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Dr. Richard de Neufville

Professor of Engineering Systems and

Civil and Environmental Engineering

Massachusetts Institute of Technology

Garage Case – Concepts / RdN ©

Background!

“Garage case” is a prototype example.

It is a model for application portfolio.

The technology is simple enough so we can

see through it and gain insights into the how

flexibility in design increases expected value.

Case demonstrates several ways that

Flexibility improves design

Garage Case – Concepts / RdN ©

Outline of presentation

1: Motivation: examples of real cases

=> HCSC building, Tufts Dental School, etc

**2: The Case itself
**

=> Logic of Analysis; description of case

=> Analysis Structure and Results

3: Interpretation of Results

=> Better quantitatively and qualitatively

=> “win-win” solution

4: Decision rules

5: Implementation Issues

Garage Case – Concepts / RdN ©

1. Motivation

The Garage Case is representative of a

broad class of infrastructure designs

1: Health Care Services Corporation Bldg.

in Chicago

2: Tufts Dental School in downtown Boston

3: Major Bridges: George Washington, NYC

Ponte 25 de Abril, Lisbon, Portugal

4: Parking Structure, Blue Water Mall, UK

Garage Case – Concepts / RdN ©

144-157. Wittels thesis http://ardent. 2nd largest in Chicago after “Sears” (now Willis) tower Garage Case – Concepts / RdN © . Guma thesis J. etc. 11(3).edu/real_options/Common_course_materials/papers. de Neufville.mit. and D. Wittels.ft.References on web site “Vertical Phasing as a Corporate Real Estate Strategy and Design Option”.. Geltner. A. K.php Garage Case – Concepts / RdN © HCSC Building (aka Blue Cross Blue Shield Tower) Original Building erected in 1997 with 30 stories 27 story expansion for 2010 Original design had to have Ø Ø Ø Strength to carry double load Empty space for possible future elevators Planning permission from City. Pearson and K. Guma. 2. 2009.3 Million Sq. Pearson. Journal of Corporate Real Estate. J.html Images: www.chicagoarchitectureinto/Building/1235/Blue-Cross-BlueShield-Of-Illinois-Tower. A. R.

Garage Case – Concepts / RdN © .Before and after picture Source: Goettsch Partners. 2008. 2008 and Pearson and Wittels.! Garage Case – Concepts / RdN © Tower under construction and finished Source: Wayne Lorentz/Artefaqs Corp.

healthcarebuildingideas.Tufts Dental School 10 story building completed in 1973 But School knew it would want more and built in structural strength 5 story addition ready end of 2009 Construction on top of building in middle of city obviously problematic In downtown Boston theater district Pics: dental.edu/1176818445781/TUSDM-Page-dental2w_ 119271296754.com/article/going-vertical Garage Case – Concepts / RdN © Tufts dental under construction Source: nerej.html Story: www.tufts.com Garage Case – Concepts / RdN © .

com Garage Case – Concepts / RdN © Ponte 25 de Abril. within flexible framework Garage Case – Concepts / RdN © . allowances for possible rail service (pre-built station) Situation 30 years later very different Ø Ø Ø Portugal is in European Union Receives money from community. especially for Metro New Conditions lead to new solutions. Lisbon Built under dictatorship. 1966 Ø With strength for second deck.Tufts dental school doubled Source: bostonrealestateobserver.

25 de Abril Bridge. Lisbon Sources: Estudio Mario Novais Biblioteca de Arte-Fundação Calouste Gulbenkian Photo c 1966 Garage Case – Concepts / RdN © 25 de Abril Bridge in 2009 de Neufville photo! Garage Case – Concepts / RdN © .

panels Garage Case – Concepts / RdN © Aeriel view of site Source: webaviation.uk Garage Case – Concepts / RdN © .Blue Water Shopping Centre Blue Water one of biggest in UK. Southeast of London. in Kent Parking facility made of precast reinforced concrete Built for possible addition of several extra levels Could be expanded rapidly using precast columns.co.

