Flexibility and Real Estate Valuation under Uncertainty

DAVID GELTNER, PhD is Professor of Real Estate Finance in the MIT Department of Urban Studies & Planning. He has taught for over 15 years in the MIT Center for Real Estate, playing a lead role in its Master of Science in Real Estate Development (MSRED) program. Geltner is a winner of the prestigious Pension Real Estate Association's Graaskamp Award for excellence and influence in the real estate investment industry. RICHARD DE NEUFVILLE, PhD is Professor of Engineering Systems at the Massachusetts Institute of Technology. He has received many international professional and teaching awards, including the Sizer Award for the Most Significant Contribution to MIT Education.

• Foreword xiiiAuthor’s Preface xviiAcknowledgement xxiAbout the Companion Website xxiii1 Discounted Cash Flow Valuation: The Basic Procedures and Concepts Underlying Spreadsheet Valuation Constitute the Springboard to our Approach of Analyzing Flexibility Under Uncertainty 11.1 Why the Focus on the Discounted Cash Flow Model? 21.2 Structure of a Discounted Cash Flow Spreadsheet 31.3 The Cash Flow Projection 51.4 Discount Rate 71.5 Market Value and Forward‐Looking (Ex‐Ante) Analysis 71.6 Backward‐Looking (Ex‐Post) Analysis 91.7 Conclusion 92 Economics of the Discounted Cash Flow Valuation Model: Understanding the Discount Rate is Critical 112.1 Choice of Discount Rate 112.2 Differences between Discount Rate, Opportunity Cost of Capital, and Internal Rate of Return 132.3 Net Present Value 142.4 Relationship between Discount Rate, Growth Rate, and Income Yield 152.5 Relationship between Discount Rate and Risk 182.6 Conclusion 193 Future Scenarios Matter: We Need to Recognize that Future Projections are Uncertain 213.1 The Standard Discounted Cash Flow Model Appears to be Deterministic 213.2 We Live in a World of Uncertainty 233.3 Discounted Cash Flow Pro Forma Cash Flows are Expectations 243.4 Flexibility and Options 263.5 Conclusion 264 Scenario Analysis: Future Scenarios can Significantly and Surprisingly Affect the Present Value 274.1 Discounted Cash Flow Scenario Analysis 274.2 Scenarios Affect Value 294.3 Flexibility Has Value 304.4 Conclusion 325 Future Outcomes Cover a Range of Possibilities: We Can Describe Uncertainties in Real Estate Using Probability Distributions of Possible Future Outcomes 335.1 Distribution of Future Outcomes 345.2 Quantifying Input Distributions 345.3 Distributions of Outcomes Differ from Distributions of Inputs 385.4 Flaw of Averages 395.5 Conclusion 406 Simulation of Outcomes: Simulation is a Practical, Efficient Way to Explore Uncertainty and to choose between Alternative Strategies for Managing it 416.1 Generating Scenarios 416.2 Real Estate Simulation in a Nutshell 426.3 Simulation is an Efficient Process 436.4 Number of Trials 446.5 Conclusion 457 Modeling Price Dynamics: Using Pricing Factors to Model the Dynamics of Real Estate Markets 477.1 Pricing Factors 477.2 Random Walks 497.3 Real Estate Pricing Factor Dynamics 517.4 Conclusion 528 Interpreting Simulation Results: Target Curves and Scatterplots can be used to Graph the Distribution of the Sample Output 538.1 Target Curves 538.2 Comparing Target Curves 578.3 Value at Risk 578.4 Scatterplots 578.5 Conclusion 599 Resale Timing Decision: Analysis: Let’s See what happens when we apply the Tools of Flexibility Analysis to a Classical Investment Decision: when to sell the Property 619.1 The Resale Timing Problem 629.2 Extending the Time Horizon of the Discounted Cash Flow Model 629.3 IF Statements 639.4 Trigger Value for Stop‐Gain Rule 649.5 Value of Example Stop‐Gain Rule 649.6 Conclusion 6810 Resale Timing Decision: Discussion: Let’s think about Additional Insights we can get from Simulation 6910.1 Sensitivity Analysis 6910.2 When to Use the Stop‐Gain Rule 7010.3 Implications of Flexibility for Property Valuation 7110.4 Conclusion 7211 Development Project Valuation: This Chapter Looks at Valuation of Development Projects From an Investment Perspective, Considering Uncertainty, Flexibility, and Time‐to‐Build 7311.1 Time‐to‐Build Difference between Development Projects and Existing Assets 7411.2 Lower Opportunity Cost of Capital for Construction Costs 7511.3 Illustrative Example 7711.4 Residual Value of Development Land 7811.5 Investment Risk in Development Project 7911.6 Conclusion 8012 Basic Flexibility in Development Projects: The Most Basic Flexibility in Real Estate Development