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Conceptual Analysis of Real Options

Highland properties owns two adjacent four-unit apartment buildings that are both on 20,000 square feet of land near downtown Portland, Oregon. One of the properties is in very good condition, and the apartment can be rented for $2,000 per month. The unit in the other property requires some refurbishing and in their current condition can be rented for only about $1,500 per month.
Recent zoning changes, combines with changes in market demand, suggest that both lots can be redeveloped. if they are redeveloped, the existing unit would be torn down and new luxury apartment buildings would be build on the site, each with 10 apartments units. The cost of the 10-unit buildings is estimated to be about $1.5 million, and each of the 10 apartments can be rented for $2,500 per month under current market conditions. Similar properties that have been refurbished are selling for 10 times their annual rentals.

a. Identify the real option(s) in this example.
b. What are the basic elements of options(s) (i.e., the underlying asset on which the option is based, the expiration date, and the exercise price)?
c. Estimate the value of the option to develop the property.

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a. You have a call option here. If Sale value of new property is greater than construction cost, then ...

Solution Summary

Highland properties owns two adjacent four-unit apartment buildings that are both on 20,000 square feet of land near downtown Portland, Oregon. One of the properties is in very good condition, and the apartment can be rented for $2,000 per month. The unit in the other property requires some refurbishing and in their current condition can be rented for only about $1,500 per month.
Recent zoning changes, combines with changes in market demand, suggest that both lots can be redeveloped. if they are redeveloped, the existing unit would be torn down and new luxury apartment buildings would be build on the site, each with 10 apartments units. The cost of the 10-unit buildings is estimated to be about $1.5 million, and each of the 10 apartments can be rented for $2,500 per month under current market conditions. Similar properties that have been refurbished are selling for 10 times their annual rentals.

a. Identify the real option(s) in this example.
b. What are the basic elements of options(s) (i.e., the underlying asset on which the option is based, the expiration date, and the exercise price)?
c. Estimate the value of the option to develop the property.

$2.19