Real Options And Property Development Decision Making

Real options are increasingly being promoted in the academic world for use by developers to make more informed decisions on the timing of property development and the valuation of development land. The proponents of the theory propose that property development investments provide developers with several options that can increase value through flexibility of decision-making.

Decision-making under conditions of uncertainty requires managers to make financial decisions that affect the future, whilst they are unable to predict future events with absolute certainty. Any decisions that are being made now assume a certain amount of inefficiencies arising from the risk of making a partially incorrect decision due to the inability of managers to predict the future with absolute certainty. The converse statement to this is that one can wait a bit longer for more information to make better decisions, which delay gives rise to an option. Real options theory claims to be able to value the option contained in this delay.

Various decision-making methods, like the discounted cash flows (DCF) are used extensively to forecast the future. One of the most common DCF techniques is the net present value (NPV) technique. This technique holds that an NPV calculation that returns only a positive result means that a development should go ahead. An NPV calculation only uses information that is known at the time of the calculation, whereas property development is an at-least 50-year decision. NPV evaluates a development project as if it will be completed, regardless of whether they it still makes sense mid way through the project or not. Cash flow and discount rate variables change over time and as a result the NPV should also change. A project that may look positive now may not be attractive a few months later and vice versa, thereby increasing the chance that the wrong decision can still be made.

Property development is an extremely complex activity which involves significant numbers of people and skills, utilising extensive resources over an extended period, for the provision of physical buildings in the future. It all starts with the provision of development land. The most popular method of valuing the land component in a development is the residual valuation method. Briefly, this method works by calculating the development’s NPV and confirming that the project should be embarked upon. Thereafter the building cost must be subtracted from the total investment outlay, thereby arriving at the residual value of the land. It therefore not scientific in that it works in reverse logic.

Other questions arise when the DCF is used, for example: what discount rate should be used on the future cash flows? What are the variables used to build up the discount rate? What time period must the calculation be done over? How is the risk premium to be calculated? Practitioners often do away with the complexities of the NPV and dispense with the investment decision by capitalising the first year’s projected net income with an appropriate rate to arrive at a value estimate.

NPV gives no indication as to when the decision should be implemented, whereas real options can help with such a determination. The decision as to when to proceed with a particular development has generally been based on the position of the rental growth curve in relation to the building cost growth curve, as observed over a period of time. However, the exact timing as to when this condition will be reached and for how long it will last can never be predicted accurately. Another trigger used to to time hotel development is to observe what is called the hurdle rate, and again, as with NPV, once discount rates get used then the chance exists that an incorrect decision could be made. The hurdle rate is tied to to the company’s cost of capital.

Real options mean various things to various people. The synthesis below explains what they say about real options as they could be applied to property development. In finance, an option is a contract between a buyer and a seller that gives the buyer of the option the right, but not the obligation, to buy or to sell a specified asset (underlying) on or before the option’s expiration time, at an agreed price, the strike price. Real options are an off-shoot of financial options, and can be defined thus: A situation in which an investor is able to choose between two different decision options where both choices involve tangible assets, such as real estate. Real options allow developers the ability to treat vacant lots of land as options to wait to develop. By considering developments which provide the ability to react accordingly to the uncertainty of future forces, developers can better manage the risk associated with a potential weak market while also gaining the potential to benefit in a strong one. Flexibility of this type in real estate is generally known as a real option. Real options add value to a project by providing developers with flexibility to minimize downside risk or take advantage of upside potential as conditions change from deterministic expectations. The model proposed values these managerial flexibilities and shows improved risk management, identifying the optimal strategy and timing for the construction phases.

The assumption with NPV is that the investment decision must be made now or never. However, many projects create future opportunities or threats, which may be a significant source of value or loss. These opportunities can be modelled as real options. With this view, an investment decision can be considered as a call option. The value of the project is just the value of the option to invest. The exercise price is the cost of the investment, and the gross option return is the discounted expected value of the investment returns. This option is exercised when the gross return is high enough. The DCF method fails to evaluate this option correctly.

Short term land speculators also use options extensively whereby they pay a fixed sum to a seller of a prime parcel of land, subject to a higher, final payment should a development be proceeded with on the land. If the development does not go ahead then the option lapses and the land reverts to the seller, together with the initial payment.  This is a powerful example of how options can be used in property development. However if the entire development decision is treated as an option, even better land-banking decisions can be made. Banks have, much less now than in the past, used financial options to facilitate loans to their blue chip corporate clients for property developments. Real options are different in that the option is integral to the entire development and the valuation methods used to value the options do not rely on discounted cash flow analyses.

Real options use some intricate mathematical tools, which are not the subject matter of this article, to value the subject land and the development. Suffice it to say that the list includes decision-tree analysis with probability theory, binomial theory, derivatives and stochastic processes and others. However the techniques seem to cover most of the abstract mathematical concepts that DCF does not cover. Perhaps in a later article I will attempt to explain the mechanics of the proposed theory works in practice.

