Natural Resources and Land

Question 1

1. What is a split estate and in what region are split estates uncommon?

Answer 1

• 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.

Question 2

2. List the three factors that drive the underlying asset volatility used to price an exchange option.

Answer 2

• 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.

Question 3

3. What is the name of an option with no expiration date? Would that option typically be a European option or an American option?

Answer 3

• 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.

Question 4

4. What is the name of a lot of land that is vacant, approved for development but for which infrastructure construction has not commenced?

Answer 4

• Paper lots

Question 5

5. When and why are risk-neutral probabilities used?

Answer 5

• 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.

Question 6

6. What is the role of a Timberland investment management organization (TIMO)?

Answer 6

• Timberland investment management organizations (TIMOs) provide management services to timberland owned by institutional investors such as pension plans, endowments, foundations, and insurance companies.

Question 7

7. How do agency risks and political risks relate to institutional ownership of farmland?

Answer 7

• 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.

Question 8

8. 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?

Answer 8

• High similarity among the profitability of each alternative
• Low volatility of the profitability of each alternative
• High correlation between the profitability of each alternative.

Question 9

9. What is the effect of smoothed asset values on the measured risks of the asset?

Answer 9

• Smoothed asset values mask risk thereby biasing risk estimates downward.

Question 10

10. What is contagion in a financial market?

Answer 10

• 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.

Question 11

agency risk

Answer 11

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).

Question 12

binomial option pricing

Answer 12

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.

Question 13

blue top lots

Answer 13

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.

Question 14

cap rate

Answer 14

In real estate, this (capitalization rate) or yield is a
common term for the return on assets (7.33% in this
example).

Question 15

Contagion

Answer 15

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.

Question 16

exchange option

Answer 16

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.

Question 17

favorable mark

Answer 17

is a biased indication of the value of a

position that is intentionally provided by a subjective source.

Question 18

finished lots

Answer 18

are fully completed and ready for home

construction and occupancy.

Question 19

intrinsic option value

Answer 19

is the greater of $0 and the value of

an option if exercised immediately.

Question 20

land banking

Answer 20

is the practice of buying vacant lots for the

purpose of development or disposition at a future date.

Question 21

low-hanging-fruit priniciple

Answer 21

states that the first action that
should be taken is the one that reaps the highest benefits over
costs.

Question 22

managed returns

Answer 22

are returns based on values that are

reported with an element of managerial discretion.

Question 23

market manipulation

Answer 23

refers to engaging in trading activity
designed to cause the markets to produce favorable prices for
thinly traded listed securities.

Question 24

model manipulation

Answer 24

is the process of altering model
assumptions and inputs to generate desired values and
returns.

Question 25

natural resources

Answer 25

are real assets that have received no or

almost no human alteration.

Question 26

negative survivorship bias

Answer 26

is a downward bias caused by
excluding the positive returns of the properties or other assets
that successfully left the database.

Question 27

paper lots

Answer 27

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.

Question 28

perpetual option

Answer 28

is an option with no expiration date.

Question 29

political risk

Answer 29

is economic uncertainty caused by changes in
government policy that may affect returns, perhaps
dramatically.

Question 30

pure play

Answer 30

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.

Question 31

risk-neutral probability

Answer 31

is a probability that values assets
correctly if, everything else being equal, all market participants
were risk neutral.

Question 32

rotation

Answer 32

is the length of time from the start of the timber

(typically the planting) until the harvest of the timber.

Question 33

selective appraisals

Answer 33

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.

Question 34

smotthing

Answer 34

is reduction in the reported dispersion in a price

or return series.

Question 35

split estate

Answer 35

is when surface rights and mineral rights are

separately owned.

Question 36

TIMOs

Answer 36

Timberland investment management organizations
provide management services to timberland owned
by institutional investors, such as pension plans,
endowments, foundations, and insurance companies.

Question 37

time value of an option

Answer 37

is the excess of an option’s price

above its intrinsic value.

Question 38

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%.

Answer 38

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

Question 39

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).

Answer 39

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

Question 40

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?

Answer 40

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

Question 41

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?

Answer 41

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%.

Question 42

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?

Answer 42

Value of Real Estate = Annual Operating Income/Cap Rate

$360,000 = $40,000 / cap rate

cap rate = $40,000/$360,000
= 11.11%