L9 Valuation of Land and Redevelopment

L9 Valuation of Land and Redevelopment - Valuation of Land...

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Valuation of Land and Redevelopment HKU Real Estate Finance K. S. Maurice Tse School of Economics and Finance The University of Hong Kong [email protected]
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Content Framework for Analysis I. D iscounted C ash F low Approach (DCF) Reference: “Valuation of the Effects of Asbestos on Commercial Real Estate,” Journal of Real Estate Research Jeffrey Fisher, George Lentz, and Kwok Sang Tse II. O ption P ricing M odel Approach (OPM) With Time Constraint to Develop : Black-Scholes OPM Without Time Constraint to Develop (in Appendix): Reference: “An Option Pricing Approach to the Valuation of Real Estate Contaminated with Hazardous Materials” Journal of Real Estate Finance and Economics, George Lentz and Kwok Sang Tse III. Valuation of Redevelopment
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Introduction This lecture note provides a set of principles on how the value of land can be determined. One key assumption underlying our analysis is that a vacant land site, if to be developed, will be developed to the highest and best use . Land is a derived asset of which its value derives solely from the optimal use of property built on it. Therefore, the pricing of an undeveloped land site requires the estimation of rental income that can be generated from the property that will be built on the land site. An important issue about land pricing is that the value of land also depends on timing of development. Land valuation also requires that we determine the optimal timing of development. Example.
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Example: Value and Timing Consider a vacant land site that is going to be developed into a residential area. Residential property will generate rental income one year after construction is completed. First year rental income is $100 and will grow at 11% per year. Property life = 2 years (at the end of yr 2, property is worthless). Construction cost today = $100 Inflation rate of construction cost = 4% per year. Cost of capital reflecting the risk = 20%. The land owner can decide when to develop the land site. How does the land value depend on the timing of development?
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Example Contd: Analysis Suppose the land is developed today. 0 1 2 3 4 5 6 -100 100 100(1.11) Value of the land site today is: 42 . 60 $ 100 2 . 1 ) 11 . 1 ( 100 2 . 1 100 2 0 = + = V
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Example Contd: Analysis Suppose the land is developed end of yr 1 Value of the land site today is: 72 . 61 $ 2 . 1 1 * ) 04 . 1 ( 100 2 . 1 ) 11 . 1 ( 100 2 . 1 ) 11 . 1 ( 100 2 2 0 = + = V 0 1 2 3 4 5 6 -100(1.04) 100(1.11) 100(1.11) 2
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Example Contd: Analysis Suppose the land is developed end of yr 2 Value of the land site today is: 14 . 62 $ 2 . 1 1 * ) 04 . 1 ( 100 2 . 1 ) 11 . 1 ( 100 2 . 1 ) 11 . 1 ( 100 2 2 2 3 2 0 = + = V 0 1 2 3 4 5 6 -100(1.04) 2 100(1.11) 2 100(1.11) 3 Value of land site if developed at yr 3 = $61.87 Value of land site if developed at yr 4 = $61.02 Key Principle in Valuation: The value of a property should reflect the BEST & HIGHEST use.
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Example Contd: Observation Land value is a function of the timing of development Land Value if Developed at Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 60.42 61.72 62.14 61.87 61.02 <61.02 Land value = ? Based on “Best & Highest Use”
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I. DCF Approach ( Fisher, Lentz , and Tse)
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