Modeling of Risk in Cost of Construction in Real Estate in India

MODELING OF RISK IN COST OF CONSTRUCTION IN REAL ESTATE IN INDIA

BY Saurabh Ashok Thadani 10FN-102 Srikanth Kumar Konduri 10FN-109 Tushar Gupta Nikhil Gupta 10FN-115 10FN-121

IMT

Modeling of Risk in Cost of Construction in Real Estate in India

Table of Contents
1. 2. 3. 4. Introduction .......................................................................................................................................... 4 The Research Design ............................................................................................................................. 6 Step 1: Identification of the factors to be considered as a part of cost of construction ...................... 7 Step 2: Data Collection for the historical prices of each factor ............................................................ 9 4.1 Historical Cement Prices ..................................................................................................................... 9 4.2 Historical Iron and Steel Prices ......................................................................................................... 10 4.3 Historical WPI for All Commodities ................................................................................................... 10 4.4 Historical Minimum Monthly Wage Rates ........................................................................................ 11 4.5 Historical Monthly Yields on 10 Year GOI Securities ........................................................................ 11 5. Step 3: Forecasting of the future prices of each factor and the volatility associated with them....... 12 5.1 Forecasted Cement Prices................................................................................................................. 13 5.2 Forecasted Iron and Steel Prices ....................................................................................................... 14 5.3 Forecasted WPI for All Commodities ................................................................................................ 15 5.4 Forecasted Minimum Monthly Wage Rates ..................................................................................... 16 5.5 Forecasted Monthly Yields on 10 Year GOI Securities ...................................................................... 17 6. Step 4: Creation of the financial model and Monte Carlo Simulation ................................................ 18 6.1 Control Sheet .................................................................................................................................... 18 6.2 Project Snapshot ............................................................................................................................... 18 6.3 Modeling Section .............................................................................................................................. 18 6.4 Cost Summary Section ...................................................................................................................... 19 6.5 Revenue Summary Section ............................................................................................................... 19 6.6 Term Loan ......................................................................................................................................... 19 6.7 Project Profit and Loss ...................................................................................................................... 19 6.8 Tax Summary..................................................................................................................................... 19 6.9 Cash Flow Statements ....................................................................................................................... 19 6.10 Simulation ....................................................................................................................................... 20 6.11 Defining Assumptions ..................................................................................................................... 20 6.12 Input and Output ............................................................................................................................ 21 7. Step 5: Results and interpretation ...................................................................................................... 24

8. Conclusion ............................................................................................................................................... 26 9. Limitations and Future Work .................................................................................................................. 27 2

Modeling of Risk in Cost of Construction in Real Estate in India 10. References ............................................................................................................................................ 28

Modeling of Risk in Cost of Construction in Real Estate in India

1. Introduction
Large construction projects require detailed cost risk analysis to analyze the profitability of the project. A cost risk analysis is the quantitative process used to determine how the project cost may vary because of systemic and project specific risks, positive or negative. The analysis uses a model reflecting the estimated project cost and potential variations in that cost. Traditional corporate finance theory suggests that firms should use a Discounted Cash Flow (DCF) model to analyze capital allocation proposals. Given the uncertainty inherent in project forecasting and valuation, analysts will wish to assess the sensitivity of project Net Present Value (NPV)/ Internal Rate of Return (IRR) to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV/IRR to a change in that factor is then observed, and is calculated as a "slope": NPV / factor. For example, the analyst will determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5 %....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface" (or even a "valuespace"), where NPV/IRR is then a function of several variables. Using scenario analysis, analysts also run scenario based forecasts of NPV/IRR. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product, exchange rates, and commodity prices, etc.) as well as for company-specific factors (unit costs, etc). As an example, the analyst may specify specific growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the NPV/IRR for each. For scenario analysis, the various combinations of inputs must be internally consistent, whereas for the sensitivity approach these need not be so. An application of this methodology is to determine as an "unbiased" NPV/IRR, where management determines a (subjective) probability for each scenario the NPV for the project is then the probability-weighted average of the various scenarios. In this project we will try to incorporate further advancement which is to construct stochastic or probabilistic financial models as opposed to the traditional static and deterministic models as above. For this purpose, we will use Monte Carlo simulation to analyze the projects NPV/IRR. This method was introduced to finance by David B. Hertz in 1964, although has only recently become very common: We will run simulations in spreadsheet based DCF models, using Monte Carlo Simulation technique. Using simulation, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". Here, in contrast to the scenario approach above, the simulation will produce several thousand random but possible outcomes, or "trials"; the output will then be a histogram of project NPV/IRR, and the average NPV/IRR of the potential investment. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value).
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Modeling of Risk in Cost of Construction in Real Estate in India

