Real Estate as a Financial Asset

Table of Content

List of Figures

1 Introduction

2 General Assumptions
2.1 Land characteristics
2.2 Loan characteristics
2.3 Construction characteristics
2.4 Sale characteristics
2.5 Time characteristics

3 Standard Project Scenario

4 Alternative Project Scenarios
4.1 Alternative case 1 – extra cost for management and holding
4.2 Alternative case 2 – change in volatility of office properties
4.3 Alternative case 3 – change in correlation of volatilities
4.4 Alternative case 4 – change in land increasing rates

List of Literature

List of Appendices

List of Figures

Figure 1: Decision status - standard case

Figure 2: Development surplus - standard case

Figure 3: Opportunity value - standard case

Figure 4: Decision status - standard case

Figure 5: Decision status - alternative case 1

Figure 6: Decision status - alternative case 2 with 5% volatility

Figure 7: Decision status - alternative case 2 with 40% volatility

Figure 8: Development surplus - standard case

Figure 9: Development surplus - alternative case 3

Figure 10: Land selling surplus – alternative case 4

Figure 11: Decision status - alternative case 4

1 Introduction

A developer named Jemima bought a plot of land. She acquired this in order to develop the land, want to erect an office-building complex and to sell this one after completion of constructions. The question is, at which point of time should she starts the construc­tion works with the aim to maximize the surplus of the property development, when she going to sell it. Based on a few key assumptions, it should be examined, what could be possible strategies and how the uncertainties of future expectations can influence these decisions.

2 General Assumptions

It is needed to figure out a base of key assumptions to form a few possible scenarios. Further, caused by the intention of the assignment, general answers of developing strat­egy questions, instead of having completed calculations, should be found. The next lines will characterise the standard case. Differences will be defined in the alternative cases separately.

2.1 Land characteristics

- Land is being suited for development
- Land is owned, but 100% financed by credit (20 M EUR) - (like introduced by Gianluca Marcato – 31st of March. 2008)
- Land value increase rate: 5% p.a.
- It is possible to sell it undeveloped at every stage
- Inflation rate is considered in the increasing rate of the land

2.2 Loan characteristics

- InBan payments for construction are considered in the construction cost; no ex­tra calculation

2.3 Construction characteristics

- Construction cost will be paid in one account at the end of the construction works
- Time for construction: 1 year
- Standard volatility of construction: 5% p.a. after year 1

2.4 Sale characteristics

- Estimated office property value: 100 M EUR incl. land value
- Income cash flow at the same time as the construction cash flow
- Volatility of development value: 20% p.a. after year 1

2.5 Time characteristics

- Development period: 1 year
- Could been started now or over the next 4 years at the beginning of every year
- Latest finish: at the end of the 5th year, so latest start at the beginning of year 5

To simplify the standard case, it was assumed, that there is a direct positive correlation (+1) between the movement of construction cost and property values. As well all as­sumptions are valid for the alternative cases, except the in the subsections described deviations.

3 Standard Project Scenario

The standard scenario for the planned development is completely based on the facts which are defined in point 2. At first, the surplus for a straight development without any delays is calculated in table 1 (see appendix A – standard case) and would be:

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(Land value increasing is covered by the estimated property value. Land cost will be paid in arrear.)

For second, Jemima can wait with the development of the land. As the assumption of the increasing in land values and interest rates of the land financing showed, is there roughly no changing in the worth of the land. That means, that in year 2 the value of the undeveloped land would be 22.05 M EUR minus interest payment for 2 years, -2.0 M EUR. When she would sell this undeveloped place at the end of year 2, she would make a minimal profit of 0.05 M EUR. This cannot be a reason for an investment. It is more like a put option (only if rate of growth stays at the same level). Jemima can buy the land, hold it for 5 years and sell it at every stage without a loss. So she does not pay at­tention to the worth of the land for her decision of developing or waiting.

More interesting is the link between the construction cost and the possible values of the property. Caused by the different volatility of both values and the assumed perfect posi­tive correlation, the property value can increase 22% in reference to only 5% increasing in construction cost in the 2nd year. That means that the surplus rises from 10.0 M EUR to 26.55 M EUR (26%). Otherwise, when property values and construction cost fallen, there will be already a loss (-6.71 M EUR) after 1 year of hesitating (see figure 1). The other possibilities are calculated in table 1 / appendix A – standard case.

When she now takes a look to the opportunities of development over the next 4 years, she can calculate project surpluses, which are possible in the future. Among other num­bers, it seams to be possible to wait until year 5 and making still a profit of 5 M EUR (average line). As well Jemima can wait until the beginning of year 4, after 3 downward moves with her decision to sell the land. Further, out of the option to develop, she can also wait to sell the site, although possible gains of the property sale are already nega­tive. But she only can wait or sell, not develop.

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Figure 1: Decision status - standard case

At least not to forget is a view backwards. For sure, Jemima cannot make a loss (only if she decide to develop at a point of time, when the surplus is negative), but if she decided to wait too long, she can lessen her gain – a short example:

- Development possibility in year 4 with a surplus of 24.55 M EUR
- Option value at this point of time: 27.73 M EUR – better to wait for another year
- But, a possible downward movement in year 5, reduce the development sur­plus to only 5 M EUR – 19.55 M EUR less than a year before (see figure 1 and 2), and she cannot longer wait to develop.

