Is there Super-normal Profit in Real Estate Development?
43 Pages Posted: 5 Sep 2019 Last revised: 15 Jun 2020
Date Written: June 12, 2020
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' Tobin's-Q ratios increase significantly as a function of the ratio of development assets to total assets in the firm, controlling for other factors. The magnitude of the positive NPV generated by real estate development appears to be economically significant. This added value is net of land cost and is at the firm level, therefore also 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 at real estate development of investment properties.
Keywords: Real Estate Development, REITs, Super-normal Profit, Positive NPV, Real Option
JEL Classification: G10, G32, R30
Suggested Citation: Suggested Citation