ACADEMIA Letters

Application Mixed Integer Non-Linear Programming in

Commercial Real Estate Development
Vishal A., GMU Dept of Operations Research

In commercial real estate development, the generally accepted methodology in the design of
hotel projects is to commission a market study to ascertain the economic supply and demand
of a local market the hotel will serve, and then construct the hotel such that it will contain on
average the mean number of room types (1 bedroom, 2 bedrooms, suites, etc.) and amenities
(meeting rooms, restaurants, fitness center, pool, etc.) as its market competitors. In doing so,
the developer aims to achieve a mean rate of return on her building, assuming the market is
stable and she is able to capture the mean economic demand of the local market. The only
way in which the developer can maximize her returns to equity is thus to add leverage or debt
to her capital structure to finance the construction of the project. Her return mathematically
is presented below:1

Total Equity Return Rate (IRR) = Returnequity + (Returnequity – Costdebt)*Debt/Equity

Thus as she increases leverage (debt/equity ratio) and under normal financing transactions
as her cost of debt is less than her cost of equity (Returnequity), the developer will maximize
her equity returns and achieve superior risk-adjusted returns for her project than if she financed
construction with 100% equity.
The purpose of the study (the Study) will be to apply mixed-integer non-linear optimiza-
tion (MINLP) in the design of a hotel property in order to maximize the annual profit of the
asset subject to various design and construction constraints. NPS formulation will be utilized
in the definition of the objective function and formulation of the MINLP model throughout
the Study.
1
Journal of Hospitality Financial Management, Hotel Industry Demand Curves, 2012

Academia Letters, August 2021 ©2021 by the author — Open Access — Distributed under CC BY 4.0

Corresponding Author: Vishal A., aryav2010@gmail.com

Citation: A., V. (2021). Application Mixed Integer Non-Linear Programming in Commercial Real Estate
Development. Academia Letters, Article 2594. https://doi.org/10.20935/AL2594.

1
Study Model Formulation
The Study is a special application of the union of two disjoint knapsack linear optimiza-
tion problems subject to the same convex set (upon relaxation of integrality constraints) de-
fined by the problem constraints hyperplanes. Specifically, the Study aims to achieve op-
timal profit from the union of two disjoint assets in a commercial real estate hotel design
project: the number of hotel room types and amenities the hotel offers. We define profit
as Net Operating Income (NOI), which is equivalent to Revenuerooms+amenities – Vari-
able_Costsrooms+amenities – Fixed_Costshotel.2 For purposes of the Study we explicitly
exclude the effect of income taxes and financing costs on profit, consistent with the manner
in which NOI is computed.3
By simple inspection, we note the objective function is multivariate, nonlinear, and non-
convex since various decision variables interact with each other.
Several constraints define the convex hull of feasible solutions. These include: constraints
that limit the quantity of hotel room types and number of restaurants and meeting rooms the
property can build subject to the maximum gross square footage allocated to each in the build-
ing. Constraints that limit the quantity of room types, restaurants, and meeting rooms built
subject to the maximum allowable budget. Constraints that limit the annual quantity of rooms
demanded to the maximum annual quantity of the total number of rooms built and similarly
constraints that require a minimum number of restaurants and maximum number of meeting
rooms to be built on the subject asset, respectively. Constraints that serve to approximate the
quantity demanded of a room type as a function of its price utilizing a linear approximation
of an exponential function that captures the elasticity of demand with respect to price for the
specific room type are also included. As further discussed below in Section “Data Gathering”,
the short run natural log demand elasticity, dQ/dP was found to be -0.7. Thus we formulate a
function to estimate the annual demand of a room type as: Qi(p) = mean_roomnights (-0.07p).
Since the coefficient -0.7 represents the per cent change in quantity per the per cent change in
price, we define p to be the per cent change from the mean room price of a particular room
type in the hotel property.

