Is there Value in Waiting? An Empirical Study of Real Options Application to Australian Property Developments A thesis submitted in fulfilment of the requirements for the degree of Doctor of Philosophy Kwabena Mintah MSc Real Estate Economics –Aalto University, Finland BSc Land Economy- Kwame Nkrumah University of Science and Technology, Ghana School of Property, Construction and Project Management College of Design and Social Context RMIT University January, 2019 Declaration I certify that except where due acknowledgement has been made, the work is that of the author alone; the work has not been submitted previously, in whole or in part, to qualify for any other academic award; the content of the thesis is the result of work which has been carried out since the official commencement date of the approved research program; any editorial work, paid or unpaid, carried out by a third party is acknowledged; and ethics procedures and guidelines have been followed. I acknowledge the support I have received for my research through the provision of an Australian Government Research Training Program Scholarship. Kwabena Mintah 29th January 2019. ii | P a g e Dedication I dedicate this dissertation to my mother, Grace Mensah and my two Aunties, Akosua Tiwaa, Abena Konadu of blessed memory and my dear wife, Betty Norah Agyemang.
How I wish… iii | P a g e Acknowledgements First and foremost, my profound gratitude goes to all my supervisors, especially, Professor David Higgins, formerly of RMIT University and now at Birmingham City University for assuming the role of primary supervisor for this dissertation for two years. David has been pivotal in completing this dissertation even as an external supervisor, particularly, comments and feedback for improving the dissertation, suggesting possible interview participants for its second phase and research training. I am forever grateful to you for your contribution and motivation during this journey. I am also grateful to Professor Ronald Wakefield who was an associate supervisor, and later became my primary supervisor, for the constructive criticisms and suggestions to improve the dissertation.
Your contribution in terms liaising with industry partners for the semi- structured interviews was instrumental. You provided insightful and thought-provoking comments to ensure that the dissertation is devoid of ambiguity. Sir, your support and contribution towards its completion is greatly appreciated. I also owe a special gratitude to Dr Judith Callanan for her role as a co-supervisor in shaping this dissertation.
Judith read every Chapter, the complete draft and provided very valuable and insightful comments to improve its practical relevance. She also liaised with industry partners to access data on the selected case studies used in this dissertation. Beyond research supervision, Judith has nurtured my passion for teaching and given me numerous opportunities to develop my teaching and research skills. Truly, I am forever grateful to you.
The nature of research is such that the views of practitioners are always invaluable to validate findings. As a result, my gratitude also goes to the numerous property practitioners in the Australian property industry who contributed in diverse ways including practitioners from Frasers Property, Oliver Hume Property, Ernst & Young, Knight Frank, JLL, Pointier Advisory, ISPT, Herron Todd White, CBUS Property, Mirvac and CBRE. All other contributors from various organisations whose names are not mentioned are also acknowledged. I am truly grateful to RMIT University for the research scholarship and technical training that has aided me in undertaking my doctoral studies.
