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Development Value: A Real Options Approach Using Empirical Data

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Abstract

This paper combines an empirical methodology and a theoretical options approach to determine the real option values of development and delay for vacant parcels of land in the City of Chicago. A theoretical options model provides an option price that incorporates future uncertainty. The data allow for disaggregation down to specific land use categories and results show option values vary across zoning categories and within zoning categories for specific land uses.

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Notes

  1. It should be noted that Grenadier (1995) implies that the option may effectively expire due to preemption.

  2. Other theoretical, real option research in real estate includes Grenadier (1995, 1996), Geltner et al. (1996), and Holland et al. (2000).

  3. The option to delay development modeled as a compound option is presented in Somerville (2001).

  4. The result in Eq. 3 is slightly different than Quigg’s (1993) research. There appears to be a misreported exponent of (γ/(−γ)) from the derivative of the residual function. The impact of this understates the optimal building size for γ < 1 which leads to lower values of the development option.

  5. The maximum building size is computed using the floor to area ratio (FAR) and the lot size; δ = FAR * LOTSIZ.

  6. The 20% land to developed value ratio can be obtained from Eq. 9. The 1% income divided by 5% implies that land is 20% of the total value after development, P.

  7. Annual price volatilities are computed using the hedonic estimation results to create an index over the holding period. The result is an annual price volatility range from 16% to 30%.

  8. A section is one square mile or 640 acres. So a quarter section is a half mile square or one quarter of a square mile or 160 acres.

  9. The central business district is defined as the corner of State and Madison.

  10. The models used to estimate the cost elasticity have R-squared ranging from 0.95 to 0.99.

  11. The hedonic estimates provide a market pricing mechanism for improved properties.

  12. The delay option premium reported is the average of the delay premium found for each observation. The delay premium is defined as \( \left( {{V_i} - V_i^I} \right)/{V_i} \).

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Authors and Affiliations

  1. Fairfield Residential LLC, Grand Prairie, TX, 75050, USA

    Robert A. Grovenstein

  2. University of Georgia, Terry College of Business, Athens, GA, 30602-6255, USA

    James B. Kau & Henry J. Munneke

Authors
  1. Robert A. Grovenstein
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  2. James B. Kau
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  3. Henry J. Munneke
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Correspondence to James B. Kau.

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Grovenstein, R.A., Kau, J.B. & Munneke, H.J. Development Value: A Real Options Approach Using Empirical Data. J Real Estate Finan Econ 43, 321–335 (2011). https://doi.org/10.1007/s11146-010-9277-9

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  • DOI: https://doi.org/10.1007/s11146-010-9277-9

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