Mintah, K; Higgins, D and Callanan, J (2018) A real option approach for the valuation of switching output flexibility in residential property investment. Journal of Financial Management of Property and Construction, 23(2), pp. 133-151. ISSN 1366-4387
Abstract
Purpose: Uncertainties in residential property investment performance require that real estate assets are designed in a flexible manner to respond to impacts of market dynamics. Though estimating the cost of flexibility is straightforward, assessing the economic value of flexibility is not. The purpose of this study is to explore the potential practical application of real option analysis to determine the economic value of a switching output flexibility embedded in a residential property investment in Australia. The study involves the exploration of an optimal strategy for investment in a residential development through real option analysis and valuation of a mixed use investment. Design/methodology/approach: The real option valuation model developed by McDonald and Siegel (1986) is adopted for the evaluation because the switching output flexibility is likened to a perpetual American call option with dividend payout. Findings: Through real option analysis, the economic value of switching output flexibility of the mixed use building was determined to be higher than the initial upfront costs. Moreover, a payoff of about $4million was determined to be the value of the switching output flexibility, therefore justifying upfront investments in flexibility as an uncertainty and risk management tool. Practical implications: This application is an important demonstration of the practical use of options pricing techniques (real options analysis) and delivers further evidence needed to support the adoption of real option valuation in practice. Flexibility can also enhance risks and uncertainty management in residential property investment better than the adjustment of discount rates. Originality/value: There is limited evidence on the use of real options techniques for the valuation of switching output flexibility in practice, and this comes as an original application; both the case study and data are all initial applications of switching flexibility in the Australian property market.
| Item Type: | Article |
|---|---|
| Uncontrolled Keywords: | discounted cash flow; real options; valuation |
| Index terms: | real estate, dynamics, uncertainty management, real option, risk management tool, real options analysis, residential development, option, pricing, case study, residential property, Australia, methodology, exploration, evidence, estimating, discount rates, strategy, property market, discounted cash flow |
| Subjects: | financial and cost management, design economy, economic analysis, environmental resource management, real estate economics, evaluation and assessment methods, data collection methods, construction type, risk assessment, systems engineering, financial analysis, decision analysis, Geography, financial risk, management, economic development, research methods |
| Topics: | Sustainability, Construction Technology, Risk Management, Engineering Principles, Research Practice, Geographical Context, Cost Management, Business Strategy, Urban Studies, Design Practice |
| Descriptive scope: | 5 PCTEA |
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