Land Development: Risk, Return and Risk Management |
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Authors: | Richard J Buttimer Jr Steven P Clark Steven H Ott |
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Institution: | (1) Belk College of Business, University of North Carolina Charlotte, Charlotte, NC 28223-0001, USA |
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Abstract: | We model and examine the financial aspects of the land development process incorporating the industry practice of preselling
lots to builders through the use of option contracts as a risk management technique. Using contingent claims valuation, we
are able to determine endogenously the land value, presale option value, credits spreads and the effects of presales on debt
pricing and equity expected returns. We show that using presales options effectively shift market risk from the land developer
to the builder. Results from the model are consistent with the high rates of return on equity observed in empirical surveys;
they also suggest that developers may be justified in pursuing projects with substantially lower expected returns to equity
when a large number of lots can be presold. Additionally, we show that presales reduce default risk dramatically for leveraged
projects and can support a considerable reduction in the cost of construction financing. Large debt risk premiums are justified
for highly levered projects, which helps explain the use of mezzanine financing in the land development industry to reduce
expected default costs.
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Keywords: | Land development process Preselling Risk management Real options |
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