (Module 2)

2.1. The Consultant’s Role in Decision Making

THE unique Role of the real estate consultant, unlike others who serve the real estate market
incidental to a main service (such as brokerage or appraisal), actually enters into the client’s
decision-making situation where the client objectives and criteria are applied (altered,
modified or restated) and a decision is made. The consultant simulates the decision-making
process for the client, the client reacts to the plan with possible modification of original
objectives and criteria, and finally decides, with continuing guidance and advice from the
consultant. The consultant’s significant service objective is to ensure that the client’s problem
in terms of objectives is clearly defined and alternative strategies or solutions are suggested
and analysed and a course of action is selected.

The consultant is both a specialist and a generalist as he brings his own special expertise to
the client’s decision-making process and recognizes the potential need for capabilities
beyond his own in acting on or implementing a decision on professionals for particular
specialties that pertain to the questions at hand. Such professionals might include lawyers,
accountants, architects, engineers, economists, leasing agents, brokers, appraisers, financial
analysts, or others whose knowledge is pertinent and beyond the consultants own expertise
in any of these disciplines. It is the consultant’s responsibility to use any of these specialists to
coordinate their collective efforts on behalf of the client and to interpret the contribution of
each specialist to the client’s decision-making process and to the implementation of a
decision.

The consultant’s area of expertise may be limited to some real estate expertise in the
general areas of marketing, management, or finance. The consultant who is highly
specialized in a single area may require the services of other consultants with other real
estate-oriented skills. With the advances in decision theory, consultants may find the need
for modest retooling in their particular specialty, as well as others, to be able to understand
and interpret for the client the analysis of others and their input to the decision-making
process of the client.

Preliminary Analysis of Client Problems (Needs and Objectives)

A problem may be defined as a situation in which something has gone wrong without
explanation. This definition provides a distinction between problem solving and decision-
making. Problems are historical in nature, and problem solving involves finding the cause of
a deviation from a normal situation. As such, a problem in the strict sense of the word may
not actually exist, as the client’s “difficulty” may be one of making a decision from among
alternative courses of action (such as selecting from among alternative investment
opportunities or making a decision to buy, sell, lease, etc). The consultant’s role, therefore, is
more often that of aiding the client in decision making rather than problem solving. Thus, it is
important for the consultant to make this distinction between problem solving and decision-
making at the outset in order to serve the client’s needs best. Historically, emphasis has been
placed on identifying and solving “problems” for clients when the ultimate need to make a
decision has been the main issue. Emphasis should be placed more on decision- making
and on decision-making tools. Client “problems” are not problems at all. It is the client
objectives and their articulation, refinement, and ordering that are central to the
consultant’s role and represent the foundation upon which the analysis of the alternative
courses of action and ultimate decisions are based.

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Identification and Statement of Objectives

The most critical step to the client’s decision-making process is to identify precisely the
client’s goals or objectives to avoid the vague notion of objectives in his investment
decisions, such as conflicting objectives that require articulation and resolution prior to the
formation of a decision process or the analysis of that process. This information is acquired in
the initial information-gathering interview with the client. The goals or objectives elicited
from interview with client may require either broadening or narrowing, refinement or
restatement in a more precise manner that may require prioritizing their relative importance
to the client as well as to minimize or eliminate conflict.

Being the first step in the decision-making process, it is imperative that the consultant identify
the precise nature of the client’s “difficulty” in terms of his real objectives and how those
objectives can be best achieved within the context of investment opportunities. The major
concern of the consultant at this stage is to distinguish between the client’s perceived and
real needs and to translate those needs into weighted options for decision making.

Statement of client objectives The ability of the client to explain his objectives in precise
terms may be so limited that the consultant must add precision to client’s statements
regarding his goals. For example, investment objectives may be stated in the form of cash
flow or yield and cash flow return objectives may be in the form of rates or pesos. The
consultant provides the desired precision by separating the concepts and applying specific
pesos and/or percentage terms of each. The consultant has an obligation to resolve any
conflicts that result from more precise statements of client goals. For example, the client
may state that cash flow is relatively unimportant but that a high yield is required. That
statement implies staying power, a possible need for tax shelter, and an emphasis on capital
gain. These objectives need to be restated by the consultant as precisely as possible and
reviewed, possibly revised, by the client before alternative courses of action may be
considered.

Nature of investment objectives There are two categories of client objectives about his
investment position. Pride of ownership, specific location, design, accessibility and Fung Sui
conformance are criteria that are easily described but are non-quantifiable. The impact of
such non-quantifiable objectives may influence the level of cash flow or return, but this is a
consideration the consultant must decide on. The quantifiable and measurable features of
client objectives are usually less clear but which can be specifically qualified and analyzed
by the consultant. These objectives include levels of cash flow in either peso amounts or
rates, level of investment by the client, capital recovery, tax shelter, leverage, profitability
versus liquidity requirements, and risk versus return. These more measurable objectives need
to be defined and discussed with the client before the consultant can proceed with the
decision plan, utilizing these objectives as criteria against which alternative courses of action
may be evaluated.

Alternative course of action Alternative courses of action or strategies are drawn from
client objectives involving identification of needed data and tools of analysis and decision
making that might be applicable, resources to carry implement the engagement and
identification of the time and money constraints imposed on the entire process. In
hypothesizing alternative strategies or courses of action, the consultant sets the work plan for
establishing desirable action and implementing the decision. Based on the consultant’s
knowledge, experience, and judgment as well as the agreed objectives of the client, the
decision may range from no action at all to a complete change of the client’s investment
position. All these steps are described in the Consulting Process.

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Scientific Steps in Decision Making

The scientific method of decision-making starts with the client “problem” that needs
definition and solution. Problem solving and decision-making are two separate processes,
each one presenting different perspectives to the client and the consultant. While they may
utilize similar tools of analysis, they will utilize those tools differently, providing different forms of
input and information into the process. Problem solving requires finding a means for
overcoming a barrier to an objective. Decision-making is action oriented and need not
deal with a “problem” in the strict sense of the word. To repeat, too much emphasis is
usually placed on problem solving when in fact, clients have sought assistance in their
decision-making process.

Decision-making Process vs. Consulting Process The following shows The Decision-
Making Process incorporating the modification regarding definition of the problem. This
Decision-Making Process differs from the Consulting Process. Although there are some
similarities, the Decision-Making Process focuses on a decision being reached, whereas the
Consulting Process is concerned with the consulting engagement that covers the other terms
and conditions that govern the client-consultant relationships. Further, and perhaps more
important, the use of more sophisticated techniques by others may be understood and
countered if this is necessary and appropriate.

STEPS IN REAL ESTATE DECISION MAKING The decision making process in real estate consists of
a series of steps that gather real estate data and information, analyze the information, and
then arrive at a decision based on the analysis. The formal procedure is called the scientific
method involving the following series of steps:

1. Clearly identify and define the problem or purpose of the investigation. This step is
critical, for unless a real estate investor knows exactly what he is attempting to
decide, the investor will not acquire the information needed to make a sound
decision. One clearly defined purpose might be to decide if now is the time to
purchase a particular real estate property, say Property X.

2. Collect relevant date. With the problem or purpose clearly defined, the investor then
gathers information that would be useful in arriving at a decision it is equally important
to avoid material that is extraneous and irrelevant to the problem at hand. An
investor would attempt to gather as much economic, social, physical and political
data relevant to Property X as time and money allow.

3. Analyze the data collected. With the problem clearly defined and the relevant data
collected, an investor must the correlate, classify, and analyze the data and arrive a
preliminary decision – often called a hypothesis. After analyzing the information, an
investor may tentatively decide that Property X is the right property and that now is
the time to buy.

4. Formulate and test the tentative decisions (hypothesis). At this point in most scientific
investigations, experiments are conducted to see if the tentative decision or
hypothesis is correct. For real estate, it is difficult to experiment without having to make
firm commitment in advance. In other words, few sellers let an investor try the property
before buying to see if the property produces the desired results. Frequently. The only
testing available is to determine how other similar parcel with similar owners is doing in
the marketplace.

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5. Arrive at a final decision or conclusion. Taking into consideration steps 1, 2, 3 and 4,

the investor now makes a final decision by either accepting or rejecting the tentative
decision (hypothesis). If an investor decides to accept the tentative decision, say to buy a
property now, it should be recognized that there is a possibility that the investor is making
a mistake. In other words, there is chance that this is not the time to buy. So an investor
should then estimate the probability of being wrong and decide if he is willing to take the
risk. If it is decided that the property is an acceptable risk, the purchase takes place.

The scientific method is the rational way to approach real estate decisions. Unfortunately,
too many people make real estate decisions based on emotions. The role of the real estate
consultant is to bring rational behavior to a very emotional business. Below is the diagram of
the steps in the scientific method.

STEPS IN THE REAL ESTATE DECISION MAKING PROCESS

(A Supplement to the Real Estate Consulting Process)

I. Preliminary Statement of Objectives

A. Investment-return analysis (ratios and relationship)

1. Sophisticated projections and historical figures analysis

2. Less sophisticated on-the-spot decision analysis (by hunch, intuition,
3. Judgment and logic of the consultant’s long experience and continuing
education)

II. Refinement and Directing of Objectives

A. Express complex relationship in simple statements
B. Simplify large data sets into more comprehensible proportions for mathematical
analysis (modeling)
C. Verify and validate the on-the-spot judgment (of the consultant or client)

III. Identification and Analysis of Alternative Courses of Action

A. Decision-Making Tools

1. Statistical Decision Tools (to identify and explain variability in data sets)

a. Collation, classification and interpretation of data

b. Decision on the basis of the analysis
c. Identify the limitations and applications of the statistical measures that
evolve from statistical analysis (that may fall short, particularly in real
estate decision making) such as:
1) measures of central tendency
2) measures of dispersion
3) statistical inference and prediction
4) regression and correlation analysis

2. Financial Decision Tools (to provide the basis for achieving a balance investment
risk and investment return and between profitability and liquidity, and for making selections
from among investment opportunities); Recognize the valid criticism and problems on the
various tools for either simplicity or complexity, inconsistencies in ranking investment
alternatives, for wide-ranging investment return calculations, for differences in the timing and
direction of cash flows, and the like. Distinguish ratio models vs. yield models.

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a. Profitability measures, to recover capital and achieve return on capital

1) Net present value model (Decision rule: highest net present value)
2) Profitability index model (Rule: highest positive index)-IRR, AIRR, MIRR,
FMRR.

b. Liquidity measures (Rule: shortest period to recover investment from cash

flow)-Payable period, current ratio, D/E ratio.

3. Operations Research (an analysis of the efficiency of operations of one or more

investment vehicles to better ensure the long-term investment potential of the
investment in achieving explicit goals precisely expressed by the client) include
the following:

a. Linear programming, to determine the best allocation of scarce resources

(planning by mathematical techniques)
b. Monte Carlo simulation, to enable the client or consultant to analyze by
computer simulation various combinations of the risk and return and make
more profitable decisions over the long term.
c. Bayesian analysis, a form of statistical analysis where subjective
probabilities (referred to as prior probabilities) are assigned to the
occurrence of some real-world phenomena.
d. Game theory (regardless of model) forces the participants to make a
series of interrelated goals-oriented decision regarding the disposition and
development of aspects abstracted from real-world phenomena.

