1 Real Options Analysis Office Tower Building Portfolio Presentation Fall 2008 ESD.71 Professor: Richard de Neufville Presented by: Charbel Rizk

Introduction 2 Application of Real Options in construction field Time between design and completion relatively long Large Investment, expected long life cycle Office Building Tower – Based on real projects 2 types of offices: o For Investor’s Use o For Sale Project completion around 2000 Lack of space in

Objective & Procedure 3 Analyze project based on tools and method learned in class: Identify main uncertainties in design: o Investor’s Office requirement o Market Demand (Offices, Stores) - For simplicity considered only Investor’s office demand Identify different scenarios: -Low; -Medium; -High Find possible (feasible) options to be added: o Original: Fixed, deterministic design o Re-buy Option o Option to Add Floors Evaluate all designs o Evaluation based on expected monetary value o Two stages decision analysis o Lattice decision analysis

Summary of Designs 4 Fixed design: (3 floors for investor’s use) o 7 Floors office tower o 4 Floors for sale Flexible contract: (2, or 3, or 4 floors for investor’s use) o 7 Floors office tower o 3 Floors for sale o 2 Other floors for sale with option to Re-buy Flexible design: (2, or 3, or 4 floors for investor’s use) o Start with 6 floors office tower o 4 Floors for sale o Option to add 1 or 2 Floors o Maximum number of floors is higher due to lower risk

Assumptions (Simplifying) & Expected Demand 5 Floors to be sold will be sold upon completion Time for execution 1 year Construction cost paid at t=0 r=10% i=2% Assumed Cost of not having when required based on lost opportunities Benefits are not included (Since using incremental NPV’s) Area per floor= 220m 2

General & Particular Costs 6 General, defined per unit applicable to all designs - Construction Cost - Maintenance - Running & Fees(Power, Ventilating, etc…) - Cost of Lacking space Particular, unit rate differs or not applicable to all designs - Permit cost - Option Cost a)Allow for Re-buy option in contract b)Allow for adding floors (thicker columns, etc…) - Strike price a)Re-buying floor/s b)Adding floor/s

Two Stages Decision Analysis 7 Probabilities are shown below Flexible contract or design : Add option to change decision Year 5

Two Stages Decision Analysis (Cont.) 8 NPV calculation for each end node ENPV calculation Pruning based on maximize ENPV

Two Stages Decision Analysis (Cont.) 9 Best Strategy & VARG: At t=0 choose flexible design a)If demand during first period Was high => Add 2 Floors b)If demand during first period was Medium => Add 2 Floors c)If demand during first period was Low => Don’t Add Floors

Lattice Decision Analysis 10 Determine: u, d, & p using: - Maximum Value= S u u => u= Sqrt(Max/S) - Minimum Value= S d d => d= Sqrt(Min/S) - Most Likely= p 2 * (S u u ) + 2*p*(1-p)*(S u d) + (1-p) 2 * (S d d) Results: -u= d= p=

Lattice Decision Analysis (Cont.) 11 Resulting outcome & probability lattice: Probability distribution function: Data for PDF:

Lattice Decision Analysis (Cont.) 12 Option evaluation: - Prepare cash flow per state & stage for each design - Find ENPV for each design: ENPV = Cash Flow Lattice * Probability Lattice - Decison Lattice (Strategy):

Lattice Decision Analysis (Cont.) 13 VARG For Lattice: - Enumeration of all paths (5 periods 2 decisions => 32 Paths) - Calculate PV for each path - Find probabilities and prepare cumulative distribution

Conclusions 14 Demand variance was small and still: - Based on decision trees: Flexible design was best alternative - Based on lattice analysis: Option value above $ 1 M All values are not accurate, they are upper & lower bounds only Designers should take uncertainty into consideration, especially with the availability of all new tools Discussion in this paper is based on NPV analysis only Other tools metrics can also be taken into consideration for example: - Benefit to cost ratio - Payback period - Risks - Range of outcomes (maximum, minimum)

15 Thank you For Your Time Comments? Questions?