Construction Economics

Why I choose Real Estate?

• Deals are won or lost by microscopic margin
• With knowledge of probabilistic valuation
methods, real options, and economics, real
estate professionals can effectively improve
the odds in their favor.
• Very low uses of Stochastic Models
• Disconnect between academia and industry.
 Current Industry Practice
1. MS Excel

• Despite the prevalent usage of Excel in the

workplace, generally very few features of the
program are used by professionals.
• Using special features of excel requires study
of computer programming.
 2.Discounted Cash Flow Analysis
• Involves projecting future years of cash flow
and discounting them using a risk adjusted
discount rate to arrive at the Net Present
Value.
• Limitations-
a)Single discount rate
b)Asymmetry between upside and downside risk
c)Ignores the effect of possible changes which
may occur to real estate over its life
 Reluctance to adopt New Techniques

• Small Team
• Lack of Reliable Data
• Humans try to avoid these negative
experiences that shake our confidence even if
great benefits are possible.
• Entrepreneurial nature of real estate industry,
real estate equity as a securitized asset only
began trading in 1960’s.
 Basic Terms
• A stochastic or probabilistic model relies on
probability to obtain its values.
• A deterministic model has no randomness
involved in generating its future output values
• Monte Carlo Simulation just refers to a
simulation where the number of iterations are
set by the user taking different input
parameters.
SimpleCo
 SimpleCo Tower: A Deterministic Example

• 10 story office tower ; Cost= $17M

• Assumptions- Rent and Discount rate
• After cash flow calculations for SimpleCo Tower,
NPV @ 12.5% discount rate is
-$135,000 and the IRR is 12.37% .
• The NPV will change with change in
assumptions .
• If other factors apart from what we have
assumed changes, THEN?
 ModerateCo Tower -Incorporating
Uncertainity into a Financial Model
• It expands on the SimpleCo Towers by adding
uncertainty to one of the assumptions (Rent
Growth).
• Excel’s random number function is used
• The uncertainty is created as a symmetrical
Normal Distribution around a mean that in
this case is 3% (Rent Growth).
• 5000 iterations were performed, mean of the
5000 NPVs to yield an Expected NPV.
 Comparison and Discussion
• Simulated NPN - $375,575 HUGE
• Deterministic NPV - $134,701 VARIATION?

# The Flaw of Averages and Jensen’s Inequality

• Flaw of Averages is a major error that occurs
when using averages in deterministic models
i.e. Historic Values instead of proper stochastic
variables.
 Jensen’s Inequality
“The average of all the possible outcomes
associated with uncertain parameters is
generally not equal to the value obtained from
using the average value of parameters”
• Symmetric distributed input variables leads to
an asymmetric distribution of output values,
model is said to be Non-Linear.
• Asymmetry between upside and downside
effects.
Figure- Non Linearity in the Rent Growth Rate

•The Flaw of Averages has a significant impact on

NPV and could spell the difference between
winning a bid and loosing a bid, as seen in the last
case studies.
Static Input Variables versus Random Walks
• The rent growth rate’s behavior in ModerateCo
model is static variable.
• Growth rates generally follow “Absolute
Randomness”; rates tend to vary around the
results from the preceding periods.
Pearson(1905) termed it as “Random Walk”.
• A random walk will allow an investment’s
profitability performance to decline and
recover over the investment horizon.
 COMPARISION

• Random walk behaviour

Figure-Random Walk illustration
adds greater volatility
to the model which
inflates the effect of the
Flaw of Averages even
further.

Figure- Comparison of Returns between

ModerateCo and SimpleCo
 Real Option Analysis in ChallengeCo using IF
Statements
• Two piece of info are required to model real
options-
1. What conditions need to occur before the option is
exercised?
2. What is the effect if the option is actually
exercised?
• After gathering this, Monte Carlo simulation
examines the effect of the option on the NPV in
comparison with an identical development without
the option.
 ChallengeCo
• 1st case – NPV for a development project with a
flexible design option built-in to the model to
construct an additional 10 floors later
• 2nd case – NPV for a standard 10 story
development with no option built in.
• 3RD case – NPV for a 20 story development
without an option built-in to the design
CDF of various alternatives plotted
Important Conclusions from Graph
• Flexible alternative can be advantageous
• When economic conditions are good, the
flexible alternative takes advantage of the
upside by exercising its option to build more
space.
• For investors seeking to limit their downside
exposure, while taking advantage of the upside
as much as possible, flexibility can be a major
win.
 Sources of Uncertainty in Real Estate

• Long-run Market Trend- Inflation,Depreciation

• Long-run Market cycle- Oscillating Nature
• Market Volatility- Monthly or Daily Variations
• Short-run Inertia – Previous year influence
• Individual asset volatility- Personal risk
• Individual Asset Pricing Noise- Appraisers
 BLACK SWAN EVENTS
• An “OUTLIER” – It lies outside the realm of
regular expectations, no relevance with past
• It carries an extreme impact
• Example - A new renewable energy
source(making combustion engine obsolete)
• Each type of uncertainty can be quantified on
their own. Then a Monte Carlo Simulation
outputs the effect of uncertainty as a whole on
real estate projects.
 Real Estate Indices
• Provides some of the data from which 7 forms
of uncertainty can be extracted.
1. Appraisal Based Indices
• Independent Professional Appraisals of
properties to track real estate markets
2. Transaction Based Indices
• Actual sales data of real estate to track market
3. Stock Market Based Indices
• Publicly traded Real Estate investment trusts