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

44 Pages Posted: 22 Jan 2003 Last revised: 27 Jul 2011

See all articles by Laarni T. Bulan

Laarni T. Bulan

Cornerstone Research

Christopher J. Mayer

Columbia University - Columbia Business School, Finance; National Bureau of Economic Research (NBER)

C. Tsuriel Somerville

University of British Columbia (UBC) - Division of Strategy and Business Economics

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Abstract

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.

Keywords: real options, real estate, uncertainty, investment

JEL Classification: E22, G12, G31, R31

Suggested Citation

Bulan, Laarni Tobia and Mayer, Christopher J. and Somerville, C. Tsuriel, Irreversible Investment, Real Options, and Competition: Evidence from Real Estate Development. Journal of Urban Economics, Vol. 65, pp. 237-251, 2009, Available at SSRN: https://ssrn.com/abstract=354800 or http://dx.doi.org/10.2139/ssrn.354800

Laarni Tobia Bulan

Cornerstone Research ( email )

Boston, MA
United States

Christopher J. Mayer

Columbia University - Columbia Business School, Finance ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

C. Tsuriel Somerville (Contact Author)

University of British Columbia (UBC) - Division of Strategy and Business Economics ( email )

2053 Main Mall
Vancouver, British Columbia
Canada
604-822-8341 (Phone)
604-822-8351 (Fax)

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