Master Thesis

Can Real Options improve the results of investment valuations?

A Case study on real estate development objects in Downtown Detroit

Date: June 2015

Author: Tom Kircher
MSc Finance and International Business
Advisor: Stefan Hirth
Department of Economics and Business
 Abstract

This paper has the central objective to describe the existing concept of the real option theory,
to differentiate its characteristics from the net present value and to test its applicability based
on a case study.
It is the goal to point out differences between the net present value and the real options
analysis and to determine whether the latter of them is a superior method.
The valuation is done on a chosen real estate development object in Downtown Detroit, USA.
Accessable data is used together with making necessary assumptions in order to apply the real
option theory.
For valuation purposes, a binomial lattice model is selected.
The model incorporates the option to defer, to abandon and to expand the investment and is
divided into stages leading the model to contain of sequential compound options in order to
capture the potential flexibility. The calculation results are compared to the before provided
and estimated static net present value benchmark.
The findings confirm the stated hypothesis of the real options analysis delivering better results
compared to the net present value.
It is found that by applying the sequential decision strategy, the payoff of the project can be
increased by 12.825 percent, which is matching the existing empirical findings of previous
conducted research papers.

KEY WORDS: Case study; Net present value; Real options analysis; Flexibility; Sequential
compound options
 I

Table of content

1. Introduction .................................................................................................................. - 1 -
1.1. Background and Motivation ................................................................................... - 1 -

1.2. Problem Statement and Objective .......................................................................... - 3 -

1.3. Outline .................................................................................................................... - 4 -

1.4. Evaluation of sources.............................................................................................. - 5 -

1.5. Delimitation ............................................................................................................ - 5 -

2. Methodology ................................................................................................................. - 7 -
2.1. Research Structure .................................................................................................. - 8 -

2.2. Research Process .................................................................................................... - 9 -

2.3. Introducing Detroit The Case Study .................................................................. - 12 -

3. Literature Review ...................................................................................................... - 15 -

3.1. Net Present Value A Traditional Decision Tool ................................................ - 15 -

3.1.1. Limitations of the Net Present Value Method ............................................... - 17 -

3.2. Real Options ......................................................................................................... - 19 -

3.2.1. What are Options Definition ...................................................................... - 20 -

3.2.2. Options Three Different States of Value .................................................... - 21 -

3.2.3. Financial versus Real Options ....................................................................... - 24 -

3.2.4. Types of Options ........................................................................................... - 25 -

3.2.4.1. Option to Expand ................................................................................... - 26 -

3.2.4.2. Option to Defer ...................................................................................... - 27 -

3.2.4.3. Option to Contract.................................................................................. - 27 -

3.2.4.4. Option to Abandon ................................................................................. - 27 -

3.2.4.5. Sequential Compound Option ................................................................ - 28 -

3.2.5. Value Drivers ................................................................................................ - 28 -

 II

3.2.6. Differences Net Present Value vs. Real Options Analysis ............................ - 30 -

3.3. Real Options Valuation Methods ......................................................................... - 32 -

3.3.1. Partial Differential Equations ........................................................................ - 32 -

3.3.2. Simulation ..................................................................................................... - 33 -

3.3.3. Binomial Lattice ............................................................................................ - 34 -

3.4. Approaches to Real Options ................................................................................. - 36 -

3.4.1. The Classic Approach ................................................................................... - 37 -

3.4.2. The Subjective Approach .............................................................................. - 37 -

3.4.3. The Marketed Asset Disclaimer Approach ................................................... - 37 -

3.4.4. The Revised Classic Approach ..................................................................... - 38 -

3.4.5. The Integrated Approach ............................................................................... - 38 -

3.5. Real Options in Real Estate .................................................................................. - 38 -

3.5.1. Volatility........................................................................................................ - 40 -

3.5.1.1. Risk versus Uncertainty ......................................................................... - 42 -

3.5.1.2. External Risk Factors ............................................................................. - 42 -

4. Case Study Reviving Downtown Detroit............................................................... - 44 -

4.1. Project Description ............................................................................................... - 44 -

4.2. Underlying Drivers ............................................................................................... - 46 -

4.2.1. Income ........................................................................................................... - 46 -

4.2.1.1. Rent ........................................................................................................ - 46 -

4.2.1.2. Net Operating Income ............................................................................ - 47 -

4.2.1.3. Terminal Capitalization Rate ................................................................. - 47 -

4.2.2. Costs .............................................................................................................. - 47 -

4.2.2.1. Construction Costs ................................................................................. - 47 -

4.2.2.2. Operating Expenses ............................................................................... - 48 -

4.2.3. Cost of Capital ............................................................................................... - 48 -

4.2.3.1. Risk free rate .......................................................................................... - 48 -

 III

4.2.3.2. Beta ........................................................................................................ - 49 -

4.2.3.3. Market Risk premium ............................................................................ - 49 -

4.2.3.4. Cost of Equity ........................................................................................ - 50 -

4.2.3.5. Comparable industry ratios .................................................................... - 51 -

4.2.3.6. Discount Rate Development Time ...................................................... - 51 -

4.3. Base Case Valuation ............................................................................................. - 51 -

4.3.1. Expected Static Net Present Value ................................................................ - 52 -

4.4. Real Options Analysis .......................................................................................... - 53 -

4.4.1. Volatility........................................................................................................ - 54 -

4.4.2. Binomial Lattice ............................................................................................ - 54 -

5. Discussion.................................................................................................................... - 59 -
5.1. Results .................................................................................................................. - 59 -

5.2. Critique and Reflection ......................................................................................... - 60 -

6. Conclusion .................................................................................................................. - 61 -

Bibliography ...................................................................................................................... - 63 -

Appendix ............................................................................................................................ - 66 -
 IV

List of figures

Figure 1 A four-step Process ............................................................................................. - 8 -

Figure 2 Research Structure .............................................................................................. - 9 -
Figure 3 Comparing the S&P Case-Shiller Home Price Index ....................................... - 12 -
Figure 4 Monthly Return Development of Home Price Index ........................................ - 13 -
Figure 5 Payoffs Call Option .......................................................................................... - 22 -
Figure 6 Payoffs Put Option ............................................................................................ - 23 -
Figure 7 Mapping a Development Opportunity onto a Financial Call Option ................ - 25 -
Figure 8 Displaying Advantages from Fluctuations of Options ...................................... - 26 -
Figure 9 Scenarios of Real Options Value Creation ....................................................... - 31 -
Figure 10 Option Value of a One-step Binomial Lattice ................................................ - 34 -
Figure 11 Allocation of Expected Return ....................................................................... - 40 -
Figure 12 Project Description of the Individual Stages ................................................... - 45 -
Figure 13 Comparable industry ratios ............................................................................. - 51 -
Figure 14 Input Variables ................................................................................................ - 52 -
Figure 15 Summary Input Variables for Binomial Lattice ............................................. - 55 -
Figure 16 Present Value Binomial Tree and Development of Construction Costs .......... - 56 -
Figure 17 Individual Combined Equity Lattice for Phase 1, 2 and 3 ............................... - 58 -

List of tables

Table 1 Display of an Investment Opportunity ............................................................... - 17 -

Table 2 Comparing Discounted Cash Flow and Real Options Analysis ......................... - 31 -
 V

List of abbreviations

CAPM - Capital Asset Pricing Model

CF - Cash Flow
DCF - Discounted Cash Flow
ENPV - Expected Net Present Value
GBM - Geometric Brownian Motion
HPI - Home Price Index
MAD - Marketed Asset Disclaimer
MAX - Maximum
NPV - Net Present Value
PV - Present Value
REIT - Real Estate Investment Trust
ROA - Real Options Analysis
ROV - Real Options Valuation
USA - United States of America
 VI

Acknowledgements

This Thesis has been carried out from January 2015 to June 2015 at the Department of
Economics and Business, Aarhus University, Denmark in order to finalize the Master of
Science program in Finance and International Business.
I would like to thank my supervisor, Stefan Hirth, for his guidance and energy that assisted
me in understanding, structuring and writing my paper and helped me to conduct a goal-
oriented research.
Furthermore, I would like to thank all of my classmates and the teachers, who made the years
of the programme such a great experience. I am blessed to not only have learned about a new
culture and education system, but also to have met several interesting and valuable people
from all over the world, a lot of whom I now call friends.
Finally, I am entirely appreciative for my family and especially my parents, Ellen and Frank
Kircher, who always have had my back and have supported me unconditionally regardless of
the direction or the difficulty of my chosen path.
 -1-

1. Introduction

1.1. Background and Motivation

Real estate investments are one of the most chosen answers if it comes to the question how
best to invest money in order to gain long-term returns and secure peoples pension plan
[Focus (2013)]. The endless lifespan of real estate objects hereby presents a valuable level of
security together with the possibility of continuous cash flow income to the investor [Geltner
et al. (2007)]. Therefore, understanding the real estate market, the relation to financial
economics and its dynamics always has been in the centre of research attention for decades.
Borison (2005) sees an increasing number of articles, which focus their research on how to
extract the most value out of investments in real assets rather than in the more and more non-
arbitrary offering financial assets. As lucrative as this might happen to be seen, as crucial it is
to evaluate this investment opportunity correctly. The real estate bubble in 2008 and 2009 has
shown in a spectacular way that the demand in the market and its prices can break away from
one day to another and what kind of consequences and impacts wrong assessments or
estimates regarding the realistic value of real estate objects can have.
A lot of expertise together with an accurately working model is required, which not only is
easily applicable but also includes the most important and essential variables impacting the
value of the objects. Besides that, the model is required to still be able to mirror the variables
in a realistic setting.
Examples of those variables can include several risks and uncertainties related to demand and
sale prices in the market, government risks and possible changes in regulatory or development
costs. In their paper, Sun et al. (2008) identify four main categories of risks (political, social,
economical and technical) influencing the real estate development process.
Consequently, making the decision based on the correct and accurate valuation is essential as
investments in real estate and commercial development of buildings also bind a lot of capital,
which only recovers slowly and over time in form of cash flow income or the sale price. In
addition to the uncertainty and the high amount of required capital, the decision to develop a
real estate object often is irreversible or at least partly irreversible and is associated to a high
quantity of sunk costs.
One way to evaluate real estate investment opportunities is to use the net present value
method. It in practice is widely adopted and supports the investor in the decision whether or
 -2-

whether not to undertake the investment. Its easy application is at the same time its biggest
flaw. The approach can be described as deterministic, because it misses out on taken the
above mentioned variables of risk and uncertainties into account. This leads it to being a static
valuation tool, which only refers to one specific moment in time. As a consequence, the
investor is put into a passively spectator role, unable to react to the change of circumstances
as they unfold during the development process. Once the simultaneous decision to invest is
made, it is irreversible and the costs for the investment decision can be seen as fixed capital,
which stands in contrast to the way a real estate development normally evolves. Real estate
development is not straightforward and linear but includes different stages during the process,
leaving room for changes, optimizations and adjustments. Renegotiations of terms, delaying
or abandoning of further development steps or stages and the option to expand the investment
are examples of the additional value an investor can receive when he takes future
uncertainties and their impact on the asset into consideration before making the committing
investment decision.
This value of flexibility cannot be fully captured by a static model like the net present value
approach, thus, making the real option theory interesting for this field of research. It has led to
the literature and research to focus on retrieving an alternative approach, which is able to
capture the additional value through flexible decision making and has resulted in the real
options analysis. McDonald and Siegel (1986) first identify an economic value in the option
to wait to invest. Williams (1991) and Quigg (1993) empirically prove that there is additional
value in the option to defer a development of real estate land. And even though real options
theory also has been incorporated as a decision tool in relevant books or research papers on
real estate development [e.g. Geltner (2007)], the static net present value approach is still
widely used in practice as the major tool for investment valuation. One reason for that is that
the gap between theoretical approach and practical application of the real options valuation
models are found to be too broad. In addition to that, it is often seen that it is difficult to apply
the analysis or to fulfill all the industry-specific requirements due to its mathematical
complexity and different assumptions needed to be made regarding specific industries [Lucius
(2001)].
This paradox between theoretical and practical application of real options delivers an
interesting starting point for a deeper research.
In order to make a sequential development including options lucrative, the necessary criteria
of high uncertainties, irreversibility of investments and the exposure to external risk factors
have to be met. The real estate industry perfectly meets these criteria.
 -3-

Beyond that, understanding the price dynamics and the development of the real estate market
has already been a central research interest by the author since 2008, reflected also in the
authors bachelor thesis.

