A Real Option Approach to Valuing the Option to Defer in a Residential Project in Melbourne, Australia

Mintah, K, Higgins, D, Callanan, J and Wakefield, R 2017, 'A Real Option Approach to Valuing the Option to Defer in a Residential Project in Melbourne, Australia', in Proceedings of the 23rd Annual Pacific Rim Real Estate Society Conference (PRRES 2017), Sydney, Australia, 15-18 January 2017, pp. 1-15.


Document type: Conference Paper
Collection: Conference Papers

Title A Real Option Approach to Valuing the Option to Defer in a Residential Project in Melbourne, Australia
Author(s) Mintah, K
Higgins, D
Callanan, J
Wakefield, R
Year 2017
Conference name PRRES 2017
Conference location Sydney, Australia
Conference dates 15-18 January 2017
Proceedings title Proceedings of the 23rd Annual Pacific Rim Real Estate Society Conference (PRRES 2017)
Publisher Pacific Real Estate Society
Place of publication Sydney, Australia
Start page 1
End page 15
Total pages 15
Abstract Property development feasibility evaluation is a precursor to any real estate development activity. The evaluation is predominantly calculated via the use of discounted cash flow (DCF) technique to quantify the future benefits to determine viability of the development. The DCF has been criticised on grounds of inflexibility and that it fails to evaluate real estate projects properly, leading to bias in the results. Real options theory has been proposed as a solution to the deficiencies in the DCF and to complement it. However, the real options theory has lacked practical adoption by industry due to the unavailability of comprehensive evidence to support its application in practice. The purpose of this paper is to examine a practical application of real option to a residential real estate project and compare the results with DCF to determine which of the methods deliver superior results. Dynamic programming, specifically the certainty equivalence approach of the binomial real options pricing model is applied to an actual Australian residential development project. The binomial option pricing method is a discrete time model and uses the multiplicative stochastic process to project the price evolution of the underlying real estate development value and complements the existing valuation methods to deliver better results. The real options valuation gives the developer a reason to hold uncertain projects over a period of time before commencing development. This mitigates the risks associated with projects and leads to the retention of projects that would have otherwise been abandoned by the DCF technique of evaluation. It was found out that should the developer wait until it is optimal to start development, the flexibility would add $2.58 million to the value of the development which would account for about 3.3%. This is the initial application of the certainty equivalence approach of the binomial option pricing method to evaluate an Australian residential case study pro
Subjects Building not elsewhere classified
Keyword(s) Discounted Cash flow
Uncertainties
Valuation
Real Estate Development
Binomial option pricing method
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