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The option to change the use of a property when future property values and construction costs are uncertain

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  • Åke Gunnelin

    (Section of Building and Real Estate Economics, Royal Institute of Technology, Stockholm, Sweden)

Abstract

This paper models the decision to change the use of a property when its value in the current use and the new use, as well as construction costs, are uncertain. In the case of development of vacant land, when cash flows and construction costs are lognormally distributed, the development of the property optimally takes place when the ratio of benefit to cost of development reaches some fixed level. In the redevelopment case, the timing problem is found to be more complex, as the cost of exercising the conversion option consists of two parts, the construction costs and the surrendered value of the property in the current use, which may evolve differently over time. In this case, optimal redevelopment will take place for different benefit-cost ratios, depending on the relative sizes of the property values in the different uses and the construction costs. Also, for a given current benefit-cost ratio, the option value will vary significantly, depending on the relative size of the state variables. Copyright © 2001 John Wiley & Sons, Ltd.

Suggested Citation

  • Åke Gunnelin, 2001. "The option to change the use of a property when future property values and construction costs are uncertain," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 22(7), pages 345-354.
    • Handle: RePEc:wly:mgtdec:v:22:y:2001:i:7:p:345-354
    DOI: 10.1002/mde.1024
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    References listed on IDEAS

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    1. Paul D. Childs & Timothy J. Riddiough & Alexander J. Triantis, 1996. "Mixed Uses and the Redevelopment Option," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 24(3), pages 317-339, September.
    2. Bar-Ilan, Avner & Strange, William C, 1996. "Investment Lags," American Economic Review, American Economic Association, vol. 86(3), pages 610-622, June.
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    Cited by:

    1. Bun Lee & Eui-Chul Chung & Yong Kim, 2004. "Dwelling Age, Redevelopment, and Housing Prices: The Case of Apartment Complexes in Seoul," The Journal of Real Estate Finance and Economics, Springer, vol. 30(1), pages 55-80, October.
    2. Winfree, Jason A. & McCluskey, Jill J. & Mittelhammer, Ronald C., 2002. "An Option Value Approach To Valuing Preservation Properties," 2002 Annual Meeting, July 28-31, 2002, Long Beach, California 36619, Western Agricultural Economics Association.
    3. Cunningham, Christopher R., 2006. "House price uncertainty, timing of development, and vacant land prices: Evidence for real options in Seattle," Journal of Urban Economics, Elsevier, vol. 59(1), pages 1-31, January.
    4. Jason Winfree & Jill McCluskey & Ron Mittelhammer, 2006. "Buyer-Type Effects in Conservation and Preservation Property Values," The Journal of Real Estate Finance and Economics, Springer, vol. 33(2), pages 167-179, September.
    5. Huimin Yao & Frederik Pretorius, 2014. "Demand Uncertainty, Development Timing and Leasehold Land Valuation: Empirical Testing of Real Options in Residential Real Estate Development," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 42(4), pages 829-868, December.
    6. Bonde, Magnus & Song, Han-Suck, 2016. "“Green” refurbishments under uncertainty," Working Paper Series 15/11, Royal Institute of Technology, Department of Real Estate and Construction Management & Banking and Finance.

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