The support of my PhD colleagues and staff of the School of Property, Construction and Project Management of RMIT University is greatly appreciated. To my dearest wife, Betty Norah Agyemang and all family members (especially Akosua Tiwaa and Osei Kuffour), I appreciate your support, love, encouragement and patience during this incredible journey. Finally, to everyone who contributed in any way towards my successful completion of this dissertation, I appreciate your support. iv | P a g e Table of Contents Declaration ii Dedication iii Acknowledgements iv List of Figures xii List of Tables xiv List of Publications xvi Abbreviations xvii Abstract 1 Introduction 4 1.1 Background to the Dissertation 4 1.3 Scope of the Dissertation 10 1.5 Objectives of the Dissertation 12 1.7 Limitations of the Dissertation 17 1.8 Dissertation Outline 18 Literature Review 21 2.2 Property Development 22 Definition of Property Development 22 Property Development Process 24 Stages of Property Development 29 2.3 Property Market 40 Space Market 40 Asset Market 41 DiPasquale and Wheaton’s Model 41 Real Estate System 43 2.4 Risks and Uncertainty in Property Development 45 Definition of Risk and Uncertainty 45 Sources of Risk and Uncertainty in Property Development 47 Dealing with Risks in Property Development 49 2.5 Property Valuation 52 v|Page Residual Valuation Method 53 Discounted Cash Flow Technique 54 2.6 Real Options/Flexibility 58 Definition of Real Options/Flexibility 58 Terminologies in Real Options 59 When is Real Options Analysis Needed? 60 Typology of Real Options/Flexibilities 62 Real Options “in” and “on” Projects 67 Real Options/Flexibility Applications in Property 68 2.7 Summary 76 Research Methodology 78 3.3 Research Assumptions and Methodology 81 Research Paradigms 81 Methodological Fit for Different Research Worldviews/Paradigms 83 3.4 Research Methodology (strategy/enquiry) 85 Justification for Using Mixed Methodology 87 3.5 Method 88 Mixed Methods Typologies 88 Case Study Research 93 3.6 Data Collection Strategies 94 Types of Data 95 Sources of Data/Evidence for Case Study Research 96 3.10 Summary 104 Systematising Real Options in Property Development: A Conceptual Framework 107 4.2 Four-Stage Property Development Process 108 4.3 Real Options Embedded in Property Development 110 4.4 Conceptual Framework 110 North West Quadrant 111 vi | P a g e North East Quadrant 113 South West Quadrant 117 South East Quadrant 119 Middle Circle 120 4.5 Real Options as a Strategic Tool for Property Development under Uncertainty Conditions 121 Case Study 1-Staging Option Using Fuzzy Pay Off Method (FPOM) 128 5.2 Evaluation of Staging Options on Residential Project 128 Description of Large-Scale Residential Case Study 130 Features of Townhouses 131 Features of the Apartments 132 Data on the Case Study Project 133 5.3 DCF modelling (base case scenario of 10.23% required rate of return) 136 Sensitivity Analysis 138 DCF Modelling (worst-case scenario using 20% required rate of return) 141 Sensitivity Analysis for Worst Case Scenario 142 5.4 Real Options Modelling 144 Modelling Uncertain Sensitive Variables 147 Data and Methodology for Real Options Modelling 148 The Value of Staging Flexibility 151 Methodology 154 Results and Discussion of Staging Real Option Valuation (base and worst cases) 157 5.5 Summary 170 Case Study 2-Evaluation of Option to Delay in a Brownfield Residential Development 174 6.2 Case Study Description 175 Features of the Apartment Building 177 Data on the North Melbourne Case Study Project 178 6.3 DCF Modelling 180 Sensitivity Analysis 182 6.4 Real Option Modelling 186 vii | P a g e Data and Methodology for Real Options Modelling 188 Volatility 188 Risk Free Rate (rf) 190 Consumer Price index 190 Modelling Uncertain Variables (Value and Cost) 191 Costs 191 Modelling the Value Evolution (Binomial Tree) 192 Model and Real Option Value (ROV) Computation 194 6.5 Results and Discussion 195 6.6 Summary 210 Case Study 3-A Switching Output Option Application to a Mixed-Use Development 213 7.2 Case Study Description 215 7.3 Data on the Project and Location 217 7.4 DCF Modelling 218 Results from DCF 222 Sensitivity Analysis 223 7.5 Issues with the Project 225 7.6 Real Option Modelling 227 Switching Proposal 227 Justification for the Proposal 231 7.7 DCF Evaluation of the Switching Option 232 7.8 Methodology for Real Options Modelling 234 Data for Real Options Modelling 235 Investment Required for Switching Option (Cost) 236 Current Value 237 Volatility 238 Risk Free Rate 240 7.9 Results and Discussion 240 7.10 Summary 245 Integrating Real Options Theory into Practice: Requirements and Challenges 247 8.2 Accounting for Risks in Property Development 253 viii | P a g e Discount Rate as