Flexibility and Real Estate Valuation under Uncertainty

Flexibility and Real Estate Valuation under Uncertainty

by David Geltner, Richard de Neufville
Released April 2018
Publisher(s): Wiley-Blackwell
ISBN: 9781119106494

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Book description

Provides a revolutionary conceptual framework and practical tools to quantify uncertainty and recognize the value of flexibility in real estate development

This book takes a practical "engineering" approach to the valuation of options and flexibility in real estate. It presents simple simulation models built in universal spreadsheet software such as Microsoft Excel®. These realistically reflect the varying and erratic sources of uncertainty and price dynamics that uniquely characterize real estate. The text covers new analytic procedures that are valuable for existing properties and enable a new, more profitable perspective on the planning, design, operation, and evaluation of large-scale, multi-phase development projects. The book thereby aims to significantly improve valuation and investment decision making.

Flexibility and Real Estate Valuation under Uncertainty: A Practical Guide for Developers is presented at 3 levels. First, it introduces and explains the concepts underlying the approach at a basic level accessible to non-technical and non-specialized readers. Its introductory and concluding chapters present the important “big picture” implications of the analysis for economics and valuation and for project design and investment decision making.

At a second level, the book presents a framework, a roadmap for the prospective analyst. It describes the practical tools in detail, taking care to go through the elements of the approach step-by-step for clarity and easy reference.

The third level includes more technical details and specific models. An Appendix discusses the technical details of real estate price dynamics. Associated web pages provide electronic spreadsheet templates for the models used as examples in the book.

Some features of the book include:
•    Concepts and tools that are simple and accessible to a broad audience of practitioners;
•    An approach relevant for all development projects;
•    Complementarity with the author's Commercial Real Estate Analysis & Investments—the most-cited real estate investments textbook on the market.

Flexibility and Real Estate Valuation under Uncertainty: A Practical Guide for Developers is for everyone studying or concerned with the implementation of large-scale or multi-phase real estate development projects, as well as property investment and valuation more generally.

