Real Estate Development Financial Risk Analysis: Monte Carlo Simulation (MCS) Approach

*Wan Norhishamuddin Wan Rodi

*Center of Studies Estate Management, Faculty of Architecture, Planning & Surveying, UiTM Shah Alam hishamuddinrodi@salam.uitm.edu.my
Abstract This papers main principal aim is to demonstrate the application of Monte Carlo Simulation (MCS) on a proposed residential real estate development project and to interpret the results gathered from the analysis to deduce the conclusion regarding the level of risk inherent in a principal project. This study uses one sample of residential development project carried out in Malaysia. It was tested via the Monte Carlo Simulation (MCS) and the risk level was identified by the results generated from this computer program. From the analysis of MCS, it was recorded that the range of profit that could be attained by the developer was between RM 4,006,737 to RM 10,074,282. If the developer opt for RM 9 million profit, the probability was analysed between 0% to 10%. Decisively, it can be considered as a high risk project. This study successfully identifies the importance and usefulness of risk analysis using Monte Carlo Simulation (MCS) as it is user-friendly and reliable analysis at hand for developers. Keywords- Real Estate Development, Risk Analysis, Monte Carlo Simulation, Residual Method

I.

INTRODUCTION

The word risk was originated from the French words risque which carries another interpretation, danger (Littr, 1863). As far as concern, when there is a risk, there will be a situation where people called hazard. The hazard word came from a game known as the game of chance invented in Palestine inside a castle named Hasart (Oxford English Dictionary, 1989). At the modern time, risk by far evolved into different classification as the economic system expands and everything is engulfed into numerous types of risk with variation in term of risk level. In brief, the risk level may be denoted by the high, medium or low extent on certain type of business activities. Construction Industry is well known to engross a multi billion turnover to countries Gross Domestic Product (GDP), private developers and it is well dictated by the number of demand, supply, demographic and legal factors. From the Malaysias Economic Report, the construction industry contributed 5 percent to the GDP amounting a total value of RM18.2 billion in 2010, and 3.2 percent in 2011 totalling RM18.8 billion. While it is known that this industry is highly profitable, the risks intrinsic when venturing into this area are not something that could be taken lightly. While some projects generate an outsized return, others experiencing diminish or

entirely erase capital investment [1]. The involvement of various industrial players, together with a pool of multiplicative variables attached to each of the development stage process makes it vulnerable to be hit by the failure and profit losses as a result of poor risk assessment at the beginning of the project stage. Based on the data from the Malaysia Ministry of Housing and Local Government, as of Jun 2011, sick projects in Malaysia were recorded having a substantial number of 246 projects. In Selangors alone, there were 88 sick projects existed within this state. On the other hand, the overall abandoned private projects in Malaysia from National Housing Department as at February 2011 was represented by 38 projects comprise of 13,825 units largely as a result of financial problems i.e. bankruptcy faced by the private developers. Respectively, the sick and abandoned projects are originated from various factors including the inaccuracy of estimating time/cost/ resources and forecasting, insufficient funds, site technical problem, companys i nternal problem and others [2]. Within the feasibility studies, there is a provision to analyse the risk inherent to the real estate projects. One of the key determinants to successful project management is the element of estimating and forecasting, where it should be conducted as accurate as possible especially in the area of detailed cost estimate and more accurate fortune telling [2] so as to avoid future tribulations. It is very crucial for developers to understand and comprehend the risk engulfing their future project by conducting proper and thorough risk analysis with the assistance from the Monte Carlo Simulation (MCS) program. This may help in reducing the risk that they will endure when decided to continue with the project planned before. This paper is structured into five (5) sections. First section introduces the background of the study and focuses on the Malaysias construction industry. Second section represents the literature review regarding the topic under study. It discusses the residual method of valuation applied in appraising real estate projects and introduction to risk. Third section describes the operational framework of study, which is the application of MCS in a residential development project. It uses the Crystalball@risk software to generate results relevant for risk assessment. While Section Four touches on the result and discussion from the generated outcomes and lastly Section Five concludes the overall achievement of the study.