In the following project we would try to build upon a financial model of a township project in Mullanpur, Chandigarh, which besides predicting the value of NPV/IRR, will also describe the risk associated with it. We will try to outline the process with the help of a sample project. The most basic financial model is Profit = Revenue Cost This simply means that the profit or returns will vary depending on the cost or the revenue. In the following project we will try to study how the change in the construction cost will affect the returns on the project and how an analysis of each of the costs and proper weight age for each of them will tell us the risk associated with the complete project. When designing, planning as well as constructing a commercial property the costs involved are of paramount importance. Unfortunately this is even truer today than it was 10 years ago for the simple fact prices of materials etc., are continually increasing. The project assumes that the revenue stream is constant and as predicted by the financial analyst and only the cost price of various commodities vary. This will vary the cost of construction associated with our project and in turn would affect the expected returns. While a probabilistic model is followed for the future costs, the same will result in a probabilistic output and will define the risk associated with any of the real estate projects.

Modeling of Risk in Cost of Construction in Real Estate in India

2. The Research Design

This project is an Exploratory Research for the purpose of assessing the risk of the cost of construction on real estate investments in India. The factors considered as a part of the cost of construction were: Cement Prices Iron and Steel Prices Labour Wages Inflation Rates Interest rates

The standard deviation of the prices of each factor has been used to quantify the risk associated with that factor which is then translated into risk in the final IRR value calculation for the project. To prepare a model to assess and analyze the risk the following steps were undertaken: Step 1: Identification of the factors to be considered as a part of cost of construction. As a part of the first step, research was carried out to identify the major factors to be considered as a part of the cost of construction in a real estate project and also to decide on the weight age to be allocated to each factor. After which meetings were held with project management teams to confirm the factors and their weight ages. Step 2: Data Collection for the historical prices of each factor. After identifying the major factors in the cost of construction, historical data for each factor was collected from various databases like CMIE and websites like www. labourbureau.nic.in. Step 3: Forecasting of the future prices of each factor and the volatility associated with them. The historical data was then analyzed using various tools and techniques as described later based on which the future prices for each factor and the volatility associated with them was forecasted. Step 4: Creation of the financial model and Monte Carlo Simulation. In this step the financial model was created which accepted the various parameters related to a real estate project as inputs and provided the profitability of the project in the form of the IRR value as the output. After which the factors associated with the cost of construction that were identified in the first step were varied as per the predictions and its effect was seen on the IRR value by using Monte Carlo Simulation. Step 5: Results and interpretation. In the final step the output obtained from the Monte Carlo Simulation was analyzed and recommendations were made corresponding to the output.
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Modeling of Risk in Cost of Construction in Real Estate in India