IV. Development of Decision Models/ Statement/ Plan

V. Selection of Course of Action that:

A. Best fits objectives
B. Minimizes conflicts
C. Can be implemented within the time and money constraints imposed

2.2 The Consulting Process

Definition

The Realty Estate Consulting Process may be defined as the professional tool in pursuing a
real estate consulting engagement to ensure an orderly method of solving a real estate
problem or helping a client reach decision on alternatives available. The Consulting Process
is a distinct and systematic method by which competent consultants apply their knowledge
and skills to the solution of real estate problems. It is one of the sources of standards for
practice common to the different consulting disciplines and, therefore, unifies the disciplines
into a single profession.

The Consulting Process is a model for resolving all kinds of real estate problems, regardless of
whether the subject matter is real property, personal property, or a business. The Consulting

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Process provides the framework for developing and reporting any type of realty consulting.
The recommended standard steps involved in this process are summarized in the
accompanying outline or flowchart.

DEFINITION AND TERMS OF ENGAGEMENT

Identification of Problem and Objective Standard 1 addresses the concept of identifying the
client’s objective or purpose and the problems and issues raised for solution or decision-
making. There is an important difference between performing an impartial consulting service
as a disinterested third party that responds to the client’s stated objective and performing a
consulting service that is intended to facilitate the achievement of the client’s objective,
such as that performed by an appraiser, broker, or other licensed specialists.

Defining the real estate engagement includes the initial identification of the client problem
and statement of the objective and purpose for which the consulting engagement is to be
carried out. The consultant and the client must determine as completely as possible the
questions to be raised, the realty problems and issues to be solved, and the ultimate goals to
be achieved.

Initial interviews with the client by the consultant are necessary to determine as many of the
client’s objectives and acceptable alternatives. It is essential to know the client’s attitude
about the project and the problems. Is the attitude positive, or does the client have some
doubts and questions about the engagement? What long-term or short-term goal the client
is attempting to achieve, and what priorities should be considered? For example, the
engagement may be to find a suitable location for a project. If a location has been found,
the engagement may be to help the client decide what kind of building should be built on
the site and the probable market and the prospective tenants for the proposed project.
Finally, the consultant may assist in the planning of an entire proposed project.

Financial, social and ethical issues At the start of the engagement discussions, it is
important to know from the client the financial status of the project. Is there adequate
financing available from equity and mortgage loan, or will the project be financed entirely
by mortgage loan. If there are equity partners, the consultants may consider the after-tax
impact to partners in different tax brackets. In the case of limited partnerships, syndications,
or institutional investors on a cash basis, the consultant’s concern becomes one of cash flow
to property rather than cash flow to equity. These matters relate directly to the time
involvement of the consultant and the final recommendations.

Constraints in the Engagement

Physical and Time Considerations At the beginning of the engagement process, it is

necessary to determine what kind of property is involved. Is it proposed construction, an
existing distressed project, project to be improved, demolished, rented or sold?

A proposed construction or property that is to be altered or expanded may very well involve
a long-term commitment on the part of the consultant. An existing project may involve only
an investment analysis to determine whether or not the financial goals of the client can be
achieved in the project. Any unique or unusual features of the property might influence the
issues to be solved and the questions to be answered.

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In determining the time frame involved, consideration should be given also to the time of
submission of various parts of the report and ascertain whether the entire engagement will
be completed as a single and final report.

A major project to be constructed in stages over a number of years would involve detailed
analysis of the initial stage and consideration of the potential impact of the later stages. The
consultants may be called upon for analysis of the timing of the later stages.

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FLOWCHART OF THE REAL ESTATE CONSULTING PROCESS

(For Licensed Real Estate Consultants)

I DEFINE THE ENGAGEMENT

Draw Client Profile
Purpose & Identify Subject Report
Report
Problem Property Time/Date
Format

II FORMALIZE THE CONSULTING RELATIONSHIP

Fee/Expense Sign Engagement
Agree on Purpose Preliminary Scope
Arrangement Contract
& Defined Problem Of Work/Budget

III PLAN THE ENGAGEMENT

Set Work Assign
Review Set Critique
Deadlines Task
In-house file Points

IV EXECUTE THE PLAN OF ENGAGEMENT

Compile Data Analyze Data & Formulate Conclusions

Develop Information Recommendations

V PREPARE THE REPORT WITH CONCLUSIONS & RECOMMENDATIONS

CONSISTENT WITH:

Definition of Data Analyzed & Report Format & Engagement

Purpose & Problem Info Developed Critique Points Obligation

VI REVIEW THE REPORT

Check Accuracy of Check Logic & Reasonableness

Computations of Conclusions & Recommendations

VII PRESENT THE REPORT

Presentation Authenticate/Distribute Post-Report

Meeting Written Report Dialogue

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The Consultant as a Coordinator

Coordination and Communication An engagement involving a proposed construction would

normally require meeting with the client and the architect in the earliest stages of preliminary
architectural scheme and plans. Such meeting will determine the eventual success of the
entire construction and market absorption program. The coordinating relationship is an
important part of the definition of the engagement as this will also affect the fees to be
charged by the consultant.

The initial step of a consulting process also includes consideration of the resources and the
personnel that will be needed. Such personnel requirement includes the staff of the
consultant and outside specialists such as architects, accountants, engineers, contractors,
management personnel, landscape architects, surveyors, demographics, ecologists, and
lawyers. It is critical to have an understanding what data the consultant must generate and
what data the client will furnish. The set of plans and specifications on proposed projects or
on projects to be altered or expanded must be available, though a final set of working
drawings may not be required. Copied of contracts with the lessees and other parties may
affect the work or recommendations of the consultant.

Planning and Budgeting the Engagement

The consulting process includes engagement budget for in-house manpower, outside
specialists, special tasks of individuals, and a job plan and work flowchart.

Most experienced consultants have in-house data files on similar types of project where
reference can be had for demographic information, construction cost data on similar
projects, revenue and expense data for comparative analysis, and information on public
utilities, much of supplementary data and information for the engagement come from such
in-house file.

THE ENGAGEMENT CONTRACT: ESTABLISHING THE FORMAL CONSULTING RELATIONSHIP

In order to further insure the satisfactory implementation of the engagement, it is important

to establish the consulting relationship with the client, particularly the agreement reached
exactly as (1) what services the consultant will provide (2) in what form, and (3) at what time.
This understanding will clearly define the responsibility of the client and the consultant.
Likewise, it is important to agree on the fee or fees for the service contract and the
incidental expenses to be borne by the client to avoid misunderstanding, the fee may be in
a lump sum or on a per diem or hourly basis. A retainer basis may be appropriate in some
cases, especially in major engagement involving long-term consultation or where the client’s
credit and financial standing is unavailable.

The schedule of fee payment may be in periodic retainer fee as a part of the total fee, plus
progress payments. With well-establish clients or in small engagements the entire fee may
be paid after completion of the report.

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PLANNING THE ENGAGEMENT EXECUTION

When the consulting engagement contract is signed, the consultant prepares the plan to
implement the engagement, beginning with the setting of deadlines and coordinating the
effort of the staff and outside services. It is desirable to set review points to see if the tasks
are on schedule and to check the quality of the works completed to date. This review
technique will determine if mid-project changes are needed to produce on time the desired
quality results. A review technique frequently used for big engagements is the so-called PERT
(Project Evaluation and Review Techniques) or the CPM (Critical Path Method) network.

EXECUTING THE PLAN OF ENGAGEMENT

Performance of the engagement calls for the compilation of all required data from both
internal and external sources and the development of relevant and useful information from
such data. As necessary data and information are compiled, the analysis work of the
engagement is undertaken. The data and information are analyzed from the standpoint of
quality, quantity, and relevance to the engagement. Data processing frequently involves
computer analysis in the special program developed for the engagement. Unlike real estate
appraisers’ fairly standardized format, consulting works are rarely uniform with each other
consulting works done in the past. Although there may be a considerable degree of
similarity among consulting engagements, a particular real estate problem or issue will
require the development of a specific program for data and information analysis.

THE CONSULTING REPORT: PREPARING, REVIEWING AND PRESENTING

Preparation The preparation of the actual report may begin early in the plan of execution
with the preparation of supporting tables, schedules and other illustrative materials. No part
of the report may be prepared until the completion of the relevant conclusions and
supporting materials. The final report should be carefully prepared and edited to assure that
it answers the main problem and issues, and that the conclusions and recommendations will
assist the client in making a prudent decision.

The report should comply with all the contractual obligations pertaining to the purpose of
the engagement, timing, and the form of presentation. The volume of data and information
in the report is dependent on the nature of the problem and the form of report agreed
upon. A verbal presentation of the written report may contain less data but with reasonable
explanation of the kinds of data analysis used, with minimum but significant graphs, charts,
photographs, and other visual aids.

Reviewing All computations in the report should undergo accuracy tests. A final check of
the logic and reasonableness of the conclusions and recommendations should be made (by
a review panel for big engagements) to assure that the report and all its findings have
considered the main purpose of the engagement. Sometimes, the final report is preceded
by meeting with the client before this is finalized and submitted.

Presenting The written report is presented in pre-set appointment with the client. The
presentation is given completely but briefly, with adequate time allowed to
accommodate any questions from the client. The written report should adequately convey

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the findings in accordance with the definition of the agreement and should always reflect
the professional integrity of the consultant.

2.3 PROJECT FEASIBILITY STUDY

Definition and Purpose of Project Feasibility Study (PFS)

PFS is a thorough and systematic analysis of all the factors that affect the possibility of
success of a proposed project or undertaking. The findings presented in the PFS serve as the
basis for deciding whether the project is to be abandoned, revised or pursued. The PFS is a
tool or technique in the unification or synthesis of individual studies on the market, technical,
financial, socio-economic, and management aspects of the project.

In developing a project feasibility study or analysis, a consultant must observe the following
specific guidelines when applicable: (a) prepare a complete market analysis, (b) apply the
results of the market analysis to alternative course of action to achieve the client’s objective:
consider and analyze the probable costs of each alternative, the probability of altering any
constraints to each alternative, the probable outcome of each alternative. (Standard Rule 1-
6, USPRCP)

An important step in feasibility study or analysis is to prepare or obtain a complete market

analysis. The consultant should compare the following criteria from the client’s project to the
results of the market analysis: the project budget (all construction costs, fees, carrying costs,
and ongoing property operating expenses); the time sequence of activities (planning,
construction, and marketing); the type and cost of financing obtainable; and cash flow
forecasts over the development and/or holding period; and yield expectations. The
consultant should have enough data to estimate whether the project will develop
according the expectations of the client and is economically feasible in accordance with
client’s explicitly defined financial objectives.

