Decision Theory and Real Estate Development: A Note on Uncertainty

25 Pages Posted: 23 May 2005

See all articles by Elizabeth Atherton

Elizabeth Atherton

UK Nirex Limited

Nick French

University of Reading

Laura Gabrielli

IUAV University of Architecture of Venice

Date Written: May 1, 2005

Abstract

Real estate development appraisal is a quantification of future expectations. The appraisal model relies upon the valuer/developer having an understanding of the future in terms of the future marketability of the completed development and the future cost of development. In some cases the developer has some degree of control over the possible variation in the variables, as with the cost of construction through the choice of specification. However, other variables, such as the sale price of the final product, are totally dependent upon the vagaries of the market at the completion date. To try to address the risk of a different outcome to the one expected (modelled) the developer will often carry out a sensitivity analysis on the development.

However, traditional sensitivity analysis has generally only looked at the best and worst scenarios and has focused on the anticipated or expected outcomes. This does not take into account uncertainty and the range of outcomes that can happen. A fuller analysis should include examination of the uncertainties in each of the components of the appraisal and account for the appropriate distributions of the variables. Similarly, as many of the variables in the model are not independent, the variables need to be correlated. This requires a standardised approach and we suggest that the use of a generic forecasting software package, in this case Crystal Ball, allows the analyst to work with an existing development appraisal model set up in Excel (or other spreadsheet) and to work with a predetermined set of probability distributions.

Without a full knowledge of risk, developers are unable to determine the anticipated level of return that should be sought to compensate for the risk. This model allows the user a better understanding of the possible outcomes for the development. Ultimately the final decision will be made relative to current expectations and current business constraints, but by assessing the upside and downside risks more appropriately, the decision maker should be better placed to make a more informed and better decision.

Keywords: Development appraisal, uncertainty, decisions theory, sensitivity analysis

JEL Classification: C10, C15, R10, R15

Suggested Citation

Atherton, Elizabeth and French, Nick and Gabrielli, Laura, Decision Theory and Real Estate Development: A Note on Uncertainty (May 1, 2005). Available at SSRN: https://ssrn.com/abstract=727204 or http://dx.doi.org/10.2139/ssrn.727204

Elizabeth Atherton

UK Nirex Limited ( email )

Harwell, Oxfordshire OX11 ORH
United Kingdom

Nick French (Contact Author)

University of Reading ( email )

Whiteknights
Reading, Berkshire RG6 6AH
United Kingdom

Laura Gabrielli

IUAV University of Architecture of Venice ( email )

30135 Venezia, Venice
Italy

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