3. Step 1: Identification of the factors to be considered as a part of cost of construction

As a part of the first step, research was carried out to identify the major factors to be considered as a part of the cost of construction in a real estate project and also to decide on the weight age to be allocated to each factor. After which meetings were held with project management teams to confirm the factors and their weight ages. It was identified that for most construction projects the price of the civil structure and the interest to be paid on debt has the largest importance. The primary reason for it is the security and stability of the structure. The structure always has to be designed with the specifications from the structure engineer. The rigidity in the structural specifications means that if the prices for certain commodities increase the total cost of construction will increase by the same amount. However, if the finishing budget overshoots, the construction company can make amendments in the plan or quality of material to keep it within the budget. Similarly, change in the interest rate will shoot up the interest payments needed to be made on the amount of debt raised for the project. The primary focus of the research was identifying the main components which affect the civil structure cost. After several discussions, it was identified that civil structure cost mainly comprises of four components which are as follows: Iron and Steel: Steel is an alloy consisting mostly of iron, with carbon content between 0.2% and 2.1% by weight, depending on the grade. Iron and steel are used widely in the construction of roads, railways, other infrastructure, appliances, and buildings. Most large modern structures, such as stadiums and skyscrapers, bridges and airports, are supported by a steel skeleton. Even those with a concrete structure will employ steel for reinforcing. Cement: In the most general sense of the word, cement is a binder, a substance which sets and hardens independently, and can bind other materials together. The most important use of cement is the production of mortar and concretethe bonding of natural or artificial aggregates to form a strong building material which is durable in the face of normal environmental effects. Labour (skilled and unskilled): Labours in construction can be both skilled and unskilled. The labour plays the most important role in any manufacturing or production activity. They are required for skilled jobs like running heavy machines, basic calculations and measurement etc. and some unskilled jobs like carrying raw material, building bases etc. Miscellaneous Costs: Miscellaneous costs were the costs that could not be divided into any of the above components and were linked to Wholesale Price Index (Inflation) figures.

Modeling of Risk in Cost of Construction in Real Estate in India

These identified factors were then analyzed for the amount of contribution each makes to the total cost of civil structure psf (per square foot). On analyzing the data of few projects, it was estimated that the percentage contribution of each of these factors to the total cost of construction is as given in the table: Factor Cement Iron and Steel Labour Miscellaneous Total Percentage Contribution 28% 39% 26% 7% 100%

Table 1: Percentage contribution of each factor to the total cost of construction Interest Costs: The interest costs are the interest payments that need to be paid on the amount of debt that is raised for the project. Hence the risk of changing interest rates during the tenure of the project becomes significant when the amount of debt raised is large. Since real estate projects are usually on a large scale, significant amount of the capital requirements are fulfilled by raising debt and hence the changing interest rates have adverse effects on the cost of the project.

Modeling of Risk in Cost of Construction in Real Estate in India

4. Step 2: Data Collection for the historical prices of each factor

After determining the factors to be considered for further analysis, data was collected of the historical prices of each factor from various databases like CMIE, labourbureau.nic.in. This was an important step because the accuracy of the output depends on the quality and correctness of the data obtained.

4.1 Historical Cement Prices

Weekly Cement Prices were considered from 1st April 1995 to 30th April 2011. The source of the data was Industry Analysis Service, CMIE.

Historical Average Retail Prices of Cement (CMIE): Delhi (Rs. per Kg)
6 5 Price per Kg (in Rs.) 4 3 2 1 0

Figure 1: Historical Average Retail Prices Of Cement (CMIE): Delhi (Rs. per Kg)

Modeling of Risk in Cost of Construction in Real Estate in India

4.2 Historical Iron and Steel Prices

Bi-weekly iron and steel prices were considered from 10th April 2004 to 7th May 2011. The source of the data was Industry Analysis Service, CMIE.

Historical Prices of HR Coils 2.00 mm in Delhi (Rs. per Kg)

60 Price per Kg (in Rs.) 50 40 30 20 10 0 10-Apr-04 10-Apr-05 10-Apr-06 10-Apr-07 10-Apr-08 10-Apr-09 10-Apr-10 10-Apr-11

Figure 2: Historical Prices of HR Coils 2.00 mm: Delhi (Rs. per Kg)

4.3 Historical WPI for All Commodities

Monthly Inflation rates were considered based on the Wholesale Price Index from April 1995 to March 2011. The source of the data was Business Beacon, CMIE.

Historical WPI of All commodities (wt 100.00)

300 250 Price Index 200 150 100 50 0

Figure 3: Historical WPI of all Commodities (wt 100.00)

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Modeling of Risk in Cost of Construction in Real Estate in India

4.4 Historical Minimum Monthly Wage Rates

Annual Minimum Monthly wage rates were considered from 1993 to 2010 since these rates are published only annually. The source of the data was labourbureau.nic.in.

