Occam's Razor and Income Analysis - Real Estate Valuation

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Occam's Razor and Real Estate Income Analysis
Of two equivalent theories or explanations, all other things being equal, the simpler one is to be preferred.

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Occam's (or Ockham's) razor is a principle attributed to the14th century logician and Franciscan friar; William of Occam. It is stated in various forms. One form is cited above. Another that applies in the context of performing an Income Analysis is "one should not increase, beyond what is necessary, the number of entities required to explain anything." In its most simple, unscientific form it is often referred to as the KISS principle - Keep It Simple Stupid. Another commonly used one is "Don't miss the forest for the trees."

We quote, in part, an explanation of this principle, taken from the Principia Cybernetica Web ⁽¹⁾

The principle states that one should not make more assumptions than the minimum needed. This principle is often called the principle of parsimony. It underlies all scientific modelling and theory building. It admonishes us to choose from a set of otherwise equivalent models of a given phenomenon the simplest one. In any given model, Occam's razor helps us to "shave off" those concepts, variables or constructs that are not really needed to explain the phenomenon. By doing that, developing the model will become much easier, and there is less chance of introducing inconsistencies, ambiguities and redundancies.

Though the principle may seem rather trivial, it is essential for model building because of what is known as the "underdetermination of theories by data". For a given set of observations or data, there is always an infinite number of possible models explaining those same data. This is because a model normally represents an infinite number of possible cases, of which the observed cases are only a finite subset. The non-observed cases are inferred by postulating general rules covering both actual and potential observations.

The above paragraphs could not be more true than when you are analyzing the income streams of real property. We often forget that a real estate Income Analysis is a model, a prediction - not a statement of fact. Both explicit and implicit assumptions are made about the past, present, and future as the model is developed. Some of the many assumptions that an analyst of income producing property makes are listed below.

1.	The analyst assumes that the property's past income and expense history is correctly stated.
2.	The analyst assumes that the present observations of the property's income and expenses are good indicators of future income and expenses.
3.	The analyst assumes that future income and expenses can be predicted, based upon historical information and current observations.
4.	The analyst assumes that an investor requires a specific rate of return, and further, that the investor knows what rate that is.
5.	Implicitly or explicitly, the analyst makes predictions about future economic conditions; inflation rates, interest rates, vacancy rates, yield requirements, banking conditions.
6.	The analyst even makes implicit predictions about global warming, earthquakes, terrorists and hurricanes and how these uncontrollable items will impact the property's future income stream.
7.	The analyst makes one huge explicit assumption about the future - that he knows at the start what the value of the property will be when the property is sold in five, seven, ten or more years. This usually is called the "Reversion."

An Understanding of the History of Real Estate Income Analysis is Important to Prepare Better Analyses Today

Over time, various methods have been employed to arrive at the "income value" of a property. Before handheld calculators, and then desktop computers, the methods were simple. One common method was to determine the net income of a property and divide that income by a capitalization rate. The capitalization rate was usually somewhere between 9% and 10%, and this range had some historical justification. Real estate experts observed the capitalization rates of similar properties over time and a consensus among experts developed that a capitalization rate between 9% and 10% was usually appropriate. It still has validity today. Unfortunately, this method, for various reasons, does not sufficiently explain the analyst's prediction of value.

The Band of Investment emerged as a more "refined" technique, in an effort breakdown the components of a capitalization rate. Later, when large computers were able to generate books of tables, these tables (among them Ellwood tables) were used by industry experts to further evaluate individual components of a capitalization rate. As financial calculators became readily available, more sophisticated mathematical techniques were developed, among them the Mortgage Equity Technique. Finally, as desktop computers became commonplace, complicated discounted cash flow models were built using spreadsheets, and later by customized software application programs.

The State of Real Estate Income Analysis Today
As new real estate income analysis tools were introduced over the years, forward looking real estate experts employed each new tool to better understand and predict the value of income producing properties. Today, software is available (including Investment Analyst) that can precisely model an income property's leases and expenses. But the more that these complicated models were employed, the more obvious it became to real estate experts that the results produced by these software applications were often less reliable indicators of value than the old rule of thumb - "use a cap rate of between 9% and 10%". Users of these complicated models violated Occam's razor and the experts intuitively knew it. So many unnecessary items and assumptions were introduced into the models that inconsistencies, daty entry errors, and possible manipulation of the data made the results suspect. "Proofing" the models was difficult or impossible.

Among the reasons why these software applications can be less than reliable indicators of value:

1.	So much lease detail and expense detail is entered that it is difficult to check. Assumptions about rate increases, rollovers, and vacancy are built into each lease, requiring the analyst to verify assumptions on a per lease basis. The information entered is prone to entry error and manipulation that cannot be easily discovered because it is "buried" in a report that only expert users of the software can interpret.
2.	Complicated lease conditions like leasing commissions and expense reimbursements are entered on a lease by lease basis, again making entry errors and/or manipulation difficult to uncover.
3.	Specialized training is often required to use these applications. If the user does not use the software on a regular basis, he is prone to enter information incorrectly.

