Combining Monte Carlo simulations and options to manage the risk of real estate portfolios

Purpose – This paper aims to show that the accuracy of real estate portfolio valuations and of real estate risk management can be improved through the simultaneous use of Monte Carlo simulations and options theory. Design/methodology/approach – The authors' method considers the options embedded in Continental European lease contracts drawn up with tenants who may move before the end of the contract. The authors combine Monte Carlo simulations for both market prices and rental values with an optional model that takes into account a rational tenant's behaviour. They analyze how the options significantly affect the owner's income. Findings – The authors' 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. Research limitations/implications – Some limitations are inherent to the authors' model: these include the assumption of the rationality of tenant's decisions and the difficulty of calibrating the model given the lack of data in many markets. Originality/value – The main contribution of the paper is both by accounting for market risk (Monte Carlo simulations for the prices and market rental values) and for accounting for the idiosyncratic risk (the leasing risk).