D’Alpaos C., Marella G.(2014).
Urban Planning and Option Values. Applied Mathematical Sciences, Vol. 8, 2014, no. 158, 7845 – 7864.
Abstract:
Starting from the late 1990’s, innovative regulation mechanisms and laws were introduced in the Veneto Region with the aim of encouraging real estate investments and urban development. Urban development involves the social, economic and physical transformation of cities and requests high capital outlays and relevant financial resources that, due to stringent budget constraints, forces Public Administration to public private partnerships. In this respect, when introducing public-private partnership in urban planning many questions arises on the benefit sharing and relative valuation procedures between private operators and Public Administrations. The crisis of the real estate market jointly with the global financial crisis that erupted in 2007, made investors and developers more cautious on the evaluation of private benefits generated by negotiation in urban planning and it highlighted the limits of evaluation procedure so far adopted by Public Administrations and the need for innovative valuation approaches. Present evaluation procedures implicitly assume that developers invest immediately and start properties construction confident on favorable market absorption and increasing real estate market prices. This assumptions is no more realistic. In time of financial crisis when the future is uncertain and investments are more illiquid, private investors changed their investment strategy: they might rather defer investments and negotiation with Public Administration in order to gain higher payoffs in the future. In this changing scenario, investment timing flexibility plays a key role on developer’s investment strategies as it gives the entrepreneur the option to strategically decide the optimal investment timing and significantly contributes to profit maximization and hedging of risk. It is widely recognized that the NPV rule and traditional Discounted Cash Flow (DCF) analysis fail because they cannot properly capture managerial flexibility to adapt and revise later decisions in response to unexpected market events. DCF approaches presume investor’s passive commitment to a “certain static operating strategy”, but as new information arrives and uncertainty about future cash flows is gradually resolved, management may have valuable flexibility to alter its initial operating strategy in order to capitalize on favorable future opportunities. Aim of the paper is to provide a theoretical model to determine the value of flexibility to defer in integrated urban development and public private partnership. The land owner has the possibility to decide whether and when it is optimal to invest and is holding a real option analogous to a financial call option. If optimally exercised, this option value may increase the investment payoff and alter the investment timing.