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Figure 2: Development surplus - standard case

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Figure 3: Opportunity value - standard case

Decisions can now be based on the possible surplus out of the property at a given point in time and the possible opportunity value at the same point. If the option value is higher than the surplus, it is better to wait. If the surplus goes below zero it is also possible to wait, caused by an estimation of a positive future increase. In this first scenario an im­mediately start of construction works can make a profit of 10.0 M EUR. An only up­ward movement will lead to higher property values and more profit. The best case in year 5 – 112.06 M EUR; the average case are creating 5 M EUR; only downward moves have to lead at the end to a resale of the undeveloped plot of land.

But the decisions should not only be made by the numbers, but also by the personal de­veloper behaviour. Not to forget: 10 M EUR are 10 M EUR and a possible helpful profit for other investments. Four years of waiting in estimation of possible gains and without doing anything can be lost, at least with no capital growth and paying interests, which terminate the land value increase. So the strategy for the investment should be define borders for the decision to develop a site or not (e.g. waiting only, until the option value fall not under a 20% limit above the development surplus).

4 Alternative Project Scenarios

4.1 Alternative case 1 – extra cost for management and holding

When Jemima starts immediately with the project, all effects of holding cost and other expenses will be no significant influence the gain of the property sale after year 1. Otherwise the waiting cost will be activated in year 2 and multiplied by every year of hesitating. To figure out the effect, let’s assume, that after the first year of waiting cost of 5 M EUR p.a. appear and influence the strategy massively. So the decision graph gives a completely other impression. Suddenly it is a good time for development in year 1 (see standard case: only after 4 years the status switches to develop). Also a drop off property values will already lead in year 2 to a sale decision of the undeveloped land (in standard case: only after a 3 times downward moves). Of course the holding cost are ex­tremely high, but the effect becomes clear: extra cost for managing and holding oppor­tunities changing the numbers of option values and shorten the decisions. So a basic economic principle will influence the development: time is money! (see table 2 / appen­dix B – alternative case 1 for details and figure 3 and 4)

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Figure 4: Decision status - standard case

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Figure 5: Decision status - alternative case 1

4.2 Alternative case 2 – change in volatility of office properties

If the volatility of the property value decreases from 20% to 5%, the next imaginable scenario gives the developer another significant answer for her future strategy. For the

one hand the value increasing out of the volatility is not as high like in the standard case – but the decreasing is also not so dramatic. So the possible gain out of the development is up to only in one case, always positive. Also the spread of profit between the highest (11.64 M EUR) and lowest (-0.44 M EUR) value becomes lower than in the initial stage. Depended on the interest payments for the land, still the first year is suited for the investment. If this chance is missed, it takes until the 5th year that the status switches back to develop. (see figure 5 and table 3 / appendix C - alternative case 2).

If instead volatility goes up from 20% to maybe 40%, there is no change to the standard case (see figure 5). (Notice: This case are not considered any management or holding cost – with these expenses it would be like in alternative case 1 – extra cost force earlier development decisions)

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Figure 6: Decision status - alternative case 2 with 5% volatility

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Figure 7: Decision status - alternative case 2 with 40% volatility

4.3 Alternative case 3 – change in correlation of volatilities

In the standard case a perfect positive correlation (+1) between construction and prop­erty values was estimated. The 3rd case switches this one to a perfect negative correla­tion (-1). The outcome of this case is just like expected, then a profit is now a better profit (which means higher) and the losses are worse than in the standard case (means more loss). So with a perfect positive correlation between construction cost and property Jemima can find the lower limit, with a perfect negative correlation she can find the upper limit of possible profits (the upper limit for losses is the less loss, the lower limit is the highest loss). The status of decision becomes the same like in the standard case. (see table 4 / Appendix D – alternative case 3 and figure 6 and 7)

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Figure 8: Development surplus - standard case

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Figure 9: Development surplus - alternative case 3

4.4 Alternative case 4 – change in land increasing rates

Let’s assume, that the area is good for investments in Real Estate and becomes better and better over the next 5 years. Than it is possible, that the rate of increasing goes up from 5% to 10%. The value of this undeveloped place now goes up every year by round about 5%, because the interest rate for the loan stays further at the same. So Jemima makes a profit out of owning and holding the site. Nevertheless, this has only a small ef­fect to the decision status graph. Only at the worst case in year 4, the status switches from sell to wait. Very interesting is, that the next two stages in year 5 stay both at sell. So she can wait with the sale of the land, because she could take in year 5 an extra 5% profit out of the increasing worth of the land, but not in expectation of a later develop­ment start.

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Figure 10: Land selling surplus – alternative case 4

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Figure 11: Decision status - alternative case 4

List of Literature

Ward, C, Marcato, G: Options introduction workshop, Spring course University of Wuppertal at the School of Real Estate and Planning, University of Reading, Reading, April 2008

Howell, S, Stark A, Newton D, Paxson D, Cavus M, Pereira J. and Patell K,: Real Options: Evaluat­ing Corporate Investment Opportunities in a Dynamic World., Financial Times, 2001

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