RETwit & FinTwit have more in common than each believes. Finance people know that a convertible bond is a loan w/ an option to buy equity attached to it. Convertible bonds exist in real estate but in 2 forms because real estate enjoys both explicit & implicit options. 1/11

Explicit financial options are the LESS interesting of the 2 option forms. For ex., a lender (senior/mezzanine etc.) makes a loan secured by real estate w/ an (American or European) option to convert it into equity. A construction lender manages risk by providing draws to a 2/11

developer. Initially there's construction & lease up risk. Borrower & lender agree ahead of time that, upon a trigger event such as a permanent lender taking out the construction loan, the construction lender then has the right but not the obligation to take a stake in the 3/11

building. This option is valuable because between when the lender committed to the construction loan & when a perm lender took out this loan, market conditions could've changed. Voila convertible bond. The more interesting & valuable options in RE are implicit REAL options. 4/11

Real options provide the right but not the obligation to engage in real estate project(s) & can be in, at & out of the money. The persistency of price momentum as a factor demonstrates real estate's inefficiency--you know if your option is moving into or out of the $$. 5/11

RE values that have risen for 3 years in a row are more likely to keep rising vs. those that have been flat or down for 3 years. This is valuable as it means the real option on a little $1,200/month SFR rental on a large lot zoned for 25 apts (like this) might be out of 6/11

the $$ today but in the money in 3 years. So today the house is valued as a SFR, but in 3 years if apt prices rise, it might be valued based on the OPTION to build 25 units. How is this a convertible bond? If the house is bought for $100K cash & does $9K of NOI it has a ~9% 7/11

yield. When it's in the $$, the owner may sell it to a builder for a price that reflects the OPTION value of building 25 apartments, she may wait, or she may choose to build it herself. A big difference between the stock market & RE is this option execution risk. As a real 8/11

option in the $$ can't be executed at the push of a button. What are the most valuable real options in real estate? Those already in the $$ & the market doesn't know it. Hard to believe but this happens & when it does back up the truck. @moseskagan put me on to Greenburger's 9/11

bio Risk Game. For years he scooped up NYC apts & condo converted. When others caught on, the market started pricing, "in the money condos" to reflect an option premium, tightening its spreads. A failure to understand real options (& networked RE assets) has led equity 10/11

guys struggling to value $JOE for years. If you enjoyed this thread, please retweet it. I'll be writing more on my blog about networked real options created through malls & land assemblage. Don't bring your DCF models, they'll let you down. Join me http://www.inefficientpursuits.com/email-sign-up/  11/11