Flexibility in building design : a real options approach and valuation methodology to address risk

Abstract

This research develops an approach to designing and valuing flexible systems subject to identified future uncertainties. The approach addresses two shortcomings of current design and decision-making practices that are particularly evident in the buildings industry: 1) systems are designed as though they will remain as static entities despite existing in uncertain environments, and 2) typical decision-making methods, such as net present value and life-cycle costing, do not recognize uncertainty and the ability to make decisions in the future as uncertainties are resolved. The flexible design approach produces an improved design result by addressing the risks and opportunities induced by uncertainty. Two applications relevant to sustainable building design are developed to demonstrate the approach. First, the value of the flexibility to change the use of a space, thereby increasing building longevity and reducing waste, is evaluated. Option value is defined as the savings of low renovations costs as compared to the cost of renting space on the market. Uncertainties include the market price of rent, timing, amount of space needed, and number of renovations. It is shown that higher upfront investment leading to reduced cost for future change is economically justified in certain scenarios. The value of flexibility increases with increased time horizon and increased uncertainty in the market price of rent. The Black-Scholes formula can be used to approximate the value of flexibility in some cases. Second, the risk of employing an innovative technology is addressed with a flexible design that provides a fallback position.

(cont.) Specifically, the risk that a naturally ventilated (NV) building becomes overheated in the future due to climate uncertainty is addressed with an option to install mechanical cooling (MC). A model that simulates the system's technical performance under uncertainty demonstrates the value of the option. It is shown that in some locations, increased climate variability does not reduce the viability of NV (i.e., the option to install MC remains unexercised). The likelihood of installing MC is sensitive to design parameters. The results also demonstrate the benefits of the flexible, NV building as compared to MC: delayed or avoided capital costs (e.g., chillers) and cooling energy savings.