The Uncertainty of House Prices and Real Options in China

Abstract

This study investigates the real options with spatial analysis in China’s real estate markets. We employ new detailed macro-level data set for 31 provinces in China to test the central predictions of real options with respect to land development. We extended the real options method with spatial Durbin model (SDM), making this the first time that real option predictions have been tested in a spatial manner. We also examine the tests of SDM including spatial fixed measures, time fixed measures, and spatial and time fixed measures of expected future prices and price uncertainty. This method improves the accuracy of predicting the value of house prices and considers the neighbouring regional house prices. We measure the degree of price uncertainty by a generalized autoregressive conditional heteroskedasticity (GARCH) model. To explore for the presence of real options in house prices, vacant land sales price is regressed on SDM measures of future house price uncertainty. Moreover, we employed Black-Scholes’ (1973) pricing model to explore the option premium of land value. The weight of the evidence in this paper suggests there are real options in China’s real estate markets. Uncertainty about future house prices of neighbouring regions drives up land prices in China. The findings suggested that uncertainty about future housing prices of neighbouring regions decreases investment activity in the current period; uncertainty about future house prices of neighbouring regions raises land prices above the discounted stream of rents in their current use.Market house prices of neighbouring regions reflect a premium for optimal development, which based on our estimates has a mean of 16.28% of the land value. A one-standard-deviation increase in uncertainty lowers the likelihood of development by 1.101%.

Keywords: House Prices, Land Prices, Real Options, Option Premium, Spatial, Spatial Durbin Model, GARCH, Black-Scholes’ Pricing Model

JEL Classification: D1, H31, O18, R21, R31, D46, J18, G12, G13, G18