Real Estate Finance

Land Valuation and

Redevelopment
Kwok-Sang (Maurice) Tse

Faculty of Business and Economics

The University of Hong Kong
ktse@hku.hk

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 Valuation of Real Estate
• 1. Properties (relatively new, not that old)
– Hedonic approach
– Comparable approach
– Cost approach
– Income approach

• 2. Land ??

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 Introduction
• This lecture note provides a set of principles on how the value of land
can be determined.
• One key assumption underlying our analysis is that a vacant land site,
if to be developed, will be developed to the highest and best use.
• Land is a derived asset of which its value derives solely from the
optimal use of property built on it.
• The pricing of an undeveloped land site requires the estimation of
rental income that can be generated from the property that will be
built on the land site.
• An important issue about land pricing is that the value of land also
depends on timing of development.
• Land valuation also requires that we determine the optimal timing of
development.
• Example.
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 Example: Value and Timing
• Consider a vacant land site that is going to be developed into a
residential area.
• Residential property will generate rental income one year after
construction is completed.
• First year rental income is $100 and will grow at 11% per year.
• Property life = 2 years (at the end of yr 2, property is worthless).
• Construction cost today = $100
• Inflation rate of construction cost = 4% per year.
• Cost of capital reflecting the risk = 20%.
• The land owner can decide when to develop the land site.
• How does land value depend on the timing of development?

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 Example Contd: Analysis
• Suppose the land is developed today.

-100 100 100(1.11)1

Today 1 2 3 4 5 6

◼ Value of the land site today is:

100 100 (1.11)

𝑉0 = + 2
− 100 = $60.42
1.2 1.2

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 Example Contd: Analysis
• Suppose the land is developed end of yr 1
-100(1.04) 100(1.11) 100(1.11)2

Today 1 2 3 4 5 6

◼ Value of the land site today is:

100 (1.11) 100 (1.11)2 1
𝑉0 = + 2
− 100 (1.04) × = $61.72
1.2 1.2 1.2

Land Value at year 1

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 Example Contd: Analysis
• Suppose the land is developed end of yr 2
-100(1.04)2 100(1.11)2 100(1.11)3

Today 1 2 3 4 5 6

◼ Value of the land site today is:

100(1.11)2 100 (1.11)3 2
1
𝑉0 = + 2
− 100(1.04) × 2
= $62.14
1.2 1.2 1.2

◼ Value of land site if developed at yr 3 = $61.87

◼ Value of land site if developed at yr 4 = $61.02
◼ Key Principle in Valuation: The value of a property should reflect
the BEST & HIGHEST use.
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 Example Contd: Observation
• Land value is a function of the timing of development

Land Value if Developed at

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
60.42 61.72 62.14 61.87 61.02 <61.02

◼ Land value = ? Based on “Best & Highest Use”

◼ The land site is worth $62.14 and the timing of

development is 2 years !!!

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 Contents

• Valuation of Land
– Discounted Cash Flow Approach (DCF)
– Option Pricing Model Approach (OPM)

• Valuation of Old Properties

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 I. DCF Approach (Fisher, Lentz, and Tse)
• The first step in the DCF approach to land valuation is to estimate
all the cash flows associated with the land before and after
development.
– Before development, the land needs maintenance and the
corresponding cost is C which is assumed to grow at some
constant growth rate c.
– After development to the highest and best use, the property
on the land site will generate rental income which when
assessed at the time of valuation is NOI.
– NOI is assumed to grow at a constant growth rate g.
– The development cost of the land which includes the
construction cost is R and again is assumed to grow at a
constant rate of r.
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 ◼ NOI at time t = NOI egt
DCF Approach ◼ Construction Cost at time T = R erT
◼ Maintenance Cost at time t = C ect
Cash Flows ◼ NOI, R, and C are in today’s dollar.

Value of Land = ??
NOI eg(T+N)

NOI at time t

NOI egT

Time t
T t T+N
Construction
Maintenance Cost
Cost (R) at time T
(C) @ time t before
Development
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 DCF Approach
List of Valuation Variables
NOI of Comparable Property at Growth Rate of Maintenance
NOI c
the time of Valuation (t = 0) Cost
g Constant Growth Rate of NOI T Time of Development
Time Constraint for
R Construction Cost t Development
Growth Rate of Construction
r N Property Life
Cost
Maintenance Cost before
C k Cost of capital
develop

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 DCF Contd
• Value of the land V can be directly estimated by
subtracting all the costs associated with the land
from the expected future net operating income
that can be generated after development.

