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Real Options in Real Estate. Theory and Evidence. Overview. Options Real Options Development Option Empirical Evidence Applications. Options. Call option: The right (not the obligation) to purchase a share of stock at a date T in the future for price P. Option Valuation. Stock price

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Real options in real estate

Real Options in Real Estate

Theory and Evidence


Overview
Overview

  • Options

  • Real Options

  • Development Option

  • Empirical Evidence

  • Applications


Options
Options

  • Call option: The right (not the obligation) to purchase a share of stock at a date T in the future for price P.


Option valuation
Option Valuation

  • Stock price

  • Strike price

  • Interest rate

  • Volatility of stock return

  • Time to maturity

  • Black-Scholes formula: C ( S, K, r, σ, T)


Volatility and call option
Volatility and Call Option

  • No downside cost, so no downside risk.

  • Upside payoff, so risk is good.

  • Method of valuation:

    • Call option payoff can be locally matched by borrowing, and holding some amount of the stock.

    • As S changes, this “replicating portfolio” must be adjusted.

    • We know the price of the stock and the bond at each moment, so we can calculate the equivalent price of the option.


Real options
Real Options

  • Fisher’s NPV criterion: take any project that project that provides a positive Net Present Value.

  • Suppose, however, that taking one project costs you the opportunity to take another positive NPV project?

  • Take the highest NPV of the two.


Example plant construction
Example: Plant Construction

  • Cost of Plant: $100 million

  • Net after-tax cash flow/yr. in perpetuity from plant: $3 million.

  • Cot of capital = current interest rate.

  • Current cost of capital today: 3%.

  • NPV = $3 m/ .03 = $100 m.

  • Build the plant?


Stochastic interest rates
Stochastic Interest Rates

  • Interest rates go up or down each year by 100 BP.

  • If they are certain to go to 2% next year:

  • NPV = [$3 m/.02 - $100m]/(1.03) = $48.54 m

  • Wait one year to build!

  • Each project competes with itself delayed by one period.

  • But ONLY if both projects cannot be undertaken!

  • Irreversible investment.


Implications
Implications

  • Irreversible investment involves a timing decision.

  • Relevant stochastic variables:

    • Interest rates

    • Demand

    • Investment cost

  • Autocorrelation of variables are relevant.


Real estate example
Real Estate Example

  • Rents vary through time, with some momentum.

  • Rents are locked in for 10 years when you lease.

  • Costs to build are fixed (as are interest rates): $ 400/square foot. Build and lease instantaneously.

  • Current rents are $40/square foot.

  • Current cost of capital is 10%.

  • Rents are trending up: prob 60% of rents going to $50/sq.foot and 40% chance of $30/square foot.


Build or wait
Build or Wait?

  • NPV = $40/.1 - $400 = 0

  • Exp. Value: .6($500-$400)/(1.1) + .4(0)= $90.9

  • Optionality premium = $90.09

  • What if rent (t) = a + b*rent(t-1)+e ?

  • Wait for rents to tip and then build?

  • Issues:

    • Construction time.

    • Build but hold vacant.


Do real options matter
Do Real Options Matter?

  • Laura Quigg (JF, 1993)

  • Examines Seattle market for undeveloped land.

  • Estimates building prices, development costs and models development costs as stochastic.

  • Value with and without std of DC = 0.



Evidence from office construction
Evidence from Office Construction

  • Rena Sivitanidou & Petros Sivitanides (RE Econ 2000)

  • Construction starts should depend upon option value.

  • Higher volatility of rents should cause delay of construction.


Approach
Approach

  • Time-series of commercial property completions in U.S. Office markets: CC

  • Data: Torto-Wheaton Research: 1982 – 1998.

  • Model:

  • Completions = a+ a1*Completions t-1 + a2*Income + a3*EmpGrowth+ a4*EmpVolatility +a5*Interest +a6*Cost + a7*Commute +a8 Temperature

  • Also used Rents and Vacancies in other models


Results
Results

A = constant: + insignificant

A1 = Lag Comp: + significant

A2 = Income: + significant

A3 = EmpGrowth + significant

A4 = Volatility-- significant

A5 = Interest Rate -- significant

A6 = Cost -- insignificant

A7 = Commute -- significant

A8 = Climate + significant


More

  • Other variables: Income and Rents both are positive and significant in other models. Vacancies are negative and significant in other models

  • Some evidence that development in 1990’s took optionality more into account.

    • Conservatism or increased volatility expectation?


Applications
Applications

  • Empirical results suggest that developers already value optionality:

  • Land prices are higher than simple present values.

  • Volatility in demand causes construction delay.


Application to development
Application to Development

  • Vacant land represents an option.

  • Option exercise triggered by peak valuation

    • Demand, construction costs, financing.

    • Strategic considerations.

    • Rents.

  • Complex issues

    • Time to build.

    • Competitor decisions.

  • Steven Grenadier (Stanford) “Construction Cascades.”

    • One exercise, all exercise.


Application to leasing
Application to Leasing

  • Each floor is a separate option.

  • High volatility of rents implies value in short-term lease/ vacancy.

  • Peaking rents a sign to lease up.

  • Low rents a sign to keep vacant space.

  • Low rents + vacancy = negative economic sign – or not?

  • Low vacancy + high rents = positive sign – or not?


Agency theory and real estate

Agency Theory and Real Estate

Theory, Insights and Applications


Background
Background

  • Ross (1973) "The Economic theory of agency: the principal's problem.“

  • “Agency relationship when one, designated as the agent, acts for, on behalf of, or as representative for the other, designated the principal, in a particular domain of decision problems.”


Structure of analysis
Structure of Analysis

  • Agent and Principal agree on a fee structure.

  • Agent takes actions that are not directly monitored or observable.

  • Fees determined by outcomes and external events, perhaps.

  • Agent motivated to act in his/her own interest.


Why is it interesting
Why is it Interesting?

  • Imperfect information

  • Management

  • Complex organizations

  • Co-operative ventures

  • Negotiation


Issues in analysis
Issues in Analysis

  • What fee structure will best align interest of P & A?

  • Is it possible to find something that achieves a “first best” solution which maximally motivates the Agent?

  • What additional mechanisms exist to align interests/motivate Agent?

    • Costly auditing/ monitoring an option


General analytical results
General Analytical Results

  • There are agency costs

    • Shirking

    • Pilferage

    • Risk-shifting

  • Near alignment of interests possible

    • Stock option programs a major solution

  • Solutions must be incentive-compatible and individually rational.


Examples in real estate
Examples in Real Estate

  • Real Estate Agents

    • Local knowledge essential (before web)

    • Commission earned on transaction.

    • Effort unobservable.

    • Result: Realtors leave their own home on the market longer and get higher adjusted prices for it.

  • Home-ownership and urban quality

    • Home ownership aligns upkeep incentives.

    • Rental home are not well-maintained.

    • Externalities imposed.


Real estate portfolios
Real Estate Portfolios

  • Real estate development and management is local.

  • Real estate portfolios are diversified.

  • Principal = national owner, Agent = local manager.


Approach1
Approach

  • Understand differing motivations

    • Where will conflicts arise?

  • Understand differing strengths

    • These provide the gains to trade.

  • Understand the IR and IC constraints on both

    • This means the deal will not fall through in the future.


Contracting
Contracting

  • A solution should be possible (Ross result) for a wide range of agents and principals.

  • Negotiation process should help reveal the relative strengths and motivations (Raiffa result).

  • Use the power of incentive alignment

    • Equity sharing.

  • Look for judicious use of monitoring.


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