Valuing Options

Valuing Options

A valuable option has a good price and a good period. Now let me make it simple for you. Always remember this:

A good price is a cheap one

A good period is a long one

You can remember that can't you?

You want to have the price of the property bought as cheaply as possible (no surprise there!) and you want to be able to do that over the longest period of time. That is where the negotiation comes in.

Look at this example:

A property has a market value today of £100k. You find a seller who will grant you an option to buy this property in 5 years time for £110k.

So the Price is £110k

And the Period is 5 years.

Now you have to decide whether you think:

The Property's price will rise in excess of £110k over the next 5 years or not.

This is the key question you have to ask yourself. If you say I don't know then this is a good answer! No one knows.

However lets just say you think the property will be worth £150k in 5 years then the option could generate you a profit before fees of:

£150k - £110k = £40k.

So the option can make you a good return if you can keep the exercise price as low as possible and the period for as long as possible.

So to increase the value of this option of £110k over 5 years you could:

Decrease the exercise price to £108k

Increase the period to 7 years

Or decrease the exercise price AND increase the period to 6 years.

All of these things will increase the value of the option.

The key point to note is the option still may be worthless. The reason being no one knows what the property prices are going to be like next year, the year after or the year after that!

So if after a 5 year period property prices have declined and the property is now worth £90k then the option to buy at £110k is worthless. You would simply offer market value of £90k.

So I hope you can see that valuing an option is not an easy thing. It largely depends on where you think property prices are going to be. The longer the period you set the more assurity you have that prices are going to rise as property prices rise in the long term.

A typical property cycle lasts around 10-15 years so you have to say if you had an option for 15 years and property prices were currently on the line of the long term average you would be assured the long term average rate (2.9% p.a.) of property price inflation.

So the big question is:

What would you pay for an option to buy a property for £110k within a 5 year period that is currently worth £100k?

Now let me tell you the owner of the property is going to want something off you. The owner is not going to give you the option for free!

My next blog entry deals with the nitty gritty of it. I will warn you it gets complicated!

Posted on: 17th Sep 2009

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	Home Services Property News Free Resources Partners Contact Page you're viewing > Home Page > Property News > Ajay's Blog > Valuing Options Valuing Options A valuable option has a good price and a good period. Now let me make it simple for you. Always remember this: A good price is a cheap one A good period is a long one You can remember that can't you? You want to have the price of the property bought as cheaply as possible (no surprise there!) and you want to be able to do that over the longest period of time. That is where the negotiation comes in. Look at this example: A property has a market value today of £100k. You find a seller who will grant you an option to buy this property in 5 years time for £110k. So the Price is £110k And the Period is 5 years. Now you have to decide whether you think: The Property's price will rise in excess of £110k over the next 5 years or not. This is the key question you have to ask yourself. If you say I don't know then this is a good answer! No one knows. However lets just say you think the property will be worth £150k in 5 years then the option could generate you a profit before fees of: £150k - £110k = £40k. So the option can make you a good return if you can keep the exercise price as low as possible and the period for as long as possible. So to increase the value of this option of £110k over 5 years you could: Decrease the exercise price to £108k Increase the period to 7 years Or decrease the exercise price AND increase the period to 6 years. All of these things will increase the value of the option. The key point to note is the option still may be worthless. The reason being no one knows what the property prices are going to be like next year, the year after or the year after that! So if after a 5 year period property prices have declined and the property is now worth £90k then the option to buy at £110k is worthless. You would simply offer market value of £90k. So I hope you can see that valuing an option is not an easy thing. It largely depends on where you think property prices are going to be. The longer the period you set the more assurity you have that prices are going to rise as property prices rise in the long term. A typical property cycle lasts around 10-15 years so you have to say if you had an option for 15 years and property prices were currently on the line of the long term average you would be assured the long term average rate (2.9% p.a.) of property price inflation. So the big question is: What would you pay for an option to buy a property for £110k within a 5 year period that is currently worth £100k? Now let me tell you the owner of the property is going to want something off you. The owner is not going to give you the option for free! My next blog entry deals with the nitty gritty of it. I will warn you it gets complicated! Posted on: 17th Sep 2009 Bookmark: del.icio.us digg Furl Facebook Reddit Yahoo Spurl Smarking Simpy Stumbleupon Tell a friend Your name Friends email 2008 2009 2010 2011

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