I have a cousin who worked for Goldman Sachs and he is brilliant. I think he should have just moved into a professor position at MIT, but I digress. I was discussing the way loans are processed and deals are underwritten in our industry and we started to discuss the different models we were exposed to in school and how many formulas I had to remember in Grad School. One such model was Binomial Option Pricing Model. Sure we both nodded, I am sure we used it on a test.
Binomial Option Pricing Model formula as it is commonly adapted for real estate we said, but what is it really?
Binomial Option Pricing Model Formula is simple, maybe!
The Binomial Option Pricing Model calculates the value of an option by modeling the potential future outcomes of the underlying asset’s value over discrete time periods. The formula involves constructing a binomial tree to represent the possible paths of the asset’s value and then discounting the expected payoffs back to the present value.
The formula for pricing using the Binomial Option Pricing Model is:
The image actually has the formula if you are interested in ever solving it.
So there is more than one way to price real estate we surmised? Sure there is, well sometimes… The industry usually if not always defaults to; what is someone willing and “able” to pay at time of purchase seems to always wins out, unless trumped by an appraisal. Darn those models, what did that last house on that block with the same footprint sell for!?! ” That is the value of my real estate! ”
While option pricing models provide a rigorous framework for valuing real estate options, their application in real estate valuation entails challenges such as data availability, parameter estimation, and model validation. Moreover, real estate option pricing may require modifications to account for unique features of real estate investments, such as physical depreciation, property-specific risks, and market dynamics. I guess we will stick to the appraisal and sales price method, just know we all know there is a difference.
Remember when working with a lender, real estate lending is a little more complex than just taking an application online. Make sure you partner with a lender who knows what matters and also knows the Math!
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