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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

slide17
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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