A GOOD FEASIBILITY STUDY is a key to investment decision and helps avoid the pitfalls after
the project has been committed. A feasibility analysis focuses at how well a proposed
project is likely to succeed for a particular client-investor’s objectives. Briefly, there are four
major steps for good feasibility study:

1. Identify the objectives of the client-investor, including the impact the investor wants the
project to make and the financial requirements of the investment.
2. Undertake a thorough market analysis that will indicate reasonable turnover.
3. Identify the constraints and costs of the project.
4. Apply the financial measures and techniques as the final determinant of Feasibility, the
stated objectives of the client-investor.

The credential and qualifications of the consultant will offer clues as to expertise and
experience in the type of property under consideration.

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Project feasibility study flowchart

PROJECT PROPONENT

PRE-FEASIBILITY

PROJECT FEASIBILITY

SOCIO-
MARKET TECHNICAL FINANCIAL MANAGEMENT ECONOMIC

TOTAL/EXCESS PRODUCT PRODUCT COST BUSINESS SOCIAL

DEMAND STUDY & EXPENSES ORGANIZATION BENEFIT

PRODUCT INCOME MANPOWER & ECONOMIC

DEMAND PROCESS STATEMENT SPECIALISTS VALUE ADDED

MARKET PRODUCT BALANCE ENVIRONMENT

SHARE VOLUME SHEET LEGAL & AUDIT PROTECTION

PRICE / SALES ADMINISTRATION

FORECAST MATERIALS FUNDS FLOW COMMUNITY
& HRD

MARKET MIX
STUDY LABOR

-D. D. DE VERA
march 2003
X X X
Legend: - GO X - ABANDON

Basic Parts of a Comprehensive Project Feasibility Study

There are generally five major components of a comprehensive PFS, namely: the
market study, the technical study, the financial study, the management study, and social
desirability study. The first four determines the final feasibility level that will decide as to
whether to go ahead or abandon the project.

Market study Generally, an investor is attracted to invest in a business project with a

minimum risk and a higher rate of return on investment. However, the major consideration is
whether there is an ample effective demand for the product being produced or proposed
to produce. If reasonable demand exists, current supply is then investigated to determine
whether there is a substantial excess demand so that a new project could enter into the
industry. If it is discovered that there is not enough demand for the product nor a new
demand can be created, then the project may be abandoned; otherwise, unreasonable
loss may be incurred if the project is implemented

On the other hand, if the findings indicate that there is a sufficient effective demand for the
product, the competitive position of the firm in the industry is evaluated. Information on the
prevailing prices of the product are gathered and analyzed. Pricing for the project and the
quality of the product relative to the products of the current and potential procedures are

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carefully studied, followed by the examination of the marketing program. The present
marketing strategies of the competitors, selling organization, terms of sales, channels of
distribution, location of sales outlets, transportation and warehousing, and other relative
information are taken into account.

Finally, conclusions drawn from the study specifically identify whether there is excess
effective demand for the product and that the project shall enjoy competitive marketing
position.

Technical study This study identifies whether the product could be produced at the desirable
volume and standards of quality, with minimum cost. In a manufacturing firm, study focuses
on the following:

1. The material component of the product and the sources of such material
components are identified, including the alternative raw materials, availability,
current and prospective sources and costs, the uses and other applications of the
product and its by-product.
2. The production process, where the detailed flow charts indicate materials and energy
requirement at each step, the normal duration of the process, the production
processes used by the competitors and the process or processes to be adopted.

3. The production machinery and equipment, their specifications, rated capacities, cost
and balancing of capacities of each major and auxiliary equipment, availability of
spare parts and repair service, identification of machinery suppliers, their guarantees,
delivery and terms of payment.

4. Plant location and layout, distance to source of raw materials and markets, the effect
of layout in materials flow and materials handling and storage, provision for
expansion, the structures to be constructed or rented, improvements like roads,
drainage facilities and their costs.

5. Utilities for waste disposal, specific facilities like electricity, fuel, water, supplies and
their respective uses, quantity required, availability of sources and capacities,
alternative source and costs, with the usual environment impact assessment.

6. Recruitment and training programs of personnel as well as the status and timetable of
the project.

Financial study This study determines the profitability level of the project that is generally
defined as the relationship of the net income after taxes to the total investment. It is mainly
based on the available opportunity cost in a particular period of time and place. This study
also involves the following:

1. A thorough coverage of all the detailed monetary information on the total project
cost, initial capital requirements, sources of financing, financial statements and the
financial analysis, and the validity of the assumptions used which are crucial in view
of their impact on the variable factors of the study.

2. Identification of sources of financing indicating the currency, security, repayment

period, interest and other features, the status of financing from each source
relating to actual release already made, applications already approved,

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applications pending and applications still to be made including information on

how the contingencies and seasonal peaks in working capital shall be financed.

3. Analysis of the financial statements (balance sheet, income statement, funds flow)
to show the financial health of the business, financial information to provide
operational measurement such as break-even volume, sales and prices, amount of
sales required to earn a certain amount of profit, and the cash payback period,
and sensitivity analysis.

Management study The objective of the management feasibility study is to determine the
appropriate business organization, manpower required before and during the commercial
operation of the project and their functions. It covers the following:

1. Type of business organization, organization chart and functions of each unit of

management.
2. How the project shall be managed before and during the operating periods,
identification of the firms or persons involved or to be involved in studying the different
aspects of the project.
3. Number of labor, skills, duties, and time to be devoted to the project, l compensations,
fringe benefits and manpower facilities.
4. Recruitment and training programs of personnel.
5. Status and timetable of the project.

Socio-economic study The project may be classified as a government or a private project.

To a government project, socio-economic desirability is given priority over profitability.
Therefore, feasibility is characterized by the level of socio-economic desirability.

A private entity’s main priority, on the other hand, is profitability, with socio-economic
desirability as a desired consequence of profitability. Thus feasibility is characterized mainly
by profitability with socio-economic as necessary con. Sequence. In government feasibility
studies, socio-economic desirability is given distinct focus, while in private project studies, it is
treated as a part of the economic aspect.

Socio-economic desirability is measured in terms of the volume and value of employment

generated and taxes paid to the government, public services, economic contribution and
environment protection.

Steps (Pointers) in Preparing Project Feasibility Study

The following steps may serve as a general guide on how to prepare a PFS:

1. Identify and list down the technical people (and firms) who will be involved in
preparing the various aspects of the study. The list usually includes the project
proponents and investors.

2. Investigate the market feasibility both by observations and by scientific research.

Feasibility is generally characterized by excess effective demand and a
competitive and long-term market position of the project. If not feasible,
abandon immediately the idea of putting up a new project to avoid unnecessary
losses. Investment options related to the same market may be considered, such
as just joining the equity of an existing company.

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3. If the market is feasible, proceed with the technical study, which refers to
sufficient availability of the resources required on a long terms basis, and at the
reasonable cost produce the product at the best possible quality and price
acceptable to the market. If not feasible, abandon the project.

4. If technically feasible, proceed with the financial study which refers to the
availability of the necessary financing at reasonable cost and terms, and
profitable operation that will satisfy the desirable investment value.

5. If financially feasible, proceed with the management study that refers to the
organizational set-up that can perform its functions efficiently and effectively,
with available qualified labor. If not feasible, abandon the project.

6. In a case of a government project, the next step is the assessment of the social
desirability of the project, which refers to the reasonable economic benefits that
will accrue to the people living in the community and to the immediate vicinities.
In the case of a private project, viability depends largely on the project
proponent’s concepts of values beyond profit. Social viability is, therefore, very
relative to the values equated to social benefits.

7. Prepare the Summary of the Project Feasibility, indicating a brief description of

the project, the highlights of the major assumptions made, such as effective
demand projections, market share and price, investment cost, method of
financing, and other important factors, and the summary of findings and
conclusions regarding market, technical, and financial feasibilities.

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Updated Feasibility Study Flow Chart

FEASIBILITY Involves various analysis approaches

STUDY geared towards determining the
viability and feasibility of your project.

MARKET TECHNICAL ENVIRONMENT

STUDY STUDY STUDY

Is there a gap? Is it technically Is it environment-

feasible? friendly?

FINANCIAL ORGANIZATION& SOCIAL

ANALYSIS MGT. STUDY ACCEPTABILITY
STUDY
Can it pay its Can the organization
loan? support the project? Is it acceptable to
the community?
ECONOMIC
ANALYSIS VIABLE &
Does it contribute to the FEASIBLE
economy?

Definition:

Feasibility Study is a thorough and systematic analysis of all the factors that
affect the possibility of success of a proposed project or undertaking.

Purpose:

The findings presented in the PFS serve as the basis for deciding whether the
project is to be abandoned, revised or pursued. The PFS is a tool or technique
in the unification or synthesis of individual studies on the market.

Types of PFS:

1. Market and Real Estate Feasibility

o Market Feasibility Study typically involves testing geographic
locations for a real estate development project, and usually
involves parcels of real estate land. Developers often conduct
market studies to determine the best location within a
jurisdiction, and to test alternative land uses for a given parcels.
Jurisdictions often require developers to complete feasibility
studies before they will approve a permit application for retail,
commercial, industrial, manufacturing, housing, office or mixed-

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use project. Market Feasibility take into account the importance

of the business in the selected area.
2. Technology and System Feasibility
This involves questions such as whether the technology needed
for the system exists, how difficult it will be to build, and whether
the firm has enough experience using that technology. The
assessment is based on an outline design of system requirements
in terms of Input, Processes, Output, Fields, Programs, and
Procedures. This can be quantified in terms of volumes of data,
trends, frequency of updating, etc in order to estimate if the new
system will perform adequately or not.

3. Resource Feasibility
o This involves questions such as how much time is available to
build the new system, when it can be built, whether it interferes
with normal business operations, type and amount of resources
required, dependencies, etc. Contingency and mitigation plans
should also be stated here so that if the project does over run
the company is ready for this eventuality.

4. Cultural Feasibility
o In this stage, the project's alternatives are evaluated for their
impact on the local and general culture. For example,
environmental factors need to be considered and these factors
are to be well known. Further an enterprise's own culture can
clash with the results of the project.

5. Operational Feasibility
o Do the current work practices and procedures support a new
system? Also social factors i.e. how the organizational changes
will affect the working lives of those affected by the system.

6. Legal Feasibility
o Determines whether the proposed system conflicts with legal
requirements, e.g. a Data Processing system must comply with
the local Data Protection Acts. When an organization has either
internal or external legal counsel, such reviews are typically
standard. However, a project may face legal issues after
completion if this factor is not considered at this stage. It is about
the authorization.

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7. Schedule Feasibility
o A project will fail if it takes too long to be completed before it is
useful. Typically this means estimating how long the system will
take to develop, and if it can be completed in a given time
period using some methods like payback period.

8. Economic Feasibility
o Economic analysis is the most frequently used method for
evaluating the effectiveness of a candidate system. More
commonly known as cost/benefit analysis, the procedure is to
determine the benefits and savings that are expected from a
candidate system and compare them with costs. if benefits
outweigh costs, then the decision is made to design and
implement the system.

