Is there value in waiting? An empirical study of real options application to Australian property developments

"Real options are toehold investments designed to better prepare the investor to meet uncertain events in the future" (McGrath, 1997). Property development is inherently uncertain. As a result, prognosis of the performance of any property development market is fraught with uncertainties which can cause serious financial consequences for property developers. Australian property developers consistently struggle with uncertainties attached to decision making regarding property development projects because of the inevitable boom and bust periods. As a result, property development projects are initiated based on uncertain outcomes. The situation is compounded using the discounted cash flow technique (DCF) which adopts adjustment to discount rates to reflect uncertainties in financial feasibility evaluation. Similarly, its inability to incorporate a broad range of values for dealing with uncertainties in development feasibility evaluation affects property decision making under uncertainty conditions and has been criticized severely. Thus, DCF relies on uncertain inputs to derive outcomes. Despite its numerous shortcomings, DCF is still a popular method for evaluating financial feasibility of property development projects in Australia. Real options; a theory developed to incorporate flexibility in decision making for dealing with uncertainties in evaluating capital intensive projects has been used in industries such as mining, oil and gas, pharmaceuticals, research and development and now, Australian residential property development. Real options can provide solution to investments under uncertainty, particularly, relating to capital intensive projects. Despite the potential of real options, the theory has not been widely adopted for decision-making by practitioners in determining financial feasibility of Australian residential property development projects. Literature shows that the slow adoption is due to factors including lack of empirical support for real options through practical applications. Furthermore, practitioners, especially those operating in Australian property developments (long term investors, valuers, developers etc.) are yet to fully understand how to value embedded flexibility. Beyond empirical support, countries where selected case studies have used real options for evaluating financial feasibility of projects also lack wide practical adoption. This suggests the possibility of other reasons behind the slow adoption. It must be stated that real options and flexibility, for the purposes of this dissertation are used interchangeably. The focus of this dissertation is to examine the empirical support for real options through valuation of flexibility using selected real options valuation models, identify risk management strategies from flexibility and investigate requirements for potential integration of real options theory and valuation in practical property development decision making. The overall aim of this dissertation is to deliver evidence that supports the adoption of real options theory in practice, which can then drive adoption in property development decision making in Australia. The dissertation adopted a mixed method (quantitative and qualitative) approach with embedded case studies. Firstly, case studies were selected based on gaps in literature using theoretical sampling. Similarly, the risk management characteristics of real options theory through flexibility was explored using the case studies, visualized in a conceptual model and validated by practitioners during the second phase of the research. The second phase adopted semi-structured interviews for data collection, which was analyzed using thematic analysis. In conceptualizing flexibility in property development, results indicated that there are several flexibilities embedded at different stages of the property development process. These options are either naturally embedded or require a property developer to invest in creating such flexibilities. It is argued that real options in property development can be classified into four categor es depending on where they are embedded in the property development process. For example, initiation of a project, design, construction and after completion. Selected real options models that could be used for evaluating the value attached to flexibilities were explored to deepen practitioners' understanding for potential adoption in practice. Based on the conceptual model, a risk management tool for mitigating risks throughout an entire property development project was developed and validated by practitioners. Findings from the application of real option models for evaluating financial feasibility of selected residential property development projects embedded with specific types of flexibilities delivered evidence in support of real options as opposed to discounted cash flow techniques. Three case studies embedded with different types of flexibilities; a large-scale residential project including medium rise buildings and two high rise residential projects embedded with: - Staging-executing a capital project in stages; - Delaying-postponing the start of a project to a later date; - Switching options-changing the use of a project respectively. Results from the staging option application (base and worst cases) revealed that real options valuation was able to capture approximately 11.4% and 2.7% respectively, of profitability through flexibility missed by the DCF technique. Similarly, results from the delay option indicated to the developer that deferring the start of an unviable project until a later date when uncertainties are resolved can have a positive impact on profitability. The final case study involved a switching option application. The original idea of a mixed-use project was profitable under both DCF and real option valuations albeit better results from the options valuation. For example, whereas the IRR was 12.95% for the switching flexibility, the original design had 11.5%. The potential payoff from the switching output flexibility as opposed to the original idea was found to represent 7.2% of the undiscounted cost of the project including extra investment required to embed the flexibility. The second phase of the dissertation examined how property developers deal with known and unknown risks, factors required for integrating real options valuation into practical property development decision-making, how long-term investors perceive real options/flexibility and potential barriers to adoption. Findings revealed that contrary to suggestions in property literature that practitioners set discount rate based on potential risks, contingency is rather used to deal with risks in property development. Requirements for integrating real options in practical property decision-making include education and training of practitioners, highlighting the benefits of real options theory over existing property valuation models and involvement of stakeholders. On the contrary, certain factors that could pose as hindrances to the adoption of real option in practice were identified as a vicious cycle of blame, planning related issues, financing and design obsolescence of embedded flexibility.