APPLICATION OF OPTION PRICING THEORY IN PRIVATE RESIDENTIAL LAND PARCELS IN THE GOVERNMENT LAND SALES PROGRAMME

Abstract

Past works have ascertained that the Net Present Value (NPV) approach undervalue the true value of investment as it does not takes into consideration the flexibility to alter any course of action over time. Therefore, this leads to the evolution of the real option application which is a better investment decision making tool. This approach takes into account the embedded option values in the development. The research targets at 110 residential private non-landed land parcels in Singapore. It explores the local developers' bidding behaviour and also determines the relationship of the real option valuation and the traditional NPV approach. The model used to compute the embedded option premium in the land parcels is similar to the theoretical land option valuation model that Sing & Patel (2001) had used to estimate the option value to wait in the United Kingdom (UK) context. There are two different assumptions made for the intrinsic land value: 1) in a deterministic scenario when volatility is 0, and 2) the winning tender bids. However, emphasis is made on the latter as it reflects the true bidding style of the investors. The research concludes that local investors recognise the benefit of the real option application and had incorporated the embedded option values in their tender bids. In addition, it is shown that when there are more uncertainties, especially in bad market conditions, the option premium is higher. Furthermore, there is a close relationship with the computed land value with option value as well as the NPV. This proves that the NPV approach and real option application are complementary in their relationship. Last but not least, the regression results revealed that variables such as the land area, selling price, construction costs as well as the type pf property are significant factors that explain the variation in the option premiums of the land parcels.