2.edu/real_options/Common_course_materials/ papers. It is definitely not simple-minded! Garage Case – Concepts / RdN © 2. Garage Case! Reference on web: “Valuing Options by Spreadsheet: Parking Garage Case Example. not “academic” idea Therefore Ø Ø Although “garage case” is simple. S.mit. 107-111. Vol.12. for clarity of presentation.html Garage Case – Concepts / RdN © . Journal of Infrastructure Systems. de Neufville.” R. Wang. and T. 2006 http://ardent. Scholtes. American Society of Civil Engineers. no.Take-away from these cases Vertical phasing of major infrastructure is a serious business Practical. pp.

due to system non-linearities Ø Different designs are also possible. demographics speculative Ø Mall success chancy (in case of Blue Water. takes opportunities Ø Win-win solutions Garage Case – Concepts / RdN © Parking Garage Case Major garage serving mega-mall Actual demand necessarily uncertain: Ø Population growth. likely Incorporate flexibility Ø A design with high expected value Ø Avoids downside losses. a major competitor opened up nearby) Ø Competition from other parking facilities Engineering design assumes a fixed forecast Garage Case – Concepts / RdN © .Logic of Analysis Consider engineering base case design Ø for fixed objective (mission or specifications) Recognize reality of uncertainty Ø different values.

Parking Garage Case details Demand Ø At start is for 750 spaces Ø Over next 10 years is expected to rise exponentially by another 750 spaces Ø After year 10 may be 250 more spaces Annual revenue/space used = $10.000/space + 10% for each level above the ground level Ø Can accommodate 200 cars per level Garage Case – Concepts / RdN © . cleaning.6 Million Ø construction cost = $16.) = $2.000 /year/space available (note: spaces used < spaces available) Ø Annual lease of the land = $3.000 The discount rate is taken to be 12% Garage Case – Concepts / RdN © Parking Garage details (Cont) Costs annual operating costs (staff. etc.

000 $6.200 1.200 1.200 1.000 $3.000.000 $1.200 $12.600.696 1.400.600.335.000 $2.600.000.736 $6.000 $3.953.339.000 $10.416 Garage Case – Concepts / RdN © Optimizing the base case Optimization = find highest value for all designs Ø Solution: consider each major design alternative Ø In this case.600.000.000 $3.400.000 $4. value look like? Garage Case – Concepts / RdN © .Engineering Base Case Demand growth as predicted.600.000 $1.001 $32.000 $2.000.688 1.888 19 20 1.641 $2.930.286 $2.000 1 2 3 750 893 1.320 $6.015 1.336.500.000 $2.238.000 $696.150.000 $12.400.000 $8.150.000 $3.200 $7.600.000 $6. a “sweet spot” What does graph of floors vs.574.500.778 $2.400.000 $622.000 $3. no variability Year Demand Capacity Revenue Recurring Costs Operating cost Land leasing cost Cash flow Discounted Cash Flow Present value of cash flow Capacity costs for up to two levels Capacity costs for levels above 2 Net present value 0 $3.000 $2.000 $16.000 $2.400.930. number of floors Ø Typically.400.

MILLIONS) 10 5 0 2 3 4 5 6 7 8 9 -5 -10 -15 NUMBER OF LEVELS TRADITIONAL NPV Garage Case – Concepts / RdN © Recognizing Uncertainty Many things uncertain Ø Costs may be easier to estimate.Optimal design for base case (no uncertainty) is 6 floors EXPECTED NPV ($. either way. farther in future Ø Assume: could be 50% off the projections. more uncertain. Ø Annual volatility for growth is 10% Garage Case – Concepts / RdN © . contractors may give fixed bids Focus on Demand.

Distribution of Outcomes Recognizing Uncertainty => implies many possible future scenarios We calculate possible value of system for each possible scenario We obtain a distribution of outcomes (as indicated in ESD70) Also Cumulative distributions or “target curves” Garage Case – Concepts / RdN © Target Curves Represent cumulative chance of getting a result below any specific level Ø Going from below lowest value (no chance) Ø To at or below the highest value (100% chance) Allows read on Value at Risk (VAR) : Ø Definition: VAR is A loss that will not be exceeded at some specified confidence level Ø “We are p percent certain that we will not lose more than V dollars for this project.” Garage Case – Concepts / RdN © .

risks However. for NPVB. B: Ø 90% VAR for NPVA -$91. designers also need to look at upside potential: “Value of Gain” So we expand VAR to VARG Ø Value at Risk and Gain Garage Case – Concepts / RdN © .Target curves graphically Cumulative Probability CDF 100% 80% 60% 40% 20% 0% -400 -200 0 200 NPVA NPVB NPV 90%VAR for NPVB 10% Probability 400 600 90% VAR for NPVA Look at distribution of NPV of designs A. $102 Garage Case – Concepts / RdN © A few notes on VARG VAR is a common financial concept It stresses downside losses.

