The option value of vacant land: Don't build when demand for housing is booming

Coen Teulings and Rutger-Jan Lange

No 16023, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We consider an investor with the exclusive right to develop a property on a vacant piece of land, where the timing of the investment and the scale of the property are chosen optimally. The cash flow generated by the property follows a geometric Brownian motion with a stochastic drift, which is itself a mean-reverting Brownian motion. This setup allows for prolonged periods of above- or below-average growth. We prove that rational developers optimally postpone construction when prospects are gloomy, but also when they are bright: under sufficiently high growth, it is never optimal to invest. Perversely, the desire to ‘build big’ under high growth is stymied by a cost-of-capital argument, ultimately stifling investment. The combination of predicable growth and flexible investment may thus explain why construction in superstar cities appears sluggish,

Keywords: Real options; Mean-reverting growth; Irreversible investment; Real-estate construction; Urban growth (search for similar items in EconPapers)
JEL-codes: C41 C61 D81 R14 R31 R51 (search for similar items in EconPapers)
Date: 2021-04
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Working Paper: The option value of vacant land: Don't build when demand for housing is booming (2021)
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