University of Nottingham
APPLICATION OF REAL OPTION VALUATION TO REAL ESTATE INVESTMENT APPRAISAL — A CASE STUDY
YISHA LU
MA in Finance and Investment
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Application of Real Option Valuation to
Real Estate Investments Appraisal
—A Case Study
by
Yisha Lu
2007
A Dissertation presented in part consideration for the degree of
MA in Finance and Investment
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Abstract
This dissertation provides an insight of real option valuation application into real estate investment appraisal. Real estates investments have the features of low liquidity, slow payback and high sunk costs. This is especially the case appearing in emerging economics, due to the volatile demand, house price and land costs. The application of real options theory in real estate investment analysis considers a real estate development as an investment opportunity that reduces the uncertainties in the real estate development and creates economic value on real estate projects. A case study of a Chinese real estate development project “Jiangnan New Village” is conducted to illustrate the application of real option valuation to real estate investment appraisal in emerging real estate market. Binomial Tree approach is employed for real option valuation in the case study. The results lead to the conclusion that real options embedded in the real estate projects do create significant economic values on underlying project, and improve risk management of the project.
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Acknowledgement
I would like to take this opportunity to express my sincere thankfulness to all the people who helped and support me in completing this dissertation.
At the very first, I would thank gratefully to my supervisor Professor David Newton, for his invaluable guidance, comments and suggestions throughout the dissertation.
I also wish to thank all my friends Yuqi Li, Cui Wang, Hongfei Wang, Lujie Chen, Si
Zhou, Xin Ye etc. who had given me technical support for this dissertation and who made my life brighter in last year of my scholastic life at University of Nottingham.
Finally, I would like send my deepest gratitude and love to my parents, for their greatest encouragement and support all the way through my oversea studies.
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Contents
Abstract…………………………………………………………………
i
Acknowledgements………………………………………………………ii
Table of Contents………………………………………………………
iii
List of Tables…………………………………………………………….vi
List of Figures………………………………………………………… 
vii 
List of Appendices…………………………………………………… 
vii 
Chapter 1 Introduction……………………………………………………1
1.1 Research Background…………………………………………………………… 
1 
1.2 Research Objectives and Methodology………………………………………… 
2 
1.3 Research Structures……………………………………………………………… 
2 
Chapter 2 Real Option Theory……………………………………… 
4 
2.1 Concepts of Real Options………………………………………………………….4
2.1.1 Definitions of Real Option………………………………………………………………4
2.1.2 Types of Real Options…………………………………………………………………
8
2.2 Real Option Valuation Theory……………………………………………………14
2.2.1 
Real Option Pricing fundamentals: Terminology, Intrinsic and Time Value………… 
15 
2.2.2 Variables Determine Real Options Value…………………………………………… 
16 

2.2.3 
Riskneutral Valuation ………………………………………………………… 
17 
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2.2.4
Basic Option Pricing Models………………………………………………………….17
2.3 
Summaries……………………………………………………………………… 
23 
Chapter 3 Application of Real Options in Real Estate Investment…… 
24 

3.1 Real Options Commonly Exist in Real Estate Investment ….………………… 
24 
3.2 Prior Research on Real Options Application in Real Estate …………………….26
3.3 Research in Real Option Application in Chinese Real Estate Market………… 
29 
3.4 Summaries……………………………………………………………………… 
31 
Chapter 4 Case Study…………………………………………… 
32 
4.1 Case Background……………………………………………………………… 
32 
4.2 Case Statement—Jiangnan New Village…………………………………………34
4.3 Real option Identification……………………………………………………… 
35 
4.4 Valuation Model Choice……………………………………………………… 
37 
4.4.1 Real Option Model…………………………………………………………………….37
4.4.2 Expanded NPV Framework………………………………………………………… 
38 
Chapter 5 Real Options valuation and Analysis……………………… 
39 
5.1 Timetobuild Option…………………………………………………………….39
5.1.1 Parameters Estimation………………………………………………………………
39
5.1.2 Timetobuild Option Valuation……………………………………………………….42
5.2 Option to Abandon 
…………………………………………………………… 
47 
5.2.1 Parameters Estimation………………………………………………………… 
47 
5.2.2 Abandon Option Valuation…………………………………………………………….48
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5.3
Result Analysis and Further Discussion………………………………………….50
5.4 Sensitivity Analysis………………………………………………………………52
5.4.1 Volatility Sensitivity Analysis………………………………………………………….53
5.4.2 Riskfree Rate Sensitivity Analysis………………………………………………… 
54 
5.5 Limitations………………………………………………………… 
56 
5.5.1 Oversimplified Model Assumptions………………………………………………… 
56 
5.5.2 Limitations of the Real Options Approach…………………………………………….57
Chapter 6 Conclusion…………………………………………………
59
References……………………………………………………………….61
Appendices………………………………………………………………70
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List of Tables
Table 5.1 Volatility Estimation……………………………………………………
41
Table 5.2 Inputs…………………………………………………………………….42
Table 5.3 Estimation of underlying asset value…………………………………….43
Table 5.4 Phase III option value Tree…………………………………………… 
45 
Table 5.5 Phase II Option Value Tree…………………………………………… 
46 
Table 5.6 Compound Option value Tree……………………………………………47
Table 5.7 Abandonment Option Value Tree……………………………………… 
49 
Table 5.8 Volatility Sensitive Analysis…………………………………………… 
53 
Table 5.9 Riskfree Interest Rate Sensitive Analysis……………………………….54
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List of Figures
Figure 5.1 Relationship between Volatility and Real Option Value………………….53
Figure 5.2 Relationship between Riskfree Rate and Real Option Value……………55
List of Appendices
Appendix 1 
Analogy between Real Options and Financial Options………………71 

