Major leaps forward in real estate thought leadership are few and far between, such as the application of discounted cash flow to real estate valuation in the 1970s, and of portfolio theory to property investment in the 1980s and 1990s. This seminal book by Professors Geltner and de Neufville provides the vanguard for the next major leap in thought leadership, being optionality in real estate.

While optionality, as distinct from option pricing theory, has been conceptually discussed by the world’s leading real estate academics for the last few years, including at the landmark RICS Foundation Global Symposium on “Optionality” in early 2012, little has been written until now.

Similarly, while the use of spreadsheets for development cash flows and the application of probability analysis and scenario analysis are not new ideas, their combination within a framework of flexibility or optionality is a new concept. This changes the way we think about real estate valuation, with their guided application through the use of spreadsheets rendering them accessible to all practitioners. Such techniques as probability analysis and scenario analysis are no longer possible add‐ons to development cash flows, but now have a central role.

Henry Ford is often misquoted as saying:

If I had asked people what they wanted, they would have said “faster horses.”

This was academia’s previous response to the real estate industry and profession through such developments as financial management rate of return and the modified internal rate of return for discounted cash flow. This book does not provide a faster spreadsheet or a simpler probability application, but instead provides a new way to conceptualize real estate as a bundle of opportunities with positive or negative contributions to value that can be combined to optimize value to an individual party or to a market. Significantly, rather than the traditional view of land value theory, this book views land as a call option on development. As the authors note in the Preface:

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.

Optionality in real estate valuation essentially addresses the three realms made famous by former US defense secretary Donald Rumsfeld—known knowns, known unknowns, and unknown unknowns—providing a framework within which each may be quantified and modelled. It is optionality manifest in flexibility arising from uncertainty in the investment and development process, which is the focus of this book.

This book logically and sequentially moves through three phases—acquainting the reader with the quantitative foundations, then introducing the concept and framework of optionality, before combining these through application to an increasingly detailed example of a real estate project.

Chapter 1 sets out the rationale for and structure of the cash flow model, with a focus on retrospective and prospective assessment, while Chapter 2 extends the discussion to net present value (NPV) and internal rate of return (IRR), with a focus on the opportunity cost of capital and the discount rate. Chapters 3–8 introduce the recognition of uncertainty through probabilities and scenarios, simulation, pricing factors, and random walks, importantly recognizing the differences between inputs and outputs. Chapters 9 and 10 apply these quantitative foundations to a simple example of optionality in real estate, being the sale timing decision. Chapter 11 moves to the development process and the opportunity cost of capital for construction, while Chapter 12 focuses on the decision of whether and/or when to develop.

The concept and framework of optionality in the context of real estate are introduced in Chapter 13, with Chapter 14 focusing on product options and Chapter 15 on timing options. The quantitative foundations and concept and framework of optionality are then combined through application to the large‐scale Garden City residential development project. Chapter 16 presents the traditional cash flow, with uncertainty (but without flexibility) discussed in Chapter 17. Both uncertainty and flexibility are examined in Chapters 18 and 19 through the start date, in Chapter 20 through modular production timing flexibility, in Chapter 21 through product mix flexibility, and in Chapters 22 and 23 through sequential phasing delay. The use of the same example evolving through a series of chapters allows the reader to easily understand the respective applications and their differing impacts on the outputs of the analysis.

Chapter 24 then summarizes the book. Text boxes throughout provide illuminating commentary, and the Appendix provides key information on the real estate system, uncertainty, and the eight components of real estate price dynamics. The accompanying website provides very helpful sample spreadsheets and supporting material. Usefully, each chapter is bite‐sized, being generally 15 pages or less and written in a conversational style that makes reading both quick and enjoyable, satisfying the author’s intention to present:

… common‐sense methods rooted in the spirit of engineering, rather than highly complex models typical of academic literature in the field of economics. (Chapter 24)

Significantly, the book bridges concepts of value with development analysis. Rather than the traditional focus on concepts of market value, the book views development through the lens of investment value (or its economic equivalent, private value) from the perspective of the developer, which is contingent on the ability and willingness of the developer to exercise the flexibility being modelled. A key output of this book for valuation theory is the bridging of investment value and market value in a development context:

Furthermore, at a deeper level, private valuations underlie, and determine, market values. Buyers will not pay more than their private valuations for an asset, and sellers will not take less than their private valuations for assets they own. The equilibrium prices that we define as market values evidenced by consummated transaction prices can therefore reflect private valuations. (Chapter 19)

The overall contribution of this book to an understanding of flexibility and optionality in real estate is aptly summarized by the authors:

We can distill the results of our analysis into a general rule: Make as much of the project as flexible as possible, as early as possible, but think about the implications of the market cycle.

Professors Geltner and de Neufville are to be commended for their contribution to the next major leap in real estate thought leadership, being optionality in real estate.

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 developers to new ways to evaluate and improve their projects. The book presents the new approach one concept at a time. It builds up your understanding, step by step, in short chapters that you can cover in about an hour each. We illustrate topics with practical examples. And we have written the text in straightforward language. The goal is to help you quickly understand the concepts and the principles of how you can use flexibility and options to create and increase value in real estate.

The basic idea is to imagine what could happen and then examine the consequences. It’s a “what if?” analysis. We show how to do this simply and quickly using laptops. A computer simulates the possibilities and the consequences rapidly—thousands of times in just seconds. The process then compares the results to identify the benefits of possible flexible strategies and options.

The process mechanics should be accessible to practicing real estate analysts. The calculations build on the standard financial spreadsheets (such as Microsoft Excel^®) that are almost everywhere in real estate valuations. The approach does not involve fancy mathematics—we just calculate possible values many, many times. Nor does it require special software beyond standard spreadsheets such as Microsoft Excel^®. We use a disciplined approach structured to provide the results numerically and graphically.

In addition, the analyses are transparent. The spreadsheets clearly display inputs and assumptions and allow users to change them easily. Users are not required to assume that uncertainties and trends are stationary (that is, do not alter over time), a commonly required assumption in academic economic options models.

We describe (and provide freely via the web) a series of spreadsheet templates to simulate a plausible range of possible uncertain outcomes based on our knowledge of real estate markets, and to calculate the resulting distribution of the investment performance outcome for a typical illustrative project. The electronic templates effectively supplement the examples in the text for readers who want to replicate the examples or build on them to create their own applications. Thus, the web material, which is well annotated at the “nuts‐and‐bolts” level in Microsoft Excel^®, can be used by readers who want to value flexible real estate strategies themselves. The web material is also suitable for students, either in class or for self‐study.

In a nutshell, the way to access the material is to:

• Read the text for overall comprehension of our approach;
• Dip into the web material for detailed explanations as desired; and
• Draw on the web material for detailed examples and templates you can use as starting points for your own projects.

The authors gratefully acknowledge the professional support and advice of Professor David Parker of the University of South Australia and Dr. Paul McNamara of Linden Parkside Ltd in the UK; the technical support of our graduate assistants Nick Foran, Saurabh Jalori, Eric Mo, and Qing Ye; the helpful feedback of the hundreds of MIT and Harvard students who have followed our class at MIT over the years; our home copy editor Susan Matheson; our Wiley‐Blackwell editor Paul Sayer; and of course the Wiley‐Blackwell production team in the UK and India, including Blessy Regulas, Adalfin Jayasingh, Shalisha Sukanya Sam and Aravind Kannankara.