◼ V = PV of all future NOI after construction

– PV of all Maintenance Cost Until Development
– PV of Construction Cost.

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 Recall V = PV of all future NOI after construction
DCF – PV of all Maintenance Cost Until Development
– PV of Construction Cost.

• If the land site is to be developed at time T, then the value

of the land site is :
𝑇+𝑁 𝑇

𝑉 = න 𝑁𝑂𝐼𝑒 𝑔𝑡 𝑒 −𝑘𝑡 𝑑𝑡 − න 𝐶𝑒 𝑐𝑡 𝑒 −𝑘𝑡 𝑑𝑡 − 𝑅𝑒 𝑟𝑇 𝑒 −𝑘𝑇

𝑇 0
◼ After integration, the value of land becomes

V=
NOI
k−g
1− e (
−( k − g ) N
e)− ( k − g )T
−
C
k −c
( )
1 - e -(k-c)T − (Re rT )e −kT

◼ Question: When it is optimal to develop the land so that the

value of the land is maximized?

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 DCF Contd
The objective of the developer is to choose the optimal time T *
to develop so that V is maximized.
First-order derivative of V with respect to T:
¶V
= -NOI (1- e-(k-g) N ) ´ e-(k-g)T - Ce-(k-c)T + (k - r)(RerT )e-kT = 0
¶T
◼ Solving for T* gives the general solution for the optimal time to
develop.
◼ To simplify our analysis further, we assume that c = r (same
inflation rate for construction and maintenance cost).
¶V
= -NOI (1- e-(k-g) N ) ´ e-(k-g)T + [ R(k - r) - C ] ´ e-(k-r)T = 0
¶T

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 DCF Analysis
• For urban land sites, the land owner usually is required to
develop the land site within certain number of years (usu. 3 years
in Hong Kong).
• If the developer fails to develop the land site within the time
constraint, the government may re-enter the land and re-auction
it to another developer.
• Our next discussion will focus on the conditions underlying the
timing of development of the land site.
• We want to understand
– when the developer will develop immediately
– when the developer will wait until the last possible moment within the
time constraint
– when the developer will develop some time between now and the time
constraint
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 1. Condition for Immediate Development ?
• Examine the value function NOI
k −r
(
1− e )
−( k − g ) N
+
C
k −r
R
Value (V)
𝜕𝑉
𝐴𝑡 𝑃𝑜𝑖𝑛𝑡 𝐴, < 0 𝑎𝑡 𝑇 = 0
A 𝜕𝑇
V
= − NOI (1 − e −( k − g ) N ) + R(k − r ) − C   0
T

( )
NOI 1 − e − ( k − g ) N  R(k − r ) − C

0 t Time

◼ Implication: Develop immediately if the value of future net

operating income throughout the life of the building is greater
than the construction cost net of the saved maintenance cost.
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 2. Condition for Development at the end of the
time Constraint t
Value (V) 𝜕𝑉
𝐴𝑡 𝑃𝑜𝑖𝑛𝑡 𝐵, > 0 𝑎𝑡 𝑇 = 𝜏
𝜕𝑇
B

◼ What does this

condition mean??

0 t T* Time
¶V
= -NOI (1- e-(k-g)N ) ´ e-(k-g)t - [ R(k - r) - C ] ´ e-(k-r)t > 0
¶T
NOI (1- e-(k-g)N ) ´ egt < [R(k - r) - C]´ ert
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 2. Condition for Development at the end of the
time Constraint t
• Recall from last slide: NOI (1 − e −( k − g ) N )* e gt  [ R(k − r ) − C ] * e rt
C
(g-r)t R(k - r) - C R−
e < = k −r
NOI (1- e -(k-g) N
) NOI
(
1 − e −( k − g ) N )
k −r
◼ RHS = Cost to Benefit ratio
◼ Implication: Develop as late as possible if the ratio of the
construction cost net of the saved maintenance cost to the
value of future net operating income throughout the life of
the building is greater than the threshold value exp(g-r)t.

