A Real Options Model of Real Estate Development with Entitlement Risk

Abstract

Real option theory models real estate development as a developer-controlled exercise of an option to construct the optimal structure at the optimal time. In practice, most projects encounter a highly uncertain entitlement (i.e., regulatory approval) process that is largely uncontrollable by the developer. In this study, entitlement is modeled as a separate stage in a compound development option, where the developer begins with minimal control and maximum risk, and each successful stage increases control and reduces risk. We solve the model analytically, provide three-dimensional numerical comparisons, and empirically test the model's predictions using manually collected data from rezoning petitions. Our main result implies that developers initiate the entitlement process early in order to counter uncontrollable delay and exogenous risk. Accordingly, a municipality attempting to moderate development via the entitlement process may find more applications filed instead of discouraging construction. Overall, our study refines the development option model, where developers first invest early (secure entitlements) and then subsequently delay investment (wait to construct the optimal building at the optimal time).

Keywords: Real options, entitlement, development, real estate, regulations

JEL Classification: R11, R14, R21, R31, R33, R52