Appendix 2 
Jiangnan New Village Investment Cash Flows, NPV and Construction 

Costs………………………………………………………………… 
72 

Appendix 3 
Sales Plan for Jiangnan New Village…………………………………73 
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Chapter 1 Introduction
1.1 Research Background Real estate investments are characterized by low liquidity, slow payback and high sunk costs, involving high uncertainties about demand, house price and land costs (Rocha et al., 2007). These characteristics are particularly notable in emerging markets such as Chinese real estate market. Traditional NPV (Net Present Value) approach for real estate investment appraisal ignores changing dynamics of real estate markets and the inherent flexibilities in decisionmaking process. For example, the actual cash flows may differ from the streams what real estate developers originally expected, and developers may have flexibility to alter its original strategy by deferring, expanding, contracting, abandoning or redeveloping real estate projects to capitalize opportunities or to mitigate potential losses (Rocha et al., 2007). Such investment flexibilities can represent a substantial part of the real estate projects values. Neglecting them can grossly undervalue the real estate investments and lead to misallocations of resources in the economy (Schwartz and Trigeorgis, 2001).
Real option theory, on the other hand, provides a better valuation methodology for investment projects in the presence of these managerial flexibilities involved in the process of real estate investment decisionmaking. The use of real options analysis realizes management flexibilities and the economic values they create, by which enhancing real estate project expected net present value and facilitate decisionmaking effectiveness. By identifying and managing these flexibilities, real estate developers could obtain a more accurate estimation of the project value, and a better analysis of investment opportunities. Competitive advantages thereby can be sustained by developers.
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Nevertheless, there is a considerable gap between theory and practical applications of real option, and this is especially the case in emerging market. One application example in emerging market is Rocha et al. (2007), who study a twophase residential housing in the west zone of Rio de Janeiro in Brazil, showed that real option application in emerging real estate market improves the risk management of project by identifying the optimal strategy and timing for the construction phases. Interactions among multiple real options embedded in one single underlying project barriers the effective application of real option models in real world context.
1.2 Research Objectives and Methodology
The dissertation is motivated by the gap between the real option theory and its practical application, as well as the limit examples in emerging market application. The objective of this dissertation is to give a practical example of application of real option valuation into real estate investment appraisal in an emerging market, providing an insight of how real options can add economic values on real estate projects, and offer managerial implications for real estate developers’ investment decisionmakings. Methodology of case study will be used in this dissertation, where a real option valuation on real estate investment project in Guangzhou China representing an emerging market example will be employed. Binomial tree approach will be chosen as the valuation model for the real options embedded in the case.
1.3 Research Structures
The rest of the dissertation is organized as follow. Chapter 2 is going to present a literature review on general real option theories. First, definition and origins of real
options will be introduced, where concepts of real option will be explained. Different types of real option and literatures on them will be interpreted. Further, real option valuation theory will be review, in which fundamentals of real option valuation will be explained; real option valuation models include binomial tree model,
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BlackScholes model and compound option model will then be introduced.
Chapter 3 provides review on literatures specifically in the application of real option in real estate market. It starts from introduction of typical real options exist in real estate market, followed by the review of previous research contributions. As the example is from Chinese real estate market, literatures of real option application in Chinese real estate market will also be reviewed.
Chapter 4 introduces the case of Jiangnan New Village, an investment project carried out by Guangzhou City Construction & Development Property Holdings Co., Ltd. (GCCDP) in Haizhu District, Guangzhou, one of the most boom areas of real estate development in China. Case statement will be presented, followed by the identification of real options embedded and the preference of real option valuation methodology.
Real option valuation and analysis is then conducted in Chapter 5. Results will be discussed based on its implications for improving economic analysis of real estate investments and decisionmaking support. Limitations of model assumptions and real options approach will be discussed at the end of the chapter.
Finally,
implications.
chapter
6
will
summarize
the
whole
paper,
and
discuss
the
further
3
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Chapter 2 Real Option Theory
This chapter aims to give review of existing literature of general real options, its concepts and pricing theories and applications. As the real option analysis provides a framework analyzing and quantifying the flexibilities to react to uncertainties in real estate investment projects, this chapter presents as a background for real options application in real estate development projects.
2.1 Concepts of Real Options
2.1.1 Definition of Real Options “A real option is the right, but not the obligation, to take an action (e.g., deferring, expanding, contracting, or abandoning) at a predetermined cost called the exercise price, for a predetermined period of time—the life of the option”. (Copeland and Antikarov, 2003, p5) A simple example of real options could be a vacant land that gives its holder the right but not obligation to develop it (Titman, 1985).
The real options revolution for investment valuation arose partly because of the dissatisfaction of traditional NPV approaches by corporate practitioners, and some academics with traditional capital budgeting techniques (Schwartz and Trigeorgis, 2001). The traditional approach that most widely used for valuation of real estate and other investment projects is based on net present value (NPV), which essentially involves discounting the expected net cash flows from a project at a discount rate that reflects the risk of those cash flows (i.e. the “riskadjusted” discount rate) (Schwartz and Trigeorgis, 2001). It makes implicit assumptions of passive investment management, implies that a) the cash flows in each year must be estimated precisely, so does the corresponding riskadjusted discount rate; b) once the project has started,
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it has to follow the expected scenario of cash flows until end of the expected project life, which has no management flexibilities. However, in the actual market place, the realized cash flows may differ from what management have expected due to uncertainties and changes involved in the market. Management may have valuable flexibility to alter its operating strategy (e.g. defer, expand, contract, abandon a planned or in processing project) to capitalize on favorable future opportunities or mitigate losses, since arrival of new information may resolve the uncertainties about market conditions and future cash flows (Trigeorgis, 2001). Corporate managers and strategists were grappling intuitively elements of managerial operating flexibility and strategic interactions (Schwartz and Trigeorgis, 2001), but traditional NPV valuation approach cannot capture such management flexibilities and trends to underinvestment investment projects.
Early critics on traditional NPV approach are Dean (1951), Hayes and Abernathy (1980), Hayes and Garvin (1982). They recognize that traditional discounted cash flow method often undervalued investment opportunities by either ignore or disvalue important strategic considerations, thereby induce myopic decisions, underinvestment and loss competitive positions eventually (Schwartz and Trigeorgis, 2001). Followers like Hodder and Riggs (1985) argued that the problem of underinvestment arises from the misapplications of traditional DCF techniques. On the other hand, Hertz (1964), Magee (1964) suggested that simulation and decision tree analysis may capture the value of operating management flexibility instead of traditional NPV methods.
Myers (1977) further points out that the inherent limitations of traditional discount cash flow method are its ignorance of significant operating or strategic options in investment. He suggests that option pricing provide the best means to value such investments. For example, sequential interdependence among investment over time may be neglected by traditional DCF method, while option pricing model may capture such interdependences. Myers (1977) is the one who first proposed the analogy of management flexibilities to options, who recognizes that companies’ discretionary
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investment opportunities can be seen as call options on the future growth which offers companies the rights but not the obligations to buy financial assets.
Kester (1984)’s study is consistent with Myers’s (1977) argument, indicating that the value of growth options contribute to over half of companies’ equity market value. He further emphasizes the importance of capital allocation, which could help companies develop growth opportunity and thus to achieve competitive advantages. Consequently, an insight of growth options can assist companies integrate capital budgeting with longterm strategic planning.
Trigeorgis and Mason (1987) further introduced option valuation as an economicallycorrected version of decision tree analysis, which is thought to be better suited for valuing various strategic management flexibilities. They argued that traditional NPV analysis is inadequate to capture the operating flexibilities (e.g. option to defer, expand or abandon a project) and the strategic option values (i.e. the option value on a project from its interdependence with future investments) embedded in an investment project. While reorganization of these operating flexibilities and strategic option values can improve the risk management of projects and take advantage of the upside potential gains at the mean time, thereby enhance the expected project net present value. Option premiums thus should be paid for the additional economic values that the flexibilities and strategic options enhanced, to recognize and exercise these real options.
Besides Myers (1977) and Kester (1984), Dixit and Pindyck (1995) present an alternative conceptual real option framework for capital investment, evaluating the effects of real option approach on the investment decisionmaking process. They emphasis the importance of the option to wait, referring to the feature of irreversibility (due to specialized assets and huge sunk costs) in most investment projects. They state that option to wait is analogous to a call option that offers investment decisionmaker the right but not the obligation to exploit an investment opportunity. Decisionmaker
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can either wait for more information gathered if the uncertainties are high or exercise this call option immediately by carrying out the investment. In the latter case, the option to wait is an opportunity cost that should be taken into capital investment decision.
Kogut and Kulatilaka (1994) suggest that corporations should focus on longterm growth opportunities from the viewpoint of real option approach. Current investment can be viewed as the options for future further investments, by which companies can bide their time for full investment. They figure out that options pricing theory can be used for quantify such investment opportunities. And later, Amram and Kulatilaka (1999) argued that, for investment appraisal of a multiphased project (especially sequential multiphased project) with high uncertain expected cash flow returns, real option approach is highly recommended, which can capture the value of operating flexibilities in multiphasing decisionmaking.
Based on above, an “expanded NPV” rule represented by Trigeorgis (2001) arises in response to the needs of management flexibilities adaptation and enhancing investment opportunities’ value. The rule reflects both traditional NPV of direct cash flows (with passive management) and the value of operating and strategic flexibilities. “This does not mean that traditional NPV should be scrapped, but rather should be seen as a crucial and necessary input to an optionsbased, expanded NPV analysis, i.e., Expanded (strategic) NPV= Static (passive) NPV of expected cash flows + Value of options from active management” (Trigeorgis, 1996, p124).
Real option approach thus allows both conception and quantification of strategic values created from active management. This value is presented as a collection of real options embedded in capital investment opportunities, with gross project value of expected operating cash flow as the underlying asset (Trigeorgis, 2001).
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2.1.2 Types of Real Options Real options’ classification are primarily based on the type of flexibility they offer (Copeland and Antikarov, 2003). For example, Trigeogis (1996) classified common real options into seven categories: option to defer, timetobuild option, option to alter operating scale, option to abandon, option to switch, option to growth and multiple interacting options; in which option to alter operating scale includes option to expand, option to contract and option to shut down and restart. One of the most boosting real options literature areas is on valuing these various types of real options quantitatively by deriving analytic, closedform solutions.
Option to defer Option to defer is important in industries with longterm operating horizons and highly uncertain investment environments, like natural resource extraction industries, real estate development, farming and paper products (Trigeorgis, 1988). It is an American call option where one has the right to delay the start of a project (Copeland and Antikarov, 2003). When uncertainty is high, the opportunity to wait allow investment decision maker to gather more information and to protect the investment returns from the high uncertainty.
Literatures contributed to real options to defer includes Tourinho (1979), Titman (1985), McDonald & Siegel (1986), Paddock, Siegel & Smith (1988), Ingersoll & Ross (1992).
Titman (1985), by using a simple binomial model illustrated that to leave a valuable land vacant rather than develop them immediately can contribute significantly to the value of land. And the value of the option adding to the land is positively related to the uncertainty towards construction costs and risk free interest.
McDonald and Sigel (1986) built a model for the value of option to wait and applied to a commodity producing project. They find that the consideration of investment
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timing is quantitatively important and the optimal timing to invest is when the net present value of cash flow returns is double the investment cost. McDonald and Sigel again, address the practical importance of the value of option to wait.
Paddock, Siegel and Smith (1988) conduct valuation of offshore petroleum leases taking into consideration of the option to defer, by which they confirm that the real option approach offer a more accurate estimation of the lease value than traditional NPV approach does and grant a guide for the optimal develop timing.
In addition, Tourinho (1979) have done further research in valuation of the option to reserves of natural resources. Ingersoll and Ross (1992) examine the impact of riskfree interest rate variation on the uncertain cash flow returns, finding that variation of riskfree interest rate creates the value of option to wait, where increase in volatility of riskfree interest rate declines the immediate investment value.
TimetoBuild Option Many capital projects (e.g. real estate development and R&D project investments) involve staging investments where the investment decisions and outlays are often made sequentially throughout the project’s life, rather than a single decision and expenditure only at the beginning of the project. Such a series of outlays creates the option to default given stage if market situation is acceptable, or to abandon the investment in midstream if new information is unfavorable to the project. Construction of previous stage created the right but not the obligation to default subsequent stage. Hence, each stage can be viewed as an option on the value of subsequent stages, and valued as a compound option (Trigeorgis, 2001).
Such real options are most observable in R&D intensive industries, especially pharmaceuticals and longdevelopment capitalintensive projects, such as largescale construction or energygenerating plants, as well as startup ventures (Trigeorgis,
2001).
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Majd and Pindyck (1987) try to derive optimal decision rules for each investment stage and to value a time to build option by determining the effects of time to build, opportunity cost and uncertainty on the investment decision. Their research shows that investment decisions can be extremely sensitive to the level of risk, and the simple NPV rule can mislead investment decisions due to the ignorance of the stage sequential investment flexibilities embedded in the project. Carr (1988) also provided valuation of sequential exchange options, with further stage expenditures into consideration.
Option to alter operating scale Option to alter operating scales allows investment decision makers adapt various management flexibilities according to different market conditions. If the market conditions are more favorable than expected, there is an option to expand capacity or accelerate resource utilization; if the market conditions become less favorable, decision makers can shrink the scale of operations, cut cost and protect business from further loss. In the extreme case of unfavorable market conditions, investment decision makers can even temporarily shut down the projects, which can be reopen until the market conditions getting better (Trigeorgis, 2001). Hence, option to alter operating scale including three types of real options: option to expand, option to contract or scale down and option to shut down and restart. Such management flexibilities provide opportunities to pick up the upside profit potential while limiting downside losses, which should be taken into investment decision considerations (Trigeorgis and Mason, 1987).
These kind of real options are especially important in natural resource industries (e.g. mine operations), commercial real estate developments, and hightech incentive industries. They are also common in cyclical industries (e.g. in facilities planning and construction), fashion apparel and consumer goods industries. (Trigeorgis, 2001)
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Pindyck (1988)’s research is an example analysis for option to expand, who develops a model to quantify the option to expand, by which the optimal capacity of a firm can then be decided. The research result shows that a firm’s optimal capacity will be achieve under the condition that the expected cash flow from a marginal unit of capacity equals to the total cost of that marginal unit (composed by purchase and installation costs, and opportunity cost of exercising the option to buy the unit). Companies are recommended to hold less capacity if they face highly uncertain or unknown demands. Pindyck highlights the importance of including the opportunity cost for exercising the expand option when making expand decision, ignoring which would lead to overinvestment on expansion.
An example of temporarily abandon option valuation is illustrated by Brennan and Schwartz (1985) using an example of mine operation. They recognize that operating flexibilities embedded in natural resource projects allows operator to close or reopen the mines according to the natural resource prices. Real option approach is confirmed to be a better valuation method in capture the temporarily abandon options, which contributes a substantial fraction to the overall mine value.
Option to abandon If the market conditions decline severely, the option to abandon provides the flexibility to abandon current project for the realized resale value of rest capital assets, which protect against failure of the project and the further losses. It is analogous to an Americanstyle put option on the current project value, with the salvage value or the best alternative use as the exercise price (Myers and Majd, 1990). In this case the salvage value is the main determinant for abandonment option value, where general capital asset has higher salvage value than specific capital asset.
Option to abandon is vital in capital intensive industries, such as airlines and railroads, financial services industries and new product introductions in uncertain markets (Trigeorgis, 2001).
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Myers and Majd (1990) presented numerical estimates for abandonment value of a capital investment project. They set up a portfolio that can replicating abandonment option’s payoff, and valued the option to abandon as an American put option. The computation starts with the value at the terminal boundary, and working back to the abandonment values at the start of the project. At each point of time, the expected value of option to abandon is compared with the immediate exercise payoff, if immediate exercise payoff is relatively high, the project will be abandoned.
Option to switch (e.g. outputs or inputs) In the case of the demand sensitive operating system, management has the option to change the output mix of the facility (i.e. “product” flexibility), or in the case of volatile supply, the same outputs can be produced using different types of inputs (i.e. “process” flexibility) (Trigeorgis, 2001).
Example operation systems that have potential to apply such management flexibilities are consumer electronics, toys, machine parts, autos productions for output shifts; and all feedstockdependent facilities for input shifts, like oil, electric power, chemicals, crop switching and sourcing (Trigeorgis, 2001).
The typical literature that analyzed the option to switch is Kulatilaka and Trigeorgis (1994). Kulatilaka and Trigeorgis present a simple analysis of the generic flexibility to switch between alternative operating modes, by which they found that the value of the project with switch flexibilities can be seen as the value of the project without such flexibilities plus the sum of the future switch option values. Nevertheless, they realize that there are compoundness effect by exercising the switch options, and the effect consist with the problem of that immediate exercise of switching although seems attractive in short term, it may be longterm optimal to wait.
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Growth options Growth options are compound options, i.e. one option is on another. An early investment, such as R&D, lease on undeveloped land or oil reserves, strategic acquisition or information network/infrastructure, is a prerequisite or link in a chain of interrelated projects, opening up future growth opportunities, like new generation product or process, oil reserves, access to new market, strengthening of core capabilities (Trigeorgis, 2001). Companies also often cite “strategic” value when taking on negative NPV projects, which however reveals call options on followon projects in addition to the immediate projects’ cash flows.
Growth options are commonly embedded in infrastructurebased or strategic industries, especially hightech, R&D industries, or multiple product generations or applications (e.g., computer, pharmaceuticals industries) and multinational operations, also common in strategic acquisition (Trigeorgis, 2001).
Such real options are analyzed by Myers (1977), Brealey and Myers (2000), Kester (1984), Trigeorgis (1988), Pindyck (1988), Chung and Charoenwong (1991). For instance, Kester (1984) conducted a comparison among 15 listed companies’ expected cash inflows and their market value, reveal that the value of growth options contribute to over half of companies’ equity market value.
Multiple interacting options Often in real life applications, there is a “collection” of various options embedded in a single project, both upwardpotential enhancing calls and downwardprotection put options present in combination (Trigeorgis, 2001). Such combination of options does not mean their effect on the project value is simply sum of each option value. They interact and may also interact with financial flexibility options (Trigeorgis, 2001).
Hence literatures for valuing these interactions are presented, such as Brennan and Schwartz (1985), Trigeorgis (1993) and Kulatilaka (1994).
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Brennan and Schwartz (1985), besides their contribution on research of temporarily abandon option in natural resource industries, is an early study on interaction with single real options. They realized the inertia effect of exercising switch mine operating state, which causes partial irreversibility from the costs of switch. This makes it optimal in longterm to remain the original operating state regardless the switching option is attractive in shortterm cash flow consideration. But the interactions effect among individual option values are not explicitly addressed in this paper (Trigeorgis, 2001). Similar findings of such interaction effect are shown in the study of Kulatilaka and Trigeorgis (1995).
Subsequently, Trigeorgis (1993) studies the nature of the real options interaction, shows the nonadditivity principle of individual option values. He find that the presence of subsequent options increase the value of the earlier options, whereas exercise of earlier real options (e.g. expand or contract option), may change the underlying asset value, and hence the value of subsequent options on it. Trigeorgis finally concluded that the combined value of a collection of real options may differ from the sum of single option values.
Kulatilaka (1995) further examines the interactions effects among multiple real options on their optimal exercise schedules. By realizing the interdependences between real options, the gap between a theoretical real option research and practical application will be bridged.
2.2 Real Option Valuation Theory For the valuation of the real options, due to the relationship between real options and financial options ^{1} , may numerical methods derived from financial options valuation can be applied in the valuation of real options.
^{1} See appendix 1 Analogy between Real Options and Financial Options
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2.2.1 Real Option Pricing Fundamentals: Terminology, Intrinsic and Time Value Real options use the same terminologies as financial options even though there are remarkable differences between them in terms of underlying asset ^{2} and time to maturity.
Ø A call option is the right but not the obligation to acquire a given asset at some future time for a predetermined cost.
Ø A put option is the right but not the obligation to sell a given asset in future for a predetermined price.
Ø An American option can be exercised on or at any time before the maturity date.
Ø A European option can only be exercised on the maturity date.
Ø A compound option is an option whose value is based on another option.
Ø A rainbow option is any options with the uncertainties from more than one source.
Ø A call option is in the money when the underlying asset value is above the exercise price.
Ø A call option is out of money if the underlying asset value is lower than the exercise price. In this case, the call will not be exercised immediately. But one could not lose money on the option other than what have paid for obtaining the option (i.e. option premium).
The value of a real option, same as the financial option, is composed by its intrinsic value and its time value. The intrinsic value is the value if the option is exercised immediately (i.e. S _{0} X). The time value refers to volatility value, reflecting the value of uncertainties that leads to the fluctuation of underlying asset value (Bodie, Kane and Marcus, 2005). Therefore, option value is dependent not just on the current underlying asset value and its exercise price, but also the volatility of underlying asset,
^{2} The main difference between real option and financial options is that exercise of real options can change value of underlying asset (e.g. an expand option will enhance the underlying asset value).
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the time to maturity, the payout of underlying asset, and the riskfree interest rate. The effects of these factors influencing real option values are analyzed in next section.
2.2.2 Variables Determine Real Options Value Also similar to financial options, value of real options depends on five basic variables (Copeland and Antikarov, 2003), which are the inputs for applying option valuation model for real option valuation:
1. The value of underlying risky asset, for example, a project, investment, or acquisition, or even an option in the case of compound options;
2. The exercise price, which is the money invested to exercise the option if buying the asset or money received if selling the asset;
3. The time to expiration of the option;
4. The standard deviation of the value of the underlying risky asset;
5. Riskfree rate of interest over the life of the option.
If there are dividends that may be paid out by the underlying assets, the sixth variable is required, which is the cash outflows or inflows over its life.
According to Copeland and Antikarove (2003), each of the six variables will have an effect on the real options analysis value. An increase in the present value of the project will increase the NPV and therefore the real option value. It has to be pointed out that one of the important differences between real and financial option is that the option holder can affect the value of the underlying asset. The value of the underlying asset could be increased by the operating management, so is the option value. Exercise price has a negative effect on the real option value; higher investment cost gives a lower real option value. A longer time to expiration allow more knowledge of uncertainty, thus leads to higher real option value. Volatility (i.e. uncertainty about the present value of the underlying assets) is positively related to the value of real option value. An increase in riskfree interest rate will increase the time value of money thus
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increase real option value. And dividends (e.g. cash outflows) will decrease the real option value.
2.2.3 Riskneutral Valuation
Riskneutral valuation is the basic idea behind options and real options valuations. Cox and Ross’s (1976) recognize that an option can be replicated (or a “synthetic option” created) by an equivalent portfolio of traded securities assuming no arbitrage opportunities. Rubinstein (1976) extend Cox and Ross’s idea to risk aversion situation, where standard option pricing formulas can be alternatively derived, thus the riskless hedging assumption is not necessary. It implies that the risk attitudes are not relevant to option valuations. Such riskneutral valuation enables expected options future payoffs to be discounted at the riskfree interest rate (i.e. with actual probabilities replaced with riskneutral ones) (Trigeorgis, 2001).
Mason and Merton (1985) and Kasanen and Trigeorgis (1994) further extend the riskneutral valuation to nontraded real asset, as the existence of a traded “twin security” or a dynamic portfolio for nontraded asset would have the same risk features. Such risk is closely correlated to the nontraded asset’s uncertainty, and can be used as the nontraded asset’s risk factor. In a completed market, using this risk factor can be sufficient for the real option valuation.
More generally, Constantinides (1978), Cox, Ingersoll, and Ross (1985), and Harrison and Kreps (1979) have suggested the risk neutral valuation can be applied to pricing of any contingent claim on an asset, traded or not, since the actual growth rate can always be replaced with a certaintyequivalent riskneutral rate.
2.2.4 Basic Option Pricing Models
Black and Schles (1973) and Merton (1973) originate the first model for option valuation, which is derived from their seminal work. Cox, Ross and Rubinstein’s (1979) later develop binomial tree approach that allows a more simplified valuation
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approach for options. Geske (1979) and Carr (1988) further build up models for compound options.
BlackScholes Model The most fundamental and acknowledged option valuation model is the BlackScholes equation, developed by Black, Merton, and Scholes (1973). The model
is a breakthrough in option pricing theory, and has been widely used in valuation of
various financial asset valuations and real options.
Below is a review of BlackScholes Model:
Call
Where
d 1
=
= Stf 
( d 
) 
 
