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The option value of vacant land: Don't build when demand for housing is booming

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  • Teulings, Coen
  • Lange, Rutger-Jan

Abstract

We consider an investor with the exclusive right to develop a property on a vacant piece of land, where the timing of the investment and the scale of the property are chosen optimally. The cash flow generated by the property follows a geometric Brownian motion with a stochastic drift, which is itself a mean-reverting Brownian motion. This setup allows for prolonged periods of above- or below-average growth. We prove that rational developers optimally postpone construction when prospects are gloomy, but also when they are bright: under sufficiently high growth, it is never optimal to invest. Perversely, the desire to ‘build big’ under high growth is stymied by a cost-of-capital argument, ultimately stifling investment. The combination of predicable growth and flexible investment may thus explain why construction in superstar cities appears sluggish,

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  • Teulings, Coen & Lange, Rutger-Jan, 2021. "The option value of vacant land: Don't build when demand for housing is booming," CEPR Discussion Papers 16023, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:16023
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    More about this item

    Keywords

    Real options; Mean-reverting growth; Irreversible investment; Real-estate construction; Urban growth;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • R14 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - General Regional Economics - - - Land Use Patterns
    • R31 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - Housing Supply and Markets
    • R51 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Regional Government Analysis - - - Finance in Urban and Rural Economies
    • C41 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Duration Analysis; Optimal Timing Strategies
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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