Evaluating Real Estate Development Using Real Options Analysis

Abstract

This paper uses an example involving a commercial real estate project to demonstrate the practical application of real options analysis. The approach described can be used to value the project at any stage of construction, which is especially useful when market conditions are poor and suspension of many partly-completed projects is being considered. It builds on static DCF analysis and offers instructors the opportunity to give students with basic knowledge of the binomial option pricing model exposure to a practical real-options toolkit. All the calculations can be performed in a spreadsheet and only one parameter - the volatility of the price of the completed project - needs to be estimated in addition to those required for static DCF analysis.