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Real Options in Real Estate

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Real Estate Example. Rents vary through time, with some momentum. ... Real estate portfolios are diversified. Principal = national owner, Agent = local manager. ... – PowerPoint PPT presentation

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Title: Real Options in Real Estate

1
Real Options in Real Estate
• Theory and Evidence

2
Overview
• Options
• Real Options
• Development Option
• Empirical Evidence
• Applications

3
Options
• Call option The right (not the obligation) to
purchase a share of stock at a date T in the
future for price P.

4
Option Valuation
• Stock price
• Strike price
• Interest rate
• Volatility of stock return
• Time to maturity
• Black-Scholes formula C ( S, K, r, s, T)

5
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
• We know the price of the stock and the bond at
each moment, so we can calculate the equivalent
price of the option.

6
Real Options
• Fishers 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.

7
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?

8
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.

9
Implications
• Irreversible investment involves a timing
decision.
• Relevant stochastic variables
• Interest rates
• Demand
• Investment cost
• Autocorrelation of variables are relevant.

10
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.

11
Build or Wait?
• NPV 40/.1 - 400 0
• Exp. Value .6(500-400)/(1.1) .4(0) 90.9
• What if rent (t) a brent(t-1)e ?
• Wait for rents to tip and then build?
• Issues
• Construction time.
• Build but hold vacant.

12
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.

13
14
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.

15
Approach
• Time-series of commercial property completions in
U.S. Office markets CC
• Data Torto-Wheaton Research 1982 1998.
• Model
• Completions a a1Completions t-1 a2Income
a3EmpGrowth a4EmpVolatility a5Interest
a6Cost a7Commute a8 Temperature
• Also used Rents and Vacancies in other models

16
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

17
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 1990s took
optionality more into account.
• Conservatism or increased volatility expectation?

18
Applications
• Empirical results suggest that developers already
value optionality
• Land prices are higher than simple present
values.
• Volatility in demand causes construction delay.

19
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.
• One exercise, all exercise.

20
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?

21
Agency Theory and Real Estate
• Theory, Insights and Applications

22
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.

23
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.

24
Why is it Interesting?
• Imperfect information
• Management
• Complex organizations
• Co-operative ventures
• Negotiation

25
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

26
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.

27
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.

28
Real Estate Portfolios
• Real estate development and management is local.
• Real estate portfolios are diversified.
• Principal national owner, Agent local
manager.

29
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.

30
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.