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Combining Monte Carlo Simulations and Options to Manage the Risk of Real Estate Portfolios

  • Charles-Olivier Amédée-Manesme

    (THEMA - Théorie économique, modélisation et applications - CNRS : UMR8184 - Université de Cergy Pontoise)

  • Michel Baroni

    (Finance Department - ESSEC Business School)

  • Fabrice Barthélémy

    (THEMA - Théorie économique, modélisation et applications - CNRS : UMR8184 - Université de Cergy Pontoise)

  • Etienne Dupuy

    (Real Estate Investment Services - BNP-Paribas)

This paper aims to show that the accuracy of real estate portfolio valuations can be improved through the simultaneous use of Monte Carlo simulations and options theory. Our method considers the options embedded in Continental European lease contracts drawn up with tenants who may move before the end of the contract. We combine Monte Carlo simulations for both market prices and rental values with an optional model that takes into account a rational tenant's behavior. We analyze to what extent the options exercised by the tenant significantly affect the owner's income. Our main findings are that simulated cash flows which take account of such options are more reliable that those usually computed by the traditional method of discounted cash flow. Moreover, this approach provides interesting metrics, such as the distribution of cash flows. The originality of this research lies in the possibility of taking the structure of the lease into account. In practice this model could be used by professionals to improve the relevance of their valuations: the output as a distribution of outcomes should be of interest to investors. However, some limitations are inherent to our model: these include the assumption of the rationality of tenant's decisions, and the difficulty of calibrating the model, given the lack of data. After a brief literature review of simulation methods used for real estate valuation, the paper describes the suggested simulation model, its main assumptions, and the incorporation of tenant's decisions regarding break options influencing the cash flows. Finally, using an empirical example, we analyze the sensitivity of the model to various parameters, test its robustness and note some limitations.

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Paper provided by HAL in its series Post-Print with number hal-00671067.

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Date of creation: 01 Jan 2011
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Handle: RePEc:hal:journl:hal-00671067
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  1. Fabrice Barthélémy & Jean-Luc Prigent, 2009. "Optimal Time to Sell in Real Estate Portfolio Management," The Journal of Real Estate Finance and Economics, Springer, vol. 38(1), pages 59-87, January.
  2. Baroni, Michel & Barthélémy, Fabrice & Mokrane, Mahdi, 2004. "Physical Real Estate: A Paris Repeat Sales Residential Index," ESSEC Working Papers DR 04007, ESSEC Research Center, ESSEC Business School.
  3. Baroni, Michel & Barthélémy, Fabrice & Mokrane, Mahdi, 2006. "Optimal Holding Period In Real Estate Portfolio," ERES eres2006_123, European Real Estate Society (ERES).
  4. Martin Hoesli & Elion Jani & André Bender, 2005. "Monte Carlo Simulations for Real Estate Valuation," FAME Research Paper Series rp148, International Center for Financial Asset Management and Engineering.
  5. Fabrice Barthélémy & Jean-Luc Prigent, 2008. "Optimal Time to Sell in Real Estate Portfolio Management," THEMA Working Papers 2008-13, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
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