Pricing of real estate Case Study Example | Topics and Well Written Essays - 3500 words

Pricing of real estate - Case Study Example Real options have been in existence since centuries and the earliest references are found in the story of Thales, a Greek philosopher. Thales predicted a bumper olive harvest and paid a large premium to local olive refiners for the right to hire their entire olive pressing facilities for a specified fee during that year's harvest season.'Thales however did not have the obligation to use the facilities and had the option to let his right lapse if he chose to do so, at the cost of losing the premium he had paid already. The bumper crop did take place and Thales exercised his real option. He allowed other producers to use the facilities he had got at a predetermined price, but at a large additional premium. Thales is said to have profited immensely by his use of the real option. Real options in real estate are best illustrated by examples. Consider a prospective home owner who identifies a dream home available at an attractive price. Several others too would have arrived at the same conclusion and may be ready to make competitive offers. The first homeowner however does not have his finances tied up and needs a fortnight to get it done. Waiting for a fortnight may push the dream home into another's possession, a situation that throws up the concept of a real option. The prospective owner could offer the seller a sum of money just to hold the property for the two weeks he needs to arrange the funds and buy the home at the offering price. If the funds don't come through or if he changes his mind, he loses the money paid, while the seller keeps the sum of money and can easily find another buyer from among the numerous others interested in buying the property. Just how much the sum paid should be involves putting a value on the real option. A similar situation may arise in the case of a real estate development company holding vacant land. The possession of vacant land confers a right or an option, but not an obligation, to develop a completed building at a future date. The value of vacant land is a consequence of this right to develop an asset, the completed construction, at a price, the cost of construction. The decision to build or not and when to build if at all, are subject to several uncertainties. The future value of the constructed building may be uncertain - if property values rise, the builder is more certain of profits, while lower values at a specified time may justify delaying construction by avoiding potential losses. Delaying the construction may make more information available, allowing for a change in land utilization, nature of the project, tenant mix, funding options etc. The option to wait itself becomes valuable. Thus the uncertainty by itself has value, and if that value can be quantified, the decision making process would become more accurate. Real options analysis thus assumes relevance and importance in real estate pricing by allowing a value to be put on uncertainty. The value of the real option increases when uncertainty about the future value of the built property increases. Thus, development of the property will take place when the value of the completed project exceeds the costs by a premium determined by a combination of uncertainty of asset value, irreversibility of the development and the choice of waiting. In many cases, projects that might have been dropped as unviable become attractive when associated real options are evaluated and quantified. In a