Irreversible Investment, Real Options, and Competition: Evidence from Real Estate Development
Christopher J. Mayer
C. Tsuriel Somerville
The real options framework has been used to characterize the timing of irreversible investment in the presence of uncertainty. Despite a well developed theoretical literature, there are few empirical studies that use investment level data to examine the link between real options theory and investment. We examine 1,214 individual real estate developments in Vancouver, Canada using neighborhood level returns over a twenty year period to identify the extent to which uncertainty delays investment. The condominium developments in our sample cannot easily be redeployed to alternative uses, which allows us to isolate the call option, the value of delay, from the put option, which is based on the disinvestment potential of an asset. We find that increases in both idiosyncratic and systematic (market) risk lead developers to delay new real estate investments. Empirically, a one-standard deviation increase in the volatility of real estate returns reduces the hazard rate of investment by 13 percent, equivalent to a 9 percent decline in the real price level. Finally, we show that the value of the (call) option to delay a project is eroded by competition. Increases in the number of potential competitors negates the negative effect of idiosyncratic risk on the probability of development. This competition result provides support for the real options interpretation over alternatives such as risk aversion.
We examine the extent to which uncertainty delays investment and the effect of competition on this relationship using a sample of 1,214 condominium developments in Vancouver, Canada built from 1979-1998. We find that increases in both idiosyncratic and systematic risk lead developers to delay new real estate investments. Empirically, a one-standard deviation increase in the return volatility reduces the probability of investment by 13 percent, equivalent to a 9 percent decline in real prices. Increases in the number of potential competitors located near a project negate the negative relationship between idiosyncratic risk and development. These results support models in which competition erodes option values and provide clear evidence for the real options framework over alternatives such as simple risk aversion.
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