Application of Real Option Approach in China Real Estate Development-A case study

Chen, Lu (2007) Application of Real Option Approach in China Real Estate Development-A case study. [Dissertation (University of Nottingham only)] (Unpublished)

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Abstract

The real estate development in emerging economies such as in China presents great uncertainty due to unstable macroeconomic conditions and regulatory changes over the life of the investment project. The traditional valuation approach Discount Cash Flow (DCF) model may be insufficient to evaluate real estate project since it cannot properly deal with the uncertainty, irreversibility and managerial flexibility of the real estate investment and thus lead to inadequate decision has been made. Instead, this paper will use a real option approach which remedies these shortfalls and provides a more scientific valuation for a real estate investment project.

There are substantial applications of real options in real estate development that can be found in the literature and most of the real estate literatures look at the value of an option to wait or defer and suggests that the uncertainty makes deferring an investment more valuable than immediate investment. However, most of these studies assume that the evolution of underlying asset value follows a geometric Brownian motion process and did not taken into account any jump behaviour in the real option valuation such as the regulatory shocks, thus this paper will follow the line of previous research that focus on the analysis on the optimal timing of a real estate investment case and extend the existing model with addition of a fixed jump process that incorporating the regulatory risk into the real option analysis. Moreover, the innovative feature of this paper is to estimate the jump parameters through an event study methodology which can effective capture the impact of the regulatory change on the real estate company in terms of the abnormal returns on the company's stock price during the event day.

The result of this study confirms the previous research findings that the value of the investment with the option to defer is greater than the NPV of the project and the trigger value to invest is above the current project value. Thus waiting to invest is better than immediate investment. However, the regulatory shocks result in a negative impact on the value of a project and lowered the trigger value as well as the value of the investment. Thus, delaying an investment too long may result in a loss on the project.

Item Type: Dissertation (University of Nottingham only)
Keywords: Real Option, Real Estate, Regulatory risk, Jump Process
Depositing User: EP, Services
Date Deposited: 06 Mar 2008
Last Modified: 22 Oct 2016 17:15
URI: http://eprints.nottingham.ac.uk/id/eprint/21152

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