Decision Theory and Real Estate Development

Subject: Finance
Pages: 20
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13 min
Study level: College

Like any long-term investment, the weighing of return and profit potential must be balanced against the availability and costs of the factors of production, alternative investment opportunities, and numerous risks. In this section, we address decision stages, theory and models in general while justifying and mining the decision model in respect of Turkey and the Bodrum area in Chapter 3 “Turkey as work area for foreign property developers” (below).

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It stands to reason that decision-making of the business investment type is always a dynamic, multi-stage process. The most basic paradigm is the five-stage model but Roberts suggests that decisions in his field require seven stages whilst Welsh argues for a 9-step decision-making model. The variations are summarised below in Table 1 and discussed in some detail below, mainly for their didactic value to the case of property investment and development.

Stages Minimum Standard Robertsa Welchb
1 Define situation Identify the decision to be made Identify objective
2 Generate alternatives Account for strengths, weaknesses, opportunities, and constraints. Preliminary survey of options
3 Gather information Identify and list options Value: investment cost and return
4 Select from among alternatives Gather information and data about each alternative Assess importance of decision required
5 Implement Narrow down to options that will solve the problem; assess pros, cons and risks of each alternative. Budget time and energy
6 Select the best option, though; revert to information-gathering mode if new uncertainties are uncovered Choose a decision-making strategy or model
7 Develop a plan of action and implement! Re-assess options
8 Evaluate options
9 Make timely and cost-efficient choice
  • a = Derived from work in career decisions
  • b = Welch, 2001

Define the situation

In all other contexts, decision-making is defined as starting with identifying the heart of the problem one wants to solve. Is declining company productivity a question of outdated machinery and equipment or a function of employee morale devastated by continuing layoffs in virtually every one of the leading industrialised economies? Should a GP in Dean Street near London’s Chinatown routinely have his patients tested for HIV if they are admitted homosexuals and for hepatitis antigens even though asymptomatic just because they are of Asian and African extraction? Should the leaders of the EC side with Palestinians or Israelis when it comes to ownership of the West Bank? Clearly, it is critical to understand what the situation is and what one seeks to achieve.

For a European real estate development firm, defining the situation is more straightforward, businesslike and closer to a feasibility study in concept: what site and type of project offers superb market “take out” or acceptance for the risks that must be taken? Given the flexibility offered by the European Community, problem and situation definition encompasses the whole of the Continent.

At this initial phase of the five-stage model, happily, most Community-spanning real estate development firms are perfectly clear about what situation and decision they must address since they routinely address the question of what to do for the next project when developments previously undertaken have been completed and either attracted enough buyers or failed to meet break-even projections. Hence, the enterprises subject of this Dissertation can be usually be counted on to have clear and measurable outcomes when viewing potential new markets or sites.

Generate alternatives

All decision theories and models presume the availability of alternatives. Otherwise, if a conclusion existed alone and was inescapable, no judgment need be made nor any analysis required.

The capacity for envisioning alternatives, in the case of real estate development firms, depends on experience in the business, knowledge about market conditions and trends, the size of the project team tasked to develop comprehensive alternatives, the vision of the company and financial resources available to it. For example, an English company with relatively puny cash on hand and financing leverage may find that frequent travel to Turkey to inspect progress of a project may be beyond its resources. The firm may not even examine distant alternatives or, if so inclined, may wait to be approached as a co-investor.

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Information gathering

If resources were not a serious constraint, then a developer on the other side of the Continent would feel free to examine project sites increasingly attractive to the wealthy and the upwardly mobile. Whether chalets in Gstaad or seaside villas in Bordum are trendy among the rich certainly diminishes the difficulties of marketing the development later on.

In this third stage of decision-making, therefore, a developer would:

  • Update costs of site clearing and unit construction to account for the impact of construction industry price inflation;
  • Gather information about whether buying trends in this desirable socio-demographic remained in the growth stage of the product life cycle or had hit saturation point, making unit sell-off a harder proposition.
  • Whether, within that overall trend, there remained fertile market niches, e.g. timeshare villas in Mallorca or majestic mountaintop mansions in the satisfying solitude of the Norwegian fjords.
  • And, with reference to Bordum specifically, a developer inexperienced in wending its way through the complexities of permits and suppliers in Turkey would certainly need to gather the kind of information set out in Chapter 3, ‘Turkey as work area for foreign property developers’.

