Commercial Investment Real Estate November/December 2018 | Page 16

FINANCING
FOCUS
Gaining Options
Evaluate if real options will add real value to an asset.
nvestors in large, non-financial assets, such as land or factories,
frequently value them through a “real options” framework.
But what are real options, how do they differ from finan-
cial options, and how can their use add value to an asset
or company?
Most investors are familiar with financial options, such as
call options on stocks, which give the holder the right, but not
the obligation, to buy the stock in the future for a price specified
in the option contract. Call options on stocks have been traded
widely on exchanges since the early 1970s, and they are used
routinely both to hedge investment risk and to speculate on future
price appreciation of the stock. The famous Black-Scholes model
provides a way to explicitly price these options.
Real options, in contrast, are not traded, but are provisions
on how investors may respond as uncertainty is resolved. With
real options, an investor has flexibility in responding to future
uncertainty, and this flexibility (the option) itself has value.
I
Applying Real Options
Consider an investor in a factory that currently runs one shift
per day, which meets current demand for a product. The investor
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November | December 2018
believes that demand may increase in a year, but recognizes that
it may not. If demand does increase, the investor could begin a
second shift at the factory, but if demand stays flat, the operation
would remain at one shift. This option to begin a second shift in
the future, if conditions warrant it, is called a real option.
Now consider if the investor wants to value the factory today.
In its traditional form, the most widely used investment valua-
tion methodology — discounted cash flow analysis — doesn’t
consider the uncertainty in what will happen a year from now.
The standard approach considers the most likely outcome only,
and assumes that will happen. It fails to consider the value in the
option to decide later whether to add a new shift. The traditional
DCF approach would undervalue the factory.
Both academics and practitioners proposed methodologies that
incorporate real options into investment valuations, as described
in the textbook Investment Under Uncertainty by Avinash K.
Dixit and Robert S. Pindyck (Princeton University Press, 1994).
Although many techniques and methodologies are available, they
all share a common trait: They explicitly build into the invest-
ment valuation model uncertainty about the future and value the
flexibility the investor has as that uncertainty resolves.
COMMERCIAL INVESTMENT REAL ESTATE
by Murray C. Grenville and Richard J. Buttimer, Jr., Ph.D.