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Title: An integrated application of real option theory in the urban redevelopment projects
Authors: Zhong, Jiawei
Degree: Ph.D.
Issue Date: 2019
Abstract: Urban redevelopment is a measure for handling urban decay problems. As an important component of urban renewal, urban redevelopment helps change original and outdated land use, replace severely dilapidated buildings, upgrade building structures, and rearrange communal facilities. Dilapidated buildings put many lives in danger; thus, finding a solution to this problem is imperative. Undertaking redevelopment on multi-owner buildings usually takes a long time and requires an accurate valuation method for proper planning and scheduling. Real option approach is accepted as a superior framework that allows investors to choose their preferred scheduling to maximize project revenue. However, existing option pricing models fail to consider two special characteristics in the redevelopment of multi-owner buildings. Firstly, investors have to predict the values of old and new properties separately during the entire two-phase option period to reflect the difference between the properties in the same location; meanwhile, depreciation effect should be embedded in the pricing model. Secondly, when new buildings adopt vertical mixed-use, an improved pricing model should be required to consider the difference in design and lease restrictions against horizontal mixed-use developments. A literature review in Chapter 2 explains the reasons for considering these characteristics, which were not covered in extant studies. This PhD study aims to bridge the two gaps in the valuation of redevelopment projects. Four research objectives are established to fill these gaps as follows: (1) to identify new parameters that capture the effect of depreciation on a building; (2) to examine the potential influences of depreciation rate and other new parameters on project value; (3) to evaluate the expected waiting time to demolish and rebuild with depreciation effect; and (4) to establish an option pricing model for vertical mixed-use developments and examine the influence of different designs (horizontal or vertical) on project values.
The quantitative approaches and theoretical assumptions adopted in this study are demonstrated in Chapter 3. Three novel real option models are developed in Chapters 4, 5 and 6 to achieve the aforementioned four research objectives. A constant depreciation rate assumption and a new parameter of annual increase on the average building age are introduced to measure the depreciation effect. Chapter 4 explores the roles of depreciation rate and annual increase of average building age in the project valuation within a finite option period. The influences of the two factors are found greater than those of the price/cost volatility and interest rate. Chapter 5 examines the feasibility of the existing optimal exercise strategy when the length of the redevelopment period is unbounded. The optimal strategy is found to be considerably affected by depreciation rate and capital return rate. When the depreciation effect is small and capital return rate is high, investors can still start the demolition and rebuilding immediately as the optimal demolition price-to-cost ratio is reached. However, as the depreciation rate increases (e.g., 2% p.a. or above) and the capital return rate decreases (e.g., 8% p.a. or below), redevelopment should start when the optimal rebuilding price-to-cost ratio is reached at this point. Chapter 6 focuses on the differences of valuation models between horizontal and vertical mixed-use developments. A new parameter, critical height premium, is introduced to aid investors determine the building type with a higher value. This chapter also reveals how the volatilities in different markets influence the critical height premium and the choice of building type. This study offers several theoretical and practical contributions. It provides an in-depth discussion why depreciation effect should be embedded in redevelopment option models and how to measure this effect properly when more than one property is involved in redevelopment. The findings from discrete- and continuous-time models for two-phase redevelopment projects have proved the importance of depreciation effect on project valuation and optimal timing. This study also identifies the differences of valuation models between horizontal and vertical mixed-use developments. Developers can apply the three novel models developed in this study to assist in their decision making on redevelopment projects and extend to more complicated projects, such as redevelopment of several vertical mixed-use buildings. Policy makers can predict developers' choices in redevelopment timing or building type accurately by incorporating the depreciation effect and vertical mixed-use forms into real option models.
Subjects: Hong Kong Polytechnic University -- Dissertations
Urban renewal
Real options (Finance)
Pages: xii, 172 pages : color illustrations
Appears in Collections:Thesis

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