Buy to Scrape? The Hedonic Model with Redevelopment Options

Abstract

In Rosen’s (1974) model, implicit market prices can be interpreted as the present values of rents per unit of each hedonic characteristic. But when rents rise, there may be substantial value associated with the option to redevelop the bundle of characteristics to higher intensity. In the presence of option value, hedonic regressions should include an additional non-negative term for the value of the option. If this option term is omitted, then estimates of implicit market prices for a positively valued characteristic will be biased downward. We use simulations to compare the standard hedonic regression to a nonlinear regression designed to produce consistent estimators of implicit prices and to estimate the value of the redevelopment option. The simulations show substantial downward bias even in the presence of small amounts of option value. Moreover, nonlinear estimation can do a good job of recovering the amount of option value and estimates of implicit market prices.

Keywords: real options value, hedonic model, nonlinear regression, valuation, human capital, real estate

JEL Classification: C8, D4, D81, E22, R11