Methodology for the Evaluation of Real Options in Real Estate Development in Areas Characterized by Uncertain Scenarios

Marina Bravi, Stefano Rossi and Antonio Talarico

ERES from European Real Estate Society (ERES)

Abstract: The recovery of brownfield sites has been in the past and still is today at the center of urban policies that have started, set up and, in some cases, completed the main projects of urban transformation. In this regard it should be noted that large transformation areas often require a preliminary remediation before that the urban functions are established. The recovery of these areas has, among other things, the character of public interest in relation to the environmental protection and public health goals. Basically, the investment decision, concerning the development of brownfields is affected by two critical variables: the remediation costs and the market value of the area after completion of the environmental recovery. This last is in fact a complex process, which cannot be estimated with certainty, influenced by many variables, such as, for example, the cost of the single operations, the timing, the technology and the uncertainty of achieving the remediation goals (Weber et al., 2008). In the past and in many countries, the public resources were preferred to encourage the development of urban transformation projects of contaminated lands. On the contrary, the current economic scenario requires a new insight that includes the possibility of involving the private developers from the early stages of the transformation. In this regard, given the uncertainty surrounding the remediation costs, some authors (Espinoza & Luccioni, 2007) have aimed to the definition of the optimal size of the investments, able to make feasible the land transformation from the financial and economic point of view, through the Real Options Theory (ROT). In this light, the work attempts to argue and support the application of the ROT, considering a contaminated area where the plan allows the change from industrial to residential and commercial use, but where the remediation costs are unavoidable. The numerical example, that is solved using the Black & Scholes formula, shows that, the higher is the volatility – the uncertainty – of the transformation value of the land, more the deferral option value is increasing . After a year, the landlord will proceed with the remediation, only if the market value of the land is greater than the cost of its recovery; otherwise it will not. As a result, the payoff for the landlord is obtained from the maximization of the value added and from the sales price of the land, that, in turn, will result from the transformation value.

JEL-codes: R3 (search for similar items in EconPapers)
Date: 2013-01-01
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