II.

LITERATURE REVIEW

Project failures in real estate development mostly originated from the lack of proper planning and a comprehensive, thorough, in-depth and detailed feasibility study (FS) [2]. With proper planning and thorough FS, it will ensure the project success in the standpoint of economically, technically and engineering. Feasibility studies for real estate development normally being conducted at the initial stage of development. The purpose of feasibility studies is to identify the highest and best use (HBU) of certain proposed real estate development project. Within the FS, there are five (5) contents including the site, economics, market, design and financial feasibility. These contents of FS help in identifying whether the proposed project satisfies the test of HBU which are the maximal productive use, physically allowable, legally permissible and financially feasible. The aims and purpose of FS is generally; (1) to promote and protect shareholders and stakeholders interest in the project; (2) for purchase of lands that can be injected into companies as a corporate exercise [2]. Regarding the financially feasible test, several methods of measurement or assessment normally conducted to identify the proposed project financial performance. These methods of assessment are segregated into Residual and Cash flow techniques [3], [4]. Both method have a different sets of mathematical calculation whereby the Residual technique uses total income and cost spread around years for its period of assessment while the cash flow technique, assesses the inflow of income and the outflow of cost by spreading it into monthly, quarterly, and half yearly amount. As far as the industry concern, both methods shall be applied to obtain as much information needed to assist in decision making to determine the financial feasibility of a certain development project. Despite, the financial feasibility should not only cater the financial aspect i.e developers profit, it shall also addresses the issue of risk inherent to a certain project. This study, enable developers to assess risks while identifying solutions to avoid them from affecting the project. It is crucial to incorporate the risk level of a certain proposed development project so as to understand the actual risk-return scenario and to avoid developers from overly expecting target profit from the proposed real estate project. A. Residual Technique The Residual technique of appraisal entails the use of residue amount to estimate the developers profit. Developers profit can be defined as a figure to take account of the reward expected by a developer for taking the risks associated with a scheme of development and applying his management expertise to the project is either included within the residual valuation or is the result of it (Ratcliffe & Stubbs, 1996, pp. 263). The proportion of profit on TDC and GDV is normally applied by developers to determine the project viability. Research suggested the minimum proportion of profit on cost accepted by developers is between 15 17 percent [5]. The

income from the development is considered under the Gross Development Value (GDV) while expenses and costs are accounted as Total Development Cost (TDC). In general, the estimation for developers profit can be scruti nised below:Gross Development Value (GDV) Total Development Cost (TDC) Land Cost Acquisition Cost Holding Cost of Land Residual Value/ Profit in 2 years time A B C D E (B,C,D,E) Z

(-)

There are several sub-items within the GDV and TDC where it relates to the stages of construction. These sub items such as income from sales down payment, sales final full payment, preliminaries cost, site preparation, title preparation, survey and subdivision, contribution to authorities, infrastructure cost, building construction cost, professional fees, project management cost, marketing, landscaping, contingencies, bridging finance, land cost, acquisition cost and holding cost of land can be used as a variables in determining the overall project risk using Monte Carlo Simulation (MCS). The rational of using all these subitems is basically the fact that it influences the developers profit as a whole. Thus, by controlling these variables, the analysis of MCS can be done objectively focusing only these variables as determinant to profit. B. Risk Analysis Risk can be associated with the relationship of outcomeprobabilities. As such, it is a condition when the outcome may or may not occur, but the probability is known [6], [7]. In addition, risk can also take place where the alternative outcomes are known, but their probabilities are unknown especially in a partial uncertainty [7]. In real estate development project, the outcomes are normally known i.e to achieve the expected target return/ profit. Despite, the probabilities of achieving thus target are unknown. The developers may decide whatever monetary figures they want to attain, but the question lies to whether their project can achieve those target when completed and what are the probabilities of generating those target return? Thus, this situation can be regarded as risk, with the existence of uncertainty lies within the proposed project. Risk Analysis on the other hand is [. . .] a formal technique which attributes probability distributions to the values ascribed to key benefits and costs such that it becomes possible to calculate the expected probability distribution of the rate of return of outcomes [8]. This analysis can be done using the Monte Carlo Simulation (MCS) technique where the relationship between assumption and forecast is measured to produce a set of probabilities. It is also considered as a quantitative approach that has been used in numerous decision analysis models. These probabilities will then be manipulated to assist in decision making. As such, MCS in development appraisal is a prescriptive analysis [9] where it uses normative

