Location: Physical and Environmental Factors in Real Estate

The phrase “location, location, location” is a phrase used over and over again in the discussion of real estate markets. It continues to be as relevant today because location is ultimately what brings value to a piece of real estate. For example, a high-rise office building in downtown New York City would have comparatively little value in the middle of rural Texas. Value is not only a function of the component parts but of the market demand for that particular structure in that particular place. Location itself is what makes real estate assets completely unique. Since no two structures can occupy the exact same location, each asset’s value characteristics are one-of-a kind.

Physical Factors in Real Estate Analysis

Physical factors of a property are important because they can be the driving factor behind a community’s economy. For example, a location next to a protected harbor would be expected to develop industries related to shipping. Physical factors can determine whether a location is feasible for development at all based on the soil conditions and topography. They can also drive the market demand for specific types of real estate development in the location. A market analysis should consider these physical factors for the subject property and their potential impact on current value and future cash flows. Physical characteristics that both limit and encourage new development are key to understanding the demand for and value of real estate in all market segments.

Physical factors important to real estate market analysis may include:

• Location – Define the property boundaries and consider the neighboring properties as well. How does this location fit in with the surrounding properties? Is the property being used in a way that makes financial sense given the surrounding property types and property mix? Do the neighboring properties add value to the location or not?
• Natural geographic boundaries – Some properties have natural geographic boundaries such as rivers, lakes, and oceans. While these natural boundaries limit the availability of land for development, they can also add value to neighboring properties if utilized appropriately. So, the market analysis should consider the impact on development options and value drivers for the subject due to the natural geographic boundaries.
• Topography – The topography of an area can have a huge impact on real estate development and can be a crucial factor in a market analysis. Topography can influence issues such as runoff and flooding hazards as well as availability of land for development. Areas in the Mid-west have large, flat plots of land that would be easy to develop. On the other hand, areas on the west coast have a limited amount of land along the coast that can be developed. California has little flat ground between the Pacific Ocean and the mountains, so people are forced to develop into the sides of mountains.
• Soil conditions – The market analysis may also contain information about the soil conditions of the subject property, especially when they are relevant to the planned use or value of the property. Soil conditions are most important when the planned land use involved growing crops or other vegetation. Ideal soil types should also provide adequate drainage and be able to support the structure without slippage that can cause cracks in the foundation.
• Climate – To a certain extent, climate is important in any market analysis. Climate may be directly relevant to income if the subject property is a resort or entertainment facility. Climate, however, is also important to understanding the demand for real estate and economic drivers of an area. Locations with warmer weather and mild winters tend to attract people and businesses. Therefore, population and economic growth tend to be higher in these areas.
• Natural resources – Historically, cities grew in locations with important natural resources. Today, natural resources are still major economic drivers of industry and employment opportunities. Natural resources can serve as an important economic factor for transportation (rivers or seaports), mining (natural gas, coal, oil, etc.), or tourism (beaches and mountains).
• Water availability – Water availability is not only important for factories or farmlands requiring water for business but also for all economic stability in an area. A city without adequate water resources and water quality faces poor economic growth prospects. This in turn influences the overall real estate market forecasts for a location.
• Transportation patterns– Current transportation patterns and proposed changes to those patterns are critical components of a market analysis. Traffic patterns determine the travel paths for the population and thus the areas that will receive the highest concentration of potential client activity. Traffic patterns are especially important for tenants whose business requires a high amount of foot traffic and visibility. A location along a major roadway can represent a much higher demand then the neighboring population would otherwise suggest.

Environmental Factors in Real Estate Analysis

Environmental factors refer to the interaction between people and urban development with the natural environment. Every piece of real estate development impacts the environment in some way because development changes the natural interaction among land, water, and animals. In many cases, development occurs specifically because people desire to utilize the natural environmental resources of a location. A market analysis should consider the property’s interaction with and impact on the surrounding natural environment to the extent it will influence the project’s feasibility and value. The overall impact on the environment is usually proportional to the size of the development, but there may be other considerations due to the specific location or proposed use of the property.

