New Generation Whole‐life Costing: Property and Construction Decision Making under Uncertainty

Citation

Ooi, J.T.L. (2007), "New Generation Whole‐life Costing: Property and Construction Decision Making under Uncertainty", Journal of Property Investment & Finance, Vol. 25 No. 6, pp. 668-670. https://doi.org/10.1108/14635780710829333

The seminal work by Titman (1985) stimulated using real options theory as a new and useful way to interpret land values under uncertainty. Investments in real estate structures, once put into place, are highly durable and costly to reverse. The option value approach implies that vacant land has greater value than the expected discount return to current development because it reflects the value of being able to adapt development plans to future market conditions as they become known.

While option theory offers a useful way of modeling property value under uncertainty, it is not widely appreciated or adopted by the industry. This can be attributed in part to poor dissemination of the concept, which is couched in academic and mathematical terms that may not be readily understood by real estate practitioners. New Generation Whole‐Life Costing: Property and Construction Decision Making under Uncertainty is a valuable addition to the literature as it is written with the practitioners in mind. The book is written in a non‐technical way to reach out and disseminate the innovative concept to the industry. The 208‐page book is divided into 14 chapters. Each chapter is appropriately structured around a real case with the key concepts drawn out from the story to aid decision makers understand and apply option theory to real estate and construction decisions.

The first five chapters are devoted to basic ideas on evaluating long‐term projects under uncertainty. The foundations are laid in Chapter 1 to Chapter 4 where fundamental concepts related to net present value and discounted cash flow analysis are covered. Chapter 1 starts with the case why it is always a good idea to carry out quantified evaluation of construction and real estate projects. The authors argue that gut feel and quantified methods should be complementary aspects of top level decision making. The time value of money concept, the building block for all financial and investment analyses, is presented clearly in Chapter 2. The shortcomings of the simple payback method to decide whether to go ahead with a project are also highlighted. Chapter 3 explains how uncertainty and project risk can be represented and incorporated into project evaluation. In addition to conventional risk concepts such as volatility, expected value, risk aversion and risk‐adjusted returns, the authors also illustrate how the binomial tree can be employed to give a quantified picture of uncertainty. Chapter 4 focuses on the data required to carry out whole‐life costing analysis, namely estimating the project cash flow, and choosing the discount rate. The CAPM and WACC concepts are introduced in a non‐technical way.

Those who are familiar with time value of money and discounting can go straight to Chapter 5, which explains the lifecycle options and shows how they provide the basis for a new generation of whole‐life costing. For those who are not in the construction industry, the term “whole‐life costing” needs to be defined first. Simply, it is the application of net present value analysis to construction projects[1]. The authors argue that option value will always figure strongly in overall project value and in the choice between investment alternatives. They highlight many lifecycle options which exist but are unrecognized by the owner of a building, such as the options to sell, develop, improve, refurbish and so on[2]. These are rights that come with property ownership, or “embedded options” as they are commonly known in the economic literature. Decision makers who do not recognize and appreciate these embedded options may undervalue their property assets and inadvertently, destroy the value associated with the embedded options. In the face of constant changes, investors are naturally reluctant to make expensive and long‐term commitments that are likely to change in a few years. It is not uncommon for buildings to be reconfigured to meet changing needs. This justifies why a developer may insist on a design which can be subdivided easily even though it reduces the building's efficiency. Whilst it is reasonably easy to estimate the cost of providing the option to switch use during the design stage, valuing the option poses a greater challenge. Anchoring around case study applications of lifecycle options, Chapter 6 to Chapter 11 addressed how the value of various embedded options can be valued. These include the option to develop (Chapter 6), option to expand (Chapter 7), option to switch use (Chapter 8), option to reconfigure (Chapter 9), option to refurbish (Chapter 10), options on new technology (Chapter 11). In the process, readers will get acquainted with the valuation of put and call options and how much one should pay for procrastination and flexibility under uncertainty.

Chapter 12 presents the case for time‐varying discount rates to value very long‐term projects. Even with a low discount rate of 3 per cent, the authors argue that in the very long term it still reduces future values to practically nothing, which is not satisfactory. Consequently, for assets that have very long‐term value, they suggest a gradually reduced discount rate for more distant benefits. The 2003 revision of the UK government treasury's guidelines on public sector investment, which recommended a rate that starts at 3.5 per cent per year but declines to 1 per cent for benefits accruing beyond 300 years in the future, was cited a case in point. Chapter 13 uses simulation to study budgeting when service lives are uncertain to determine the occurrence of replacement. In closing, Chapter 14 presents a non‐quantified tool for assessing whole‐life costing issues in a decision context.

I would recommend this book to developers, facility and property managers who seek a new approach to understand option values, minimize long‐term risk and optimize their decision making under uncertainty. I find the book easy to read and comprehend. The coverage of the basic concepts in the first few chapters, such as time value of money, discount rate, etc. is surprisingly crisp and refreshing. The book does not assume the readers have any prior training in investment and finance. Hence, these chapters serve as very good background and self‐reading materials for those who are new to investment analysis. The case for adopting the option value approach to capital budgeting decisions and risk management is expertly developed through the real life case stories which practitioners would readily identify with. The case studies are further backed by clear presentation of basic principles and mathematical techniques. It will definitely provide a stimulating introduction to the application of options to real estate decision making. Finally, there is a section on useful references for readers who want to find out more on the various concepts discussed.

Notes

Whole‐life costing in the construction convention is normally used to compare alternative specifications for building components, rather than a building project as a whole. Consequently, the objective is to find the component with the lowest whole‐life cost.

For example, many buildings are capable of expansion, so their owners have an option to expand. Another example is the option to switch use, say between retail and office use for the ground floor space of a commercial building.