models, in limited cognitive parameters to funnel the decision maker [10]. There are eventually four (4) steps in conducting MCS including; (1) defining the capital resources by developing the deterministic model of the estimate; (2) identifying the uncertainty in the estimate by specifying the possible values of the variables in the estimate with probability ranges (distributions); (3) to analyse the estimate with simulation; and; (4) The model is run (iterated) repeatedly to determine the range and probabilities of all possible outcomes of the model [11]. This paper adopted these four (4) steps of analysis to obtain the desirable result. Further explanation is elaborated in Section III (C). III.
DESIGN AND METHOD

5.0 Contribution To Relevant Authorities 6.0 Infrastructure Cost 7.0 Building Cost 8.0 Professional Fees 9.0 Project Management Cost 10.0 Marketing 11.0 Landscaping 12.0 Contingencies 13.0 Bridging Finance 14.0 Land Cost 15.0 Acquisition Cost 16.0 Holding Cost

300,000 438,000 7,129,202 454,032 720,000 771,159 61,200 227,016 568,159 6,181,164 309,058 1,497,677

This paper uses a case study adopted from the proposed residential development project in Malaysia. It encompasses a structural element of the Residual Method of valuation adopted by valuers to measure the viability or feasibility of a certain development project. By using sample adopted from Malaysia, the utilization of Monte Carlo Simulation can be well understood by interested parties. The sample of residual calculation will then be used by Monte Carlo Simulation in order to demonstrate the application and the significance of MCS in determining the success of a particular project. A. Sample Characteristics We tested a residual calculation on Residential development comprises of proposed high rise property located on 0.946 acres land in Selangor, Malaysia. This project comprises of 68 units of apartment and 5 units of shop lot. The data for each element in Gross Development Value (GDV) and Total Development Cost (TDC) were collected from various secondary sources including from the Quantity Surveyors Bill of Quantity, suppliers, local and state government department records, JPPH and others. It was recorded that the total Gross Development (GDV) for this type of project reaches RM25,705,300 while the Total Development Cost (TDC) was calculated at RM18,723,493. The rational for adopting this project as a case study depend on the ability of this project to generate a reasonable amount of profit as to compare with other projects while at the same time, the subjected residual calculation was deemed fit for Monte Carlo simulation (MCS) analysis. The development items and costing used in the residual method are observed in Table 1.0. Table 1.0: Development Items for Residual Method Calculation
GROSS DEVELOPMENT VALUE (GDV) 1.0 Service Apartment 2.0 Retail-Shop Lot (Gf) 3.0 Parking Lot TOTAL DEVELOPMENT COST (TDC) 1.0 Preliminary Work 2.0 Site Preparation 3.0 Title Preparation 4.0 Survey and Subdivision RM 22,582,800 2,582,500 540,000 RM 18,920 9,460 8,246 30,200

B. Materials and Apparatus To assess the risk in a case study project, the residual calculation was prepared and tested using the Monte Carlo Simulation (MCS). With respect, there were about 3 items of GDV and 16 Items of TDC subjected to MCS analysis. Each of these items was treated as independent variables (Assumption) while the results; Profit item was regarded as the dependant variable (Forecast). Using Crystalball@Risk Software, the Residual calculation was analyzed according to four (4) steps of MCS analysis; (1) Developing a modelResidual Calculation; (2) Identifying Uncertainty determine their possible values with probability distributions and the results of the analysis; (3) Analyzing the Model with Simulation and; (4) Making a Decision based on the results and personal preferences. MCS has been widely used with other methods to measure the risk inherent in development projects C. Data Analysis In MCS, the variables were measured using the probability analysis, whereas it generates a certain number that mostly achieve by random calculation. The most recorded numbers generated using several thousand trials will be adopted as the highest probable number that the developers will obtain if the project is realized. In regards to the case study, the highest amount of the developers profit generated from MCS were used to make a decision in the context of risk level attached to the case study. The MCS approach enabled the analysis on each variable to be done thoroughly and results cover extensive information including the sensitivity analysis and the level of risk that the project could obtain. The data analysis procedures comprises of four (4) steps as follows: i. Developing a model- Residual Calculation

