| Summary: | The real estate development in emerging economies such as in China presents great uncertainty due to unstable macroeconomic conditions and regulatory changes over the life of the investment project. The traditional valuation approach Discount Cash Flow (DCF) model may be insufficient to evaluate real estate project since it cannot properly deal with the uncertainty, irreversibility and managerial flexibility of the real estate investment and thus lead to inadequate decision has been made. Instead, this paper will use a real option approach which remedies these shortfalls and provides a more scientific
valuation for a real estate investment project.
There are substantial applications of real options in real estate development that can be
found in the literature and most of the real estate literatures look at the value of an option
to wait or defer and suggests that the uncertainty makes deferring an investment more
valuable than immediate investment. However, most of these studies assume that the
evolution of underlying asset value follows a geometric Brownian motion process and did
not taken into account any jump behaviour in the real option valuation such as the
regulatory shocks, thus this paper will follow the line of previous research that focus on
the analysis on the optimal timing of a real estate investment case and extend the existing
model with addition of a fixed jump process that incorporating the regulatory risk into the
real option analysis. Moreover, the innovative feature of this paper is to estimate the jump
parameters through an event study methodology which can effective capture the impact
of the regulatory change on the real estate company in terms of the abnormal returns on
the company's stock price during the event day.
The result of this study confirms the previous research findings that the value of the
investment with the option to defer is greater than the NPV of the project and the trigger
value to invest is above the current project value. Thus waiting to invest is better than
immediate investment. However, the regulatory shocks result in a negative impact on the
value of a project and lowered the trigger value as well as the value of the investment.
Thus, delaying an investment too long may result in a loss on the project.
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