Valuation of farmland using real options theory: An economic analysis of the impacts of urban development on Ohio farm real estate

Just like a corporate investment opportunity, owning farmland always involves a call option because the owner/farmer has the right, but not the obligation, to keep the land in farming or to sell it for a development. Exercising this real call option means that the owner is selling the land and hence closing the doors to all the future opportunities that might be brought by the land being sold. Thus the sale decision has an opportunity cost that must be included as part of the price for the land because it is an irreversible decision.; This research paper seeks to find out evidence, if any, supporting the hypothesis that a common result with an NPV rule is an inequality between land values and capitalization bid prices. The option value of delaying the sale of a farm property has been measured using an emerging, relatively new theory called the theory of real options pricing. As opposed to standard conventional corporate finance theory, this new option theory has incorporated both the uncertainty about the future net benefits of a selling decision and the irreversibility of this action taken.; So, this research inquiry assesses the real option values of farmland using data from Ohio. Results from this option value calculation show that the vast majority of the real call option values calculated for this sample are positive, suggesting that deferring the decision to sell farmland is optimal for most Ohio landowners.; The study then seeks to associate the impacts of urban development on Ohio farm-real estate with some important real option-determining factors suggested by the literature. To set forth this association, these option-determining factors were jointly regressed on some urbanization-related variables to find out the relation between them. Urban influences on these real option values are captured using a gravity model. Results from this econometric analysis indicate that urban influences along with population density, absolute population growth, the percentage of land area classified as farmland, median household income, and quality as measured by the corn yield per acre all have been important factors affecting the value of real call option of farmland, calculated for this sample of Ohio landowners.