A Real Options Model of Real Estate Development with Entitlement Risk

Most development projects encounter a highly uncertain entitlement process that is largely uncontrollable by developers. In this study, entitlement is modeled as a separate stage within a compound real option, where developers begin with minimal control (maximum risk) and each successful stage increases control (decreases risk). We solve the model analytically, provide three‐dimensional numerical comparisons, and empirically test the model's predictions using hand collected rezoning petitions. Our main result refines the classic development option model: developers first invest early (secure entitlements) in order to obtain the option to subsequently delay investment (construct the optimal building at the optimal time).     

Riskiness of Real Estate Development: A Perspective from Urban Economics and Option Value Theory

In this article, we define a new construct for urban economic and investment analysis, which revisits the conventional wisdom that investment in real estate development is riskier than investment in stabilized property assets. This new construct, referred as a “development asset value index” (DAVI), is a value index for newly developed properties (only) in a given geographical property market. It tracks longitudinal changes in the highest and best use (HBU) value of locations, and it reveals developer and landowner behavior taking advantage of the optionality inherent in land ownership. In particular, the DAVI reflects developers' use of flexibility in the exercise of the call option to (re)develop the property to any legal use and density. We empirically estimate a DAVI for commercial property (i.e., central locations) and compare it with a corresponding traditional transaction‐price‐based property asset price index (PAPI) corrected for depreciation. We believe that the difference primarily reflects the realized value of flexibility in land development. We find that the DAVIs display greater value growth and are smoother over time and less cyclical than their corresponding PAPIs for the same locations. This suggests that developers successfully use flexibility, and that development may be riskier than stabilized property investment due primarily only to leverage effects (construction costs). Practical implications are also discussed.     

Equilibrium Real Options Exercise Strategies with Multiple Players: The Case of Real Estate Markets

This article derives a closed-form solution for an equilibrium real options exercise model with stochastic revenues and costs for monopoly, duopoly, oligopoly and competitive markets. Our model also allows one option holder to have a greater production capacity than others. Under a monopolistic environment we find that the optimal option exercise strategy in real estate markets is dramatically opposite to that in a financial (warrant) market, indicating the importance of paying attention to the institutional details of the underlying market when analyzing option exercise strategies. Our model can be generalized to the pricing of convertible securities and capital investment decisions involving both stochastic revenues and costs under different types of market structures.     

Pricing Mortgage-Backed Securities: Integrating Optimal Call and Empirical Models of Prepayment

Residential mortgage borrowers frequently appear to behave suboptimally with respect to their mortgage prepayment options. Many borrowers fail to exercise even well-into-the-money options while others prepay when the call option is out-of-the-money. To account for these apparently suboptimal prepayments, the recent trend in mortgage-backed securities research has been away from optimal call valuation models, in which the decision to exercise is determined endoge-nously, in favor of models in which prepayment behavior is exogenously specified based on empirical estimation. This paper develops a rational model of mortgage prepayment which incorporates both types of "non-optimal" prepayment and retains endogenous call. This enables the model to disentangle and compare the separate effects of the interest rate call, impeded by transaction costs, and of non-interest-rate driven prepayment. In addition, by recognizing heterogenous borrower transaction costs, the model presents a way to account more precisely for the varying prepayment lags associated with well-into-the-money call options and to account for the phenomenon of "burnout" within a mortgage pool. The paper includes an empirical test of the unbiasedness of the integrated pricing model by comparing simulated prices from our theoretical model to observed prices on traded Fannie Mae and GNMA securities.     

Cancellation Strategies in Commercial Real Estate Leasing

In a contractionary corporate environment, lease cancellation strategy becomes an important component of corporate real estate leasing decisions. This paper presents a leasing model in which less well-informed lessors offer leases with alternative lease cancellation options. The model demonstrates that a tenant's choice of cancellation option reveals his private information with respect to the likelihood of option exercise. Tenants who select a lease with a downsizing option are more likely to exercise the option. Given the higher likelihood of option exercise, the model suggests that the downsizing option will be priced higher. We examine a sample of 311 leases, and consistent with the model's prediction, we find that on average leases with a downsizing option have significantly higher contract rent. However, termination and sublet options are not associated with higher rent. The evidence suggests that market uncertainty, private information and adverse selection affect the pricing of alternative cancellation options and the choice of cancellation option.     