1.2. Problem Statement and Objective

Although many papers and researches can be found on theoretical background that discuss
and define real option models, not only the paper of Lucius (2001) shows that still only a
small amount of literature actually applies the real options analysis to evaluate real estate
investment objects. Though, as shown in the introduction, the real options analysis often is
found to be superior over the net present value method, it is yet not as widely used in practice
as the net present value method.
Therefore, the goal of this thesis is to compare two approaches, the base case scenario
delivered by the net present value method and a self-developed efficient model based on the
theory of real option valuation [a binomial tree lattice]. Another goal is to determine the
differences between the two valuation methods. Additionally, potential value drivers of the
real options analysis are stated and the applicability of both models is tested and compared.
This is done through a case study, conducted on investment and development objects, located
in the city of Detroit, USA.
The above stated goals aim to achieve a central objective of this paper, which is to contribute
to a more applicable real options analysis model in the sector of real estate development.
Furthermore, with the provision of the theoretical background and the appliance of the models
to the case study of a real estate development project in Detroit, the following main research
question shall be answered:

Can real options analysis deliver more appropriate and superior results compared to
the net present value method in terms of the valuation of real estate objects through
their characteristics of taking into consideration the steps of sequential development?

In addition to that, the answers to the following sub-questions provide a deeper understanding
of the topic and by this support the solving of the main research question:

How are real options defined and what kinds of options exist?
 -4-

What assumptions have to be made or what conditions have to be matched for real
options analysis to be more feasible in practice than the net present value method?
What are the variables and risk factors influencing the outcome?
What are similarities and where are differences between the two approaches?

In order to answer the above stated research questions, the structure given in section 2.1 is
followed, i) determining and ii) applying the theory to a real case study, iii) describing and
evaluating the data in order to achieve numerical results and iv) analyzing the findings.

1.3. Outline

The thesis in total contains six chapters. Chapter one and two can be seen as the introduction
and structural framework. Chapter three through five build the central part of the thesis
concluded by the conclustion on the findings of the research.

- Chapter one delivers the background and the motivation for this study. It states the
objective and the main research questions for this paper. It provides the outline on how
the paper is structured, evaluates and reasons for the used sources and states the
delimitations, which are necessary in order to accomplish an efficient and realistic
scope.
- Chapter two explains how the research in this thesis is conducted in terms of strategy,
approach and methodology. It includes an overview of the different steps and the
models used in the paper. It also reasons for the necessity of an accurately conducted
case study and explains why the City of Detroit and its real estate situation deliver
good input and the desired data for the case study.
- Chapter three contains and describes the relevant theoretical background. This
includes a review of the existing valuation models and their definitions. A comparison
of the models with and to each other is made. In addition to that, all complementary
models and theories are explained that are necessary in order to conduct the case
study. This includes defining the term volatility and the external risk factors that can
affect real options in real estate, but also the adequate approaches to incorporate these
variables into a model.
- Chapter four deals with the City of Detroit and its real estate situation. It applies the
two models to the case study. This includes generating and describing the raw data
 -5-

necessary to run the analysis and preparing descriptive statistics. Additionally, the data
is utilized to run the numbers; and the four-step process valuation process is applied
[see Methodology, Chapter 2].
- Chapter five analyzes and discusses the findings and compares the results to previous
research findings from papers, conducted on similar topics or case studies.
- Chapter six contains the conclusion and provides the main results and findings with
references to the research questions of the paper. The results are put into perspective
and suggestions for possible further research are delivered.

1.4. Evaluation of sources

The choice of the sources is crucial for a successfully conducted research project. Therefore,
the main sources used in this paper are articles from academic journals that are available
online and accessable through the library of Aarhus University. This approach follows the
main assumptions that published articles in highly ranked journals have to go through and
pass a process of academic review and hence automatically contain quality and valuable
research aspects.
Additionally, prior studies on related research fields are taking into consideration and are
hereby cited to provide a broader perspective and an overview of the existing and relevant
research, which previously dealt with the application of real options analysis. This is done in
order to deliver a better understanding of the central research question of this study.

1.5. Delimitation

While the goal is to contribute new ideas and findings to the research regarding the
applicability of real options in real estate development, the paper underlies the specific
limitations.
Since real options have been first introduced by Myers (1977), a lot of research on this topic
has been conducted and various different models have been developed as well as more and
more types of options have been defined. In order to deliver the best and most accurate results
possible, the focus of this paper has been narrowed down to four different kinds of options
and a comparison of one static with one dynamic model. Furthermore, research almost always
aims to empirically test and prove the theoretical findings and hypotheses. The problem that
often occurs is for one the limited available and accessable data. Because of the limited
access, this paper uses secondary data sources such as the accessable websites census.gov and
 -6-

research.stlouisfed.org, REITs published in articles and found via search engines like
Business Source Complete and data directly extracted from DataStream. While the data from
DataStream is considered to be unbiased, the other sources have to be read and used with a
critical eye as they might be biased. Often assumptions and limitation have to be made
regarding input variables used in the model which further narrows done the range and
accuracy of the simulation. The author is aware of this possible error leading to incorrect or
inaccurate results regarding the comparison of real options analysis and the net present value
method and therefore this is taking into consideration in the final reflections and conclusions
of the paper.
The paper focuses on the books of Mun (2006) and Copeland and Antikarov (2003), which
not only deliver a four step model to conduct the valuation, but also deliver main and
important assumptions essential for applying the real options methodology to a real case
study. The question of the right approach to value real option is answered, which sets out the
framework of how to deal with the data. Additionally, different real options valuation
methods are presented, which all fulfill two essential assumptions. For one, the concept of an
efficient market with no arbitrage opportunities and the process of the geometric Brownian
motion [GBM]. Both are further explained and discussed in the chapter of the literature
review.
The author is aware that throughout the thesis additional assumptions and limitations might be
required in order to increase the accuracy or correctness of the research study.
 -7-

2. Methodology
In the world of research, many different real option valuation models and with it different
level of complexity can be found. The goal of this paper is to find and develop a discrete-time
real option valuation model, which can easily be applied to a case study and still being able to
capture most of the essential variables.
Therefore, the approaches described and defined by Copeland and Antikarov (2003) and Mun
(2006) in their books with the titles: Real Options: A Practitioners Guide and Real
Options Analysis Tools and Techniques for Valuing Strategic Investments and Decisions
build the foundation for the methodology used in this paper. The application of the model
follows and includes the following four-step process approach for valuing real options [see
Figure 1], where:

- Step one contains calculating the standard and static net present value of the
investment possibility using the Discounted Cash Flow analysis. It presents the base
case without flexibility, needed for further valuation and comparison. The assumption
of the market asset disclaimer [MAD] holds and helps to identify the value of the
underlying asset without flexibility also known as the static net present value and
represents the best unbiased estimate of the market value of the investment.
- Step two has the main purpose to first identify all different possible uncertainties and
then to combine all the defined risk variables into one. This is achieved through
running a Monte Carlo simulation and through the estimation of comparable market
proxies, which are further defined and explained in the literature review. Examples for
uncertainties can be found in sale prices, interest rates, employment rate, purchase
power, rental rates, etc. and are determined in the literature review in general and then
in specific regarding the case study in Chapter four. The assumption that all
uncertainties are unrelated is important and therefore stated in order to simplify the
analysis. This supports the ability to better evaluate and analyze the results.
- Step three uses the calculated standard deviation to build the binomial tree. The
volatility displays the up and down movements of the tree. The tree is a summary of
every possible value the underlying risky asset may take through time depending on
the different states, which are presented through nodes. These nodes also indicate a
point of possible and potential managerial interaction as they represent real options
 -8-

nodes. The viewed time in which the nodes appear are set to be regular and one year
intervals, again for simplicity reasons.
- Step four describes the valuation of the different paths of the created binomial tree and
its with coming payoffs. The risk-neutral probabilities approach is applied to assess
the different outcomes, going backwards in time and taking into consideration every
node and each of the possible included different option along the path.

Figure 1 - A four-step Process [Source: Adopted from Copeland and Antikarov (2003)]

Excel and necessary extensions are used to design the modeling framework for this thesis.

2.1. Research Structure

The research structure is divided into four main parts, which can be seen in Figure 2.
Each part plays an essential role for creating a fully comprehending of the paper as it is the
goal to not only display the status of the latest models and theories [Part one], but to use the in
the literature existent and through previous research supplied tools and the available and
generated data [Part two] to run an analysis on both the base case NPV and the developed real
options valuation method [Part three] in order to come to results, a conclusion and to answer
the central research questions of the paper [Part four].
All four individual steps are essential as they prepare the foundation for the thesis, gather and
set up the data, run the analysis and reflect and conclude on them.
 -9-

The paper only is able to contribute new findings through the application to a case study,
which transforms the gathered data and identified real options into an analysis and therefore
tests the hypotheses and models.
Saunders, Lewis and Thornhill (2012) compare the research process to a research onion and
confirm in their book the necessity of a divided structure in order to conduct and write a
complete and value-adding paper. The onion refers to the different fields during the research
process and is described and explained more in detail in Chapter 2.2.

Figure 2 Research Structure [Source: Own Creation]

2.2. Research Process

This section deals with the research process that is utilized in this paper. That includes
reasoning for the research paradigm, the research approach and the research strategy as well
as the time horizon is determined. It delivers the clarification on how this thesis is conducted
for example in terms of theory and data collection, which supplies the reader with a clear
guideline and a better understanding throughout the paper.
Positivism is a dominant chosen paradigm in how to apply research philosophy and is based
on existing theoretical research and applies logical reasoning to investors, decision makers,
companies and markets as well as it assumes rational and therefore utility maximizing
 - 10 -

behavior. It assumes the existence of one truth, observable by the scientist and leads to
science being able to predict the world. In contrast to this approach stands the post positivistic
research paradigm, which can be defined as a critical realism. Ryan et al. (2002) determine
the main difference in the critically dealing with the view on the truth and not only accepting
the observed data as the one existing truth. Post positivistic approach followers are aware and
recognize that all observations are fallible and can contain errors and that as a consequence
theory is always possibly revisable. Certain objectivity cannot fully be achieved due to biases
and subjectivity. A process of variation, selection and retention that theories can run through
and which is a natural process of selection can lead to theories approaching the objective one
truth.
The author of this paper adopts the post positivistic paradigm in order to not only follow the
above stated research methodology approach, but also to ensure having an invisible guideline
that supports and demands the reoccurring critically questioning and challenging of the
desired and intended objectivity constantly throughout the paper. The approach is reflected in
the structure of the paper as the paper begins with a literature review before setting up the
models, applying them to a numerical example, testing and questioning the consistence of the
found empirical data and comparing it to the existent literature putting it into a perspective.
The author hereby is aware that in term of the conducted case study a possible result of self
made estimations and beliefs might include and lead to a certain level of subjectivity.
Additionally, the post positivistic paradigm typically proposes a certain research approach to
be followed by the writer, which often is the method of a deductive approach. The paper at
hand embraces the deductive approach.
Saunders, Lewis and Thornhill (2012) see and define five different stages in order to conduct
a deductive research, where:
- The first step orders the author to deduct hypotheses from existing theoretical
literature that delivers a testable relationship between variables, factors or concepts.
- The second step is to transform the hypotheses into operation terms allowing an
indication on how the variables are to be measured.
- The third step involves the testing of prepared hypotheses involving a case study,
experiment or any different applied strategy instrument.
- The fourth step contains an examination of the results putting them into a perspective
regarding the existing theories, which leads to either confirmation or indicate a need
for adjustments.
 - 11 -

- The fifth step is the follow up suggestion for modification if in step four the necessity
for that has been determined.

The research structure [see Chapter 2.1.] reflects all of those five stated stages of how to
conduct and follow the deductive research approach as the starting point of the paper is the
developing of hypotheses and models out of the existing literature and theories.
In contrast to that, the inductive approach is seen to be appropriate when research starts with
observing and generating data leading to a creation of theories and analysis. While induction
emphasis the collection of quality data and allows a more flexible structure permitting the
researcher to undertake changes or adjustments throughout the research progress, the
deduction insist on gathering quantity data and a clear and highly structured approach to be
followed. [Saunders, Lewis and Thornhill (2012)]. Reality sees no absolute black or white
decision and one could argue that this paper also contains the inductive approach because the
goal of the thesis at hand is to design and deliver a practical and applicable model out of
generated and observed data.
The author is aware of the possible combination of the two different paths in order to
accomplish the goal, but for the above stated reasons the main focus is put on following and
applying the deductive approach.
As objective as the relationship between theory and practice might be seen, reality sees a
limitation to the application of the models as they are affected by necessary assumptions made
by the author resulting in a possible subjective factor of influence throughout the thesis. To
achieve scientific objectivity, the above chosen deductive approach prescribes an
independency from the observed results. This means that the achieved results could also be
achieved by any third in a run test observation and therefore are reproducible.
To support this goal, the research strategy is important. The paper at hand chooses a case
study, which when simple and well-constructed enables the author to not only challenge the
existing theory but also to come up with new hypotheses [Saunders, Lewis and Thornhill
(2012)].
 - 12 -

2.3. Introducing Detroit The Case Study

The importance of a well conducted and suitable case study to test the stated hypotheses,
answer the research questions and apply the developed models has already been mentioned
and reasoned for in this part of the paper.
Robson (2002) defines a case study in general as a strategy for doing research which
involves an empirical investigation of a particular contemporary phenomenon within its real
life context using multiple sources of evidence.
This section briefly presents Detroit and determines why Detroit is feasible and chosen for the
case study. Additionally, it combines the supplied model with the real life context, utilizing
the above stated quote.
To set up for the case study, it is important to know a few facts regarding the framework. The
case study puts the investor back into the year 2010, when prices fell over proportional in
Detroit as a result of a real estate bubble in 2008 and 2009 [see Figures 3 and 4].

