Flexibility and Real Estate Valuation under Uncertainty

5Future Outcomes Cover a Range of Possibilities: We Can Describe Uncertainties in Real Estate Using Probability Distributions of Possible Future Outcomes

LEARNING OBJECTIVES

• Understand the meaning of a probability distribution and its shape;
• Understand how we estimate probability distributions of inputs to the DCF model;
• Learn how probability distributions of DCF outcomes differ from input distributions;
• Appreciate the need to work with the entire distribution of uncertainties, as demonstrated by the “flaw of averages.”

OUTLINE OF THE CHAPTER

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

Let’s now begin to face the reality of the uncertainties that we inevitably encounter in real estate investment and development. Demand rises and falls; prices and rents do likewise; and governments change taxes, zoning, and other regulations. In short, the future is uncertain. The “forecast is always wrong” in that what actually occurs almost always differs in some way from the pro forma projection.

This reality, this uncertainty, underlies the value of flexibility, the value of the manager’s ability to adapt plans to actual circumstances. While a quiet, uneventful life has its attractions, secure, unvarying returns, on average, yield the lowest returns, the risk‐free rate. The uncertainty and variability in the market provides the opportunities ...