Empirical Testing of Real Options in the Hong Kong Residential Real Estate Market

Hong Kong has been using the leasehold system of land management rather than freehold since its colonial era. This system controlled and presently still controls uses of leased land through leasehold conditions. Many leases granted decades ago thus require formal modifications to lease conditions to formalize proposed changes in land use, or to realize the actual present economic value of the land, or to reflect the current market demands. From a real options analysis perspective, these land use conversions and analysis of real options associated therewith are significantly more complex than typical stylized land development real options encountered in academic literature and research. There is thus considerable interest in obtaining empirical evidence of the performance of real options valuation in land development applications, where options associated with land development rights are substantially constrained due to regulatory influences. The aim of this research is to outline major factors in operationalizing academic real options research for practical application in a particular land market with significant regulatory constraints, and then test two propositions derived from academic real options literature using actual residential real estate development projects in Hong Kong which require leasehold land conversion under statutory planning and zoning regulations as source of data. Typically past land use conversions in Hong Kong required developers to acquire raw or other redevelopable land through private negotiations with initial land lease owners and to wait for public provision of infrastructure and services, before applying for formal and legal conversion from a lower to higher land use. Our study concentrates on the period between when land is acquired and when actual construction of the development starts, and as becomes clear, the regulatory framework that governs land development significantly narrows typical real options as perceived in academic land development literature. Keyword: Lease modification; real option; empirical testing