S&P Case-Shiller Home Price Index

250,00

200,00

150,00

100,00

50,00

0,00
2004-01-01

2008-09-01
2000-01-01
2000-05-01
2000-09-01
2001-01-01
2001-05-01
2001-09-01
2002-01-01
2002-05-01
2002-09-01
2003-01-01
2003-05-01
2003-09-01

2004-05-01
2004-09-01
2005-01-01
2005-05-01
2005-09-01
2006-01-01
2006-05-01
2006-09-01
2007-01-01
2007-05-01
2007-09-01
2008-01-01
2008-05-01

2009-01-01
2009-05-01
2009-09-01

Home Index USA Home Index Detroit

Figure 3 Com paring the S&P Case-Shiller Hom e Price Index for Detroit and the USA [Source:
research.stlouisfed.org]
 - 13 -

Monthly Development - Bubble (June 2006 - June 2009)

1,00%
0,50%
0,00%
-0,50%
-1,00%
-1,50%
-2,00%
-2,50%
-3,00%
-3,50%
-4,00%
HPI USA HPI Detroit

Figure 4 Monthly Return Developm ent of Hom e Price Index [Source: research.stlouisfed.org]

Looking at those two figures, the question that surely arises in the readers mind is whether it
is lucrative to analyze an investment opportunity under these circumstances and what exactly
might create value for an investor at the beginning of the year 2010 when he thinks about
investing in Detroit.
Volatility and bubbles not only create downside risk that the investor has to face, but also
provide upside potential of recovering markets with increasing demands and a turnaround of
the devils circle in a positive nature. Detroit hereby displays a perfect example and in the
opinion of the author can offer the recovery potential, which in the conducted case study shall
be evaluated and revealed. Figure three shows the home price development of Detroit in the
last decade. Burdened with a constantly outflow of the population, Detroits real estate prices
developed and increased under proportionally relative to the general development in the USA.
Lately and regarding the figures three and four, it seems that Detroit has reached its bottom
and as a consequence has shrunk to a healthy size that allows the administration to revive
small parts time by time.
Additionally, programs like invest Detroit1, detroitsevenpointtwo2 or the initiatives controlled
and financed by Dan Gilberts mortgage lender company Quicken Loans3 revive the urban
area of Detroit. Investments, governmental subsidies, cheap living costs and a changing and
adjusting urban Downtown attract young and skilled people and professionals. The

1
Investdetroit.org
2
Detroitsevenpointtwo.com
3
Quickenloans.com
 - 14 -

consequence is a gentrification process of the neighborhood, which attracts better, and more
retail, and industry to settle back in.
As in reality right now, this is happening in Downtown Detroit. In the case study at hand, the
investor as earlier described is at the beginning of this potential process. It is not the goal of
the thesis to describe and define the general process of gentrification, but to rather supply a
foundation, which aims to simplify the understanding of the model and the case study itself.
The starting situation is that Detroit in the year 2009 and 2010 has reached the absolute
bottom in terms of unemployment, labor and living costs and value of real estates. And this is
exactly where the connection to the theory exists. Real options enable the investor to fully
capture on the potential upside of a recovering and revived Detroit with increasing home
prices and values. Additionally, being an option; they do not bind or obligate the decision
maker to make a move, which means that in case of a stagnating or even decreasing
development of the situation, the investor does not have to and will not exercise the option.
Testing and finding the connection between the theoretical approaches and reality is one main
goal of the paper, but the author is aware of assumptions and adjustments, which always put
the case study into a reality-light or model perspective.
 - 15 -

3. Literature Review
This chapter has the purpose to supply the necessary and relevant theoretical background in
order for the reader to fully understand the numerical example and to give an overview of the
relevant research that has been conducted on the topic and research tools.
The literature review is divided into four main parts. First, the in reality often used net present
value analysis approach is presented in order to give the reader a base case and a starting
point. Limitations that this valuation method faces are pointed out leading to a presentation of
the chosen alternative valuation method the real options analysis.
As real options analysis has been chosen to be compared to the net present value analysis
based on the case study, it is described and defined more in detail.
Options are defined in general. Different types of options are stated, explained and illustrated
on the basis of an example.
In addition to that, differences and similarities between financial and real options are pointed
out. The definition and understanding of options are crucial to be able to correctly run the
valuation process in the hereafter presented case study. A direct theoretical comparison of the
two methods pointing the differences closes out the second section of this chapter.
After that, a closer look is paid to the empirical evidence of real options in real estate and real
estate development to introduce the reader to the external risk factors, which affect the value
of real options. The term volatility is defined and specified for the up following case study.
Auxiliary tools necessary for the transformation process are presented. This includes the
potential approaches like the market proxy approach together with different methods used in
the real option valuation procedure, like the Monte Carlo Simulation.
The final part sees a presentation of the Binomial Tree approach on the basis of a simple
example and additional assumptions, which need to be made in preparation for the numerical
calculations in Chapter four.

3.1. Net Present Value A Traditional Decision Tool

This paper addresses a specific audience, which already is aware of the basic financial
economics and has a certain research interest in the field of real estate. It is expected that the
reader broadly is familiar with the net present value analysis and therefore this approach is
hereafter only defined and presented briefly.
 - 16 -

Due to its easy implication, the net present value analysis has been used and taught as a
relevant investment valuation tool for a long time. It supports the firms decision maker
whether or whether not to undertake a project opportunity and achieves this with a rather
simple and easy applicable formula. Furthermore, the decision criteria can be transferred
consistently to all projects and supplies the same results regardless of the investors risk
preferences [Mun (2006)].
Koller et al. (2010) describe the solely focus on the cash flows that go in and out of the firm
as one of the main reason for the methods popularity.
Brealey et al. (2011) define the net present value in their book Principles of
Corporate Finance as a result of subtracting the initially required investment [ ] from the
sum of the discounted expected or anticipated future cash flows as equation 3.1 illustrates.
The index of the net present value [here: t = 0; today] refers to the point in time, at which the
present value of the investment opportunity shall be mirrored.

(3.1)

The sum of the discounted expected cash flows can be further divided up into an auxiliary
calculation, the Discounted Cash Flow method [DCF; see equation 3.2].

(3.2)

The factor is necessary to calculate the present value of the cash flows and hence make

them comparable. The rate of return [r] defines the opportunity cost of capital or hurdle rate,
which an investor demands in order to accept delayed payments rather to invest into financial
alternatives [Brealey et al. (2011)]. It can also represent the weighted average cost of capital
of the firm and therefore an intern hurdle rate that has to be overcome in order to accept and
undertake the investment.
Once the net present value is calculated, the method applies a rather pragmatic decision rule.
While a negative net present value leads to a decrease in the shareholders wealth and
therefore it is not recommended to undertake the project, the opposite is the case when the
calculation delivers a positive result; meaning the firm should undertake the investment
opportunity.
 - 17 -

To clarify the above stated formula, [see equation 3.1] an example is given. The formula also
is applied to the investment object of the case study.
A typical and simple example for an investment opportunity is given in table 1 using the net
present value method to evaluate the project. To set up the project, an initial investment of 50
US Dollar at time t = 0 [today] is required. The project is expected to generate 20 US Dollar
of cash flow income over the following four years. The opportunity cost of capital is set to be
five percent representing the interest rate the company could earn investing the 50 US Dollar.

Year 0 1 2 3 4
Initial Costs -50$ 0 0 0 0
Cash Flow 0 20$ 20$ 20$ 20$
Discounted CF 19.05$ 18.14$ 17.28$ 16.45$
Table 1 - Display of an Investm ent Opportunity [Source: Own Creation]

This leads to the following net present value of the project:

(3.3)

The decision rule orders the investor to undertake all projects having a positive net present
value. It is simple to explain to management. A positive outcome leads to an increase in the
wealth of the company, investors or shareholders and therefore is desirable [Mun (2006)]. In
the example at hand, the company should undertake the project because the net present value
equals 20.92 US Dollar, which means investing in this project would see the company with a
net gain of 20.92 US Dollar.

3.1.1. Limitations of the Net Present Value Method

The previous section has explained and shown how simple it is to apply the net present value
analysis. The straightforward decision rule might be feasible, but also entails some
limitations, which in the following are determined and dealt with. Regarding the topic of the
paper, the downside factors are especially looked at under the circumstances of the real estate
field and its dynamics.
Dixit and Pindyck (1994) state three main disadvantages that the net present value method
incorporates when it is used for the purpose of an investment opportunity valuation.
 - 18 -

The first problem the analysis faces is the assumption that the observed project is generating
cash flows over the expected lifetime of the project, which without any contingencies can be
determined. This stands in contrast to the reality. Every project in real estate underlies specific
external risk factors [see Chapter 3.5.1.1] that make a certain estimation of the cash flows
difficult. Cash flows usually are stochastically distributed and the net present value method
misses out on assessing all of the risk factors, which impact the variation of cash flows
throughout the lifetime of the project [Mun (2006)].
Additionally, the net present value method often is associated with a now or never decision
rule, which states either to undertake the project today or never to invest at any point in the
future. This passively treatment of the possibility to interact during the projects lifecycle does
not account for managerial flexibility. It does not reflect the reality and the field of real estate,
where managers possess a certain degree of control and are able to influence the development
process of the object [Mun (2006)].
As an example, the investment might be deferred until more information about uncertainties
and external risk factors are available or a further stage of the development might be
abandoned because it is no longer feasible. Real estate objects usually follow a sequential
development incorporating different kind of valuable options [see Chapter 3.2.4] throughout
the process.
The net present value decision rule does not account for this created option value. Another
problem that the net present value is confronted with is the assumption that all risks are
completely incorporated in the discount rate that the method applies in the calculation.
Mun (2006) argues that risks regarding a project or the firm can vary during the lifecycle of a
project. A constant discount rate based on historical data without flexibility is inaccurate. It
does not reflect the multiple possible sources of business risks a company or project can face
during the development process as the underlying parameters are likely to change over time.
Summing up all the above determined disadvantages, the net present value decision rule
underestimates the flexibility value of a project assuming possible events are static and all
decisions are carved in stone.
This leads to a constantly undervaluation of possible investment opportunities. Valuing
projects in the field of real estate therefore requires an adjusted assessment tool, which
captures the left out possible intrinsic value of projects.
 - 19 -

3.2. Real Options

Thales, a famous Sophist philosopher circa 600 B.C., gazed into the star-studded sky one evening
and predicted an outstanding olive harvest the next season. For a small up-front fee, he bought the
right from the owners of the olive presses to rent them for the usual rate during the harvest season. If
the harvest turned out to be meager, there would be less need for the presses and Thales would not
rent them, losing the up-front fee. But if the harvest was bountiful, he would rent the presses at the
regular agreed-upon price and turn around and rent them out to the farmers at a significant margin.
Sure enough, it was an outstanding harvest, and Thales rented the in-demand presses and made a
fortune. He was apparently more interested in proving the wisdom of Sophists than making money, as
Aristotle tells this story in Politics. [Kodukula and Papudesu (2006)]

The above cited story is one of the earliest examples for a real option contract, giving the
owner the right, but not obligating him to exercise the option on an underlying real asset.
While real options evolved from financial options and similarities definitely exist, this story is
a typical example for a real option because the underlying asset is a real asset and not
financial nature.
The theoretical framework of real options is capable of taking into consideration the
flexibility that can occur in real estate development projects. The flexibility value emerges
from the managers ability to undertake actions and react to uncertainty and changing
circumstances. In order for a successful implementation, not only those uncertainties and risks
have to exist and have to be successfully identified, but the decision makers also have to be
aware of their existence and capable of influencing them. Mun (2006) defines the real options
approach as a dynamic series of future decisions with the investors having the flexibility to
adjust to changes of externalities where as the traditional method assumes a single decision
pathway with fixed outcomes and regards all decision to be made in the beginning.
As real options analysis has been developed on the basics of traditional discounted cash flow
methods, Mun (2006) defines the real options value as a sum of the static and passive net
present value and the strategic option value [see equation 3.4 and 3.5].

