Real Estate Price Dynamics and the Value of Flexibility

Abstract

This paper presents a model of real estate asset price dynamics based on empirical evidence, economic theory, and common sense. We note important differences between real estate versus stock market price dynamics. We then use this model to simulate the investment performance of archetypical property investments, in stabilized income-producing property, and in multi-asset development projects. We quantitatively explore the effects of uncertainty on investment performance, for example, the positive skew in the valuation distribution and the positive bias in the pro-forma return compared with the expected return due to Jensen’s Inequality. We then focus on the value added by flexibility, including various types of real options in development projects. We consider the value of resale timing flexibility in stabilized property investment, and the value of production delay and product switching options in the development project. We find that with typical real estate price dynamics, flexibility adds considerable value, and greatly improves the expected return. In stabilized property investment, resale timing flexibility can add 25% to the private valuation of the property. In multi-asset development, we find that timing options are redundant within themselves, but additive with product type options. Delay options provide significant downside protection, and combined with product switching can add over one-third to the value of the project as measured by its implied bid-price for the land.

Keywords: Real estate valuation, Price dynamics, Real options, Real estate development, Flexibility, Simulation

JEL Classification: R30, G12, G13