Generalized Real Renovation Options

This paper revisits Williams (1997) on the effect of net rental price, asset quality and variable investment costs on the asset redevelopment decision. This paper develops a quasi-analytical method for solving the generalised real renovation option problem by treating the investment cost as having both a variable and a fixed element and then extends the analysis for the case where both the net rental price and asset quality are stochastic. Analysis on the generalised renovation option shows in common with previous real options analyses on investment opportunities that the renovation decision is triggered when the incremental net rental value exceeds the investment cost by a mark-up factor exceeding unity. The solution to the variable cost investment function is derived from the generalised model as a special case. The quasi-analytical method reveals hitherto latent conditions constraining the scope of values the various parameters can take, and in particular that the net rental price volatility limits the range of the risk-free rate. This result holds also when both net rental price and asset quality are stochastic. The paper finishes by considering the effect of the generalised renovation option on the original option to invest. JEL Classifications: D81, G31