A Real Options Model of Real Estate Development with Entitlement Risk

Abstract

Traditional real option theory model real estate development as a solely investor-controlled process. In reality, entitlement process is highly risky and out of control of the investors. Moreover, the real estate market in the U.S. has shown a trend towards more stringent entitlement regulation. We model entitlement process as a separate stage in development process where the investor has little control over the entitlement cost. In particular, we model the entitlement stage as a European style real option with a stochastic entitlement cost. We solved the model analytically. Our result implies interesting interaction between the entitlement risk and the developer’s investment decision.