This chapter introduces you to three types of flexibilities concerning the scale or type of products (buildings) that development projects produce. These concern horizontal and vertical expansion, and flexibility in the mix of product.

14.1 Concept of Base Plan

In general, expansion options reflect the ability of the developer to add an additional quantity of built space to a “base plan” of the project. The base plan refers to the initial plan for the complete project, what the developer intends to build with a high degree of commitment. It is the reference point for our analyses.

For definitional clarity and analytical convenience, we focus on the notion of expansion options as being those that enable developers to add more total real estate product (greater amounts of built space), beyond that in the base plan.

Developers may, of course, exercise flexibility to abandon parts of the base plan. This possibility, a type of defensive option, is inherently part of the way we define the production timing options to be described in Chapter 15.

14.2 Product Expansion Flexibility

We can view expansion flexibilities as call options “in” the overall project. Or, they could equivalently be viewed as options “on” whatever is the additional product entailed in the expansion. As with all call or offensive options, they enable the developer to take advantage of better‐than‐anticipated circumstances in the relevant real estate markets (as described in Section 12.1).

We now introduce the two basic types of expansion options: horizontal and vertical. A horizontal expansion consists of building more structure across additional land, increasing the overall “footprint” of the development. A vertical expansion adds extra floors to one or more structures, without expanding the footprint, increasing the floor area ratio (FAR) of the project. (FAR is a measure of the density of construction.) Both vertical and horizontal expansion options may exist in some projects. One of the original designs for the Court Square Two project in New York City envisaged this possibility (see Figure 14.1). With a horizontal expansion option, developers obtain ownership or control over extra land, but set it aside and hold it in reserve (or “banked,” as it is sometimes called), without immediate plans for development in the original project base plan. (They may develop it to a low‐intensity use, such as parking or open space.) The cost of this extra land is the cost of obtaining the horizontal expansion option.

With a vertical expansion option, developers design buildings to allow them to add floors to the existing structure, generally while maintaining the functioning of the original lower floors. The cost of enabling such vertical expansion, in the form of both incremental construction costs and loss of building efficiency in the lower floors (less rentable space due to need for greater shafts and common spaces), is the cost of the vertical expansion option. The Bentall 5 project, described in Chapter 12, is an example of such an option, at least in the manner in which it was actually built. Another famous example is the Health Care Service Corporation (HCSC) building in Chicago.

You can see that the expansion option is like a call option because it allows the project to obtain assets that were not part of the base plan. Expansion options represent adding to the quantity of the project. Thus, they are “offensive” in nature. They enable developers to strike opportunistically to obtain a greater upside than they envisioned in the base plan, which they already viewed as being sufficient and complete. Expansion options generally become relevant and valuable in scenarios in which the real estate market turns out to be more favorable than developers expected when they settled on the base plan, or when the development has an extremely long time horizon. (For example, in the case of the HCSC building, the project was owned by the user/occupant of the building as their corporate headquarters, so the “developer” could have a virtually unlimited time horizon.)

We will note some basic considerations for modeling expansion options in Chapter 23, after we have discussed the modeling of project phases in Chapter 22. For the moment, let us simply note that, despite the cost of giving a structure the strength to carry eventual heavier loads, expansion options may actually reduce initial capital expenditures because they permit developers to build only for immediate requirements (see Box 14.1).

14.3 Product Mix Flexibility

Product mix flexibility consists of the option to change the mix of product types in a development. Also referred to as a product “switching” option, we can view this type of flexibility in two ways.

In the case of a project producing many small‐scale structures or built units, it is most appropriate to think of this option as the flexibility to vary the proportion of different types of buildings or units. For example, a housing development might involve some proportion of its output as condominiums and some as rental units, or some as upscale three‐bedroom units and some as lower‐priced efficiency apartments. The option in this case would enable the developer to change the proportions from those in the base plan.

In the case of a project producing one or a few large structures, product mix flexibility is more like a discrete option to convert the structure from one type to another just prior to (or conceivably even during) the construction process. For example, the architect might have designed the building so that it could be readily finished out as either office space or lab space, or as apartments or extended‐stay hotel rooms.

Product mix flexibility is interesting, in that it essentially involves a combination of the call and put options. Switching the previously planned product mix from Type A to Type B is the simultaneous exercise of a call on B and a put on A. The product switching option enables the developer to avoid downside outcomes in the market for either alternative type of structure, and/or to take advantage of upside outcomes for either type. The switching option is both offensive and defensive; it pushes the target curve to the right all along the curve, both in the downside and upside tails (and therefore in the middle).

The value of product mix flexibility depends heavily on the correlation between the markets for the alternative types of real estate products. The lower the correlation, the more valuable is the switching option, other things being equal (including the volatilities). The option has value only when one alternative turns out to be more valuable than the other. The likelihood of this is greater when there is less chance that the prices of the two alternatives move together. In the extreme, if the correlation were 100%, then the switching option would have no value; you would always stick with the alternative that appeared best to begin with (and which would presumably therefore be included in the base plan).

14.4 Conclusion

This chapter introduced three types of product options that build upon the developer’s original base plan:

• Horizontal and vertical expansion options, which are essentially like call options, and are effectively offensive options in the project.
• Product type switching option, to change from a base plan product type or product type mix, which is really a combination of the call and put options, and can act both offensively and defensively within the project.