Waiting Option

A commonly used real option in real estate development is the “Timing or Waiting Option.”

This is the case when the project’s NPV is positive, but starting it is still not rational.

Let’s assume you are a real estate developer and own land valued at $1 million. The project can be implemented in one year and requires an additional investment of $1 million. If you start the project now and complete it in one year, the return on investment will be $200,000 (10%).

Now, let’s assume there is a probability of increased demand next year, with no change in the required investment capital. If you wait, the scenario can develop in two ways: either demand will increase and your project’s profit will be $300,000, or the situation could worsen and the profit will be only $150,000.

Is it worth waiting? If we use the risk-free world assumption method and take the annual risk-free rate at 3%, we can calculate the risk-free probability of increased demand and, consequently, the value of the project’s option to delay.

In our case, this value is $37,000. This means that before starting the project, you have an asset worth $37,000 in your hands. It’s up to you to decide whether this asset compensates for the costs associated with delaying the project. In our case, since the ROI is 10% and the expected profit is $200,000, the annual cost of waiting is $20,000. Therefore, as long as the option’s value is higher than this cost, waiting is a more rational decision.

P.S.
Of course, the example is very simplified, but the key takeaway is that a positive NPV does not always mean that the project should be started immediately. It might be better to wait and observe.

P.P.S.
A similar situation is shown in the photo below, where the developer has to decide whether to build offices or a hotel. The calculation of the real option to wait tells us that up to a certain point (but not indefinitely), waiting is worthwhile until the correct choice becomes clear.

Photo and insights from the book:

Principles of Corporate Finance – by F. Allen, R. A. Brealey, & S. Myers