Real Options

One of the most exciting areas of modern real estate theory is the study of real options. Different from their financial cousins where an option is a "side bet" on stock that does not affect how the company operates, real options involve restricting a real asset.

This changes behavior. Also, embedded optionality exists in many situations. The decision to develop, redevelop, abandon or wait until doing anything are all examples of embedded options. Finally, the exercise of an option on a share of stock has little or no affect on supply where the exercise of an option to build adds to supply in ways that changes the plans and fortunes of other market participants.

A thoughtful analysis of options discloses value completely missed by net present value analysis. Investors whose advisors fail to consider option value often leave money on the table for those who retain advisors skilled in evaluating real options.

The graphic above shows how the difference in probabilities (the solid red line is 50/50, the dotted blue line favors the best case outcome 60/40) converge over time as one delays the option to redevelop. The calculation underlying these plots considers, among other things, the value of existing income foregone when redevelopment commences.