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

Abstract

In this article, we define a new construct for urban economic and investment analysis, which revisits the conventional wisdom that investment in real estate development is riskier than investment in stabilized property assets. This new construct, referred as a "development asset value index" (DAVI), is a value index for newly developed properties (only) in a given geographical property market. It tracks longitudinal changes in the highest and best use (HBU) value of locations, and it reveals developer and landowner behavior taking advantage of the optionality inherent in land ownership. In particular, the DAVI reflects developers' use of flexibility in the exercise of the call option to (re)develop the property to any legal use and density. We empirically estimate a DAVI for commercial property (i.e., central locations) and compare it with a corresponding traditional transaction-price-based property asset price index (PAPI) corrected for depreciation. We believe that the difference primarily reflects the realized value of flexibility in land development. We find that the DAVIs display greater value growth and are smoother over time and less cyclical than their corresponding PAPIs for the same locations. This suggests that developers successfully use flexibility, and that development may be riskier than stabilized property investment due primarily only to leverage effects (construction costs). Practical implications are also discussed.

Where is the opportunity in opportunity zones?

“…Vacant land has the highest option value and capital requirements as there is no structure (e.g., see Cunningham, 2006; Titman, 1985). The land value fraction ($$\frac{\text{land value}}{\text{total property value}}$$) is 100%, whereas the average land value fraction for newly build properties is estimated to be 20% of total value (Albouy et al., 2018; Bokhari & Geltner, 2018; Geltner et al., 2020). Therefore, we assume buyers of vacant land deploy approximately 400% of the purchasing price in additional capital, far beyond the OZ program threshold of 100%.…”

“…If a property is newly constructed, it will be built according to its HBU. It will have the optimal density (measured by floor area ratio [FAR]), and “best” property type to maximize NPV (see, e.g., Geltner et al., 2020). However, HBU can change over time, leading to “better” suited building types for a location.…”

“…Another explanation for additional price effects are renovations, improving old properties to the Highest‐and‐Best‐Use (HBU) (Geltner et al., 2020). Even in the absence of expected land value appreciation, the quality of OZ investment properties increases through renovations, reducing income risks and increasing future cash flows from higher rents.…”

“…One important variable is price per square foot of land. Controlling for the capital intensity of the property (measured by the FAR), price per square foot of land proxies the productive capacity of the land (Clapp et al., 2012; Geltner et al., 2020). Price per square foot of land further makes the results more comparable with vacant land.…”

Challenges of housing development in the Federal Capital City, Abuja

“…According to Evans (2018), it is particularly very important in improving public health; reducing societal injustice and poverty; ensuring social order and accommodating population growth. According to Ezeh (2014), and (Geltner, 2018), several studies have indicated that public housing provision involves policy formulation, institutional development, actual housing provision, allocation and management. This goes to suggest that challenges in public housing provision are related to policy formulation, institutional growth and development as well as actual production and consumption of housing units and services (World Health Organization, 2016).…”