Hunting the Higgs Boson
February 16, 2012 / By
Reports from the world of physics suggest that scientists are closing in on the Higgs boson. This sub-atomic particle is apparently the key to unlocking the deepest secrets of the universe, but until now it has evaded detection. Scientists at the CERN facility in Switzerland are, according to recent reports, ramping up their search for the boson.
Real estate analysis faces a similar challenge. Recently the Royal Institute of Charted Surveyors (RICS) held a two-day seminar in Adelaide on the subject of real options, attended by distinguished academics from the US, Singapore, China, New Zealand and, of course, Australia., as well as a few practitioners from the real world.
Real options are the rights that owners, investors … tenants…everybody in fact…have to exercise choice. In the real estate world obvious examples are options to renew or extend leases, to build or to demolish a property. As attendees at the RICS seminar learned, turnover rents in shopping centres can be modeled as real options. As a building gets older, it loses value from a future cash flow perspective, but gains optionality value.
In the world of finance, optionality value is most obviously on display when predators pay a big premium to take over a company. The right to control a company confers real optionality value on the majority shareholders. They can make decisions and implement them. Minority shareholders have no such rights.
But there is a conundrum…
If optionality is so pervasive, like dark matter in the world of cosmology, then where is it? After all, investors assess the market value of assets all the time. They conduct detailed analysis of the cash flows. They apply a discount rate. They capitalise the rents after a decent interval, say ten years. And they calculate the value.
But where is the optionality value?
There are two possibilities:
1) Either the standard valuation ignores optionality, in which case all valuations are understatements of actual market value (which seems an incredible proposition), or, more likely:
2) Those valuations incorporate optionality value but it is embedded somewhere in the DCF (discounted cash flow) valuation: just like the Higgs boson is out there, somewhere.
But, of course, if optionality is embedded in the discounted cash flow (DCF) calculation this means that either the cash flows or (more likely) the discount rates are biased. Perhaps all discount rates are too high? And perhaps this doesn’t matter too much. If you could extract optionality value as a separate constituent of value, the higher discount rate would be exactly offset by the additional optionality value. This seemed to be the broad, if tentative, conclusion from an interesting discussion at the RICS seminar in Adelaide.
DCF calculations were controversial when they were first introduced. Option pricing is at a similar stage now. The RICS seminar was only the opening broadside. Expect to hear more about real options in the future.