CONTENTS of the PFS

I. Project Summary

A. Name of the Enterprise

– Briefly explain the choice of name

B. Location
– Pinpoint the location of the head office/ project site
– Factors which affect the choice affect the choice of location

C. Descriptive definition of the project

1. relation to national program
2. affinity to regional or sectoral studies
3. Project potential and proponent
D. Long-range objectives
size, capacity, volume, worth, role in the industry and impact on the
economy

E. Feasibility Criteria
Most important guidelines used: profitability, socio-economic,
environment

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F. Highlights of the Project

1. History
2. Project Timetable and Status
3. Nature of Industry
4. Mode of financing
5. Investment costs

G. Major Assumptions Used & Summary of Findings and

Conclusions:
1. Market feasibility
2. Technical Feasibility
3. Financial Feasibility
4. Socio-Economic Feasibility
5. Management Feasibility

II. MARKET STUDY

Lifeblood of PFS
Profitability – focal point
Demand- basic issue
Seeks to find:
1. Size, nature and growth of total demand
2. Description & price
3. Supply situation and the nature of competition
4. The different factors affecting the market
5. The appropriate marketing program
Market Study Outline
A. Product Description
B. Demand
C. Supply
D. Demand-Supply Analysis
E. Price Study
F. Factors Affecting the Market
G. Analysis of Research Data
H. Marketing Program
I. Marketing Plan
A. Product Description

B. Demand
1. Macro Analysis
GNP, growth rate of a GNP component
2. Micro Analysis
- price
- price of substitutes/alternatives
- income

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- population

Concepts in demand analysis

1. PRICE ELASTICITY- measures the responses of quantity
demanded of a particular product to variations in price
2. INCOME ELASTICITY – measures the response of quantity
demanded of a particular product to variations in income

C. SUPPLY Situation
1. Who & Where are the direct competitors
2. Determine the historical domestic supply
3. If there is a foreign market, determine the supply pattern
4. Evaluate supply growth patterns and project future supply

D. Demand-Supply Analysis
1. Compare the demand-supply trends
2. Determine the amount of demand unsatisfied*
3. Determine the share of the market
* If demand is fairly satisfied:
a. Whether factors affecting the market may disrupt the
equilibrium so as to cause demand to grow faster than
supply
b. Whether the qty of the product is such that may create
additional demand or cause a shift of a portion of the
existing demand in its favor.

E. PRICE STUDY
1. Determine the selling prices of all similar and substitute
products
2. Look into the history of these prices (Range of fluctuations)
establish the factors that mostly influence their fluctuation
over time.
3. Determine the responsiveness of demand to price changes
4. Establish the selling price: market segment targeted,
operating cost and expenses, estimate increases foreseen in
the subsequent years.

F. FACTORS AFFECTING THE MARKET

1. Demand may be affected by population growth, income
changes, taste, rural/urban developments, prices of
substitute and complementary, marketing tools like
advertising, promotions and credit policies
2. Supply may be influenced by the development of substitute
products, entry & exit of firms, sources & cost of

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production factors, government policies, improve

technology, etc.
3. Prices may be affected by production costs, price controls,
inflation, etc.

G. Analysis of Research Data

Data analysis and interpretation is one of the most critical phases
of market research.
1. Descriptive analysis use mean, median, mode,
frequency distribution, range and standard deviation
2. Inferential Analysis – tests the validity of the
hypothesis and identifies standard errors.
3. Difference Analysis – determine if differences exist
between groups of respondents
4. Associative Analysis- determines the associations or
relationships of variables
5. Predictive Analysis – forecasts based on the results of
the survey

H. Marketing Program – end product of the MS

1. Determine the types of mktg. programs prevalent and
gauge their respective effectiveness
2. Draw up marketing plan:
defines the market, price, packaging, distribution
network, sales management mechanism, advertising
and promotion programs
3. Ps – product, price, place, promotions
4. Design the marketing organization and cost – the most ideal
organization that allows maximum efficiency at the lowest
workforce level possible.

I. PARTS of a Marketing plan

1. Introduction
2. General Business Condition
3. Competitive Conditions
4. Market Research Results
5. Sales & distribution plan
6. Advertising & Sales Promotions
7. Other Related Aspects: product formulation, packaging, legal
clearance
8. Budget Summary
9. Profitability (Net Income Targets)

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III. TECHNICAL STUDY

A. The Product
B. Site Development Plan
C. Construction Plan / Process
D. Construction Schedule
E. Materials & Equipment Supplies
F. Utilities
G. Waste Disposal
H. Construction Cost
I. Labor Requirements

IV. FINANCIAL STUDY

A. MAJOR ASSUMPTIONS
1. Existing business practices in the industry may provide some
valuable information and insights on the ff:
a. Credit Terms
b. Credit Extensions
c. Bad debt allowances
d. Bad debt write-off
e. Quality related cost
f. Dividend Policies
g. Sales discounts, and refunds
h. Labor management compensation
i. Overhead Accounts
j. Operating Accounts
k. Absorption rate
l. Fixed-Asset requirements
m. Method of depreciation and amortization
n. Intangible-asset pre-requisites

2. Past Feasibility studies may reveal other factors not yet

considered, specially those items involved in the computations of:
a. Selling price
b. Sales Forecast
c. Unforeseen Costs
d. Production Volume
e. Product Mix

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3. Governmental Regulations and incentives directly or indirectly

affecting the product, such as:
a. Tax rates
b. Ownership
c. Tax Exemptions
d. Price Ceilings
e. Relevant PDs and EOs

4. Other pertinent data which can justify assumptions:

a. Industry profiles,
b. Pre-feasibility studies,
c. Proceedings of symposia and conferences,
d. Research or policy studies of industry associations

In general, assumptions - kept to the minimum

Formulated only when necessary
Should remain intact and consistent throughout the analysis
– Factual
– Justifiable
– Realistic
– Workable

B. Total Project Cost

-Estimation of pre-construction, construction and post construction
costs- initial asset or capital requirement
1. Fixed Assets- land & improvement
2. Current Assets- project’s initial current asset needs
a. Inventory Investments - materials + freight
b. Inventory-related costs – direct & indirect
labor, utilities, maintenance, warehousing
c. Cash credits- pre-paid expenses, intangibles,
organization expenses, pre-operating costs,
operating salaries, wages and fringe benefits,
operating taxes, transpo, office, advertising, cost of
borrowings, unforeseen costs.

C. Sources of Project Financing

1. list all sources both short term and long term: bank
credit, insurance term loans, mortgage loans,
leasing arrangements, issuance of bonds &
stocks, private placements, investment banking
arrangements, etc.
2. Select according to max. profitability

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3. Finalize the amount and the terms of each selected

source
4. Determine the status of financing; releases,
approved application, pending application
5. Provide allowances for financing contingencies
6. Identify alternative sources

D. Preparation of financial statements

1. Income Statement
2. Cash Flow Statement
3. Balance Sheet
E. Financial Analysis
1. Profitability
2. Liquidity
3. Cash Solvency
4. Growth Over Time

1. Profitability -Operational performance and efficiency of the project

a. Net profit margin = Net Income AT / Sales
b. Operating Profit Margin = Profit before Interest & taxes / Sales
c. Gross Profit Margin = Gross Profit / Sales
d. Return on financier’s investment = Net Income / Stock equity
e. Return on Owner’s Investment = Net Income/ Stock Equity
f. Return on Common Stock equity=
Net Income-PS Dividend / Net worth- par value of preferred stocks
g. Return on Net Operating profit = Profit before Interest & Taxes /
Total tangible assets
h. Asset Turnover = Sales / Total Tangible Assets
i. Return on Assets or earning power = Net Income /
Total Tangible Assets

2. Liquidity- firm’s ability to meet short-term obligations and to remain

solvent during hard times
a. Current Ratio = Current Assets/ Current liabilities
b. Quick or Acid-Test ratio =
Current Assets-Inventories / Current Liabilities
c. Liquidity of inventories = Cost of Sales / Average Inventory
d. Defensive position = Cash + marketable securities + receivables
projected Operating expenses/ no. of days

3. Test of debt service – project’s ability to meet long-term obligations

a. Debt-to-net worth ratio= Total liabilities / Total equities
b. Total capitalization ratio =
Long-term liabilities / Long-term liabilities & equity

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4. Test of total debt coverage =

a. Profit before interest & taxes / (Interest+principal
payments) (1/1- income tax rate)

5. Funds-Flow Analysis- determine the major uses & sources of funds

w/in one year in a project’s life
a. Cash Flow Analysis
b. Working Capital Flow analysis

6. Test of operating leverage – indicates how the project uses its assets for
which it pays a fixed cost difference between fixed and variable costs
a. Break-even Volume analysis
BEV = Fixed Cost / Selling Price-variable cost/unit
b. Break-even Cash Analysis
BEC = Cash Fixed Cost / Selling Price- cash variable cost/unit
c. Break-even Selling Price Analysis
BESP= Variable Costs+ fixed costs / Unit volume
= Total Cost/ Sales x Selling Price
d. Break - even Sales Analysis
BES = BESP x unit volume
= Fixed Cost / 1-( Variable Cost/ Net sales)

7. Test of financial leverage- ratios present how a project employs funds

which pay a fixed return
a. Earnings per share = Net Income/ Shares
b. Dividends per share =
Net Income-Preferred stock dividends - retained earnings /
common share

8. Test of Capital Investment – evaluate the justification for investing in the

project
a. Average rate of return =
Ave.Net Income / Ave. Net Investment
b. Payback Period in years =
Initial-year cash outflow/succeeding annual net cash flow
c. Capital recovery or cash pay off period (in years )=
Stocks / Annual Cash Dividends

F. Decision Criteria
1. Payback Period
2. Net Present Value
3. Benefit/Cost Analysis (Profitability Index)
4. Internal Rate of Return

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1. Payback Period - Capital budgeting decision define as the

no. of years required to recover the initial cash investment.
Time period required is based on industry’s performance.

2. Net Present Value - decision tool most favored because:

 It deals with cash flow and not accounting
profits.
 Considers time value of money & allows
comparison of the benefits and costs in a logical
manner.
 It uses hurdle rate that is acceptable to the
investor and would increase the value of the firm
if NPV were positive.
o n
NPV= ∑ ACF t - I.O.
t=1 (1 + k) 1
n
NPV= ∑ ACF t - I.O.
t=1 (1 + k) t
Where:
ACF t = annual after-tax cash flow in time period t
K = hurdle rate, discount rate; required rate of return of the
investor
I.O. = Initial outlay = cost of matls + shipping, transpo and instl.
+ working capital reqmt. (1 to 2 months)
n = the projects’s expected life

3. Benefit / Cost Analysis ( Profitability Index )

n
PI = ∑ ACF t / I.O. Or = NPV / I.O.
t=1 (1 + k) t

Where:
ACF t = annual after-tax cash flow in time period t
k =hurdle rate, discount rate; required rate of return of the investor
I.O. = Initial outlay = cost of matls + shipping, transpo & instl +
working capital reqmt. (1 to 2 months)
n = the projects’s expected life

4. Internal Rate of Return - use in determining viability

n
I.O = ∑ ACF t

t=1 (1 + IRR) t

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Where:
ACF t = annual after-tax cash flow in time period t
I.O. = Initial outlay=cost of matls + shipping, transpo & instl + working
capital reqmt. (1 to 2 months)
n = the projects’s expected life
IRR = the project’s internal rate of return

I. Other Approaches In Evaluating Project Risks

1. Simulation – Evaluating the performance of the project in different
scenarios.
Factors: market size, selling price, fixed cost, market growth rate,
investment required, residual value of investment, share of
market, operating costs, useful life of facilities

2. Sensitivity Analysis –determine how the distribution of possible NPVs

and IRR for a particular project is affected by a
change in one particular variable from the factors
listed above.

