Super-Normal Profit in Real Estate Development
42 Pages Posted: 5 Sep 2019 Last revised: 18 Sep 2019
Date Written: August 28, 2019
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: Suggested Citation