Real Options in Real Estate Development Investment

Abstract: Real estate development investment requires a large capital funding but it has slow payback with many risks and uncertainties in the investment. The current approach by using NPV to evaluate this type of investment is not adequate anymore. This is because NPV does not thoroughly capture the uncertainties in the investment and the method ignores the management flexibility whether to postpone or abandon the project in the future. An alternative approach that addresses these issues is to use real options to evaluate this type of investment. The thesis uses the real option model that was proposed by McDonald and Siegel (1986) to evaluate real estate development investment. The model captures value and cost uncertainty in the investment and considers that managements have the flexibility to defer the investment into the future. The thesis analyzes the model critically by sensitivity analyses and shows that using the model requires the input parameters to be carefully determined, especially the ones that relate to unit rental rate.  Furthermore, the paper uses Monte Carlo simulation to determine the optimal ratio between value and cost which suggests that the investment should be deferred or invested now. The result shows that, in general, a real estate project should be invested when the value of the project doubles the cost. Also, the result from the simulation allows investors to adjust the ratio according to their risk behavior. Lastly, the thesis performs another Monte Carlo simulation in order to quantitatively identify the effect of the real option model on the investment decision. The result shows that using only the traditional NPV to evaluate the investment can lead to the wrong investment decision more than 90% of the time. Therefore, using both real options and NPV together can improve investment decisions on the real estate development project.