Xe 
 r f ( T ) f ( d 

ln( S X 0 
) 1 + 
( 
r f 
+ 
2 )( 1 ) s 2 T 

s 
T

d
2
= d s
1
Inputs:
)
Put
=
Xe
 r
f
(
T
)
f
(

d
2
)

Sf
(

d
1
)
φ The cumulative standard normal distribution function;
S 
The value of the underlying asset; 
X 
– The exercise price or the cost of developing the intangible; 
r _{f}  The nominal riskfree rate;
σ The volatility measure;
T  The time to expiration or the economic life of the strategic option.
Assumptions of BlackScholes Model are a) underlying asset’s price structure follows
a Geometric Brownian Motion with drift factor (μ) and volatility parameter (σ), and this motion follows a MarkovWeiner stochastic process; b) there is an efficient
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market with no riskless arbitrage opportunities, no transaction costs, no dividend payout and no taxes; c) price changes in a continuous and instantaneous way.
Despite the widely application of the BlackScholes formula in not only financial options valuation but also real options areas, BlackScholes model is still subjected to the criticism that lacking of model flexibilities. It only works on European options with a fixed decision date, but hard to provide valuation of American options, which are more common in actual real option world. It is also hard to apply to valuation of options with dividends payment and compound options. In addition, it is difficult to explain due to the highly technical stochastic calculus mathematics. Nevertheless, BlackScholes is an exact, quick and easy numerical method and can provide a useful gross approximation as a benchmark (Mun, 2002).
Binomial Tree Approaches Binomial tree approach was first suggested by Cox et al. (1979), which is essentially based on the riskneutral valuation. It assumes that the time to the option’s maturity can be divided into a number of subintervals in each of which there are two possible price changes for underlying risky asset. One possible direction is upward movement by a multiplication factor u with the riskneutral probability p. One the other possibility is downward movement by a multiplication factor d with the riskneutral probability 1p. V is the value of the underlying asset; u and d are determined by
uncertainties of underlying asset value (i.e. u =
uV (with probability p)
V
e s
, d =
e
s
).
dV (with probability 1p)
A riskless hedge portfolio with one share of the underlying risky asset and a short position in h shares of call option is then created (see below). Thus if the value of the
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underlying risky asset goes down, so does the value of the call option written on it,
but as we are in the short position, our wealth hence goes up; and if the hedge ratio is
exactly right, the loss on the underlying asset is exactly offset by the gain on the short
position of call option (Copeland and Antikarov, 2003).
V hC
uVhCu
dVhCd
Under the assumption of no arbitrage opportunities, the present value of the portfolio
in the up state should be equal to present value of the portfolio in the down state (i.e.
VhC(1+r _{f} ) = uVhCu = dVhCd).
Thus, we can solve h = [(ud)V]/(CuCd).
Substitute n into present value of the hedge portfolio VhC(1+r _{f} ) = uVhCu
And get C =
pCu
+
(1

p Cd
)
1 + r
f
, where p =
(1
+
r
f
)

d
u

d
.
And if continuous riskfree rate is used, p =

e
r
f
d
t

d
u

d
probability.
. This p is the riskneutral
This process can be continued repeatedly till period n, which create binomial tree of
underlying asset value as below (e.g. n=3).
Vu ^{3} 