(3.4)
(3.5)

The N (d) hereby describe the multipliers behind both benefits and costs and represent the
probabilities of their occurrence achieved through a discrete simulation run in the binomial
 - 20 -

lattice. In the existence of uncertainty, both N (d) are not equal to 100 percent supplying the
option owner with the right to capitalize on the upside volatility while hedging the downside
risk. Real options therefore deliver not only risk reduction but also add value to investment
possibilities and real assets.
Triantis (2005) adds that managers, who apply real options valuation, view volatility as a
possibility to take advantage of rather than seeing it as a risk that is purely harmful for the
venture and which should be avoided. Understandably, the increase in volatility of the
outcomes leads to an increasing option value.
The goal of this section is to deliver the definition of options in general, compare and find the
similarities between financial and real options and define the different types of options as a
preparation for the case study and following analysis. Furthermore, the value drivers of real
options are stated and the differences between the net present value and the real options
approach are pointed out.

3.2.1. What are Options Definition

In contrary to the use of the net present value method, where after having made a decision the
managers or decision makers are compelled to wait passively for the uncertain future
outcomes to unfold, options can provide the investor with a valuable flexibility [Brealey et al.
(2011)].
Although options only recently have become a major contributing part in global working
markets, their history goes back centuries, for example to the Romans who already wrote
option contracts on cargo ships [Smit and Trigeorgis (2004)]. The transformation of options
into the modern financial world was then achieved by Black and Scholes (1973), who
developed the famous and Nobel-prize winning formula that determines equity as an option
on the firm.
Four years later, Myers (1977) first used the term of real options, defining it as a decision
opportunity for a corporation or an individual. He describes real options as a right, rather
than an obligation, whose value is contingent on the uncertain price(s) of some underlying
asset(s).
The definition of the option being a right, rather than an obligation is important as it also leads
to options never containing a negative payoff. If, for example, the option is not in-the-money
meaning the value of the option is not above zero, at or before maturity date, a rational and
risk-neutral investor is not going to exercise the option.
 - 21 -

Consequently, in real option terms, it supports the investor with a decision rule on whether to
delay, expand, abandon or reposition a project and therefore enables the owner to flexibly
react and act to an uncertain and unfolding future.
Additionally, Smit and Trigeorgis (2004) differentiate between call and put options. While the
holder of a call option has the right, but not the obligation to acquire an asset at a prespecified
price, the put option enables the owner to sell an asset at a prespecified price, both limited in
terms of their specified period of time.
A typical example of a call option in real option terms can be seen in a land option. It endows
the owner with the right, but not the obligation to acquire land at the predetermined sales price
[strike price]. Understandable, the owner of the option only is going to buy the piece of land,
when his projected valuation of the land is equal or higher to the strike price and therefore the
option is in-the-money. If this is not the case, the investor can just walk away, letting the
option run out, facing only the price of the option as sunk costs.
In general, options lower the risk of investments, because the holder can use the time until the
expiration date of an option to acquire knowledge about the potential project, its risks and
underlying uncertainties. The following part [see Chapter 3.2.2] sees a graphical example for
the possible different money states options can possess.
Furthermore, options can occur as American or European options. They differ in their
possible exercise date. While an American option can be exercised at any time till the
maturity date, the European option can only be exercised on its maturity date. The term
maturity date hereby defines the date, where the option runs out.
Finally, two different price tags have to be differentiated regarding options. First, the option
price or premium represents the price paid in order to acquire the option itself. In contrast to
that, the price at which the underlying asset of the option can be bought or sold is defined as
the exercise or strike price [Kodukula and Papudesu (2006)].

3.2.2. Options Three Different States of Value

After having delivered the definition of options, this part intends to explain the three different
states an option can be seen in leading to the different payoff conditions. For further
clarification and a better understanding, a simple numerical example is given.
Figure 5 and 6 differentiate hereby between a call (right to buy) and a put (right to sell)
option. A call option can take three different states in terms of money, which result from the
maximization of the following formula:
 - 22 -

C = Max [0, S X], which deducts the strike or exercise price [X] from the value of the
underlying asset at maturity date [S]. If the option owner has to pay more to acquire the asset
than the value of the underlying asset is worth [S < X], the option is out of the money and the
owner will not exercise the option. A practical example can be seen in the option to acquire a
share of a company. The strike price is set to be 50 US Dollar, but at maturity date the share
price actually amounts to 40 US Dollar. Exercising the option would leave the owner of the
option with a negative payoff of 10 US Dollar and therefore he will not exercise the option.
The second state represents the condition where the strike price and the value of the
underlying asset at maturity date are equal and therefore the owner is indifferent whether or
whether not to exercise the option [S = X]. The option is at the money. In terms of the earlier
given example, the share price would have developed to be 50 US Dollar at maturity date.
In the third state, the option owner sees a positive payoff of the option as he can acquire the
asset for less than it is worth [S > X]. In this situation, the option is defined to be in the
money. A share price of 60 US Dollar at maturity date is an example as the option allows us
to acquire a share that is worth 60 US Dollar for the predefined strike price of 50 US Dollar.
All three calculations deliver the gross profit. In order to get the final net gain or value, the
option price has to be deducted from the gross profit. This has to be taken into consideration
while valuating the option payoffs as a gross profit not automatically leads to a positive net
value. If in case three, the price for the option is set to 11 US Dollar, the net gain is negative
while the gross profit still is positive.

Figure 5 Payoffs Call Option [Source: Adopted from Kodukula and Papudesu (2006)]
 - 23 -

Similar to the call option, a put option can also take on three different states. As the put option
gives the owner the right to sell an underlying asset at a predetermined strike price, the
maximization of the formula:
P = Max [0, X S] represents the opposite compared to the payoffs of the call option. As long
as the strike price is bigger as the underlying value of the asset at maturity date, the option is
therefore seen to be in the money. This is comparable to the first given example of the call
option, where the strike price is set to be 50 US Dollar and the share price amounts to 40 US
Dollar in the market. Being able to acquire a share through the market for 40 US Dollar and
directly sell it because the option would lead to automatic gross profit of 10 US Dollar for the
option owner. As the value of the underlying asset increases, the gross profit decreases, being
zero when the asset value reaches the exercise price [S = X]. Further increase and exceeding
of the strike price of 50 US Dollar leaves the option to be out of the money and the exercising
of the option undesirable for the owner [S > X].

Figure 6 Payoffs Put Option [Source: Adopted from Kodukula and Papudesu (2006)]
 - 24 -

3.2.3. Financial versus Real Options

As stated in section above, the central idea of real options is based on the concept of financial
options provided by the paper of Black and Scholes (1973), which first have defined and
explained the upside potential resulting from financial options and uncertainties.
Many authors like Myers (1977) then have applied this theory to investment cases in real
assets.
Both financial and real options therefore show similarities in terms of variables and
conceptions. While both financial and real options give the owner the right, but not the
obligation to invest or to undertake a project, they differ in the underlying asset. Financial
options use intangible assets traded in the market, which stands in contrary to the tangible
assets used for real options such as a business unit, a factory or a real estate object, which are
not being directly traded in the market. This makes one liquid [financial asset] and the other in
most of the cases illiquid [real asset].
Another difference is that if the future unfolds to be favorable the owner of a financial call
option can always exercise the option collecting the underlying asset directly while a real
option merely presents a project or investment opportunity which still is influenced by
changing and uncertain future market condition as well as possible decisions made by other
investors or competitors.
Adding to that is the difference in terms of the resolution of uncertainty. Kodukula and
Papudesu (2006) see an automatically clarification of uncertainty along the time scale for the
financial option while the holder of the real option has to further actively invest in market
research or testing of a product in order to clear possible uncertainty. Financial and real
options also differ in terms of how the value of the option can actively be controlled over its
life period. While in the financial form, the owner has no control of the development of the
value other than to observe its development, a real option leaves the owner with possibilities
to achieve an increase in value through proper management actions like for example an
expansion alternative or the developing of a complementary product.
Figure 7 gives an example how an investment opportunity can be seen as and transformed
onto a financial call option.
 - 25 -

Figure 7 - Mapping a Developm ent Opportunity onto a Financial Call Option [ Source: Adopted from
Luehrm an (1998)]

The present value of the underlying risky object (V) Mirroring the value of the real
estate investment opportunity object. This is identical to the stock price when
evaluating the financial call option.
The exercise price (X) Cost for investment or construction costs of the object as well
as possible investment costs for the conduct of an additional phase.
The time to expiration (t) Duration in which the option is available and the decision
whether to develop and to invest or not can be deferred.
The risk-free rate of return ( ) Indicator for the value of money a firm could earn
when instead of undertaking the project; the money is invested otherwise.
The variance Representing the amplitude of outcomes in terms of the
performance of a stock index and there corresponds to the riskiness of a project asset
in a real option case.

3.2.4. Types of Options

After having delivered the definition of an option and how it evolved from a pure financial
instrument to being also used in form of real options, this section deals with the different
types of options. The earlier determined differentiation between call and put options turns up
again as examples for both variations are stated.
 - 26 -

Options are valuable in terms of adding flexibility in the decision making process and
therefore can increase the upside potential or hedge the downside risk of an uncertain project
outcome in the future [see Figure 8].
The figure illustrates in a simple but understanding way how the management can react to the
spreading volatility of expected cash flows throughout the project duration. The black solid
line hereby represents the predicted mean of cash flows. Both areas above and under the solid
line yield considerable and additional value when the management is aware of the possibilities
and possesses option to adjust to the circumstances.

Figure 8 - Displaying Advantages from Fluctuations of Options [Source: Adopted from Mun (2006)]

While a lot of different possibilities have been created throughout the last years, the main and
most relevant examples are hereafter presented in detail. In order to supply a better
understanding, the definitions and clarifications are underlined by adequate and realistic
examples. The chosen options also represent the options appearing in the case study. All
options are set to be American options giving the option holder the right to exercise the option
at any given time until the expiration date.
The option to construct the object is the most basic example for a call option. It gives the
owner the right to undertake the investment and due to its simplicity is hereafter not further
explained in detail.

3.2.4.1. Option to Expand

The option to expand enables the owner to increase the investment or scale if the market
conditions turn out to be even more favorable than expected. A typical example for this option
can be a commercial real estate object such as a factory. The firm wants to keep the
 - 27 -

possibility of a later expansion open and therefore acquires the option to expand. In reality
this would mean that the firm buys for example a right to build a second floor on top of the
existing factory at a certain predefined price if for example production capacity needs to be
increased because of increasing product demands. The choice to expand is an example for a
call option.

3.2.4.2. Option to Defer

The option to defer is another example for a call option. It provides the owner with the right to
wait and to delay the investment decision to a later point in time and therefore enables the
owner to acquire more information about possible outcomes and the project itself. The option
to defer can often be found in real estate development, where investors acquire inexpensive or
undeveloped land, but wait with the development decision until more favorable market
conditions eventuate. This is especially reasonable in the field of real estate development,
because once a project is started; it ties a lot of capital and the investment costs are almost
irreversible and therefore fixed.

3.2.4.3. Option to Contract

In contrary to the option to expand, the option to contract supplies the owner with the right to
scale back on the project or the investment and therefore represents a put option. Usually this
is achieved by disposing some of the assets. When market conditions developed into non
favorable directions, the firm tries to hedge itself against the downside risk with for example a
legal contract providing them with the right to sell some of not needed assets [Mun (2006)].
In terms of the earlier stated example of the factory, the firm would be able to sell some of the
factory space or some of the not required productions capacity to a vendor, which would see
their costs reduced.

3.2.4.4. Option to Abandon

If the market conditions turn out to be less favorable than expected, this option gives the
owner the right but not the obligation to realize the salvage or rest value of the project or
object. In terms of the factory example, this means that the object or usable items and
inventory can be resold for an adjusted market price or salvage value helping to recover some
or all of the initial investment costs. A typical example in the field of real estate development
is described by the undeveloped land that also can be resold and with it the transferred right to
build or develop an object on it. This often still has an intrinsic value and can be realized.
Similar to the option to contract, the abandonment option is an example for a put option. The
 - 28 -

difference between the two options is that the right to abandon a project always exists
resulting in the salvage value. The value of salvage can hereby in the worst case equal zero.
The option to contract in contrary requires a contracting party, which acquires the assets at a
predefined price.

3.2.4.5. Sequential Compound Option

The concept of a sequential compound option describes the option on an option. It
characterizes the predefined staging of development. It gives the owner the choice to flexibly
adjust and react to changing conditions. This can for example be a signed contract that
includes different abandoning, deferring or expanding options depending on earlier executed
options. In terms of the factory, a further expanding option for example to a third floor would
need a previous exercising of the option to expand the factory to a second floor. Trigeorgis
(2011) defines the compound option as each stage being an option on the value of
subsequence stages. In terms of the case study, the sequential compound option is represented
by the possibility of exercising option two and three expanding the investment with an
exercise of option one being a necessity.

