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Making decisions in an uncertain world: Intuition vs analysis Jane E. Mather, Ph.D.

President, Critical Core, Inc.

Prepared for Occupiers Property Databank Annual Conference, February 2004

"Truly successful decision making relies on a balance between deliberate and instinctive

thinking." Malcolm Gladwell, Blink: The Power of Thinking Without Thinking.

No where is there a better example of this than in the world of corporate real estate and facilities

management. In a world of continuous change, corporate real estate executives need good

intuitive strategies and reasoned decision making. Experienced real estate professionals have

consistently demonstrated well-honed skills for intuitively identifying the right strategies. During

negotiations, quick calculations can be invaluable.

Nevertheless, as other corporate disciplines increase the sophistication of their analysis, senior

executives have begun to expect the same from real estate professionals. They still want

simple summaries, but they want to be sure that there is reasoned analysis behind them. They

want real estate professionals to set targets and demonstrate that they are achieving them. In

addition, in a world of change, they must explain the risks of their recommendations,

This presentation addresses how portfolio managers and strategic planners can make better

decisions in an uncertain business environment. It considers when intuition is sufficient and

when a more detailed analysis can be beneficial. After a review of some of the basic issues in

decision making in an uncertain environment, it turns to some typical strategies for managing

uncertainty to show which of those can benefit from a more technical analysis. Then it addresses the role of metrics in decision making and demonstrating performance.

Role of costs in decision making In workplace decisions, the goal is to identify the solution that provides the best balance of

productivity enhancement, cost control, and risk minimization. While these goals are widely

recognized, most of our decision making revolves around costs. In some situations, costs

maybe taking too central a role.

Making Decisions in an Uncertain World p. 2

Costs versus productivity. It’s important to remember the relative role of real estate in the

organization. Workplace costs per person, which typically include real estate, facility

operations, and furniture costs, and should also include workplace-specific data and

telecommunication costs, can range from £4,000 to £8,000 per person. At the same time, the

salary and benefits of the person, which reflect the productivity added by the worker using those

workplace assets, can range from £20,000 to £80,000 per person. Thus a 5% reduction in

costs, which would total £200 to £400 per person, would not be warranted if it led to even a 1%

reduction in productivity.

Costs versus risk. Much of the decision making in an uncertain business environment reflects

the trade-off between cost and risks. Often it can be considered within the framework of

whether the insurance that provides flexibility is worth the cost. There are two primary

approaches for evaluating these trade-offs: expected net present value, which assigns

probabilities to various outcomes, and simulations, which demonstrate the range of possible

outcomes.

We have used expected net present value analysis to evaluate the appropriate term lengths and

options for leases in different situations. This analysis will be described in the section on how

analytical approaches can be used to evaluate different approaches to managing uncertainty.

Simulation approaches can be beneficial in a number of situations. As financial analysis has

become so central to decision making, simulations can help us understand whether the

estimated cost differences are really meaningful within the context of uncertain assumptions.

They can also identify the risks that accompany a recommendation, for example, a long term

lease might reduce costs, but might lead to additional costs if that space is not needed in the

future. Figure 2 shows how a simulation analysis can identify the relative costs and risks.

Decision makers might determine that solution 3 is the best, but they need to note that the

reduced cost comes with the risk of higher costs in some situations.

From a technical perspective, simulation analysis is most beneficial when the range of potential

outcomes is not symmetrical, for example, due to limits on price changes, such as upward only

rent reviews, or due limits on losses, such as cancellation options.

Making Decisions in an Uncertain World p. 3

We’ve used simulations and related techniques to price cancellation, contraction, and expansion

options, that is, to identify the increase in rent that a landlord should charge or a tenant should

be willing to pay. As described by Tony Key in his presentation at last year’s conference, these

approaches typically do not add much more value than intuition. In our projects, our estimates

have shown that the tenant ought to be willing to pay £5 to £12 per square meter ($1 to $2 per

square foot) for various options. The exact pricing is difficult because we do not have sufficient

information to accurately estimate the likelihood of various market rent trends in the future.

These techniques can be beneficial when decision makers need to demonstrate that an option

is worth at least a specific price, but they don’t provide sufficient information to provide an exact

value. Thus intuition is often sufficient for evaluating real estate options.

