A real option approach for the valuation of switching output flexibility in residential property investment

Mintah, K, Higgins, D and Callanan, J 2018, 'A real option approach for the valuation of switching output flexibility in residential property investment', Journal of Financial Management of Property and Construction, vol. 23, no. 2, pp. 133-151.


Document type: Journal Article
Collection: Journal Articles

Title A real option approach for the valuation of switching output flexibility in residential property investment
Author(s) Mintah, K
Higgins, D
Callanan, J
Year 2018
Journal name Journal of Financial Management of Property and Construction
Volume number 23
Issue number 2
Start page 133
End page 151
Total pages 19
Publisher Emerald
Abstract Purpose Uncertainties in residential property investment performance require that real estate assets are designed in a flexible manner to respond to impacts of market dynamics. Though estimating the cost of flexibility is straightforward, assessing the economic value of flexibility is not. The purpose of this study is to explore the potential practical application of real option analysis to determine the economic value of a switching output flexibility embedded in a residential property investment in Australia. The study involves the exploration of an optimal strategy for investment in a residential development through real option analysis and valuation of a mixed use investment. Design/methodology/approach The real option valuation model developed by McDonald and Siegel (1986) is adopted for the evaluation because the switching output flexibility is likened to a perpetual American call option with dividend payout. Findings Through real option analysis, the economic value of switching output flexibility of the mixed use building was determined to be higher than the initial upfront costs. Moreover, a payoff of about $4million was determined to be the value of the switching output flexibility, therefore justifying upfront investments in flexibility as an uncertainty and risk management tool. Practical implications This application is an important demonstration of the practical use of options pricing techniques (real options analysis) and delivers further evidence needed to support the adoption of real option valuation in practice. Flexibility can also enhance risks and uncertainty management in residential property investment better than the adjustment of discount rates. Originality/value There is limited evidence on the use of real options techniques for the valuation of switching output flexibility in practice, and this comes as an original application; both the case study and data are all initial applications of switching flexibility in the Australian property
Subject Building not elsewhere classified
Keyword(s) Valuation
DCf
Real option
DOI - identifier 10.1108/JFMPC-05-2017-0017
Copyright notice © 2018 Emerald Publishing Limited
ISSN 1366-4387
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Created: Fri, 14 Dec 2018, 16:06:00 EST by Catalyst Administrator
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