Historical Minimum Monthly Wage (in Rs.)

5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 Minimum Monthly Wage (in Rs.)

Figure 4: Historical Minimum Monthly Wage (in Rs.)

4.5 Historical Monthly Yields on 10 Year GOI Securities

Monthly Yields on 10 year GOI securities in the secondary market were considered from October 2003 to April 2011. The source off the data was Business Beacon, CMIE.

Historical Yield on 10-Year GOI Security in secondary market

Yield on 10-year GOI security in secondary market (Percent) 10 8 6 4 2 0

Figure 5: Historical Yield on 10-Year GOI Security in secondary market (in %)

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Modeling of Risk in Cost of Construction in Real Estate in India

5. Step 3: Forecasting of the future prices of each factor and the volatility associated with them
The historical data as obtained in the previous step is a time series data. A time series is a sequence of data points, measured typically at successive times spaced at uniform time intervals. Time series can be represented as a curve that evolves over time. Forecasting time series means that we extend the historical values into the future where measurements are not yet available. Several methods were considered to get the forecast of the data. Some of them were Regression Analysis and Auto Regressive Integrated Moving Average (ARIMA) model. But since the main concern of the project is to analyze the risk and the effect on NPV and IRR where we would be using a probability distribution for the prices in future, it was decided to follow regression analysis to forecast the data. The forecasted data had the weekly price data for cement and iron and steel, monthly Wholesale Price Index data for all commodities, monthly yield data on 10 Year GOI securities and annual data on minimum monthly wages of the labours for the next six years which is the tenure of the project. The historical data for each factor was analyzed with various trend lines that is, linear, logarithmic and exponential. The trend line that explained the maximum percentage of variation in each factor was used for forecasting the future values of that factor. The calculated values are shown in the Appendix 2. The following charts show the forecasted values for the price data.

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Modeling of Risk in Cost of Construction in Real Estate in India

5.1 Forecasted Cement Prices

The percentage of variation explained by each trend line is given below: Type of Trend Line Linear Logarithmic Exponential R2 (Amount of Variation Explained) 69.04% 31.68% 68.01%

Table 2: Percentage of variation explained by each trend line for historical cement prices The linear trend line explained the maximum variation in the historical cement prices; hence it was used to forecast the cement prices for the next six years. The equation formed for forecasting the data was: Y=0.0029X+2.1103 Where Y is the Retail Price of Cement Per kg in Delhi (in Rs.) And X is the No. of the period (For Example, 1 is for week ending 1st April 1995 and 2 is for the week ending 8th April 1995 and so on)

Forecasted Average Retail Prices of Cement : Delhi (Rs. per Kg)

6 5 Price per Kg (in Rs.) 4 3 2 1 0

Figure 6: Forecasted Average Retail Prices of Cement: Delhi (Rs. per Kg)

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Modeling of Risk in Cost of Construction in Real Estate in India

5.2 Forecasted Iron and Steel Prices

The percentage of variation explained by each trend line is given below: Type of Trend Line Linear Logarithmic Exponential R2 (Amount of Variation Explained) 50.51% 31.16% 50.94%

Table 3: Percentage of variation explained by each trend line for historical iron and steel prices The exponential trend line explained the maximum variation in the historical iron and steel prices; hence it was used to forecast the iron and steel prices for the next six years. The equation formed for forecasting the data was: Y=29.869e0.001X Where Y is the Retail Price of HR Coils 2.00 mm per Kg in Delhi (in Rs.) And X is the No. of the period (For Example, 1 is for week ending 10th April 2004 and 2 is for the week ending 17th April 2004 and so on)

Forecasted Prices of HR Coils 2.00 mm in Delhi (Rs. per Kg)

70 60 Price per Kg (in Rs.) 50 40 30 20 10 0

Figure 7: Forecasted Prices of HR Coils 2.00 mm in Delhi (Rs. per Kg)

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Modeling of Risk in Cost of Construction in Real Estate in India

