Equilibrium Real Options Exercise Strategies with Multiple Players: The Case of Real Estate Markets

Abstract

This article derives a closed-form solution for an equilibrium real options exercise model with stochastic revenues and costs for monopoly, duopoly, oligopoly and competitive markets. Our model also allows one option holder to have a greater production capacity than others. Under a monopolistic environment we find that the optimal option exercise strategy in real estate markets is dramatically opposite to that in a financial (warrant) market, indicating the importance of paying attention to the institutional details of the underlying market when analyzing option exercise strategies. Our model can be generalized to the pricing of convertible securities and capital investment decisions involving both stochastic revenues and costs under different types of market structures.The option framework developed in the finance field has been used extensively for analyzing investment decisions related to nonfinancial assets. For example, Brennan and Schwartz (1985) and Paddock, Siegel and Smith (1988) use an option approach to evaluate natural resource investments and offshore petroleum leases. McDonald and Siegel (1986), Majd and Pindyck (1987) and Ingersoll and Ross (1992) explicitly analyze the impact of option value on capital investment decisions. McDonald and Siegel (1985) and Berger, Ofek and Swary (1996) address the termination option of an investment project. Childs, Ott and Triantis (1998) use the option valuation framework for analyzing the capital budgeting decisions of interrelated projects. Grenadier (1995) and Grenadier and Weiss (1997) apply the real options concept to value lease contracts and technological innovations. Schwartz and Zozaya-Gorostiza (2000) design a real options approach for evaluating information technology investments. However, it might be fair to say that, among all the areas embracing the application of the real options concept, real estate markets seem to draw the most attention from researchers. This is probably due to the large size of real estate markets and the availability of empirical data, which make it easier for researchers to

Stickiness of Rental Rates and Developers’ Option Exercise Strategies

“…While oversupply in property markets has been widely investigated from different points of view, 1 only a few studies, such as Grenadier (1996), Wang and Zhou (2000) and Wang and Zhou (2006), offer theoretical justifications for the results they present. Grenadier studies the timing of real estate developments using a strategic option exercise approach based on stochastic demand.…”

“…The models in Grenadier (1996), and Wang and Zhou (2006) are basically market clearance models. This type of model is not suitable for explaining the excess vacancy puzzle because it assumes that any excess space will be absorbed by adjusting rental rates.…”

Presale Contract and its Embedded Default and Abandonment Options

“…We had tried to use the normal distribution assumption instead; however, we cannot derive a closed-form solution under this assumption. 12 Wang and Zhou (2006) report that, historically, the construction cost volatility could be higher than the price volatility in certain periods. 13 It might not be realistic to assume that a developer can spend exactly the amount d c during the first construction phase as the value of c will not be realized until at the end of the first construction phase (or t = 1).…”

“…7 We develop a simple two-period game theoretical model in a perfectly competitive development market, where both property price and construction cost are uncertain at the time a buyer and 4 Many practices in real estate markets are associated with the use of options, see Grenadier (1995Grenadier ( , 1996, Wang and Zhou (2006), Lai et al (2007), and Buttimer et al (2008). 5 and Wang et al (2002), among others, also used a game-theoretical approach to model the seemingly irrational phenomena observed in real estate markets.…”

An investigation of Australian and New Zealand hotel ownership

“…When the hotel property market is depressed or experiencing extreme levels of volatility, the preferred capital spending strategy will be to defer property acquisitions (Chu & Sing, 2007). Application of this strategy has to be weighed, however, against any competitive disadvantage resulting from a competitor securing first mover advantage resulting from pre-emptive market entry (Grenadier, 2002;Wang & Zhou, 2006;Williams, 1993). Where a hotelier feels exposed to such a competitive threat, irrational over-expenditure on building infrastructure can result (Grenadier, 2002).…”