Binomial option pricing models for real estate development
| DOI | https://doi.org/10.1108/JPIF-10-2012-0046 |
| Date | 02 August 2013 |
| Published date | 02 August 2013 |
| Pages | 418-440 |
| Author | Jianfu Shen,Frederik Pretorius |
| Subject Matter | Property management & built environment |
ACADEMIC PAPER
Binomial option pricing models
for real estate development
Jianfu Shen
Department of Finance and Insurance, Lingnan University,
Hong Kong, China, and
Frederik Pretorius
Department of Real Estate and Construction, The University of Hong Kong,
Hong Kong, China
Abstract
Purpose – The purpose of this paper is to construct option pricing models for real estate
development by considering and incorporating institutional arrangements, direct interactions and
financial constraints in the model. It extends the application of real option theory from the framework
borrowed from financial option pricing, and considers the case where a development company has
restrictions from outside environment and financial constraint. It explores the effects of these
additional practical factors on real asset project value and development timing. This paper makes
contributions to bridge the theoretical models and practical applications.
Design/methodology/approach – Real estate development is modelled in the binomial option
pricing framework with the considerations of time-to-build, foregone rent if delaying, institutional
environment and capital budgeting. The investment timings are derived from the models and
sensitivity analysis is conducted to explore the effects of these factors.
Findings – Apart from the factors in traditional option pricing theory, this paper confirms that the
contractual covenants, positive synergies between properties and financial status of the firm, which
enhance or restrict real flexibility embedded in the development land, influence project value and
investment timing. Numerical examples illustrate the effects of these factors. It is argued that the
valuation of real options should place emphasis on industry-specific characteristics and start from the
perspective of the firm rather than individual options.
Practical implications – The models constructed in this paper and the results can be directly used
in the practical real estate development.
Originality/value – This paper incorporates many practical factors in real estate development
which are not investigated in previous studies. It values the option project from the firm perspective
rather than project perspective as previous studies. It also shows the effects of institutional
arrangement and firm factors on project value and development timing.
Keywords Real estate, Propertyfinance, Option pricing, Real estatedevelopment,
Institutionalarrangement, Interactions, Financialconstraint
Paper type Research paper
Classical real option theory has progressed some way towards identifying main real
option categories like the option to delay or defer investment, the time to build option,
the option to alter scale, the abandonment option, the switch option, growth option
and compound options (Trigeorgis, 1996). These categories cover much flexibility in
economic activities, also in real estate. Theoretical studies like Titman (1985),
Williams (1991, 1997), Capozza and Li (1994) and others have investigated flexibility in
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1463-578X.htm
Received October 2012
Accepted April 2013
Journal of Property Investment &
Finance
Vol. 31 No. 5, 2013
pp. 418-440
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/JPIF-10-2012-0046
JPIF
31,5
418
real estate development, including the option to delay development, time to build
option, the option to alter land density, the option to switch land use and others. Quigg
(1993) empirically confirms the value of the option to delay in land development in the
USA, while for the UK (Sing and Patel, 2001a, b; Sing, 2001), Japan (Yamazaki, 2001)
and Hong Kong (Chiang et al., 2006) show that waiting value is significant in land price
and the real option method is an effective tool to evaluate the pricing of vacant land.
Practical application of real options theory in real estate development is however rare,
although important texts (Geltner, 2007) have included real option theory as a core
part of land development decision-making. Lucius (2001) suggests it may be due to
“theoretical difficulties”, “mathematical complexity”, identification of real option
categories and other problems. In theory, real option analysis can be applied to
describe and model various categories of flexibility, but such theoretical categories are
also often problematic when industry-specific problems are analyzed, as theory
typically assumes that options occur in a perfect, institution-free world.
This paper develops real option pricing methods following the binomial option
pricing framework to assess the value of real estate development projects, while taking
into account practical details and firm factors. With further development and taking
into account specific corporate, regulatory and institutional requirements, the models
can be developed and used in practical business applications. We commence with
analysis of the institutional environment surrounding the projects that are being
evaluated. In reality real options are not well-defined and explicit as theory indicates,
and many variables have to be identified from details of the projects and contracts
comprising the transactions. The contracts often function to determine whether any
real options exist, which party owns those options and how many options each party
owns. Such details have been largely ignored, with few studies including them in
research into real option theory (Rose, 1998; Giaccotto et al., 2007)[1]. Transaction
details and industry-specific details also introduce different characteristics into real
options pricing across industries, although in theory such options may fall into similar
categories. In real estate development, for example, several parties are involved in the
process including developers, the government[2] and contractors, while in countries
that manage their land as a publicly owned resource through leasehold typically adds a
layer of participation and complexity. For example, in the Hong Kong institutional
context, two types of flexibility, the timing of payment of the land conversion fee for
lease modification to change land use, and constrained time flexibility to start actual
construction (affecting the option to wait), are owned by the developer but only in
limited form (Yao, 2006). This paper follows the idea that to apply real option theory
we first have to identify the exact flexibility allowed in the contractual arrangements
which define the transaction to identify exactly which rights the developer holds, in
order to value accurately the real options embedded in the development project.
By examining institutions and the regulatory arrangements set by the Hong Kong
Government our paper proposes three distinct categories of real estate development
projects that typically occur in this jurisdiction, but which also cover most land
development cases in most cities with well-developed and regulated markets, including
in Asia, Europe, the USA, Australasia, and also to some extent also emerging markets
such as China.
Limited insight into practical details of land lease contracts may not be the only
problem in defining real options in real estate development projects; there are also
Binomial option
pricing models
419
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