The first step begins by developing a model. In an exact situation, one should be able to develop a complete set of calculation (residual calculation) as in the Table 1.0. This full calculation will be used to establish a model suitable for Risk Assessment. Our calculation suggests there are three (3) basic components of the residual method calculation. It consists of Gross Development Value (GDV), Total Development Cost (TDC) and Developers Profit. These three (3) components or variables are imperative mechanisms in determining the

project success and feasibility as they interact between each other to generate a certain level of risk. Respectively, these components can be grouped mainly into two (2) variables, which are the dependent and independent variables. Dependent variables are likely being affected by the independent variables while the independent variables, stand alone without any dependency towards other variables. Example of dependent variables is the developers profit while independent variables are the sub-items within the GDV and TDC. Using the case study given previously, the parametric model can be developed as;
y = f(x1, x2, ..., xq). PROFIT = f (GDV, TDC) PROFIT = f (UNIT PRICE, UNIT COST)

MCS software will calculate the probabilities using 100,000 trials as applied to our case study. Then, it will show the user, three (3) windows containing the results in the form of a histogram. These results were used for decision making in determining the level of risk for our case study. IV.
RESULT AND DISCUSSION

As a result, our model fundamentally consists of the Profit (as dependant variables) and Unit price (GDV)/ Unit Cost (TDC) as independent variables. The objective of developing the model is to ensure the items of Profit, GDV and TDC are properly identified and accurately calculated for our next step. ii. Identifying Uncertainty

As far as this topic concern, this section focuses on the preparation and discussion regarding the results obtained from the application of MCS on residual calculation for residential development. Within this section, it is further segregated into four (4) subsections including the tabulation of developers profit probability, Profit as a percentage from GDV and TDC, and lastly the risk assessment of the results generated. The probability result for developers profit was indicated Figure 1.0, while developers profit as a percentage from GDV and TDC was tabulated in Figure 2.0 and 3.0. In order to attain the results, the researchers follow the procedures mentioned in the Data Analysis Section and the Crystalball@Risk software runs the simulation with preferred settings. The aim of this research is to demonstrate the application of MCS in risk assessment for the residual technique of appraisal and the results tabulated were used to achieve the following aim. A. Developers Profit Developers profit is one of the measurements to determine the project viability. Higher the profit, more viable is the investment. The level of profit can become an indicator to determine project risk by analysing the probability of profits that the developer could attain as the project completed. From the analysis of MCS, it was recorded that the developers profit frequency statistic for this particular project represented by Mean of RM 6,989,111 while the Median was approximately RM 6,981,649 the range of profit that could be attained by the developer was between RM 4,006,737 and RM 10,074,282 based on the minimum and maximum statistical results. In respect to the probability percentage of developers profit, it was analysed that the developer may attain 100 per cent probability of RM 4,006,737 and it was impossible to get RM 10,074,282 as the probability is 0 per cent. The detail results can be scrutinized in Table 3.0. Fig. 1.0 Histogram of the Forecast Profit

Monte Carlo simulation performs risk analysis by building models of possible results by substituting a range of valuesa probability distributionfor any factor that has inherent uncertainty. It then calculates the results continuously, each time using a different set of random values of the probability functions. By using probability distributions, variables can have different probabilities of different outcomes occurring. Probability distributions are a much more realistic way of describing uncertainty in variables of a risk analysis. Within the residual technique of appraisal, we are only using two (2) types of probability distribution due to the nature of real estate development appraisal data itself which is limited in terms of price and cost data. Nonetheless, it is still adequate to use only two (2) types of probability distribution Triangular and Uniform distribution. iii. Analyzing the Model with Simulation