Vu ^{2} 

Vu 
Vu ^{2} d 

V 
Vud 

Vd 
Vud ^{2} 

Vd ^{2} 

Vd ^{3} 
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And the value of option can be resolved by applying a “rollback” procedure in each period back to the presence. For European options, the options value at each end node is computed and discounted stepwise at riskfree interest rate back to time zero. For American options, the opportunities of early exercise need to be checked by comparing the immediate exercise payoffs with the expected payoff of keep holding the option.
As mentioned above, the multiplication factor u and d are determined by uncertainty of underlying asset value, captured by the volatility (σ); because of which the binomial tree comprises up and down movements. Such up and down movements generate the value of an option; the higher the volatility, the higher the u and d, and thereby the higher option value; the more timesteps there is, the more accurate is the result (Mun, 2002).
In contrast to BlackScholes model, Binomial tree approach is much easier to operate and explain; and even very flexible to be tweaked easily to accommodate most types of real options problems (Mun, 2002). But in order to acquire a good approximation, great computing power is requested.
Monte Carlo Simulation Another major approach to value real options is simulation method, which imitate thousands of possible combinations of uncertain variables to simulate the reallife system. The variables (e.g. interest rates, staffing needs, revenues, stock prices, inventory, discount rates) have a known or estimated range of values but are uncertain values at any particular time or event (Mun, 2002). Monte Carlo simulation is one of the simulations, proposed by Boyle (1977). It conducts with following steps: first, determine the stochastic process that state variables would follow; second, simulate a series of paths that affecting the option values assuming riskneutral; third, for each path, the payoffs of each paths can be calculated and average these to obtain the expected payoff; finally, discount the expected payoff at riskfree rate and the option
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value can be estimated (Hull, 2006).
As Monte Carlo simulation allows state variables to follow different paths, it can be used to deal with pathdependence options (Mun, 2002). Further, Monte Carlo simulation is superior to binomial trees model and BlackScholes model in terms of application to option valuation with multiple uncertainties (Hull, 2006). But Monte Carlo simulation has a major drawback that it is unable to adapt the early exercise feature of Americanstyle options.
Compound Option Models Compound option is an option to acquire another option, which was first valued by Geske (1979). A compound option can be simultaneous or sequential. Example of simultaneous compound options can be exchange options (e.g. exchange one risky asset for another or for several risky assets), which are valued by Margrabe (1978), Stulz (1982) and Johnson (1987). A sequential compound options exists in multiple phases project, the latter phases depend on the success of previous phases (Mun, 2002). Carr (1988) values a sequential compound option, involving an option to acquire a subsequent option to exchange the underlying asset for another risky alternative.
In a compound option analysis, the value of the option depends on the value of another option. For example, exercise of the first option give the holder the right to acquire the second option, and the second option gives the holder the right to buy or sell the underlying asset. Thus, the value of the first option is dependent on the second option. The typical compound model based on binomial lattice approach has three valuation steps: first, value underlying asset value (underlying lattice); second, value second option on the underlying asset (equity lattice); finally, value the first option (valuation lattice) (Mun, 2002).
Compound option models are often applied to the valuation of phased investments
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with various real options embedded in. They are particularly adopted for the valuation of projects that can switched to alternative states of operations, or the projects with strategic interdependences values (Schwartz and Trigeorgis, 2001).
2.3 Summaries In this chapter, the concept of real option and theory of real option valuation are reviewed. Real option revolution raised as a response of dissatisfaction of traditional NPV approach, where investment opportunities and management flexibilities are ignored and investment are undervalued. There are various kinds of real options; each realizes one or more types of investment management flexibilities. Numerous literatures focuses on modeling valuation of different types of real options, from which interactions among multiple real options embedded in a single project are realized. The fundamental of real option valuation is riskneutral valuation, based on which, a variety of valuation models such as BlackScholes, Binomial trees, Monte Carlo simulation are developed. Strengths and drawbacks of each valuation models are discussed.
Based on this general review of real option literatures, next chapter will focus on the literatures of real option application in real estate area.
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Chapter 3 
Application 
of 
Real 
Options 
in 
Real 
Estate 
Investment 
Real estate investments are characterized by low liquidity, slow payback and high sunk costs, involving high uncertainties about demand, house price and land costs (Rocha et al., 2007). Such characteristics are especially remarkable in emerging markets. The application of real options theory in real estate investment analysis considers a real estate development as an investment opportunity that reduces the uncertainties in the real estate development and creates economic value on real estate projects.
3.1 Real Options Commonly Exist in Real Estate Investment Various real options exist in real estate development projects, examples are listed as follow.
The most typical real option exist in real estate market is an option to wait. For example, vacant land gives its owner the right but not the obligation to develop property at any point in the future (Titman, 1985). Due to high uncertainties involved in real estate development, landowner can defer the large scale construction and wait until necessary market information available. Hence, it is an American call option, whose main value is from the time value of the option that allows developer to gain more knowledge and the risks it reduces for the investment. The longer the option life time, the higher level of the uncertainty is associated in the real estate project. As time passes, the project’s value is more certain. Developers can either proceed with the construction if the market situation is favorable, or defer the construction to avoid potential losses in case of adverse market situation. It thus performs as a mean of risk management on irreversible investments, by which developers will not lose any thing other than the option’s premium.
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Also construction of a real estate site is often divided into phases. A TimetoBuild option can be realized here, where the initial phase of a project provides its performance that can be responded for future phases designing. For large, multibuilding developments, timetobuild option reduces risks and capitalizes risk management flexibilities. The larger the scale of the investment, the higher the uncertainties, thus the timetobuild option is more valuable. Exercising the option of building a previous phase offers another option to build a subsequent phase. Thus, it is analogous to a compound call option. Similar to the option to wait, timetobuild option also represents an approach of risk management in real estate investment.
When previous phase provides unfavorable performances or the market condition turns extreme unfavorable, a developer can exercise the option to abandon or scale the project back by selling a fraction of it. They are American put options that protect the developer from further losses. Conversely, if the market situation provide positive feedback, the option to expand provides developers the opportunity to scale up the property development, and obtain the upside potential probability.
Option to switch can also be applied into real estate developments (e.g. in terms of switching land intended use or operation modes). According to market demand changes, developers often have the option to convert land use between industrial, commercial and residential use. An example can be conversing an office building to residential property, which is an option to converse with the value of the proposed residential project as underlying asset and the value of office building as exercise price (Barman and Nash, 2007). Real estate developers can also switch between different modes of operation such as switching between construction materials for cost saving.
Real option concept can also be applied to project financing in real estate development. For a levered real estate project, its equity providers hold a call option on the project with the outstanding value of debt as the exercise price; the option is in
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the money if the project value over the debt value, where the equity provider has a positive payoff (Barman and Nash, 2007).
There is even an option to growth for the real estate developers. One real estate project can setup value chains with other valuable projects, thereby early real estate projects could provide later growth opportunities for the development company.
Overall, a real world real estate project is normally phased, with other types of options embedded in each single phase. The most common options exist in single phase are timetobuild option, options to wait and options to abandon. A typical sequential phased project is described by Rocha et al. (2007) with the following decision tree:
Rocha, K. Salles, L. Garcia, F. A. A, Sardinha, J. A. and Teixerira, J. P. (2007), “Real Estate and Real
Options—A Case Study” Emerging Market Review, 8, pp.6779
3.2 Prior Research on Real Options Application in Real Estate Various studies have applied real option theory and pricing models to real estate. The earliest work is Titman (1985), who first proposed the analogy that holding vacant land can be recognized as an option to develop a completed building at the future. By investigating the reason of why lots of land in Los Angels leaved undeveloped, Titman figures out that an option to wait is analogous to an American call that contributes significantly to the value of land. Value of the call option is positive related to the uncertainties of the proposed project cash inflows and its construction costs. Thus, the vacant land value should enclose both the value of its best immediate
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use and the value of option if development is delayed or the land is converted into its best alternative use in the future (Trigeorgis, 2001). In that sense, holding a vacant land undeveloped is thus reasonable since deferral option added economic value to the land. Williams (1991) confirms Titman’s results and expands the research on option to abandon, optimal timing for development and optimal density for a property.
In addition to the real option application in land valuation, operation flexibilities and opportunities to redevelopment are realized as real options, and their impacts on value of real estate development project are discussed. Examples of these literatures include Williams (1997) and Childs et al. (1996)’s discussion of repeated redevelopment impacts on project value; Grenadier (1995)’s research on optimal tenant mix determinants; Capozza and Sick (1994)’s study on conversion of property alternative use; and Capozza and Li (1994)’s research on optimal intensity and timing for investments. Literatures find that the values of those options are significantly contributed to the value of land and developed properties, which explains the current continuing patterns on investments in existing (already developed) real estate assets (Ott, 2004). However, above researches examines only singular real options embedded in real estate investment, whereas real world situation are much more complex.
Numerous empirical studies conducted to test validity of the realoption model on land valuation and real estate development decisionmaking. Quigg (1993), an earlier empirical test on real option pricing models, studies 2700 land transactions in Seattle, confirms the explanatory power of real option model in land transaction price prediction, and finds that the deferral option represents 6% on average of the theoretical land value. Ott and Riddiough (2000) and Ott and Yi (2001)’s empirical study results also favors real option model prediction power and highlight the importance of deferral option value in irreversible real estate investment. By studying aggregate U.S. and regional commercial real estate data, they find real option model, especially the uncertainty variable in it, significantly explains commercial real estate
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investment and development cycles. Another example of empirical test of real option models on U.S. commercial real estate investment is Sivtanidou and Sivtanides (2000), whose results consist with Ott and Riddough’s findings. Recent empirical works includes Yao’s (2004) empirical testing of real options in Hong Kong residential market, Bulan et al.’s (2004) empirical evidence in Vancouver, Canada between 1979 and 1998, and Yavas’s (2005) experimental paper.
Recent works in real option in real estate focus on the practical applications, due to the significant gap between theory and practice. Ott (2004) tries to bridge this gap by reviewing real options in real estate and demonstrates a practical application to illustrated growth option valuation practice. Further, Masunaga (2007) explains the reason that why real option approach is not fully used in real estate world is because of the need for understanding the advanced financial theories. By doing experiment in a real estate case, Masunaga compares real option analysis result with engineeringbased approach result (the valuation approach commonly used in real estate world), concluded that real option approach though requires advance finance knowledge but can obtain accurate valuation result, which is suggested to combine with engineeringbased approach. Barman and Nash (2007), stand on the same argument with Masunaga, developed a streamlined “hybrid” model based on both the traditional economic and the more recent engineering real options methodologies, and demonstrated it with a case study. In addition, researchers realize that the existence of multiple players in the same real estate investment will affect real estate investment valuation and decisionmaking (e.g., Wang and Zhou (2006) and Schwartz (2007)). Models are also developed for multiple real options interaction. For instance, Paxon (2005) develops valuation model for up to eight different options. Based on the numerical solutions, Paxon finds that increase in number of options reduces the investment and abandonment triggers, and increases the values of the investment option and total option values.
Yet, few papers put on directly applications of real option valuation for multiphased
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real estate investment projects. Researches that focus on the emerging market application are also very limited. However, it is the market with relative higher uncertainties, where real option approach should be employed to reduce risks. One example is Rocha et al. (2007), who study a twophase residential housing in the west zone of Rio de Janeiro in Brazil. Applying their model, Rocha et al. (2007) show that real option application in emerging real estate market improves the risk management of project by identifying the optimal strategy and timing for the construction phases.
3.3 Research in Real Option Application in Chinese Real Estate Market In china, pioneers cities such Guangzhou, Shenzhen experiences a boom in real estate market due to land reform since 1980’s (Chen and Wills, 1999). As one of the emerging markets, real estate investments are especially associated with high uncertainties. Despite that, the real option methodology does not introduced to real estate investment analysis until recent years.
Most Chinese literatures theoretically realized the advantage of real option method over Traditional NPV in capture the investment and operation flexibilities in Chinese real estate market. Zhao (2006a) compares real option and NPV analysis in commercial real estate investment, concludes NPV ignores the irreversibility, uncertainty and flexibility involved in commercial estate investments, so that undervalues the investment value and leads to incorrect investment decision. Liu and Liu (2006) provide a case study on the comparison of real option and NPV analysis in investment decisionmaking on real estate project, and draw the same conclusion with Zhao (2006). Li et al. (2003) explain the various types of real options exist in real estate investment, study on the strategies in investment decisions with consideration of real options, and finally observed above discussion with an example of option to wait. Zhao (2006b) studies the real option characteristics in real estate market and conducts a framework for the commercial real estate investments. Nevertheless, practical and empirical papers are not rich in real option research on Chinese real
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estate market.
Different from real options literatures in Europe and US, researches on multiphased investments in Chinese real estate market are limited. The only example is Zeng and Qiu (2006), who provide a real option model for a threestage real estate investment and development project, state that each stage of the three stages (land obtain, construction and sales) in real estate development gives the option to conduct the next stage.