5.3 Forecasted WPI for All Commodities

The percentage of variation explained by each trend line is given below: Type of Trend Line Linear Logarithmic Exponential R2 (Amount of Variation Explained) 96.8% 67.16% 99.32%

Table 4: Percentage of variation explained by each trend line for historical WPI for all commodities The exponential trend line explained the maximum variation in the historical WPI for all commodities; hence it was used to forecast the WPI for all commodities for the next six years. The equation formed for forecasting the data was: Y=116.26e0.0043X Where Y is the WPI of all commodities (in Rs.) And X is the No. of the period (For Example, 1 is for month of April 1995 and 2 is for the month of May 1995 and so on)

Forecasted WPI of All commodities (wt 100.00)

400 350 300 Price Index 250 200 150 100 50 0

Figure 8: Forecasted WPI of all Commodities (wt 100.00)

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Modeling of Risk in Cost of Construction in Real Estate in India

5.4 Forecasted Minimum Monthly Wage Rates

The percentage of variation explained by each trend line is given below: Type of Trend Line Linear Logarithmic Exponential R2 (Amount of Variation Explained) 98.54% 86.18% 95.99%

Table 5: Percentage of variation explained by each trend line for historical Minimum Monthly Wage Rate The linear trend line explained the maximum variation in the historical minimum monthly wage rate; hence it was used to forecast the minimum monthly wage rate for the next six years. The equation formed for forecasting the data was: Y=173.89X+1167.9 Where Y is the Minimum Monthly wage of Labours (in Rs.) And X is the No. of the period (For Example, 1 is for year of 1993 and 2 is for the year of 1994 and so on)

Forecasted Minimum Monthly Wage (in Rs.)

6000 Minimum Monthly Wage (in Rs.) 5000 4000 3000 2000 1000 0

Figure 9: Forecasted Minimum Monthly Wage (in Rs.)

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Modeling of Risk in Cost of Construction in Real Estate in India

5.5 Forecasted Monthly Yields on 10 Year GOI Securities

The percentage of variation explained by each trend line is given below: Type of Trend Line Linear Logarithmic Exponential R2 (Amount of Variation Explained) 27.03% 47.05% 27.97%

Table 6: Percentage of variation explained by each trend line for historical Monthly Yields on 10 Year GOI Securities The logarithmic trend line explained the maximum variation in the historical monthly yields on 10 Year GOI Securities; hence it was used to forecast the monthly yield on 10 Year GOI Securities for the next six years. The equation formed for forecasting the data was: Y=0.7437ln(X)+4.8192 Where Y is the Yield on 10-Year GOI Securities in Secondary Market (in %) And X is the No. of the period (For Example, 1 is for month of October 2003 and 2 is for the month of November 2003 and so on)

Forecasted Yield on 10-Year GOI Security in secondary market

Yield on 10-year GOI security in secondary market (Percent) 8.6 8.5 8.4 8.3 8.2 8.1 8 7.9 7.8 7.7

Figure 10: Forecasted Average Yield on 10-Year GOI Security in secondary market (in %)
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Modeling of Risk in Cost of Construction in Real Estate in India

6. Step 4: Creation of the financial model and Monte Carlo Simulation

A financial model was created for the Project. The model is for a township project of Spire World at Mullanpur, Chandigarh. The assumptions for the model were based on a market research done about the Mullanpur area and also experience from past projects undertaken by the company. The description of each section is given below. The complete model is attached in Appendix 3.

6.1 Control Sheet

Control Sheet is the main input section in the model. It contains almost all the important parameters with respect to the project. The various parameters are price of land, area, cost assumptions, project revenues, FAR (Floor Area Ration), different fees and taxes etc. This primarily provides flexibility to the model to change the price of various inputs all at one place to view the changes in the output. It also contains data corresponding to the cost of construction of various types of buildings. These costs can be modified through this section depending on the changing cost of the input material. It also contains the inputs for the Monte Carlo simulation model. The price of raw materials is varied depending upon the probability distribution they follow. By varying the input costs, the total cost of the building psf (per square feet) changes which in turn changes the other sections of the model. The Monte Carlo Simulation works on the principal of ratios. This means that if the present cost of a commodity is x and it contributes 25% of the total cost, and its price changes to y its contribution changes to (y/x)* 25% of total cost.