3.2.5. Value Drivers

This section works under the assumption that real and financial options roughly are based on
the same parts and concentrates on determining uncertainties and value drivers of the
flexibility for real options.
Recalling that a financial option gives its holder the right but not the obligation to buy or sell
a certain amount of the underlying asset at a specific price before or at the maturity date
[Copeland and Antikarov (2003)], it is the goal to point out how one can extract this generated
value.
Mun (2006) defines five necessary assumptions in order for real options to incorporate
strategic value. First, he states the need for a finance model, which can incorporate variables.
Additionally, uncertainty as an input variable is essential, because without it, real options and
there flexibility value are not present. Furthermore, the uncertainty has to directly impact the
project value. Consequently, decisions regarding the project are affected by the risk mapped
in the financial model. Finally, the assumption of rational acting management and decision
makers has to be fulfilled together with the investors possessing the options or strategic
flexibility to undertake corrections. This means that the investors have to be able to react to
the changing and unfolding future during the development process.
 - 29 -

Having stated the necessary assumptions for real options providing value, it is the goal to
define what variables impact the value of real options. Copeland and Antikarov (2003)
specify six fundamental variables, which are known from financial options due to their
similarities and hereafter are defined.

Present Value of the Project

In contrary to the financial options, real options are harder to estimate with absolute certainty
as they are not so frequently traded on the stock markets in comparison to financial options.
And even though similar housing objects and their real estate or rental prices can be used for
evaluation, they only can display an approximation of the actual present value of the project.
Besides that, the relationship between the underlying asset and the value of the call option is
positive meaning an increase in the asset also increases the value of the option. The opposite
is the case for the value of a put option.

Project Cost
This describes the investment costs to undertake a project. It corresponds to the exercise price
of a financial call option and understandably stands in a negative relationship to the option
value. If a company or investor has to pay for example 10.000 US Dollar instead of originally
5.000 US Dollar for a piece of land, it affects the call option value leading to a decrease and
vice versa for a put option.

The risk free Interest Rate or Weighted Average Cost of Capital

The interest rate or the weighted average cost of capital stands for the opportunity costs a
company faces. It represents the money a company can earn when instead of undertaking the
project; it would invest the capital in financial markets earning the risk free interest. An
increase in the interest rate leads to an option becoming more valuable and therefore the
owner more likely to defer the investment decision. Again, put options behave reversely. In
terms of the case study, the US ten year treasury spot rates are applied [see Appendix 2].

Time to Expiration of an Option

The longer the company has the possibility to defer its decision, the more value lies in it as the
firm can gather more and possibly essential information about the investment opportunity. In
case of a real estate development, this can play a crucial rule as throughout the different,
sequential stages of the development, the owner might be better able to identify and estimate
 - 30 -

the underlying uncertainties of a project. Both, call and put options are positively related to
the length of time to expiration date of an option.

Dividends or Opportunity Costs

In financial terms a pay of dividends automatically leads to a decrease of the call option value.
It makes an earlier exercising of the call option more lucrative to allow the owner to capture
the dividend and therefore dividends can be identified as opportunity costs. In the topic of real
estate development, a competitor entering the market increasing the supply of houses and
therefore leading to a decrease of the market price for houses or rental prices can be seen as
such opportunity costs. Competition has a negative impact on the call option value and might
provoke an early exercising of the call option, while a put option value increases from the
investment facing additional competitors or other opportunity costs.

Volatility or Project Risks

Volatility represents the standard deviation and therefore directly mirrors the uncertainty
regarding the possible performance outcomes of the underlying asset. As only positive
[negative] outcomes are exercised in terms of call [put], a higher uncertainty automatically
leads to an increase in the option value.
The problem each real option valuation faces is that there are many different risk factors
affecting the volatility of a real estate development object making it hard to fully describe and
define all risks. Regarding the case study in Chapter four, a selection of risk factors are
described more in detail to give the reader an overview of possible influencing factors [see
Chapter 3.5.1.1]. In order to transform the selections of risk variables, which define the
volatility, usually data from comparable objects regarding settings and risks are taken or the
Monte Carlo simulation is applied. An overview of alternatives to estimate the volatility is
given in Chapter 3.5.1 together with a further explanation of two for the case study relevant
methods.

3.2.6. Differences Net Present Value vs. Real Options Analysis

Both methods have been presented and this section sums up the main differences between the
two valuations approaches [see Table 2]. The discounted cash flow method is set up as a
deterministic model and it neither accounts for uncertainty in a project nor is the method
capable of acknowledging and incorporating the possibility of managerial adjustments to
changing circumstances. The real options analysis recognizes the additional value under the
 - 31 -

assumption of proper and rational managerial decision making, which means that managers
undertake the value-maximizing decision at each decision node during the lifetime of the
project.
Discounted Cash Flow Real Options Analysis
All or nothing strategy. Does not capture the Recognizes the value in managerial flexibility to
value of managerial flexibility during the project alter the course of a project.
life cycle.
Uncertainties with future project outcomes are Uncertainty is a key factor that drives the
not considered. options value.
Undervalues the asset that currently (or in the The long-term strategic value of the project is
near term) produces little or no cash flow. considered because of the flexibility with
decision making.
Expected payoff is discounted at a rate adjusted Payoff itself is adjusted for risk and then
for risk. Risk is expressed as a discount premium. discounted at a risk-free rate. Risk is expressed in
the probability distribution of the payoff.
Investment cost is typically discounted at the Investment cost is discounted at the same rate as
same rate as the payoff, that is, at a risk-adjusted the payoff, that is, at a risk-free rate.
rate.
Table 2 - Com paring Discounted Cash Flow and Real Options Analysis [Adopted from Mun (2006)]

Having pointed out the differences between the discounted cash flow method and the real
options analysis, it is essential to determine under what circumstances the real options
analysis delivers the most potential and value. Figure 9 displays a briefly division into four
different categories, which depend on the level of uncertainty and managerial flexibility.
Additionally, the net present value of the project plays a role in how the additional value of
the real option affect the decision. A project with a very low [high] net present value might be
rejected [accepted] regardless of the impact of the real options, because the additional value is
negligible and the project still would be a no go. In case of the high basic net present value,
the project is already lucrative enough for the company to undertake the investment.

Figure 9 - Scenarios of Real Options Value Creation [Source: Kodukula and Papudesu (2006) ]
 - 32 -

3.3. Real Options Valuation Methods

Kodukula et al. (2006) state three dominant methods when valuing real options, which in the
following are presented and discussed.

3.3.1. Partial Differential Equations

Mun (2006) differentiates between closed form solutions, numerical methods and analytical
approximations. Generally spoken each of the partial differential equations is solved with the
help of boundary conditions, which often can complicate the solving of the models. Within
the partial differential equation methods, the most used version is the closed form solution,
which often applies the famous Black-Scholes model (1973) and is giving by the following
formula and represents the value of either European call or put options:

(3.6)
(3.7)

Where is the value of the underlying asset or stock price, X is the cost to exercise the
option or the strike price, rf is the risk free rate, T is the expiration time or the duration of the
strategic option, is the annualized volatility of the underlying asset or stock and N stands for
the cumulative probability of a normal distribution and d is given by:

(3.8)

(3.9)

One big advantage of applying the closed form solutions is that all of the input parameters are
known or easily calculated based on made assumptions. While delivering exact results, the
models are often hard to explain due to high level of technical stochastic calculus
mathematics applied. Additionally, models like the Black-Scholes Model are only exact for
European options. When it comes to American options and more advanced versions of
options like for example a compound option, they often deliver only an approximation.
Regarding the case study, the closed form solution is not applied.
 - 33 -

In order to understand the model and how it is applied, specific assumptions have to be
satisfied. The main assumption states that the returns of the underlying asset follow a
stochastic process, typically a geometric Brownian motion [GBM] with static drift and
constant volatility parameters, which follow a Markov-Wiener stochastic process [Mun
(2006)]:

(3.10)

Where is the growth variable that increases with the time steps , defines the volatility
and represents the stochastic part, which grows at the multiplier rate of the square root of the
time steps and the simulated error term variable ( ). This part often is called Wiener
process. Additionally, the error term follows a normal distribution with the mean of zero and a
variance of one [N (0,1)].
Further required assumptions are that there are no transactions costs, no taxes or dividends, no
riskless possibility of arbitrage, a known and constant exercise price, which can only be
exercised at expiration [European Option] and therefore the existence of an efficient market.

3.3.2. Simulation

Monte Carlo simulation is an extension of but not a substitute for the Discounted Cash Flow
method. Whereas the Discounted Cash Flow method takes one set of input parameters and
calculates the deterministic net present value of one project, the Monte Carlo simulation
makes the exact same calculation thousands of times by just changing the input parameters
each time. The simulation results show a distribution of the project payoff, with the "average"
case representing the net present value based on the Discounted Cash Flow method. Whereas
the simple Discounted Cash Flow method is seen to be deterministic, the Monte Carlo
simulation results in a probability distribution of the possible project net present values.
Simulation in general has the same drawbacks as the Discounted Cash Flow method. It does
not take into account the contingent decisions and their impact on the project valuation. The
model beneath has been proposed by Boyle (1977) and defines the connection between
present values and future predictions.

(3.11)
 - 34 -

Equation 3.11 estimates the value of the underlying asset on the basis of the value from the
previous period , which represents the deterministic part and the multiplication of the
value of the previous period with the stochastic part of the constant drift and the
volatility , multiplied with the simulated error term drawn from a standard normal
distribution with mean zero and variance of one.

3.3.3. Binomial Lattice

The third method to be presented is the binomial option pricing and was originally developed
by Cox, Ross and Rubinstein (1979). Similar to the before presented simulation and Black-
Scholes rule, it assumes the existence of the no arbitrage rule. With the help of the binomial
tree, the different possible developments of the underlying asset are displayed. The tree
structure is reoccurring and creates the basic foundation for any real options model is of
interest [see Figure 10]. One essential advantage of this approach is that it enables the investor
to calculate exact numbers for both, the American and the European version of options.
Mun (2006) describes the necessity of minimum two lattices required to mirror the option.
First, there is a lattice, which replicates the value of the underlying asset and second, a lattice,
which represents the intrinsic value of the option. The intrinsic value is the difference of the
value of the underlying asset S and the exercise or strike price X.

Figure 10 - Option Value of a One-step Binom ial Lattice [Source: Adopted from Mun (2006)]

Up [u] and down [d] movement of the underlying asset can be displayed as the following:

(3.12)
 - 35 -

(3.13)

Where stands for the volatility of the movement of the underlying asset and t represents the
predetermined time steps. Based on the calculated up and down movements, it is possible to
estimate the risk neutral probabilities with the following formula:

(3.14)

The variable b hereby only comes into play in case dividends are paid or exist. The present
value of the option is then calculated by discounting the individual intrinsic values of the
different paths with the risk free rate rf [see equation 3.15].

(3.15)

Usually an option in the field of real estate has a maturity of more than one step. Equation
3.16 is an example for calculating the value of a two-step binomial tree of a recombining
lattice.

(3.16)

It is then possible to expand the binomial tree from a one-step to a multi-step valuation tool.
The following two formulas display the value of multi-step European call and put options:

(3.17)

(3.18)

Where

(3.19)
 - 36 -

This formula consists of the variable n for total number of steps, k for the number of up
movements, (n-k) for the number of down movements and t for the time steps.
The above stated formulas represent solely the European version of options, which can only
be exercised at the maturity or expiry date of the option. American options enable the owner
to exercise an option early when market conditions are favorable. One important variable that
makes an early exercise of the option profitable is the existence of dividends. While in the
case of non-dividend paying American call options not exercising the option early protects the
holder against the volatility of the value of the underlying asset and against the value to fall
beneath the strike price, the holder misses out on income in the case of dividends when he
does not exercise the option early.
For the case study at hand two variations are important. First, the formula for maximizing the
option value comparing immediate exercise with the value to abandon, which equals:

(3.20)

Where T stands for the point in time, d for the down movements within the time period, X
represents the amount of costs to exercise the option at point T.
The second important equation for the case study is the comparison of exercising the option
immediately and the value generated through deferring the investment. Again, the following
formula is maximized:

(3.21)

In order to determine the present value of the option, the comparison step of equation 3.21 is
applied for every step throughout the binomial tree.

3.4. Approaches to Real Options

Real options are based on assets that are not like financial assets widely traded, which leads to
an increased importance of management assumptions in order to apply real options.
Borison (2005) defines five different approaches of how to approach real options, which in
the following are differentiated and discussed briefly.
 - 37 -

3.4.1. The Classic Approach

Based on the assumption of no arbitrage from the classic option pricing theory, the classic
approach states that with the help of a portfolio of traded investments a replicate of the returns
of the real option can be created. The underlying important assumption is that the price
movements follow the geometric Brownian motion [GBM]. If fulfilled, the Black-Scholes
model can be used to calculate the option value. Concerning real options, this assumption
often is violated. Additionally, it is difficult to identify replicating portfolios for illiquid traded
real assets. On top of that, the approach does not account for market uncorrelated risk.