When every variable has been set into Assumption and Forecast, the next step is to analyse the model so as to record the result of the overall analysis. Monte Carlo Simulation (MCS) is able to analyse thousand probabilities of variables using the built-in function within the software. iv. Making a Decision

One of the key elements behind the Monte Carlo Simulation is the result of the analysis. In the CrystalBall@risk software, the users are given various options to present their results of analysis. There are a few histogram, bar graphs, and can be printed in the form of a report. The

B. Developers Profit as a percentage of Gross Development Value (GDV) Another main criterion to determine the project risk is through the estimation of the developers profit as percentage of GDV probability. MCS analysis simulates the frequency statistic result with the mean of 27.09 per cent and median of 27.16 per cent. The minimum and maximum percentages were denoted by 16.93 per cent and 36.06 per cent respectively. Minimum and maximum value shows the range of Profit and GDV ratio if the project is to be undertaken. The forecast value results explain the 100 percent probability of achieving 16.93 per cent ratio as to contrast with 0 per cent probability of 36.06 per cent.

D. Risk Assessment of the results generated by MCS Results obtained showed a vital information regarding the probability of the developers profit and the percentage of GDV and TDC that can be used to assess the level of risk that certain project encompasses. It contemplates the probabilities of profit should the developer obtained if the project is undertaken. Within the example, it shows that the profit was 100% (sure) at RM4,006,737 while the developer will not obtain RM10,074,282 (due to 0% probability) if he ventures into this project. The results also assist the developer or project consultant in making a sense decision whether to proceed or not to proceed with the proposed development. As far as the industry concern, developers profit is one of the main criteria considered when determining the success of the projects and it can also be used to identify levels of risk by applying the probability analysis or MCS. Profit as percentage of GDV and TDC shows the ability of the project in achieving the distribution and manufacturing efficiency during the production process. The higher profit ratio tends to replicate a good efficiency in resource management (i.e. Capital cost) as to against the competitor or other alternative project. MCS is able to measure the probabilities of achieving reasonable amount of profit ratio for the project.

Fig 2.0: Histogram of the Forecast Profit as % from GDV

Table 2.0: Descriptives statistics from the analysis

Forecast values

Developers Profit as a percentage of Total Development Cost (TDC) From the results of the analysis, it was recorded that the frequency statistic mean, minimum and maximum results for profit as a percentage from TDC were 37.36%, 20.38% and 56.40% respectively. Minimum and Maximum value indicate the range of profit and TDC ratio that this project could achieve. The forecast value results explain the 100 per cent probability of achieving 20.38 per cent ratio as to contrast with 0 per cent probability of 56.40 per cent. C. Fig. 3.0 Histogram of the Forecast Profit as % from TDC

Statistics: Trials Mean Median Mode Standard Deviation Variance Skewness Kurtosis Coeff. of Variability Minimum Maximum Range Width Mean Std. Error

RATIO FROM PROFIT GDV 100,000 RM6,989,111 RM6,981,649 --RM963,503 0.0025 2.55 0.1379 RM 4,006,737 RM10,074,282 RM6,067,545 RM3,047 100,000 27.09% 27.16% --2.86% 0.08% -0.1451 2.66 0.1057 16.93% 36.06% 19.13% 0.01% TDC 100,000 37.36% 37.29% --5.38% 0.29% 0.0464 2.63 0.1441 20.38% 56.40% 36.01% 0.02%

Table 3.0: Forecasts Value for Profit, Profit as percentage from GDV and TDC
Forecasts Value RATIO FROM GDV TDC 16.93% 23.26% 24.62% 25.59% 26.41% 27.16% 27.91% 28.71% 29.62% 30.79% 36.06% 20.38% 30.31% 32.67% 34.39% 35.88% 37.29% 38.72% 40.28% 42.09% 44.49% 56.40%