3. Probability Tree - graphic illustration of the sequence of possible

outcomes; schematic representation of the
problem in which all possible outcomes are
accounted for.

G. With or Without a Project Analysis - used to compare two scenarios used

for the following:
1. A New Project
2. Rehabilitation / Modernization Project
3. Loss Prevention Project
4. Improvement / Rehabilitation Project
1. A New Project- In this scenario
The Investor = will receive an additional benefit
- not involved in any business
- first time to invest
2. Rehabilitation / Modernization Project
3. Loss Prevention Project
4. Improvement Project

IV. FINANCIAL STUDY

1. Presentation of major assumptions
2. Summary of Project Cost
3. Sources of Financing

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4. Financial Statements
5. Financial Analysis
6. Decision Criterion
7. Sensitivity Analysis
8. Analysis of ‘With or Without the Project

V. SOCIO-ECONOMIC STUDY
Show how a project can contribute to:
– The standard of living
– Enhance community development
– Increase both foreign exchange savings and reserves,
– Aid in the lowering of prices
– And increase local demand for local materials & labor

Impact of the project in terms of:

1. Employment & Income, resulting in the improvement in the
standards of living of its employees and their families.
2. Taxes, since the increase revenues of local and national
governments can then be used for the development of the
community.
3. Supply of housing, observing the different possibilities of
influencing prices and foreign exchange balances
4. Demand for home-grown to allow local producers to sell
more materials

VI. ORGANIZATION & MANAGEMENT STUDY

Formulation of Goals

– Example
 Market Study- To acquire at least 10% market share
 Technical – Increase supply of housing unit by 20% in the
next two years.
 Financial - A payback of 5years, an ROI of 30%, a positive
NPV of not less than 1.5, an IRR minimum of 12%

Characteristics of well-designed Goals & Objectives:

– Expressed in terms of results rather than actions
– Measurable and quantifiable
– Clear time frame
– Challenging and yet attainable
– Written down on paper
– Communicated to all members of the organization &
stakeholders

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Prepare an overall IMPLEMENTATION PLAN

A. BASIC Considerations
1. Purpose of the project must be reinstated.
2. Consolidate all inputs from marketing, technical financial,
socio-economic and environmental studies that are relevant to
organization & management
3. Design project organizational chart.
B. Forms of Ownership
1. Single proprietorship
2. Partnership (general or limited)
3. Corporation (small to large scale)
4. Cooperatives
C. Organizational Chart
presented in a diagram which shows relationships, flow of authority
Includes:
All personnel from the management to the rank-and-file
employees
D. Officers & Key Personnel
Names of specific Individuals
Necessary educational background, work experience and
training, and net worth of each position must be adequately
described
E. PROJECT SCHEDULE
Different activities involved in the preparatory stage of the
project—presented in a GANTT Chart, stating duration of an
activity or a PERT Network to establish the sequence to be
followed for the different activities.

Project implementation needs to be planned well to ensure that:

– Tasks and activities are done
– Schedules are met
– Human resources are properly deployed
– Financial resources are properly spent
– Outputs are delivered
– Note: Some tools used in project implementation planning are
used in designing. Example is work breakdown structure, which is
done to determine the project cost

Project Implementation Planning

In practice, this consists of the following stages:
– breaking the project down into tasks
– deciding how long each task will take and what resources it will
require

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– deciding on the interdependency of tasks and a consequent

logical order
– producing a Plan so that it is possible to see how well the project
is progressing generally this means that there are milestones
during the project where it can be seen whether the project is
on target or not.

Scheduling Tasks & Activities

The most usual way of doing this is to produce a Gantt chart
Gantt charts (also referred to as project timelines) are bar graphs
that help plan and monitor project development or resource
allocation on a horizontal time scale.

VI. Environmental Study - Impact Assessment

VIII. RECOMMENDATION

XI. ANNEXES

FINAL NOTE:
One must evaluate the project as a whole. This is where qualitative
insights come in. Such insights become critical especially when some
uncertainty is concluded from quantitative findings.

A project study is, in essence, is a scientific & systematic approach to

decision-making. It is really a guide not an imposition.

2.4 INVESTMENT MEASUREMENT TOOLS

In developing a cash flow and/or investment analysis, a consultant must observe the
following specific guidelines when applicable: (a) consider and analyze the quality of the
income stream, (b) consider and analyze the history of expenses and reserves, (c) consider
and analyze financing viability and terms, (d) select and support the appropriate method of
processing the income stream, (e) consider and analyze the cash flow return(s) and
reversion(s) to the specified investment position over a projected time period(s). (Standard
Rule 1-5, USPRCP)

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MARKET VALUE AND INVESTMENT VALUE

THE WORD VALUE as applied to real estate must be qualified. “The value of your property is
P500,000” is a statement not specific enough to be meaningful to real estate professionals.
The statement “Your property is estimated to have a market value of P500,000” conveys
more explicit meaning. Of necessity, consultants and appraisers refer to market value,
insurable value, liquidation value, and other precisely identified and defined types of value.
Consulting assignments frequently call for estimates of market value or investment value as
well as associated analyses that will enable a client to make one or more real estate
decisions.

Market value refers to the value in the marketplace. Investment value is the specific value of
goods or services to a particular investor (or class of investors) based on individual investment
requirements. Market value and investment value are different concepts; the values
estimated for each may or may not be numerically equal depending on the circumstances.
Moreover, market value estimates are commonly made without reference to investment
value, but investment value estimates are frequently accompanied by a market value
estimate to facilitate decision-making.

Market value estimate assumes no specific buyer or seller; the estimate considers a
hypothetical transaction in which both the buyer and the seller have the understanding
and motivations that are typical of the market for the property or interests being valued.
Appraisers must distinguish between his own knowledge, perceptions, and attitudes and
those of the market or markets for the property in question. The special requirements of a
given client are irrelevant to a market value estimate.

In contrast, the goals of a specific investor are directly related to investment value, which
reflects the advantages or disadvantages of a particular property or real estate situation to
that investor. A consultant may be asked to analyze a series of investment opportunities or
possible business decisions and evaluate them in terms of their benefits to a given client.
Even decisions involving a single parcel of real estate may require the evaluation of other
possible decisions and an analysis of how each possibility may affect the decision being
considered.

Real Estate Investment Analysis

Investment analysis is a technique in determining if a particular investment opportunity is

right to meet the client’s objectives. This analysis involves at least three basic steps:

1. Define the client’s investment objectives and translate them into criteria that will allow
rejecting inappropriate investments and select the best among the appropriate ones.
2. Decide on the type of real estate investment: raw land acquisition, development,
buying and selling, income properties, foreclosed assets, mortgage securities, joint
venture.
3. Screen the available opportunities to eliminate those that don’t fit the criteria and
decide the best one by using detailed analysis that will project how the investment will
likely to perform in the light of the chance that something will go wrong and
comparing the projected return with other investment opportunities.

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In terms of time horizon, the analysis can be classified as short-term analysis and long-term-
analysis. Short-term analysis can be used to screen properties with the following indicators
that can be calculated quickly with available information based on current performance:

1. Gross rent multiplier – the total gross rent divided by the price of the property. The
lower the number, the less the investor is paying for the gross income.

2. Overall rate of return or capitalization rate – the net operating income (rent less
operating expenses divided by the value of the property. This measure is preferred to
the gross rent multiplier because it accounts for operating expenses and it offers a
percentage rate, which is a customary way to express rate of return.

3. Cash-on-cash return or equity dividend rate – the cash flow divided by the required
equity investment. This is useful when how the property will be financed is known. Either
before-tax or after-tax may be used. If after-tax cash flow is used, adjustment should
be made on the returns on alternative types of investment for taxes to make a
meaningful comparison.

Long-term analysis requires more information and assumptions because it involves

projecting several years. This type of analysis is more applicable if the value of the property
being considered is likely to increase or decrease in the near future, or if inflation is
significant. Long-term analysis requires projection of the growth rates for rents, operating
expenses, and property value. Changes in debt service and taxes are also considered. The
result of the analysis can be a measure of yield to maturity called the internal rate of return,
the projected annual rate of return over the entire holding period. Alternatively, the net
present value of the investment based on the required rate of return may be calculated. This
is often useful when comparing investment that require different levels of cash investment or
when putting together a portfolio of several investment. (Note that there are computer
programs available to do long-term investment analysis.

Real Estate Investment Objectives

Investors consider different objective according to their financial status, their access to
credit, and their investment motives. Obviously, not all investors seek to maximize net annual
income. Besides real estate varies in its ability to meet the various objectives, suggesting that
real estate investment may not be approached with simple measurement of the rate of
return on invested capital. The investment analysis must consider financing, capital gains,
and income tax consequences.

Real estate consultant must first identify the client’s investment objectives and the real estate
selected in order to select the appropriate method of analysis. Investors emphasize seven
objectives and may consider a combination of them: (1) liquidity and cash flow, (2)
maximum current income, (3) future income, (4) protection from inflation, (5) tax shelter, (6)
capital gains, and (7) safety of principal.

Liquidity is the ability to convert an asset to cash with a minimum loss. Generally, real estate is
one of the least liquid investments. A condo owner could convert his unit to cash
immediately if sold at the prevailing market value. But typical market conditions do not allow
immediate sale unless the unit is sold at an attractive price discount and better broker’s
commission. An investor who desires high liquidity may consider buying a share in a real
estate investment trust or in mortgage securities available in the stock exchanges. These

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securities are readily converted to cash at current market value. However, real estate
investors generally sacrifice liquidity in favor of other ownership benefits.

Maximum current income can be achieved by buying real estate in cash to avoid the cost
of mortgage payments, or invest in high return but risky investment such as in resort properties
dependent on recreation and tourism industries. Compared to investments in government
securities, real estate may give better current income. Such property is judged by its current
income and value, applying appraisal techniques without regard to income taxes and
financing.

Future income is preferred by some investors over current income, particularly persons in
relatively high income bracket and facing lower incomes at retirement or families investing a
real estate for their children. Investment in timberland or productive farmland requires a
considerable capital outlay over five to 15 years before the yield increase to the point that
reasonable returns are realized. Investment in residential subdivision in growth areas or in
shopping centers in anticipation of urbanization and population growth also meets future
income objective.

