Decision theory and real estate development: a note on uncertainty

Purpose – 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. However, other variables 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 the developer will often carry out a sensitivity analysis on the development. This paper aims to look at the processes for so doing and the role of the decision maker in the analysis. Design/methodology/approach – 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. This requires a standardised approach and the use of a generic forecasting software package. Findings – There are numerous risks involved in the development of real estate. By allowing the decision maker to contribute to the assessment of these risks, the analysis provides the decision maker with a greater understanding of the critical variables and their impact upon the viability of the final scheme. Originality/value – This analysis shows that developers can get a better understanding of the upside and downside risks associated with their project.