methodology for the evaluation of real options in real estate development

Methodology for the Evaluation of Real Optionsin Real Estate Development

in Areas Characterized by Uncertain Scenarios

Paper authors: Marina BRAVI, Stefano ROSSI, Antonio TALARICO Polytechnic of TurinSpeaker: Stefano ROSSI Polytechnic of Turin

Theme M: REAL ESTATE DEVELOPMENT

3rd-6th July 2013 - Vienna - AustriaVienna University of Economics and Business

Research Institute for Spatial and Real Estate Economics

European Real Estate Society20th Annual Conference

1Chapter

European Real Estate Society Paper authors: 20th Annual Conference - 3rd-6th July 2013 - Vienna – Austria Marina BRAVI, Stefano ROSSI, Antonio TALARICO - Polytechnic of Turin

DEVELOPMENT INDUSTRY SPACE MARKET

ASSET MARKET

SUPPLY(Landlords)

DEMAND(Tenants)

Rent and occupancy

CASH FLOW

PROPERTY MARKET VALUE

EXPECTED RETURN

DEMAND(Investors

buying)

SUPPLY(Owners selling)CONSTRUCTION

COSTS INCLUDING LAND

Is development profitable?

REAL ESTATE DEVELOPMENT

PROJECT

LOCAL AND NATIONAL

ECONOMIES

YES FORECAST FUTURE

FORECAST FUTURE

Methodology for the Evaluation of Real Options in Real EstateDevelopment in Areas Characterized by Uncertain Scenarios

The real estatesystem

1Chapter

The development phase is quite risky for two reasons:

• it is not known for certain what occupancy will be achieved within what period of time and at what rental rate, or at what price the building will be sold;

• development projects inherently contain ‘operational leverage’; even if the project is financed entirely with equity and even if it is entirely pre-leased, because they have high fixed or committed costs relative to potentially variable revenues.

Investments in stabilized properties have no operational leverage, because the investments cost occurs entirely al time 0.



Development projects

1Chapter


Selling

Construction costs

Cost of land acquisition

Time

Bene

fits

Sacr

ifices



1Chapter

Development project phases with relative expected return



Construction phase

Stabilized operation

Expe

cted

retu

rn E

0[r]

Time

Land purchase

Development completion


1Chapter

So:

• what determines land values?• what causes land prices to move up and down?



Volatilityin land prices

We can simulate thousands of possible project scenarios by means of the Monte Carlo analysis to compare the risk profile of a fully operational property and a development project (to build an essentially identical property), calculating their Present Values.

Each project scenario is created by means of a Normal probability distribution for the key input, reversion value, while construction cost is assumed to be deterministic.

1Chapter



If we analize the probability distribution of the PV results, we see that, although the magnitude of change is the same…


1Chapter



…the impact on expected return is significantly different, expecially in terms of standard deviation!


1Chapter



So, changes in expected net operating income and/or reversion value and their growth rates are the basic causes of volatility in land prices.

Development project

Stabilized property

Risk free


1Chapter



If this relationship does not hold, then there are ‘supernormal’ (disequilibrium) profits (expected returns) to be made somewhere and, correspondingly, ‘subnormal’ profits elsewhere, accross the markets for land, stabilized property and bonds. Development project

Stabilized property

Risk free


1

The most important and commonly used metric in the decision-making process is the net present value (NPV) which is the difference between the present value of the expected payoff and the project investment.If the project NPV is significantly positive or significantly negative, even with a probabilistic payoff, the decision to invest or not to invest would be obvious if the whole range of the expected payoff values is either far higher or far lower.



Inflexibilityof DCFA

Chapter

1

Expected payoff > Investment cost: the project should be undertaken



A


Chapter

1

Expected payoff < Investment cost: the project should be rejected



B


Chapter

1But sometimes there is a ‘gray zone’ where the investment values may be in the range of the expected payoff values, making the decision somewhat difficult.



C


Chapter

1

If flexibility can be embedded in real property in a way which allows the investment to respond accordingly to favorable conditions in the future, or to avoid potentially negative outcomes, the asset may inherently be more valuable.

But this flexibility is not accounted for in the DCF approach, which is effective at the ‘extremes’.



