Creating a practical model using real options to evaluate large-scale real estate development projects

Abstract

Real Options analysis has only begun to be recognized as way to evaluate real estate and is considered "beyond the cutting edge" of financial analysis. Several academic papers have looked at ways that real estate can be analyzed using real options; however a universally practical financial model using real options has not successfully been achieved. There are several reasons why real options analysis has not quickly come to the forefront of financial analysis. The first obstacle is that real options analysis can be quite rigorous and mathematically complex, making it difficult to be easily adopted by the everyday analyst. Presently, the most common method of analyzing real estate is using Discounted Cash Flow, which is relatively systematic and can be universally understood by most persons in the finance world. However, real options theory is not nearly as intuitive, even to the most sophisticated financial persons. There is no tried and true, universally recognized methodology for real options analysis of real estate, at least not yet. Discounted Cash Flow does a very good job analyzing most real estate. However, complex, multi-phased, or very speculative developments justify significantly more sophisticated analysis methods, such as real options.

(cont.) Real options is relatively new to real estate, and awaits daring pioneers who are willing to create intuitive, thorough, and transparent models that could be used by future real estate analysts before real options analysis will ever become a mainstream method for analyzing real estate. With this in mind, this thesis intends to present a practical, comprehensive, and intuitively transparent financial model using Microsoft Excel for analyzing real estate development projects. This thesis will hopefully serve as a basis for future models, and will aid in others' understanding of the advantages and drawbacks of such analysis and how to properly utilize it as a tool for real-world projects. It is also the intent of this model to be utilized and further refined by future students in the Real Estate Development Studio course at MIT and by real-world real estate practitioners.