The option to change the use of a property when future property values and construction costs are uncertain

This paper models the decision to change the use of a property when its value in the current use and the new use, as well as construction costs, are uncertain. In the case of development of vacant land, when cash flows and construction costs are lognormally distributed, the development of the property optimally takes place when the ratio of benefit to cost of development reaches some fixed level. In the redevelopment case, the timing problem is found to be more complex, as the cost of exercising the conversion option consists of two parts, the construction costs and the surrendered value of the property in the current use, which may evolve differently over time. In this case, optimal redevelopment will take place for different benefit-cost ratios, depending on the relative sizes of the property values in the different uses and the construction costs. Also, for a given current benefit-cost ratio, the option value will vary significantly, depending on the relative size of the state variables. Copyright © 2001 John Wiley & Sons, Ltd.