Is There Super-Normal Profit in Real Estate Development?*

Abstract

This paper explores the question of whether real estate development (RED) projects systematically present positive net present value (NPV) and therefore, provide super-normal profit. Such projects are the products of a business operation that governs the exercise of the real call option on development that is represented by developable land. We present a framework for considering super-normal profit in the RED industry, and then in light of that framework we examine RED projects produced by publicly-traded equity real estate investment trusts (REITs). We find strong evidence of positive correlation between REITs’ Tobin-Q ratios, indicative of positive NPV, and the ratio of development assets to total assets in the firm, controlling for other factors. The nature of the firm’s Tobin’s-Q metric is such that the implied added firm value is net of land cost and net of overhead and search costs associated with the RED business operation. While our findings do not prove a direction of causality between REITs’ RED activity and positive NPV, the robust positive correlation controlling for other factors raises interesting implications which are discussed in the paper.