Land Development as a Portfolio of Real Options

In the paper a step-by-step model will be developed that enables the valuation of land- and real estate development projects with multiple embedded real options that are subject to both market risk in the form of fluctuating gross market values, and project specific risk in the form of uncertain outcomes of zoning procedures. The rationale for this model is to be able to explicitly value the flexibility present within projects. The standard NPV approach cannot value this flexibility. The valuation is done from the viewpoint of a land developer who wants to estimate the maximum price for which he can acquire the land, given a known portfolio of options that is available throughout the development process. The real options to defer, abandon, expand or contract and the option to switch are included in this portfolio. The model itself is based on the value creation process in land and real estate development (residual valuation) and is used to value four development scenarios with multiple underlying assets, each with their own option structure and uncertain zoning procedures. The valuation process produces an Expanded NPV of the development project which is by definition the summation of the Static NPV and total Option Value. The Real Options Growth Matrix of Smit and Trigeorgis (2004) is finally used to illustrate the four development scenarios by their Static NPV and total Option Value, providing a benchmark for strategic considerations concerning the management of the future development process. The underlying assets in the model are specified as the gross market value per m net floor area of four possible property types: retail, office, residential and industrial space. Gross market values are based on current property specific market rents and gross initial yields. Using the Marketed Asset Disclaimer assumption of Copeland and Antikarov (2004), the discounted gross market value represents the value ëas ifí the underlying asset were traded on the financial markets. The binomial option pricing framework of Cox, Ross and Rubinstein (1979) is subsequently used to model the market risk of the underlying assets. The fluctuations of the underlying assets are based on a Geometric Brownian Motion process, which is defined by the historical standard deviations of the property specific total returns. The exercise prices represent the land- and development outlays that are necessary to develop the project and follow a deterministic path over time. The sensitivity analysis of the model shows that the options in the portfolio display interesting and significant interaction effects, dependent on their order of valuation and sensitivity to varying levels of volatility, time-to-maturities, moneyness, risk-free interest rates, dividend yields and cross correlations. Overall it can be concluded that the characteristics of financial options are mostly preserved when modeling the development process of real estate as a collection of real options.