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A real options approach to housing investment

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  • Chris Downing
  • Nancy Wallace

Abstract

In this paper, we study investments by existing homeowners to improve their homes. The value of a house is modeled as the expected net present value of a perpetual stream of service flows emanating from the attributes of the house. An important innovation in our model is that the set of house attributes evolves over time according to the investment decisions of the homeowner. The homeowner's decisions to invest in house attributes are modeled as real options. Our model of investment embeds a multi-factor term structure model and a general model of the evolution of service flows. We employ numeric simulations to explore the properties of the investment model, and to motivate our empirical test of the model. Using a panel from the American Housing Survey, we test two implications of the real option theory. We test whether investment is more likely when the spread between the return to housing and the cost of capital is wide, and we test whether greater spread volatility depresses investment. The results indicate that homeowner investment behavior is consistent with the theory, even after controlling for business cycle, aging, tenure and for-sale influences.

Suggested Citation

  • Chris Downing & Nancy Wallace, 2000. "A real options approach to housing investment," Finance and Economics Discussion Series 2000-30, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2000-30
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    Cited by:

    1. Weiß, Dominik, 2009. "Keeping the Bubble Alive! The Effects of Urban Renewal and Demolition Subsidies in the East German Housing Market," IWH Discussion Papers 11/2009, Halle Institute for Economic Research (IWH).
    2. Roberto J. Santillán Salgado, 2004. "Application Of The Real Options Methodology To Value A Cement Firm'S Acquisition," Remef - Revista Mexicana de Economía y Finanzas Nueva Época REMEF (The Mexican Journal of Economics and Finance), Instituto Mexicano de Ejecutivos de Finanzas, IMEF, vol. 3(4), pages 313-331, Diciembre.

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    Keywords

    Housing; Investments;

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