Keywords: Housing, investment, real option, empirical, theory
Abstract: In this paper, we study investments by existing homeowners to improve
their homes. The value of a house is modeled as the expected net
present value of a perpetual stream of service flows emanating from
the attributes of the house. An important innovation in our model is
that the set of house attributes evolves over time according to the
investment decisions of the homeowner. The homeowner's decisions to
invest in house attributes are modeled as real options. Our model of
investment embeds a multi-factor term structure model and a general
model of the evolution of service flows. We employ numeric
simulations to explore the properties of the investment model, and to
motivate our empirical test of the model.
Using a panel from the American Housing Survey, we test two
implications of the real option theory. We test whether investment is
more likely when the spread between the return to housing and the cost
of capital is wide, and we test whether greater spread volatility
depresses investment. The results indicate that homeowner investment
behavior is consistent with the theory, even after controlling for
business cycle, aging, tenure and for-sale influences.
Full paper (664 KB PDF)
| Full paper (651 KB Postscript)
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Last update: June 7, 2000