Gathering information also necessitates obtaining projections about the near- and medium-term prospects for the above project success factors. If the most authoritative projections for general inflation, wages and fuel costs that underlie cement production and many other inputs to real estate development, a developer would certainly take out hedges for the period of months and years from groundbreaking till a profitable sales volume could be reached. Such a moderately high risk will then need to be offset by a better profit margin and higher price points to take care of hedge cover fees.

For decisions as risk-filled as real estate development, therefore, the information-gathering stage can be the lengthiest unless the firm already has had recent experience with the market, both the buyer side and country situation in Turkey. Since stockholders being asked to spend millions are nothing if not risk-averse, real-life decision processes tend to be dynamic. Many planners and investors who learn of new developments or other considerations may therefore interrupt the later stages of selection and implementation to get back to the drawing board, as it were and request more information.


If the previous stages of scanning for alternatives, gathering information about each, and weighing the pros and cons of each alternative have been done fairly exhaustively, then the superior alternative should be self-evident at the fourth stage. There is still no gainsaying temperament and decision-making style, however. Intuitive ‘seat of the pants’ decision makers may still select the alternative that bears favourable associations or for which they have fond memories. On the other hand, rational decision modelling tends to skew results toward alternatives with more favourable than risk factors.


Theoretically, many a businessman flounders in the area of implementing the alternative of choice, regardless of having the human, technical and financial resources to proceed. But this fault tends to prevail in such decisions as hiring or firing, expansion or maintaining the status quo. In these cases, there may be no pressing need to take action or there are unspoken and qualitative factors at work that militate against urgent action.

Unless completely unexpected ‘force majeure’ sours the economy or international posted prices for crude oil rocket to an $200 per barrel, implementation inertia is unlikely in real estate development projects. After all, there are always confident colleagues on the board or among the financing partners who are anxious to see reasonably healthy ROI in the medium term.

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The Nine-Stage Model

Beyond the fundamental similarities with the five-stage model – confronting a problem, marshalling alternatives, gathering information about the benefits and risks, making a choice and implementing what has been decided, the 9 steps process propounded by Welch (2001) is unique for:

  • An approach geared towards efficiency for recommending a limit on information gathering and analysis of alternatives. Decisions, Welch urges, should be expedited to realise returns on opportunities sooner and if only to free up the time and energies of planners and businessmen for other strategic goals.
  • The explicit recognition of ‘subjective expected utility maximisation’ in any decision process. ‘Utility’ is a technical term transplanted from economics and philosophy to refer to the reward, pleasure or satisfaction one derives from a decided course of action. Specifying that utility is ‘subjective’ and ‘expected’ means that decision-makers anticipate personal pleasure from a decision that yields a satisfactory result but of the postponed gratification type.
  • Adopting ‘9 steps’ means making room in the process for a preliminary survey of options; to recognise the potential contribution of the development project to company revenue; how much time, energy and money that assessed importance is worth; set a finite expenditure of time and effort to decide on this one project; and opting for the high-potential decision-making strategy.
  • When penetrating a new buyer or country market, the budgeting of resources referred to above may mean accommodating unique factors. For example, catering to the super-wealthy pulls the emphasis in marketing and sales media away from mass media and toward high-powered individual selling or celebrity-focused advertising. Entering the Turkish market may mean sacrificing corporate governance strictures against bribes and payoffs in the interest of expediting permits and site inspections.

Decision Methods

Given the host of factors that impinge on site and partner choices, decision methods in real estate investment may look tremendously complex. However, decision theory recommends reducing or representing the complexities to at least one action axiom. An example might be, “choose Site C if market acceptance matches the revenue target that meets the minimum acceptable economic profit.

Choosing to use formal decision methods means embarking on three stages: formulation, evaluation and appraisal.

At the formulation stage, first of all, one takes the inputs from environmental scanning (see Chapter 5, section 5.2 “External Market Analysis” below) and from property analysis (Chapters 3 and 4) to formalize the property development decision model specifications outlined in Chapter 6.

At the second stage of evaluation, the analyst hypothesizes a full algorithm, the desired outcome being a complete decision model, with sensitivities accounted for, so as to be able to put forward a formal recommendation (and its associated sensitivities). In this case, the desired outcome is an algorithm that unequivocally justifies the choice of Bodrum as primary project site.

Finally, the appraisal stage aims to capitalise on insights gained earlier in the activity, on mining the model by exploring the implications, and deriving a course of action that maximises revenue potential, mitigates or neutralises the risks, and promises to maximise satisfaction for homeowners in the long run. “Mining the decision model” means extracting such model components as sensitivity, relative value of the information, and the benefits of maximising financial interest in the project (or conversely, needing other principals to proceed).

