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Real Option Analysis: A Switching Application for Mixed-Use Real Estate Development

Author/s: Ron Throupe, Sewalk Stephen, Juncheng Zhong, Huo Chen

Date Published: 1/01/2012

Published in: Volume 18 - 2012 Issue 3 (pages 277 - 291)

Abstract

In real estate development, properties are developed irreversibly in an uncertain economic environment. The uncertain environment for rents or occupancy may jeopardize the return on investment. In this paper, to mitigate the risk, we use a real option valuation analysis to find the optimal strategy for developing a mixed-use property. A mixed-use real estate project under construction in Denver incorporating apartments, retail, and parking is used as an example. We adopt a switch-option valuation analysis to compare the return on investment for building as planned or switching to a different property mix conforming to allowable zoning codes. We then examine the use of various option models for optimizing when to switch the property mix.

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Keywords

Black-Scholes - Decision Tree - Hotel - Mixed-Use - Real Option - Switching Option

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