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The Value of Break -options

José Antonio Roodhof (Amsterdam School of Real Estate) & Ronald Huisman (Erasmus School of Economics). The Value of Break -options. Research. Work in progress Model is tested in practice However, this was not the purpose of the research

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The Value of Break -options

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  1. José Antonio Roodhof (Amsterdam School of Real Estate) & Ronald Huisman (Erasmus School of Economics) The Value of Break-options

  2. Research • Work in progress • Model is tested in practice • However, this was not the purpose of the research • Presentation is about pricing flexibility, the break-option is an example

  3. Motivation In The Netherlands: • Leases are becomingshorter • Also; more flexible • Possibilityto change rentedsurface • Flexible lease terms • Break-options

  4. Flexibility in leases • For the lessee • Advantage • Less risk • Responsive to change • For the lessor • Disadvantage • More risk • Uncertainty in future cash flow

  5. Flexibility in leases • From perspective of lessee: • Lessee is willing to pay for the given flexibility • From perspective of lessor: • Lessor must be compensated for the exposed risk But: How much?

  6. Value of the Break-option • An upfrontpayment is unusual (in NL) • A higher rent is accepted • a risk premium as a compensation But: How much? But: How much?

  7. Value of the Break-option • The concept of option-value in real estate is difficult • We do not want toknow the value of the option. • No financial product • But what premium is rationalforgiving the option away?

  8. Value of the Break-option • Assumptions • A standard lease of five yearwithout noticeperiodsandrenewal options v/s • The standard lease plus the option toterminate the lease at the end of year 3 or at the end of year 4 with a notice of 1 month (the flexible lease)

  9. Value of the Break-option • Furthermore, we assume • The lessor is indifferent whether he offers the standard lease or the flexible lease with risk premium and break-option when the value of both alternatives is equal • We apply the ‘real option theory’ • Binomial tree

  10. Value of the Break-option • Value of the flexible lease • Is lowerthan standard lease without risk premium • Is equal as standard lease with risk premium

  11. Value of the Break-option • Flexible lease consists of twocomponents • First component: • The standard lease with the risk premium on top of the rent • Value = Vs(S+P) • Second component: • The option toterminate the lease prematurely • Value = Vp(S+P) Value of the flexible lease = Vs(S+P) - Vp(S+P) • The value of the first component minus the option value

  12. Value of the Break-option • The lessor is indifferent if: • Vs(S) = Vs(S+P) - Vp(S+P) But: howmuch is P? • Whichvalue of P makes the lessor indifferent?

  13. Value of the Break-option • The formula in our research shows that the lessor is indifferent whether he offers the standard lease or the flexible lease (with premium and option) if the value of the option is equalto the value of the revenuesfrom the premia

  14. Value of the Break-option • A methodtovalue ‘P’ • We us the ‘real’ option theory • Binomial tree

  15. Value of the Break-option • Looking for the value of ´P´ in such a way that the net present value of the premia of five year is equal to the value of the break-options • Option valuation programmed in VBA, Excel • Solver to reach to the optimal premium

  16. Value of the Break-option • Parameters • Discount rate • Volatility • Possibility • Risk-neutral

  17. Value of the Break-option • Results • Rent: €175 • Discount rate 3% • Volatility 17.04% • Optimal premium €6.96 • Premium as % 3.97% • Rent incl. premium €188.56

  18. Value of the Break-option • Survey among senior appraisers • Rent: €175 • Discount rate 3% • Volatility 19.94% • Optimal premium €8.75 • Premium as % 5% • Rent incl. premium €182.75

  19. Value of the Break-option • Small differencebetween model and survey • Model depends on a correct determination of the volatility of a single object • Motivationtoexcercise break-option in this model is financial gain or loss • Use in practice? • Further research on volatility in real estate

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