Q4.2) How may a real option framework be used to illustrate how the behavior of residential and c...
1. 1. usage
1.1. The use of a real option approach can complement traditional DCF techniques in evaluating leasing and development decision making
2. Q4.2) How may a real option framework be used to illustrate how the behavior of residential and commercial developers differs?
2.1. 1.real options in development context
2.1.1. As already noted a major factor of uncertainty in the development process comes from the inability to immediately exercise the option
2.1.2. Purely due to the time it takes to complete a development market conditions may have changed
2.1.2.1. --Competing developments --Economic conditions changed thus impacting occupational demand --Interest rate movements impact financing costs --Investment flows into real estate in that market
2.1.2.1.1. These and other factors may therefore have led to market rents and yields shifting
2.1.3. One useful use of option techniques is to aid in the explanation of the tendency for overbuilding
2.1.3.1. ---COMMERCIAL
2.1.3.1.1. Grenadier (1996) noted that overbuilding tends to be concentrated or occurs more frequently in space markets that can be characterised by: –Large buildings –Widespread use of long-term leases
2.1.3.1.2. overbuilding is the result of the combination of the development and leasing options available to a developer
2.1.3.2. facts
2.1.3.2.1. In most cases the development option is not perpetual
2.1.4. Real Options and Housing Markets
2.1.4.1. RESIDENTAL
2.1.4.1.1. Housing markets often see a reduction in supply during a boom
2.1.4.1.2. If house prices are increasing rapidly due to improving economic conditions and that this rate of increase is higher than interest rates, then developers will delay projects
2.1.4.1.3. This approach can also explain the over-reaction effect of house prices to income shocks as noted in many studies
2.1.4.1.4. As papers such as Poterba (1991) have argued, participants in housing markets often display extrapolative expectations, with past movements in prices playing a large role in the determination of expectations
2.1.4.1.5. Malpezzi & Wachter (2005) argue that myopic expectations may also play a role in market participants failing to anticipate potential reversals in price trends
2.1.4.1.6. It can be argued that the predictive nature of housing markets may lead to the presence in the market of rational investors, entering the market on the expectation of excess returns (Kim & Shu, 1993, Sheinkman & Xiong, 2003)
2.1.4.1.7. If extrapolative and myopic expectations are dominant across housing markets then this is extended as the resulting impact on supply though the actions of developers will encourage further price increases due to supply constraints
2.1.4.1.8. Furthermore, developers will be aware of the asymmetry that commonly characterises house price dynamics
2.1.4.1.9. This asymmetry provides a safety net for developers and will further encourage delaying tactics in their pursuit of profit maximisation
3. 2. Differences between Real & Financial Options
3.1. Real options may be perpetual
3.1.1. Unlike say a stock option with a fixed maturity date many real options do not have an expiry or maturity date
3.2. Exercise may not be immediate
3.2.1. A prime example being the development process and which can create additional uncertainty and lead to the possibility of overbuilding
3.3. Uncertainty over the value of the underlying asset
3.3.1. Whereas the value of the underlying stock in a stock option is known with certainty at any one point in time there may be uncertainty regarding the value of real estate or land
3.4. The exercise of real options will lead to the creation of unique assets such as a new development
3.4.1. In contrast exercising a traded stock option does not lead to the creation of new stock in the company