Combining Monte-Carlo Simulations And Options To Manage Risk Of Real Estate Portfolios

This paper aims at showing that using simultaneously Monte-Carlo Simulations and options theory may improve real estate portfolio valuations accuracy. Our method considers the options embedded in lease contracts, especially as conceded to tenant in continental Europe. We combine Monte-Carlo simulations for both the market prices and rental values with an optional model that takes into account a rational tenantís behavior. We analyze to what extent the options exercise by the tenant significantly impact the ownerís income. Our main findings are that simulated cash-flows taking into account such options are more reliable that those usually computed by DCF traditional methods. Moreover this approach provides interesting measurements such as the cash-flows distribution, the probability of leaving for the tenants and the derived optimal holding period for the owner. The model also provides a risk measurement by computing the Value-at-Risk and a risk-adjusted performance measurement by computing a forward Sharpe Ratio of the considered portfolio. After a brief review of literature on simulations methods used for real estate valuation, the paper describes the suggested simulations model, its main assumptions, and the incorporation of tenantís decisions as break-options influencing the cash-flows. Finally, through an empirical example, we analyze the sensitivity of the model to various parameters and we test its robustness.