Do Standard Real Option Models Overestimate the Required Rate of Return of Real Estate Investment Opportunities?

Luis H.R. Alvarez, Jukka Lempa and Elias Oikarinen
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Luis H.R. Alvarez: Department of Economics, Turku School of Economics, 20500 Turku, Finland
Jukka Lempa: University of Oslo, CMA, P.O. Box 1053 Blindern, NO-0316 Oslo, Norway
Elias Oikarinen: Department of Economics, Turku School of Economics, 20500 Turku, Finland

No 52, Discussion Papers from Aboa Centre for Economics

Abstract: We consider how the inter-temporal discreteness of the revenue and cost processes affect the optimal timing of a real estate investment opportunity in comparison with the investment timing strategy obtained by relying on the traditional continuous real option model. We characterize both optimal investment rules explicitly and show that the continuous model may lead to a significantly higher required rate of return than the discrete model. Hence, our results show that the use of continuous time models leads to smaller and suboptimal amount of investment. Our numerical illustrations also indicate that this difference grows as volatility increases. Consequently, even though higher volatility decelerates investment in the discrete case as well, it decelerates it less than the continuous model would predict.

Keywords: Real options; real estate investment timing; exchange option (search for similar items in EconPapers)
JEL-codes: G11 R31 C44 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn
Date: 2009-08
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