Permits, Starts, and Completions: Structural Relationships Versus Real Options

Real estate development from raw land to completed structures is a multistage process. Given the current view of development as the exercise of a real option, the question arises whether development should be modeled as a compound option. This paper tests the validity of the compound option characterization by determining whether builders start units for which they have permits and then complete units started consistent with the predictions of the real options model. To do so, I first identify a reduced form relationship between permits and starts and then between starts and completions. The parameters of this relationship indicate how well permits proxy for starts and starts for completions. Then, I determine whether controlling for this structural relationship, new information, and uncertainty in returns affect permit exercise and completion rates, as in the exercise of real options. I find that current and previous quarter permits forecast current single-family starts, while multifamily starts require more quarterly lags of permits. More than one and two year's worth of lagged starts numbers are needed to estimate current quarter completions for single- and multifamilys buildings, respectively. The principal result is that once building permits have been obtained, the development process proceeds to completion. While there is no evidence that completion is the exercise of an option embedded in a start, some aspects of permits are consistent with builders treating them as an option for starts. However, even if they do, given permits obtained, it takes large changes in market conditions to affect small changes in starts.     

Brokerage commissions and margin requirements: With special reference to Japan

In Japan, brokerage commissions and margin requirements are currently regulated by the Ministry of Finance. However, commissions may soon be deregulated. This paper examines several economic factors which determine commissions and margins in a deregulated environment. The analysis is motivated by the observations that for Japan's securities companies, 1) brokerage commissions constitute a large component of their revenues; 2) margin transactions account for a significant proportion of their trading volume; 3) their gross income exhibits a great deal of volatility; 4) income tax is one of their two largest expenses; and 5) they face a significant tax asymmetry.While executing an unmargined long transaction for a customer is a riskless activity, executing either a margined long or a short transaction exposes the firm to some risk and possibly negative profits. While the commission charged by a brokerage firm for executing a riskless (unmargined) long transaction is simply equal to the marginal cost of producing the firm's total number of transactions, it is demonstrated that the gross commission charged for executing either a margined long or a short transaction includes two other components. The first additional component is a risk/tax premium that is determined by the brokerage firm's tax rate and degree of tax asymmetry, the security's volatility, and the customer's margin deposit. The second additional component is the premium required for the implicit put option associated with a margined long transaction, or for the implicit call option associated with a short transaction. The option falls in-the-money if the security's price changes significantly, so that it is optimal for the customer to default on his contract with the brokerage firm.The determinants of the customer's optimal margin, for both long and short transactions, are also examined. The benefit to the customer of depositing a higher margin is that his commission cost declines. For example, with short transactions a higher margin increases the exercise price of the implicit call option, causing both the risk/tax premium and the implicit option premium to decline. However, a higher margin may increase the customer's opportunity cost of capital. Consequently, the optimal margin increases with the firm's tax rate and degree of tax asymmetry, and decreases with the customer's opportunity cost of capital. An increase in the security's volatility has an ambiguous impact on the optimal margin.The authors are from York University, Canada and International University of Japan, respectively. Part of this paper was written while the first author was on leave at Kyoto University, Japan. We acknowledge helpful comments by Richard Arnott, Lawrence Harris, Hiromitsu Ishi, Eliakim Katz, Johannes Raaballe and Lim Kian Guan (the editor).     

Redevelopment of Real Assets

Real assets can be redeveloped repeatedly. Unlike financial assets, the option to redevelop real assets can be exercised infinitely often. For a depreciating real asset, the optimal exercise policy and resulting market values are calculated analytically and compared to the standard solution with at most one redevelopment. Relative to the standard solution, redevelopment is on average more frequent and less extensive, and the resulting market values are greater.     

