Evaluation of the economic effectiveness of investments in commercial real estate using the switch option

Abstract

Deciding whether an investment should be made or not requires an evaluation of the investment’s effectiveness. The choice of evaluation methods is related to the basic objective conditioning the implementation of the investment project. It often happens that the conditions in which a specific investment has been formulated change and so does the basis for its implementation, and it is necessary to adapt it to the new conditions. These new conditions could be recognized during the exploitation of the project so it is hard to take them into consideration at the stage of planning. The paper aims to evaluate the investments in commercial real estate with the option of alternative way of usage. This evaluation was carried out using the classical (discounted) methods of economic efficiency of investments and real options. Two groups of pricing real options models were used in the study: binomial models and continuous-time models. Results based on varied valuation methods lead to different conclusions. Unlike the discount methods, the real option approach allows valuing the project flexibility (which cannot be valued by classical methods). This value of flexibility in certain conditions indicates what should be the path of development of the project related with the transformation of commercial real estate for other purposes.