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How We Do Credit: Part II – Location – A More Holistic View
August 1 | 2016

How We Do Credit: Part II

Location has been the bane of many real estate investors who have failed to appropriately scrutinize the merits of a particular site. The question that every prudent real estate investor must consider when analyzing a location is whether value is truly maximized and if the proposed investment achieves or sustains that optimal value.

If you’ve visited our Articles page earlier this week, you may have read my colleague’s insightful piece on location, and how different metrics and factors are evaluated for each property type (and if you haven’t, you should consider reading it).

While it is absolutely true that we examine different metrics when evaluating the location of different property types, here are two fundamental approaches that provide a more holistic view of the underwriting we do here at

Approach 1: Qualitative Analysis – Functional Groups

On the subject of location, the late Dr. James A. Graaskamp, who is recognized by many as a pioneer in modern real estate theory, stated in his publication titled Fundamentals of Real Estate Development that “Location is often identified as the critical factor in a site, but it is seldom understood that location value is related to the functional needs of the activity and not the site.” He later goes on to provide the example of a family unit: families tend to determine where to live based on the convenience between their home, schools, retail stores, recreation centers, and their place of employment.

We’ll use this family unit to explain the concept of the Space User, otherwise defined as the functional group that rents or purchases real estate to fulfil habitual satisfaction and security – ultimately drawing net benefit from the real estate location. Other examples of space users are businesses that occupy office, retail, hospitality, or industrial space, utilizers of self-storage units, or tenants of manufactured housing parks.

This graph will help as we define the terms that come up for this particular process:

Figure 1. The Real Estate Process. Graph by Dr. James A. Graaskamp, Fundamentals of Real Estate Development, ULI Development Component Series 1981; drafted by

In order for real estate to serve the needs of the user, resources and expertise must be brought to the site to fulfill its highest and best use. Space Producers, or investors, developers, property managers, and large corporations, serve the purpose of bringing these resources in the form of capital, physical resources, and expertise in the form of investment, legal, construction, and management knowledge. In exchange for this, space producers anticipate the potential for profit or capital gains. By enabling the real estate to provide for the net benefit of the space users, the space user pays the space producers through rents or purchases.

The final functional group in this relationship triangle is the Public Infrastructure group. This group encompasses much more than public infrastructure such as roads, bridges, and highways. It includes tangible and intangible off-site systems for the individual space user, including sewer and other utilities, educational institutions, police and fire departments, governmental buildings, and all forms of economic activity with efficiencies of scale that suggest collective off-site action. Any external function that allows the general function of the real estate and provides other services and benefits for space users not provided by space producers is considered part of the public infrastructure group.

Qualitative Analysis - Theory in Action

It is important to note that locational value is subjective to the user. The value of location is directly tied to net benefits. Dr. Graaskamp gave the example that “as the costs of energy, congestion, and time have risen for commuters and the need for suburban school linkages has diminished, the opportunity for reducing costs of friction by trading the house in the suburbs for a condominium downtown has been transferred into rent or the price of a condominium.” In other words, change initiated by the added difficulty in commute – a function of the public infrastructure group - in the form of higher service costs and reduction of convenience, resulted in a perceptional shift of convenience and thereby a reduction of net benefit by the suburban residents - space users - which resulted in a reduction of locational value of the real estate from the suburbs to downtown.

In another example, should an owner of an office building – a space producer - decide not to provide capital for the renovation of his or her office building to accommodate the growing affluence of the high-tech start-ups in the market - space users - who, due to shifting trends and demographics, now want to see added luxuries at an office they plan to utilize, changes in both functional groups result in the reduction of locational value of the site.

When underwriting real estate, it is crucial to consider past, current and potential future changes by the three functional groups. As one can see in the examples given above, qualitative analysis is imperative. It is important to thoroughly understand the relationship between these three functional groups to avoid drawing invalid conclusions on locational value.

Approach 2: Quantitative Analysis - Market Fundamental Metrics

Since we now understand the importance of qualitative location analysis, we now have to determine how to measure and interpret it through the second approach to reviewing a location - quantitative analysis. For commercial real estate, locational value is measured in various market metrics – the most common being rental rate, vacancy rate, and net absorption.

Rental Rent is defined as the market rate that a property could achieve if it were leased up today. Most states measure commercial property rents on an annual per square footage basis (i.e. $36.00/SF/year), with the exception of a few states such as California that measure on a monthly per square footage basis (i.e. $3.00/SF/month). Multifamily properties, on the other hand, are almost always measured on a monthly per unit basis (i.e. $1,250/unit/month). It is important to recognize the difference in how rents are measured across different markets and asset classes in order to determine the performance of an individual site relative to the rest of the market. Over time, individual property rents are assumed to revert back to mean market levels.

Vacancy Rate is defined as the percentage of physically unoccupied space in a commercial or multifamily property. If 2,000 SF of a 10,000 SF office building or 4 units of a 20-unit apartment complex are vacant, the vacancy rate of the property is 20%. As with rents, the vacancy of a site will allow you to compare the performance of the asset to that of the market.

Absorption is calculated as the total amount of new space leased by tenants in a certain time period. If a total of 50,000 SF of retail space in the market was leased up in the month of June, the total absorption is 50,000 SF. However, the more commonly used metric would be Net Absorption. Net absorption is the total amount of new space leased by tenants less the total amount of space vacated by tenants and less the total amount of newly constructed space within a given time period. So, if 15,000 SF of space was also vacated in the month of June and 5,000 SF of space was constructed and delivered within the same time period, the net absorption would be 30,000 SF. This metric allows one to determine and gauge the supply and demand activity of the overall market.

Quantitative Analysis - Theory in Action

Typically, when a specific property over or under performs the market on a particular metric, it is due to the congruent relationship between rents and vacancy. As rents are increased, tenants begin to contemplate similar and cheaper alternatives which causes vacancy rate to increase as tenants leave for other sites. Inversely, should rents decrease and tenants from other sites begin seeing potential cost-benefit for being at this particular site, vacancy rates can be expected to decline as demand increases at the property. However, it is important to note that this is an oversimplification of a very complex concept that is beyond the scope of this article. For example, over-performance of an asset can also be attributed to superior attributes or amenities of an asset and not all tenants being price sensitive within a certain margin.

In the next part of this credit series, that will focus on the property, we will present a much more comprehensive view of our quantitative analysis, but it is important to introduce these three quantitative metrics, as they are closely connected to the location of the property. These metric allows prudent investors to identify opportunities ranging from over-arching trends in a market to pinpointing specific potential to improve a particular site.


Both these methods are important to understand before making investment decisions. At, we recognize this importance when reviewing deals for our platform. Our team of underwriters go through a stringent credit process that includes both qualitative and quantitative analysis through numerous data and research resources. This allows our investors to understand and feel comfortable that every deal that is presented to them has gone through the analysis covered above, as well as sophisticated real estate concepts well beyond the scope of this article.

As with all investments, investors should evaluate each individual real estate opportunity to see which best fits his or her investment strategy. Real estate investments carry risks and do not guarantee a return of any sort.

We invite you to learn more about our opportunities and process by contacting a member of our Investor Relations team here.

Martin M. Q. Nguyen
Written by , Associate, Commercial Debt & Equity at

Martin, an Associate on the commercial team, is responsible for the analysis of CRE assets for placement into structured senior debt, mezzanine, preferred equity, and/or JV equity products. Since joining, Martin has underwritten and analyzed over $1.5 billion worth of national CRE across all asset classes. He graduated in three years from the Shidler College of Business at the University of Hawai’i at Mānoa with a B.B.A. and double majors in Finance and International Business.​

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