A real options approach to development

land valuation
Corporate Professional Local
Research www.rics.org
FiBRE
Findings in Built and Rural Environments
September 2007
Sixty second summary
Flexibility is an inherent part of real
estate project developments, and the
value associated with exibility is an
integral part of the total value of
undeveloped sites. The standard
decision rule states that the
development should be undertaken
when the residual value is positive and
left undone if it is negative. However, if
it is possible to postpone the
development decision, then the standard
rule can actually lead to premature
development and an underassessment
of land value, by ignoring other
possibilities that may arise. Real options
theory, using pricing techniques initially
developed for financial options may
offer a valuable alternative approach, in
that it treats explicitly the exibility that
is inherent in any project development
and offers an attractive complement to
standard valuation approaches.
Empirical studies on real options are
generally in short supply, and a way to
assess the content of the theory and its
applicability is to compare valuations
undertaken using a real options
approach with observed transaction
prices. However this requires market
data which is in short supply. In this
research, which was funded by the
RICS Education Trust, Norman
Hutchison and Rainer Schulz of the
University of Aberdeen, Scotland, set
out the case for adopting a real option
approach to valuing development land
and provide an illustration of the
technique. The key requirement, though,
is to be able to take this research to the
next stage, by testing the methodology
on real development data, and the
researchers call for collaboration with
the development industry to fully
explore the benefits that adopting such
an approach would bring.
A real options approach to development land valuation
Introduction
The real options approach seems to be an attractive
complement to standard valuation approaches, because
it treats explicitly the exibility that is inherent in any project
development. According to this approach, an undeveloped site
can be viewed as the option of a future project development
or, more precisely, as a bundle of options. The project developer,
once ownership is secured, has flexibility on three key decisions:
on the future starting date of development; on the type
of property to be built; and on quality and size of the property.
The power of real options models is that, provided one can produce
assumptions on the future behaviour of risky state variables like net
operating rents and construction costs, they can deliver answers
to the above decision problems. Moreover, based on arbitrage pricing
arguments that two similar portfolios must offer the same returns to
avoid arbitrage profits (i.e. there is comparable evidence) the real option
approach also gives the value of the real option, which in this research
is the value of the site.
Compared with the large body of theoretical literature on real options by,
for instance, Avinash Dixit and Robert Pindyck, and Lenos Trigeorgis, empirical
studies on real options are generally in short supply. As Norman Hutchison
says, One simple way of assessing the value of the theory is to see how its
results compare with real life results. In other words, how would valuations
undertaken using a real options approach compare with observed transaction
prices? In the context of a real estate application, real option values (land
prices) are, in principle, observable. Given this, real estate applications are
of great interest for testing the real options approach.
The main aim of their research was to explore the applicability of the real
options approach for land valuation. They looked at two key questions.
First, is the real option theory a convenient way to model the complexity
of project developments? Secondly does real option theory facilitate the
discussion on development opportunities? In other words, how plausible
are the assumptions of the approach in a real estate context?
A real options approach to development land valuation
The valuation of development land
Attempts to explain the triggers to the development of land have been the
subject of considerable theoretical and empirical analyses (see for example
the work by Patsy Healey). Neo-classical approaches have been employed by
such researchers as Jan Brueckner, William Wheaton and Henry Munneke to
determine the stage at which development becomes feasible. The approaches
that they used rely on pricing such land through the market, leading to them
concluding that the development of land occurs when the price of land for
new development exceeds the price of land in its current use by the cost of
demolition and clearance the so-called optimal development rule. In other
words, if the value of land in its redeveloped state increases relative to the
value in its current use, then the probability of development is increased.
However, this process is not without its difficulties,
partly because the estimate of the likely exchange
price of the land in its redeveloped state is not a
precise science, as the inputs are subject to risk
and uncertainty, and partly because of a lack of
expertise among the profession in the valuation
of development sites (see, for example, the work
by Richard Beattie of 1991 and Alastair Adair of
2005). Alastair Adairs work suggests that the
valuation of development land is one of the most
challenging tasks confronting the valuation
profession today. They base this assertion on a
number of factors. First, the nature and extent of
factors that influence a valuation such as
planning, rental growth, yields, development costs,
stigma, time and nance result in the profession
trying to come up with a value where there is
considerable risk and uncertainty. Secondly, over
the last two decades UK government policy on
contaminated land has evolved as the extent of the
problem has became fully understood. This has
resulted in changes to the recording of
contaminated land and on the level of acceptable
clean-up required. Thirdly, in the UK there is a
scarcity of reliable data on development projects
which includes, for example, lack of information on
rents and yields as well as the costs associated
with remediation. In earlier work, Alastair Adair
emphasised that data deciencies often lead
valuers to work with secondary and incomplete
information. Fourthly, the potential volatility of land
values has serious consequences for traditional
comparative analyses, as past evidence is quickly
out of date. As a result, the valuation task
becomes more difficult, given the severe limitations
on the availability of information, and all these
factors exacerbate the risk and uncertainty
regarding the level of returns from investments
made. As Norman Hutchison concludes, Given the
high risk associated with development land, the
need for more accurate valuation processes
cannot be more pressing.
...the estimate of the likely exchange price
of the land in its redeveloped state is not
a precise science