Integrating Real Options with Managerial Cash Flow Estimates

This article presents a real options model that fits managerial cash flow estimates (optimistic, likely, and pessimistic projections) to a continuous geometric Brownian motion (GBM) cash flow process with changing growth and volatility parameters. The cash flows and the value of a project are correlated to a traded asset, so the real option is priced under the risk-neutral measure with a closed-form solution. The analysis is extended to a sequential compound call option for investments over multiple periods. If the project is correlated to the market, then some of the risk may be mitigated by a delta-hedging strategy. A numerical example shows that the effect of the correlated asset on the real option value is significant, and the relationship between the volatility of the project and the real option value is not analogous to the typical relationship found in financial option pricing. Integrating the expertise and industry knowledge of management, this approach makes possible a more rigorous estimation of model inputs for real option pricing.     

Mortgage Pricing: Some Provisional Empirical Results

We test some of the qualitative properties of mortgage pricing models. The models use option pricing techniques, focusing on prepayment as a call option. They imply a quite nonlinear relationship between mortgage price and coupon, interest rates and volatility. We test for both the first and second derivatives of the effects of these variables using data on Ginnie Mae mortgage backed securities. We find that the model is largely supported by the data.     

Optimal Mortgage Refinancing with Stochastic Interest Rates

The purpose of this paper is to develop a dynamic model of mortgage refinancing in a contingent claim framework that simultaneously solves for the borrower's optimal mortgage refinancing strategy, the value of the refinancing call option, the value of the mortgage liability to the borrower, and the market (lender) value of the fixed-rate contract. We also calculate the minimum differential between the contract rate on the existing mortgage and the current interest rate that is required to trigger an optimal mortgage refinancing.     

Evaluating Product Plans Using Real Options

Product planning helps a company to strategically plan its current and future product platforms and offer product variants in the marketplace. Product platforming is widely touted as a successful strategy for mass customization. However, due diligence should be exercised before implementing any product platform strategy. The product planning exercise should account for future uncertainties. Traditional financial tools such as the net present value (NPV) are static since they do not compensate for any exogenous and endogenous uncertainties during the course of the project. The crux of the problem lies in the evaluation model that is used for evaluating the product planning projects. While many view uncertainties in a product planning project as problematic, it can also be viewed as a source of new opportunities. We argue that uncertainties should be an integral part of the evaluation model. If the future possibilities (or strategic options) are not considered in the evaluation model, a corporation may face a “myopic syndrome”.

In this article, we consider two important product planning decisions—platform decisions and product variant decisions. The platform decision involves strategic selection of a concept product platform from various possible alternative concept product platforms. The product variant decision involves deciding how long a company should continue to offer its current product variant in the marketplace and whether the existing product variant should be discontinued, scaled down, or scaled up with additional product features. To address the two aforementioned decisions, we developed a real options–based methodology that considers technical, project implementation, and market-related uncertainties. The proposed methodology uses a binomial and quadranomial lattice approach to build a decision tree. Product planning decisions at various decision tree nodes are evaluated using a risk-neutral option valuation methodology. We demonstrate the working of the proposed methodology using an illustrative example.     

Real options in equity partnerships

We examine factors influencing the decision to acquire additional equity in partner firms in research‐intensive industries. This decision involves choosing between flexibility and commitment. Option theory motivates hypotheses regarding the effects of uncertainty, valuation of developing technologies, and the threat of preemptive rivalry. Our main hypothesis is that the resolution of uncertainty for high‐value technologies motivates commitment decisions. We also argue that when the underlying growth option is at risk of preemption by rivals, greater uncertainty encourages commitment. An event history model tests these hypotheses using data from minority investments in the biotechnology industry. Copyright © 2002 John Wiley & Sons, Ltd.     

Project valuation in the pharmaceutical industry: a comparison of least‐squares Monte Carlo real option valuation and conventional approaches

Least‐squares Monte Carlo simulation (LSM) is a promising new technique for valuing real options that has received little or no attention in the pharmaceutical industry. This study demonstrates that LSM can handle complex valuation situations with multiple uncertainties and compounded American‐type options. The limited application of real option valuation (ROV) in the pharmaceutical industry is remarkable, given the importance of accurate project valuation in an industry that requires large investments in high‐risk projects with long pay‐back periods, which is furthermore suffering from ever‐increasing development costs and shrinking profit margins. The LSM model developed in this study is constructed as an extension of a discounted cash flow model that should be familiar to economists active in the pharmaceutical industry. A number of pharmaceutical projects have been evaluated using LSM ROV, binominal real option valuation and expected net present value techniques. The different results yielded by these methods are explained in terms of differences in risking assumptions and ability to capture the value of flexibility. The analysis provides a framework to introduce the basic concepts of real option pricing to a non‐specialist audience. The LSM model illustrates the potential for real‐life commercial assessment as the versatility of the technique allows for an easy customisation to specific business problems.     