9 -2.6 1.2 -7.3 -9.0 -4.8 -15.7 -0.9 8.5 -11.6 -13.7 5.Why? Ø Capacity constraints systematically limit ability to profit from good opportunities Changes design – Why? Ø Above encourages lower investment Garage Case – Concepts / RdN © Simulated results uncertainty Why is Right-hand side “gone”? Lower demand => Loss .0 Garage Case – Concepts / RdN © . Higher demand => Gain limited by garage size 600 5-floor design Frequency 500 Simulated Mean 400 6-floor design 300 Deterministic Result 200 100 0 -17.Effect of uncertainty on analysis Changes results – Why? Ø Non-linearities in model Lowers results in this case -.6 3.

3 Result of 0.9 Probability 0.1 0 -20 -15 -10 -5 0 5 10 Garage Case – Concepts / RdN © Recognizing uncertainty => different design: 5 floors EXPECTED NPV ($.4 floor) Implied CDF for 0.7 0. MILLIONS) 10 5 0 2 3 4 5 6 7 8 9 -5 -10 -15 NUMBER OF LEVELS TRADITIONAL NPV RECOGNIZING UNCERTAINTY Garage Case – Concepts / RdN © .8 0.2 Deterministic NPV Analysis (6-floor) 0.5 Simulation Analysis (5- 0.6 CDF for Result of 0.NPV Target Curve (CDF) Compare Actual (5 Fl) with unrealistic fixed 6 Fl design 1 0.

foundations Ø More cost than for inflexible garage with same number of floors. opportunities Ø According to how future develops Ø We exercise intelligent management of development of system over time How do we do this here? Ø Make it possible to add more levels as needed Ø Stronger columns.Recognizing uncertainty => different value! Value calculated for deterministic case = $6.5 million deterministic value is FALSE Conclusion: deterministic analysis has given both wrong design and value! Garage Case – Concepts / RdN © Introduce flexibility into design How can we make garage design “flexible”? What is flexibility? Ø Ability to adjust project to needs. = $3. Garage Case – Concepts / RdN © .2 million Value with uncertainty much different.

600 $12.600.287 Including Flexibility => Another.600.878.517.000 $16.200.000 $3.044 800 1.536.000 $8.600.000 $3.898.519 1.270.000 $2.600.440.140 Why is the optimal design much better when we design with flexibility? Garage Case – Concepts / RdN © .000 $689.000 $974.304 $8.000 $3.800.190.000.160.000 $10.200 expand 400 $8.136 $9.000 -$4.000 $1.000 $3.000 $3.600.200.416 $3.000 $30.600 20 1.000 2 3 924 1.647 1.000 -$6.320 $2.400.200.000 $3.000 $7.474 $10.000.600.440.Result – greater expected value Year Demand Capacity Decision on expansion Extra capacity Revenue Recurring Costs Operating cost Land leasing cost Expansion cost Cash flow Discounted Cash Flow Present value of cash flow Capacity cost for up to two levels Capacity costs for levels above 2 Price for the option Net present value 0 1 820 800 $8.390.000 $4. better design: 4 Fl with stronger structure enabling expansion Garage Case – Concepts / RdN © Summary of design results from different perspectives Note: good result from deterministic case is a sham Perspective Deterministic Recognizing Uncertainty Simulation No Yes Option Embedded No No Incorporating Flexibilty Yes Yes Design 6 levels 5 levels 4 levels with strengthened structure Estimated Expected NPV $6.000.944.000 $3.144.600.238.000 $3.320 $2.392.400.287 $6.600 $15.214 19 1.600.000 $953.734 $1.500.000 $3.

600 $21.168 -$18. 1 dimension is not enough Design Initial Investment Expected NPV Minimum Value Maximum Value Design with Flexibility Thinking Design without Flexibility thinking (4 levels. Interpretation of results Why do Flexible designs systematically provide better value? What is the insight? Does Flexibility cost? Why it can be “win-win” Garage Case – Concepts / RdN © .517.536.Multi-dimensional valuation For uncertainty.790.062 $29.602 Comparison Better with options Better with options Better with options Better with options Everything is better! How did it happen? Root cause: change the framing of design problem From: focus on a (mythical) forecast or set of specs To: managing (realistic) uncertainties by flexibility Garage Case – Concepts / RdN © 3.651. strengthened structure) (5 levels) $18.138.024.200 $10.140 $3.474 -$13.316.081.838 $8.

7 0. Profit from Upside Cumulative Probability Expand upside potential Original distribution Distribution with flexibility Cut downside risks Value Garage Case – Concepts / RdN © Sources of value for flexibility 1) Minimize exposure to downside risk! 1 0.2 0.8 0.1 0 -20 -15 -10 -5 5-Floor Design 0 5 10 4-Floor Design Garage Case – Concepts / RdN © . Expand Upside Avoid downside .6 0.Sources of value for flexibility Cut downside .4 0.3 0.5 0.9 Probability 0.

