Flexibility and Real Estate Valuation under Uncertainty: A Practical Guide for Developers

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 xiii Author's Preface xvii Acknowledgement xxi About the Companion Website xxiii 1 Discounted Cash Flow Valuation: The Basic Procedures and Concepts Underlying Spreadsheet Valuation Constitute the Springboard to our Approach of Analyzing Flexibility Under Uncertainty 1 1.1 Why the Focus on the Discounted Cash Flow Model? 2 1.2 Structure of a Discounted Cash Flow Spreadsheet 3 1.3 The Cash Flow Projection 5 1.4 Discount Rate 7 1.5 Market Value and Forward-Looking (Ex-Ante) Analysis 7 1.6 Backward-Looking (Ex-Post) Analysis 9 1.7 Conclusion 9 2 Economics of the Discounted Cash Flow Valuation Model: Understanding the Discount Rate is Critical 11 2.1 Choice of Discount Rate 11 2.2 Differences between Discount Rate, Opportunity Cost of Capital, and Internal Rate of Return 13 2.3 Net Present Value 14 2.4 Relationship between Discount Rate, Growth Rate, and Income Yield 15 2.5 Relationship between Discount Rate and Risk 18 2.6 Conclusion 19 3 Future Scenarios Matter: We Need to Recognize that Future Projections are Uncertain 21 3.1 The Standard Discounted Cash Flow Model Appears to be Deterministic 21 3.2 We Live in a World of Uncertainty 23 3.3 Discounted Cash Flow Pro Forma Cash Flows are Expectations 24 3.4 Flexibility and Options 26 3.5 Conclusion 26 4 Scenario Analysis: Future Scenarios can Significantly and Surprisingly Affect the Present Value 27 4.1 Discounted Cash Flow Scenario Analysis 27 4.2 Scenarios Affect Value 29 4.3 Flexibility Has Value 30 4.4 Conclusion 32 5 Future Outcomes Cover a Range of Possibilities: We Can Describe Uncertainties in Real Estate Using Probability Distributions of Possible Future Outcomes 33 5.1 Distribution of Future Outcomes 34 5.2 Quantifying Input Distributions 34 5.3 Distributions of Outcomes Differ from Distributions of Inputs 38 5.4 Flaw of Averages 39 5.5 Conclusion 40 6 Simulation of Outcomes: Simulation is a Practical, Efficient Way to Explore Uncertainty and to choose between Alternative Strategies for Managing it 41 6.1 Generating Scenarios 41 6.2 Real Estate Simulation in a Nutshell 42 6.3 Simulation is an Efficient Process 43 6.4 Number of Trials 44 6.5 Conclusion 45 7 Modeling Price Dynamics: Using Pricing Factors to Model the Dynamics of Real Estate Markets 47 7.1 Pricing Factors 47 7.2 Random Walks 49 7.3 Real Estate Pricing Factor Dynamics 51 7.4 Conclusion 52 8 Interpreting Simulation Results: Target Curves and Scatterplots can be used to Graph the Distribution of the Sample Output 53 8.1 Target Curves 53 8.2 Comparing Target Curves 57 8.3 Value at Risk 57 8.4 Scatterplots 57 8.5 Conclusion 59 9 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 61 9.1 The Resale Timing Problem 62 9.2 Extending the Time Horizon of the Discounted Cash Flow Model 62 9.3 IF Statements 63 9.4 Trigger Value for Stop-Gain Rule 64 9.5 Value of Example Stop-Gain Rule 64 9.6 Conclusion 68 10 Resale Timing Decision: Discussion: Let's think about Additional Insights we can get from Simulation 69 10.1 Sensitivity Analysis 69 10.2 When to Use the Stop-Gain Rule 70 10.3 Implications of Flexibility for Property Valuation 71 10.4 Conclusion 72 11 Development Project Valuation: This Chapter Looks at Valuation of Development Projects From an Investment Perspective, Considering Uncertainty, Flexibility, and Time-to-Build 73 11.1 Time-to-Build Difference between Development Projects and Existing Assets 74 11.2 Lower Opportunity Cost of Capital for Construction Costs 75 11.3 Illustrative Example 77 11.4 Residual Value of Development Land 78 11.5 Investment Risk in Development Project 79 11.6 Conclusion 80 12 B