Optimal timing of a real estate development under uncertainty

This paper recasts the land development problems of Williams (1991) and Quigg (1993) by explicitly dealing with the effects of scale elasticity of unit rental and unit construction cost in a real estate project. Two different diseconomies of scale constraints are imposed on the rental and cost variables. We assume a concave function for the rental variable with respect to the scale of development. Whereas, on the cost side, the diseconomies of scale effect of the variable component of the construction cost is incorporated via a elasticity of scale factor that is larger than unity. The comparative statics simulated positive relationships between the premium that keeps the option of waiting to develop alive and the volatilities of the unit rental and unit construction cost. It was also found that the cost elasticity of scale and the financing cost are factors that increase the premium of the waiting option, whereas, the rental yield factor reduces the incentive of waiting. A high rental yield tends to expedite a development project because the opportunity cost of not developing the land is high. In the case analysis involving a vacant land of 8,000 square meters at Spitafield, East London, a unit rental of £267.2 per square meter (psm) is obtained, which would breakeven a cash flows of the project when the traditional “invest now or never” assumption is made. Compared with the optimal unit rental of £677.0 psm estimated by the real option model, the traditional DCF results tend to accept the feasibility of the real estate project too early and at too low a cut‐off rental.