Title

Binomial option pricing models for real estate development

Document Type

Journal article

Source Publication

Journal of Property Investment and Finance

Publication Date

1-1-2013

Volume

31

Issue

5

First Page

418

Last Page

440

Publisher

Emerald Publishing Limited

Keywords

Financial constraint, Institutional arrangement, Interactions, Option pricing, Property finance, Real estate, Real estate development

Abstract

Purpose: The purpose of this paper is to construct option pricing models for real estate development by considering and incorporating institutional arrangements, direct interactions and financial constraints in the model. It extends the application of real option theory from the framework borrowed from financial option pricing, and considers the case where a development company has restrictions from outside environment and financial constraint. It explores the effects of these additional practical factors on real asset project value and development timing. This paper makes contributions to bridge the theoretical models and practical applications. Design/methodology/approach: Real estate development is modelled in the binomial option pricing framework with the considerations of time-to-build, foregone rent if delaying, institutional environment and capital budgeting. The investment timings are derived from the models and sensitivity analysis is conducted to explore the effects of these factors. Findings: Apart from the factors in traditional option pricing theory, this paper confirms that the contractual covenants, positive synergies between properties and financial status of the firm, which enhance or restrict real flexibility embedded in the development land, influence project value and investment timing. Numerical examples illustrate the effects of these factors. It is argued that the valuation of real options should place emphasis on industry-specific characteristics and start from the perspective of the firm rather than individual options. Practical implications: The models constructed in this paper and the results can be directly used in the practical real estate development. Originality/value: This paper incorporates many practical factors in real estate development which are not investigated in previous studies. It values the option project from the firm perspective rather than project perspective as previous studies. It also shows the effects of institutional arrangement and firm factors on project value and development timing.

DOI

10.1108/JPIF-10-2012-0046

Print ISSN

1463578X

E-ISSN

14702002

Publisher Statement

Copyright © Emerald Group Publishing Limited. Access to external full text or publisher's version may require subscription.

Full-text Version

Publisher’s Version

Recommended Citation

Shen, J., & Pretorius, F. (2013). Binomial option pricing models for real estate development. Journal of Property Investment & Finance, 31(5), 418-440. doi: 10.1108/JPIF-10-2012-0046

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