Get Out Of The Stone Age: Monte Carlo Simulation For Real Estate
Monte Carlo simulations have been around forever and are an underutilized tool that could give you a leg up over the next guy
Tl;dr
Typical real estate models only give you a single outcome based on fixed assumptions.
Monte Carlo simulation can give thousands of potential outcomes based on variable assumptions.
Simulations will not replace the good instincts that are needed in real estate, but can enhance decision making with more information
Real estate has a reputation of being an industry that is so simple that even a caveman can do it. The reality is this is mostly true. Real estate is a very simple business to operate. But it isn’t an easy business.
Because the barrier to entry for real estate is so low (hence so many cavemen), you need to find any edge at your disposal. Monte Carlo simulations have been around forever and are an underutilized tool that could give you a leg up over the next guy who is only running simple DCF models or even :gasp: pen to paper pro formas (cavemen).
I Thought Monte Carlo Was A Place Rich People Visit
Monte Carlo simulations are used to model outcomes by assigning multiple values to variables.
These simulations help understand the impact of risk in financial models. Why you may want to consider using this tool:
Typical discounted cash flow models only give a single outcome based on fixed assumptions. You have 1 chance of being 100% right or 100% wrong. Monte Carlo gives thousands of potential outcomes.
Monte Carlo simulation allows you to reduce risk by assigning a range of values to assumptions for rent growth, expense growth, cap rate change, etc.
It's possible to run these simulations in Excel using stochastic modeling tools, but unless you are an Excel wizard, you are better off using a pre-built model and learning how to use the tool instead of trying to build your own. Adventures In CRE have an easy to use Monte Carlo model and tutorial that shows you how to set it up.
What Monte Carlo Simulation Is Not
These simulations will not replace the good instincts that are needed in real estate. It can only enhance your decision making with more information. 10/10 times I will take good instincts over a fancy pedigree. There are people that make good money in real estate that don’t even know what Excel is.
Why Isn’t Everyone Doing This?
A research paper from 2007 written by Keith Chin-Kee Leung postulated these reasons are why there is a reluctance to adopt probabilistic techniques:
Small teams and the entrepreneurial nature of real estate prevents acceptance.
Real estate has always been perceived as less sophisticated (that caveman guy again) compared to other asset classes and have historically used intuition for decision making due to fragmented market data.
Using Monte Carlo simulations requires some understanding of statistics and there is a fair amount of time investment to learn how the model works and what your inputs should be and what the output means. You need to have reasonably high confidence of the ranges you are using for the variables being entered, otherwise your output will be meaningless.
The old adage of garbage in, garbage out is certainly applicable to Monte Carlo simulations, so do your homework before leaving the stone age.
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