A Real Options Model of Real Estate Development with Entitlement Risk

Real Estate Economics, Forthcoming

68 Pages Posted: 3 Sep 2012 Last revised: 24 Apr 2019

See all articles by Yiying Cheng

Yiying Cheng

University of St Thomas

Steven P. Clark

University of North Carolina (UNC) at Charlotte

Kiplan S. Womack

UNC Charlotte, Department of Finance, Belk College of Business

Date Written: April 20, 2019

Abstract

Real option theory models real estate development as a developer-controlled exercise of an option to construct the optimal structure at the optimal time. In practice, most projects encounter a highly uncertain entitlement (i.e., regulatory approval) process that is largely uncontrollable by the developer. In this study, entitlement is modeled as a separate stage in a compound development option, where the developer begins with minimal control and maximum risk, and each successful stage increases control and reduces risk. We solve the model analytically, provide three-dimensional numerical comparisons, and empirically test the model's predictions using manually collected data from rezoning petitions. Our main result implies that developers initiate the entitlement process early in order to counter uncontrollable delay and exogenous risk. Accordingly, a municipality attempting to moderate development via the entitlement process may find more applications filed instead of discouraging construction. Overall, our study refines the development option model, where developers first invest early (secure entitlements) and then subsequently delay investment (wait to construct the optimal building at the optimal time).

Keywords: Real options, entitlement, development, real estate, regulations

JEL Classification: R11, R14, R21, R31, R33, R52

Suggested Citation

Cheng, Yiying and Clark, Steven P. and Womack, Kiplan S., A Real Options Model of Real Estate Development with Entitlement Risk (April 20, 2019). Real Estate Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2140213 or http://dx.doi.org/10.2139/ssrn.2140213

Yiying Cheng (Contact Author)

University of St Thomas ( email )

713-525-2108 (Phone)

Steven P. Clark

University of North Carolina (UNC) at Charlotte ( email )

9201 University City Boulevard
Charlotte, NC 28223
United States

Kiplan S. Womack

UNC Charlotte, Department of Finance, Belk College of Business ( email )

9201 University City Blvd.
Charlotte, NC 28223
United States
704.687.7584 (Phone)

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