OPTION PRICING UNDER STOCHASTIC VOLATILITY OF US REITS

Tumellano Sebehela and Gianluca Marcato ()

ERES from European Real Estate Society (ERES)

Abstract: Margrabe (1978) developed the first option pricing model to value the exchange of two financial assets. One of its main applications is the pricing of M&A activities. In the real estate industry, however, the development of some sector-specific measures and the (real) nature of underlying assets require an adaption of the model to study M&A activities for the REIT (Real Estate Investment Trust) industry. We argue that an application to this specific equity sector allows us to study the impact of internal and external funding more carefully because of the presence of a specific measure of funds created internally (FFO) and assets used to guarantee lenders. Both external and internal funds are treated as additional items to the existing capital structure of the company/project, with the latter being treated as cash flows of the project and the former as additional value to the project NPV. The empirical study demonstrates that there is an emerging optionality when one REIT takes over another. Moreover, consideration of funding for expansion should lead to a REIT trading at a premium to its NAV and the introduction of a stochastic volatility should increase the option value. Finally, we show that our model explains the behaviour of M&A pricing better than any traditional method and that an appropriate calibration enhances the pricing capabilities of the model under different scenarios.

JEL-codes: R3 (search for similar items in EconPapers)
Date: 2010-01-01
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