0% Mean for NPV with Flexibility 20.0% 0.Sources of value for flexibility 2) Maximize potential for upside gain! 100.0% Probability 70.0% Mean for NPV without Flexibility 80.0% 90.0% 50.0% 10.0% CDF for NPV without Flexibility 30.0% -20 -15 -10 -5 0 5 10 15 20 25 30 35 Garage Case – Concepts / RdN © What is cost of flexibility? Often said: “Flexibility costs” In what sense is this true? Clearly 4-story garage with strength to add floors cost more than an inflexible one that does not have this capability Is flexible design more expensive? Garage Case – Concepts / RdN © .0% CDF for NPV with Flexibility 60.0% 40.

Defer costs. and thus decrease their NEGATIVE Present Value 3. it saves money 3 ways.What is fair comparison? To be fair. what is best choice? Ø 5 or 6 story garage!! Fair comparison is between Ø flexible design 4-stories Ø Inflexible 5 or 6 stories Garage Case – Concepts / RdN © Flexible Design as Win-Win Flexible design not only increases value. compare relative cost of design with flexibility with one without So. You can: 1. Build smaller – don’t have to meet future needs right at start 2. Avoid costs completely – some projected needs will not occur Garage Case – Concepts / RdN © . if you had to make a 1-time decision.

4.17: Spreadsheet for Garage Case (Source: “Flexibility in Design”) Garage Case – Concepts / RdN © . Decision Rules 1: What is different about analysis for “garage case”? 2: How we implement flexibility in spreadsheet analysis Garage Case – Concepts / RdN © What is different? Here is image of a spreadsheet for garage case: How does it differ from standard format? Figure D.

“expand”.Difference subtle but crucial Difference not immediately visible Difference is in formulas behind number: … Rules for exercising flexibility Ø The way we implement flexibility in spreadsheet Ø “If” statements that trigger actions based on past situations Garage Case – Concepts / RdN © Implementation of a Rule In cell E6 (which has ‘expand’ in it: Ø IF(AND(D4<MAX_CAP.E5) = D5+E5).D5) + MIN(E4.E5) = D5+E5 => demand in past 2 years more than current capacity of garage Ø Then “expand”.D5) + MIN(E4. for more capacity next year – or “” Garage Case – Concepts / RdN © . MIN(D4. “”) Interpretation Ø IF(AND => two conditions to be respected Ø (D4<MAX_CAP => number of spaces in previous year less than maximum capacity Ø MIN(D4. triggers expansion cost in E11.

to reflect changing situations Examples for garage case? Ø Expansion at end of project may not make sense. Not enough time to make profits to pay for costs.How many “rules” ? What is limit on number of rules? Ø No theoretical limit Ø Practical limit … we and eventual audience for analysis … may get confused Rules need to cover important possible decisions Ø Expand or not? Ø Close? Ø Raise prices? Etc. Garage Case – Concepts / RdN © Can rules vary over time? Often should. Ø May want to include consideration of changing construction costs Garage Case – Concepts / RdN © .

M.-A. MIT Technology and Policy Program. http://ardent.Is it “right” rule? What is criterion for “right” rule? Two perspectives: Ø Descriptive (you do): Rule reflecting managers’ choices (might not be optimal!) Ø Normative (you should): Rule to maximize Expected Net Present Value (ENPV) Not obvious how to determine optimal Ø Can try several possibilities Garage Case – Concepts / RdN © Reference Cardin. May.mit.edu/real_options/Real_Opts_papers/ Cardin_SM_Thesis..pdf Garage Case – Concepts / RdN © .” Master of Science thesis. “Facing Reality: Design and Management of Flexible Engineering Systems. 2007.

suppliers) Ø Compatible regulations – they can change Garage Case – Concepts / RdN © Implementation plan needed More on this later Basics concept is that you have to keep flexibility alive: Ø Knowledge of Possibilities Ø Collaboration of stakeholders Ø Monitoring.5. anticipating regulatory changes An implementation plan necessary part of good design Garage Case – Concepts / RdN © . Example: Bluewater model for this case What happened? Ø Ignorance of new owners Ø Ready collaborators (designers. Implementation Caution: We need to make sure that flexible designs can be implemented when needed.

Summary of Concepts Flexibility Design is practical and used by top professionals It increases expected value by Reducing downside losses Increasing upside gains Ø Thus improving on many dimensions Ø Ø It can be a “win-win” solution It requires thoughtful implementation Decision rules are “secret sauce” for analysis of flexibility Garage Case – Concepts / RdN © .

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