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 3. Optimal Timing for Development btw 0 and t
• Question: When should the land be developed at T* before
time t ?
Value (V) 𝜕𝑉
𝐴𝑡 𝑃𝑜𝑖𝑛𝑡 𝐶, = 0 𝑎𝑡 𝑇 = 𝑇 ∗
C 𝜕𝑇

¶V
= -NOI (1- e-(k-g)N ) ´ e-(k-g)T - [ R(k - r) - C ] ´ e-(k-r)T = 0
¶T
0 T* t Time
◼ The optimal time of development
 C 
 R(k − r ) − C   R − 
T =
* 1
ln  or T = * 1
ln  k − r
−( k − g ) N  
g − r  NOI (1 − e ) g − r  NOI (1 − e −( k − g ) N ) 
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k −r  20
 Valuation R T* ?
Factors C T* ?
• Value of Land at Different Time NOI T* ?
of Development for T* over [0, t] N T* ?

V=
NOI
k -g
(
1-e -(k-g)N
e)-(k-g)T*
-
C
k -c
( )
1- e-(k-c)T* -(RerT* )e-kT*

◼ Evaluate the impact on optimal timing of development of

the following valuation factors
◼ Construction Cost (R)
1  R(k − r ) − C 
◼ Maintenance cost (C ) T =
*
ln 
−( k − g ) N 
◼ Operating income (NOI)
g − r  NOI (1 − e )
◼ Property life (N)

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 Case Analysis
• The attachment below presents the land auction outcome in
1995 in HK.
• Apply the DCF approach to valuing the land site Tuen Mun
(Section 16)
March 14, 1995
The
construction
cost estimated
by the
developer Tuen
Mun (16th
District) was
$0.5b.

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 Case
Analysis
Contd
• Construction
(Development)
Cost = $0.5 bill
◼ We are going to
analyze the value of
the land site
assuming monthly
rental income per sf
ranges from $7 to
$10.
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 Case Analysis: DCF Approach
• Tuen Mun (16th District): Auction Price = HK$0.137 billion
Commercial with Parking; Usable Area after Construction: 510,369 sq. ft.; Assume C = 0
$Rent NOI
R ($bill) g r N (yr) k T* V(T*) V(T=0)
per sf ($bill)
7 0.5 6% 0% 0.0429 50 15% 9.5 0.080 NA
8 0.5 6% 0% 0.0490 50 15% 7.3 0.112 0.038
9 0.5 6% 0% 0.0551 50 15% 5.3 0.150 0.106
10 0.5 6% 0% 0.0612 50 15% 3.6 0.195 0.173
$Rent NOI
R ($bill) g r N (yr) k T* V(T*) V(T=0)
per sf ($bill)
7 0.5 7% 0% 0.0429 50 15% 8.3 0.127 0.026
8 0.5 7% 0% 0.0490 50 15% 6.3 0.169 0.101
9 0.5 7% 0% 0.0551 50 15% 4.7 0.217 0.176
10 0.5 7% 0% 0.0612 50 15% 3.2 0.272 0.252
æ R(k - r) - C ö
T =
* 1
ln ç ÷
g - r è NOI(1- e-(k-g) N ) ø
V [T = 0] =
NOI
k−g
( )
1 − e −( k − g ) N − R

V=
NOI
k−g
( )
1 − e − ( k − g ) N e − ( k − g )T * −
C
k −c
( )
1 - e -(k-c)T* − (Re rT * )e −kT *
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 Case Analysis Contd
• Questions:
– How does the result compare with the auction
outcome??
– What are the implications??

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 Framework for Analysis
I. Discounted Cash Flow Approach (DCF)
Reference: “Valuation of the Effects of Asbestos on Commercial
Real Estate,” Journal of Real Estate Research
Jeffrey Fisher, George Lentz, and Kwok Sang Tse

II. Option Pricing Model Approach (OPM)

With Time Constraint to Develop: Black-Scholes OPM
Without Time Constraint to Develop (in Appendix):
Reference: “An Option Pricing Approach to the Valuation of
Real Estate Contaminated with Hazardous Materials”
Journal of Real Estate Finance and Economics,
George Lentz and Kwok Sang Tse
k s tse, hku 26
 Contents

• Valuation of Land
– Discounted Cash Flow Approach (DCF)
– Option Pricing Model Approach (OPM)

• Valuation of Old Properties

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 II. Option Pricing Approach
• Option
– Derivative—cannot exist on its own
– Land is derived asset and land value does not exist unless the
land can be developed according to BEST & HIGHEST use !!

