Real Options to Evaluate Real Estate Development

Gordon Brown, Witvoet, A.M.C. van de Ven, D. Witvoet and A.M.C. van de Ven

ERES from European Real Estate Society (ERES)

Abstract: Since the 1990s real options analysis (ROA) gained popularity among finance researchers in real estate. Recent research by Quigg, Buetow and Albert, Hendershott and Ward and Holland et al. have included real option valuation models to real estate investment decision-making. Kemna and Trigeorgis have identified options embedded in capital projects that apply to real estate valuations. In the real estate development market there is evidence of multiple real options embedded within real estate development projects which add value to the project, such as the option to abandon, defer, expand, downsize or switch use. This paper aims to bridge the gap between theoretical studies and applied project valuation by describing the actual application of ROA to two real estate development projects. In one case, the real options were defined in a mutual agreement between the developer and the municipality allowing the developer to defer phases up to three years for a 5 percent premium. ROA enabled the valuation of managerial flexibility, instead of obtaining premiums based on financing costs of holding land. In the other, an approach integrating decision tree analysis and ROA involved outcomes from rezoning scenarios. In this case, the ROA model is dependent on the accuracy of the NPV from the DCF analysis. We compare these two cases and conclude by showing how the data needs and specifics of the assumptions involved need to be clarified in order to apply ROA to real estate decisions.

JEL-codes: R3 (search for similar items in EconPapers)
Date: 2007-01-01
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