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ACADEMIC PAPERS Academic

papers: Real
Real options in real estate options in real
estate
development
Dominik I. Lucius 73
European Business School, Schloû Reichartshausen, Oestrich-Winkel, Received August 2000
Germany Revised October 2000

Keywords Real options, Pricing, Real estate, Theory

Abstract The interpretation and valuation of real options by means of options pricing theory
can be regarded as a relatively new paradigm of investment theory. Option pricing theory based
investment valuation represents a sound theoretical basis and offers principally a simple decision
base. The approach recognises entrepreneurial flexibility and risk explicitly. It implies a positive
correlation between flexibility respectively uncertainty and the value of options. Traditional
deterministic-dynamic standard methods of valuation are not able to value flexibility or risk
effectively so that option values are adequately reflected. As property investors gradually embrace
modern financial concepts it is clear that real estate valuation theory will have to change. One of
the most promising areas that could have an important implication on the further development of
valuation is the application of the real options paradigm. The author investigates the transfer of
general real options theory through an examination of academic results in the field of real estate
development. He comes to the conclusion that current research generates highly academic-abstract
results with limited practical value. So far a limited number of quantitative studies regarding the
valuation real estate projects with the real options method have been conducted. Practical
valuations have yet to be comprehensively carried out. For doing so, further research concerning
the basic prerequisites of real options theory has to be undertaken.

Introduction
Over the last decade powerful theoretical advances in valuing uncertainty and
managerial flexibility have been achieved with the development of real option
valuation. The basic idea of this concept is based on an analogy with financial
options. The opportunity to invest is much alike a financial call option: a
subject has the right but not the obligation to invest in an asset at a future time
of its choosing. When investing in an asset the subject exercises the option. To
fulfil the conceptual analogy between financial and real options the asset's cash
flows need to be replicable in the financial market. The application of the
principle ``valuation by replication'' allows the mathematical application of
financial option pricing theory when valuing an investment. The application of
this theory prerequisites the existence of an industry specific real option
valuation concept. Today, the real option paradigm slowly enters the
investment valuation practice. Analysing the fields of application, it can be
stated that particularly resource based enterprises such as the oil, electric
power and mining industry have already implemented first valuation models to
capture the full effect of uncertainty and the full value of optionality from an Journal of Property Investment &
investor perspective. Beyond the commodities industries only the pharma/ Finance, Vol. 19 No. 1, 2001,
pp. 73-78. # MCB University
biotech and the high technology industries appear to take the first steps in Press, 1463-578X
JPIF using the new valuation tool. The use of real option theory in the management
19,1 of real estate is not yet wide spread. One reason for this could lie in the absence
of a conceptional real option framework that allows not only the
communication of the real option idea but that would also represent a
prerequisite of its application in the various fields of real estate practice.
Section 2 provides a literature review to reflect the academic results in real
74 option research in the field of project development. In Section 3, a real estate
specific concept is drafted. Section 4 deals with the real estate specific problems
in the application of the concept. Finally, the conclusion of the paper
summarises the results.

Literature review
In real estate specific literature real options models are applied in the fields of real
estate finance (Kutner and Seifert, 1989), lease contract contingencies (Buetow
and Albert, 1998), and microeconomic market analysis (Capozza and Sick, 1991).
With respect to the numerous options embedded in real estate development, in
this paper the emphasis is laid on the investment theoretical application of the
real option approach. Due to the complexity of real option models, the author
only summarises the essential results of real option research in this field.
Titman (1985) uses a simple binomial model to explain why lots remain
undeveloped. He interprets an option to wait as an American call without
dividends and draws the following conclusions: Options to wait contribute
significantly to the value of land. Project related cash-flow gains, uncertainty
towards construction costs and risk free interest influence the option value
positively. Therefore the attractiveness of real estate development decreases.
Williams (1991) confirms Titman's results and expands the investigation focus by
analysing the effects of an option to abandon on the value of project developments.
He interprets the option to abandon as an American put without dividends and
uses an analytic model to solve the problem. Williams introduces maintenance
costs for undeveloped property and concludes that undeveloped properties that
are more costly to maintain are on average abandoned and developed sooner.
Childs et al. (1996) focus on a redevelopment option. They use a numeric model
to analyse the effect of sequential investment on property value by evaluating a
sequence of American calls (options to wait) without dividends. In the presence
of relatively low costs to conversion, flexibility with respect to mixed uses and
redevelopment contributes significantly to the value of the built property or
undeveloped land. In a later model Williams (1997) analyses the redevelopment
option in an analytic framework. He confirms the results of the preceding study
and adds a comparison between single and sequential redevelopment options.
Therefore, the sequential redevelopment option is of higher value than the single
use rededication. In comparison to the standard solution with one redevelopment,
sequential redevelopment is on average more frequent and less extensive.
Capozza and Li (1994) integrate a tax component in their analytic model and
investigate the effect of pre- and post-development tax rates on the timing of
investment and the intensity of development. While pre-development tax rates
hasten the time of development, post-development tax rates delay the time of Academic
development. The density of development is reduced by both tax rates. papers: Real
The review of the existing academic literature can lead to the conclusion that options in real
the current real option research examines with singular problems in a highly
academic framework generating general qualitative results. Despite its enormous
estate
theoretical contribution, the literature is of limited practical value because it
focuses on valuing individual real options without providing a general 75
theoretical framework. In the following the author tries to develop a concept
which facilitates the understanding of real options in real estate. The objective is
not to analyse further models but to enable real estate practitioners to understand
the concept of real options and in addition to range in existing academic results.