Strategies for managing uncertainty The first step in assessing decision making is to review various strategies than can help

manage the uncertainty. In this section, we review some suggested strategies for managing

Figure 1. Simulations enable planners to review the costs and risks of each solution

$150

$156

$160

$170

$140

$180

Occupancy Costs (millions)

$130

$164

Expected cost for solution 3 - $150 mil.

Expected cost for solution 1 - $164 mil.

Expected cost for solution 2 - $156 mil.

Each box shows range of costs for one decile (10%) of cost outcomes.

$150

$156

$160

$170

$140

$180

Occupancy Costs (millions)

$130

$164

Expected cost for solution 3 - $150 mil.

Expected cost for solution 1 - $164 mil.

Expected cost for solution 2 - $156 mil.

Each box shows range of costs for one decile (10%) of cost outcomes.

Making Decisions in an Uncertain World p. 4

uncertainty and assess when more sophisticated analysis approaches can add value to

implementing these strategies. The strategies considered include:

• Better headcount forecasts,

• Duration matching

• More flexible work environments

• Clustering

Better headcount forecasts. Many organizations have tried to manage uncertainty by trying to

develop better headcount forecasts and thus reduce uncertainty. Unfortunately, business unit executives are generally uncomfortable providing a one-year forecast, while real estate

professions are looking for three to five year forecasts.

Some real estate professionals have suggested quantitative approaches for headcount

forecasting. They range from relating headcount forecasts to revenue projections, if available,

to complex econometric time-series methodologies. Certainly business unit revenue forecasts

and headcount forecasts are beneficial, but most of the more complex forecasting

methodologies provide few insights within the real estate context. As with option pricing,

planners generally do not have sufficient data to make use of sophisticated forecasting

techniques. Spending more time talking with the businesses, combined with intuition, will reap

more benefits.

As part of these discussions, corporate real estate executives should on focus on achieving a

better understanding of the range of possible outcomes. For those who want a more systematic

approach to specifying these ranges, we suggest a review of the historical values specified in

Figure 2. This matrix highlights the different types of business units and the types of historical

information about employment and revenues that can be beneficial.

With this understanding of the possible future scenarios, planners can intuitively specify lease

terms and options to provide the flexibility needed to match the wide range of business

outcomes, as illustrated in Figure 3.

Making Decisions in an Uncertain World p. 5

Duration matching. In an uncertain environment, most real estate professionals recognize that

the low-cost long-term lease is not always the best solution. Many have suggested shorter-term

leases to provide the needed flexibility and some have suggested “duration matching” as one

approach to identify the appropriate lease term. Duration matching in real estate is similar to

this concept within the financial sector. This approach stresses the importance of matching the

duration of the lease to the demand uncertainty, shorter leases for more uncertain business

environments. Some go further and recommend that the lease term match the expected life

cycle for the business or product. While the former is certainly true, the more specific focus on

the product life cycle can lead to too much flexibility because other factors are not being

considered.

Evaluating lease term lengths and ownership structure depends on whether the real estate

executive is looking at individual properties, such as field sales offices, or a portfolio of

properties within a city or considering a portfolio of “fungible” properties whose activities can be

relocated among the properties, for example, a campus or a number of call center facilities.

For individual properties, analytical models using probabilities can be used to identify the

appropriate term lengths and options. Landlords charge more for shorter-term leases due to the

amortization of tenant improvement costs and a premium to compensate the landlord for the risk

Figure 2. Historical workforce and revenue characteristics for estimating the range of outcomes

Range of Rates of Change for Workforce / Revenue Business Unit Categories

Share of Workforce Average Recession Recovery

Mature business units - stable, low variance

Mature business units - cyclical, high variance

Timing for Workforce / Revenue Average rate of

change Time to maturity

Time to closure

New, growing business unit

Contracting business unit

Making Decisions in an Uncertain World p. 6

of having to release the space at the end of the term. Probability analysis show when an

organization should be willing to pay more to eliminate the risk of be caught with excess space.