Regards to the real option valuation applied in real estate investment, BlackScholes models are commonly used in real estates real option research (e.g., Xiang and He (2002) and Yang and Zhang (2005)). Only few papers focus on the binomial tree method application in valuing real options in real estate area. For instance, Sun (2006) builds up a binomial model for real estate investment and applies it in his case study.
Hence, it can be concluded that although Chinese real estate market is more volatile than developed market, Chinese literatures about real option application are still constrained on theories, lack of empirical and practical studies, especially for the phased real estate investments. And most of the case studies are conduct the valuation with BlackScholes models, but few apply binomial tree method to the real option evaluation, despite better model flexibility of binomial approach on capturing real option characteristics (refer to 2.3.3).
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3.4 Summaries Regardless the enormous theoretical contributions, current real option research in real estate constrained in singular real option valuations, multiphased real option models are limited. Moreover, there is a notable gap between theory and practice, especially in emerging real estate markets, which is probably because of the requirement of advance finance knowledge when applying real option analysis. Hence, the literature of real options in real estates lacks practical value (Lucius, 2001). Recent papers thus much more focus on the practical applications in order to bridge the gap. Nevertheless, fewer researches pay attention to emerging market applications. In Chinese real estate market, as one of the major emerging market, real option analysis should have been applied into real estate investment valuation for risk management. However, researches on Chinese real estate market in application of real option theory are still restricted in theoretical framework with limited practical examples, particularly in multiphased investments. Even in practical examples, binomial method is rarely used for valuation, which would actually offer a more accurate valuation result.
Hence, in the following chapters I try to provide a practical application of binomial tree method to a phased real estate investment project in Guangzhou China, observe the importance of investment flexibilities in adding value to real estate project and reducing uncertainties.
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Chapter 4 Case Study
In the following two chapters, methodology of case study will be used to provide insight for real option analysis applied in a real estate investment project. The objective is to show the importance of the real option in adding value to the whole project, accounting into the uncertainties involved in the project. For the real option analysis in this case, binomial trees approach is chosen for real option valuation, due to its model flexibility and computation accuracy compared with other methods.
The case is referred to a real estate project located in Guangzhou, one of the boom emerging real estate markets in china for recent ten years. It is a case that usually exampled for real estate development planning, where traditional NPV is used as investment appraisal method. However, without considering the investment flexibility, some of project value was neglected by the developer. This chapter is going to introduce the background and statement of the case, and the real option analysis for the case will be conducted in next chapter.
4.1 Case Background ^{3} In 2001, Guangzhou City Construction & Development Property Holdings Co., Ltd. (GCCDP) was considering to purchase a land in Haizhu District, Guangzhou, with a land cost of RMB ¥480 million, develop it into residential housing property “Jiangnan New Village”. The whole project will take 6 years to build. If the development is success, the property will be the present largest residential property development in Guangzhou.
The real estate market in Guangzhou thrived since 1990’s. It grew fast from 2000, in
^{3} All the figures and background information about Haizhu District and Jiangnan New Village are sourced from Jia, S. (2005), Real Estate investment project planning—Theory, Practice and Case Study, Guangdong Economic publishing, Guangzhou.
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which year real estate development investment was 356.05 million RMB, 20.33% more than the investment amount in 1999. Haizhu District is one of the most boom districts in real estate investment and development. During three quarters of 2000, there was1,080,000m ^{2} housing property sold in Haizhu District, which was the highest deal amount in Guangzhou, about 25% of overall sales. The land GCCDP considered to purchase is located on a traffic conjunction of main streets, with other residential housing properties and many colleges and schools surrounded. But the security, noise and pollution become the weakness of the development. More important, it will face the threats of intensive competition from other residential properties, such as Haifu Garden and Fujing Garden. Hence, the treats and environment determined that the land can not be used as luxury property development but intends to be built as a residential property for middle classes. Nevertheless, middle classes are more sensitive to price, therefore the demand is very elastic and involve more uncertainties regarding Chinese economic environment. In addition, the project is going to be the largest residential development property, so that faces much higher risks than any other middle class residential property developments.
The developer Guangzhou City Construction & Development Property Holdings Co., Ltd. is one of the leading real estate developers in Guangzhou, opened in 1978. Through asset restructuring with Yuexiu Enterprise (Holdings) Ltd. in 2002, the company was listed in Hong Kong Exchanges in the name of Guangzhou Investment with total capital assets of RMB 21 billion. GCCDP has developed more than 40 residential areas over the years, in which Jiangnan Village was one of the earlier development and operating property. Other projects include 5.2 sq.km Tianhe Construction Section (integratedly developed for the sixth national games and collaboration in the implementation of the strategy of shifting the center of Guangzhou eastward), Ershadao Islet Villa Complex (the most luxurious complex in Guangzhou) and Glade Village and Southern Le Sand (GCCDP, 2007). From the position of present time, Jiangnan Village offered a growth opportunity for GCCDP to become an integrated enterprise with a robust brand. In addition, the first Real Estate
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Investment Trusts (REITs) in mainland China also went public under the name of GCCDP.
4.2 Case Statement—Jiangnan New Village ^{4}
If GCCDP decide to purchase the land, the residential property “Jiangnan New Village” would be developed, with a gross land area of 106,690 m ^{2} , and building area of 352290m ^{2} (including 12 midhigh units, 8 low units and 8 high units residential houses). The project starts on January 2002, and expected completed at the end of 2007, with duration of 6 years.
The project involves 3 Phases including initial investment setting up and building constructions:
Phase I —initial launch phase (from Jan. 2002 to Dec. 2002, duration 1 year,) The first phase involves the initial investment and preparation including market research, sales planning, and initial investment feasibility analysis; building design; land acquiring, document and permission obtaining. It is expected to cost an initial expenditure with a present value of RMB ¥ 109.2452m (see Appendix 1).
Phase II—1 ^{s}^{t} stage construction phase (from Jan. 2003 to Dec. 2004, duration 2 years) In the first construction stage, the construction plan contains 12 midhigh residential units, 6 low residential units, and nursery school, Central Park and other basic facilities, with building area of168435.56m ^{2} . The total construction cost for this phase is expected to have a present value of RMB ¥496.4299 (Appendix 2). Sales plan begins from phase II, in which 40% of midhigh units is planning to be sold in 2004
^{4} The case is quoted from Jia, S. (2005), Real Estate investment project planning—Theory, Practice and Case Study, Guangdong Economic publishing, Guangzhou. And all the relevant data are quoted from the book.
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with a price of ¥5200/m ^{2} (refer to Appendix 3). Further sales are planned to be conducted in Phase III.
Phase III—2 ^{n}^{d} stage construction phase (from Jan. 2005 to Dec, 2007, duration 3 years) Second construction stage contains 8 high residential and commercial units, 2 low residential units, with 16970414m ^{2} building area. A construction cost with a present value of RMB ¥393.1843m is needed for phase III (Appendix 2). Sales activity are mainly planned to be conducted in this phase. 40% of midhigh units and 40% of low units are expected to be sold in 2005 with a price of ¥5200/m ^{2} and ¥5400/m ^{2} respectively. And in 2006, it has the budget to sale rest of the midhigh units and 40% of low units and 60% of high units. High units sold in a price of ¥5600/m ^{2} . Rest of the property (20% of low units and 40% of high units) are planned to be sold in 2007 (see Appendix 3).
When constructions completed, the residential property will be operated and managed for 20 years by GCCDP, after which the property is proposed to be resold. The total project is expected to generate a cash flow with a present value of RMB ¥1,061.894282m (see Appendix 2). And the investment appraisal of Jiangnan New Village was done by traditional net present value approach, with the net present value of is RMB ¥150.4934m (refer to Appendix 2).
4.3 Real Options Identification
To identify the real options embedded in the project, we need to look the project closely phase by phase. Below is a summary of the case project phases:
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RMB ¥496.4299m
TimetoBuild Option By showing above, we can see that each phase can be seen as an option on the value of subsequent phases by investing the construction cost required to proceed to the next stage. Such an option gives the real estate developer the flexibility to conduct the next phase construction. For example, after the initial launch phase, the GCCDP does not have to start the construction immediately, but can decide what to do according to the first phase result. The success of the initial launch provides an option to conduct the 1 ^{s}^{t} stage construction phase. Similarly, 1 ^{s}^{t} stage construction phase also provide such an option to carry out 2 ^{n}^{d} stage construction. As well, the investment of initial launch opens the opportunity to conduct the later two construction phases. Nevertheless, exercises of investment in each phase are not obligations. Hence, there is a sequential compound option exists in this threephase real estate development project, composed by three simple European call option at each phase. The exercise of previous option gives the right to buy the subsequent option. The value of option in phase II is based on the option in phase III, and the option value in phase I is compound on phase II option value. The exercise price for each simple call option is the construction costs for each phase.
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Abandon option In addition to the compound deferral option, it can be recognized that an abandon option exist during the whole project, which can be exercised any time before the end of the project. In the case of the extreme unfavorable market situation, such an option allows GCCDP to abandon the project at the salvage value of the project, and thus limit the downside loss. This is an American put option alive during entire project periods.
Both types of options would mitigate the risks faced by Jiangnan New Village’s development, and can be seen as risk management flexibilities that can be employed by GCCDP.
4.4 Valuation Model Choice
4.4.1 Real Option Model For the real option valuation conducted in the following chapter, binomial trees approach is chosen as the valuation model. This is mainly because of its advantage in the model flexibility. Other real option valuation models like BlackScholes are lack of such flexibility in easy adaptation in various type of real options, such as American real options (as it requires a fixed decision date) and options with dividends payment (refer to section 2.2.3). Nevertheless, the abandon option identified above is an American put option that cannot apply BlackScholes for valuation. BlackScholes cannot capture the value of complicated compound real options either. But in this case study and most real estate investment projects are not single existed but compounded by phases, which are easier to be captured by Binomial Tree approach. Binomial models also have the advantages of easy explanation and operation. In practice, most real estate developers are lack of financial options knowledge, whereas the binomial tree is easy to understand and managed, and is a relative practical valuation method
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compared with BlackScholes Model, which requires specific financial knowledge for understanding. Other methodologies such as Monte Carlo simulation are either difficult to explain in theory or complicated in technical application, hence are not considered as appropriate valuation methodology.
4.4.2 Expanded NPV Framework After the valuation of real option, the Expanded NPV framework will be applied to calculate the expended project value with each option. Trigeorgis (1996) propose an expanded or strategic NPV criterion which does not only reflect NPV of project cash flow, but also the real option values by adding them on traditional net present value. Namely, Expanded (strategic) NPV equals Static (passive) NPV of project expected cash flows plus Value of flexibilities (real options) embedded in the project (Trigeorgis, 2001). By applying such a framework, the effect of real option analysis on project valuation can be directly illustrated.
To sum, under the framework of the expanded NPV rule, the real option will be analyzed by Binomial Trees Approach. All the data (including NPV and cash flows of the project, construction costs) are quoted from Jia’s (2005) book on real estate investment project planning. Some assumption will be made for the project valuation in the next chapter.
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Chapter 5 Real Options Valuation and Analysis
5.1 TimetoBuild Option This is a sequential compound option composed by three European call options. The exercise of phase I option (C _{1} ) give the Jiangnan New Village’s developer the right to buy another call option (C _{2} ), and which also offer a right to buy phase III option (C _{3} ). C _{2} is active only after the exercise of C _{1} and C _{3} is alive only when C _{2} is exercised. Hence, from an economic point of view, the third option chronologically is the first option (Copeland and Antikarov, 2003). The underlying asset for C _{1} is based on C _{2} , which is, on the other hand, based on the value of C _{3} .
5.1.1 Parameters Estimation Underlying asset As I stated above, the timetobuild option is a sequential compound option, and value of C _{1} is based on C _{2} , and value of C _{2} is based on C _{3}_{.} Thus, the underlying asset for phase I option is the option value of C _{2} at the exercise date of C _{1} ; the underlying asset for phase II is the option value of C _{3} at the exercise date of C _{2} ; whereas, the underlying asset for phase III option is the value of cash flows that generated by this real estate project at the date of C _{3} ’s exercising. The present value of these cash inflows can be derived from the net cash flows of the Jiangnan New Village (See Appendix 2), which is RMB ¥1,061.894282 million (i.e. sum of the present value of cash inflows).
Exercise price For real options, option is exercised when investment is made, and the exercise price is the cost of making investment on the project. Hence, the construction costs for each phase in Jiangnan New Village project are assumed to present the exercise prices for the single option in each phase. Those are RMB ¥109.2452m for phase I, RMB ¥496.4299m for phase II and RMB ¥393.1843m for phase III respectively.
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Time to Maturity Assume year 0 is 2001, when the company has to make the decision of Jiangnan New Village investment. For the option to develop phase III, the time to maturity (T _{3} ) is equal to the development time of phase III in 2005, which is 4 year from year 0. And for the phase II option, the time to expire (T _{2} ) is 2 years from year 0. Phase I then has a time to maturity (T _{1} ) of 1 year from year 0. But it has to be noticed that Phase III option is not alive until the exercise of the Phase II option, as well as for Phase II option that can only exercised after phase I has successes launched.
Volatility estimation Many different methods are available to estimate the volatility in real option, including logarithmic cash flow returns, logarithmic present value approach and GARCH approach (Mun 2002). In this dissertation, logarithmic present value of returns approach is adopted. Six years history stock price of GCCDP ^{5} is assumed having the same volatility with Jiangnan New Village development cash flows, and has been used to derive the volatility. Namely, the volatility is measured as standard deviation of the logarithmic GCCDP history stock prices by the formula
where
R
formula
=
ln(
P
t
/
P
t 1
)
.
The
daily
standard
s
annualized
= SQRT (n / years) ¥s
daily
deviation
is
then
to
get the annual
volatility. Detailed calculation of the volatility estimation is illustrated as below (Table 5.1).
As shown, a result of 41.43% annualized volatility was obtained from this process for Jiangnan New Village project, and assumed to be constant over the entire project life.
^{5} Quoted from Yahoo! Finance (2007), trading code 0123
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Table 5.1 Volatility Estimation
Date 
Close 
pt/pt1 
r=ln(pt/pt1) 
rr' 
(rr')2 

