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Do Standard Real Option Models Overestimate the Required Rate of Return of Real Estate Investment Opportunities?

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Author Info

  • Luis H.R. Alvarez

    (Department of Economics, Turku School of Economics, 20500 Turku, Finland)

  • Jukka Lempa

    (University of Oslo, CMA, P.O. Box 1053 Blindern, NO-0316 Oslo, Norway)

  • Elias Oikarinen

    (Department of Economics, Turku School of Economics, 20500 Turku, Finland)

Abstract

We consider how the inter-temporal discreteness of the revenue and cost processes affect the optimal timing of a real estate investment opportunity in comparison with the investment timing strategy obtained by relying on the traditional continuous real option model. We characterize both optimal investment rules explicitly and show that the continuous model may lead to a significantly higher required rate of return than the discrete model. Hence, our results show that the use of continuous time models leads to smaller and suboptimal amount of investment. Our numerical illustrations also indicate that this difference grows as volatility increases. Consequently, even though higher volatility decelerates investment in the discrete case as well, it decelerates it less than the continuous model would predict.

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Bibliographic Info

Paper provided by Aboa Centre for Economics in its series Discussion Papers with number 52.

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Length: 28
Date of creation: Aug 2009
Date of revision:
Handle: RePEc:tkk:dpaper:dp52

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Keywords: Real options; real estate investment timing; exchange option;

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References

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  1. Karl E. Case, 1989. "The Asset Approach to Pricing Urban Land: Empirical Evidence," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 17(2), pages 175-176.
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