A new perspective of real estate

Traditional investment theory defines real estate as a triangle of space, money
and time. In this sense a particular usage is attributed to a defined space which
generates an estimated cash flow over a specific period of time. This
perspective implies a relatively deterministic understanding of real estate
where immobility and inflexibility appear to be the characteristic features.
Immobility and inflexibility generate the impression of certainty concerning
the use of real estate. Against this background traditional net present value
methods perfectly match the requirements of investment valuation. The more
uncertainty is included in the investors' considerations the less adequate the
traditional valuation methods appear. Especially when aspects of
entrepreneurial flexibility are concerned, the standard methods undervalue
investment opportunities and myopic decisions result because they ignore or
do not properly value important alternative decisions.
The real option view of real estate refrains from the traditional perspective
and stresses the aspects of flexibility and variability. Thus when real estate is
defined as a real option it may be interpreted as a product of miscellaneous
decisions an investor has taken out of a range of options. This understanding
changes the view of real estate completely. The real option approach focuses on
entrepreneurial flexibility rather than on the traditional characteristic features.
Flexibility equals a range of options an investor can choose from. Against this
background the real option approach can supplement the weaknesses of
traditional methods by adding an option value to solely NPV-based static value
of an investment project. The expanded net present value does not replace the
traditional value, but uses it as a passive value to which an active value is added.

Application of real options in property development

Project development combines the factors site, idea and capital in such a way, that
competitive, employment creating and saving as well as socially and ecologically harmless
real estate is created and can be profitably used (Diederichs, 1996).

Out of a life-cycle oriented perspective this definition can embrace the entire
time span from project initiation to project finish whereby revitalisation can
JPIF also be understood as project development in a larger sense. While traditional
19,1 definitions focus on the actual process of development, the real option approach
concentrates on property related options. Therefore, from a real option view
property development can be interpreted as the action of choice between a
variety of miscellaneous options actions an investor can choose from. This
interpretation clearly stresses the entrepreneurial view of project development
76 and concentrates on the active decisions embedded in a project.
Before valuing a project it is to be decided which valuation method is
appropriate for the type of project. The more important flexibility and uncertainty
become the more advantageous the real option approach appears. The
paradigmatic suitability can be regarded as a first step in the valuation process.
A next step is the examination of the application prerequisites: real estate
investment differs essentially from other real investments. Some constitutive
characteristics of real estate are: immobility, heterogeneity, limited
substitutability, investment volume, transaction costs, time-span of life cycle,
and duration of development process. Having defined these characteristics the
prerequisites of real option theory can be tested: intuitively heterogeneity, limited
substitutability do not seem to fulfil the prerequisite of perfect replication.
Analytically, site and estate are interpreted as a unit (Guntermann, 1994). This
interpretation in combination with a risk-free asset allows the construction of a
duplication portfolio. Consequently, the prerequisite of perfect replication can be
fulfilled. Perfect irreversibility is to be understood as an exception in real estate
practice. Due to high investment volumes, heterogeneity, limited substitutability
and relatively high transaction costs, irreversibility of real estate investments in
the sense of the real options paradigm can be assumed. Within the bounds of real
estate investment, uncertainty is of particular interest. The duration of
development process and life cycle complicate the prediction of value
determining influences. Therefore real estate relevant uncertainty can be
postulated. The fourth prerequisite to the application of the real options theory is
the existence of options. Provided, that time, uncertainty, and options stand in a
positive correlation to another, investments in real estate should be connected to
a high degree of flexibility in action. While the development of new estate offers a
wide variety of options, revitalisation, and purchases of existing estates are
relatively limited in terms of options an investor can choose from.
In the literature a systematisation of real estate specific options does not exist.
Based on the general systematisation scheme developed by Trigeorgis (1996) a
real estate specific classification can be deduced. Options can be distinguished in
terms of flexibility and growth options: flexibility options comprise operative
options which cope with an investment itself. One group of flexibility options are
Reduction Options. These include the Option to Abandon, the Option to Shut
Down, and the Option to Contract. The first describes the disposal of a developed
project. The option to shut down can be interpreted as market induced vacancy
and represents the exception at long sight. An analogy to a percental alteration of
production as found in options to contract is the spatial diminishment of real
estate. On the contrary, Options to Expand refer to spatial enlargement
measures. Options to expand and options to contract can both be interpreted as Academic
Options to Alter Scale. As a second group Delay Options embrace Options to papers: Real
Defer (Options to Wait) as well as Options to stage investment. The first contains options in real
the contingency to prolongate a project development profit from a more sound
base of information. The second describes the option of a multistage investment.
estate
This can be regarded as redevelopment. The aggregation of all development
measures over the entire life cycle which contribute to a project results in a 77
Compound Option. Switching Options contain input and output flexibility. On
the one hand varying material can be used in the construction process, on the
other hand output flexibility allows the construction of individualised residential
estates. Growth Options on the other hand include strategic options on the
highest level of management and refer to the real estate portfolio as a whole.
Relating to the idea of platform investments Growth Options can include the
purchase of a company with complementary portfolio or the development of a
new scope of business to entry in new market segments. Also synergies can be
viewed as growth options as they incorporate options to implement generated
knowledge from running projects in the new ventures.