Table of contents

  1. Cover
  2. Title Page
  3. Foreword
  4. Authors’ Preface
    1. What this book is about, and how to use it.
    2. The Value Proposition
    3. Accessibility
    4. How to Use this Book
  5. Acknowledgments
  6. About the Companion Website
  7. 1 Discounted Cash Flow Valuation
    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
    4. 1.4 Discount Rate
    5. 1.5 Market Value and Forward‐Looking (Ex‐Ante) Analysis
    6. 1.6 Backward‐Looking (Ex‐Post) Analysis
    7. 1.7 Conclusion
  8. 2 Economics of the Discounted Cash Flow Valuation Model
    1. 2.1 Choice of Discount Rate
    2. 2.2 Differences between Discount Rate, Opportunity Cost of Capital, and Internal Rate of Return
    3. 2.3 Net Present Value
    4. 2.4 Relationship between Discount Rate, Growth Rate, and Income Yield
    5. 2.5 Relationship between Discount Rate and Risk
    6. 2.6 Conclusion
  9. 3 Future Scenarios Matter
    1. 3.1 The Standard Discounted Cash Flow Model Appears to be Deterministic
    2. 3.2 We Live in a World of Uncertainty
    3. 3.3 Discounted Cash Flow Pro Forma Cash Flows Are Expectations
    4. 3.4 Flexibility and Options
    5. 3.5 Conclusion
  10. 4 Scenario Analysis
    1. 4.1 Discounted Cash Flow Scenario Analysis
    2. 4.2 Scenarios Affect Value
    3. 4.3 Flexibility Has Value
    4. 4.4 Conclusion
  11. 5 Future Outcomes Cover a Range of Possibilities
    1. 5.1 Distribution of Future Outcomes
    2. 5.2 Quantifying Input Distributions
    3. 5.3 Distributions of Outcomes Differ from Distributions of Inputs
    4. 5.4 Flaw of Averages
    5. 5.5 Conclusion
  12. 6 Simulation of Outcomes
    1. 6.1 Generating Scenarios
    2. 6.2 Real Estate Simulation in a Nutshell
    3. 6.3 Simulation Is an Efficient Process
    4. 6.4 Number of Trials
    5. 6.5 Conclusion
  13. 7 Modeling Price Dynamics
    1. 7.1 Pricing Factors
    2. 7.2 Random Walks
    3. 7.3 Real Estate Pricing Factor Dynamics
    4. 7.4 Conclusion
  14. 8 Interpreting Simulation Results
    1. 8.1 Target Curves
    2. 8.2 Comparing Target Curves
    3. 8.3 Value at Risk
    4. 8.4 Scatterplots
    5. 8.5 Conclusion
  15. 9 Resale Timing Decision: Analysis
    1. 9.1 The Resale Timing Problem
    2. 9.2 Extending the Time Horizon of the Discounted Cash Flow Model
    3. 9.3 IF Statements
    4. 9.4 Trigger Value for Stop‐Gain Rule
    5. 9.5 Value of Example Stop‐Gain Rule
    6. 9.6 Conclusion
  16. 10 Resale Timing Decision: Discussion
    1. 10.1 Sensitivity Analysis
    2. 10.2 When to Use the Stop‐Gain Rule
    3. 10.3 Implications of Flexibility for Property Valuation
    4. 10.4 Conclusion
  17. 11 Development Project Valuation
    1. 11.1 Time‐to‐Build Difference between Development Projects and Existing Assets
    2. 11.2 Lower Opportunity Cost of Capital for Construction Costs
    3. 11.3 Illustrative Example
    4. 11.4 Residual Value of Development Land
    5. 11.5 Investment Risk in Development Project
    6. 11.6 Conclusion
  18. 12 Basic Flexibility in Development Projects
    1. 12.1 Review of Call (and Put) Options
    2. 12.2 Land as a Call Option on Development
    3. 12.3 Drivers of Option Value
    4. 12.4 A Practical Example of a Call (and Put) Option
    5. 12.5 Flexibility and Scenario Analysis for Development Projects
    6. 12.6 Conclusion
  19. 13 Option Dichotomies
    1. 13.1 Three Dichotomies for Thinking Generally about Development Options
    2. 13.2 Defensive versus Offensive Options
    3. 13.3 Options “On” and “In” Projects
    4. 13.4 Timing Options versus Product Options
    5. 13.5 Conclusion
  20. 14 Product Options in Development
    1. 14.1 Concept of Base Plan
    2. 14.2 Product Expansion Flexibility
    3. 14.3 Product Mix Flexibility
    4. 14.4 Conclusion
  21. 15 Timing Options in Development
    1. 15.1 Project Start‐Timing Flexibility (The Delay Option)
    2. 15.2 Project Production Timing Flexibility
    3. 15.3 Modular Production Timing Flexibility
    4. 15.4 Phasing Timing Flexibility
    5. 15.5 Types of Phasing
    6. 15.6 Recognizing Defensive and Offensive Options in Simulation Results
    7. 15.7 Conclusion
  22. 16 Garden City: An Example Multi‐Asset Development Project
    1. 16.1 Overview of Multi‐Asset Development Project
    2. 16.2 Structure of a Realistic Multi‐Asset Spreadsheet Pro Forma
    3. 16.3 Cash Flows for the Example Pro Forma
    4. 16.4 Temporal Profile for Base Case
    5. 16.5 Expected Economics of the Garden City Project
    6. 16.6 Conclusion
  23. 17 Effect of Uncertainty without Flexibility in Development Project Evaluation
    1. 17.1 Modeling Uncertainty for the Multi‐Asset Development Project
    2. 17.2 Generating Random Future Scenarios
    3. 17.3 Outcomes Reflecting Uncertainty for the Multi‐Asset Development
    4. 17.4 Effect of Different Probability Inputs Assumptions
    5. 17.5 Conclusion
  24. 18 Project Start‐Delay Flexibility
    1. 18.1 Project Start‐Delay Option
    2. 18.2 Option Exercise Decision Rule
    3. 18.3 Defining “Profit” in the Decision Model
    4. 18.4 Value of Start‐Delay Flexibility in the Garden City Project
    5. 18.5 Conclusion
  25. 19 Decision Rules and Value Implications
    1. 19.1 Simple Myopic Delay Rule
    2. 19.2 Trigger Values
    3. 19.3 Value Implications of the Decision Rules
    4. 19.4 Effect of Trigger Values (Start or Delay Bias)
    5. 19.5 Review the Meaning of Flexibility Value
    6. 19.6 Conclusion
  26. 20 Modular Production Timing Flexibility
    1. 20.1 Modular Production Timing Flexibility
    2. 20.2 Modeling the Modular Production Option
    3. 20.3 Value of Modular Production Timing Flexibility
    4. 20.4 Effect of Trigger Values (Bias toward Pause or Continue)
    5. 20.5 Effect of Combining Start‐Delay and Modular Production Delay Flexibility
    6. 20.6 Conclusion
  27. 21 Product Mix Flexibility
    1. 21.1 Product Mix Flexibility
    2. 21.2 Modeling the Product Mix Option
    3. 21.3 Value of Product Mix Flexibility
    4. 21.4 Effect of Combining Product Mix Flexibility and Timing Options
    5. 21.5 Effect of Correlation in the Product Markets on the Value of Product Mix Flexibility
    6. 21.6 Effect of Volatility on the Value of Flexibility
    7. 21.7 Conclusion
  28. 22 Project Phasing Flexibility
    1. 22.1 Modeling the Sequential Phase Delay Option
    2. 22.2 Modifying the Garden City Project Plan
    3. 22.3 Project Economics
    4. 22.4 The Delay Decision Model
    5. 22.5 Exploring the Value of Project Phasing Flexibility
    6. 22.6 Conclusion
  29. 23 Optimal Phasing
    1. 23.1 Effect of Increasing the Number of Phases
    2. 23.2 Principles for Optimal Phasing
    3. 23.3 What Is the Difference between a Phase and an Expansion Option?
    4. 23.4 Conclusion
  30. 24 Overall Summary
  31. Appendix Quantifying Real Estate Uncertainty
    1. A.1 The Real Estate System
    2. A.2 Sources of Uncertainty and Some Practical Advice for Simulation
    3. A.3 The Nature of Real Estate Price Dynamics and Uncertainty
    4. A.4 Putting It All Together
  32. Glossary
  33. Acronyms and Symbols
  34. Index
  35. End User License Agreement

Product information

  • Title: Flexibility and Real Estate Valuation under Uncertainty
  • Author(s): David Geltner, Richard de Neufville
  • Release date: April 2018
  • Publisher(s): Wiley-Blackwell
  • ISBN: 9781119106494