A real options approach to development land valuation

Modelling real options
Real options theory emphasizes explicitly the value of exibility in every
investment decision and developing new property is no exception here.
Based on the observation that even at times of high property prices land
can remain undeveloped, Sheridan Titman applied techniques from nancial
options theory to derive the optimal development date and the price of land
(the option). As in the traditional residual land valuation, the option based land
value depends on property prices and construction costs, but the difference is
that it explicitly takes their future behaviour into account. As described by the
work of Dennis Capozza and Yuming Li, when it is likely that values will go up
and costs go down in the future, then the developer should wait for that
before starting with development. Indeed, option theory offers significant
opportunities in the context of real estate development, as there are many
types of flexibility that can exist, such as the option to expand or alter the
scale of the development.
However, although the real option model gives a
good qualitative account of the exibility inherent
in property development, it remains an open
question as to whether the actual numbers are
accurate. Dominik Lucius has given a
comprehensive account on real options in property
development, where he also emphasizes that some
assumptions of real options theory, like the
availability of a replicating portfolio, may not be
exactly fullled in many development situations.
This may indicate that the numbers might be
inaccurate. There are only a few studies that
evaluate empirically the content of real options
theory in real estate economics. Laura Quigg
tested the real option theory with transaction data
for land and developed income-producing
dwellings, and she found positive premiums for
waiting and implied volatilities of considerable
magnitude. Using an example from Londons
Canary Wharf, Kanak Patel and Dean Paxson
compared a real option valuation approach with
deterministic net present value approaches with
reasonable results. Barbara Leung and Eddie Hui
looked at Hong Kongs Disneyland project, and
found that the real options approach is a
convenient way to value all possible
development potentials.
real options theory emphasizes
explicitly the value of flexibility
in every investment decision

