Super-Normal Profit in Real Estate Development

42 Pages Posted: 5 Sep 2019 Last revised: 18 Sep 2019

See all articles by David Geltner

David Geltner

Massachusetts Institute of Technology (MIT); MIT Center for Real Estate

Anil Kumar

Aarhus University, Department of Economics & Business Economics; Danish Finance Institute

Alex Van de Minne

University of Connecticut - Department of Finance

Date Written: August 28, 2019

Abstract

This paper explores the question of whether real estate development projects systematically present positive net present value (NPV) and therefore, provide super-normal profit. Such projects are the products of a business operation that governs the exercise of the real call option on development that is represented by developable land. We find that super-normal profits do tend to exist in the investment property development projects produced by publicly-traded equity real estate investment trusts (REITs). Specifically, we find that, over the 1998-2018 period, REITs Price/Earnings ratios increase as a function of the ratio of development assets to total assets, controlling for other factors including the general Tobin's-Q ratio (market/book value) of the firm. For the typical REIT the magnitude of development project positive NPV equals 46% of the costs of the development assets. This added value is at the firm level, therefore net of overhead and search costs associated with the real estate development business operation. Our findings suggest either that the commercial real estate development industry tends to be broadly characterized by super-normal profits, or that there is a beneficial capital allocational efficiency effect of the stock market in attracting, supporting or cultivating firms that are particularly successful in that industry. We also explore some correlates of the price/earnings effect, and find that super-normal profits from development are more likely to be earned by REITs that are headquartered in larger metropolitan areas.

Keywords: Real Estate Development, REITs, Super-normal Profit, Positive NPV, Real Option

JEL Classification: G10, G32, R30

Suggested Citation

Geltner, David and Kumar, Anil and Van de Minne, Alex, Super-Normal Profit in Real Estate Development (August 28, 2019). Available at SSRN: https://ssrn.com/abstract=3444309 or http://dx.doi.org/10.2139/ssrn.3444309

David Geltner

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
Cambridge, MA 02139
United States

MIT Center for Real Estate ( email )

77 Massachusetts Avenue
Cambridge, MA 02139
United States

Anil Kumar (Contact Author)

Aarhus University, Department of Economics & Business Economics ( email )

Fuglesangs Alle 4
Aarhus V, 8210
Denmark

Danish Finance Institute ( email )

Alex Van de Minne

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States

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