Protection from inflation is achieved by the upward movement of the market value of land
and construction costs in accord with the declining value of the peso. For example,
residential lots in Ayala Alabang bought in the early 80s at about P600 per square meter are
now valued at P10,000 to P15,000, which also reflected the depreciation of the peso
currency and the increase in price of construction materials and labor. However, not all real
estate increase in value; not all real estate values move in sympathy with the consumer price
index; and not all real estate increase in value at the same time

Tax shelter is primarily attractive to taxpayers subject to high income taxes and for whom
real estate has the advantage of accelerated depreciation allowances that can offset
other income. This investment motive may override other investment objectives. Cash flow
analysis will show the degree to which real estate serves this objective.

Capital gains to some taxpayers may be more favorable in terms of paying the final 6%
capital gains tax on gross sales than pay the normal income tax at very high bracket even
after considering allowable deductions from gross income. An investor may be willing to
forego current income in anticipation of later savings from much lower final tax.

Safety of principal, the main objective of trust institutions charged with preserving capital,
can be achieved by investing in prime real estate, such as commercial and properties
leased to multinational and dividend paying companies, government agencies and other
tenants with high credit rating. Investors are sometimes willing to accept lower rentals or yield
in favor of the security that such tenancy provides.

Common Measures of Investment Performance

Simple Ratio For many years investors have used simple ratio relationships to compare and
evaluate the returns from investment properties. One of the most common relationships is
the overall rate of return, which is the ratio between the net earnings of a real estate
investment and its price or value of. It is expressed as R in the formula R= Income over
Investment. Other formulas employ simply gross income or net income multipliers. In these
formulas the price or value of a property is expressed as a multiple of its potential gross or
effective gross earnings, or as a multiple of its net earnings. This multiple is the reciprocal of
the overall rate.

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Payback Period As a measure of investment return, the payback (PB) is seldom used alone; it
is commonly employed in conjunction with other measures. The payback period is defined
as the length of time required for the stream of net cash flows produced by an investment to
equal the original cash outlay. The breakeven point is reached when the investment’s
cumulative income is equal to its cumulative loss. The PB period can be calculated from
either before– or after-tax cash flows, so the type of cash flow selected should be identified.
The equation for PB period may be expressed as follows: PB= Equity Capital over Annual Net
Equity Cash Flows. This measure of performance is used by investors who simply want to
know how long it will take them to recapture the pesos they have invested. In theory an
investment with a PB period of five years would be preferable to one with a PB period of
seven years, all else being equal. Similarly, an investment that will return the investor’s
capital in ten years would be unacceptable to an investor who seeks investment PB within six
years. For an equity investment that is expected to produce equal cash flows, the PB period
is simply the reciprocal of the equity capitalization, or equity dividend, rate such that PB = 1
over RE .

If annual equity cash flows are not expected to be equal over the PB period, the equity cash
flows for each year must be added until the sum equals or exceeds the equity capital outlay;
this point indicates the year in which PB occurs.

Investment Proceeds Per Peso Invested Investment proceeds per peso invested is a simple
relationship calculated as the anticipated total proceeds returned to the investment position
divided by the amount invested. The resulting index or multiple provides a crude measure of
investment performance that is not time-weighted.

Profitability Index Although measuring the investment proceeds per peso invested is too
imprecise for general use; a refinement of this technique is commonly applied. A profitability
index (PI), or benefit/cost ratio, is defined as the present value of the anticipated investment
returns (benefit divided by the present value of the capital outlay (cost). Present value of
anticipated investment returns over Present value of capital outlay. This measure employs a
desired minimum rate of return or a satisfactory yield rate. The present value of anticipated
investment returns and the present value of the capital outlay are calculated using the
desired rate as the discount rate. If, for example, the present value of the capital outlay
discounted at 10% is P12,300 and the present value of the benefits is P12,399, the profitability
index, based on a satisfactory yield rate of 10%, is P12,300 = 1.008.

A PI greater than 1.0 indicates that the investment is profitable and acceptable in the light of
the chosen discount rate. A PI of less than 1.0 indicates that the investment cannot
generate the desired rate of return and is not acceptable. A PI of exactly 1.0 indicates that
the opportunity is just satisfactory in terms of the desired rate of return and, coincidentally,
the chosen discount rate is equal to the anticipated IRR. The discount rate used to compute
the PI may represent a minimum desired rate, the cost of capital, or a rate that is considered
acceptable in light of the risks involved.

Net Present Value Net present value (peso reward) is defined as the difference between the
present value of all expected benefits, or positive cash flows, and the present value of
capital outlays, or negative cash flows. Net present value (NPV) is simply the present value
of anticipated investment returns minus the present value of the capital outlay. This
measure, like a profitability index, is based on a desired rate of return. It is computed using
the desired rate as a discount rate and the result is viewed as an absolute peso reward. The
reward (or penalty) is expressed in total peso, not as a ratio.

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A number of decision rules can be established for applying the NPV. For example, assume
that a property with an anticipated present value of P1,100,000 for all investment returns over
a 10-year holding period can be purchased for P1,000,000. If one investor’s NPV goal for an
NPV of P100,000, but it would not qualify if the goal were P150,000.

NPV considers the time value of money and different discount rates can be applied to
different investments to account for general risk differences. However, this method cannot
handle different required capital outlays. It cannot differentiate between an NPV of
P100,000 on a P1,000,000 capital outlay and the same NPV on a P500,000 capital outlay.
Therefore, this technique is best used in conjunction with other measures.

Time-Weighted Rate A time-weighted rate is technically an average of all actual,

instantaneous rates over a period of time. It is similar to the rate of growth for capital
invested in a mutual fund in which all dividend income is automatically reinvested. The time-
weighted rate, which is also known as the unit-method rate of the share-accounting rate, is
used primarily to measure the performance of a portfolio manager, not the performance of
the portfolio itself.

Discounted Cash Flow Discounted cash flow (DCF) analysis provides investment analysts
with the most detailed, precise means of considering the amounts and timing of investment
cash flows and outflows over the life of an investment. With this procedure any series of cash
inflows and outflows over any specified time frame at any rate of return can by analyzed
and the present value of the investment’s anticipated performance can be measured.

DCF techniques may be applied to cash flows before or after income tax in comparisons
made with profitability indexes or net present value methods. DCF can be applied on either
a constant peso or nominal-peso basis. If constant pesos are used, they are discounted with
rates that do not include an allowance for inflation. Consequently, investment performance
is measured without considering the effects of inflation. More often, nominal or actual pesos
are measured for the cash inflows and outflows anticipated. In this case the discount rate
applied contains a component that accounts for inflation. However, because the rate of
inflation is an element of risk, a specific analysis of future inflation rates or components of
inflation is not usually included in the discount rate, although this may be done in more
detailed analyses.

For income streams that extend over many years, such as those stipulated in long-term
leases, DCF is commonly performed for terms of five, 10, or 15 years. Although these terms
may be shorter than the term of a given property lease, they offer two principal advantages:
(1) buyers and sellers in many markets develop their expectations of future price changes
over short or medium-length terms; thus, the analyst can establish market expectations
regarding the terminal values of the investment and factor these expectations into income
analysis time frames that are consistent with market thinking and behavior. (2) the
mathematics of compound interest is data-specific and precise, but they sometimes lead to
conclusions that are difficult to accept.

Although DCF analysis can be applied to historical investment results, it is usually applied to
future expectations. Therefore, DCF analysis frequently involves forecasting cash inflows and
outflows.

DCF techniques have the advantages of being precise, persuasive, and time-sensitive. They
can be applied to different income patterns and risk situations. They reduce the number of

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assumptions required for a given analysis and explicitly consider both advantageous and
disadvantageous investment expectations. DCF techniques, however, have some
disadvantages. They are based on forecast estimates and the analyst must consider and
have access to historical data. The precision of DCF techniques can suggest greater
accuracy than is warranted and the rates applied in discounting may be highly subjective.

Internal Rate of Return The internal rate of return (IRR), which is developed in the context of
yield analysis, expands on present value calculations and techniques. It represents a special
case among investment performance measures. The IRR is simply defined as that rate of
discount that produces a profitability index of one and a net present value of zero.
Measured separately, the IRR is the discount rate at which the present value of all net
investment returns, including any return of capital from disposal of the investment, exactly
equals the capital outlay for the investment.

In other words, the IRR calculation is a DCF analysis solved backwards – i.e., all cash flows
and outflows are analyzed to find what discount rate can be applied to make them exactly
equivalent to the original capital outlay. Thus, the IRR considers all positive and negative
cash flows from the inception of the investment to its termination and reflects the indicated
return on the investment in addition to the return of the investment.

The reinvestment presumption is a controversial aspect of IRR analysis. The presumption that
money received from the investment before its termination is actually reinvested is not
essential to the IRR concept. Nevertheless, mathematical consistency can be demonstrated
between the results of such an analysis and the presumption that these funds are reinvested
at the same rate of interest as the IRR. This controversy, and other weaknesses in the IRR, has
led to the development of alternative measures such as the financial management rate of
return (FMRR), the adjusted internal rate of return (AIRR), and the modified internal rate of
return (MIRR). These methods were created to address other factors or to compensate for
the reinvestment consideration.

Calculating an IRR is a process of successive series of calculations to establish a range for the
IRR and this range is refined to the required degree of precision. These calculations can be
facilitated with financial calculators and computers, but they can also be done manually.
Because many variables are usually involved, no formula can calculate the IRR in a single
step.

Although the IRR is of substantial importance in the analysis of investment properties, it has
been subject to abuse. When properly applied and interpreted, however, this measure may
be given significant weight in analyzing and comparing investment alternatives. Because
the IRR normally deals with unknown factors in the future, the forecast data required in its
estimation should never misinterpreted as predictive. The IRR can be of particular value to
decision makers when the likelihoods and risks associated with each component of data in
the analysis can be fully assessed. Like other measures of investment performance, the IRR
should be used in conjunction with other techniques and considerations.

No single investment performance measure is the best…

… or most appropriate in all situations. Each has its advantages and disadvantages and all
are more effective when used in conjunction with other measures. Under certain
circumstances one or more of these measures should be given greater weight, but the
analyst must always recognize the individual limitations of each measure.

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Omitting one or more of these measures in making a given real estate decision does not
indicate the likely failure of the investment; similarly, applying appropriate measures is no
guarantee of success. All decisions are made under conditions of uncertainty, but the
measures of investment performance discussed here represent valuable tools that allow
consultants and investors to weigh the facts, exercise sound judgment, and make reasoned
decisions. They also provide a framework for implementing an investment program and
monitoring investment decisions once they are made.

Judgment is the ability to draw on information and individual experience to make better
decisions. As used in consulting assignments, investment performance measures are not all-
inclusive solutions, but aids that can be useful in developing, considering, and explaining
investment decisions and judgments.

