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Irreversible Investment, Real Options, and Competition: Evidence from Real Estate Development

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  • Laarni Bulan
  • Christopher Mayer
  • C. Tsuriel Somerville

Abstract

The real options framework has been used to characterize the timing of irreversible investment in the presence of uncertainty. Despite a well developed theoretical literature, there are few empirical studies that use investment level data to examine the link between real options theory and investment. We examine 1,214 individual real estate developments in Vancouver, Canada using neighborhood level returns over a twenty year period to identify the extent to which uncertainty delays investment. The condominium developments in our sample cannot easily be redeployed to alternative uses, which allows us to isolate the call option, the value of delay, from the put option, which is based on the disinvestment potential of an asset. We find that increases in both idiosyncratic and systematic (market) risk lead developers to delay new real estate investments. Empirically, a one-standard deviation increase in the volatility of real estate returns reduces the hazard rate of investment by 13 percent, equivalent to a 9 percent decline in the real price level. Finally, we show that the value of the (call) option to delay a project is eroded by competition. Increases in the number of potential competitors negates the negative effect of idiosyncratic risk on the probability of development. This competition result provides support for the real options interpretation over alternatives such as risk aversion.

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Paper provided by Wharton School Samuel Zell and Robert Lurie Real Estate Center, University of Pennsylvania in its series Zell/Lurie Center Working Papers with number 391.

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Handle: RePEc:wop:pennzl:391

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Cited by:
  1. Carlos Pestana Barros & Zhongfei Chen & Luis A. Gil-Alana, 2012. "Housing sales in urban Beijing," Applied Economics, Taylor & Francis Journals, vol. 44(34), pages 4495-4504, December.
  2. Maria Cecillia Bustamante, 2011. "Strategic Investment, Industry Concentration and the Cross Section of Returns," FMG Discussion Papers dp681, Financial Markets Group.
  3. Timothy Dunne & Xiaoyi Mu, 2008. "Investment spikes and uncertainty in the petroleum refining industry," Working Paper 0805, Federal Reserve Bank of Cleveland.
  4. William Hedberg & John Krainer, 2012. "Housing supply and foreclosures," Working Paper Series 2012-20, Federal Reserve Bank of San Francisco.
  5. Steven Ott & W. Hughen & Dustin Read, 2012. "Optimal Phasing and Inventory Decisions for Large-Scale Residential Development Projects," The Journal of Real Estate Finance and Economics, Springer, vol. 45(4), pages 888-918, November.
  6. Wrenn, Douglas H. & Sam, Abdoul G. & Irwin, Elena G., 2012. "Searching for the Urban Fringe: Exploring Spatio-Temporal Variations in the Effect of Distance versus Local Interactions on Residential Land Conversion Using a Conditionally-Parametric Discrete-Time D," 2012 Annual Meeting, August 12-14, 2012, Seattle, Washington 125007, Agricultural and Applied Economics Association.
  7. Clapp, John M. & Bardos, Katsiaryna Salavei & Wong, S.K., 2012. "Empirical estimation of the option premium for residential redevelopment," Regional Science and Urban Economics, Elsevier, vol. 42(1-2), pages 240-256.
  8. John Clapp & Piet Eichholtz & Thies Lindenthal, 2012. "Real Option Value over a Housing Market Cycle: West Berlin," ERSA conference papers ersa12p264, European Regional Science Association.
  9. Jeffrey Stokes, 2012. "The value of the option to preserve farm real estate," Journal of Economics and Finance, Springer, vol. 36(1), pages 162-175, January.
  10. Bontempi, Maria Elena & Golinelli, Roberto & Parigi, Giuseppe, 2010. "Why demand uncertainty curbs investment: Evidence from a panel of Italian manufacturing firms," Journal of Macroeconomics, Elsevier, vol. 32(1), pages 218-238, March.
  11. Maria Ibanez & Anthony Pennington-Cross, 2013. "Commercial Property Rent Dynamics in U.S. Metropolitan Areas: An Examination of Office, Industrial, Flex and Retail Space," The Journal of Real Estate Finance and Economics, Springer, vol. 46(2), pages 232-259, February.
  12. Kuhnen, Camelia M. & Oyer, Paul, 2012. "Exploration for human capital: Theory and evidence from the MBA labor market," MPRA Paper 39411, University Library of Munich, Germany.
  13. Robert Grovenstein & James Kau & Henry Munneke, 2011. "Development Value: A Real Options Approach Using Empirical Data," The Journal of Real Estate Finance and Economics, Springer, vol. 43(3), pages 321-335, October.
  14. William Miles, 2009. "Irreversibility, Uncertainty and Housing Investment," The Journal of Real Estate Finance and Economics, Springer, vol. 38(2), pages 173-182, February.
  15. John Clapp & Katsiaryna Bardos & Tingyu Zhou, 2014. "Expansions and Contractions of Major US Shopping Centers," The Journal of Real Estate Finance and Economics, Springer, vol. 48(1), pages 16-56, January.
  16. Maria Cecilia Bustamante, 2011. "Strategic investment, industry concentration and the cross section of returns," LSE Research Online Documents on Economics 37454, London School of Economics and Political Science, LSE Library.
  17. Sangcheol Song, 2014. "Entry mode irreversibility, host market uncertainty, and foreign subsidiary exits," Asia Pacific Journal of Management, Springer, vol. 31(2), pages 455-471, June.
  18. Clapp, John M. & Salavei, Katsiaryna, 2010. "Hedonic pricing with redevelopment options: A new approach to estimating depreciation effects," Journal of Urban Economics, Elsevier, vol. 67(3), pages 362-377, May.
  19. W. Hughen & Dustin Read, 2014. "Inclusionary Housing Policies, Stigma Effects and Strategic Production Decisions," The Journal of Real Estate Finance and Economics, Springer, vol. 48(4), pages 589-610, May.
  20. Andrianos Tsekrekos & George Kanoutos, 2013. "Real Options Premia Implied from Recent Transactions in the Greek Real Estate Market," The Journal of Real Estate Finance and Economics, Springer, vol. 47(1), pages 152-168, July.
  21. Sven-Olov Daunfeldt & Matilda Orth & Niklas Rudholm, 2010. "Opening Local Retail Food Stores: A Real-Options Approach," Journal of Industry, Competition and Trade, Springer, vol. 10(3), pages 373-387, September.

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