6.2 Project Snapshot

The project overview presents the overview of the complete project with respect to its cost and revenues. It presents what will be the different costs (total) and how much revenue will be generated. This primarily takes data from primary input and primary data section. This however is not a profit and loss statement of the project. It is just a snapshot which tells as to how much money is going into which head of the project and what will be the approximate total expenses and revenues.

6.3 Modeling Section

The modeling provides information about the time of various expenditures. This is also an input section where various percentages can be modified. The primary aim of this is to have the timelines in such a form that matches the construction schedule and it must also be possible to maintain the project within the specified cash budget. The initial part of the project requires huge expenditures but revenues are low whereas in the later parts revenues are more and expenses are

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Modeling of Risk in Cost of Construction in Real Estate in India

less. This section provides a snap shot of timelines of various expenses and when will they be incurred and how will the revenue flow be in the future.

6.4 Cost Summary Section

The cost summary describes the individual cost every year on each of the heads. This takes in yearly expenditure from the model section and total from the project overview and gives the results. This section is useful as it helps in monitoring the expenses and matching the budget over each of the heads.

6.5 Revenue Summary Section

The revenue summary tells us about the annual revenue of the project. The revenue is based on previous experiences of the individual projects and a market research of the current real estate market in Mullanpur. From the revenue summary we can decide approximate payments on each of the heads to get the approximate profit.

6.6 Term Loan

The term loan specifies the amount of loan as collected in each year and then calculates the amount of interest paid each year. The term loan section helps in calculating annual interest for the use in profit and loss account. The interest rate is received as an input from the control sheet and the amount to be raised is Rs. 60 Crore.

6.7 Project Profit and Loss

Project Profit and Loss is a step ahead of the project snapshot. It does not show the breakup of the costs but it shows the consolidated costs and revenues for the project. It also involves getting interest paid from the loan summary and calculates total tax over the project life and finally gives us the total profit generated by the project. However, this profit value is not the cash value which we receive. It is just an indicative figure of the total profit the project will make over the term of project.

6.8 Tax Summary

Tax summary uses the cash flows for each year and calculates the profit each year and tax thereof. This annual tax will be helpful in calculating the exact cash flows each year for the project and hence the NPV and IRR of the project.

6.9 Cash Flow Statements

The cash flow statements are the final link in the chain. It gets data from all the previous sections and presents the annual cash flow per year for an investment decision. These annual cash flows are then used to calculate the NPV/IRR of the project. This NPV/IRR is then used to make a business decision. Since this NPV/IRR is the function of inputs, they vary with the variation in the inputs and this variation results in the variation in the output which defines risk associated with the project.
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Modeling of Risk in Cost of Construction in Real Estate in India

6.10 Simulation
The simulation was done using Crystal Ball. It comes as an add-in in the Microsoft Excel. The most important part of running the simulation is setting the assumptions for the various inputs.

6.11 Defining Assumptions

The definition of assumptions was the most important part of the simulation. The correctness of the model and the output depends on the assumptions taken for each of the input. For each input the previously discussed distribution was analyzed to fit the probability distribution of the price. Discreet distribution cannot be used for the price data because the price data is not discreet. To apply a discreet distribution we must be able to assign a definite probability to each price value which is not possible in this case. So, we cannot assign a discreet distribution for the price data. After this the scatter plot for the price, data is plotted around the mean value and it was found that the prices are randomly distributed along the mean line. This means that the price data follows a random distribution. So, one of the possible distributions is the normal distribution. However, a normal distribution can get negative values also and for the same reason it is generally not used in the option pricing, therefore, a log normal distribution is used. So, for our purpose the assumptions for the price data was made that it follows a log normal distribution as it was randomly distributed. The assumptions are defined as follows: Factor Cement Prices Iron and Steel Prices Inflation Minimum Monthly Wage Rate GOI Bond Yield Mean Rs. 5.01 per Kg Rs. 50.7 per Kg Rs. 313.93(base price Rs. 100) Rs. 4993.48 per month 8.32% Standard Deviation Rs. 0.27 Rs. 4.64 Rs. 29.39 Rs. 375.65 0.15%

Table 7: Assumptions of the mean and standard deviation of the forecasted values for each factor The IRR and NPV values were defined as the forecast and analyzed. The analysis results for the IRR analysis are as given in the next section.

