Investors buy the Real Estate Call Options,
to benefit from property value appreciation and volatility. Let us walk through a specific example.
As an example, let us take a property in La Jolla, CA and the current derived value is $1 million, which is derived from the last sale date and sale price of the property. Learn how property price is derived.
IRESE underwrites the Real Estate Call Options contract with a term of 5 years and strike value of $1.2 million.
An investor believes that the value of that specific property will be above $1.2 million in 5 years. The investor wants to profit from the property value appreciation above $1.2 million and is willing to purchase this Real Estate Call Options.
The Real Estate Call Options contract based on the example is a call option for a term of 5 years and with an expected future value of $1.2 million,
which is called a strike price. Investor can price such an option given data about price volatility and risk-free investment return rate using binominal trees or Blacks-Scholes methodologies.
IRESE provides research tools to help investors to price an option. In our example, the contract is valued at $60,321 today. The contract is divided into 1,000 units called shares, each valued at $60.321. Investor can purchase a minimum of 1 share and maximum of 500 shares (up to 50% of any individual contract).
The payoff can be demonstrated with the following graph.
In 5 years, the investor payoff is based on an observed value of the property which is determined from publicly available price index data.
If the observed value is above the strike price of $1.2 million, the investor gets the difference. In our example, if the property value is $1.4 million, the contract payoff is $200,000 or $200 per share. Thus investor return per share is $140 or 47% per year ($200 - $60 = $140).
On the other hand, if the observed value is below the strike price of $1.2 million, the investor gets nothing and the option which expired worthless.
A call option position has risk-return tradeoffs similar to holding properties, with following benefits:
- Investors benefit from appreciation in real estate values, similar to buying and holding properties
- Investors benefit from real estate values volatility by trading in and out of options contracts
- Investors benefit from diversification with investment in the mixed-asset portfolio
- Inflation hedge to the extent real estate price change is correlated with inflation