From the Real Estate Call Options example provided here, let’s assume that a property is in La Jolla, CA and the derived value of the property on January 1st, 2008 at $1m. Considering a historical rate for San Diego real estate returns, it is likely that the house price will appreciate to, say, $1.4m in 5 years.

We use binominal pricing and historical price volatility. Below are four Real Estate Put Options scenarios, which differ by strike price.

Let’s review Option 1

The property is valued on Jan 1st, 2008 at $1m. The term of the call option is 5 years with a strike price of $1.1m. An investor purchases this option contract and pays $100 per share today. The value of the house on Jan 1st, 2013 is $1.4m. Option payoff is the difference between the strike price of $1.1m and property value in year 5 of $1.4m which is $300,000 or $300 per share. Thus, the investor who invested $100 today per share, receives $300 in 5 years with accumulated return of 200% and an annualize return of 40%. This option is “in the money.” Options 1, 2 and 3 are all “in the money.”

In contrast, let’s review Option 4

The property is valued on Jan 1st, 2008 at $1m, the term of the call option is 5 years with a strike price of $1.5m. An investor purchases this option and pays $5 per share today. The property value on Jan 1st, 2013 is $1.4m. The property value is below the strike price of $1.5m and, therefore, the investor payoff is $0. Thus, the investor gets nothing and loses $5 per share. This option is “out the money.”