A formal term length and option analysis can be completed by considering the relative costs of

space with different term lengths and options, the tenant-specific improvements, market rent

forecasts, and the historical probabilities that the tenant of this type will want to move. With

these estimates, one can identify when the probability of moving is sufficiently high to warrant a

short-term lease, and when the probability of staying is sufficiently high to suggest the long-term

lease. In the situation described in Figure 4, the probability of staying that would warrant a

longer lease term (in this case from 3 to 6 years) ranged from 40% to 60%. In other words,

even if the tenant had only a 60% chance of staying it would be better to choose the longer

lease. (The analysis in the UK is likely to be different in the US because the US has had a

Figure 3. Matching supply to range of outcomes with staggered leases and options

Cancellation option for Lease F

Square Feet (millions)

Owned Space

20 04

20 08

Building planned for owned land

20 06

20 10

Leased Space

Expansion option for Lease C

Bldg A

Bldg B

Lease D

Lease C

Lease E Lease F

Lease G

Space required with forecasted

growthLease H

Space required with high-growth

scenario

Legend Planned building Expansion option Cancellation option Leased space Owned space

Space required with low-growth

scenario

20 12

Cancellation option for Lease F

Square Feet (millions)

Owned Space

20 04

20 08

Building planned for owned land

20 06

20 10

Leased Space

Expansion option for Lease C

Bldg A

Bldg B

Lease D

Lease C

Lease E Lease F

Lease G

Space required with forecasted

growthLease H

Space required with high-growth

scenario

Legend Planned building Expansion option Cancellation option Leased space Owned space

Space required with low-growth

scenario

20 12

Making Decisions in an Uncertain World p. 7

stronger push for short-term leases to provide flexibility than in the UK.) The challenge in this

case is gaining the trust from senior executives, that if your organization is left with excess

space, they would understand that the decision was based on sound analysis that considered

this risk.

As illustrated in this analysis, term length analysis should go beyond the life cycle of the

business activity and also reflect amount of tenant specific improvements within a space. One

of the primary downsides of a short-term lease is the need to renew the lease if the tenant

decides to stay. When there are tenant specific improvements, the tenant is at a disadvantage

because the landlord knows it will cost a great deal to recreate these improvements at another

location.

There are many examples in which the amount of tenant specific improvements drives the

approach to flexibility. For example, a leading high-tech manufacturing company has production

plants with products that have very short, and uncertain, product life cycles. They don’t follow

the pure duration matching example and negotiate a short-term lease. Instead they own these

properties since these factories are core to their business and they can be retooled to meet

future business needs. They understand that if they leased the property and decided to renew,

they would be in a very poor negotiating position.

Figure 4. Probabilities of staying that warrant longer lease terms

6-year lease, no cancellation option

3-year lease, no credit for TI amortization

6-year lease, canc. penalty = unamort TI

+ 1 year gross rent

3-year lease, fixed renewal rate ½ credit for TI amortization

Tenant Improvement Requirements

$25 / sf $40 / sf $75 / sfLease Comparisons

62% 50% 35%

60% 50% 40%

6-year lease, no cancellation option

3-year lease, no credit for TI amortization

6-year lease, canc. penalty = unamort TI

+ 1 year gross rent

3-year lease, fixed renewal rate ½ credit for TI amortization

Tenant Improvement Requirements

$25 / sf $40 / sf $75 / sfLease Comparisons

62% 50% 35%

60% 50% 40%

Making Decisions in an Uncertain World p. 8

Some organizations are increasing their lease flexibility through portfolio contracts with real

estate owners. These contracts enable the tenants to give back a certain amount of space

across their portfolio as part of the contract. As in the case of shorter lease lengths, this

flexibility comes at a cost. In this case, the landlord or owner may not need to charge as much

for the flexibility because they are able to limit the cost across portfolios and because they may

win leases that they would not otherwise have gotten because of the opportunity to be part of

this more flexible national contracts.

More flexible work environments. Many organizations have increased the flexibility of their

portfolios by providing more flexible work environments, through strategies such as hotelling, or

some other form of shared officing, and more standardized space. Both of these situations

achieve flexibility by limiting the extent to which the space is customized to the occupant. Some

organizations that have implemented hotelling approaches have found that the cost reduction

was minimal but that true benefits were the increased flexibility they achieved during tight real

estate markets and the increased worker satisfaction of those who appreciated the ability to

work remotely.

