Decision Theory and Real Estate Investment Essay

Introduction

Decision making in the allocation of assets and their pricing exist in the real estate circles. The models of judgment so involved in the making of the deliberate and usually rational choice may be explained by the decision theory. Owners or managers will allocate the resources aforementioned, as guided by their retrospective judgment of performance and risks. The decision theory borrows not only from economics discipline, but also from others like mathematics, statistics and psychology.

In this paper, the authors present argument that the interface between legal, physical and financial aspects of land and property form the basis of the analysis of real estate. The profession being practiced will determine the influence by each of these three properties mentioned. The role of property as an investment as influenced by the financial and economic analysis of the real estate is discussed in this paper. Pricing and allocation models in Real estate investment suggest that retrospective judgment of and risk influence the investment of the three classes of assets, namely, bonds, equities and property.

Discussion

Investors in the real estate market are also influenced by the existing market conditions in the making of their decisions, in addition to the consideration of the required optimum exposure level stipulated in the asset allocation model. The author looks into the role of decision analysis as practiced in the decision-making in the real estate investment.

Author carried a survey to collect the views of individuals in a range of institution and their advisers in the UK market, on expectations regarding inflation, real estate returns and risks, and correlations with other asset classes. The survey involved their views on the future on the basis of immediate short term of 1 year, medium and long term of 3 and 5-10 years respectively.

Descriptive and normative models are discussed in the decision theory literature, where the first one looks at how decisions are actually made, while the other looks at how they should be made. Normative models like the portfolio maximization model in property management, may be initially erroneous or may fail to encompass the whole thought process influencing the final decision, and thus may differ from what is practically done. In other words, other factors may influence the process of decision making such as what competitors are doing. The author gives the idea held by Phillips (1984), that the bridge between the normative and the descriptive model may be bridged by a requisite decision model, which is an amended model. Although normative models may have precise inputs and thus definitive answers, the input to the model may be influenced, in reality, by the decision-maker’s view of the world. The evolution of the normative model through the influence of the decision-maker’s judgment at any point in time leads to the generation of the requisite model, and the process is guided by sensitive analysis.

Another model that has been proposed involves the application of the normative ideas in the findings of descriptive studies that lead to the making of a ‘good’ decision rule by the decision-maker.

Portfolio theory guides the allocation of assets and involves the analysis of the risks and returns for each class of assets over time. Modern Portfolio Theory (MPT) focuses on financial optimization as the basis for all preferences, and thus the decision-maker must be influenced by the parameters within optimal financial outcome. The author argues that different interpretation of risk may not be captured in the normative model. There are might be more risk criteria involved in the choosing portfolio prospects and minimizing of the risks involved in the decision alternatives is one such criterion. Although the portfolio model defines risk as deviation from the expected returns, investors may have to face the risk of deviation from an index of performance or other qualitative risk criteria. As the number of assets increases there is an overstatement of expected returns from efficient portfolio, and an underestimate of the risk in MPT optimizers. This is because they overweight assets which have large estimated returns, negative correlations and small variances while they underweight those assets with reverse characteristics. The overestimation eliminates the possibility of a better mix in the portfolio.

Conclusion

The decision of the portfolio managers do not only emanate from the normative models of allocation of resources in the real estates, but that the decisions are also influenced by some other factors that may not be present in the initial model.

References and Bibliography

1. French Nick. (2001). Decision Theory and Real Estate Investment: An Analysis of the Decision-Making Processes of Real Estate Investment Fund Managers. Managerial and Decision Economics. 22: 399-410. John Wiley & Sons Ltd.
2. Phillips LD. 1984. A theory of requisite decision models. Acta Psychologica 56: 29–48