3.4.2. The Subjective Approach

While based on the same assumptions as the classic approach, the subjective approach uses
subjective rather than objective gathered data, which leads to the approach being exposed to
stating the right and accurate assumptions. Furthermore, generated data based on subjective
made assumptions is hard to examine and therefore hard to verify. Ignoring potential
differences between private project-related and market risk can lead to false estimation
results.

3.4.3. The Marketed Asset Disclaimer Approach

In their book, Copeland and Antikarov (2003) bring up the Marketed Asset Disclaimer as
approach to value real options. They reason that the best unbiased estimator of a project
should be the project itself and address the market value of the underlying object as if it is
traded in the market. The problem that occurs is that the approach uses subjective data and is
based solely on the project itself. Possible correlations to traded similar assets are ignored,
which can lead to inaccurate estimations. More importantly, the MAD approach is not
guaranteed to follow the geometric Brownian motion because it uses subjective data.
Schneider et al. (2008) address this problem and have develop an extended MAD approach,
which with increasing complexity are capable of dealing with market and private risk.
Borison (2005) argues that the three above stated methods should be applied with care
because of the above mentioned pitfalls.
 - 38 -

3.4.4. The Revised Classic Approach

The Revised Classic Approach is an answer to the problem of how to deal with market and
private risk and induces that depending on the major type of risk exposure, the approach
should be selected. The Black-Scholes model can be applied when the major risk type is in
market form regarding the project and in contrast to that the subjective MAD approach is
applied. One major disadvantage of this procedure is that by trying to handle both risk
segments, it is hard to find a combined and accurate discount rate.

3.4.5. The Integrated Approach

The Integrated Approach points in the same direction as the Revised Classic Approach, trying
to incorporate both risk types. This makes this approach complex to apply and suffer from
similar problems, which the Revised Classic approach also faces.

3.5. Real Options in Real Estate

As shown and stated in the introduction and background section, real options perfectly meet
the necessary criteria to deliver accurate and appropriate valuation results in the field of real
estate development. This section deals with the empirical evidence of real options in real
estate as well as it supplies and explains the external risk factors real estate development
faces. Defining external risk factors helps setting up the model in preparation for the case
study, where the different risk factors are taken into account for the analysis.
Various theoretical papers like Capozza and Li (1994), Titman (1985) or Lucius (2001) have
dealt with the occurrence of real options in real estate. The effect on the development process
is caused by the flexibility the option to defer or expand an investment, the switching or
abandonment option or the time to build option can offer [Trigeorgis (1996)].
Titman (1985) identifies a relationship between the uncertainty of vacant land values and the
building activity. Increased volatility leads to a decrease in building activities in order to keep
the option alive. Cunningham (2006) confirms these hypotheses. He finds evidence that
greater price uncertainty not only delays the decision of development, but also raises the land
prices as partly the option value are implied in the rising prices.
Williams (1991) adds to this work by also taking the cost of development variable into
consideration and has examined the optimal density and timing for development or
abandonment of an object when the value of the object is influenced by volatile outcomes.
 - 39 -

Quigg (1993) has been among the first to test the empirical evidence of the value to wait to
develop land using a sample of market prices. She confirms a mean premium of six percent as
well as 18 to 28 percent implied volatility for the prices. Geltner et al. (2007) endorse the
volatility findings and set the typical volatility of individual properties in a range from 10 to
25 percent. Additionally, Geltner et al. (2007) see the real option theory as a central element
of investment decision regarding land development due to their ability to capture the value
and flexibility of sequential development. This stands in contrast to the paper of Lucius
(2001), which sees the still rare practical applications of real options theory in the real estate
development process being a result of mathematical complexity.
Though, a number of papers have applied and tested the real options analysis using market
data from real estate. Sing and Patel (2001) investigate transactions of properties in the United
Kingdom estimating a premium for the option to delay investment and development in the
sectors of office, retail and industry. Bulan et al. (2002) find an empirical connection between
uncertainty and investment in development of objects. Their results based on evidence in
Vancouver confirm the hypothesis that an increase in return uncertainty drives down the
amount of investment.
Furthermore, a direct comparison of the two at valuation methods, the net present value and
the real options analysis, and their performance in the field of real estate has been examined
by Rocha et al. (2007). Their findings point out that the real options methodology is superior
compared to the net present value. The applied methodology follows a sequential decision
making process, which enables the investor to identify the right strategy along the path.
Because of this strategy, the applied real options model not only increases the value of the
project by ten percent, but also reduces risk the project is confronted with by more than 50
percent in comparison to the static and traditional discounted cash flow analysis.
Baldi (2013) applies the real option theory to a real estate development project and compares
the inherent flexibility of that process with the static net present value. His results support the
findings of Rocha et al. (2007) that applying the real option valuations allow the investor to
capitalize on the volatility in either directions because of the strategic nature of call and put
options. Because the discounted cash flow method misses out on the managerial flexibility,
following this approach would lead to a constantly underestimation of the assets in real estate.
In the following, the above mentioned term volatility is presented and determined more in
detail.
 - 40 -

3.5.1. Volatility

Pomykacz (2013) defines volatility as the amplitude of how a future price or value of a stock
can vary. Transformed to the field of real estate, volatility represents the standard deviation
and therefore directly mirrors the risk regarding the possible performance outcomes of the
underlying asset. Because it has a relevant impact on the value of the option, it is an important
variable for the real options analysis process.
Volatility in the field of real estate is difficult to calculate or estimate, which often leads to the
usage of historical volatility indices. The problem that arises out of this method is that making
predictions about future development of the volatility based on historical data can be
inaccurate or flawed, because historical developments cannot guarantee a prediction for future
development. Part of this sections supplies tools that offer a way on how to deal with data in
order to estimate volatility.
Figure 11 shows two examples for normal distributed curves of expected returns r and their
distribution for the underlying asset and explain in a simple way how different levels of
volatility can create value. The dashed line hereby contains a higher standard variation in
comparison to the solid line illustrated through the wider range of returns. This is of interest
regarding the case study as the two valuation approaches treat risk and therefore the standard
deviation, which impacts the object, differently. The static approach of the net present value
reacts to the increase of volatility by adjusting the discount rate. This is a result of perceiving
the higher volatility purely as higher risk affecting the project, which leads to a lower
estimated outcome. In contrast to that, the real options analysis incorporates the flexibility of
managerial interactions and therefore enables the investor to adjust to both possible directions
movement of the volatility.

Figure 11 - Allocation of Expected Retu rn [Source: Own Creation]

 - 41 -

The problem that arises when the volatility is calculated is that even though the factor in the
options models is represented by one combined variable [Kodukula and Papudesu (2006)],
multiple risk factors exist and influence the uncertainty of the cash flows of the underlying
asset. Examples can be found in directly attributable factors like the sale price or the building
costs or indirectly through external risk factors emerging from social, political or economical
nature. In order to deal with the different sources of uncertainty and to make them applicable,
Kodukula and Papudesu (2006) see two different possibilities of dealing with the volatility.
For one, it is possible to retain all the variance separately when it is assumed that the variables
are uncorrelated, develop differently in the viewed timeframe and influence the value of the
object in opposite directions. The second method suggests combining all individual risk
factors into a merged and representative variable. The transformation process irrelevant of the
chosen approach can be conducted using five different methods, which in the following are
presented and described briefly.
Based on Kodukula et al. [2006] and Mun [2006] a short overview of different methods to
estimate volatility is given.
Logarithmic Cash Flow Returns or Logarithmic Stock Price Returns Method is
mainly applied when the volatility is calculated on the basis of liquid and tradable
assets, for example the price of oil or electricity. It benefits from its easy
implementation, high transparency and that it uses the same cash flow estimates as in
the calculation of the underlying asset value. Main disadvantages of this approach are
that it cannot be used for negative cash flows and in the case of only a few quantities
of cash flows, the volatility generally is overstated.
Logarithmic Present Value Returns Approach is applied when the volatility of assets
with cash flows are calculated. While it does account for negative cash flows and
through more rigorous analysis delivers more accurate estimation of the volatility, it
requires simulation to obtain a single volatility.
Generalized Autoregressive Conditional Heteroskedasticity [GARCH] similar to the
first method is used for liquid assets and is capable of delivering different estimates
over time, but its econometric complexity and high data demand require advanced
expertise.
Management Assumptions or Guesses can be used for both financial and real options
and is easy applicable. Subjective guesses though do not deliver very reliable
estimates.
 - 42 -

Market Proxy Using Comparables or Indices is mainly used in order to compare

liquid and non-liquid assets. The need for comparable market-, sector-, or industry-
specific data can be the downside of the method, as it can be hard to identify a public
traded company or project with a similar risk profile.

3.5.1.1. Risk versus Uncertainty

Mun (2006) states an important differentiation between risk and uncertainty as they are often
treated and defined to be the same. The uncertainty that a project has can throughout the
duration of the option, interactions or events and the lifecycle of the project be resolved while
the risk of a project is carried along the project. Risk is an outcome of uncertainty and while it
stays constant, the uncertainty increases over the project time duration.

3.5.1.2. External Risk Factors

This section deals with the factors of risk and uncertainty influencing the process of real estate
development. Sun et al. (2008) identify four main groups of risks affecting the industry of real
estate of which three (Political, Social and Economical) hereafter are presented more in detail.
They are found to be the most significant for the case study. The goal of this section is to give
an overview of what each category includes and stands for as well as give a preview of how
the risk factors are applied to case study.

Political Risk
Real Estate development underlies regulation which can include industrial policy in terms of
commercial real estate development as well as development of factories or producing real
estate. In addition to that, Sun et al (2008) name housing regulation and land regulation
reforms as possible influencing factors. This can appear in regulations regarding on directly
housing attributes such as how high or densely an object can be built as well as land
regulations, whether or not the owner is allowed to build the desirable type of real estate.

Social Risk
Social risk can include very external and broad aspects like the changing city planning, which
can have a direct influence on the development of the housing prices. Imagine for example the
city decides to construct a new city highway which passes directly the real estate object of the
investor. Resulting noise and smug might directly lead to decrease in value. A further risk
might be seen in zone development, which can have both a positive and negative effect on the
investment opportunity. Shopping centers, bars, restaurants, cultural objects or parks can
upgrade the investors land value while for example the developing of an industrial area
 - 43 -

would see the prices directly decrease. In addition to that, the process of gentrification can
influence the value of the real estate positively as well as the building of ghettos, including
increased crime rates or unemployment rate, can have a negative impact on the firms
investment.

Economical Risk
Not since the real estate bubble in 2008 and 2009, the financing is a topic in the real estate
industry. While through credit financing and hypothecs, the demand for housing and therefore
the value and sale prices of objects can be increased, it has its limits. The financial situation of
the city or the population of the city therefore always has a direct influence on the price and
represents a risk factor. Breaking away of big industrial companies can be essential for the
going-concern of a city and its financial situation as it is directly mirrored in terms of
employment, purchasing power and paid taxes. The example of Detroit illustrates perfectly
this potential devil circle.
 - 44 -

4. Case Study Reviving Downtown Detroit

Using the real options approach to value real estate development projects is crucial to capture
the flexibility value. Recalling the earlier mentioned equations describing the difference
between the static net present value and the expanded version that incorporates the intrinsic
option value [Trigeorgis (2005)]:

(4.1)
(4.2)

This chapter aims to apply the delivered theoretical framework of real options analysis to a
real estate development project in Downtown Detroit. Running the numbers, this section
additionally aims to answer the posted theoretical hypotheses.
An interesting area with two suitable investment projects has been identified and chosen for
this case study. Where exact specifics and characteristics of the objects have been hard to
obtain, assumptions are made in order to comply with the requirements.
The two chosen buildings [The Broderick Tower and The David Whitney Building]4 are
located side by side in Central Downtown Detroit, USA. Both are separately financed through
Detroit investment funds and belong to different clients.

4.1. Project Description

In the case study at hand, several important adjustments are made in order apply the real
options analysis to the development objects.
First, the investment case puts the decision maker back into the beginning of the year 2010.
The decisions whether to renovate the investment objects have not been made.
Furthermore, the objects are seen as one combined project, divided into different sequential
stages that can be developed by the option holder [investor]. The different stages underlie a
specific order of construction. In reality, both real estate objects possess a share of retail,
which in the case study is combined to one. The third stage can only be developed if option
one and two are exercised and constructed.

