Complexities of Investment Decisions in Real Estate Development

Abstract

The research paper is an attempt to emphasize the importance of sensitivity analysis and scenario analysis while making the strategic investment decision particularly in a real estate firm. The complexities involved in computing the after tax cash flows have been illustrated by introduction of various variables such as price, operating expenses, rent, vacancy percentage, depreciation, salvage value, interest on debt, tax rates etc. The hypothetical example uses the popular Net Present Value technique of capital budgeting to help in decision making. The two options of cent percent equity financing vis-a-vis use of debt in capital structure have been discussed. In all, 243 scenarios with different values for determinants of cash flows have been considered. Although NPV is negative for most of the scenarios, it is more sensitive to changes in purchase price, vacancy percentages and rent received. The forecasting risk involved and sources of value creation are thus important for capital appraisal. The paralysis of analysis with discounted cash flow techniques of capital budgeting may be overcome by the use of sensitivity analysis. Future market expectations of the decision maker also play a key role; the best scenario may not be probable but still be possible.