Flexibility and Real Estate Valuation under Uncertainty

7Modeling Price Dynamics: Using Pricing Factors to Model the Dynamics of Real Estate Markets

LEARNING OBJECTIVES

• Learn about pricing factors and their role in defining scenarios;
• Learn about random walks describing evolution over time;
• Review dynamics of real estate markets: inertia, cycles, and mean‐reversion.

OUTLINE OF THE CHAPTER

1. 7.1 Pricing Factors
2. 7.2 Random Walks
3. 7.3 Real Estate Pricing Factor Dynamics
4. 7.4 Conclusion

This chapter deals with the question of how we should define the input probability distributions and dynamics for the simulation of real estate investments. It covers the

• Concept of pricing factors;
• Random walk model of asset pricing; and the
• Price dynamics that characterize real estate investments.

7.1 Pricing Factors

Pricing factors provide a simple and straightforward way to reflect uncertainty over time in the DCF pro forma. They provide the means to incorporate our estimates of the probability distributions for relevant parameters (such as revenues) in the spreadsheet. Pricing factors are thus a key tool that we use to do the type of simulation analysis described in Chapter 6. What exactly do we mean by a “pricing factor”?

A pricing factor is a ratio that multiplies the original, single‐stream pro forma cash flow expectation to arrive at a future cash flow outcome for a given scenario. The idea is that we take a good (that is, unbiased) original (or “base case”) pro forma as a starting point, and we modify its cash flows by multiplying ...