Why a lack of advanced modeling techniques? Anyone who uses probabilistic modeling justification for this?

From what I have seen, real estate modeling (at least on an asset level) seems to be relatively rudimentary in comparison to almost all other financial sectors, could anyone possibly speak to why very few firms utilize advanced modeling techniques and probabilistic modeling in real estate? Or if your firm does use these techniques, what programs are you using and in what context are you using this?

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Comments (35)

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Dec 19, 2018 - 1:55pm

Because there are so many variables in a real estate deal that are subject to change, that running probability analysis above and beyond pretty simple sensitivity matrices becomes a dumb mental jerk-off exercise that is not grounded in reality.

Take a traditional development deal. Things that are almost guaranteed to change from start to finish--construction duration, actual start date, final hard costs, the size and rent on the initial pre-lease, the pace and lumpiness of the cash flows from the balance of the lease-up, the interest carry on floating debt, the property tax bill at stabilization, the actual value of concessions, how much density you actually get approved...there are a billion items that change. Better to come up with a concept you think stands a reasonably likely chance of being built and run that on general market assumptions, than do a circle jerk.

Some shops do it though, I think it is an incredible waste of time and analysis by paralysis.

Dec 19, 2018 - 1:58pm

Complete waste of time, totally agree. You really only need to have one case in real estate investing in my mind, the downside case. If you are comfortable with this case and still think the deal is good, then you don't need to spend time doing a ton of what-ifs on every other slight change in variable.

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Dec 19, 2018 - 2:01pm

I think there is an important distinction to make here: portfolio level vs asset level. In regards to a asset-level analysis, these types of sensitivity's or analyses are largely a waste of time, however, on a portfolio level. I work on the asset level side but I would venture to assume this type of analysis is being done on a portfolio level at some shops. Can anyone speak to this?

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Dec 19, 2018 - 2:06pm

Even at fairly large funds, this doesn't happen as often as you think (we don't do this deep of an analysis). Again, you're basically trying to predict a range of values, so rather than wasting time doing a billion+ combinations of different variables going up and down, most shops pick one metric and piggyback off that. For example, most groups will play with the exit cap rate and run down, base, and up side cases based on that. It gets you to the same place as if you do a ton of different rent growth projections, starting market rents, cap ex contingencies, etc. There are a lot more variables that can go into a real estate deal than almost any other asset class, so it's a lot more head trauma to do some of these 'advanced' metrics. If someone did this and was pitching us as the LP, candidly I would think they don't know what they're doing. I would have a much higher confidence level in a developer that walks into the meeting with a simple range of values based on one or two variables changing and then being able to speak to the process, as opposed to giving me a simulation that's taken into account all 1,956,345,754,342 possible combinations that are all based on pure speculation anyways.

"Who am I? I'm the guy that does his job. You must be the other guy."
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Dec 19, 2018 - 2:15pm

Because 99% of real estate firms are small potato's and employ zero PhDs

Come work for a company with trillion dollar+ assets and you will see those in use

Dec 19, 2018 - 2:20pm

Which firms are doing this? I have spoken with an applied math Phd who consulted for some of the multi billion aum firms helping them develop their models who said even they don't use these techniques

Dec 25, 2018 - 8:39pm

I worked at a half trillion dollar asset manager that employs a lot of PhD's. Most overrated people on the face of the earth. Just like the other commenters have already suggested . . they run all these extra numbers in an apparent attempt to make simple things complicated and justify their existence. Or as my dad would say, they piss on your head and tell you it's raining so they can sell you an umbrella.

They hired me out of IB into a job where some folks have a PhD and others have a "quanty" MBA that the PhD's deem analytical enough (I was in the latter category). It quickly became clear that everyone I work with, whether full PhD or quanty MBA, had avoided developing a fundamental valuation skill set because analyzing businesses is actually hard. Meanwhile building huge excel sheets and running all kinds of tests appears difficult but is actually quite simple and adds little value.

Got regular offers to join even larger managers (the multi-trillion kind) but had long since learned my lesson that math ability is not a source of alpha. Understanding how and why people (mostly and especially PhD's) misuse math is a useful thing though.

Dec 22, 2018 - 10:17am

If you want a practical guide for doing this in the RE industry, I highly recommend this book.

That said, I've talked about this with people who work at major REPE and development firms that invest many billions of dollars, and they don't seem to do anything more complex than scenario analysis. The authors of the linked book are academics who are trying to increase the sophistication of the industry.

Dec 27, 2018 - 10:13am

Academics who probably have never developed/managed/investing in a single development project. The most successful real estate investors/developers I know do simple back of the napkin analysis to determine project feasibility. They generate tremendous alpha through their ability to buy well located land below market and/or cut leases at above market rates with favorable legal terms to landlord.

Dec 23, 2018 - 9:53pm

It depends on asset class, if you're doing an office value-add with a lot of tenants and roll it could get pretty complicated with renewal probabilities. While buying NNN lease properties their isn't much to do. Some large Gateway players also have complicated models. If you doing a dev deal in New York and you got all your closing cost and tax assessment assumptions it can get very complicated.

Dec 26, 2018 - 2:52am

I cannot speak on behalf of other financial sectors, however, rudimentary modeling is sufficient because underwriting is primarily done on general assumptions. At the previous REIT I worked for and my current job within a Real Estate Advisory practice, we use ARGUS for Cash Flow modeling and paste into Excel models for the analysis of an Acquisition, Development and Disposition. At the previous REIT we maximum ran 4 scenarios and would do modeling based on 10 years (hold period). For example, Tenant renews at the expiration of a 5 year lease, Tenant vacates at the expiration of a 5 year lease and takes 6, 12, 18 months for lease-up.

Jan 2, 2019 - 9:45pm

On that note could it be argued that the real estate industry is largely stuck in the past terms of complexity of analysis or would you also agree that this would simply lead to analysis paralysis? I understand that it's difficult to quantify all the variables but having the ability to layer 30+ variables for example each with their own respective std. dev. and range of possibility to come to probabilities of success or failure would seem hugely beneficial especially when pitching to investors or investment committees possibly

Jan 3, 2019 - 11:40am

If you think it is 30 variables you are laughably mistaken. There is more than 30 variables in site inspections alone in a small development project. The average RE project I have has upwards of 150+ variables from project inception to completion, and these aren't even projects on the level of what is being discussed here. It isn't a reality that the industry wouldn't use more sophisticated analysis tools, it is just that the time it would take to do so is insane.

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