RISK-SENSITIVE PRESCRIPTIVE ANALYTICS

REAL ESTATE CASE STUDY

Disclaimer: This case study is written solely for educational purposes and is not intended to represent
successful or unsuccessful managerial decision making.

Ahmed Youssef, PhD www.ld-research.com

youssef@ld-research.com LD-Research, 78/79 Pappelallee, 10437 Berlin
 LD-Research case study, 2017

Risk-sensitive prescriptive analytics: Real Estate

case study

Abstract

Based on actual data and Monte Carlo simulations, we demonstrate that the use of advanced analytics can
lead to substantial performance improvements in real estate investments. Moreover we show that risk-sensitive
proprietary algorithms developed at LD-Research are able to increase the risk adjusted return as measured by
the Sortino ratio by a remarkable 180% over state-of-the-art prescriptive analytics.

Keywords
Prescriptive Analytics Quantitative Risk Management Real Estate

Far better an approximate answer to the right question,
which is often vague, than the exact answer to the wrong ques-
tion, which can always be made precise. John Tukey
1. Introduction
The use of advanced analytics has the potential to give real
estate investors a competitive edge. We quantify these perfor-
mance gains in this case study, which has several interesting
features:
Prescriptive analytics: Recent advances in the field of
machine learning make it possible to build algorithms
that learn from data and lead to powerful predictive
models. Applying them to real estate, we can use histor-
ical housing price data to predict with higher accuracy
the actual selling price of a house, based on many of
its features. This process is referred to as predictive
analytics. But real estate investors are more interested
in making the right investment decisions than pure price
predictions. With prescriptive analytics, the subject of
this study, real estate investors will directly get good
buy/sell recommendations instead of house prices pre-
dictions alone.
Actual data: We use publicly available house sale prices
for King County, WA, which includes Seattle. The data
references more than 20.000 homes sold between May
2014 and May 2015, along with their selling price and
18 features such as location, surface area, condition,
year built, and whether they have a view. A few exam-
ples are shown in table (1).
Monte Carlo simulations: In order to quantify the
actual effect of prescriptive analytics, we use Monte
Carlo simulations repeated random samplings to
generate thousands of instances of a simple investment
scenario.
Three methods: We compare the performance of in-
vestors using three different strategies: i) an analyst
using traditional statistical tools ii) an expert using
cuttingedge machine learning and optimization tools
iii) LD-Research proprietary algorithms.
The procedure: First, the data is divided into two equal-
sized parts: a training set the system will use to learn
a pricing model, and a test set that will serve to sim-
ulate an investment process and evaluate the different
algorithms in a business-relevant context. It is critical
to only use the test data in the very last step, otherwise
the reported returns will be over-optimistic.
2. Three algorithms
We will compare the performance of three analytics algo-
rithms.
Simple algorithm
The first valuation algorithm is a multiple linear regression
model (not so simple after all). The accuracy of the algorithm
is measured by its ability to predict the prices in the test set,
that is on houses it has never seen before. This algorithm has
a low predictive power and makes an average error of 25%
(mean absolute percentage error).
Expert algorithm
Our second model is a state-of-the-art machine learning algo-
rithm, known as a gradient boosting machine [1] . This is the
algorithm used to win most machine learning competitions
and is typically the most accurate algorithm out there. The
 Risk-sensitive prescriptive analytics: Real Estate case study 2/4

Date Zipcode Lat Lon Lot (ft2 ) Bedrooms Waterfront Price

2014-07-22 98023 47.3277 -122.341 9480 3 No 86 500
2014-05-15 98106 47.5341 -122.358 6345 2 No 312 500
2014-06-11 98004 47.6500 -122.214 37325 5 Yes 7 062 500

Table 1. A few examples of the King County housing data.

Figure 1. Location of a few sold houses in the dataset.

