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 Basic Flexibility in Development Projects: The Most Basic Flexibility in Real Estate Development is the Option to Choose whether and when to Build 83

12.1 Review of Call (and Put) Options 84

12.2 Land as a Call Option on Development 85

12.3 Drivers of Option Value 85

12.4 A Practical Example of a Call (and Put) Option 86

12.5 Flexibility and Scenario Analysis for Development Projects 88

12.6 Conclusion 90

13 Option Dichotomies: We Introduce a Typology of Flexibility in Development Projects 91

13.1 Three Dichotomies for Thinking Generally about Development Options 91

13.2 Defensive versus Offensive Options 92

13.3 Options “On” and “In” Projects 93

13.4 Timing Options versus Product Options 94

13.5 Conclusion 94

14 Product Options in Development: We Discuss Three types of Product Options 95

14.1 Concept of Base Plan 95

14.2 Product Expansion Flexibility 96

14.3 Product Mix Flexibility 98

14.4 Conclusion 98

15 Timing Options in Development: Now we Turn to the Types of Timing Options 99

15.1 Project Start‐Timing Flexibility (The Delay Option) 99

15.2 Project Production Timing Flexibility 100

15.3 Modular Production Timing Flexibility 102

15.4 Phasing Timing Flexibility 103

15.5 Types of Phasing 103

15.6 Recognizing Defensive and Offensive Options in Simulation Results 104

15.7 Conclusion 107

16 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 109

16.1 Overview of Multi‐Asset Development Project 110

16.2 Structure of a Realistic Multi‐Asset Spreadsheet Pro Forma 111

16.3 Cash Flows for the Example Pro Forma 113

16.4 Temporal Profile for Base Case 115

16.5 Expected Economics of the Garden City Project 116

16.6 Conclusion 118

17 Effect of Uncertainty without Flexibility in Development Project Evaluation: We Re‐analyze the Garden City Project by Reflecting Uncertainty Without Flexibility 119

17.1 Modeling Uncertainty for the Multi‐Asset Development Project 120

17.2 Generating Random Future Scenarios 122

17.3 Outcomes Reflecting Uncertainty for the Multi‐Asset Development 123

17.4 Effect of Different Probability Inputs Assumptions 127

17.5 Conclusion 129

18 Project Start‐Delay Flexibility: We Model the Value of the Most Basic and Widely Available Development Project Option 131

18.1 Project Start‐Delay Option 132

18.2 Option Exercise Decision Rule 132

18.3 Defining “Profit” in the Decision Model 134

18.4 Value of Start‐Delay Flexibility in the Garden City Project 134

18.5 Conclusion 138

19 Decision Rules and Value Implications: We Further Explore the Option to Delay the Project Start 139

19.1 Simple Myopic Delay Rule 140

19.2 Trigger Values 140

19.3 Value Implications of the Decision Rules 141

19.4 Effect of Trigger Values (Start or Delay Bias) 143

19.5 Review the Meaning of Flexibility Value 145

19.6 Conclusion 146

20 Modular Production Timing Flexibility: We Explore the Timing Option to Pause and Restart the Project Any Time After its Commencement 147

20.1 Modular Production Timing Flexibility 148

20.2 Modeling the Modular Production Option 148

20.3 Value of Modular Production Timing Flexibility 150

20.4 Effect of Trigger Values (Bias toward Pause or Continue) 152

20.5 Effect of Combining Start‐Delay and Modular Production Delay Flexibility 154

20.6 Conclusion 157

21 Product Mix Flexibility: This Chapter Presents the Option to Change Product Mix, and Examines the Effect of Volatility on Option Value 159

21.1 Product Mix Flexibility 160

21.2 Modeling the Product Mix Option 160

21.3 Value of Product Mix Flexibility 161

21.4 Effect of Combining Product Mix Flexibility and Timing Options 165

21.5 Effect of Correlation in the Product Markets on the Value of Product Mix Flexibility 167

21.6 Effect of Volatility on the Value of Flexibility 169

21.7 Conclusion 172

22 Project Phasing Flexibility: We Show How to Model and Evaluate the Delay Flexibility Inherent in Project Phasing 173

22.1 Modeling the Sequential Phase Delay Option 173

22.2 Modifying the Garden City Project Plan 174

22.3 Project Economics 177

22.4 The Delay Decision Model 178

22.5 Exploring the Value of Project Phasing Flexibility 179

22.6 Conclusion 182

23 Optimal Phasing: We Now look at Adding Phases, Delineating Phases, and Distinguishing them from Expansion Options 183

23.1 Effect of Increasing the Number of Phases 184

23.2 Principles for Optimal Phasing 186

23.3 What is the Difference between a Phase and an Expansion Option? 190

23.4 Conclusion 191

24 Overall Summary: We summarize the Main Takeaway Points from this Book 193

Appendix 197

Glossary 213

Acronyms and Symbols 219

Index 221

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