18Sep07 
2.76 
1.01845018 
0.018282045 
0.017268974 
0.000298217 

17Sep07 
2.71 
1.08835341 
0.084665924 
0.083652854 
0.0069978 

14Sep07 
2.49 
0.95402299 
0.047067511 
0.048080582 
0.002311742 

13Sep07 
2.61 
1.12017167 
0.113481954 
0.112468883 
0.01264925 

12Sep07 
2.33 
1.02192982 
0.021692825 
0.020679754 
0.000427652 

11Sep07 
2.28 
1.01785714 
0.017699577 
0.016686506 
0.000278439 

10Sep07 
2.24 
1 
0 
0.001013071 
1.02631E06 

7Sep07 
2.24 
1.00900901 
0.00896867 
0.007955599 
6.32916E05 

6Sep07 
2.22 
1.01369863 
0.013605652 
0.012592581 
0.000158573 

 
 
 
 
 
 

 
 
 
 
 
 

 
 
 
 
 
 

10Jan02 
0.67 
1 
0 
0.001013071 
1.02631E06 

9Jan02 
0.67 
0.98529412 
0.014815086 
0.015828157 
0.000250531 

8Jan02 
0.68 
0.97142857 
0.028987537 
0.030000608 
0.000900036 

7Jan02 
0.7 
1.04477612 
0.043802623 
0.042789552 
0.001830946 

4Jan02 
0.67 
1.046875 
0.045809536 
0.044796465 
0.002006723 

3Jan02 
0.64 
1 
0 
0.001013071 
1.02631E06 

2Jan02 
0.64 
1.03225806 
0.031748698 
0.030735627 
0.000944679 

1Jan02 
0.62 

r'= 
0.00101307 
sum 
1.029294152 

n= 
1475 
variance 
0.0006983 

n/6 
245.833333 
S.D.Daily 
0.026425366 

SQRT(n/6) 
15.6790731 
S.D.Annualized 
0.414325245 
Where S.D Annualized =SQRT(n/6)*S.D.Daily
Riskfree rate The interest rate of government bond with correspond life time to option’s time to maturity can be used for estimation of the risk free rate. In this case, it is assumed to be 3.78%, which refers to 5 year government bond interest rate in 2001 quoted from The People’s Bank of China. It is also assumed that the riskfree rate is constant and continuous.
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5.1.2 TimetoBuild Option Valuation Based on the assumption stated above, an 8 timestep binomial tree is developed for the valuation of this time to build option. As analyzed in last section, the third option chronologically is the first option from the economic point of view. Thus the valuation process starts from the estimation of Phase III value and calculated backward to Phase I option.
Underlying asset value tree To value the phase III option value, its underlying asset, the returns of Jiangnan New Village has to be estimated first. It has a present value of RMB ¥1,061.894282m, which has two possibilities at each timestep: increase by up state multiplier u, with riskneutral probability p; or decrease by the down state multiplier d, with riskneutral probability of 1p. All the values are presented in ¥m.
Table 5.2 Inputs
present value of cash inflows 
1061.894282 
u 
1.340382 
Riskfree rate 
0.0378 
d 
0.746056 
Time to expiry 
4 
a 
1.0191 
time steps 
8 
p 
0.4594 
sigma 
0.4143 
1p 
0.5406 
Delta t 
0.5 
Exp(r delta t) 
0.9813 
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Table 5.3 Estimation of underlying asset value
Y0
V
1061.894282
Vu
1423.343542
Vd
792.2328184
Y1
Vu
^{2}
1907.823475
Vud
1061.894282
Vd ^{2}
591.0502102
Y2 
Y3 
Y4 

