Real Options in Real Estate

Yale School of Management
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.
K
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

• 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
• 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

• 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

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

• 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.
Optionality Premium
0.3
0.25
0.2
Bus.premium
0.15
Ind-premium
0.1 HD residential prem.
0.05
0
1977 1978 1979
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
• 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
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
• 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
• 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
• 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
Theory, Insights and Applications

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
• 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?
• Imperfect information
• Management
• Complex organizations
• Co-operative ventures
• Negotiation
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

• 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

• 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 development and management is
local.
• Real estate portfolios are diversified.
• Principal = national owner, Agent = local
manager.
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
• 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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Yale School of Management

Real Options in Real Estate

Theory and Evidence

Volatility and Call Option

Example: Plant Construction

Stochastic Interest Rates

Real Estate Example

Do Real Options Matter?

Evidence from Office Construction

• Rena Sivitanidou & Petros Sivitanides (RE

Agency Theory and Real Estate

Theory, Insights and Applications

General Analytical Results

Examples in Real Estate

Real Estate Portfolios

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