Effects of uncertainty on the investment decision : an examination of the option-based investment model using Japanese real estate data

Abstract

This paper examines the validity of the option-based investment model as opposed to the neoclassical investment model in the decision-making of commercial real estate development, using aggregate real estate data from Japan. I particularly focus on the effect of uncertainty because it is the central difference between the two models. I specify a structural model in order to incorporate the interactions between supply and demand in the real estate asset market. In order to conduct detailed empirical tests for a long period of time, I set three data series. The Long Series uses quarterly data of 25 years and Short Series 1 and Short Series 2 use monthly data of about 15 years. I find strong evidence that supports the option-based investment model. Especially in the supply equation, total uncertainty has significant effects on the investment decision. A lag structure is found in the effect of total uncertainty. The parameters for other variables also generally favor the option-based model. In the demand equation, too, the results strongly support the option-based investment model. It should be concluded from these results that various kinds of real options must be incorporated in investment and economic models.