Option Value Created and Destroyed by the Big Bang in the Berlin Housing Market, 1978-2007

Abstract

This paper adds the option substantially renovate or rebuild to a standard hedonic regression model. It shows that the unrealized renovation potential can be measured and included as an additional hedonic variable.

A new dataset for West Berlin suggests that the events surrounding the fall of the Wall in 1989 and the return of the federal government to Berlin in 1992 produced a boom and then a prolonged decline in the housing market. This paper demonstrates that, when the housing market is booming (declining), the value of the renovation option can add (subtract) significantly to growth in house value. Change in option value accounted for about 17.3 % of the change in house value from about 1985 until the peak of the boom. But, option value played a much bigger role in the decline: the elimination of option value after 1994 accounted for about 53.6 % of the decline from 1994-2007, and most of this occurred abruptly towards the beginning of the period.

Moreover, our data suggest that a hedonic model omitting option value can produce coefficient estimates that differ by as much as 40% from those with option value included, and the direction of the differences is predicted by real option theory.

Keywords: Real options, housing markets, Berlin wall, market decline

JEL Classification: D12, D46, G13, R31