A Real Options Approach to Housing Investment
38 Pages Posted: 21 Dec 2001
Date Written: December 18, 2001
In this paper, we focus on investments by existing homeowners to improve their homes. The homeowners' decisions to invest in house attributes are modeled as real options. The homeowner compares the value of an additional attribute, net of the value of the opportunity to invest in the future, to the cost of the investment when deciding whether or not to invest. We employ numeric simulations to explore the properties of the investment model, and to motivate our empirical test of the model.
The main contribution of this paper is an empirical test of whether or not observed homeowner investment behavior is consistent with the real option theory of investment. Using a nationally representative panel from the American Housing Survey, we test two broad implications of the real option theory. First, we test whether investment is more likely when the spread between the return to housing and the cost of capital is wide. Second, we test whether greater spread volatility depresses investment. Our empirical results indicate that observed homeowner investment behavior is consistent with these implications of the theory, even after controlling for business cycle, aging, and tenure effects. We also identify important regional differences in net investment returns and building costs, which translate into different investment dynamics across regions. The results suggest that models of housing investment that ignore investments by existing homeowners, and in particular the effects of volatility in net returns on these investment decisions, are likely to produce misleading results.
JEL Classification: G12, G13, R31
Suggested Citation: Suggested Citation