4
investdetroit.com/representative-projects/
 - 45 -

Additionally, it is assumed that in the base case scenario only one phase can be constructed at
the same time, which means that the earliest construction of phase two is year three of the
option, even if an earlier exercise of the option would be profitable because of favorable
market developments. In the real options analysis, the construction of the up following phase
can start as soon as the option of the prior option has been exercised. The construction or
renovation time for the options one and two are two years and one year for option three.
The project is assumed to be completely equity financed. Therefore the Capital Asset Price
Model is applied in order to calculate the essential inputs for the cost of capital rates.
Figure 12 shows a summary of the basic facts regarding the different stages. The numbers are
based on real figures, retrievable on the website investdetroit.com, but edited in order to make
each option valuable and dividable.
The total building area is the result of numbers of apartments multiplied with the average
square foot per apartment. For simplifying reasons, the two apartments possess the same size.
One major assumption has been made in order of efficiency, which describes the percental
share of the total building area that is available for leasing. The maturity of the options has
been set to two and five years for option one and two and ten years for option three. The
longer maturity of option three realistically reflects the adaption time of the multihousting
apartments. The option therefore should enable the owner throughout the lifecycle to identify
whether a retail investment expansion is profitable.

Figure 12 - Project Description of the Individual Stages

 - 46 -

In contrast to the staging of the different phases in the used real option approach, the static
valuation applies an inflexible development, which means that the up following phase is
constructed immediately after the previous one is finished.
In order to be able to successfully estimate the underlying drivers of the assets it is important
to select a suitable approach, which is applied to the case study. It sets out the direction of
how the data of the case study is treated and which assumptions are necessary to be made and
followed. Recalling the different approaches to apply real options, presented in Chapter 3.4, it
is hard to select one specific approach. The case study at hand utilizes a mixture of different
approaches, because it is for one hard to believe that the assumption of an efficient market is
satisfied, but on the other hand essential to rely on market comparable data in order to be able
to calculate the underlying drivers. The consequence of a possible violation of assumptions is
therefore critically questioned in the results.

4.2. Underlying Drivers

Different variables that impact the value of the project have to be estimated before the
valuation can be applied. This is done on the foundation of assumptions and historical data.

4.2.1. Income

The potential income from the different phases of the project is divided into the income
generated from rent [multi-housing and commercial] and the terminal capitalization, which in
the following are described and estimated.

4.2.1.1. Rent
Historical data of the rent index in Detroit is used in order to estimate the average percental
changes throughout the years from 1982 to 2010 [See Appendix 3]. The mean growth rate of
the rent for the mentioned period has been estimated to 4.10 percent. The growth rate is
hereafter assumed to be constant throughout the time of the project. Therefore, rents in the
static discounted cash flow valuation therefore are set to grow constantly with 4.10 percent
per year.
The detroitsevenpointtwo5 report delivers an exact figure in terms of the rent per square foot
for the Broderick Tower in the year 2014. The 1.88 US Dollar per square foot rent, which
represent the monthly per square foot figure, is discounted back and forward with the

5
7.2SQ Final report detroitsevenpointtwo.com
 - 47 -

calculated average rent growth rate [4.10 percent] for the years of the project. For the year
2010, this means a rent of estimated 1.60 US Dollar per square foot.
Additionally, the rent is an essential variable of the income parameters and underlies
fluctuation. The volatility of the rent income is assumed to follow the geometric Brownian
motion stochastic process. A simulation with 50.000 iterations has been run in order to
confirm the average fluctuation of the rent growth [see Appendix 4 and Excel sheet GBM
Simulation].

4.2.1.2. Net Operating Income

The net operating income is crucial in the valuation process because it impacts all income
variables resulting from the received rent and it defines the terminal value the object generates
for the owner. The net operating income results from subtracting the vacancy costs and the
operating expenses from the potential gross income. The terminal capitalization is hereafter
defined.

4.2.1.3. Terminal Capitalization Rate

The rate determines the resale value of the real estate object at the end of the leasing lifecycle.
It is estimated by dividing the anticipated expected net operating income of the following year
by the exit cap rate. The cap rate survey estimates the exit cap rate within a range from 7.5
8.5 percent for the area of Detroit and to stay constant in the forecast [see Appendix 8]. The
rate for the case study has been fixed to 7.8 percent, which lies within the normal estimated
range.

4.2.2. Costs

The outcome is reduced to two variables. First, the construction costs of the different phases
when the option is exercised and second, the operating expenses, which arise when the
apartments or the commercial area is leased out.

4.2.2.1. Construction Costs

The development of the construction costs has an essential impact on the timing of the
development, because over proportional increasing costs for construction raise the opportunity
costs a firm faces and might lead to an early exercise of the option. Data from the years 1992-
2010 have been collected and the average increase during this time has been estimated. The
result accounts for a mean increase of 3.406 percent per year, which is considered to be
constant for the lifetime of the valuation.
 - 48 -

Appendix 1 additionally shows the development of the American Consumer Price Index as a
benchmark putting the development of the construction costs into perspective. It is assumed
that the growth rate of the construction costs is independent and outweighing the discounting
risk free rate and therefore displays an additional opportunity cost in order to cause a possible
early exercising of the option.

4.2.2.2. Operating Expenses

Operating expenses are all costs, arising from running the object. This includes costs for
property management, wages for stuff and employees, costs of vacancies or maintaining costs.
Usually, the operating expenses ratio varies depending on the type of building and range
between 40 and 50 percent of the rent per square foot.6
To simplify the application of the case study, one constant operating expense ratio is
predetermined, which is then directly related and connected to the rent income. For both types
of buildings [multi-housing and commercial retail], the ratio is fixed to 35 percent of the
effective gross income. The lower than average ratio rate results from the fact that the costs of
vacancies already have been accounted for.

4.2.3. Cost of Capital

In order to simplify the application of the case study, it is assumed that the investment is
purely equity financed. The case at hand is based on adjustments and assumptions made by
the author, which differ from the reality, because no direct data regarding the investment
company and its cost of capital or beta exists. Instead, it is assumed that the financial
estimates of the investing firm are conform to the figures of the S&P Case-Shiller Detroit
Home Price Index on which basis the beta is calculated [see Appendix 2 and Excel sheet
S&P Beta Calculation].

4.2.3.1. Risk free rate

The risk free rate is estimated based on the average interest rate of US 10-Treasury bonds.
The average of the years 2001-2009 accounts to 4.28 percent [see Appendix 2]. 100 bps are
deducted from the computed average risk free rate in order to account for an inflation
premium [Geltner et al. (2007)]. This results in a final risk free rate of 3.28 percent, which
displays a realistic figure for the estimated period. The ten years of the treasury bonds reflect
the maturity time of the longest option regarding the project and therefore are a realistic

6
Income and Expenses Survey 2014 naahq.org
 - 49 -

estimate. The calculated risk free rate is assumed to stay the same throughout the life cycle of
the project.

4.2.3.2. Beta
The beta represents the sensitivity of an underlying asset to the volatility of the market. Mun
(2006) defines it as a measurement of risk, which is not hedgeable and systematic relatively
seen to the market. The calculation of the beta supports the investor to find the appropriate
discount rate in order to compensate for the undiversifiable and systematic risk. It is
calculated as the covariance cov of the returns from the underlying asset and the market
and then divided by the variance var of the market returns [see Equation 4.3.].

(4.3)

To compute the beta for the case study, it is assumed that the imaginary investing company
possesses a return structure identical to the S&P / Case Shiller Michigan Detroit Home Price
Index [see Excel sheet S&P Beta Calculation]. Then, the index is compared to the S&P /
Case-Shiller 20-City Composite Home Price Index in order to calculate the beta based on
formula 4.3.
The average beta for the years 2002 to 2010 amounts to 0.813. Although this figure lies
within the region of the industry comparable ratios [see Chapter 4.2.3.5.], the estimate seems
smaller than expected, especially if a closer look is paid to the previous and more essential
[crisis] years regarding the future development. To calculate a comparable figure, the whole
range of years is taken into account and delivers a beta of 1.083. This is found to be more
appropriate and is selected to be the beta for the case study. The beta is assumed to be
constant throughout the project valuation time.

4.2.3.3. Market Risk premium

To calculate the risk premium, the Capital Asset Pricing Model is applied:

(4.4)
(4.5)
 - 50 -

The average expected return of the market is estimated on the basis of the Morgan Stanley
Capital Index for the whole world7, which amounts to an average of 7.28 percent annual
return in the time range from 1970 to 2010. The risk premium is calculated by deducting the
computed risk free rate from the market return rate.
The result is 7.28 percent 3.28 percent = 4.00 percent.

4.2.3.4. Cost of Equity

The Capital Asset Pricing Model is applied in order to estimate the cost of equity. The chosen
method is suitable regarding the integrated approach and the underlying assumption of an
efficient market with no arbitrage opportunities.
The CAPM is a risk-adjusted discount rate model [Trigeorgis (2000)].
It captures two types of risk, diversifiable and non-diversifiable risk. The first type results
from industry specific factors and therefore can easily be hedged as they are not related to
potential changes of market conditions. The second risk results from economic conditions that
affect the price but cannot be diversified nor influenced. Because of that, it is often called
systematic risk.
As the CAPM compensates for the risk of the project, it is important to find a security that
correlates perfectly with the investment. In the field of real estate development, this is rather
difficult. Potential proxies mirror the best possible approximation.
Additionally, the CAPM assumes interest rates to be held constant over the duration of the
project, which is not very realistic. To simplify the case study, the interest rates are assumed
to be constant though.
This leads to required return on equity, derived from the CAPM and stated as the following:

(4.6)

In the case at hand, the required return on equity equals = 3.28 percent + 1.083 x (7.28
percent 3.28 percent) = 7.612 percent.

7
www.msci.com/end-of-day-data-search [see Excel sheet MSCI World 70 10]
 - 51 -

4.2.3.5. Comparable industry ratios

Figure 13 confirms the previous calculations. The estimated beta and the cost of equity lay
within the range of comparable ratios of similar industries and therefore display realistic
figures for the valuation process.

Name of Industry Number of firms Beta Return on Equity

R.E.I.T. 213 0.79 6.69%
Real Estate Development 18 1.02 8.04%
Real Estate Operation & Services 52 1.30 9.66%
Average - 1.037 8.13%

Figure 13 - Com parable industry ratios [S ource: Adopted from

http://pages.stern.nyu.edu/~adam odar/New_Hom e_Page/datafile/Betas.htm l ]

4.2.3.6. Discount Rate Development Time

In order to account for the higher risk an investment company faces during the development
[here: renovation] of the object, a higher discount rate has been set to ten percent and is kept
till the individual phase reaches an absorption level of 90 percent. After that, the normal cost
of equity rate of 7.612 percent per year is applied.

4.3. Base Case Valuation

In order to commence with the calculation of the net present value, it is important to recall
some of the mentioned assumptions the approach underlies. The approach assumes no
flexibility in the decision making together with deciding at t = 0, whether or not to undertake
the whole project. It is assumed that each stage is then constructed immediately after the
previous phase has been completed in order to avoid an unnecessary increase of the
construction costs. In the model at hand, three discount rates are applied. The first one is the
risk free rate, which is used to discount the construction costs to the present value. In contrast
to that, the cost of capital [hereby the cost of equity due to purely equity financed firm] is
applied to all income in order to meet the different and higher systematic risk after the object
reaches a 90 percent absorption level. Before that, the higher perceived risk level is accounted
for in the higher so called development discount rate. Achieved rent and the exit cap rate
payment at the end of the projects lifetime are therefore discounted depending on the
absorption level of each individual option.
 - 52 -

To compute the projects total net present value all three projects are added up after their
individual net present value has been calculated.

(4.7)

Summary Input Variables

Exit Cap Rate Detroit 2010 0.0780

Long-Term Building Vacancy 0.1011
Inflation - Average CPI 0.0243

10 Year US Treasury 0.0428

Risk Free Rate 0.0328
MSCI Average Return 0.0728
Risk Premium (rm-rf) 0.0400

Construction Cost Growth 0,0341

Operating Expenses 0.035*E(Rent)

Attached to Rent
Operating Expenses Growth Growth

Rent Growth 0.0410

Beta 1.0828
Return on Equity (Stab. Discount Rate) 0.0762

Figure 14- Input Variables [Source: O wn Construction ]

Figure 14 sums up the main input variables, which previously have been calculated [see
Chapter 4.2. and ExcelSheet Masterthesis Calculations]. The project is assumed to have a
total lifecycle of 18 years, in which income is generated before the owner alienates the
property. The time interval between decision nodes has been set to one year.

