An option-theoretical approach to the valuation of rights of first refusal for real estate

Abstract

Rights of first refusal are a common occurrence in real estate transactions. The finite supply of land and the historical appreciation in value of properties can be economic motives to contractually secure a right of first refusal for real estate. The right – when executed – allows the party to which it was granted to purchase the property at the conditions that the third bidding party offers. Real estate acquisitions typically incur substantial transaction costs (e.g. due diligence, legal advisory, stamp duty etc.). The uncertainty introduced trough a right of first refusal in the acquisition process can discourage potential buyers from making an offer for the property. The seller may therefore choose to remove the right of first refusal through negotiation prior to marketing of the property.Under such circumstances the knowledge of the economic value of the right of first refusal can provide a valuable information for the negotiation process. This analysis focuses on the value of the option to enter into a purchase agreement at the price offered by a third independent party. The negotiation effects of potential sunk costs or delays in the acquisition process are not considered. It is assumed that at the time of negotiation over the right no offers for the property were already made, leaving both owner and holder of the right of first refusal in uncertainty about an eventual bid. Furthermore it is assumed that all parties including potential bidders share the same information regarding the property.The value of the right of first refusal to the holder at the time an offer was made by a third party should be the difference between the inherent value assumed by the assignee and the offering price by the third party. Prior to that point the value of the option should be determined by the expected deviation of the bid from the assumed inherent market value of the property. For the purpose of this analysis the expected deviation is modeled after the statistical deviation of actual real estate transaction prices from appraised market values. The value of the option to enter into a purchase agreement at an unknown offering price is determined under the assumption of a normal distribution. The data is based on IPD and RICS studies. The model results were reproduced via Monte Carlo simulation and mirror typical estimates in literature for the value of rights of first refusal in the German property market.