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

We examine the extent to which uncertainty delays investment and the effect of competition on this relationship using a sample of 1,214 condominium developments in Vancouver, Canada built from 1979-1998. We find that increases in both idiosyncratic and systematic risk lead developers to delay new real estate investments. Empirically, a one-standard deviation increase in the return volatility reduces the probability of investment by 13 percent, equivalent to a 9 percent decline in real prices. Increases in the number of potential competitors located near a project negate the negative relationship between idiosyncratic risk and development. These results support models in which competition erodes option values and provide clear evidence for the real options framework over alternatives such as simple risk aversion.

Permits, Starts, and Completions: Structural Relationships Versus Real Options

Real estate development from raw land to completed structures is a multistage process. Given the current view of development as the exercise of a real option, the question arises whether development should be modeled as a compound option. This paper tests the validity of the compound option characterization by determining whether builders start units for which they have permits and then complete units started consistent with the predictions of the real options model. To do so, I first identify a reduced form relationship between permits and starts and then between starts and completions. The parameters of this relationship indicate how well permits proxy for starts and starts for completions. Then, I determine whether controlling for this structural relationship, new information, and uncertainty in returns affect permit exercise and completion rates, as in the exercise of real options. I find that current and previous quarter permits forecast current single-family starts, while multifamily starts require more quarterly lags of permits. More than one and two year's worth of lagged starts numbers are needed to estimate current quarter completions for single- and multifamilys buildings, respectively. The principal result is that once building permits have been obtained, the development process proceeds to completion. While there is no evidence that completion is the exercise of an option embedded in a start, some aspects of permits are consistent with builders treating them as an option for starts. However, even if they do, given permits obtained, it takes large changes in market conditions to affect small changes in starts. Copyright Blackwell Publishers Ltd 2001.

Regional housing supply and credit constraints

The construction of new housing plays a critical role in the economy, yet it is understudied by researchers. Increases in housing starts raise construction employment, and recent home buyers often purchase other consumer durables, leading through the multiplier effect to increased employment. Construction is especially important to the business cycle, because changes in residential construction tend to lead recessions and recovery.> Despite its importance, empirical research on housing supply is surprisingly rare. This article presents a new empirical model of housing supply that reflects the land development process and is consistent with the time-series characteristics of the data. The authors apply this model to the four U.S. Census regions and estimate regional housing start elasticities, which range between 0.9 and 3.9. Their estimates also show a prolonged period of below-predicted construction in the Northeast during the early 1990s that does not appear during the downturns in other regions. These results are consistent with the hypothesis that a severe negative shock to local asset values (and thus bank capital), possibly combined with changes in banking regulation, let to a "credit crunch" that reduced new housing construction.Housing