Vu ^{8} 

11063.91694 

Vu ^{7} 

8254.30389 

Vu ^{6} 
Vu ^{7} d 

6158.17464 
6158.174637 

Vu ^{5} 
Vu ^{6} d 

4594.3444 
4594.3444 

Vu ^{4} 
Vu ^{5} d 
Vu ^{6} d ^{2} 

3427.6391 
3427.63915 
3427.639149 

Vu ^{3} 
Vu ^{4} d 
Vu ^{5} d ^{2} 

2557.211 
2557.2115 
2557.21146 

Vu ^{3} d 
Vu ^{4} d ^{2} 
Vu ^{5} d ^{3} 

1907.8235 
1907.82348 
1907.823475 

Vu ^{2} d 
Vu ^{3} d ^{2} 
Vu ^{4} d ^{3} 

1423.344 
1423.3435 
1423.34354 

Vu ^{2} d ^{2} 
Vu ^{3} d ^{3} 
Vu ^{4} d ^{4} 

1061.8943 
1061.89428 
1061.894282 

Vud ^{2} 
Vu ^{2} d ^{3} 
Vu ^{3} d ^{4} 

792.2328 
792.23282 
792.232818 

Vud ^{3} 
Vu ^{2} d ^{4} 
Vu ^{3} d ^{5} 

591.05021 
591.05021 
591.0502102 

Vd ^{3} 
Vud ^{4} 
Vu ^{2} d ^{5} 

440.9567 
440.95668 
440.956677 

Vd ^{4} 
Vud ^{5} 
Vu ^{2} d ^{6} 

328.97847 
328.978465 
328.9784651 

Vd ^{5} 
Vud ^{6} 

245.43643 
245.436425 

Vd ^{6} 
Vud ^{7} 

183.109368 
183.1093681 

Vd ^{7} 

136.60988 
Vd ^{8} 

101.9186489 

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Phase III Value
Based on the underlying asset value tree, value of phase III option C _{3} can be derived.
The payoffs at the time to expiration of the option are MAX (0, S _{T} X), where X is the
construction cost of phase III, equal to RMB ¥393.1843m. Using the riskneutral
valuation
( )
C t
=
e

r
D
t
[
(
pCu t
+ D
t
)
+
(1

p Cd
)
(
t
+ D
t
)]
and
apply
the
roll
back
procedure until year 2 when C _{3} becomes alive, the value of C _{3} is then derived. As C _{3}
is not available until year 2, the option values before year 2 are zero. At nodes C _{3} u ^{2} d ^{6} ,
C _{3} ud ^{7} and C _{3} d ^{7} , the zero call option values imply that at these economic states the
market situation is not favorable enough to proceed phase III, thus the phase III
construction should be either deferred or abandon.
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Table 5.4 Phase III option value Tree
0
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Phase II Value Using the values of phase III option at year 2 as underlying asset, value of phase II option is then calculated. The payoffs at year 2 are MAX (0, C _{3} X _{2} ), where X _{2} equal to Phase II construction cost, RMB ¥496.4299m. Similar to Phase III option, Phase II option will not be valuable until the exercise of Phase I option. Thus, the option values of Phase II in Y0 are zero. Again, zero call option value at nodes C2ud ^{3} and C2d ^{4} imply that Phase II construction will not be defaulted.
Table 5.5 Phase II Option Value Tree
Y0 
Y1 
Y2 

C2u ^{4} 

2566.6539 

C2u ^{3} 

1712.346 

C2u ^{2} 
C2u ^{3} d 

1080.207081 
1046.8382 

C2u 
C2u ^{2} d 

0 
581.1757 

C2 
C2ud 
C2u ^{2} d ^{2} 

0 
311.2451753 
205.99409 

C2d 
C2ud ^{2} 

0 
92.85865 

C2d ^{2} 
C2ud ^{3} 

41.85911296 
0 

C2d ^{3} 

0 

C2d ^{4} 

0 
MAX (0, C _{3} X _{2} )
Compound Option Value After obtained the value of C _{2} , phase I option value can then be calculated, with the payoff function of MAX (0, C _{2} X _{1} ), where X _{1} is the initial launch cost RMB ¥109.2452m. Note that Phase I option will not be exercised at the node C _{1} d ^{2} with a value of zero, which means at that economic state the overall project will not conducted then.
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Table 5.6 Compound Option value Tree
Y0 
Y1 

C1u ^{2} 

970.9618814 

C1u 

544.8530666 

C1 
C1ud 

293.91641 
201.9999753 

C1d 

91.05817689 

C1d ^{2} 

0 
MAX (0, C _{2} X _{1} )
Finally, the value of compound option is derived as RMB ¥293.9164m, which is the strategic value of considering the timetobuild option. Such a value can be added on the project’s net present value based on Trigeorgis’s (1996) “expanded NPV” rule ^{6} :
Expanded NPV of Jiangnan New Village = NPV without investment flexibilities + Value of time to build option =RMB ¥150.4934m + RMB ¥293.9164m =RMB ¥ 444.4098m.
5.2 Option to Abandon As the option to abandon can be exercised at any time before the project complete, it is an American put option based on the project which provides the opportunity for GCCDP to control the downside loss.
5.2.1 Parameters Estimation Underlying asset The underlying asset for this American put option is simply the Jiangnan New Village
^{6} “Expanded (strategic) NPV= Static (passive) NPV of expected cash flows + Value of options form active management” (Trigeorgis, 1996, p124).
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cash inflows, with the present value of RMB ¥1,061.894282m.
Exercise price For option to abandon, the exercise price would be the salvage value (i.e. the resale value on the secondhand market) of the project. In this case, it is assumed the salvage value is the land price RMB ¥480m (i.e. assume the project can be sold at its land price at any time during the project life time if abandon).
Time to maturity As analyzed in last chapter, this option to abandon will not expired until the end of the project, and the project starts in one year from now (2001) having a building period of 6 years, hence, the option has a time to maturity of 7 years.
Volatility As the underlying asset is still Jiangnan New Village cash inflows, the annualized volatility 41.43% also represent the volatility for this real option, which is again assumed to be constant over the project life.
Riskfree rate The riskfree rate here is also assumed to be 3.78%, as there is no precise correspond 7year government bond available for guidance of the riskfree rate. Again, the riskfree is assumed to be constant and continuous.
5.2.2 Abandon Option Valuation Based on the assumptions made above, a 7step binomial tree is built to value this American put option. Here 7 timesteps is chosen for time conservation.
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Table 5.7 Abandonment Option Value Tree
Initial stock price 1061.894282 
Delta t 
1 

Exercise price Riskfree rate Time to expiry sigma time steps 
480 
u 1.513311052 

0.0378 
d 0.660802681 

7 
a 
1.0385 

0.4143 
p 
0.4431 

7 
1p 
0.5569 

Exp(r delta t) 
0.9629 

Y0 
Y1 
Y2 
Y3 
Y4 
Y5 Y6 
Y7 

19300.951 

0.0000 

12754.12019 

0.0000 

8427.96 
8427.9568 

0.0000 
0.0000 

5569.22 
5569.216455 

0.0000 
0.0000 

3680.15 
3680.15 
3680.1532 

0.0000 
0.0000 
0.0000 

2431.86 
2431.86 
2431.855076 

7.6994 
0.0000 
0.0000 

1606.98 
1606.98 
1606.98 
1606.9764 

28.7333 
14.3573 
0.0000 
0.0000 

1061.89 
1061.89 
1061.89 
1061.894282 

63.5790 
47.4544 
26.7725 
0.0000 

701.70 
701.70 
701.70 
701.70259 

95.6986 
77.0675 
49.9234 
0.0000 

463.69 
463.69 
463.6869513 

140.6992 
122.4110 
93.0937 

306.41 
306.41 
306.40558 

201.0541 
188.5463 
173.59442 

202.47 
202.473629 

277.5264 
277.5264 

EARLY 
133.80 EARLY 
133.79512 

346.2049 
346.20488 

EARLY 88.41217184 

391.5878 

EARLY 
58.423 

421.577 
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Different from the European option, this option to abandon can be early exercised at each node if the value of XS _{T} is bigger than the value derived by riskneutral valuation process. As shown above, it is better to early abandon the project in year 4 if the project value goes down to RMB ¥202.4736m, since payoff by exercising the American put option (XS _{4} =277.526371) is higher than the value derived from riskneutral valuation (i.e. e ^{}^{r}^{Δ}^{t} (Pud ^{4} *p+Pd ^{5} *(1p)=266.093922). With the flexibility of early exercise, the abandonment option creates a value of RMB ¥63.5790m, adding which the project’s net present value becomes RMB ¥214.0724m:
Expanded NPV of Jiangnan New Village = NPV without investment flexibilities + Value of abandonment option
= RMB ¥150.4934m + RMB ¥63.5790m
= RMB ¥214.0724m.
5.3 Result Analysis and Further Discussion The result of above real options valuation indicates that the inclusion of real options can affect project value drastically. The time to build option and the option to abandon add on the Jiangnan New Village net present value by RMB ¥293.92m and RMB ¥63.58m individually. Such dramatic strategic values have managerial implications for Jiangnan New Village’s developer GCCDP. As the risk of emerging real estate market is relatively high compared with other markets, consideration of timetobuild and abandonment opportunities can reduce the corresponding uncertainties involved, taking of the upside potential gains and limit the downside losses. For instance, if the real estate economic is declined, these options allow GCCDP either not default the next phase, or simply abandon the project in any point of time at a salvage value. Such real options mitigate the high uncertainties involved real estate developments. GCCDP should have realized these opportunities of risk management and the economic values they created, taking them account into the investment appraisal of Jiangnan New Village.
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In terms of the combined effect of these two real options on Jiangnan New Village project, possible interactions between them have to be taken into consideration. Trigeorgis (1996) suggested that managerial flexibility embedded in investment projects typically takes the form of a collection of real options, and interactions may occur among real options, thus present in combination generally make their individual values non additive. Such an interaction is obvious in our example of the timetobuild compound option, where the presence of subsequent option (Phase II and Phase III options) increases the value of the effective underlying asset for earlier options (Phase I option) (Trigeorgis, 1996). Hence, the time to build option and option to abandon are theoretically non additive, but interacted affect Jiangnan New Village’s project value. For instance, an earlier abandonment may eliminate the project, and therefore kill the later options (e.g. Phase II or Phase III options) ^{7} . Nevertheless, the combined strategic values these real options afford may be still as economically significant as the value of the project’s expected cash flows (Trigeorgis, 1996).
Furthermore, although it was not taken into consideration in real option analysis above for simplicity purpose, there are much more other options exist in such a real estate development project. For instance, the project is actually not fully financed by the developer, but 33% of the investment was financed by debt. Hence, there could be an option to optimal real estate project financing option exist for the developer, which could maximize the developer’s profit from the project investment. Also, Jiangnan New Village is one of the most important residential projects that GCCDP has developed, the success of the project generate enormous intangible income to GCCDP, brand effect for instance. Thus, the development of Jiangnan New Village can be realized as a growth option for GCCDP’s future expansion. And it is true that after
^{7} Nevertheless, this probably may not be the case under the assumptions of this dissertation. As the estimated salvage value is relative low to the underlying asset value, the early exercise of abandonment option would occur only after year 4 and only in the situation when the underlying asset goes down to ¥202.47m. While, in the same situation in year 4, the Phase III option will not exercised as its value down that state is already zero. Moreover, the two options are opposite in types (one is compound call option, and one is American put option). Thus, the option interactions are small and simple additivity could be a good approximation of combined option value (Trigeorgis, 1996). Therefore, the additive value ¥357.50m (time to build option value ¥293.9164m+ abandonment option value ¥63.5790m) may still be a reasonable approximation of the combination effect on Jiangnan New Village net present value.
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constructing the Jiangnan New Village, GCCDP developed Tianhe Construction Section in the following year, Ershadao Islet Villa Complex and Glade Village and Southern Le Sand in 2005. And it also published the first Real Estate Investment Trusts (REITs) in mainland China in 2005.
All these real options together with time to build option and abandonment option I analyzed above, taking the form of collection of real options, interact among each other and enhance the value of the real estate investment project value. Although the interactions among these various real options may generally reduce the single real option value in isolation, and the combined value may declines as more options are present (Trigeorgis, 1996), the overall effect of these real options is still noticeable and economically considerable to real estate investment decisions. Therefore, as shown in this case study, the application of the real option analysis in real estate is important in investment decision, or even decisive in the developers’ business strategic expansion. Particularly in Chinese real estate market, an emerging market with high uncertainties related to demand, land price and government policies, application of real option analysis is even more imperative.
5.4 Sensitivity Analysis As all the parameters for the real option valuation in the case study are estimated and using assumptions, different estimation will lead to changes on the real option value, and therefore lead to a different investment decision. Hence, sensitive analysis is used to find the most crucial parameters contribute to the variation of the real option values. By doing which the real estate developer can better understand the project they developed and management flexibilities on it, thereby make a better investment plan. As the estimation of volatility and riskfree rate are both rough in this case study, they are chosen as the critical parameter examined.
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5.4.1 Volatility Sensitivity Analysis Volatility is a critical parameter for real options’ values. It is estimated using history stock price data in this case study, assuming that the developers stock prices would represent the similar risk level to the real estate project they developed. In order to see how volatility changes could affect the value of the options, the range of volatility variation from 30% to 30% is chosen.
Table 5.8 Volatility Sensitive Analysis
Volatility 
29.00% 
33.14% 
37.29% 
41.43% 
45.57% 
49.72% 
53.86% 
Percentage change of volatility 
30% 
20% 
10% 
0% 
10% 
20% 
30% 
Time to Build Option value 
234.2330 
253.5220 
273.4865 
293.9164 
314.3385 
334.7231 
354.9369 
Percentage change of option value 
20.31% 
13.74% 
6.95% 
0.00% 
6.95% 
13.88% 
20.76% 
Abandonment 

