Real Estate Development as an Option
JOSEPH T. WILLIAMS
Professor of Finance and Urban Land Economics, Faculty of Commerce and Business Administration, University of British Columbia, 2053 Main Mall, Vancouver, British Columbia V6T 1Z2
Abstract
Subject to legal limitations, the owner of undeveloped real estate can determine both the date and density at which to develop his property. Alternatively, he can abandon his property. The value of these options depends partly on the stochastic evolution through time of the operating revenues and construction costs of developed property.
In this paper the option pricing problem is solved analytically and numerically for the optimal data and density of development, the optimal date of abandonment, and the resulting market values of the developed and undeveloped properties.
Keywords: Development, option.
The option to develop real estate differs in several important ways from put and call options that investors can trade on organized exchanges. Subject to legal limitations, the owner of real estate can select the scale or density at which to develop his property. Also, if the costs of carrying an undeveloped property exceed sufficiently its operating revenues, then the owner has an incentive to abandon his property. Both options affect the market value of the undeveloped property. In addition, the value of the undeveloped property depends upon not only the operating revenues from the developed property but also its costs of development, both of which can evolve stochastically over time. ~ Compared to problems with financial options, the owners options are more complex and are driven by a different set of stochastic state variables.
In other ways developing real estate is much like exercising an option. Subject to local zoning regulations, the owner chooses the date at which to develop his property. This option is more valuable the more uncertain are changes over time in either operating revenues or construction costs. If investors can trade substitute securities continuously without transaction costs in a perfectly competitive capital market, then the owner optimally develops his property only when development maximizes its market value. For example, maximizing market value is optimal if the capital market is perfectly competitive and complete, even if the market for real estate is not. Also, since the option to develop never expires, the owner optimally exercises his option only when his propertys developed value, as determined by its operating cash inflows, exceeds its costs of development. Depending upon the values of various parameters, the difference at the optimal exercise point between the developed value and the construction costs can be considerable. Finally, development is essentially irrevocable, much like the exercise of financial options. Because buildings are durable, properties are redeveloped only after prior improvements are rendered economically or technically obsolete by the passage of time.
Previous papers on this problem include Titman (1985) and Capozza and Sick (1988) 2 In Titmans article the development of urban property is recast as a problem in option pricing and then solved using standard techniques. The results have interesting implications for both the price of urban land and the partial development of urban property, explaining why, for example, high-rise buildings sometimes abut parking lots. Because the option to build is valuable, development is optimally deferred until the value of developed property is greater than its construction cost and, possibly, much greater. In Capozza and Sicks paper, landowners have the option to convert agricultural land into urban land. Urban land is priced in a competitive, complete capital market, and the price of agricultural land is then calculated analytically, using standard techniques in option pricing? The optimal point for converting agricultural into urban land is expressed in terms of the distance from the city center, using a model of the demand for urban land in which urban rents are linear in the distance. The results have interesting implications for both the boundary of the urban area and the income multiplier of agricultural land. In this paper real estate is valued as an option, and the optimal points at which to abandon and to develop property, as well as the optimal density of development are determined.
By assumption, both the operating cash inflows from the developed property and its costs of development are driven by geometric Wiener processes; the cost of density is CobbDouglas; and the maximum feasible density is determined by zoning restrictions? In the initial model undeveloped property has no carrying cost. This initial problem is presented in Section 1 and solved in Section 2. The analytical solution includes the optimal point and density of development and the values of developed and undeveloped property. A stochastic carrying cost for the undeveloped property is then added in Section 3. In this second situation the option to abandon the property is valuable, and the solution must be computed numerically. From the perspective of the literature on option pricing, the novel results relate to the optimal and maximum densities of development. Finally, the main results are summarized in Section 4. All technical details are relegated to the Appendix. An investor owns an undeveloped or underdeveloped property. Subject to legal limitations, he can choose both the date and density at which to develop his property. The date at which the owner acquired his property is denoted by t = 0. At any time t gt; 0, he can develop his property at some feasible density, scale, or quantity q satisfying 1 lt; q _ 5, where /~ denotes the maximum density permitted under zoning regulations. Development is costly. The cost, qrx~, depends on the development cost per unit of density xl, measured per u
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A Case Study of Rongchuang China Series Mergers and Acquisitions
Xianzhi Wu
Real estate mergers and acquisitions belong to the category of enterprise mergers and acquisitions, but real estate mergers and acquisitions have certain particularities compared with enterprise mergers and acquisitions. Real estate mergers and acquisitions include not only acquisitions of real estate enterprises, but also acquisitions of real estate equity and individual real estate projects. Real estate equity and real estate project acquisitions can be subdivided into cooperative development, overall real estate project acquisitions, and acquisitions of construction projects. Real estate merger and acquisition is an important means for real estate enterprises to develop rapidly in a short time, expand their own scale and improve their ability to resist risks. At the same time, it is also an effective way to optimize the allocation of real estate resources and improve the efficiency of the use of resources.