Percentiles 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

PROFIT RM4,006,737 RM5,712,304 RM6,139,855 RM6,459,582 RM6,731,353 RM6,981,646 RM7,238,980 RM7,518,025 RM7,845,923 RM8,270,876 RM10,074,282

expected profit, it can be concluded the risk level was on the high level. As far as concern, the risk analysis using the MCS projects the future probabilities of profit that achievable or not achievable once the projects are completed. The estimation of risk using MCS for a real estate development project should be exercised thoroughly. This paper successfully demonstrated the usefulness of MCS in enhancing user understanding on the possible outcomes for the proposed development. This research only demonstrates the use of Monte Carlo Simulation (MCS) in a proposed real estate project. Despite, the accuracy of the analysis can be improved by embarking on the investigation between forecasting results and their actual performance after the real estate project is completed. Conclusively, MCS is one of the powerful tools of risk analysis at the disposal of the developer and its aid in reducing the risk inherent in certain development project. ACKNOWLEDGMENT The authors wish to thank the Universiti Teknologi Mara (UiTM), and participants in the present study. REFERENCES [1] D. Gimpelevich, "Simulation-based excess return model for real
estate development: A practical Monte Carlo simulation-based method for quantitative risk management and project valuation for real estate development projects illustrated with a high-rise office development," Journal of Property Investment & Finance, vol. Vol. 29 , no. 2, pp. 115-144, 2011. A. A. Tan, Why Projects Fail? 1001 reasons, Batu Caves: Venton Publishing (M) Sdn Bhd, 2004. C. Darlow, Valuation and Development Appraisal 2nd Edition, Glasgow: Estates Gazette Ltd, 1993. P. Marshall and C. Kennedy, "Development Valuation Techniques," Journal of Property Valuation and Investment, vol. 11, no. 1, pp. 57-64, 1993. J. Ratcliffe and M. Stubbs, Urban planning and real estate development, London: University College London (UCL) Press, 1996. J. Sloman, Economics , 2nd ed., London: Prentice-Hall, 1995. appraisal property risk scoring," Journal of Property Investment & Finance, vol. Vol. 23 , no. 3, pp. 254 - 268, 2005. K. Johnson, "Risk analysis and project selection: a review of practical issues," ADB Economics Staff Paper, Vols. No. 28, ADB, Manila., 1985. S. French, Decision Theory: An Introduction to the Mathematics of Rationality, Chichester: Ellis Horwood, 1986. P. Loizou and N. French, "Risk and uncertainty in development: A critical evaluation of using the Monte Carlo simulation method as a decision tool in real estate development projects," Journal of Property Investment & Finance, vol. 30, no. 2, pp. 198 - 210, 2012. R. Lorance and V. Robert, "Basic techniques for analyzing and presentation of cost risk analysis," AACE International Transactions, Association for the Advancement of Cost Engineering.

Hence, based on the results generated, the art of making decisions in order to measure the risk level lies within the framework of measurement shown in Table 3.0. Let us assume the expected profit by developers and its target profit as a percentage from GDV and TDC is RM 9 million, 35.01 per cent (GDV) and 48.07 percent (TDC). These expectations were compared to the probabilities result generated from the MCS and tabulated inside the measurement framework. Refer Table 4.0. Thus, from our risk-level framework table, it was observed that the risk level of targeting RM 9 million profit for this particular project is at the high region due to low probabilities (between 0 to 10.0 per cent), similar to profit ratio on GDV and TDC (refer Diagram 1.0). The developer is advised to expect a target profit of between RM4 million to RM 7 million so as to reduce the project financial risk. Table 4.0: Profit range and Risk level of the case study
Profit range 4 million to 6.4 million 6.5 million to 7.4 million 7.5 million to 10.07 million Risk Level Low Medium High 9.0 million 0 - 10% Expected Probability

[2] [3] [4]

[5]

[6] [7] A. Adair and N. Hutchison, "The reporting of risk in real estate

[8]

[9] [10]

V.

CONCLUSION

The result of the analysis using Monte Carlo Simulation (MCS) summarized the probabilities regarding the project performance that reflects the risk level inherent in this particular real estate project. Based on the result and comparison between forecasting profit and developers

[11]

Diagram 1.0: Line chart of the Expected Profit and its probabilities for the proposed project.