Data Gathering
The MINLP model formulated in the Study can be applied to any hotel asset type in any
location. For the purposes of the Study, however, we define the hotel asset to be a five-star,
2
For full table of decision variable results, refer Appendix 2
3
The Dictionary of Real Estate Appraisal, The Appraisal Institute

Academia Letters, August 2021 ©2021 by the author — Open Access — Distributed under CC BY 4.0

Corresponding Author: Vishal A., aryav2010@gmail.com

Citation: A., V. (2021). Application Mixed Integer Non-Linear Programming in Commercial Real Estate
Development. Academia Letters, Article 2594. https://doi.org/10.20935/AL2594.

2
luxury asset that will be centrally located in a submarket of the City of Seattle, WA.
The elasticity of demand for a hotel property is most directly impacted by the market in
which the hotel operates and the chain scale of the property (luxury, midscale, economy, etc.).
The selected asset for the Study is defined to be an upper luxurious property in a top 50 MSA
market. Thus, the demand elastic value of -0.7 was chosen, which reflects the per unit natural
log change in quantity of rooms sold by the per-unit natural log change in price.4

Obtaining an Optimal Solution

The MINLP model was formulated in Python Gurobi and solved. An optimal solution was
found that maximized NOI to approximately $26.5MM with a room type composition for
single, double, and suite rooms of 50%, 25%, and 25% respectively, in comparison to the
competitive set of 40%, 40%, 20%. Pricing per room was higher than mean room ADR rates
in the optimal solution by approximately 20%, 35%, and 34% per room type, respectively.5
The most common measure of profitability for a developer for a newly constructed asset is
yield to cost, defined as NOI / total project costs. The yield to cost found by the nonlinear
solver is 22.60% on a total project cost of $117MM. The model was also run with decision
variables set to the mean parameters of the competitive set (the Developer Scenario), which a
developer would typically follow under standard hotel development assumptions. Under the
scenario, the NOI was computed to be $14.22MM on total project costs of $122MM, resulting
in a yield to the cost of 11.65%. Mathematical optimization thus resulted in a 1.97x improved
yield over standard development assumptions under a Developer Scenario.

Conclusion & Limitations

MINLP optimization for commercial real estate design and development is a special appli-
cation of the knapsack optimization problem and lends itself well to optimizing the return of
the asset subject to resource, time, and capital constraints to construct the asset. Although
the Study yielded superior returns compared to the traditional Developer Scenario, further
refinement of the MINLP model in the Study is warranted. Specifically, the demand curve,
which is exponential in nature can be better approximated by increasing the number of inter-
vals by which the curve is linearly approximated. Further refinement of the demand elastic
coefficient is also necessary, through a combination study of market research and predictive
4
Moglidiani & Miller, Proposition II
5
Not in NPS formulation

Academia Letters, August 2021 ©2021 by the author — Open Access — Distributed under CC BY 4.0

Corresponding Author: Vishal A., aryav2010@gmail.com

Citation: A., V. (2021). Application Mixed Integer Non-Linear Programming in Commercial Real Estate
Development. Academia Letters, Article 2594. https://doi.org/10.20935/AL2594.

3
modeling/multivariate regression techniques. Computation of interest cost per day, which
serves as the cost coefficient for the time constraints can be better approximated since inter-
ests costs are not linear but represent a cubic shape with respect to total construction costs,
congruent with the total construct project S-curve that is commonly exhibited in the market.
Finally, although MINLP found a superior optimal solution, its building efficiency use, de-
fined as % of total buildable sq ft was 87% compared to 95% of buildable square ft under
the Developer Scenario. Common industry practice in commercial real estate development
is to use 100% of buildable square feet. Additional decision variables such as penalty costs
for non-utilized buildable square feet and alternative leasing revenue for non-utilized build-
able square feet, where applicable in the building design, can be introduced into the model to
better maximize building efficiency and achieve more widespread adoption of mathematical
optimization in the commercial real estate development industry.

Academia Letters, August 2021 ©2021 by the author — Open Access — Distributed under CC BY 4.0

Corresponding Author: Vishal A., aryav2010@gmail.com

Citation: A., V. (2021). Application Mixed Integer Non-Linear Programming in Commercial Real Estate
Development. Academia Letters, Article 2594. https://doi.org/10.20935/AL2594.