models average error is roughly 12%1 ,
a very significant im-
provement on the previous linear model. Its use as the basis of
any investment strategy will obviously lead to important per-
formance gains. Such predictive power is the reason behind
the surge of modern machine learning techniques in many
fields.
LD-Research proprietary algorithm
At LD-Research we develop proprietary machine learning
algorithms particularly well suited for risk-sensitive decision
making. In the next section we will show that it remarkably
outperforms the state-of-the-art expert model described above.
3. Investment simulation
We now test these three algorithms using a very simple invest-
ment scenario. We are offered the opportunity to buy, within a
capital limit of $10M, any combination of 100 properties cho-
sen randomly from the test set. We are seeing these properties
for the first time and dont know their true price, i.e., the
price at which we will be able to resell them. Each property
1 Technicalnote: in order to level the playing field and make performance
comparison straightforward, no feature engineering was used for any of the
algorithms.
Figure 2. Return distributions of the three strategies. Each
dot represents the return realized by an investor. This
unconventional representation of the distributions has the
advantage of making the problems inherent uncertainty
utterly clear: once you choose a strategy, you have an equal
chance of being any one of these dots!
is offered at a price that is within 5%2 of its true price. For
instance, a $200K house may be offered for between $180K
and $220K. After the properties are chosen by the algorithm,
we assume that we can sell all of them at their true price, in
our example $200K. This procedure requires two steps:
Prediction: First we use a predictive model to compare
the offered and predicted price and determine wether or
not the property is worth investing in.
Allocation: Second we use an algorithm to optimally
allocate our limited capital between these 100 proper-
ties. There is a huge number of possible combinations,
precisely 2100 1030 and they cannot be exhaustively
searched.
The simple strategy will use an equally simple heuristic:
2 The offered price is generated by a gaussian distribution centered on the
true price and has a standard deviation equal to 5% of this mean value.
 Risk-sensitive prescriptive analytics: Real Estate case study 3/4
we compute the expected return of each decision and
select the properties with the highest return first. If a
property is too expensive for our remaining capital, we
check for the next ones.
The expert strategy uses a sophisticated integer pro-
gramming algorithm to make the buying decisions [2].
This algorithm solves the capital allocation problem to
optimality, meaning that, given our predictions, it will
find the best solution.
Figure 3. Average return, expected shortfall, and Sortino ratio of the three strategies. Higher values are better.
We use Monte Carlo simulations to generate 105 instances
of this investment scenario for each one of the three tested
strategies and compute the distribution of returns, shown in
figure (2). For each distribution we also report three important
measures, shown in figure (3):
Average return: LD-Research strategy outperforms the
expert strategy by a relative 7% (from 2.36% to 2.53%),
a substantial difference.
Risk: We define risk as the probability and amplitude
of losses in the worstcase scenarios. We measure risk
by the expected shortfall at the 5% level: that is, the
expected return if we are among the 5% less lucky in-
vestors. This is much lower than the average return and
is usually negative: in the worst case we lose money.
This is also where LD-Research algorithm adds substan-
tial value as it is specifically designed for risk-sensitive
decision making. The algorithm improves the expected
shortfall by an impressive 220% relative to the expert
strategy (from 0.25% to 0.31%), transforming the
worst case into a gain instead of a loss.
Risk adjusted return: This is a single metric that quickly
captures the trade-off between risk and average return.
We use the Sortino ratio, considered more meaningful
than the celebrated Sharpe ratio because it penalizes a
strategy only for downside volatility [3]. The Sortino
ratio is calculated as the average return divided by the
downside volatility, and the higher its value the better.
LD-Research algorithm improves the Sortino ratio by
180% relative to the expert strategy (from 19 to 54).
4. Robustness
In the previous simulation we showed substantial improve-
ments over state-of-the art prescriptive analytics. But how
robust are these performance gains? Extensive Monte Carlo
simulations indicate the superior performance of LD-Research
algorithms under very different conditions. The simple invest-
ment game we have been studying has two tunable parameters:
Investor size: their capital divided by the average price
of the full offered portfolio (capital / $54M in our case).
Market fluctuations: how much do quoted prices fluctu-
ate around the true price.
We examined the relative difference in the Sortino ra-
tio of LD-Research algorithm compared to the expert one.
We simulated 104 runs for each of the 100 combinations of
Investor size and Market fluctuations shown in figure (4).
LD-Research strategy dominates the expert one under all
considered conditions, by an average of 90%.
 Risk-sensitive prescriptive analytics: Real Estate case study 4/4

Figure 4. We see a consistent improvement (from 3% to

215% with an average of 90%) of the Sortino ratio relative to
the expert strategy, in a wide range of exogenous market
conditions.

References
[1] R.E. Schapire and Y. Freund. Boosting, Foundations and
Algorithms. The MIT press, 2012.
[2] D. Bertsimas and J.N. Tsitsiklis. Introduction to Linear
Optimization. Dynamic Ideas and Athena Scientific, 2008.
[3] F.A. Sortino and L.N. Price. Performance measurement in
a downside risk framework. Journal of Investing, Vol. 3 p.
593, 1994.