4.3.1. Expected Static Net Present Value

The net present value of the whole project is estimated by adding up the individual, expected
net present values of the different phases [see Equation 4.7.].
The calculation of the figures in detail can be viewed in Appendix 5 or in the Excel sheet
Static NPV Chart.
 - 53 -

While phase one has a positive net present value, the stages two and three are expected to
result in a negative outcome with a total return of -10.109 mio US Dollar. The static valuation
approaches assumes the project to be seen as one whole combined investment and not in
sequential stages. A decision has to be made whether to undertake the whole investment or
not at the beginning of the project. Under these circumstances, the recommendation would be
to decline the project, because of the negative payoff. This view on the valuation can be seen
as deterministic and not stochastic, because the expected payoffs and net present value does
not incorporate the uncertainty of the development of the rent. Instead, it is assumed that the
rent growths with a constant and in advance known rate.

4.4. Real Options Analysis

In order to be able to start valuing the strategic value of the options regarding the project and
its different phases, the existing real options have to be stated and identified.
In the literature review, the main types of options are determined and are applied also within
the project. In the case at hand, the option to defer and abandon the investment is present. On
top of that, the three options themselves appear as a sequential compound option. This is the
case, because exercising option two and after that on option three only is possible when
option one has been exercised. Also, option two and three can be seen as the option to expand
the investment, because phase one can be completed without the necessity to further invest
and develop stage two and three. The option to defer is existent in any of the three options due
to the fact that the option is assumed to give the holder a building or in this case the
renovation permit for the maturity of the option.
Option one hereby has a maturity of two years, option two and three possess a maturity of five
and ten years. At the end of the lifecycle of each option, the owner has the right to not
exercise the option, but instead to abandon the investment if the development of the market
conditions is unfavorable for the owner. Furthermore, it is assumed that the cost of not
undertaking the renovation is negligible.
The flexibility of the applied sequential strategy for the three options at hand is illustrated and
further explained in Appendix 7. The exercise of option one hereby depends on the
development of the market. This is similar for the option two and three, but additionally the
 - 54 -

second and third phases require an exercise of the previous option. The in Appendix 7 shown
structure of the compound option has to be taken into consideration regarding the valuation
model in order to test the stated hypotheses of additional flexibility value offered by real
options.

4.4.1. Volatility

To calculate the volatility of the underlying asset [here: the uncertainty regarding the
development of the rent price], the development of the Detroit Rent Index has been chosen as
a comparable and suitable proxy. The result sees an average annual volatility of 5.43 percent.
This is lower than expected and relatively far away of what other studies and textbooks have
found out. Geltner et al. (2007) determines the volatility of individual built properties
typically within the range of 10 to 25 percent. Mun (2006) argues that a mean volatility rate of
20 percent is adequate.
One reason for the underestimation of the volatility can be found in the way the index handles
the changes within the time period until the next number is published. It takes the average
figure for the time period [here: quarter of a year] and therefore evens out potential up and
down movements. Because of the above mentioned studies, this thesis assumes an annually
volatility of 15 percent, which is held constant over the estimation period. This is found to be
a reasonable estimate for Detroit, because the real estate market in Detroit is assumed to have
more volatile outcomes than the market averages, especially in the observed time frame and in
relation to the applied indices.
Additionally, the result of the performed Monte Carlo Simulation using the rent as input
variable points in the same direction resulting in an averaged annually standard deviation of
16.02 percent for the years of the project [see Excel sheet GBM Simulation].

4.4.2. Binomial Lattice

Figure 15 sums up the main input variables needed for the binomial lattice that in the
following is valued. The annual risk free rate has been determined in the previous section and
the time steps per year have been set to one for simplifying reasons.
The up and down movements have been calculated for the lattice for both, with and without
dividends, using the following equations:

(3.12)
 - 55 -

(3.13)

With the time steps =1 and = 0.15 the up movement results in 1.1618 and the down
movement in 0.8607. This is identical in the case of including dividends.
Regarding the risk neutral probabilities, the result differs when applying the following
formula:

(3.14)

The input variable b hereby represents the dividend yield. The dividend yield is held constant
for the valuation time frame as discussed in Chapter 3.2.5. For the case without dividends, the
formula leads to risk neutral probabilities of 0.5735 for the up and 0.4265 for the down
movement. The probabilities for up and down including dividends amount to 0.5224 and
0.4776.

Input Parameters
Annual Risk free Rate 0.0328
Annual Standard Deviation of PV 0.1500
Periods per Year 1.0000

Calculated Parameters
Up Movement per Step 1.1618
Down Movement per Step 0.8607
Annual Risk free Rate + 1 1.0328
Risk neutral probability (up) 0.5735
Risk neutral probability (down) 0.4265

Calculated Parameters with Dividend

Up Movement 1.1618
Down Movement 0.8607
Annual Risk free Rate 1.0328
Dividend 0.0150
Risk neutral probability up 0.5224
Risk neutral probability down 0.4776

Figure 15 Summary Input Variables f or Binom ial Lattice [Source: Excel Sheet Binom ial Lattice]
 - 56 -

Figure 16 displays the development of the whole project for the upcoming ten years, which
equals the length of the longest maturity, the maturity time of option three. The starting point
for the binomial lattice is formed by the present value of the project as if it has been
constructed. The result of 129.89 mio US Dollar is therefore the result of the cash inflows and
the terminalization value of the constructed property. In order to give an example of how each
of the individual figures is calculated, the value of year 0,6 is selected.
The calculation results in:

Figure 16 Present Value Binom ial T ree and Developm ent of Construction Costs [Source: Excel
Sheet Binom ial Lattice]

The second part of Figure 16 sums up the development of the construction costs during the
life period of the options. The annual growth is assumed to be constant and has been
implemented in order to trigger a possible early exercise of the individual underlying
 - 57 -

American options. Without facing opportunity costs, the investor would always postpone the
decision to the latest point in time in order to gather more information about the uncertainties.
Year zero hereby represents the year 2010 for all three options.
The application of the binomial lattice model is pretty straightforward. The in theory provided
steps to estimate the value of simple single options is similar to valuing compound options in
the case at hand. It is important though to solve the options backwards meaning to start with
the option three. The valuation process follows the principles of the theory in Chapter 3.3.3
and applies the calculated risk neutral probabilities and the up and down factors from section
4.4.2.
Figure 17 displays the already combined Equity Lattice including the dividends as
opportunity costs of option three. The different colors regarding the numbers set out the
instruction whether to construct [green], defer [yellow] or abandon [red] the option. The full
valuation process of all three options can be viewed in Appendix 6 and in the Excel sheet
Binomial Lattice.
Starting with the option three, the terminal nodes are calculated by applying equation 3.20
resulting in the following:

This then is repeated for the rest of the row of option three. The intermediate nodes are
determined using the equation 3.20 with the following result as an example:

The procedure is then repeated for the whole lattice of option three and also for option two,
where the combined equity lattice with dividends [see Figure 17] is the underlying foundation
for calculating the values of option two. The final option lattice one uses the lattice of option
two as the underlying asset. Option one not only represents the final lattice, but also contains
the expanded net present value at point 0,0 regarding the project.
 - 58 -

Figure 17 Individual Combined Equity Lattice for Phase 1, 2 and 3 [Source: Excel Sheet Binom ial
Lattice]
 - 59 -

5. Discussion

5.1. Results
Comparing both results, the difference is evident. The lattice includes the optimal decision
making throughout the path considering the possibility of deferring or abandoning the project
together with the opportunity of the right timing for the construction of each phase. In the case
study at hand, the optimal decision sees a delay of option one at time = 0 rather than an
immediate exercise of the option. At time t = 1, the decision to further defer or instead
abandon the project depends on whether the value of the project develops positively [up] or
negatively [down]. In year two, the decision then has to be made between exercising and
abandoning the option, because the option runs out. Figure 17 shows that only in the case of a
subsequent positive development of the value of the project in the first two years, option one
is exercised and the project is undertaken.
Summarized, by delaying the investment at t = 0, the dynamic expected net present value of
the project can be increased by 16.66 million US Dollar compared to the figures of the static
net present value:
.
This confirms that the static approach underestimates the net present value of the project,
because the additional value offered by flexibility and active management is ignored. The
payoff indicates that under given circumstances the binomial valuation method increases the
payoff result of the project by 12.825 percent resulting in additional value of 16.66 million US
Dollar. More importantly, the decision whether to undertake the project or not differs
depending on the chosen valuation approach. While the static DCF method would instruct the
investor to not undertake the project, the binomial lattice method comes up with a positive
outcome.
Figure 17 indicates that the compound option model can lead to options instructing the owner
to exercise the phase [for example: green path of option three] while the option is not yet
alive. Alive means that the previous underlying options have to be exercised as a
requirement for the option of interest being exercisable.
In the case study, the optimal decision at t = 0 for option three would be to construct, while
for option two and one it is to delay the decision. Therefore, the construction of option three is
deferred even though the optimal decision would be to immediately construct the phase.
 - 60 -

5.2. Critique and Reflection

The case study at hand has faced main critique points proposed in real estate literature,
theoretically reflected on them and after having run the figures and calculations, it can be said
that the application of real option valuation approaches indeed can be a difficult task and
some of the critique points can be confirmed.
Not only the timing of when to exercise the option has to be correct and managed ex ante, but
also often the analysis fails to fulfill essential assumptions like for example the mentioned
necessity of efficient working markets. Additionally, the real estate sector is impacted by
asymmetric information, infrequently traded objects and therefore missing comparables which
mirror the high individual risk profiles regarding projects. This leads to an inability to fully
diversify risk and incorporates that applying the risk free rate to value the options is at least
questionable.
Furthermore, limited available data has lead to both the beta and the volatility to differ from
the expected range. The author has made adjustments regarding the applied beta and volatility
in order for them to fit the proposed model, which might have violated assumptions resulting
in an incorrect valuation.
Another assumptions, that can be critically reflected, is that the author states all rates
regarding the growth of the construction costs, the volatility, the beta, the risk free rate and
therefore also the cost of equity stay constant throughout the process of the valuation.
Although it helps to simplify and apply the model, it can lead to an inappropriate and
unrealistic display of the case study and the investment objects.
The case study at hand does not apply the method of closed form solutions. This is due to the
choice of American rather than European Options, where the closed form approach only
delivers approximations or requires a lot of additional assumptions in order to work properly.
Because the paper already works under utilization of assumptions, it has been found that
applying the closed form solution would have been too theoretical in its implementation
requirements.
 - 61 -

6. Conclusion
Investment bubbles and financial crisis are becoming more and more a part of the everyday
life impacting nearly every sector and leaving people, firms and objects exposed to risk.
As mentioned in the introduction, investments in real estate objects fall into that category due
to their high intensity of capital outflows together with uncertainty in demand and the
volatility in cash flow income.
Therefore, making the right investment decision is not only crucial for the going concern of
companies, today more than ever, but also has lead to the literature to focus its research on
how to better and more accurately evaluate investment possibilities in order to maximize
value and minimize the risk. Throughout the time, different approaches have been developed
and compared to each other together with the gained insight that staging decisions adds
flexibility value. Because the real options analysis incorporates this, it is often found that it
represent a better valuation tool in theory. This has lead to the central research question of this
paper:

Can real options analysis deliver more appropriate and superior results compared to the net
present value method in terms of the valuation of real estate objects through their
characteristics of taking into consideration the steps of sequential development?

The provoking question whether real options can offer additional value has been clearly
confirmed by the underlying case study. The result of the dynamic valuation improved the
results by almost 13 percent compared to the basic net present value. On top of that, the
application of the real options valuation model changed the recommendation of whether to
undertake the investment or not. While the result of the net present value saw the project with
a negative outcome, the calculation of the real options analysis attached results in a net gain of
6.55 million US Dollar for the project.

Furthermore, the case study has identified different types of option and has showed that they
all can offer additional value to the investor. Postponing Decisions and dividing the
development process into stages enables the investor to capitalize on the volatility of
outcomes. This also stops the decision from being simultaneous and leads to viewing the
 - 62 -

decision making and the development process as a sequential one with different interaction
possibilities and individual decisions possible at each different time node.
Additionally, the thesis has compared and has shown the differences between the two
approaches. Further, it has described options in general and shown how they are applied to a
specific case study.
Though the main hypothesis has been confirmed, the author also has critically reflected on
potential difficulties the application of real options analysis in reality faces.
In order to extract the maximum value of future outcomes, not only the flexibility to react has
to exist in the first place, also the timing of the decisions has to be right. The lattice has shown
the optimal paths, but is applied backwards. In reality, the decisions are made ex ante leaving
the decision maker with facing the problems of irrational human behavior and inefficient
markets.

All in all, the thesis has shown that the value of flexibility cannot and should not be ignored
when investment possibilities are valued. Real options can further improve the correctness of
the result. Nonetheless, in order to make the real option the dominant decision tool, improved
processes have to be found to secure reliable and accurate figures of important variables, such
as the volatility or adequate rates regarding the cost of capital.
 - 63 -

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