Real estate development as real options

One of the recent advances in property valuation is to view a property or the right to develop it as a call option. Shilling et al. (1985) were among the first to apply option pricing theory in this way. For real estate development, although not explicitly said so in his paper, Titman (1985) was the first to treat vacant lots of land as options to wait to develop. A frequently cited paper by Quigg (1993) presents the first empirical effort to support the real option pricing point of view. The valuation framework of Quigg (1993) is in one sense a specialization and in another sense a generalization of the framework of Williams (1991). Unfortunately, the works of both Williams and Quigg are technically flawed, but surprisingly their errors have gone unnoticed for over 15 years and are still propagating in the literature (e.g. in Yamaguchi et al., 2000 and Patel and Paxson, 2001). In the following, we will first address the flaws of Quigg (1993). Then we will examine the problems in Williams' (1991) work. Finally, we will discuss some implications of the Williams-Quigg valuation framework.