Feasibility Analysis on Real Estate Investment

In order to sort out the appropriate measures and risks involved in the investment analysis,
another tool in consulting may be used, the feasibility analysis or study. Feasibility analysis or
study is a determination of the likelihood that a proposed development will fulfill the
(technical, market and financial) objectives of a particular client-investor. In judging
feasibility, considerable care is taken in estimating (1) the projections of gross income less
reductions and (2) expenses and other costs which must conform to the realistic experience
of like properties.

General Steps in Making a Feasibility Analysis Though subject to much qualification,

feasibility studies generally follow fairly uniform procedure. Certainly, they are more complex
than the comparison of market value with the cost of development and their details vary for
each project. A feasibility study for an organized industrial park would emphasize
marketability features not found a proposed residential development.

Feasibility analysis or study can be undertaken by a consultant in different approaches and

degree of sophistication, depending on the type of the property involved, nature of the
investment involving the property, time required to complete the study and
recommendation, and the style of the consultant as influenced by his experience and
expertise. In the discussion on the subject Project Feasibility Study two approaches or steps
are described. Generally, however, feasibility study for real estate would follow seven steps:

1. Determine the investment objectives

2. Select that type of analysis that will show whether the investment objectives will be
realized.
3. Undertake a marketability study for the estimation of gross income or sales.
4. Analyze development costs, including planning, legal and initial financing costs.
5. Project net income from a realistic study of new incomes, vacancies and expensed
of operation.
6. Capitalize net income according to the market rates of capitalization.
7. Present net income and cash flow data according to the investment objectives to
be satisfied.

The main difficulty lies in identifying realistic costs of development and projecting net
income. If the study relates to income producing property, say an apartment house, the
error in projecting gross income, vacancy rates, and expense allowance are common
deficiencies. Further, investment feasibility depends on market capitalization rates and
favourable financing.

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Drawbacks in Real Estate Investment

As there are advantages in investment in real estate there are also some serious drawbacks
which are reflecting some of the characteristics or nature of real estate as an economic
good. However, these disadvantages can also provide opportunities for wealth builders
who can overcome them, as well as opportunities to consultants and investment syndicators
who can offer services to minimize many of these disadvantages. Some of the serious
drawbacks are:

1. The big size of the investment required limits the field of real estate investment to fewer
investors. Syndicators overcome this problem by pooling a group of investors each of
whom purchases share in a partnership or joint venture in a large property investment.

2. Real estate is an illiquid investment. It is like a mousetrap – once you are in, it is difficult
to get out. Market conditions may prevent a quick sale at reasonable price. Publicly
traded syndications or mortgage securities can provide more liquid investment.

3. Being a physical asset, real estate requires management. A property manager may be
hired to handle on many responsibilities related to real estate. Also, in a limited
partnership, the investor can leave the responsibilities to the general partner.

4. Being local in nature, real estate market information is not widely available. Real estate
brokers and consultants are good source for market information.

5. Cost of purchasing a property is increased by transaction expenses (broker’

commission, legal and documentation expenses, transfer and registration fees,
appraisal and survey costs, and taxes. These incidental expenses make real estate long
term investment as short term sales may involve substantial markup to offset the
added cost.

6. Real estate is immobile, making the local market conditions determine the
performance of the investment. Real estate cannot be relocated to places where
conditions are better.

7. Government regulations and changing policies limit relatively what the investor can do
to his property. Even by mere holding on the property is subject to property tax and
local assessments. Rent control law discouraged investment in rental properties.

The consultant must be imaginative and resourceful to minimize, if not eliminate, these
disadvantages.

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2.5 Knowledge of Real Estate Economics

Economics Defined

Given that wants are unlimited and resources are scarce, economics can be defined as the
social science concerned with the problem of using or administering scarce resources (the
means of producing) so as to attain the greatest or maximum fulfillment of society’s unlimited
wants (the goal of producing). Economics is concerned with “doing the best with what we
have.” If our wants are virtually unlimited and our resources are scare, we cannot satisfy all
society’s wants. The next best thing is to achieve the greatest possible satisfaction of these
wants. Economics is a science of efficiency – efficiency in the use of scarce resources.

Economic efficiency is also concerned with inputs and outputs. Specifically, it is concerned
with the relationship between the units of scarce resources that are put into the process of
production and the resulting output of some wanted product.

Full employment and full production Society wants to use its scarce resources efficiently, that
is, it wants to get the maximum amount of useful goods and services produced with its
limited resources. To achieve this it must realize both full employment and full production.

Full employment means that all available sources should be employed. No workers should e
involuntarily out of work; the economy should provide employment for all who are willing
and able to work. Nor should capital equipment or arable land sit idle. Note we say all
available resources should be employed.

Full production means that resources should be utilized efficiently so as to make the most
valuable construction to total output. We should avoid allocating astronomers to farming
and experienced farmers to space research.

Introduction to Real Estate Economics

After reviewing briefly the foundation of economics in general, what then is the relationship
of economics to real estate? Why should we study real estate economics?

What Is Real Estate Economics?

Real estate economics is a study that uses economic principles to analyze the impact that
national, regional, community, and neighborhood trends have on real estate values. Real
estate is about people and how their actions affect real estate values. In our society, desire
for goods and services frequently exceeds the supply available. This scarcity gives rise to the
idea of economic value.

What Real Estate Economics Is Not

Real estate economics is neither the study of general economics nor a course in the practice
of real estate. Rather, real estate economics is the link between general economic theory
and applied real estate practice. A course in general economic concentrates on how
society attempts to use limited resources to satisfy the want of this people. However, such a
course doers not examine how this affects local real estate markets. On the other hand, a
course in real estate practice concentrates on the specific techniques need to complete a

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real estate transaction but spends little time discussing the economic influences that
determine whether an investment will be economically profitable over the years.

Real estate economics draws principles from both the general economics and real estate
practice and then combines them in order to study changes in real estate activity. The main
thrust of real estate economics is to help real estate students and practitioners become
aware of future trends and what impact these trends will have on local real estate values.

Why Study Real Estate Economics?

Real estate economics helps you to understand what causes fluctuations in real estate
activity and how these changes can affect local real estate markets. With this information,
you will be better equipped to make real estate decisions that will benefit you, your clients
and your entire community.

Real Estate Characteristics

The unskilled practitioner and lay persons may fail to understand or distinguish the difference
between real estate and real property, or between the physical aspects of real estate and
the property rights associated with real estate ownership. Others confuse the economic
characteristics and the physical characteristics of real estate.

Real Estate Ownership

Our system of land ownership is the allodial system, consisting of private ownership without
the payment of money or services to other persons. Under the allodial system it is necessary
to distinguish among five terms:

1. Real estate – land and its attachments or physical property

2. Real property -- the legal rights associated with landownership: the interests, benefits,
and rights inherent in the ownership of the physical real estate.
3. Land – Economic concept: the surface with all to its characteristics (water, soil,
mineral deposits, and climate)
Land as space: ownership of property gives possession and control
of a limited space and allocated at the most efficient use or highest and best use.
Land as a resource: land is scarce resource that should be maximized
4. Personal property - movable items that are not permanently attached or affixed to
the land or building.
5. Fixtures – an article, formerly personal property, installed or attached to land or
buildings in permanent way so that it becomes part of the real estate

The Concept of Land

The developer looks at land as capital whereas the planner views land more in terms of
space. Others refer to land only in the physical sense, such as a farmer who considers the
physical nature and productivity of the soil.

1. The economic concept – Land is defined broadly to include the surface with all its
characteristics: water, soil, mineral deposits, and other phenomena, including
climate. Besides referring to these natural characteristics, the economic concept
refers to all man-made improvements such as irrigation ditches, waterways, highways,
and streets.

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Land as space – Ownership of property gives possession and control to a minted

space. Some view the characteristic of space as the controlling element in
landownership. In analyzing the feasibility of a subdivision, judgments must be made
with respect to the space proposed for conversion from, say agriculture to residential
hospital areas are cases in point.

2. Land as a resource – The real estate economist views land as a scarce resource that
should be maximized and allocated to the most efficient use. In considering a multi-
family housing project, questions arise as to the number of the apartments that would
ideally be placed on a given tract. If population density is too high, traffic congestion
and the utility of multi-family space would be lowered by overcrowded facilities,
which decrease the enjoyment of property. On the other hand, if too few units are
allowed, land is not utilized in its most efficient manner.

3. Land as a space - The essential problem in considering land as space is to provide for
a system of harmonious, mutually attractive land uses. Owners and planners separate
incompatible uses of space, commercial districts and single-family dwelling. At the
same time, land must be allocated to the less desirable uses, such as garbage sites
and landfills.

Economic Characteristics of Land

Land serves as both a consumption and an investment good, and is, therefore, subject to
the economic law of supply and demand. However, the unique economic characteristics of
land complicate the allocation of land resources to the best possible use.

Immobility - Because land is fixed in place, shortage of land in one location may not be
compensated by a surplus in another area.

Durability - Land and buildings are relatively long-lasting assets. It is calculated that a
building may last virtually indefinitely if it is properly maintained and protected from wear
and tear and action of the elements.

Divisibility – Because the physical asset land and building is not transferred physically from
one buyer to another, the right to possession, use and enjoyment may be divisible into rights

Modification – While land is a relatively scarce resource, it may be modified considerably. In

fact, such modification permits alternative uses of land as economic conditions change.
Thus, a low-rise retail building gives way to a high-rise office building, land used for pasture
assumes greater importance as a shopping center, or, more dramatically, as population
expands, low-density residences are replaced by multi-family structures.

High capital value – The high value of land accounts for other market imperfections. Buyers
and sellers are not as free to enter and leave the real estate market. The high cost of
housing, which is probably the most expensive single purchase of the typical family, restricts
the number of families entering the buyer’s market.

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COMPARISON OF CHARACTERISTICS: PERFECT MARKET vs. TYPICAL REAL ESTATE MARKET

Characteristics Perfect Market Real Estate Market

1. Number of Many participants; no Few participants; seller

buyers and monopoly, oligopoly, controls during a “seller’s”
sellers or monopolistic market, buyer controls during
competition a “buyer’s” market

2. Product Buyers and sellers are Buyers and sellers are

knowledge and highly knowledgeable; not knowledgeable;
market the exchange takes the exchange is legalistic, complex
exchange place with ease and expensive

3. Standardized All products are alike Each parcel of real estate is unique
products and interchangeable; and separate from all others; no two
there is little difference are exactly alike
between products of
different sellers

4. Mobility Products can be trans- The location is fixed; a real estate

ported to capitalize parcel cannot be moved to
on more lucrative another more profitable location;
markets. Real estate market is local, not
regional or national

5. Size and frequency The item purchased is Real estate is purchased infrequently
of purchase small and relatively (rarely more than four or five times in
inexpensive; it is a lifetime); a home represents the
purchased frequently largest single investment made by
the average family

6. Government’s Government plays Government plays a dominant role

role little, if any role; in encouraging real estate
laissez-faire prevails development through the use of
fiscal and monetary tools and by use
of other controls, such as zoning,
environmental and health codes

7. Prices Prices are established Price are influenced by the interac-

by the smooth tion of supply and demand. But this
action of supply and interaction is not smooth; the lack
demand of knowledge by either the buyer or
the seller can distort the prices paid.