Optionalityof land

Chapter

2

The economic definition of ‘land value’ is based on nothing more or less than the fundamental capability that land ownership gives to the landowner :the right without obligation to develop (or redevelop) the property upon payment of the construction cost.Built property is underlying asset and construction cost is exercise price.

In essence, all real estate development projects are real options, though in some simple cases the optionality may be fairly trivial and can be safely ignored.



Optionalityof land

Chapter

2

A brownfield site is a piece of land which was previously used for industrial or commercial purposes.

Such plots of land may be contaminated by concentrations of hazardous wastes or pollution, and have the potential to be reused once cleaned up.



Brownfields

Chapter

2

In Italy, the law states that if the parties responsible for the contamination do not provide directly, the procedures and actions referring to the clean up of the brownfields will be carried out ex officio by the municipality with territorial jurisdiction and, if this fails, by the Region (L.D. n° 152 of April, 14th 2006).

In this case, the public actor that replaces the private one for the implementation of remediation could claim directly against the reclaimed area.



Brownfields

Chapter

2

Investment decisions concerning the redevelopment of these sites, in short, are affected by two critical variables:

• remediation costs; many contaminated brownfields sites sit unused for decades because the cost of cleaning them to safe standards is more than the land would be worth after redevelopment;

• market value of the area after the environmental recovery has been completed.



Brownfields

Chapter

2Methodology for the Evaluation of Real Options in Real EstateDevelopment in Areas Characterized by Uncertain Scenarios


The growth of the weight of the remediation costs, compared to the estimated land value, will not render the project feasible.

Risk profileof brownfields

Chapter



Moreover, in the event that the remediation costs are almost equal to the market value of the reclaimed land, the DCFA becomes an inflexible tool, wherein the feasibility is difficult to test.


Chapter



In addition, high volatility in expected rents and/or expected return for stabilized properties makes things even worse.


Chapter

2

If and when an upswing occurs in the property market, the owner can choose to develop the property making profits, otherwise not, thereby avoiding potential losses.

It is therefore necessary to compute the value of the deferral option, which is associated with the decision to clean-up the land, given that the remediation cost is the exercise price and the value of the underlying asset corresponds to the value of the land as not reclaimed.



The value ofdeferral option

Chapter

2

The basic assumption is that the land market value at the end of the clean-up process is equal to the market value of a land that does not require remediation.

The incurred investment by the landowner has the purpose of increasing the land market value, in order to make it competitive in comparison with other properties that have the same characteristics but which are not polluted.



Black-Scholesmodel

Chapter

2

The Black-Scholes formula computes the value of the deferral option:

C = N(d1)S0 – N(d2)X exp(-rT)where:

• C is the value of the deferral option;• S0 is the present value of the underlying asset (land value as not reclaimed);• X is the exercise price (remediation costs);• r is the risk-free interest rate;• T is the expiration time of the option;• d1 = [ln(S0/X) + (r + σ2/2)T]σT1/2;• d2 = d1 - σT1/2;• N(d1) and N(d2) the value of the normal standardized distribution of d1 and d2.



Black-Scholesmodel

Chapter



Black-Scholesmodel

Chapter

- C = N(d1)S0 N(d2)X exp(-rT)

Probability distributionof PV of revenues

Probability distribution of PV of costs

2When the investment decision may be deferred, the possibility of deferral gives rise to two additional sources of value:

1. we would always rather pay later than sooner, all else being equal, because we can earn the time value of money on the deferred expenditure; how much money is that?

PV(X) = X/(1+ rf)t

So, if NPV can be expressed as ‘NPV = S – X’, we can rewrite it using PV(X) instead of X:

‘modified’ NPV = S - PV(X) ≥ NPV



Time valueof money

Chapter

2Instead of expressing modified NPV as the difference between S and PV(X), let’s create a new metric:

NPVq = S/PV(X)

Where ‘q’ reminds us that we are expressing the relationship between S and PV(X) as a quotient.



Time valueof money

Chapter

2

2. while we are waiting, the world can change; specifically, the value of the land we intend acquire (and its expected return) may change and affect our investment decision for the better. That possibility is very important, but naturally it is more difficult to quantify because we are not actually sure that land value will change or, if it does, what the future value will be.



