Valuing flexibility in a retrofit investment

Abstract

Purpose – The need for flexibility between organisational units is well established in corporate real estate. While the cost of flexibility is rather straightforward to approximate, measuring economical value of the flexibility is not straightforward. The purpose of this paper is to explore how real options analysis can be used for valuing flexibility in a real retrofit investment case, present a research process for valuing the flexibility in the retrofit investment case, and evaluate the empirical usability of real options valuation results compared with traditional discounted cash flow valuation results. Design/methodology/approach – The research is conducted as a case study. A newly introduced real options valuation method, the fuzzy pay-off method is used for analysing data from a Finnish office building retrofit investment case. The major difference in the selected method is that it uses fuzzy set theory instead of probabilistic theory, and the main advantage is the practical applicability, i.e. only three scenarios (minimum, best guess, and maximum) are needed for the valuation of flexibility. In the case, the scenarios are determined using a seven-phase research process that incorporates data available (e.g. rental agreements, building information) to a corporate real estate unit. The research process involves defining vacancy scenarios for rental agreements, transforming them into potential income achievable with flexibility, estimating cost of flexibility, comparing the potential income with the costs, and valuing the real options. Findings – The main finding of this paper is that real options analysis; especially the fuzzy pay-off method can be used for assessing the monetary value of flexibility. The applicability of the fuzzy pay-off method into a practical investment case was found straightforward because assignment of probabilities into different uncertainty scenarios was unnecessary. In the empirical case, it was found that flexibility investments were profitable only when parts of the building instead of the whole building were designed flexible. The present value of the pay-off from flexibility ranged from negative 58/sqm to positive 130/sqm, depending on the tenant. Originality/value – Real options literature, especially in the real estate and construction sector, has requested for new applications of real options analysis in practical setting. This paper adds to that request with an example of evaluating flexibility in a retrofit investment case. The empirical analysis produced in this paper was perceived valuable by case study investor and can be used as a guidance and motivation for further applications of real options in the industry.

Adaptable healthcare facilities through modular solutions

“…Therefore, the need for enabling adaptability in retrofits of old facilities built in 1950-1980 is high. Vimpari et al (2014) conclude that adaptability investments are profitable when applied only to parts of the buildings instead of the whole building. This supports the approach provided by Battisto (2005), where different adaptability zones were designed for different parts of the building as shown in Figure 7.…”

“…Therefore, it is important to create clearly defined standards on what adaptability stands for in practice. Even though different authors had different interpretations for adaptability, they all considered it as an ability to accommodate three types of change; change of use, physical layout or size (Arge 2005;Battisto et al 2005, Bjørberg and Verweij 2009, Carthey et al 2011, Pati et al 2008, Pinder et al 2017and Vimpari et al 2014.…”

“…As found from several research articles, the definition of adaptability must be a shared knowledge inside the project organization in order to use it efficiently. Determining the right amount of adaptability is challenging as described by Vimpari et al (2014). The investment in adaptability is eligible only in parts of the building.…”

“…The potential effect of an adaptability investment (Bjørberg and Verweij, 2009). Vimpari et al (2014) researched the value of adaptability in an office space retrofit case study example. While the costs of creating adaptability in retrofits are easy to approximate, measuring the monetary value they provide is difficult.…”

“…Moreover, adaptability describes the level of effort required for implementing the changes required. Enabling adaptability, in other words 'future-proofing', requires extra investments, which is why the amount and location of its application should be carefully evaluated (Arge 2005;Carthey et al 2011, Pati et al 2008, Pinder et al 2017and Vimpari et al 2014). …”