Flexibility and Real Estate Valuation under Uncertainty

3Future Scenarios Matter: We Need to Recognize that Future Projections are Uncertain

LEARNING OBJECTIVES

• Learn the concept of “scenarios”;
• Recognize the relationship between the DCF model and uncertainty about the future;
• Understand future projections as “expectations”;
• See the difference between “flexibility” and economic “options.”

OUTLINE OF THE CHAPTER

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

Everybody loves the DCF model as a tool for valuing investment assets. And valuation is very important in real estate. But this book is about how flexibility can add value. So now we need to take a step beyond the traditional DCF model presented in the previous chapters. In this chapter, we explicitly introduce uncertainty into the cash flow projections in the DCF pro forma.

We suggest the concept of scenarios to describe uncertainties in real estate. Scenarios refer to the fact that the future may turn out differently than the prior projection. A scenario is one specific sequence of events, of circumstances that we may face. A scenario would describe the sequence of combinations of possibilities (price, vacancy, costs, etc.) in Year 1, Year 2, and so on. Any particular real estate project faces many possible scenarios. The price could go up in the first and second years, or it could go up and ...