• Important concept:
– Land = Call Option
• Call option : The right to buy an asset at a pre-determined
exercise price at the end of (or within) a period.
• Exercise Price = Construction/Development Cost
• Price of the Underlying Asset = Price of the property to be
developed on the land site

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 OPM: With Time Constraint (t) to Develop
Profit/Loss to Land
Owner at time t
• The diagram describes
the value of land on Land Value
+R
the expiration date to
develop (t ). 0 R
Land Value Property
Value

◼ Analysis with Time Constraint:

◼ R = Construction Cost (Constant between time 0 and time t)

◼ There exists a riskless interest rate r.

◼ Land users are price takers.

◼ Completed buildings are sold immediately.

◼ Property price (S) follows the Wiener process

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 OPM: With Time Constraint (t) to Develop
Land Value V V = V(S, , R, r, t)
• The Value of Land
before time t and Value before t
Value at t
at time t

0
R Property Value S

The land value is given by the Black-Scholes Option Pricing Model.

-rt
V = S ´ N(d1 )- Re ´ N(d2 )
ln( S / R) + (r +  2 / 2)t
d1 = d 2 = d1 −  t
 t
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 OPM Approach Contd
◼ Recall Land Value as given by BS-OPM
-rt
V = S ´ N(d1 )- Re ´ N(d2 )
S Value of Underlying Property
R e-rt Present value of construction/development cost
N( . ) Normal Distribution Function
Sensitivity of land value to the change in value of
N(d1) the underlying property
Probability that the property value exceeds
N(d2) construction cost at time t

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 Effects of Variables on Land Value
• The 5 pricing variables for
the option pricing
approach are: S V
– Property Value S R V
– Property Risk 
t V
– Construction Cost R
r V
– Risk-free interest rate r
– Time limit to develop t  V

k s tse, hku 32
 Valuing the Option

• The strategy is to map the development project

into a simple option and use financial valuation
tools to price the option: Black-Scholes formula.

• Oftentimes, this involves making somewhat heroic

assumptions about the project.

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 Mapping: Project ➔ Call Option

Project ➔ Call Option

Construction cost required
X Exercise price
to build the building
Value of comparable Stock price (price of the
S
properties today underlying asset)
Regulatory time constraint
T Time to expiration
for development
Riskiness of the operating
property
2 Variance of stock return

Time value of money r Risk-free rate of return

k s tse/58 34
 Example

Project ➔ Call Option

Construction cost required
X $382
to build the building
Value of comparable
S $255.8
properties today
Regulatory time constraint
T 3
for development (years)
Riskiness of the operating
 40%
property (Std Deviation)
Time value of money r 5.5%

k s tse/58 35
 Example Contd.

𝑆 𝜎2 255.8 0.42
𝑙𝑛 𝑅
+ 𝑟+ 2 𝜏 𝑙𝑛 382
+ 5.5%+ 2 3
𝑑1 = = = 0.0057
𝜎√𝜏 0.4√3

𝑑2 = 𝑑1 − 𝜎√𝜏 = 0.0057 – 0.4√3 = -0.6871

𝐿𝑎𝑛𝑑 𝑉𝑎𝑙𝑢𝑒 (𝑉) = 𝑆 × 𝑁 𝑑1 − 𝑅𝑒 −𝑟𝜏 × 𝑁 𝑑2

= 255.8 × 0.5023 − 382𝑒 −5.5% 3 × 0.246
= $48.8𝑀
k s tse/58 36
 Case Analysis: OPM Approach
• We are going to apply both OPM and DCF approach to
valuing the following 2 land sites:
– Ng Chi Wan (Fung Sing Street)
– Ma On Shan (Section 9B)