the Main Risk Measure (Changes in rents, demand, supply, interest rates, property values and costs of development) 253 Dealing with Risks as Opportunities (views on Shortened Lease Lengths, Future Proofing, Flexibility of Buildings, Value Appreciation Opportunities and Potential Technical Variations) 256 Contingency as the Risk Management Tool for Potential Uncertainties and Risks 259 Emerging Opportunities and Risks after Project Commencement 260 8.3 Justifying Initial Expenditure in Flexibility: is Flexibility Valuable? A Case of Vertical Residential Development 263 Determining the value of Flexibility: Practitioners’ perspective 266 8.4 Receptiveness of Flexibility by Key Stakeholders 269 Acceptance and Adoption of Real Options Theory in Practice 270 Practical Cases of Flexibility 273 8.5 Requirements for integrating ROV/ROA into Property Decision-Making Process 274 Education and Training 275 Highlight Benefits of ROA and ROV over Existing Valuation Models 276 Involvement of other Stakeholders 276 8.6 Barriers to Adoption of Flexibility and ROV Models in Residential Development Decision-Making in Australia 278 A Vicious Cycle of Blame? 279 Financing 282 Planning Issues and Disturbance to Existing Tenants 284 Design Obsolescence 284 8.7 Summary 285 Practical Implications and Application of Real Options to Australian Residential Property Development Market 287 9.3 Results of DCF Financial Evaluation of Case Studies 290 9.4 Results of ROV Financial Evaluation of Case Studies 291 Staging Option 291 Delay/Deferral Option 292 Switching Output Option 293 9.5 Requirements for Integration 294 9.6 Implications for Practice 296 ix | P a g e 9.2 Summary of Research 304 10.3 Conclusions 307 Objective I-To review and establish the nexus between real option theory, valuation and property development 307 Objective II- To develop real option conceptual model for categorising flexibilities embedded in the property development process to enhance risk management 308 Objective III- To examine how Australian residential property developers currently deal with uncertainty and risks in feasibility analysis 311 Objective IV- To apply real option models to feasibility evaluation of selected practical case studies using empirical data and to compare the results with conventional property development evaluation technique 311 Objective V – To suggest ways of justifying investment in building flexibility in Australian residential property development 313 Objective VI- To evaluate the requirements for integrating real option techniques into Australian residential property development decision-making 314 Objective VII- To determine any potential barrier(s) to adoption of real option theory in practical decision making in Australian residential property development 315 10.4 Contribution to Knowledge 316 10.5 Validity of the Research 322 Choice of Methodology 322 Reliability 322 External Validity 323 Internal Validity 324 Construct Validity 324 10.6 Recommendations 325 Education and Training of Practitioners 325 Harmonisation of ROV Models 326 Support from Regulatory Institutions 326 10.7 Areas for Further Research 327 Further Applications from Different Parts of the World for More Evidence 327 Datasets from New Projects 327 Unit of Analysis Using “Developer-Traders” 328 x|Page Practical Valuation of Building Flexibility by Valuers and Investors 328 Latent Value of NatHERS Rating Tool in Residential Sector in Australia 328 Receptiveness and Acceptance of Flexibility by Local Councils 329 The Value of Flexibility in Fixed Term Leases in Australian Residential Sector 329 Property Portfolio Acquisitions 329 References 330 Appendix A: Ethics Approval 343 Appendix B: Interview question guide 345 Appendix C: Visual Aid 1 348 Appendix D: Visual Aid 2 349 Appendix E: Visual Aid 3 350 Appendix F: Participant’s Matrix-Interviewed Property Professionals 351 Appendix G: Publications and Conference Papers 352 Appendix H: Awards 353 xi | P a g e List of Figures Figure 1-1 Research Framework.
16 Figure 2-1 Actors, Status and Aims in Property Development. 27 Figure 2-2 Property Development Process. 29 Figure 2-3 DiPasquale and Wheaton's Model. 42 Figure 2-4 Real Estate System.
44 Figure 2-5 Risks in Property Development Fused with Development Process. 50 Figure 2-6 Modelling Uncertainty in Property Development Projects. 51 Figure 2-7 Value of Management Flexibility. 57 Figure 3-1 A Research Framework.
80 Figure 3-2 Mixed Method Research Design. 89 Figure 3-3 Mixed Methods Design Strategy. 92 Figure 4-1 Modified Real Estate Development Process. 108 Figure 4-2 Conceptual Framework for Real Options/Flexibilities in Property Development.
111 Figure 4-3 Real Otpions as Risk Management Tool for Property Development.