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2.6 KNOWLEDGE OF MONEY SUPPLY AND CREDIT: A Tool For

Understanding Real Estate Economics

The understanding of money and credit will allow the analyst to anticipate changes in the
real estate market and explain to his clients the relationship between current real estate
market conditions and shifts in the money supply.

THE SUPPLY OF MONEY

Making money is more than just the minting or the printing process. Money in circulation
consists of currency in coins and bills and money in the form of demand deposits created by
the banks. Understanding the money supply is an important tool for understanding real
estate economics.

What is Money?

1. Money is a medium of exchange.

2. Money is a measure of value.
3. Money is a store of value.
4. Money is a standard of deferred payment.

Money in the Philippines

There are three types of money in the Philippines: coins, paper currency, and bank money.
Coins of different denominations make up the coin system. The metallic value or intrinsic
value of coins is less than their face value. If the value of the metal should exceed the value
of the coin, people would tend to hoard or keep the coins and then illegally melt them
down in order to sell the metal.

Paper currency (P5, P10, P500, P1,000 and other bills) issued by the BSP are essentially
promissory notes guaranteed by the Philippine government. BSP notes will continue to
circulate as money for as long people have faith in the strength of the government. The
paper money is no longer backed by gold but by the strength of the government. (The Iraqi
dinar became worthless when the Saddam regime was collapsed by the Iraqi War) The
biggest block of money supply is the bank money consisting of checks drawn against
checking accounts. In economic terms, checking accounts are called demand deposits.
When one writes a check, he is transferring a portion of his bank deposit to a third party. The
bank must pay this money upon demand. No time delays are allowed, hence the term
demand deposit.

BANKS CREATE MONEY

Only the national government may legally mint coins and print paper currency, but
commercial banks can legally create demand deposits. Banks create money because of a
concept known as fractional reserve banking. The average bank’s daily deposits and
withdrawals tend to equal each other. At this point, if a person adds P10,000 to his account,
the bank can take this P10,000 and grant a loan to someone else. Later, when the depositor
withdraws the P10,000, another depositor’s money will be used to cover the withdrawal.

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Occasionally, daily withdrawals exceed daily deposits, so banks keep a certain portion of
each deposit as a reserve for abnormal withdrawals. Of the P10,000 deposited, perhaps
P200 will be retained in reserve and P800 will be loaned out. This fractional reserve system will
work as long as depositors do not decide to withdraw their funds at the same time.

TOO MUCH MONEY CAN CAUSE INFLATION AND HARM REAL ESTATE MARKETS

As the money supply expands, interest rates tend to drop and credit becomes easier to
obtain. This stimulates spending and increases the demand for resources, goods, and
services. But a point is reached where additional increases in the money supply will stimulate
demand beyond the ability of the economy to increase supply. The result will be inflation – a
rise in general prices – too much money chasing too few goods.

REAL ESTATE MARKETS AND INFLATION

Increase in inflation, hurts mortgage lenders because the money they receive from loan
repayments is worth less than the money they originally loaned. Thus, to protect themselves
during periods of rapid inflation, mortgage lenders increase interest rates. An increase in
interest rates causes monthly payments to increase, thereby preventing some potential real
estate buyers from qualifying for loans. This reduces the demand for real estate.

Inflation can cause depositors in thrift institutions (such as savings and loan associations) to
withdraw their funds and seek higher returns in other money market placements, thereby
reducing the money available for mortgages.

During inflation, the cost component of construction (land, labor, and materials) rises and
drives some people out of the housing market.

Increased prices also drive up the cost of purchasing the basic necessities of life. In effect,
this reduces discretionary income – money for luxuries and leisure. A decline in discretionary
income is harmful to the recreational and leisure real estate markets, such as vacation
homes, hotels, and tourist attraction.

THE IMPORTANCE OF CONTROLLING THE SUPPLY OF MONEY

Who controls our money supply and how is it done?

THE BSP RESERVE SYSTEM

The BSP Reserve System controls the volume of money supply, especially the money created
by the credit operations of the banking system, thru the regulatory tools available to the BSP.
These tools can counteract economic imbalance.

Purpose of the Bangko Sentral ng Pilipinas (BSP)

The BSP was established by Congress in 1993 by R. A. No. 7653, The New Central Bank Act
The BSP is governed by the Monetary Board and operates as an independent body to
insulate the governors against political pressures when making economic decisions.

The BSP provides policy directions in the areas of money, banking and credit, and supervises
the operations of banks and exercises regulatory powers over the operations of finance

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companies and non-bank financial institutions performing quasi-banking functions and

institutions performing similar functions.

The primary objective of the BSP is to maintain price stability conducive to a balanced and
sustainable growth of the economy. It also promotes and maintain monetary stability and
the convertibility of the peso. In short the BSP regulates the supply of money and credit in
order to achieve growth without inflation and unemployment.

How the BSP Attempts to Control the Money Supply

The BSP attempts to control money supply by manipulating bank reserves, using the following
major tools:

1. Changes in the reserve requirements

2. Open-market operations
3. Changes in the discount rate

Change in the Reserve Requirements All agent banks of the BSP are required to maintain a
certain percentage of each deposit as reserves. These reserves are kept at the BSP. If the
BSP feels that easy money and credit are feeding inflation, it can raise the reserve
requirements, which will force banks to restrict their lending, as money must be diverted from
loans to cover the shortage in reserves. This action is designed to decrease the amount of
money in circulation, drive up interest rates, and eventually lessen inflation by slowing down
spending.

What will happen if the BSP decreases the reserve requirements? Will this increase or
decrease the money supply? Will this raise or lower interest rates?

Open-Market Operations As part of its money-management tools, the BSP is allowed to buy
and sell government securities. The public (private citizens and financial institutions) also
may buy and sell government securities as a form of investment. When the BSP buys
government securities from the public, the seller of these securities (the public) receives the
BSP check, which the seller then deposits in a local bank. The local bank forwards the check
to the BSP for payment. When the BSP receives its own check, it increases the reserves of the
local bank by the amount of that check. The local bank now, has more reserves than is
required and therefore can grant more loans. Thus, when the BSP buys government
securities from the public, it increases the money supply by increasing bank reserves, which
in turn will support more loans.

What happens to the money supply when the BSP sells government securities to the public?
The money supply tightens up, which increases interest rates and discourages borrowing.

When government securities are sold, an individual purchases them by writing a check on his
local bank. The BSP receives the buyer’s check and subtracts it from the reserve account of
the local bank. The local bank now has less reserve and, therefore, must constrict its lending.
So when the BSP sells government securities, it decreases bank reserves, which in turn
decrease the bank’s ability to grant loans. Note that the ultimate effect is a change in the
money supply by manipulating bank reserves. But the BSP has still another important tool:
changes in the discount rate.

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Changes in the Discount Rate When one needs a loan, he frequently goes to his bank.
Where does a bank go when it needs a loan? One possible place is to the BSP, the
banker’s bank. When a bank borrows from the BSP, it is charged an interest rate known as
the discount rate. By decreasing the discount rate, the BSP encourages banks to borrow.
The borrowed funds will increase the local bank’s deposits and reserves, which allows for
the expansion of loans. An increase in the discount rate discourages banks from
borrowing, which decreases the amount of money available for loans.

A Summary of the Major BSP Tools

Changes in the reserve requirement, open market operations, and changes in the discount
rate allow the BSP to control or fine tune the supply of bank money. Of these tools, the most
commonly used is that of open market operations.

To increase the money supply, the BSP will decrease the reserve requirements, buy
government securities, decrease the discount rate, or use some combination of all three.

THE ACTIONS OF THE BSP AND THEIR EFFECT ON REAL ESTATE ACTIVITY

This section explains how the money supply and the BSP attempt to regulate it can influence
the real estate market. It also points out that the cycle for real estate will not always be in step
with the general economic trends.

Tight-Money Policies and Real Estate

The BSP institutes restrictive monetary policy to combat inflation. Inflation itself is frequently
caused by excessive private demand, government deficits, or excess money supply (excess
liquidity).

When the BSP fights inflation, it tightens up the money supply, which in turn causes interest rates
to rise as government agencies and corporate borrowers bid against one another for the
shrinking money supply. Higher interest rates cause funds to flow out of savings and loan
associations, as savers go elsewhere seeking higher rates of return. Savings and loan
associations have a big share of home mortgages. Thus, when savings institutions lose funds,
mortgage lending decreases, and the real estate market heads into a recession. The
economic term for the outflow of funds from thrift institutions into corporate and government
notes is called disintermediation.

Thus, when the BSP tightens money to combat inflation, housing is one of the first economic
sectors to feel the pinch. This frequently brings cries of “discrimination” from the real estate
industry.

THE BSP DOES NOT DISCRIMINATE AGAINST HOUSING WHEN IT TIGHTENS MONEY

When the BSP decreases the money supply, it does not single out just the real estate market
and restrain only housing funds. In most cases, real estate mortgages in tight-money markets
are usually unattractive investments because they are long-term loans bearing low fixed
interest rates.

During periods of prosperity and inflation, interest rates for other investments tend to rise.
Many savers and institutional lenders refuse to loan on low-paying, long-term mortgages and
instead are attracted to high-yield, short-term business loans. As the demand for funds

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continues to exceed the supply, interest rates on Treasury and BSP instruments also increase,
and disintermediation takes place. The BSP does not specifically discriminate against
housing; rather, the structures of the mortgage market tend to defeat itself in tight-money
situations.

Easy-Money Policies and Real Estate

During periods of economic slowdown, the BSP attempts to head off a recession by easing
the money supply. An increase in money and credit may cause spending to increase, and this
expansion will ideally bring an increase in employment. As money and credit become more
plentiful, interest rates tend to decline. These lower interest rates do not immediately attract
business borrowers because the economic downturn still leaves a lingering feeling of
pessimism. Meanwhile, private savings may increase as uncertainty causes people to
become cautious and to restrict their spending.

RECOVERY IN THE REAL ESTATE MARKET NORMALLY PRECEDES

A RECOVERY IN THE NATIONAL ECONOMY

Because of the size and impact of the construction industry, an increase in home building
helps to lead the economy out of a recession. As home construction picks up, employment,
income, and spending increase. This in turn generates even more activity, and the general
business cycle heads for recovery.

However, if spending and demand rise beyond the equilibrium point, inflation will recur. If
this happens, the BSP may tighten up the money supply, and the mortgage market will start
to lose funds, causing real estate activity to decline.

The real estate market (cycle) in the short run tends to travel somewhat opposite the general
business cycle. When the general economy is at the top of a boom, real estate activity is
usually already declining because of a lack of credit. When the general economy slows
down, real estate activity may increase as funds flow back into the mortgage market.

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