Academic journal article International Journal of Business

Real Options: An Alternative Valuation Model for the U.S. REIT Market

Academic journal article International Journal of Business

Real Options: An Alternative Valuation Model for the U.S. REIT Market

Article excerpt


REITs are alternative investments that offer asset managers high returns and diversification opportunities. In an active management process, securities selection and more specifically their valuation is a key component of future performance. In this paper, we propose a model that combines a Discounted Cash Flow model with real options in order to take into account the different drivers of real estate investment value, such as net asset value, future rentals income and capital expenditures policy. Our theoretical model for Real Estate Investment Trusts provides an average spread around 16% compared with the market value.

JEL Classifications: G11, G13, R32

Keywords: real estate investments; DCF; real options; asset valuation


Institutional investors began to take interest in real estate markets at the beginning of the 1980s due to their potential for growth, their risk diversification benefits and as inflation hedging instruments. Real estate is traditionally considered as a safe haven when financial markets are unstable. Investors can access the real estate market directly by purchasing buildings, land, shopping centers, office space; or indirectly by investing in real estate investment trusts. Direct investment in real estate is characterized by a lack of liquidity, significant transaction sizes, a degree of opacity, and high levels of heterogeneity. On the contrary, real estate investment trusts provide investors with exposure to the real estate sector without liquidity constraints given that they are stocks listed on financial market. This relative lack of liquidity in real estate investments tends to smooth performance and reduce volatility levels (Fisher, Gatzlaff, Geltner, and Haurin, 2003). In a portfolio management strategy, real estate is considered as an alternative investment. Westerheide (2006) shows that REITs are a class of assets on their own that evolves differently from stocks and bonds. These features have justified real estate investment to spread the risk inherent in a portfolio made up entirely of traditional assets (stocks, bonds and cash). Simon and Ng (2009) show that real estate plays this role in spreading risk even more when the stock market is bearish. Real estate distinguishes itself by its defensive character, being less sensitive to the macro-economic environment than traditional classes of assets. According to Hoesli, Lekander, and Witkiewicz (2004), real estate leads to a reduction of 5-10% in total portfolio risk, and nearly 20% when international real estate investments are taken into account.

In a "top down" analysis, the selection of the best stocks in the real estate industry is a key performance factor. The selection of stocks to include in a portfolio is traditionally based on classic discounted or multiple valuation models. Real estate investments include options such as the utilization of property reserves, extension, renovation (brownfield sites) or the renewal of leases. These options ought to be included in valuation models. In practice, managers react to events and modify their strategy with the use of additional information. Such flexibility is lacking in standard discounted models, which make their valuation based on a single scenario for future cash flow. Flexibility based on monitoring investments with regard to incoming information is rather like an option. According to Copeland, Koller, and Murrin (2000), the development of option theory is a real innovation in the field of corporate valuation. Options take into account the ambiguous, dynamic features of financial projects. Our article proposes a valuation model of REITs that adds real options to traditional discounted cash flow. Using securities that are on both the FTSE/EPRA NAREIT North America index and the S&P 500 Index, we analyze price differences between our theoretical model with options and the market. Our paper is organized as follows. …

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