A real options approach to development land valuation

Real options at work
To see how this may work in practice, it may be useful to look at a simple
example given by Lenos Trigeorgis. In this example, the owner of a piece
of land has the option to develop a block of flats either this year or next
year in one of two designs. The first design contains six flats and has
construction costs of 480,000; the second design contains nine flats and
has construction costs of 810,000. The construction costs are fixed for
both years, but the sale price will vary in the second year. The sale price
per flat is 100,000 this year, and next year is either 150,000 (up-state)
or 90,000 (down-state). If the owner were to develop this year, she would
build the six flats design and her profit would be 120,000 (6 x 100,000-
480,000). If she were to wait until next year, she would develop the
nine flats design if the up-state occurred, making a profit of 540,000
(9 x 150,000- 810,000) and the six flats design if the down-state
occurred, making a profit of 60,000 (6 x 90,000- 480,000).
While the question with respect to the optimal design in the different
states was easy to answer, the question with respect to the optimal
period of development is more intricate. Is it better to definitely obtain
120,000 this year, or to wait a year and have a chance of p to obtain
540,000, but also the odds of 1-p of obtaining only 60,000?
Clearly, the land should not be developed this year if waiting until next year
has a higher value. How can this option value of land be determined?
The real options approach uses arbitrage arguments that we can use
pricing evidence from similar portfolios to derive the value of land. To see
how this works, assume that a liquid asset is available for investment, which
has a price of 100,000 this year and cash flows of either 150,000 (up-
state) or 90,000 (down-state) next year. Obviously, the cash flows of this
liquid asset are perfectly correlated with the price of flats. The liquid asset
can be sold short. Assume further that money can be lent or borrowed at
the risk-free interest rate of 10%. Under these assumptions, a portfolio of
x units of the liquid asset and an amount m of money could be constructed
having exactly the same cash flows next year as the developable land if the
following equations were fulfilled:
(150,000 x x) + (1.1 x m) = 540,000
(90,000 x x) + (1.1 x m) = 60,000
The portfolio that solves the above equations consists of x = 8 units of the
liquid asset and borrows m = 600,000, as can easily be checked by
putting these numbers into the equation. The price of this portfolio this year
is 200,000 (8 x 100,000- 600,000). Now that we know that it costs
200,000 to obtain a portfolio with cash flows
identical to the land, it is clear that the equilibrium
value of land must be 200,000.
To see why 200,000 is the value of land,
assume that the offer price of land is currently
180,000. Then an investor could sell 8 units of
the liquid asset short, invest 600,000 at the
risk-free rate and buy the land. This portfolio
would be self-financing next year, i.e. it has zero
net cash flows in both states next year
(-150,000 x 8) + (1.1 x 600,000) +
540,000 = 0
(-90,000 x 8) + (1.1 x 600,000) +
60,000 = 0
In each of the two states, the liquid asset has to
be delivered, the money invested is repaid plus
interest and the development of land generates
cash flows. But although this portfolio is self-
financing next year, it generates a positive cash
flow of 20,000 (8 x 100,000 - 600,000 -
180,000) this year. That is really an attractive
investment opportunity! But we expect other
investors to do the same calculations as well,
leading them to outbid each other until land
has reached its equilibrium price of 200,000.
The same line of reasoning can be made if the
offer price of land is above 200,000, say, at
220,000, in which case no investor will buy the
land, because a portfolio of 8 units of the liquid
asset and 600,000 borrowed at the risk-free
rate will have exactly the same cash flows as the
land, but only a price of 200,000.
Given that the option value of land is 200,000,
it is clear that waiting is better than immediate
development. Immediate development would
bring 120,000, less than the value of land if
it were left undeveloped this year. This example
shows that a positive residual value is not a
sufficient condition for development, because it
ignores the premium of waiting, which is 80,000
(200,000- 120,000). In addition to deriving the
optimal development decision for the developer,
the real options approach also gives the land
value in case the land owner wants to sell the
land. The value of land this year is 200,000.
A real options approach to development land valuation
Conclusion
This research has tried to set out the case for adopting a real option
approach to valuing development land and has provided an illustration of
the technique. But further empirical work is required to test the applicability
of using this approach and this is the next stage of the research. However,
gaining access to the data has been a major barrier. The researchers would
welcome collaboration with developers willing to share their data and in
return receive a better understanding of the advantages of utilising this
approach to maximise their return.
About the study
The work was carried out by Norman
Hutchison and Rainer Schulz, of the University
of Aberdeen Business School, Edward Wright
Building, Aberdeen AB24 3QY, United
Kingdom, Tel: +44 1224 273486, E-mail:
n.e.hutch@abdn.ac.uk, r.schulz@abdn.ac.uk
The financial support from the RICS
Education Trust is gratefully acknowledged.
The researchers would welcome
collaboration with developers
willing to share their data

