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

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Author Info
Laarni Bulan
Christopher Mayer
C. Tsuriel Somerville

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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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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Elena Bontempi & Roberto Golinelli & Giuseppe Parigi, 2007. "Why demand uncertainty curbs investment: Evidence froma a panel of Italian manufacturing firms," Temi di discussione (Economic working papers) 621, Bank of Italy, Economic Research Department. [Downloadable!]
  2. Timothy Dunne & Xiaoyi Mu, 2008. "Investment spikes and uncertainty in the petroleum refining industry," Working Paper 0805, Federal Reserve Bank of Cleveland. [Downloadable!]
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