Problems
Problems in the application of real option theory are manifold: theoretical
difficulties originate from the presumption of a perfect real estate capital
market. Limited divisibility and transaction costs impair this presumption.
Heterogeneity complicates the construction of a twin security at the valuation
time. In the literature there is remarkable discussion whether existing stock
prices or REIT indices can or cannot function as a sufficient measure for the
underlying. It can be stated that the problems in finding a twin security when
valuing a single project increase due to the singularity of the project.
Conceptional problems originate from differences between financial and real
options. Particularly in real estate projects important variables can be subject
to stochastic processes so that mathematical complexity complicates the
valuation process. Another difficulty lies in the stochastic process itself. While
financial option models are based in most cases on a Geometric Brown Motion,
this stochastic process can not be taken for granted in the case of real estate.
Again this question has not been resolved completely in the relevant literature.
Above all practical problems limit the application of real option theory.
Mathematical requirements and the complexity of real options can lead to
confusion and rejection of this method in real estate management which prefers
rather quick and comprehensible solutions.

Summary and conclusions

In view of multiple options in real estate the transfer of real options theory to
real estate development appears intuitively evident. Existing applications are
highly theoretical and provide mainly an abstract contribution to the
qualitative knowledge of options in real estate development. Apart from
JPIF empirical studies to validate theoretical models, practical valuations have yet to
19,1 be comprehensively carried out, as in other industries.
The theoretical prerequisites of option pricing have not entirely been solved
in the literature which hinders the frictionless transfer of the concept to real
estate projects. To bridge the gap between theoretical real option valuation and
real estate project valuation, substantial research must be conducted. A
78 consistent systematisation of different options in project development could
facilitate the understanding for real options and their valuation. Within this
framework further real estate specific options could be explored that go beyond
the basic option dealt with in the literature.
It should be made clear that the application of real options in real estate
projects still stands at the beginning. As promising as the real options
approach appears in the field of real estate research and as convincing as the
academic findings may be, the challenge lies in the transfer to practical
application in the field of investment valuation.
References
Buetow, G.W. Jr and Albert, J.D. (1998), ``The pricing of embedded options real estate lease
contracts'', Journal of Real Estate Research, Vol. 15 No. 3, pp. 253-65.
Capozza, D.R. and Li, Y. (1994), ``The intensity and timing of investment: the case of land'', The
American Economic Review, Vol. 84 No. 4, pp. 889-904.
Capozza, D.R. and Sick, G.A. (1991), ``Valuing long-term leases: the option to redevelop'', Journal
of Real Estate Finance and Economics, Vol. 4 No. 2, pp. 209-23.
Childs, P.D., Riddiough, T.J. and Triantis, A.J. (1996), ``Mixed uses and the redevelopment
option'', Real Estate Economics, Vol. 24, pp. 317-39.
Diederichs, C.J. (1996), ``Grundlagen der projektentwicklung'', in Schulte, K.W. (Ed.), Handbuch
Immobilien-Projektentwicklung, p. 29.
Guntermann, K.L. (1994), ``The valuation of undeveloped land: a reconciliation of methods,
Journal of Real Estate Research, Vol. 9 No. 2, pp. 169-74.
Kunter, G.W. and Seifert, J.A. (1989), ``The valuation of mortgage loan commitments using option
pricing estimates'', Journal of Real Estate Research, Vol. 4 No. 2, pp. 13-20.
Titman, S. (1985), ``Urban land prices under uncertainty'', The American Economic Review, Vol. 75
No. 3, pp. 505-14. After Titman, Capooza und Helsley (1990), Williams (1991), and Quigg
(1993) did research on this option.
Trigeorgis, L. (1996), ``Real options: managerial flexibility and strategy'', Resource Allocation,
Vol. 7, p. 3.
Williams, J.T. (1991), ``Real estate development as an option'', Journal of Real Estate Finance and
Economics, Vol. 4, pp. 191-208.
Williams, J.T. (1997), ``Redevelopment of real assets'', Real Estate Economics, Vol. 25 No. 3,
pp. 387-407.

Further reading
Capozza, D.R. and Helsley, R.W. (1990), ``The stochastic city'', Journal of Urban Economics,
Vol. 28, pp. 187-203.
Quigg, L. (1993), ``Empirical testing of rea option-pricing models'', Journal of Finance, Vol. 18
No. 2, pp. 621-40.