The above setting is clearly too simple for real world situations. More
realistic models are available, but they come at a price: first, the models
itself are much more complicated and second, more information is needed
in order to implement them. New work by Steffen Brenner, Rainer Schulz
and Wolfgang Hrdle shows that for a cross section of developable sites,
real option values can be of good use in practice. The work shows that real
options values are conceptually and practically better than other valuations
based on the income approach and that real option values are also on
average superior to unadjusted sales comparison land values. However,
sales comparison values adjusted by professional valuers perform better
on average than real option values. But even here, real option values can
contribute to improving such valuations. In order to examine the influence
of the assumptions and chosen parameters on real option values, Brenner
et al perform extensive sensitivity analyses, and their study suggests that
the real option approach can be viewed as a sensible complement to the
sales comparison method. As Rainer Schulz says, Real option values do
not only perform well and may be used as crosscheck, but they are also
very useful for sensitivity analyses, because they allow us to isolate the
influence of value drivers such as the future volatility of rental income and
construction cost. Thus, in the future the real option approach should
be used more extensively for the valuation of real estate.
A real options approach to development land valuation
References
Adair A., Berry J., Deddis B., McGreal S., Keogh G. and Key T. (1998)
Barriers to data sharing in the surveying profession: implications for
the commercial property market, Journal of Property Research 15 (4),
331-346.
Adair A., Hutchison N. E., Burgess J., Roulac S. (2005) The appraisal
of urban re-generation land: a contemporary perspective allowing for
uncertainty, Journal of Property Investment and Finance 23 (3), 213-233.
Beattie R. (1991) City Grant, Journal of Property Finance 1 (4), 588-592.
Brenner S., Schulz R. and Hrdle W. (2008) Real options and real estate
valuation: an implementation study (in German), forthcoming: Zeitschrift fr
betriebswirtschaftliche Forschung.
Brueckner J. (1980) A vintage model of urban growth, Journal of Urban
Economics 8, 389-402.
Capozza D. R. and Li Y. (2002) Optimal land development decisions,
Journal of Urban Economics 51, 123142.
Capozza D.R. and Sick G.A. (1994) The risk structure of land markets,
Journal of Urban Economics 35, 297-319.
Dixit A.K. and Pindyck R.S. (1994) Investment under Uncertainty, Princeton
University Press, Princeton.
Healey P., Davardi S., OToole M., Tavsanoglu S.
and Usher D. (1992) Rebuilding the City:
Property-led Urban Development, E. & F.N.
Spon, London.
Leung B.Y.P. and Hui E.C.M. (2002) Option
pricing for real estate development: Hong Kong
Disneyland, Journal of Property Investment
& Finance 20, 473-495.
Lucius D.I. (2000) Real options in real estate
development, Journal of Property Investment
& Finance 19, 73-78.
Munneke H.J. (1996) Development decisions for
commercial and industrial properties, Journal of
Urban Economics 39, 229-253.
Patel K. and Paxson D. (2001) Real urban
development options at Canary Wharf, in Howell
S., Stark A., Newton D., Paxson D., Cavus M.,
Pereira J. and Patel K. (eds.) Real Options.
Evaluting Corporate Investment Opportunities
in a Dynamic World, Pearson Education, Harlow,
163-176.
Pindyck R.S. (1991) Irreversibility, uncertainty, and
investment, Journal of Economic Literature 29,
1110-1148.
Quigg L. (1993) Empirical testing of real
option-pricing models, Journal of Finance 48,
621-640.
Titman S. (1985) Urban land prices under
uncertainty, American Economic Review 75,
505-514.
Trigeorgis L. (1996) Real Options. Managerial
Flexibility and Strategy in Resource Allocation,
MIT Press, Cambridge MA.
Wheaton W. (1982) Urban residential growth
under perfect foresight, Journal of Urban
Economics 12, 1-21.
www.rics.org
J
u
l
y

2
0
0
7
/
3
0
0
/
R
I
C
S

R
e
s
e
a
r
c
h
/
3
9
8
8
7
/
S
t
e
r
l
i
n
g
RICS (Royal Institution of Chartered Surveyors) is the largest
organisation for professionals in property, land, construction and
related environmental issues worldwide. We promote best practice,
regulation and consumer protection to business and the public.
With 130 000 members, RICS is the leading source of property
related knowledge, providing independent, impartial advice to
governments and global organisations.
This work was funded by the RICS Education Trust, a registered
charity established by RICS in 1955 to support research and
education in the field of surveying.
Research
RICS Europe
Rue Ducale 67
1000 Brussels
Belgium
T +32 2 733 1019
F +32 2 742 9748
ricseurope@rics.org
RICS Americas
The Lincoln Building
60 East 42nd Street
Suite 2918
New York, NY 10165
USA
T +1 212 847 7400
F +1 212 847 7401
ricsamericas@rics.org
The Royal Institution
of Chartered Surveyors
12 Great George Street
Parliament Square
London SW1P 3AD
United Kingdom
T +44 (0)870 333 1600
F +44 (0)20 7334 3811
contactrics@rics.org
www.rics.org
RICS Asia Pacific
Suite 2104
Central Plaza
18 Harbour Road
Wanchai
Hong Kong
T +852 2537 7117
F +852 2537 2756
ricsasiapacific@rics.org
RICS Oceania
Suite 1602, Level 16
1 Castlereagh Street
Sydney
NSW 2000
Australia
T +61 (0)2 9216 2333
F +61 (0)2 9232 5591
ricsoceania@rics.org
75%
Cert no. TT-COC-002340