THE TIMING OF REAL OPTION EXERCISE: SOME RECENT DEVELOPMENTS

This paper briefly reviews one recent development in real options modeling. This development aims to extend traditional real options models. We show that previous models are incomplete in that only the optimal action threshold is derived. The new literature aims to provide, further information on optimal option exercise. By introducing the first passage time approach, empirically testable propositions on the probability of option exercise and the expected waiting time before an option is exercised are provided.     

Coordination in a retailer-led supply chain through option contract

This paper develops a model to study channel coordination and risk sharing in a retailer-led supply chain. Such chains are characterized by a dominant retailer who aims to coordinate the upstream production quantity. We investigate a coordinating contract based on an option with two parameters. An option price is paid by the retailer for each additional unit of product reserved beyond the initial order. An exercise price serves as the unit purchasing price when the retailer sets a second order if realized demand is more than the initial order. A successful coordination needs two conditions. One condition is to maintain a negative correlation between exercise price and option price. Particularly, we draw the functional form. The other is that the firm commitment must be lower than the optimal production quantity in a centralized system. In a risk sharing mechanism, we prove that such a contract brings benefit to each party.     

FHA Terminations: A Prelude to Rational Mortgage Pricing

Recent models of pricing mortgages and/or mortgage insurance have used option-pricing models as their framework. The focus is usually on default, which is viewed as a put option (to sell the house to the lender in exchange for the mortgage) and prepayment, which is viewed as a call option (to buy the mortgage from the lender). Analysis then uses techniques like those used to price options in capital markets. Unfortunately, homeowners do not seem to exercise their option as quickly as do traders in organized markets. We estimate prepayment and default functions, which are meant to be a first step in developing modified, option-based models of mortgage pricing.     

Building Dynamic Capabilities in New Product Development through Intertemporal Integration

Although successful development of a given product may help explain the current success of a firm, creating longer‐term competitive advantage demands significantly more attention to developing and nurturing dynamic integration capabilities. These capabilities propel product development activities in ways that build on and develop technological and marketing capabilities for future product development efforts and create platforms for future product development. In this article, we develop a conceptual model of a dynamic integration process in product development, which we call intertemporal integration (ITI). In its most general form ITI is defined as the process of collecting, interpreting, and internalizing technological and marketing capabilities from past new product development projects and incorporating that knowledge in a systematic and purposeful manner into the development of future new products. Research propositions outlining the relationship of ITI to performance are presented. We provide specific examples of managerial mechanisms to be used in implementing ITI. We conclude with implications for research and practice. Effective management of ITI can increase new product development success and long‐term competitive advantage. This implies that management needs to engage in activities that gather and transform information and knowledge from prior development projects so that it can be used in future development projects. Project audits, design databases in computer‐aided design (CAD) systems, engineering notebooks, collections of test and experimental results, market research and test market results, project management databases, and other activities will all be important in the acquisition of knowledge from prior new product development (NPD) projects. Managers also should initiate the creation and maintenance of databases of technical and marketing information from prior projects, job performance reports, seminars and workshops related to technological issues and advances, and publication of technical journals to assist in the process of knowledge acquisition. Similarly, techniques such as assigning project managers from earlier development projects, reusing key components and technologies, and developing a company‐wide methodology for managing projects can be used to boost the application and use of knowledge.     

经理人股票期权价值的理论及应用

股票期权激励的研究和实践中广泛应用布莱克——斯科尔斯模型进行股票期权的公允价值计价,然而对经理人而言的股票期权价值还要考虑经理人的风险偏好、财富的多元化程度等因素的影响。经理人期权价值不等于公司期权成本的基本理论可以解决及解释在股票期权实践中的一些关键性问题,如期权激励有效性的衡量、激励期权的风险溢价、最优行权价的确定、行权时间的确定。该理论的应用对我国上市公司股权激励的实施也有重要启示。