A few of the environmental factors that a real estate market analysis may consider include:

• Air and water quality – The quality of air and water can have a huge impact on property valuation. Cities with poor air quality or poor water quality are less desirable and may over the longer-term experience decline in population and valuation. Areas with clean air and water are highly desirable, and as a result, those areas may experience higher than average growth in population and value in the future. Of course, that growth also comes at a price, and the quality of the environment must be protected. As a result, local governments may require stringent permitting procedures for large real estate development that could negatively impact the natural environment.
• Soil conditions – The soil present on a particular property can have a varying degree of impact on the value and suitability for development. The property’s soil classification is important because it has potentially huge implications to the cost and feasibility of future use and development. Issues related to soil classification are important because they determine the hydrology, the soil’s interaction with water, of the land. If the soil does not allow for adequate drainage, additional measures may need to be implemented to properly account for runoff and erosion due to rainfall. Soil classification can also determine whether or not the land has the ability to hold the weight of a structure without slipping or cracking.
• Wildlife – All real estate development impacts the area wildlife in some way. The impact may be something small related to cutting down trees in which birds and insects lived. On the other hand, real estate development may impact some type of endangered or protected plants and animals. In these cases, development may be prohibited entirely. The market analysis may need to consider the potential impact on surrounding wildlife and the cost associated with remediation efforts (such as a detailed environmental analysis report or purchase of redevelopment credits in another location).
• Wetlands – Soil that is covered by water all or part of the time may be classified as wetlands. There are wetlands areas located throughout the country, and they are important to the local ecology because they protect and improve water quality, store floodwaters, maintain surface water flow during dry seasons, and provide habitats for fish and wildlife. Development in wetlands areas may be limited by state regulators and the Environmental Protection Agency (EPA). In some wetlands areas, development may not be feasible at all due to the continual presence of water. Real estate projects located in or near wetlands areas should consider the potential costs of preparing the land for development along with the purchase or restoration credits.

Environmental Impact and Sustainability in Real Estate

State law as part of a real estate development project may require environmental impact studies. The actual regulations and requirements differ by state, but may include anything from an analysis of additional traffic conditions on roadways to the impact on native plant and wildlife. Environmental impact considerations include both the construction phase and the completed project. So, environmental impact applies to existing structures as well as proposed new development projects.

The regulations and requirements of the environmental impact study are important in a real estate market analysis because of the feasibility implications. The cost of complying with environmental regulations may make construction or renovation plans too expensive to pursue. Alternatively, compliance with environmental regulations could make a proposed use of existing construction so expensive or restrictive that the project is no longer financially feasible. The market analysis should address issues related to environmental impact, the potential costs up-front and over the expected holding period, and any influence environmental factors may have on expected cash flows from the property.

Sustainability is an increasingly important concept in global real estate development. Rather than focusing simply on direct environmental impact to the property and immediate surrounding area, sustainability considers the impact of development on the larger regional and global environment as well as human interaction with the construction. More than simply the impact of traffic or development on local air, water, or wildlife, sustainability considers the impact of building materials from their sourcing to final use. Sustainability focuses on the use of renewable, local building materials and healthier environments for living and working.

Issues of sustainability matter for market analysis because they influence the cost, risk, marketability, and value of the property. Although the initial cost of construction and development can be slightly higher, there are many long-term benefits as well. Those benefits include lower risk premiums and lower operating costs. The desirability of and demand for sustainable real estate development in the market also allows these properties to charge a rent premium and command a price premium in the marketplace. As the demand for sustainability in the market grows, these properties may experience higher than average growth rates, lower vacancy rates, and lower overall operating expense ratios. All of these factors then influence proforma cash flow expectations and property valuations.

Conclusion

Analyzing the physical and environmental factors in a real estate market analysis benefits the financial analysis in a number of ways. A thorough analysis of the location’s physical and environmental factors provides accurate estimates of development costs. Property owners and developers can better determine the financial feasibility of any project. The analysis also allows owners to create better pro forma financial statements because they understand the conditions that ultimately influence the neighborhood rental rates. Paying attention to the physical and environmental factors of a property can help owners and developers to make the best financial decisions possible.