This is also the time when investors and stakeholders can assess the reasoning that led to the selection of the elements in the model and justifications for sensitivities in the model. As a result, the range of outcomes can include complete acceptance of the recommended course of action, requesting revisions, or abandoning a project in Bordum in favour of some other project site in-country or even re-evaluating entry into the Turkish market at all (Bouyssou, Marchant, Pirlot, Tsoukiàs and Vincke, 2006).

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Decision Models

The most intuitively appealing type for the property development decision requirement has to be rational decision making models, principally owing to the explicit recognition of returns and risk needed in investment predictions and the associated fact that virtually all the decision factors can be quantified. It follows, therefore, that the real estate development firm can apply cognitive judgement of the pros and cons linked with options to build in the home country (the Netherlands), elsewhere in the European Community, in Turkey generally, or in Bodrum as opposed to other fancied second-home regions elsewhere in the country.

Rational decision models presuppose the ability to find the most logical and sensible alternative that will maximise returns, financial as well as reputation-wise. Hence, rational models mandate detailed analysis of alternatives and objective comparison of the advantages for each alternative. Owing to the breadth of factors impinging on any multi-unit real estate development, gathering the information and adding up the opportunities and risks is time-consuming.

Among the instances of rational decision-making is the Vroom-Jago decision model, though the emphasis here is on distributed decision-making. The model assumes that leaders have the flexibility to decide on the degree of involvement teams and subordinates should have in a decision making process. This is not an academic or human-relations concern solely since studies have shown that the Vroom-Jago decision model affords greater precision in situational assessment. The model posits five types of decision-making and an algorithm in the form of a decision tree (Figure 1 below).

In some business situations it may be optimal for the leader to be the primary decision maker for a workgroup. In other situations, one can make a case for at least partial group involvement or even be put in charge of making the decision entirely.

Unlike human relations theorists who generally favour participative decision-making processes, Vroom-Jago makes no value judgments about the 5 decision dynamics. These are

  • Autocratic l (Al) = the leader examines the facts and makes the decision himself.
  • Autocratic ll (A2) = The leader still arrogates the decision to himself but relies on colleagues and subordinates to provide information. They are not necessarily told what the situation is or why the data is important.
  • Consultative l (Cl) = Consultation is one-way since it consists solely of explaining to peers and subordinates what the situation is. Having no mandate as a project task force, these “outsiders” have no opportunity to work on the new decision as a group.
  • Consultative ll (C2) = The leader communicates the situation and asks for suggestions and ideas. This remains very much a command and leadership exercise, typical of Cabinet and military staff meetings. A majority stockholder in a real estate development company may retain the right to make the decision if he is so temperamentally inclined or bears all the financial risk for the real estate development project anyway.
  • Group ll (G2) = In this decision-making mode, the leader facilitates by defining the problem and decision required whilst granting the group the prerogative to define alternatives, report pros and cons, and arrive at a consensus decision (Vroom and Jago, 1988).

The elegance and utility of the Vroom-Jago decision model is not that it bends to the leadership style of the project manager, CEO or majority stockholder. Rather, the model presents a checklist of seven questions should help define which of the five processes is appropriate. The questions comprising the top of the decision tree model (see Figure 1 below) are asked in sequence and serve as a prescriptive guide. By the time one arrives at the right-hand side of the model, the reasoning for choosing one decision or the other is well and truly clarified.

The 7 questions:

  1. Is a high-quality outcome, in point of an absolutely superb solution critical? If not, skip ahead to question 4 using the upper branch. If a preeminent solution is preferred to being presented with numerous similarly-compelling alternatives, take the lower branch and ask question 2.
  2. In question 2, the leader or project manager asks himself whether he already has enough information to render a good decision on his own. If the answer is ‘yes’, skip ahead to question 4.
  3. Does the structure, definition and organization of the problem already lend itself to solutions? If not, proceed on the downward limb to question 4. Either way, proceed to question 4.
  4. Beginning with question 4 – whether the individuals concerned must agree with the decision for it to work – the tree begins to end at certain prescribed decision processes. To this point, the case of a development project in Bordum may have gone either way in question 1, both ways in question 2, and the same in question 4. since the answer to question 4 is ‘no,” A1, A2 and C2 remain workable decision processes.
  5. If the decision is rendered autocratically, can the leader be sure the group will accept it? For the real estate development firm, three processes remain: A1, A2, and G2.
  6. Is the group aligned with the corporate reputation, market impact and revenue goals desired by the leader for the new second-home project?
  7. Ultimately, might the group disagree about the final decision of a project in Bordum? Since the likely answer is ‘no,” both consultative approaches (C1 and C2) will be viable options.
The Vroom-Jago Decision Tree.
Figure 1: The Vroom-Jago Decision Tree.

