Presale Contract and Its Embedded Default and Abandonment Options

Posted: 26 Jan 2012

See all articles by Su Han Chan

Su Han Chan

Johns Hopkins University - Carey Business School

Ko Wang

CUNY Baruch College

Jing Yang

California State University, Fullerton - Department of Finance

Date Written: January 24, 2012

Abstract

The presale contract is a popular property selling method that allows a buyer to default on the remaining payment and/or a developer to abandon a project. Using a simple two-period game theoretical model, we derive a closed-form pricing equation for a presale contract that explicitly accounts for a developer's abandonment option and a buyer's default option. Although a developer has an abandonment option under either a spot sale or a presale method, the option is more valuable under a presale contract because of an additional cash inflow from the presale downpayment. A presale also provides a buyer a default option, which is valuable in a real estate market with uncertain demand and price risk. We analyze the implications of the abandonment option on a developer's construction decision and choice of selling method, as well as the implications of the default option on a buyer's purchase decision. Furthermore, our model framework has implications to the pricing of futures contracts that involve both stochastic revenues and costs.

Keywords: Property presale; Real option; Development decision

Suggested Citation

Chan, Su Han and Wang, Ko and Yang, Jing, Presale Contract and Its Embedded Default and Abandonment Options (January 24, 2012). Journal of Real Estate Finance and Economics, Vol. 44, Nos. 1/2, 2012. Available at SSRN: https://ssrn.com/abstract=1991225

Su Han Chan

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

Ko Wang

CUNY Baruch College ( email )

17 Lexington Avenue
New York, NY 10021
United States

Jing Yang (Contact Author)

California State University, Fullerton - Department of Finance ( email )

PO Box 34080
Fullerton, CA 92834-9480
United States

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