Riskiness of Real Estate Development: A Perspective from Urban Economics & Option Value Theory

Abstract

Conventionally, investment in real estate development is viewed as being riskier than investment in stabilized property assets. In this paper we define a new construct for urban economic analysis which puts this conventional wisdom in a new light. We call the new construct, the Development Asset Value Index (DAVI). The DAVI is a value index for newly-developed properties (only) in a geographical property market. It tracks longitudinal changes in the Highest & Best Use (HBU) value of locations as reflected in gross physical capital formation, and it reveals developer and landowner behavior taking advantage of the optionality inherent in land ownership. In particular, the DAVI reflects developers' use of the timing flexibility in the exercise of the call option represented by the right (without obligation) to (re)develop the property. We empirically estimate the DAVI for commercial property (i.e., central locations) and compare it with the corresponding traditional transaction price based hedonic Property Asset Price Index corrected for depreciation (PAPI), in the same geographical market. We believe that the difference primarily reflects the realized value of timing flexibility in land development. For our test cities of New York and Los Angeles, we find that the DAVIs display greater value growth and are smoother and less cyclical than their corresponding PAPIs. This suggests that development may be riskier than stabilized property investment only due to leverage effects. We also find that development density (Floor/Area Ratio) is an increasing function of the location value.