Volatility

Chapter

2We are talking about volatility: it can be estimated on the basis of the risk (standard deviation) associated with the expected return of the development project



Volatility

Chapter

2Together, our two new call-option metrics, NPVq and σt1/2, contain all the information needed to value the investment as a European call option using the Black-Scholes model locating opportunities in two-dimensional space.



New call-optionmetrics

Chapter



Locatingthe option value

Lower values

Lower values

Higher values

Higher values

NPVq

σT1/

2

Call option value

increases in these

directions

1,00

We can locate investment opportunities, the option value, in this two-dimensional space…

Chapter

2…and a stylized mapping of projects into call-option space:



Locatingthe option value

Out of the money

Lower values

Higher values

In the money

NPVq

σT1/

21,00

Exercise nowExercise never

NPV > 0 and NPVq > 1.Wait if possible.Otherwise, exercise early.

NPV < 0,but very promisingbecause NPVq > 1 andvolatility is high.

NPV < 0 and NPVq < 1.Less promising, but high

volatility.These projects require

active development.

NPV < 0, NPVq < 1, andVolatility is low.Doubtful prospects.

Chapter

2Suppose:• S0 = € 100• X = € 105• t = 1 year;• rf = 5%;• σ = 50% per year



Example

Black-Scholes value of a European call option, expressed as a percentage of underlying asset value:

Chapter

2Suppose:• S0 = € 100• X = € 105• t = 1 year;• rf = 5%;• σ = 50% per year

NPVq = € 100/[€ 105/(1,05)] = 1,00and σt1/2 = 0,50

The table gives a value of 19,79%So the project has a value of:19,79% x € 100 = € 19,79€ 19,79 > € (100 – 105) = - € 5

Option premium = € 19,79 – (- € 5) = € 24,79



Example

Chapter

3

An urban contaminated plot of land has an area of approximately 14.177 sqm. of territorial surface, in which was built one of the Media Villages that were planned for the XXth Turin 2006 Olympic Winter Games, included within the Urban Renewal Programme, Sub District 3 – ‘Michelin North’.

In order to estabilish the new functions, some demolition and land remediation actions will be required: the cost of these works was estimated to be € 516.000 and the total land value was € 10.845.615 worth.



Case study

Chapter

3As is evident, the weight of the clean-up costs on the total value is negligible. If the effect of the remediation costs were not so marginal, other scenarios would need to be considered; the table shows some types of remediation and their costs, consistent with this scenario.



Case study

Chapter

3

The estimated costs in relation to the e) hypothesis are not compatible with the project, because they significantly exceed the land value.

The landowner would not be willing to sell the reclaimed area to the developer for a price lower than the remediation costs.For other types of remediation, the costs are however compatible with the market value of the land.



Case study

Chapter

3Assuming that there is a deadline within one year to decide whether or not to perform the remediation, the value of the contaminated land is equal to the difference between the value of a plot of land that does not require remediation and the clean-up costs. The table shows the input data for the calculation of the option value for both the landowner and the developer.



Case study

Chapter

3

It is possible to compute the value of the deferral option by using the Black-Scholes formula.



Case study

Chapter

When remediation costs exceed the value of the reclaimed land, the developer will not be willing to buy, but he could still choose to buy the contaminated land if he decides to defer the clean-up over time at a price equal to the value of the deferral option

3

For an increase in remediation costs, the deferral option adds value for the real estate developer.



Case study

Chapter

3

Where the possibility of development, as imposed by the planning tools, is not enough to render the recovery feasible from a financial perspective, the public actor could decide to take action directly on the remediation costs.

Since remediation is preliminary to the real transformation of the area, the public action supporting the environmental recovery costs could take two forms:

• by means of a discount on the infrastructure costs of a portion of the remediation costs incurred by the private sector;

• by means of a direct financing of part of the remediation costs.



Case study

Chapter

methodology for the evaluation of real options in real estate development

Documents

real estatedevelopment

real estate development3rd

antonio talarico polytechnic

vienna austriamarina

turin methodology

landis development profitable

costs relative

operational leverage