Valuing a real estate project using real options approach: Is it worth it?

Abstract

Real options valuation (ROV) has been a very useful tool for valuing risky asset under uncertainty. Unlike the discounted cash flow (DCF), ROV incorporates the uncertainty of project cash flow and investor’s flexibility in dealing with such uncertainty. The uncertain asset value is usually represented as a continuous-time stochastic process, while the investor’s flexibility is accommodated using embedded real options. In this research we investigated the application of ROV in a mediumscale real estate project in Indonesia. We found that the investor did not have much flexibility due to government regulations and the industry’s business model. We assume that the asset’s value follows a geometric Brownian motion with constant volatility. The risk-free interest rates are represented using Nelson-Siegel model. Using Cox Ross & Rubinstein (CRR) binomial lattice, we found that the project’s value using ROV is slightly greater than that of using DCF. We also conducted sensitivity analysis against changes in the volatility value.