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Modeling of Risk in Cost of Construction in Real Estate in India

6.12 Input and Output

The inputs to the simulation model were given for each factor of Residential Apartments, Economic Weaker Sections, Commercial-Sector Level Shopping, Commercial-Convenient Shopping and Basement and the interest rate on the debt raised for the project. For example, the inputs for the Residential Apartment were as follows: Assumption: Cement Lognormal distribution with parameters: Location 0.00 Mean 378.00 Std. Dev. 20.37

Assumption: Labour Lognormal distribution with parameters: Location Mean Std. Dev.

0.00 351.00 26.40

Assumption: Steel Lognormal distribution with parameters: Location 0.00 Mean 526.50 Std. Dev. 48.18

Assumption: Misc(Inflation) Lognormal distribution with parameters: Location 0.00 Mean 94.50 Std. Dev. 8.85

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Modeling of Risk in Cost of Construction in Real Estate in India

Assumption: Onshore debt Lognormal distribution with parameters: Location 0.00% Mean 15.00% Std. Dev. 0.27%

Figure 11: Assumptions for residential apartments in Monte Carlo Simulation

In the output the distribution of IRR values obtained is as follows:

Figure 12: Distribution of IRR values as obtained from Monte Carlo Simulation

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Modeling of Risk in Cost of Construction in Real Estate in India

The forecasted values of IRR and the percentiles associated with them as obtained from the output of the Monte Carlo Simulation are as follows: Forecast: IRR Percentiles Forecast values 0% 17.91% 10% 21.12% 20% 21.54% 30% 21.84% 40% 22.09% 50% 22.31% 60% 22.54% 70% 22.77% 80% 23.04% 90% 23.40% 100% 25.61% Table 8: Forecasted values of IRR and the percentiles associated with them as obtained from the output of the Monte Carlo Simulation

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Modeling of Risk in Cost of Construction in Real Estate in India

7. Step 5: Results and interpretation

The results obtained in the output of the Monte Carlo Simulation and their interpretations are as follows: Statistics Forecast Values 100,000 Interpretation

Trials

Monte Carlo Simulation assumed 100,000 input points. The large sample size was used to decrease the difference between repeated simulations. The Base case of the IRR value is 22.30% which means that based on our assumptions given to financial model the return from the project will be 22.30%. The mean value of the IRR value is 22.38% which means that if investment is made on a number of similar projects the average return from all the projects will be 22.38%. The median value of the IRR value is 22.31% which means that 50% of the results from the simulation are less than 22.31% and the remaining 50% of the results from the simulation are greater than 22.31%. The Standard Deviation of 0.90% means that 68% of the IRR value will lie between 22.38% +/- 0.90%. A low value for the standard deviation means the possibility of having IRR value close to the mean is higher. The distribution has a negative skew with a long tail in the negative direction, which means that there is more chance of getting lower numbers than mean value and lesser chance of having IRR value greater than the mean value. A kurtosis value of 3.08 means that the distribution is almost a normal distribution. However being slightly greater than 3 means that there is comparatively more
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Base Case

22.30%

Mean

22.38%

Median

22.31%

Standard Deviation

0.90%

Skewness

-0.2218

Kurtosis

3.08

Modeling of Risk in Cost of Construction in Real Estate in India

data in the tail portion. Coeff. of Variability 0.0402 The Coefficient of Variability value of 0.0402 suggests that all the variability in the IRR value cannot be explained by just these 5 factors, which is true since revenue, time of revenue collection and other costs will be needed to explain the full variation. Under the most pessimistic condition the IRR value will be 17.91%. Under the most optimistic condition the IRR value will be 25.61%. The maximum variation in the IRR value is 7.71% but due to the small standard deviation most of the IRR values will lie within a smaller range.

