Authors’ Preface

What this book is about, and how to use it.

This book is a groundbreaking text for real estate developers and investors. It is about uncertainty: “unknown unknowns.” It shows how the flexibility that exists in real estate investments and development projects unlocks hidden value, and it provides easy‐to‐use tools to quantify that hidden value. If you are a developer or investor, you know that uncertainty pervades your decision‐making, and you intuitively realize the importance of flexibility for dealing with unexpected future outcomes. Flexibility includes such capabilities as the ability to sell a property whenever you choose, to delay a second phase of construction, or to change from building a hotel to building apartments. This book describes an approach to realistically quantifying the nature and effect of future uncertainty, and to putting a monetary value on these types of flexibilities.

Our approach is easy to use because it is based on the industry‐standard spreadsheets of discounted cash flow analysis. It efficiently calculates the values of flexibilities and options, and quantifies the nature of risks and opportunities. In contrast to the complex, highly mathematical procedures that academics and some Wall Street or City “rocket scientists” often use to calculate option value, the approach we present is intuitive, transparent, easy to implement, and, we think, more informative for real estate decision‐makers. The procedures described in this book are direct analogs of management decision‐making, not academic economic models of market equilibrium. In the real world of real estate investment decision‐making, this approach adds fundamental and crucial aspects of reality that are currently too much ignored or treated only with seat‐of‐the‐pants intuition. Namely, we include the explicit and quantitative consideration of uncertainty and flexibility.

The text presents and describes in detail this innovative and simple approach to valuing the types of real estate flexibility that commonly exist in real‐world investment and development. Building naturally and easily on the familiar current practice of project valuation and financial analysis, the procedure we present completes the analysis and makes it much more powerful and useful. It enhances one’s capability to evaluate the multiple, interacting options and contingencies that arise from market changes. Importantly, it does more than calculate the expected, or average, value of real estate options. It describes the range of possible outcomes, and so informs users about the possible risks and rewards, quantifying the “downside” and the “upside.” We believe it does so with sufficient depth and realism to usefully inform project planning and design decisions.

Essentially, we exploit the power of modern personal computers, combined with knowledge derived from newly available empirical data about real estate markets. Instead of using complex mathematical computations based on limited assumptions about the nature of uncertainty (for example, the random walk assumption), we use laptops to explore in detail what may actually occur. The procedure simulates the effects of the many different kinds of uncertainties that may exist, and considers the implications of a range of possible decisions that managers might take. This enables users to explore strategies of management and development in the light of a sophisticated valuation of the flexibility that exists. You can think of our approach as providing a way for decision‐makers—with more, or less, experience—to transform their intuitive sense of managing risks and exploiting opportunities into more solid, defensible, quantitative economic valuations of real estate options. Our approach is:

• Valuable: It unlocks added value by exploring options that might provide a significant increase in expected value; this may be done by exploiting upside opportunities, avoiding downside risks, and, in some cases, decreasing initial costs;
• Practical: It simply extends the standard spreadsheet‐based discounted cash flow analyses for valuing real estate projects that practitioners are already at ease with, requiring no additional special software; and
• Realistic: It builds on over 30 years of collaboration between the commercial real estate industry and the Center for Real Estate at the Massachusetts Institute of Technology (MIT), and over 90 years of combined professional investment, engineering, and teaching experience of the authors.

The Value Proposition

The book enables real‐world practitioners—managers, investors, and developers of real estate properties and projects—to evaluate their real estate options quantitatively. Practitioners can use this book to identify opportunities to increase their expected value using various types of flexibilities that can exist in real estate investment, and particularly in development projects. These opportunities arise from the possibilities to:

• Time the start, stop, or sale of developments or investments to their advantage;
• Change the mix of uses, or even the scale and density, in a development in accordance with changing market priorities; and
• In general, manage and develop properties’ flexibilities to exploit opportunities as they arise, while also avoiding risks that may crop up.

Taken together, these options allow developers to deal proactively with the many uncertainties that inevitably confront the development of real estate projects.

The use of options in real estate can significantly increase the expected value of real estate development in three ways. It can enable decision‐makers to:

• Exploit new opportunities arising from favorable upticks in market conditions;
• Reduce or avoid the downward consequences associated with unfavorable circumstances; and
• Increase the rate of return while reducing the risk in the return on investments, or reduce their initial capital requirements—for example, by delaying the implementation of project stages until the market becomes more favorable, or by resizing the initial investment to consider future expansion possibilities.

Users taking advantage of the flexibility of real options can put themselves ahead of the competition. The ability to identify greater value in investment and development projects will enable practitioners to win more opportunities. The capability to deploy innovative designs that enhance the value of new developments by incorporating valuable options should improve investment performance.

Using this approach to quantitatively document the value of options can strengthen the case for certain projects. In other cases, scenario exploration can reveal cautionary considerations that are important for investors and principals to take into account before launching the project. The methods in this book can help test the intuitive sense of opportunities and, where appropriate, demonstrate the value of options that developers are considering for a project. Reducing uncertainty by shining a more quantitative “light” on the nature of the risks faced by the developer, scenario and simulation analysis can better facilitate financing of potential projects (or weed out more risky projects). Overall, the solid analysis and the use of real estate options give practitioners an advantage over any competitors who ignore this new capability.

This innovative book is inherently future‐oriented. It describes how real estate valuation can evolve, learning from, but not repeating, the past. It’s for the new generation used to living in a world of “big data.”

Accessibility

Our approach is eminently accessible. It builds on the standard spreadsheet analyses that industry practitioners already use to evaluate projects. It extends this method to the valuation of options through commonsense and logic. It simply exploits the power of modern computers to search through a range of possibilities, to calculate the results of alternative actions, and to display those results in intuitively understandable ways. The process thus avoids the use of complicated mathematics.

We have designed the presentation for easy learning and adoption. We provide a suite of practical, realistic tools to value real estate options in different circumstances. We present this material in easy‐to‐read, bite‐sized steps. These steps build up from simple demonstrations to examples that have a degree of realism useful for actual business decision‐making. Illustrative cases and simple worked‐out examples guide users through the process. Beyond the book, an accompanying website provides spreadsheet templates that practitioners can download and adapt to their own needs.

The approach presented here results from the collaboration of two leading teachers at MIT, David Geltner and Richard de Neufville. Professor Geltner is the principal author of a leading industry text, Commercial Real Estate Analysis and Investments (3rd edition, OnCourse Learning). Professor de Neufville is the lead author of Flexibility in Engineering Design (MIT Press) and six other textbooks on systems analysis, planning, and design.

How to Use this Book

Before diving in, please take a moment to look at how we have structured the text. We have designed this book to smoothly and easily introduce real estate managers, investors, and...