Natural Resources and Land Flashcards
Practice questions
- What is a split estate and in what region are split estates uncommon?
• A split estate is when the surface rights and mineral rights are separately owned. Split estates are relatively uncommon in the U.S. where private land owners tend to own both surface and mineral rights.
- List the three factors that drive the underlying asset volatility used to price an exchange option.
- The volatility of the price of the asset(s) being delivered
- The volatility of the price of the asset(s) being received
- The covariance or correlation coefficient between the prices.
- What is the name of an option with no expiration date? Would that option typically be a European option or an American option?
• A perpetual option. A perpetual option is an American option because if it were European it would never be able to be exercised and would be worthless.
- What is the name of a lot of land that is vacant, approved for development but for which infrastructure construction has not commenced?
• Paper lots
- When and why are risk-neutral probabilities used?
• Risk-neutral probabilities are often used in derivative pricing models. A risk-neutral probability may be useful to price derivatives even when investors are risk neutral because the derivative pricing model is being calculated relative to the price of the underlying asset and because the price of the underlying asset can often be viewed as already reflecting risk aversion.
- What is the role of a Timberland investment management organization (TIMO)?
• Timberland investment management organizations (TIMOs) provide management services to timberland owned by institutional investors such as pension plans, endowments, foundations, and insurance companies.
- How do agency risks and political risks relate to institutional ownership of farmland?
• An investor in farmland does not necessarily actively manage the crops. As such, the investor relies on payment from the lessee (the agent) that operates the property. The risk that the lessor (the principal or investor) does not get paid by the agent is agency risk. Political risk is the economic uncertainty due to changes in government policy that may affect returns. The investor in farmland can be hurt by such political issues such as decreases in support payments or changes in land ownership rights.
- Other than moneyness of the best available use, what are three factors regarding the uses that would cause a multiple use option to have a low value?
- High similarity among the profitability of each alternative
- Low volatility of the profitability of each alternative
- High correlation between the profitability of each alternative.
- What is the effect of smoothed asset values on the measured risks of the asset?
• Smoothed asset values mask risk thereby biasing risk estimates downward.
- What is contagion in a financial market?
• Contagion is the general term used in finance to indicate any tendency of major market movements, especially declines, to be transmitted from one financial market to other financial markets.
agency risk
is the economic dispersion resulting from the
consequences of having another party (the agent) making
decisions contrary to the preferences of the owner (the
principal).
binomial option pricing
is a technique for pricing options
that assumes that the price of the underlying asset can
experience only a specified upward movement or downward
movement during each period.
blue top lots
are at an interim stage of lot completion. In this
case, the owner has completed the rough grading of the
property and the lots, including the undercutting of the street
section, interim drainage, and erosion control facilities, and has
paid all applicable fees required.
cap rate
In real estate, this (capitalization rate) or yield is a
common term for the return on assets (7.33% in this
example).
Contagion
is the general term used in finance to indicate any
tendency of major market movements—especially declines in
prices or increases in volatility—to be transmitted from one
financial market to other financial markets.
exchange option
is an option to exchange one risky asset
for another rather than to buy or sell one asset at a fixed
exercise or strike price.
favorable mark
is a biased indication of the value of a
position that is intentionally provided by a subjective source.
finished lots
are fully completed and ready for home
construction and occupancy.
intrinsic option value
is the greater of $0 and the value of
an option if exercised immediately.
land banking
is the practice of buying vacant lots for the
purpose of development or disposition at a future date.
low-hanging-fruit priniciple
states that the first action that
should be taken is the one that reaps the highest benefits over
costs.
managed returns
are returns based on values that are
reported with an element of managerial discretion.
market manipulation
refers to engaging in trading activity
designed to cause the markets to produce favorable prices for
thinly traded listed securities.
model manipulation
is the process of altering model
assumptions and inputs to generate desired values and
returns.
natural resources
are real assets that have received no or
almost no human alteration.
negative survivorship bias
is a downward bias caused by
excluding the positive returns of the properties or other assets
that successfully left the database.
paper lots
refers to sites that are vacant and approved for
development by the local zoning authority but for which
construction on streets, utilities, and other infrastructure has
not yet commenced.
