Empirical Testing of Flexibility Values in Land Auction Price

1. Empirical Testing of Flexibility Values in Land Auction Price SHEN Jianfu and FrederikPretorius Department of Real Estate & Construction The University of Hong Kong June 2012

2. Outline of Presentation • Background • Research Question • Literature Review and Development • Hypotheses • Data and Variables • Empirical Results and Explanations • Conclusion

3. Background • Vacant land can be considered as real option and evaluated in the option pricing framework; • In the theory, asset valuation is conducted at project level; • Yet in the practice the investment decision and asset valuation are made at the firm level; • Some firm issues involve in asset valuation: asset interdependence, capital structure, agency problem, managerial factors; • The flexibility values of real asset are not only generated by real option embedded in the asset, but also determined by the firm’s flexibility in exercise process; • The firm operation on the asset/project may alter the underlying asset price, exercise price or the nature of uncertainty; • Land auction in Hong Kong: in order to win the auction, the firm should give sufficiently high bid which may reflect its specific flexibility value.

4. Research Questions • Does land auction price contain the option value implied by the classical real option theory? • Does land auction price reflect the value of other flexibility associated with firm characteristics? • Does firm fundamental affect its land valuation and the auction results?

5. Literature Review and Development • Real option theory: view the vacant land as real option that has the right/flexibility to delay the investment, alter land use, change capital density and others. Titman(1985) and other studies. • Implications: the flexibility is valuable; the investment decision is not static (“now or never” in the NPV framework), but dynamic; the volatility of underlying asset increases option value; the option value increases with interest rate; and others. • The value of waiting to invest: through waiting, capturing the upside benefits while avoiding downside loss. Empirical studies, Quigg(1993) in US land market and Chiang, So and Yeung (2006) in Hong Kong land auctions.

6. Literature Review and Development • Interactions of multiple real options on one asset: multiple options on one underlying assets may cause super-additive or sub-additive values according to the nature of the options, Trigeorgis (1993a); Grenadier (1995) values the dynamic flexibilities from owning properties for which owners can choose the optimal tenant mix; • Interactions of multiple assets/projects: Moel and Tufano (2002) argue that the mining companies may have a large portfolio of mines and mining rights, in which the investment decision in one mine would affect others’; • The forms of direct interactions: In oil exploration industry, the information option and learning from one project can help resolve geological uncertainty and avoid the downside tail of the outcome distribution in another project (Dias, 2006, Smith and Thompson, 2008); two oil fields located together can share oil pipelines and other infrastructure, which save the total costs for development (Dias, 2006). In biotech industry, R&D projects competing with each other for the same product are substitutive and lead to sub-additive value summation (Vassolo et al., 2004, Girotra et al., 2007); • Interactions of financial flexibility and real option: financial flexibility gives value to the equity holders because they have the default option on the debt and if the lenders provide capital with cost lower than equilibrium return, Trigeorgis(1993b); • Financial constraint and capital structure: due to the constraint, projects among the firm compete with each other; external capital cannot substitute the internal fund; capital costs vary with different capital structure;

7. Interactions in Real Estate Firms • The land auction price contains several sources of flexibility value: • The value of interactions: positive locational externalities, agglomeration economy and cost saving in co-development. • Large-scale residential estates integrate recreational, shopping and social facilities, which may produce a premium of 15% above the price of non-integrated estates due to the internal agglomeration economy. • By providing common facilities to its properties in the neighborhoods, the firm may enjoy benefit of increasing property price. • Saving cost through co-development. • The financial flexibility/inflexibility: competition for limited firm resources; financing ability to capture the auctioned land opportunity and facilitate the exercise of real estate projects.

8. Hypotheses • Hypothesis One: the option premium in the auctioned land is expected to increase if the volatility of underlying property is large. • Hypothesis Two: the option premium is negatively related with rental yield of the underlying property. • Hypothesis Three: the option premium is positively related with interest rate. • Hypothesis Four: the option premium is positively related with property price. • Hypothesis Five: the option premium is negatively related with construction cost. • Hypothesis Six: the option premium is expected to be positive with the amount of potentially interacted properties in the firm. • Hypothesis Seven: the option premium reduces if the firm has made large capital expenditure in other projects. • Hypothesis Eight: the option premium reduces if the firm has invested in assets with higher returns. • Hypothesis Nine: the option premium is positively related to the internal funds in the firm. • Hypothesis Ten: the flexibility value is positively related with preserved debt capacity in the firm.

9. Data and Variable Description • Data resources: land auction information provided by EPRC Ltd; the property information in the Rating and Valuation Department; DataStream; Annual reports of listing real estate companies, Hang Seng Index. • Data sample: 188 cases of residential use auctioned land from 1992-2011; • Dependent variables: option premium is the ratio of final auction price divided by reserve price; and the winning dummy for the participant companies in the land auctions. • Independent variables: Property price, property return, volatility, construction cost, rental yield, built from Indices; market return from Hang Seng Index; • 79 auctioned land—firm cases: MTB, ROA, Long Term Debt, Net Tangible Asset, Disposed Fixed Asset, Capital Expenditure, Cash Flow from DataStream; • Investment Property, Ongoing Project from annual reports of participant firms. • Methodology: OLS regressions and probit analysis

10. Empirical Results: Classical Option Theory

11. Empirical Results: The Testing of Portfolio Effects

12. Empirical Results: The Testing of Competition Effect

13. Empirical Results: The Testing of Financial Structure

14. Robustness Test: Winning Probability and Portfolio Effect

15. Conclusions • Empirical studies only partially confirm the predictions of classical real option theory. • Positive interaction between the potential project in the auctioned and existing properties generates positive synergy for the firm, which in turn increases the option premium in the firm. • The competition effect, due to the resource constraints in the firm, may lead to lower option premium. • The financial flexibility in the firm, especially as sufficient internal funds, also is shown to have a positive impact on the option premium.

16. Q&A