In recent years, many investors, appraisers, and banks have concluded that simple is better. Some prefer only the use of a capitalization rate based upon "direct capitalization rates" extracted from the market. But sufficient good information to do this is often not available. Others use the Band of Investment to develop a capitalzation rate that they apply to net income because it is simple to understand and calculate. But too simple is not always better either. The Band of Investment does not account for fundamental conditions that influence property value; items like prevailing mortgage terms that include amortization, predictable changes in income and expenses, costs of acquistion of the property, and the cost to sell the property in the future. A postulate of Occam's razor is that sufficient information must be introduced into a model to adequately explain the result. One must adequately explain the investor's expected rate of return (or IRR) and one must correctly consider mortgage financing if it is prevalent in the market for a given property type. If income and/or expenses will likely change in the future, this must be accounted for too.

Investment Analyst and Occam's Razor

Occam's Razor Re-stated

Of two equivalent theories or explanations, all other things being equal, the simpler one is to be preferred
One should not increase, beyond what is necessary, the number of entities required to explain anything.

Investment Analyst, from its early development in the 1980's until today, has always followed Occam's razor. We believe that the simplest method of performing an income analysis is the best method, but that the method applied must be sufficiently comprehensive to "explain" the analyst's calculation of value. Often, developing a capitalization rate using Mortgage Equity and applying this rate to "Stable Net Income" is the best method. It is simple to understand, yet comprehensive in its application of the assumptions necessary to sufficiently explain the value calculations.There are also times when a more detailed analysis is required. With Analyst, one can introduce just the level of detail required to sufficiently explain the prediction of value.

Many real estate income analysis software applications will do a "simple" analysis and a few are capable of performing a complex "lease by lease" analysis. Investment Analyst can do either, or both simultaneously. Investment Analyst uses a "top down" macro approach to income analysis. It is not always necessary or desirable to enter the minute details of leases. Usually, a prospective purchaser is better served by the macro view. For example, take a typical office building. Most tenants are under 3 to 5 year leases, the range of rental rates varies modestly, different pass-throughs have been negotiated on a per tenant basis, and the leases expire at different times. Regardless of the present lease terms for individual spaces, all leases will tend towards market terms in a relatively short period of time. A prospective purchaser of the property (or the analyst who is trying to predict what a prospective purchaser will pay) does have an interest in this lease detail, but only after evaluating the long term potential of the property under market assumptions, from the macro view. We always recommend that our clients first perform a "stabilized" analysis using market terms. The stabilized analysis becomes your benchmark. Then, as necessary, an analysis of the leases in place can be compared to this benchmark. This gives you greater confidence in your final prediction of the value of the property. Simple, yet comprehensive enough to sufficiently explain the value calculation.

Investment Analyst offers the capability to perform a stabilized analysis and a lease analysis simultaneously. It can be as simple as estimating gross income ($20 per s.f. per year times 100,000 s.f.), estimating a frictional vacancy rate, and estimating an expense ratio. One can then evaluate the income stream instantly, under different conditions - different mortgage terms, various growth rates, and different required rates of return. As these conditions are changed, Analyst provides instant feedback on the cash on cash yield, the debt coverage ratio, the overall cap rate, the terminal value, and many other key indicators that are critical to a thorough understanding of the property..

Using the macro view with "clean" data, one can quickly determine value under the "simple" test of Occam's razor. Then the analyst can determine the level of detail that must be additionally considered in order to meet the "sufficiency" test of Occam's razor. When neccessary, Investment Analyst provides the capability of "drilling down" to the lease detail by allowing you to enter detailed contract lease terms for all tenants - or only selected tenants, as necessary. For example, most tenant spaces may be at "market" under relatively short term leases, but one anchor tenant may be under a long term lease that is above or below market. Detailed lease information can be entered for just the anchor tenant and the effect upon value can be evaluated.

Investment Analyst offers both the flexibility to quickly evaluate an income producing property and the sophistication to evaluate the complex lease terms of individual tenants, to the extent necessary. Because of Analyst's design and its adherance to the principles of Occam's razor, Analyst is much easier to use and its learning curve is short. Most important, you can understand and rely upon and income analysis produced by Investment Analyst because needless complexity is avoided.

Finally, Investment Analyst provides analysis tools that are not available in other income analysis products. Key indicators are at your fingertips. Assumptions are easily changed and the changes are instantly reflected in the value calculation. Both a stabilized analysis and a lease analysis can be performed simultaneously. Analyst has a built-in Review tool that reviews the reasonableness of your inputs. And the reports produced by Investment Analyst are presentation quality, they are easy to understand, and they are easy to explain

Since the 14th. century, philosophers, scientists, mathematicians, and statisticians are among the many professionals that have recognized that Occam's razor must be adhered to as theories are developed to explain various phenomena. The reliability of their models depend upon it. These same principles must be adhered to when performing an income analysis, if the results are to be relied upon. Investment Analyst was designed with this in mind.

Financial Masterplan, Inc.

Purchase Investment Analyst

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⁽¹⁾ F. Heylighen (1997): "Occam's Razor", in: F. Heylighen, C. Joslyn and V. Turchin (editors): Principia Cybernetica Web (Principia Cybernetica, Brussels), URL: http://cleamc11.vub.ac.be/OCCAMRAZ.html.

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Occam's Razor and Real Estate Income Analysis Of two equivalent theories or explanations, all other things being equal, the simpler one is to be preferred.