Making forecasts - How you think is more important than what you think

Making forecasts - How you think is more important than what you think.

• Investing requires making decisions today based on expectations of what the future holds and, therefore, necessitates prediction - sometimes over multi-decade periods. Yogi Berra said it best, however: "It's tough to make predictions, especially about the future."

• At Azimuth, we spend a great deal of time thinking about forecasts to improve our analytical thought processes and, ultimately, our forecasting abilities, focusing not on what do we forecast but how can we become better at forecasting.

• Start with the current picture - Information that exists today is the most reliable but also the most dangerous. Understanding where key determinants of the price and value of commercial real estate assets, such as rental levels and capitalisation rates or yields, stand today and how they compare to the past gives us a sense of the state of the current market, should one play offence or defence? Although understanding the current picture is essential to inform investment strategy, it also leads to a common error: assuming the future will be much like the present.

• Ask the right questions - To make good forecasts, you need to start with good questions, ones that are impactful (and, by implication, complex because there is no clear correct answer) but answerable. Where do you see the market going from here?" is not a very good question for making a prediction, but let's look at a more refined, but still very challenging, example: "'Will the capital value of Central London office properties be higher or lower than they are now in two years' time?"

• Break big, difficult questions into smaller, manageable ones - It is a better use of time to focus on the drivers of change that are more predictable. We understand market rental values are determined by occupier demand and the supply of office space. The amount of office space currently available, under construction and the occupiers looking for new space are measurable today, and this information can be used to predict how rental values likely will evolve in the future. We like to focus on early indicators, which can give a forecaster a view on future trends. Are recruitment agencies hiring additional people or taking new office space? This could indicate they see a positive trend in employment, leading to increased demand for office space. Are demolitions of existing

buildings in core office locations increasing? This could indicate developers are initiating new projects and will increase the supply of office space (although decreasing it temporarily in the short term)

• Actively search for alternative perspectives - Relying on intuition can lead forecasters to misinterpret events or make mental leaps to assume they know what the impact of new information is likely to be. To avoid this trap, it is critical to seek out alternative views. At Azimuth, one of our favourite questions to challenge our own hypotheses and flesh out alternative perspectives is, "'What would it take for this not to be true?"

• Think in terms of probabilities and ranges, not certainties - To calculate returns and carry out valuation, however, you do need to input a number in the financial model. This can lead investors to unintentionally think in terms of certainty, over-relying on one outcome. It is critical to explicitly think about the future in terms of probabilities and ranges, and these probabilities and ranges should be formed through the synthesis of genuinely alternative views. Understanding the impact a range of scenarios can have is not only good forecasting, it is also an important part of the process of gaining comfort with the risks associated with an investment.

• Understand the limits of forecasting and invest accordingly - How do you prepare for the unforeseeable? An awareness of the limits of prediction is a reminder to invest mindful of risk, worry about the ways your investment thesis might be wrong, and seek to understand and pressure test how an investment will respond to negative shocks.

‍

Published on Institutional Real Estate, Inc (IREI), Feb 2016

Making forecasts - How you think is more important than what you think

‍