This chapter suggests some ways to think generally about options in real estate development projects. Specifically, we present a three‐way typology to place these options into an overall context.

13.1 Three Dichotomies for Thinking Generally about Development Options

As we noted in Chapter 3, the terms “flexibility” and “option” overlap considerably in the context of this book. Developers have certain types of flexibilities that do not fit the technical economics definition of an “option.” An example is the resale timing flexibility of an existing property we explored quantitatively in Chapter 9. But we can view most of the types of development flexibility that we focus on in this book as options, at least conceptually, pretty much as we defined them in Section 12.1.

At this stage, we introduce three general ways to think about options in development projects. The idea is to help us think about what we can use options for, how we can implement them, and what they consist of. It is helpful to discuss these issues in terms of dichotomies, of contrasts between opposites along different dimensions. We suggest three contrasts:

• Defensive versus offensive options;
• Options “on” versus options “in” the project; and
• Timing options versus product options.

13.2 Defensive versus Offensive Options

From the perspective of investment or project management, we can often think of options in real estate development as being either “defensive” or “offensive” in nature. Specifically:

• Defensive options help to protect against downside circumstances and outcomes, if things turn out worse than anticipated.
• Offensive options allow the developer to take advantage of upside opportunities, if things turn out better than expected.

Relating to the concepts we introduced in Section 12.1, offensive options are often call options. They allow the developer to obtain something, provided the circumstances are right, that would not have otherwise been possible. For example, the ability of the Bentall 5 project developers in Vancouver to build an additional five floors on top of their building, when/if the market would provide sufficient demand, is an offensive option that we could view as a call option.

Defensive options are often like put options. They allow the developer to avoid a loss, at least at the margin. For example, if the original Bentall 5 planners had intended to build the full 27‐story building, then the ability to pause or stop at 22 floors if demand did not turn out as strong as they had anticipated, is a defensive option that we could view as a put option. (The developers could “sell” the top five floors for a certain NPV of zero, rather than the negative NPV they would get if the incremental value of the top five floors would be less than their incremental construction cost.)

As is so often the case, in the Bentall 5 project, the call option on the top five floors was also a put option on them, depending on perspective and on which design is made as the original “base plan.” Were the developers starting out planning to build a:

• 22‐floor building with the call option to add five floors? or a
• 27‐floor building with the put option to reduce the size if desirable?

The ability to look at the same thing from two different angles can usefully help designers and decision‐makers build intuition and understanding about possibilities for flexibility.

It is helpful to think of defensive options as “insurance.” While they do not provide traditional insurance policies, they fulfill the same function. They enable developers to avoid losses, at the cost of preparing the option (such as designing in the ability to reduce the size of a building). Placing options in this context helps us to recognize that an option that we do not use is not “wasted.” We do not complain to our life insurance broker that he wasted our money because we did not die last year! When you buy insurance, you buy “protection”—that is worth something even if you never end up cashing in on it.

We can also think of “offensive” options in the same light. In this case, they provide “opportunity”—to take advantage of upside opportunities when and if they are present. (Section 15.6 expands on this concept.)

13.3 Options “On” and “In” Projects

In the field of engineering systems design, the concept of options “on” versus options “in” a project refers to whether the option is on the system as a whole (“on” the project) or concerns some detailed portion of the system (“in” the project). When it concerns some constituents of the project, it typically refers to some elements of technical design. The Health Care Service Corporation (HCSC) building in Chicago provides a classic example of options “in” a project. The technical elements that enabled the owners to double the height of their 30‐floor building years after it opened consist of such things as stronger columns and footings, extra elevator shafts, etc. (see Figure 13.1).

In the case of real estate development, a useful way to view this concept is that options:

• “On” the project apply to the entire project, or to a large component of it as a whole;
• “In” the project apply at a more specific or granular level within the project or inside its major components.

Thus, the option to choose the timing of when (and whether) to begin the overall project, or a major phase of the project, would be an option “on” the project (or “on” a phase of the project). The option to time the start of a project, discussed in Chapter 12, is the most basic example of an option “on” a real estate development project.

In contrast, an option “in” a project might be the ability to pause and restart the project at any time after it has already begun (in effect, the ability to delay the completion of the project after it has begun). The ability to switch the type of building on a particular site from one use to another (such as from rental apartments to condominiums, or from office space to lab space) is another example of an option “in” the project.

The distinction between options “on” versus “in” can be rather fuzzy and ambiguous, and does not necessarily matter. As with the case of puts and calls (defensive and offensive options), the usefulness of the concept is not negated, and can even be enhanced, by the ability to look at design features from either or both perspectives.

13.4 Timing Options versus Product Options

The final dichotomy that can be useful for conceptualizing development options is between “timing” options and “product” options. Timing options are about when to build, while product options are about what to build. Timing options provide the developer with flexibility to decide the time when to start or complete a project, or some component of it. Product options give the developer flexibility about what type or size (density) of structures to build.

As with the other dichotomies, the timing/product dichotomy also includes some overlap in practice, even though the conceptual distinction is useful. For example, the vertical expansion option in the Bentall 5 development was certainly a product option. It gave the developers flexibility to decide the final size and height of their real estate product (the office building). But this option also included timing flexibility, as the developer could delay indefinitely (or at least for several years) the decision to exercise the call option (the expansion to 27 floors).

Note that timing options can have different degrees of flexibility. Some may only exist over a limited time, perhaps because planning permissions may expire. Others might be subject to uncertain limitations. For example, the governmental authorities might exercise some right to change zoning regulations describing permissible use (this was a concern for HCSC). In some cases, developers may effectively have the right to exercise their timing option at any time.

In general, timing options can be subtle. For example, in the field of financial options, analysts speak of “European,” “American,” and “Bermudan” options. You can only exercise European options at one point in time, and, if you don’t, you lose them forever. You can exercise American options at any time (at least until an expiration or maturity date, if the option is not perpetual). You can exercise Bermudan options at several possible times, but not at just any time. The point is that timing options can differ.

13.5 Conclusion

This chapter invites you to think generally about flexibilities in terms of:

• Use: Are they for exploiting new opportunities (offensive) or insuring against downside events (defensive)?
• Application: Do they apply to the whole project (“on”), or to some parts of it (“in”)?
• Type: Do they refer to the product, or merely to its timing of its start or completion?

The following two chapters will explore in more depth the two major option types: product and timing options.