19.2987 
33.3065 
48.2777 
63.5790 
78.9970 
94.3936 
110.1996 

Option Value 

Percentage change of option value 
69.65% 
47.61% 
24.07% 
0.00% 
24.25% 
48.47% 
73.33% 
Figure 5.1 Relationship between Volatility and Real Opiton Value
Volatility
Time to Build Option Value
Abandonment Option Value
As shown above, there is a positive relationship between volatility and the options value. Moreover, volatility seems to have quite significant influences on the option value. For example, 30% increase or decrease will lead about 20% up or down of
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timetobuild option value. And the change effect is more apparent on abandonment option’s value, where the same growth (30%) in volatility will increase the value of abandonment option by 73.33%.
5.4.2 Riskfree Rate Sensitivity Analysis The riskfree interest rate used in this case study is 5year government bond interest rate, which is not exactly matched the options’ life periods. Riskfree interest rate sensitivity analysis therefore exams the impact of riskfree interest rate variation on the option value. The analysis conducts by assuming that the variations of the riskfree interest rate change between 30% and 30%.
Table 5.9 Riskfree Interest Rate Sensitive Analysis
Riskfree interest 

2.65% 
3.02% 
3.40% 
3.78% 
4.16% 
4.54% 
4.91% 

rate 

Percentage change 

of riskfree interest 
30% 
20% 
10% 
0% 
10% 
20% 
30% 
rate
Time to Build Option Value 279.8032 284.4234 289.1696 293.9164 298.6631 303.4091 
308.028 

Percentage change 
4.80% 
3.23% 
1.62% 
0.00% 
1.61% 
3.23% 
4.80% 
of option value 

Abandonment 

73.5782 
70.1769 
66.8138 
63.5790 
60.4690 
57.4806 
54.6843 

Option Value 

Percentage change 
15.73% 
10.38% 
5.09% 
0.00% 
4.89% 
9.59% 
13.99% 
of option value
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Figure 5.2 Relationship between Riskfree Rate and Real Option Values
Riskfree interest rate
Time to Build Option Value
Abandonment Option Value
As illustrated in Table 5.8, the effect of change in riskfree interest on real option value is relatively less significant than the effect by change in volatility. For instance, 30% increase in riskfree interest rate lead to only 4.8% increase in time to build option value. Again, the abandonment option value is more sensitive to the riskfree rate changes than the time to build option, 13.99% value decrease with 30% increase in riskfree interest rate. It is also found that there is a positive relation between riskfree interest rate and the timetobuild option value, but it is negative correlated between riskfree interest rate and abandonment option.
Overall, the sensitivity analysis on volatility and riskfree interest rate indicates that volatility has relatively significant effects on the value of real options. As real estate investment concerning more uncertainties than other kinds of investments due to the characteristic of capital intensive, slow payback, high sunk costs and uncertainty in demand and prices (Rocha et al., 2007), careful consideration should be taken when applying real option valuation models to real estate investment.
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5.5 Limitations
5.5.1 Oversimplified Model Assumptions The result derived using binomial tree models above may be imprecise due to the simplified model assumptions I have made.
First of all, the assumption of constant and continuous volatility may be subjected to criticisms. As sensitivity analysis suggested, volatility is the most important parameters that could lead to significant variations of real options value, the estimation of volatility is vital in obtaining accurate values of real options. However, due to time constraints and absent of software resources, a simpler estimation method was applied in Jiangnan New Village case. Monte Carlo Simulation, if applied, may obtain a better estimation of volatility in the aspect of accuracy. Moreover, the assumption of constant volatility over the option life time may be unrealistic, as the volatility may change or even unknown in a real world context.
Similarly, the assumption of constant and continuous riskfree interest rate does not reflect the real world situation either. Like volatility, Riskfree interest rate could fluctuate over the real option life time, and in most cases it is not continuous but discrete. More importantly, as nonexistence of government bonds with the exactly paralleled life time to the real options, the estimation of using 5year Chinese government bond interest is not accurate. This, as sensitivity analysis showed, will lead to a considerable error in estimation of real option value.
Regards to the assumption of salvage value, for calculation simplicity, it was assumed to be the land cost. But issues like depreciation and inflation may occur during real option life time were ignored. Thus the exercise price for the abandonment option may be misestimated, thereby, the option value.
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Other over simplified assumptions such as no dividend payout, no arbitrage opportunities, no transaction costs, and instantaneous exercise, that may not be possible to achieve in the real world, should also be taken into consideration for a critical view of the result’s accuracy.
In addition, for time conservation, 8timestep and 7timestep were applied in the binomial tree model. But as argued by Mun (2002), the more time steps are applied, more accurate is the result. Thus, 20 or even 50 time steps could be still far away from an accurate answer. Lots of software have been designed and applied to run higher timestep valuations in order to obtain accurate real option values.
In sum, all these unrealistic and oversimplified assumptions could affect the accuracy of real option valuation, thereby influence on the investment decisions.
5.5.2 Limitations of the Real Options Approach As the analogy between real options and call options on stocks is not exact (Trigeorgis, 1996), the limitation of real option approach may also lead to result inaccuracy.
Initially, the underlying asset, Jiangnan New Village, is a unique asset, which does not trade in a liquid market. The value thus cannot be accurately assessed until it is marketed, as well as the variance (i.e. the risk) for it. Second, the real option analysis above ignores the possibilities that other real estate developers may also intend to acquire the land and make similar investment. But actually as stated in background section of Chapter 4, the investment of Jiangnan New Village was facing intensive competition since Haizhu District is one of the most boom real estate development areas. Such a competitive interaction may have impact on the real option values (Trigeorgis, 1996).
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In addition, much more complex circumstances exist in real world, such as independent investments act as strategic links, or intensive competition involves in acquiring the real options. These complicated situations may sometimes be neglected by real option approach, or it is unable for real option approach to offer a specific value of a package of real options including the interaction effect due to the calculation complexity.
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Chapter 6 Conclusion
Real estate investments, like other irreversible investments, face high uncertainties about demand, housing price and land costs. The investment circumstances are particularly risky in emerging markets, like Chinese real estate market. Real option approach, compared with traditional NPV method, better captures the investment opportunities and management flexibilities in real estate investment decisionmaking and performs as risk management against high uncertainties involved in real estate development. Realization of the economic values of these investment opportunities and management flexibilities can help real estate developers both utilize the investment opportunities and mitigate potential downside losses.
The aim of this dissertation is to give an insight of how real option valuation is applied in the real estate investment appraisal, to value the decision options embedded in the investment projects, to improve the economic analysis of real estate investments and support the decisionmaking by managing the different options and uncertainties embedded in the project.
To achieve the objectives above, a case study of Chinese real estate investment project, Jiangnan New Village in Guangzhou Haizhu District, has been conducted under real option analysis. The case was chosen as an emerging market example, where relative high uncertainties about demand, land costs and government policies may be involved. Analysis of Jiangnan New Village developing phases identifies two kinds of options, timetobuild option and the option to abandon. Valuations of these two real options are conducted using binomial tree approach, considering that complexities of the compound options and early exercises barrier the application of other real option valuation methods, like BlackScholes Model. Timetobuild option is considered as a compound call option composed by three simple European calls, and the valuation is conducted from the calculation of the third option chronologically to the first option.
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Option to abandon is valued simply as an American put option with life time throughout entire project life.
The result suggests that the two options can perform as protection for the project against the high risk it face, and create significant economic values that can be added on to the original project net present value. This would have implications for investment decisionmaking that the real estate developer of Jiangnan New Village should have realized these operating flexibilities as risk management strategies, and taken them into the consideration of investment appraisal. The possible interaction effects between the two real options were commented. Limitations on estimation of accurate real option values were discussed in aspect of both oversimplified model assumptions and the inherent weakness of real option approach. Further sensitivity analysis was also conducted, and concludes the substantial influence of volatility on accurate real option price estimation.
Besides the TimetoBuild option and the option to abandon, GCCDP, the developers of Jiangnan New Village was suggested that other investment opportunities and operating flexibilities such as option to optimize capital structure and growth option can be recognized from this project. All such investment opportunities and flexibilities take form of a collection of real options interacted affecting the value of the real estate investment project, adding significant economic values on it.
Nevertheless, real options approach is still underdevelopment. Gaps between real option theory and practical application are still significant. Reasons for it include the complexities of actual market situation, with various real options and competition interacted, and the high request of technique knowledge by real option valuation models but knowledge lacks of practitioners. Thus the application of real option in actual market place may still be the most focused researching area.
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