How Do You Measure Market Depth?

The consideration of a new development raises a lot of questions. How successful will a proposed property be in its initial lease-up period and will it be able to capture some of the existing demand as well as a portion of the current and projected growth? What is the optimal combination of care types? How about the mix of unit prices and floor plans; how many one- or two-bedroom units should be planned?

A market study is a critical part of strategic investment plans, project planning, and project financing. While the time and effort needed to conduct a quality market study may be significant, the study is fundamental to the success of a project, providing crucial information about the market that can slow or cancel a project—even when human intuition is giving the green light.

Indeed, a key component of any market study is gauging demand. This involves quantifying the total pool of age- and income-qualified households and/or individuals available within a defined area (the primary market area or PMA) that may be attracted to a senior living project in order to anticipate the amount of risk associated with acquiring, expanding or building a property from the ground up.

Generally, once the number of qualified households and competitive supply have been determined, a market penetration analysis is prepared to estimate market depth or net need. Net need is often referred to as a demand analysis.

1. Estimating net need

For a seniors housing project to be successful, current and projected demand needs to be strong enough so that creating additional seniors housing units will not overwhelm the market, and the property needs to be well-positioned to generate positive cash flow. Experts in the seniors housing and care industry utilize multiple methods to estimate market depth or net need, but in their simplest forms, penetration calculations express a proportion of the total eligible market that may be attracted to a project, and the degree of competitive intensity expected.

A basic penetration rate calculation considers all (or nearly all) of the competitive communities in the market area (including the units in the proposed project) and the concentration of qualified households in the primary market area. A second method estimates the remaining net pool of households after the competitive units have been subtracted to derive a project penetration rate. Considering both methods together often provides more context than simply one or the other in trying to accurately gauge market conditions, especially in deep markets where the market penetration rate may be low.

Market Penetration= Competitive and proposed project units ÷ qualified households 

Project Penetration= Qualified households - competitive units = net qualified households ÷ proposed project units

Demand studies for higher levels of care often consider net need for assisted living, memory care and nursing care properties by calculating the number of units that can reasonably be absorbed by qualified individuals while factoring in national data on the population (by age) likely to have chronic limitations in activities of daily living (ADLs), the percentage of the population that is likely to have Alzheimer’s Disease and related disorders, and/or national (and local) skilled nursing utilization rates. Assumptions may include market area draw, capture rates and the propensity to move to institutionalized care. Additionally, some analysts will only consider the household characteristics of adult child influencers in a marketplace, rather than only seniors or a combination of seniors and adult children when estimating demand for developments of higher levels of care.

2. Layer in context

So what’s the bottom line? Unfortunately, the answer isn’t that simple because penetration rates don’t tell the whole story. Determining whether a penetration rate is reasonable or excessive requires additional investigation, and specific market conditions and product offerings can affect the interpretation of the data.

Indeed, a well-planned seniors housing project in a dynamic market with a growing number of age and income qualified households or a surge in job growth might succeed even with a high penetration rate. Determining an acceptable level depends on the interpretation of additional considerations:

• Occupancy: Are competitor occupancy rates flagging? If so, can they be explained by high resident attrition, chronic vacancy, obsolescence of current stock, or something else?
• Construction vs. Inventory: Has construction activity exceeded demand resulting in an overbuilt market? If so indicated, then when will supply and demand become more balanced? How much excess supply can be tolerated before it impacts pricing?
• Rent Growth: Will proposed rents be achievable in the market? If not, can the project design be modified to accommodate lower rates while still being marketed to the target consumer? How much excess supply can be tolerated before it puts downward pressure on rents and upward pressure on concessions? Are incumbent operators buying occupancy by dropping rents and offering concessions?
• Residential Housing Sales: How do monthly rents and fees and/or entrance fees compare with fair market value of the homes in the primary market area? Because seniors tend to be home-owners and typically sell their homes before moving to seniors housing, a weak real estate market may signal delays in lease-ups.

3. Adjust accordingly

In the end, market studies conclude with an assessment of how well a property will be able to compete. Analyses of sensitivity can be run to recommend modifications in the number and types of development units, and optimal phasing, to best position the project for success.

Given the range of decision-making input that can be derived from analysis of demand, a lot of weight is put on the importance of the calculation of net need in market studies. But net need isn’t the bottom-line answer most developers and investors assume it to be when they first get that report in hand and thumb directly to the results. If any one of the assumptions is off the mark, the success or failure of a project – often a multi-million-dollar one – can be significant.

For more information about studies of market demand, look for future articles in The Insider.