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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
    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.

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
  • Optionality premium 90.09
  • 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
Optionality Premium
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.
  • Steven Grenadier (Stanford) Construction
    Cascades.
  • 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.
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