Land Development: Risk, Return and Risk Management

Posted: 31 Aug 2007

See all articles by Richard J. Buttimer

Richard J. Buttimer

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law

Steven P. Clark

University of North Carolina (UNC) at Charlotte

Steven H. Ott

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law

Abstract

We model and examine the financial aspects of the land development process incorporating the industry practice of preselling lots to builders through the use of option contracts as a risk management technique. Using contingent claims valuation, we are able to determine endogenously the land value, presale option value, credits spreads and the effects of presales on debt pricing and equity expected returns. We show that using presales options effectively shift market risk from the land developer to the builder.

Results from the model are consistent with the high rates of return on equity observed in empirical surveys; they also suggest that developers may be justified in pursuing projects with substantially lower expected returns to equity when a large number of lots can be presold. Additionally, we show that presales reduce default risk dramatically for leveraged projects and can support a considerable reduction in the cost of construction financing. Large debt risk premiums are justified for highly levered projects, which helps explain the use of mezzanine financing in the land development industry to reduce expected default costs.

Keywords: land development process, preselling, risk management, real options

Suggested Citation

Buttimer, Richard J. and Clark, Steven P. and Ott, Steven H., Land Development: Risk, Return and Risk Management. Journal of Real Estate Finance and Economics, Vol. 36, No. 1, 2008, Available at SSRN: https://ssrn.com/abstract=1010714

Richard J. Buttimer (Contact Author)

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law ( email )

9201 University City Blvd.
Charlotte, NC 28223
United States
704 687-6219 (Phone)

Steven P. Clark

University of North Carolina (UNC) at Charlotte ( email )

9201 University City Boulevard
Charlotte, NC 28223
United States

Steven H. Ott

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law ( email )

9201 University City Blvd.
Charlotte, NC 28223
United States
704-687-2744 (Phone)
704-687-6987 (Fax)

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