Minimum

17.91%

Maximum

25.61%

Range Width

7.71%

Table 9: Output obtained from Monte Carlo Simulation with their interpretation

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Modeling of Risk in Cost of Construction in Real Estate in India

8. Conclusion
The use of the static DCF model to analyze the township project in Mullanpur, Chandigarh gives us an IRR value of 22.30%. However on further investigation by supplementing the DCF model with Monte Carlo simulation, we find that 22.30% is not the final IRR value. Based on the inputs of the standard deviation and mean of the forecasted prices of each factor of the cost of construction, we get an IRR value ranging from 17.91% in the most pessimistic case to 25.61% in the most optimistic case. We also get the associated probability of attaining all possible IRR values. For example, there is a 63% probability of attaining an IRR value greater than 22%. Hence we get a better understanding about the risk associated with each IRR value. The investor should undertake the investment only if he is willing to accept the risk associated with the required return and no safer investment options are available. The output statistics as described above also tell us important characteristics about the output obtained from Monte Carlo Simulation. Since the graph is negatively skewed, there is more probability of getting an IRR value less than the mean value of 22.30% than getting an IRR value above 22.30%. The low value of Coefficient of Variability suggests that all the variability in the IRR value cannot be explained by just these 5 factors, which is true since revenue, time of revenue collection and other costs will be needed to explain the full variation. A low value for the standard deviation means the possibility of having IRR value close to the mean is higher.

The above analysis depicts as to how by creating a probabilistic model instead of a deterministic model, that is, by supplementing DCF with Monte Carlo Simulation we can arrive at better conclusion of the risks and profitability of the project than by static DCF Analysis. This improves the chances of making a successful investment.

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Modeling of Risk in Cost of Construction in Real Estate in India

9. Limitations and Future Work

Stages in the life cycle of a real estate project and the risks associated with each stage: Step 1. Stage Identify demand-supply gap and conceptualize the project, including nature, location and size. Determine Market size, demand, price, market supply etc. a) Estimate total project completion time. b) Start preparing drawings etc. c) Identify portions to be contracted out. Risk Location in environmentally, politically, socially sensitive area or in high seismic zone. Overestimation of market size, demand, price and underestimation of supply. Plethora of approvals required which is an important source of delay, defective land title deed results in expensive legal battles resulting in delay or even abandonment. a) Interest cost more than estimate due to delay in completion or disposal or increase in interest rates. b) Increase in raw materials prices more than estimates. Advance bookings and cash flows from other projects not up to the expectations. a) A few units remaining unsold. b) Overall slump in real estate prices. Problem tenants.

2.

3.

4.

Estimate the cost of the project.

5.

Identify the sources of finance and start securing commitments for funds. Dispose of the units suitably (sale/lease/license). Set up a system for maintenance of the property.

6.

7.

Table 10: Stages in the life cycle of a real estate project and the risk associated with each stage This project was undertaken to assess the risks involved in Step 4 only. Hence the other steps were assumed to be in line with the expectations of the financial model of the real estate investment project. All the risks involved can be taken into consideration for future work.

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Modeling of Risk in Cost of Construction in Real Estate in India

10. References
Paul Glasserman. Monte Carlo Methods in Financial Engineering Koop G, Introduction to Econometrics Johnathan Mun, Real Option Analysis Andrew Mclean & Gary W. Eldred, Investing in Real Estate Christopher Chatfield, Time-Series Forecasting Industry Analysis Service, CMIE Database Business Beacon, CMIE Database http://www.labourbureau.nic.in http://www.investopedia.com http://www.wikipedia.org http://www.cci.in/pdf/surveys_reports/real-estate-sector-india.pdf http://propertyinmullanpur.com http://www.ibef.org http://www.riskamp.com/files/RiskAMP%20-%20Monte%20Carlo%20Simulation.pdf http://www.oracle.com

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