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 [Dissertation (University of Nottingham only)] (Unpublished)

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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)
Depositing User: EP, Services
Date Deposited: 10 Mar 2008
Last Modified: 13 May 2016 14:08

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