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Question - You consider buying a lot on which you will build a small apartment complex. The asking price for the lot is $2,000,000 and the estimated cost to build the apartment complex is $5,000,000 (construction should take one year). One year from the date you intend to purchase the lot the city is going to make an important decision regarding the use of the land just across from your lot. You believe that there is a 35% chance that the decision would be favorable to you and a 65% chance that it would be unfavorable. In case of a favorable or unfavorable outcome your complex should generate an NOI of $400,000 or $300,000 respectively. For simplicity, you may assume that at any time you can sell your complex for a 5% CAP and your required rate of return is 8%.
Required -
a. Calculate the value of the lot using the traditional approach.
b. Calculate the value of the lot using the real option approach.
c. Should you buy the lot?
d. In case that you decided to buy the lot, should you build the apartment complex right away or wait for the city to make its decision first?
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