Asset acquisition of real estate enterprises refers to a single real estate project purchased by the purchaser in the form of cash and stock, which belongs to the commodity trading mode. Under this mode, the target of acquisition is the ownership of a single real estate project, and the acquired party is transfered to acquire funds or stocks, without any influence on the legal status of the buyer and seller. Rongchuang Chinas acquisition of a large part of the acquisition is a single project asset acquisition, such as Tianlang Wulong, Quyuan Tingxiang, Qingdao Jiakai City and other projects are of this type.
Real estate project enterprise, namely project platform company, is a company specially established for the development of specific real estate projects. It has independent subject qualification, so it can effectively control the financial risk of real estate project development. The purpose of equity acquisition of platform company is to control the project under the platform company, or to real estate project in essence, but this involves the change of legal subject, not purchasing, which belongs to the scope of company merger. Such as Rongchuangs acquisition of Zhongmou Meisheng Real Estate, Rongke Zhidi and so on, all belong to this type.
Cooperative development of real estate projects means that two or more real estate companies form new enterprises to jointly develop real estate projects and share the risks and benefits of the projects. Fundamentally speaking, this method still belongs to the category of merger and acquisition, because the purchaser will acquire the corresponding equity by forming a joint venture company with money or other forms. Its essence is similar to acquisition. Rongchuang Greentown Company (Rongchuang Greentown Platform) in Shanghai, which is formed by Rongchuang, is the representative of this type.
The theory of competitive advantage, that is, enterprises acquire competitive advantage by merging other enterprises, can be divided into two reasons according to the advantages acquired by enterprises after merger and acquisition: (1) obtain competitive structural advantage of enterprises. Through horizontal mergers and acquisitions, enterprises can reduce the number of competitors in the same industry, and reduce the competition for resources by other enterprises; (2) gain the competitive advantage of enterprises. Through horizontal mergers and acquisitions, enterprises can rapidly expand their scale, improve their market share and competitive advantage; through vertical mergers and acquisitions, upstream and downstream enterprises can acquire advantages in raw material procurement and product bargaining, in order to gain their own competitive advantage. Rongchuang Chinas Mamp;A series are mostly horizontal mergers and acquisitions between the same industries. Through the mergers and acquisitions of other real estate enterprises and real estate projects, we can obtain a large number of high-quality land resources, realize the rapid expansion of the scale of our own enterprises, and realize the 'curve overtaking' and 'the latter is in the first place'.
The purpose of Mamp;A in real estate industry is not only to gain competitive advantage, but also to obtain resources of enterprises. In the cases of mergers and acquisitions in other industries, many of the merged enterprises are well-known companies with good performance, wide brand awareness and high enterprise value. Most of the purchasers focus on the various resources of the target company, such as better brand value, large amount of liquidity, undistributed profits, lower financing costs, advanced technology, etc., and even make use of leveraged funds to make small and large investments. The play 'snake swallows elephant' was repeated. Such as the dispute over the ownership of Baoneng Vanke, Geelys acquisition of Volvo and so on. The real estate industry is mostly purchased for the purpose of acquiring the resources of the target company. Many cases of mergers and acquisitions in China are also for similar purposes.
According to the theory of Mamp;A efficiency, Mamp;A can improve the management performance, produce some synergy effects, improve the efficiency of enterprises, and ultimately promote the overall improvement of social benefits. The basic logic of this theory is that efficiency differences lead to mergers and acquisitions. After mergers and acquisitions, high-efficiency enterprises will increase inefficiency, thereby improving the efficiency of the whole social economy. This theory includes efficiency differentiation theory, inefficiency management theory, business coordination theory, diversification theory and so on. Rongchuang Chinas acquisition of shares in Tianjin Star Yao Rongwei Building is in a similar purpose. After the acquisition of inefficient Rongwei Building, it uses its own brand, capital and related sal
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