perpetual option
is an option with no expiration date.
political risk
is economic uncertainty caused by changes in
government policy that may affect returns, perhaps
dramatically.
pure play
on an investment is an investment vehicle that
offers direct exposure to the risks and returns of a specific
type of investment without the inclusion of other exposures.
risk-neutral probability
is a probability that values assets
correctly if, everything else being equal, all market participants
were risk neutral.
rotation
is the length of time from the start of the timber
(typically the planting) until the harvest of the timber.
selective appraisals
refers to the opportunity for investment
managers to choose how many, and which, illiquid assets
should have their values appraised during a given quarter or
some other reporting period.
smotthing
is reduction in the reported dispersion in a price
or return series.
split estate
is when surface rights and mineral rights are
separately owned.
TIMOs
Timberland investment management organizations
provide management services to timberland owned
by institutional investors, such as pension plans,
endowments, foundations, and insurance companies.
time value of an option
is the excess of an option’s price
above its intrinsic value.
Using the same values except that the
construction costs are fixed at $86,667 (the original expected value), find the
value of the land. Current value of the property $100,000. Value of land if economy improves $160,000. Value of land if economy falters $70,000. Risk-neutral probability of economy improvement 33.33%.
Current Value = Expected Value = (UpValue x UpProb)
+ [DownValue x (1 − UpProb)]
Find the Option Price of the Land Step One: Press 70000 → - → 86667 Step Two: Press = “-16667“ Step Three: Press 160000 → - → 86667 Step Four: Press = “73333“ Step Five: Press 0 → x → 0.6667 Step Six: Press = “0” Step Seven: Press 73333.33 → x → 0.3333 Step Eight: Press = “24444.33” Step Nine: Press 24444.33 → + → 0 Step Ten: Press = Answer: 24444.33
Return to the original values and find the value
of the land, assuming that economic uncertainty increases such that improved
properties either rise to $180,000 or fall to $60,000, with all other values
remaining the same. Following the same math, the risk-neutral probabilities are
the same (the up probability is 1/3). The value to developing is $80,000 in the up
state and $0 in the down state (the construction costs exceed the developed
value).
Current Value = Expected Value = (UpValue x UpProb)
+ [DownValue x (1− UpProb)]
Find the Option Price of the Land Step One: Press 60000 → - → 80000 Step Two: Press = “-20000“ Step Three: Press 180000 → - → 100000 Step Four: Press = “26666.67“ Step Five: Press 0 → x → 0.6667 Step Six: Press = “0” Step Seven: Press 80000 → x → 0.3333 Step Eight: Press = “26666.67” Step Nine: Press 26666.67→ + → 0 Step Ten: Press = Answer: 26666.67
Land that remains undeveloped is estimated to
generate an expected return of 5%, and land that is developed is estimated to
generate an expected single-period return of 25%. If the probability that a parcel
of land will be developed is 10% over the next period, what is its expected
return?
E(R(t)) = (P(d) x E(R(d))) + ((1 - P(d)) x E(R(nd))
Find the expected return of the Land Step One: Press 0.05 → x → 0.90 Step Two: Press = “0.045“ Step Three: Press 0.25 → x → 0.10 Step Four: Press = “0.025“ Step Five: Press 0.045 → + → 0.025 Step Six: Press = Answer: 0.07
Land that remains undeveloped is estimated to
generate an expected return of 5%, and land that is developed is estimated to
generate an expected single-period return of 25%. If 20% of land in a database is
developed in a particular year, by how much will an index based on land that
remains undeveloped understate the average return on all land?
E(R(t)) = (P(d) x E(R(d))) + ((1 - P(d)) x E(R(nd))
[(0.20 x 0.25) + (0.80 x
0.05)] = 9%.
If the annual revenue in Exhibit 10.4 is
expected to rise to $40,000 and the market cap rate rises to 8%, then with all
other values remaining constant, the farmland’s price would rise to $400,000
[($40,000 – $6,000 – $2,000)/0.08]. With a price of $360,000 and an annual
operating income of $40,000, what would the cap rate be?
Value of Real Estate = Annual Operating Income/Cap Rate
$360,000 = $40,000 / cap rate
cap rate = $40,000/$360,000
= 11.11%