is the Option to Choose whether and when to Build 8312.1 Review of Call (and Put) Options 8412.2 Land as a Call Option on Development 8512.3 Drivers of Option Value 8512.4 A Practical Example of a Call (and Put) Option 8612.5 Flexibility and Scenario Analysis for Development Projects 8812.6 Conclusion 9013 Option Dichotomies: We Introduce a Typology of Flexibility in Development Projects 9113.1 Three Dichotomies for Thinking Generally about Development Options 9113.2 Defensive versus Offensive Options 9213.3 Options “On” and “In” Projects 9313.4 Timing Options versus Product Options 9413.5 Conclusion 9414 Product Options in Development: We Discuss Three types of Product Options 9514.1 Concept of Base Plan 9514.2 Product Expansion Flexibility 9614.3 Product Mix Flexibility 9814.4 Conclusion 9815 Timing Options in Development: Now we Turn to the Types of Timing Options 9915.1 Project Start‐Timing Flexibility (The Delay Option) 9915.2 Project Production Timing Flexibility 10015.3 Modular Production Timing Flexibility 10215.4 Phasing Timing Flexibility 10315.5 Types of Phasing 10315.6 Recognizing Defensive and Offensive Options in Simulation Results 10415.7 Conclusion 10716 Garden City: An Example Multi‐Asset Development Project: We Present the Traditional DCF Valuation Spreadsheet Model for the Example Development Project We use in the Rest of Book 10916.1 Overview of Multi‐Asset Development Project 11016.2 Structure of a Realistic Multi‐Asset Spreadsheet Pro Forma 11116.3 Cash Flows for the Example Pro Forma 11316.4 Temporal Profile for Base Case 11516.5 Expected Economics of the Garden City Project 11616.6 Conclusion 11817 Effect of Uncertainty without Flexibility in Development Project Evaluation: We Re‐analyze the Garden City Project by Reflecting Uncertainty Without Flexibility 11917.1 Modeling Uncertainty for the Multi‐Asset Development Project 12017.2 Generating Random Future Scenarios 12217.3 Outcomes Reflecting Uncertainty for the Multi‐Asset Development 12317.4 Effect of Different Probability Inputs Assumptions 12717.5 Conclusion 12918 Project Start‐Delay Flexibility: We Model the Value of the Most Basic and Widely Available Development Project Option 13118.1 Project Start‐Delay Option 13218.2 Option Exercise Decision Rule 13218.3 Defining “Profit” in the Decision Model 13418.4 Value of Start‐Delay Flexibility in the Garden City Project 13418.5 Conclusion 13819 Decision Rules and Value Implications: We Further Explore the Option to Delay the Project Start 13919.1 Simple Myopic Delay Rule 14019.2 Trigger Values 14019.3 Value Implications of the Decision Rules 14119.4 Effect of Trigger Values (Start or Delay Bias) 14319.5 Review the Meaning of Flexibility Value 14519.6 Conclusion 14620 Modular Production Timing Flexibility: We Explore the Timing Option to Pause and Restart the Project Any Time After its Commencement 14720.1 Modular Production Timing Flexibility 14820.2 Modeling the Modular Production Option 14820.3 Value of Modular Production Timing Flexibility 15020.4 Effect of Trigger Values (Bias toward Pause or Continue) 15220.5 Effect of Combining Start‐Delay and Modular Production Delay Flexibility 15420.6 Conclusion 15721 Product Mix Flexibility: This Chapter Presents the Option to Change Product Mix, and Examines the Effect of Volatility on Option Value 15921.1 Product Mix Flexibility 16021.2 Modeling the Product Mix Option 16021.3 Value of Product Mix Flexibility 16121.4 Effect of Combining Product Mix Flexibility and Timing Options 16521.5 Effect of Correlation in the Product Markets on the Value of Product Mix Flexibility 16721.6 Effect of Volatility on the Value of Flexibility 16921.7 Conclusion 17222 Project Phasing Flexibility: We Show How to Model and Evaluate the Delay Flexibility Inherent in Project Phasing 17322.1 Modeling the Sequential Phase Delay Option 17322.2 Modifying the Garden City Project Plan 17422.3 Project Economics 17722.4 The Delay Decision Model 17822.5 Exploring the Value of Project Phasing Flexibility 17922.6 Conclusion 18223 Optimal Phasing: We Now look at Adding Phases, Delineating Phases, and Distinguishing them from Expansion Options 18323.1 Effect of Increasing the Number of Phases 18423.2 Principles for Optimal Phasing 18623.3 What is the Difference between a Phase and an Expansion Option? 19023.4 Conclusion 19124 Overall Summary: We summarize the Main Takeaway Points from this Book 193Appendix 197Glossary 213Acronyms and Symbols 219Index 221