With the Real Estate Call Option property owner can sell an option in exchange for debt-free cash today.
Investor, who buys the Real Estate Call Option, benefits from property price appreciation and price volatility. Let us walk through a specific example.
As an example, let us take a homeowner who lives in La Jolla, CA and the price of his or her home is $1 million, derived from the last sale date and sale price of the property.
Further, the homeowner believes that the price of the home in 5 years will not be above $1.2 million and he is willing to sell any upside above that price. In exchange, the homeowner will receive debt-free cash today.
On the other side, an investor believes that the price of that specific property will be above $1.2 million in 5 years. The investor wants to profit from the price appreciation above $1.2 million and is willing to purchase a call option.
To create a contract based on the above example, the homeowner sells a call option for a term of 5 years and with an expected future price of $1.2 million, which is called a strike price. Investor can price such an option given data about price volatility and risk-free investment return rate by using binominal trees or Blacks-Scholes methodologies. Investor can use pricing tools provided to price an option. In our example, the homeowner should get $60,321 today. This position can be demonstrated with the following graph.
In 5 years, the investor payoff is based on an observed price of the property which is determined from publicly available price index data. Learn how property price is derived. If the observed price is above the strike price of $1.2 million, the investor gets the difference. In our example, if the price is $1.4 million, the investor receives $0.2 million ($1.4 less $1.2 million).
On the other hand, if the observed price is below the strike price of $1.2 million, the investor gets nothing. Property owner received the money for the option which expired worthless.
A call option position has risk-return tradeoffs similar to holding properties, with following benefits:
- Investors benefit from appreciation in real estate price changes, similar to buying and holding properties
- Investors benefit from diversification with investment in the mixed-asset portfolio
- Homeowners who plan to buy actual property over time can “locks-in” current property market price
- Inflation hedge to the extent real estate price change is correlated with inflation