Clustering. While it is important to understand the demand uncertainty for individual spaces, it

is less important when considering a group of fungible properties. Large organizations can

consolidate activities into one general location, for example, within a campus or collection of

buildings. Then the risk that any one individual business unit needs more or less space can be

diversified across other business units. While one group is growing another might be shrinking.

Once more, the lease term does not need to match the specific life cycle for a project.

Over the years, we’ve seen significant improvement in organization taking advantage of the

benefits of consolidation. In major locations, most organizations no longer let individual

business units go out on their own to secure properties. At the same time, this approach can be

taken too far. When there are significant moving costs and reconfiguration costs to support

different business needs, the benefits of consolidation may be less than costs. In addition,

users need to consider their need to diversify activities across locations.

CoreNet Global’s Core 2010 resource classifications present a concept that complements

clustering. In this case, the workplace organization classifies its the properties based on their

“commitment” to the overall property portfolio, identifying those properties that are core to the

Making Decisions in an Uncertain World p. 9

portfolio and other properties which are more “flexible” and easier to dispose of if not needed.

In this way, when companies are making long-term plans they can focus their major investments

in core properties and avoid decisions to make major investments in “flexible” properties. At the

same time, they need to ensure that they have enough short-term flexible space to respond to

changing business requirements.

The challenge in these situations is identifying the right balance of owned properties, long-term

leases, and short-term leases. Generally, a good balance can be achieved intuitively, for

example, by using an approach similar to that shown earlier in Figure 3.

In other disciplines, optimization modeling for inventory management and supply chain

management provide key insights into setting the appropriate capacity when there demand is

uncertain. These techniques, which combine financial modeling and management science,

have enabled organizations to save millions of dollars. We are starting to do some analysis in

this area but don’t have any clear findings on our ability to find better solutions using this

approach.

Once a business has developed a cluster of properties, it can be a very complex analysis

process to determine how to best relocate business activities when business requirements

change. In these situations, we have found significant added value of through more

sophisticated analysis approaches. To evaluate these situations, we have developed

proprietary software that extends the optimization modeling techniques mentioned above. Like

internet search engines that quickly and systematically search through millions of web sites,

mathematical optimization techniques quickly search through the possible relocations to find the

set that best meet the user’s goals and requirements. This approach goes beyond databases

and spreadsheets, enabling users to consider millions of different combinations of real estate

relocation, construction and other workplace activities to find the combination that best meet

their goals.

The savings from better analysis in this area can be in the millions. In a back-office

consolidation for a financial services firm, we identified a solution that met all the business

requirements, would have reduced labor and real estate costs by over $20 million, and would

have reduced the number of lay-offs required by one-third through better relocation of activities

to locations where workers can be retrained for new positions. In another situation, the

Making Decisions in an Uncertain World p. 10

consolidation of two financial firms’ properties within one city, we identified a solution that saved

$16 million by relocating activities into spaces that required less reconfiguration and freeing up

space that had greater sublease value.

In some cases, we find the same solutions that we identified intuitively. The advantage of

optimization modeling in these situation is that it provides a systematic framework to include all

relevant factors and enables users to quickly try many different alternatives. This process also

enables real estate executives to show senior executives that they have considered all of the

possible alternatives.

Metrics “The single most important reason why corporate real estate executives and facilities managers

fail to have an influence in the boardroom is that they lack the information to demonstrate that

they are doing a great job.” Christopher Hedley, “Getting to grips with information.”

Increasingly, senior executives are evaluating the performance of workplace organizations

through selected metrics. This trend is likely to accelerate amid greater concern over corporate

accountability. To the extent that decision makers are evaluated on these metrics, they also

drive decision making

While workplace organizations recognize that success depends on more than costs, costs

continue to receive the greatest focus. A common metric is the cost per person housed or

served. To explain performance, this metrics can be decomposed into three primary

components. Changes in each of these components drives changes in occupancy costs.

