A real options model for valuing flexible space

Abstract

The continuous need for change in corporate real estate spaces warrants consideration of flexibility in new space design. To help decision makers invest more effectively in physical infrastructure and its ability to evolve, a formal method of identifying and valuing flexibility is developed. A model, based on real options techniques for valuing managerial flexibility, is constructed to answer the following question: how much is it worth to invest in a space that could be renovated to office space for a specified renovation cost in the future? Decision makers can use the option valuation results to determine whether the initial design and construction costs to achieve flexibility are justifiable. The transparent model is intended to be accessible to design teams in practice. It is an improvement on net present value and first‐cost based decision‐making techniques in that it explicitly accounts for uncertainty and for the ability of managers to make a rational future decision (between renting and renovating). The model considers three sources of uncertainty: the market price of rent for office space (as measured by volatility); date of space need; and amount of space need. Input values and/or probability distributions are needed for these variables. The model is constructed using a binomial lattice technique and Monte Carlo simulation. Results are given in a format that allows for comparison with cost estimates of physical architectural designs. For example, in a case study where current five‐year office‐space leases are estimated at US$98 per square foot and 0.39 annual volatility and the mean amount of space needed in the future is 50 per cent of the total, the real options valuation suggests that it is worth up to US$40 per square foot in initial investment expenses to achieve a space that could be renovated to office space for US$25 per square foot within the next eight years. The concept of addressing risk through ‘flexible design’ and analysing the value of flexibility is pertinent to judicious management of any new building project that is subject to uncertain future conditions.

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