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Irreversible Investment, Real Options, and Competition: Evidence from Real Estate Development

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  • Laarni Bulan
  • Christopher J. Mayer
  • C. Tsuriel Somerville

Abstract

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.

Suggested Citation

  • Laarni Bulan & Christopher J. Mayer & C. Tsuriel Somerville, 2006. "Irreversible Investment, Real Options, and Competition: Evidence from Real Estate Development," NBER Working Papers 12486, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:12486
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    JEL classification:

    • D4 - Microeconomics - - Market Structure, Pricing, and Design
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production
    • R3 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location

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