But what is the utility of a decision model that seems to apply more to questions of organisational climate and leadership? In fact, Atherton, French and Gabrielli (2008) point out that the evaluation of real estate development projects rests largely on quantification of future expectations. The authors insist that the involvement of the decision-maker, at the very least, becomes a fundamental requirement considering that:

  1. Every new project demands confident predictions about future marketability and costs in the medium term of the second-home residential development.
  2. A developer will always try to control both sources of variance from project expectations. Thus, market acceptance can be optimised, even in the presence of unexpected and equally attractive rivals, by adjusting the themes and intensity employed in advertising campaigns. Some costs may be controlled; an unanticipated adjustment in contract price for cement from a traditional supplier might be counteracted by importing the raw material from a low-price producer country like India and Indonesia.
  3. But not all costs through to completion can be controlled or even veer precisely to the most adverse value in traditional ‘best case-worst case’ sensitivity analysis. Hence, the authors call for scenario- and sensitivity-analysis to embrace intermediate outcomes, with due attention to the empirical distribution of the medium to high risks. Tools such as popular forecasting software are readily available to do this.
  4. Since the examination of uncertainties leads to an exponential rise in all possible residential project outcomes, consultative and even group processes become critical. Nonetheless, the involvement of the key decision-maker at every stage is itself required in order to sharpen the final choice of project site.

The Financial Aspect of Real Estate Decision Modelling

Beyond decision processes, the Atherton et al. (2008) conception of project site decisions is pragmatic for recognising the that the viability of a proposed development ultimately rests on net present value (NPV) analysis. That is, the developer estimates the present capital value of an estimated income stream in the future less the all the costs – site acquisition, development, unit construction, marketing and sales – required to meet the standards of the target income segment.

Table 1: Conceptual Model for Assessing Present Value of Future Income Stream and Costs.

Residual to land value
GDV: value of the completed development
-– Total costs
All construction costs. Interest on construction, professional fees and developer’s profit
= Gross residual
Maximum bid for site includes acquisition costs, professional fees and financing of land purchase
Residual to profit
GDV: value of the completed development
-– Total costs
All construction costs as above but including land value as a cost
= Gross residual

The residuals effectively stand for either the maximum bid by the real estate developer for the site being decided on or, if land value is already accounted for in total costs (as in the second line of the table), anticipated profit. Clearly, the developer requires completely accurate estimates for the middle column, ‘total costs’.

Since there are too many uncertainties in respect of both residual to income and to profit, there has to be a way of incorporating them in a decision model. And yet, traditional residual valuation considers variable costs in static fashion, at one point in time. Tables 2 and 3 below show that residual valuation is at best a rule of thumb for the viability of a contemplated gated residential community development. This industry instrument is, unhappily, unable to account for all the sensitivities in input variables.

Tables 2 and 3 illustrate what happens for a comparatively simple development project: an 18-month development period for a single 1,000-square metre office building on land acquired for a net of €2.5 million, and anticipated rental of €475 per square metre. The all-risk yield (ARY) is 6.5 per cent. The breakdown of the obvious costs for construction and professional fees is shown in Table 2 while the preliminary residual analysis is depicted in Table II. The assumption for the void period (completion of construction up to 100 per cent sale/lease) is six months.

Case Study Input Variables
Table 2: Case Study Input Variables (based on best estimates).


Atherton, E., French, N. & Gabrielli, L. (2008) Decision theory and real estate development: a note on uncertainty. Journal of European Real Estate Research, 1 (2) pp. 162 – 182.

Bouyssou, D., Marchant, T., Pirlot, M., Tsoukiàs, A., & Vincke, P. (2006) Evaluation and decision models with multiple criteria: stepping stones for the analyst. New York, Springer Publishing. (n.d.) Stages In decision making. Web.

Welsh, D. A. (2001) Decisions decisions: the art of effective decision-making. Amherst (NY), Prometheus Books.

Vroom, V.H. & Jago, A.G. (1988) The new leadership – managing participation in organizations. Englewood Cliffs (NJ) Prentice-Hall.