The Value of Flexibility: A Finance Application of Options to Real Estate
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Abstract
Real estate is among the most strategic of businesses. Each property class has both independent and linked economic, demographic, and political constituents. Moreover, there are dozens of parties involved that influence the real estate project’s final outcome. At every stage of a given project, the participants learn new information that affects their plan. Developers learn about the market, local government actions, and tenant decisions, while tenants learn about consumers and competitors. The nature of the business requires and rewards flexibility. This paper focuses on flexibility and its value in real estate dealings. Specifically, it applies the concept of optionality as considered in corporate finance to address the true value of flexible strategies to real estate practitioners. In recent decades, real estate has evolved in terms of complexity. It has adopted concepts related to valuation from the research-rich field of finance. This trend will logically continue as the real estate industry becomes more efficient and institutionalized. This paper explores the mechanics of real estate optionality and applies the discussed concepts to practical examples. The types of option agreements covered include the following: • Option to purchase developable land• Option to renew a commercial lease • Option to terminate a commercial lease Industry examples are used to provide impactful applications of these topics to developers, investors, and tenants. In the first section concerning land options, a seller faces a decision on choosing between two unique offers from independent developers. The optimal choice is determined by recognizing the financial market value of an option embedded in one of the offers. In the second and third sections of this paper, the renewal and termination options are considered from the eyes of commercial retail tenants and landlords. Unique cases are presented, and the value of each option is demonstrated using advanced, yet applicable, option pricing methods. Additionally, the renewal option is covered with respect to its value dependants, as well as its worth across U.S. markets.
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Cornell Real Estate Review
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Vol. 12
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Sponsorship
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2014-07-01
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Keywords
Cornell University; real estate; finance; options; economic; demographic; political; Developers; market; government; tenant; consumers; competitors; flexibility; corporate; finance; renewal; termination; call; put; exercised; in the money; seller; buyer; strike; land; value; replicating portfolio theory; bond; risk-free; commercial; lease; renewal; termination; lease; contract; rental; payoffs; markets; flexible; ingredients; present value; clause; risk; cash flow; Woolbright
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Required Publisher Statement: © Cornell University. Reprinted with permission. All rights reserved.
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