The flexibility inherent in real options is the cornerstone of this theory in that it allows developers to make better decisions as they have the option to delay making a decision. The abandonment option is a problem because most construction contracts do not allow for abandonment, especially when the contract is of the fast-track kind. The disadvantages of real options at the moment are that developers are still content to use the NPV. South African developers are not quick at adopting new methods of doing things, as evidenced by the slow adoption of the NEC construction contract documents.

Real options theory has been written about extensively in property development journals. Some reputable Universities are teaching real options as part of their property education curricula. Through the way that real options promise to deal with the problems inherent in NPV analysis, developers should at least look to see if its applicability in their projects can be justified.

Property Investment 101 – The Property Syndication Lesson

The recent reports and comments involving a very prominent property syndication company provide a case in point. Due to the inability of this company to make a mandatory distribution to its investors recently, various commentators have not lost the opportunity to criticise the property syndication investment model as being bad for investors. The main critics blame the lack of liquidity in the model for the said company’s problems. I do not believe that is a fair criticism for many reasons, some of which I will attempt to outline below.

Wikipedia defines liquidity as follows: “A liquid asset has some or more of the following features. It can be sold rapidly, with minimal loss of value, any time within market hours”. Property by its very nature is very illiquid. Bricks and mortar, unlike equities, cannot be turned over a short space of time. Too many variables enter the equation here. Timing is one of the most important of these. Entering and exiting the market has to be timed perfectly. It is said that a property investment cycle unfolds over seven-year periods. So it takes quite a long time for investors to start realising any serious benefits. Or, as some would say, property is a long term investment.

During this time, investors can either leave their returns in the investment or withdraw them every month. If they choose to withdraw their distributions, then they forfeit the capital growth that accrues to the investment as a result of compounded growth. In such a case then at the end of their investment period they can withdraw their capital subject to the ravages of inflation, or the time value of money. Over a period more than seven years, an investor who has left their funds in the investment are typically rewarded with a positive balance. So, such an investor would have enjoyed a monthly “dividend” plus capital growth.

Investors who are in property investments for the long haul by and large come out as winners. Advisors who direct their retired clients towards property investments when the latter cannot afford the time required to realise full benefits are doing the industry a disservice.

Long term investments, such as property syndications, do not as a rule generate “superprofits” from the annuity income from the property. However, in the long term, investors do realise very good returns. One of the reasons is that most urban environments do become attractive for other investors and they also inject their capital into the area. Those who entered the market earlier at a lower price can then sell their holdings at the appreciated price.

The liquidity argument sounds like a contradiction in terms because the long term nature of property investments is that your capital is tied down in the property for a long time. So, there is no point in looking for liquidity where it is not likely to exist. The problem with leaving capital tied down for long periods of time in any asset class is that risk also increases correspondingly. However, property is generally considered to be a “safe bet”, or as they say, property is as “safe as houses”. So, in theory, the timing risk should be adequately mitigated by the safety factor.

Property Unit Trusts were set up specifically to counter the problem of lack of liquidity in property investments. Legally, PUT operators are required to distribute their properties’ income minus expenses to investors every month. Also, investors purchase shares or linked units in the fund rather an indivisible share in the property, as in the case of property syndications. So, if an investor was to require immediate cash, then they could easily sell their shares at the ruling price on the Stock Exchange, just like they always do with equities. In contrast, investors who are interested in the physical asset would put their capital into a property syndication rather than in shares. The syndication brings together people who want to invest in commercial and retail property but cannot afford exclusive ownership in their individual right because of the large amounts involved.

Property syndications are likely to be successful when investments are made into an existing property, as opposed to when a company develops a brand new building. This is because with an existing building, the majority of costs that are payable upfront in any building have already been dispensed with. In a new development, most tenants have to invest large amounts of capital expenditure upfront, on which they have to pay financing costs and earn a quick return. Every cent that the landlord gets from the tenant has to be fought for with others. This puts pressure on rental negotiations, including turnover rentals.

When it comes to property developments, timing is of the essence too. The development profit equation is quite easy to follow – development income less development cost gives development profit. The most difficult thing in attaining maximum profit is to conduct proper research. If a developer starts a multimillion Rand development when building costs are very high, probably the highest in recent history, then the projected profits are not likely to materialise. On the other hand, when the tenant market is depressed, as most recent reports have highlighted, profits are likely to be squeezed even further.

Existing buildings are also far more preferable to new developments due to the certainty that a firmly established property management regime brings about. The process of running a management operation on a large property is a daunting task. The level of uncertainty that is brought about by forecasting the running costs of a new building can rattle even some of the most seasoned property management companies.

As with all other investment classes, the standing rules of investing in property have to be followed meticulously, otherwise the investment is likely to fail. To blame the property syndication model for failed investments when the rules were not followed properly is not fair.