Consistent measures. To provide valuable measures of performance and to motivate good

decisions, metrics need be consistent and accurately reflect cost differences. Often the

information for these metrics resides in separate, tactically-focused databases. Combining data

from different systems can lead to multiple values for the same data and inconsistencies.

Before workplace executives can demonstrate performance, they need address more resources

to making sure that their data meets both their strategic needs as well as their tactical needs.

Cost

Persons Housed Cost

Square Foot

Seat =

Seats

Persons Housed * * Cost

Persons Housed Cost

Square Foot

Seat =

Seats

Persons Housed * *

Making Decisions in an Uncertain World p. 11

One of the areas that is most often mismeasured is the cost of capital, as measured in the cost

of owned properties relative to leased properties. Most organization now require a discounted

net present value analysis for major decisions. Through this approach, the analysis explicitly

reflects the fact that if the capital wasn’t invested in the workplace assets, it could be invested

elsewhere. Yet, when it comes to metrics and chargebacks, the cost of capital that is

measured in the discount rate is ignored. The cost of owned property often only includes

depreciation, operating expenses, and property taxes. There is no charge for capital invested;

it’s like having a mortgage with zero interest.

When performance is based on calculations involving these measures, this oversight can drive

poor decisions. Within the workplace organization, business considerations may suggest

leasing property but the performance metrics will be lower if the properties are owned. For

business units occupying the real estate, owned properties may look less expensive as well.

For example, a real estate organization for a financial service firm recommended that some

business units relocate from Manhattan to less expensive locations in New Jersey. Once this

space was vacated, they would then be able to lease the space to outside tenants at the current

high market rates. But because the business unit was being charged only depreciation and

operating expenses, its costs in Manhattan appeared less than those in New Jersey. But once

the real estate organization shifted their charges for owned properties to be market rates, the

business unit’s cost reflected the true opportunity cost, and the business unit leaders readily

agreed that New Jersey was a smart move.

A key challenge in demonstrating good performance is being able to explain why any negative

changes are not the result of poor performance. It is not sufficient to say that increasing costs

reflect circumstances beyond the workplace organization’s control. Executives need to be able

to show that these negative results were anticipated, and that the cost to avoid them was too

great compared to the benefits. Better comparative data and more comprehensive decision

making, including some of the techniques described earlier, will help in these explanations.

As part of this process, workplace organization are not just responsible for reporting these

measures, they also must be able to set targets and then explain the differences when the

targets aren’t met.

Making Decisions in an Uncertain World p. 12

Setting the targets for these metrics can be even more challenging than explaining them.

While it might seem possible to use the simple decomposition specified earlier to set targets,

this approach can lead to unrealistic forecasts for improvement, setting the workplace

organization up for failure. Figure 5 shows the results of implementing a hotelling system to

reduce space usage estimated through the simple metrics and through a more comprehensive

analysis approach. While the simple analysis projects significant cost savings, the

comprehensive model shows almost no change. The simple analysis did not take into account

the implementation costs and the limited opportunities for disposing of the excess space.

Conclusion Workplace organizations generally lag behind their counterparts in other corporate disciplines in

adopting more sophisticated analysis approaches. In this paper, we’ve described several ways

in which workplace decisions can be improved:

• Focus on a range of outcomes rather than point estimates

• Use probabilities and simulations to compare costs and risks

Figure 5. Metrics forecasts vs comprehensive forecasts for cost reductions through increasing hotelling implementation

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

Init ial 200

4 200

5 200

6 200

7 200

C os

t / P

Business As Usual, Costs Grow, No Relocation

New Guidelines, Consolidation with Amortized Initial Costs

New Guidelines, Consolidation no Initial Costs

Forecast from Metrics

Making Decisions in an Uncertain World p. 13

• Consider both product life cycles and tenant-specific improvements in setting ownership

structure and lease terms

• Cluster properties and identify those that are core to the organization

• Ensure that metrics are consistent

• Use comprehensive models, not metrics, for forecasts

These recommendations and the related analytical approaches can lead to better decisions and

the ability to demonstrate the value of the workplace organization. Even if workplace executives

can identify good recommendations intuitively, senior executives are demanding more

accountability and that will require more comprehensive analysis.