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 Case Analysis: OPM Contd
− rt ln( S / R) + (r +  2 / 2)t d 2 = d1 −  t
V = SN (d1 ) − Re N (d 2 ) d1 =
 t
• Nga Chi Wan (Fung Sing Street): Auction Price = HK$1.61 billion
Construction Cost (R ) = $0.5 bill;  = 20%; Risk-free rate (r ) = 5%;
Usable Area After Construction = 703,966 sq. ft.; t = 3 years
$Price/sq. ft. S ($bill) d1 d2 N(d1) N(d2) V
2400 1.690 4.12 3.77 0.999981 0.999920 1.259
2600 1.830 4.35 4.01 0.999993 0.999969 1.400
2800 1.971 4.57 4.22 0.999998 0.999988 1.541
3000 2.112 4.77 4.42 0.999999 0.999995 1.682
3200 2.253 4.95 4.61 1.000000 0.999998 1.822
◼ Note: S = Value of Building = $Price/sf * Usable Area/1 billion
◼ DCF Approach
$Rent per sf R g r NOI N k T* V(T*) V(T=0)
18 0.5 6% 0% 0.1521 50 14% -12.6 2.195 1.366
19 0.5 6% 0% 0.1605 50 14% -13.5 2.490 1.470
20 0.5 6% 0% 0.1690 50 14% -14.4 2.807 1.573
21 0.5 6% 0% 0.1774 50 14% -15.2 3.145 1.677
22 0.5 6% 0% 0.1858 50 14% -16.0 3.506 1.781
23 0.5 6% 0% 0.1943 50 14% -16.7 3.889 1.884
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 Case Analysis: OPM Contd
− rt ln( S / R) + (r +  2 / 2)t
V = SN (d1 ) − Re N (d 2 ) d1 =
 t
d 2 = d1 −  t
• Ma On Shan (Section 90 B): Auction Price = HK$1.24 billion
Construction Cost (R ) = $0.6 bill;  = 20%; Risk-free rate (r ) = 5%;
Usable Area After Construction = 586,638 sq. ft.; t = 3 years
$Price/sq. ft. S ($bill) d1 d2 N(d1) N(d2) V
2800 1.643 3.51 3.17 0.999779 0.999230 1.126
3000 1.760 3.71 3.37 0.999897 0.999619 1.244
3200 1.877 3.90 3.55 0.999952 0.999809 1.361
3400 1.995 4.07 3.73 0.999977 0.999903 1.478
3600 2.112 4.24 3.89 0.999989 0.999950 1.595
◼ Note: S = Value of Building = $Price/sf * Usable Area/1 billion
◼ DCF Approach
$Rent per sf R g r NOI N k T* V(T*) V(T=0)
18 0.6 6% 0% 0.1267 50 14% -6.5 1.125 0.955
19 0.6 6% 0% 0.1338 50 14% -7.4 1.276 1.041
20 0.6 6% 0% 0.1408 50 14% -8.3 1.438 1.128
21 0.6 6% 0% 0.1478 50 14% -9.1 1.612 1.214
22 0.6 6% 0% 0.1549 50 14% -9.9 1.797 1.300
23 0.6 6% 0% 0.1619 50 14% -10.6 1.993 1.387
k s tse, hku 39
 Comments
• What does Option Pricing Approach say about land
and land value?
– Land = Call option on the underlying property
– Land value = Value of the underlying property adjusted for
property price volatility, construction (development) cost,
and the probability that the value of property is greater
than the construction/development cost at the time of
development.
• Discounted CF approach ignores price uncertainty
• Option pricing approach incorporates price risk

k s tse, hku 40
 Valuation of Real Estate
• 1. Properties (relatively new, not that old)
– Hedonic approach
– Comparable approach
– Cost approach
– Income approach
• 2. Land
– Land Value = Value of new property – Costs
• Affected by timing decision
• Based on Highest & Best Use
• 3. Old Properties ??
k s tse, hku 41
 Contents

• Valuation of Land
– Discounted Cash Flow Approach (DCF)
– Option Pricing Model Approach (OPM)

• Valuation of Old Properties

k s tse, hku 42
 Valuation of Real Estate: Old Properties
• Old Properties
(rental income $10/yr)

Time 0 Time t ?? Time

◼ Value of Old Property =
◼ Value of Rental Income $10/yr until time t +

◼ Value of Rental Income from the new Property $100/yr –

◼ Redevelopment Cost at time t

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 Valuation of Real Estate:
Old Properties Contd
◼ Ownership of Property =
◼ Ownership of Rental Income from Existing Property +

RIGHT of Redevelopment

Time 0
◼ What is the financial nature of the Right of Redevelopment??
◼ Call Option !!!!
◼ Redevelop if Redevelopment Cost < Value of New Property

◼ Do NOT redevelop otherwise

k s tse, hku 44
 Valuation of Real Estate: Contd

◼ Value of Property =
◼ Value of Rental Income from Existing Property +

◼ Value of Redevelopment

◼ Question: What’s the effect of property price volatility on the

market value of a new property versus an old property???

k s tse, hku 45
 Valuation of Real Estate: Contd

◼ New Property
◼ Value of Rental Income >>> Value of redevelopment option
◼ Higher volatility ➔ Higher Discount Rate ➔ Lower Property Value
◼ Old Property
◼ Value of Rental Income <<< Value of redevelopment option
◼ Higher volatility ➔ Higher option value ➔ Higher property value
◼ See Excel Template !!

k s tse, hku 46
End

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