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Benjamin Heller's avatar

Probably twenty years ago, I had a long/short equity portfolio manager working under me who wanted to get deeper into trading the mining sector. Our brainstorm was to try to model these companies using Real Options theory. It was interesting, but kind of brain-bending for someone who is used to financial options. One of the quirks we ran into was that you could not look a company in isolation. Every gold miner out there was a package of real options, and generally when it started to look like "exercising" made sense for one mine or company (because the gold forward curve had rallied substantially), many other options had gone in the money. And unlike a financial option, where exercise involved paying a known strike price in cash, to "exercise" a real option requires a specific collection of real resources. When everyone tries to exercise... good luck buying the mining equipment you need, hiring the miners you need, etc. I imagine the same is true with building. I was talking about this with some friends who live in the same town where we have some property in Montana. Some in the town are banging on about "restrictive zoning" as the cause of housing price increase. But this is a place where housing is being produced at 4x the per capita rate of the US average. I tried to explain, you are running into physical limits to production that you will not be able to transcend, regardless of zoning. Something like 3% of the workforce in the area is already employed in residential construction. That sector has a 10% wage premium over the average wage in the area, whereas in the US typical that sector's wage is at a discount to average. This is not a town that is close to other big population centers that it can draw people and equipment from. So that is part of the intertemporal trade-off -- are you better off waiting for the "strike price" to decline as those physical constraints abate (in whatever way that might happen)?

The other factor I think is worth considering is the non-capital carrying costs of land. If there is a meaningfully higher rate of taxation on undeveloped land relative to structure value, that increases the carrying cost of land, which should change the intertemporal trade-off in a way that accelerates exercise of the real option, right? Or do you think that when the tax is changed to disfavor raw land, that will be instantly reflect in a one-off adjustment in land price that restores the expected yield to the status-quo-ante?

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Ken Willett's avatar

Cameron

Thanks for your article.

I learned from Mason Gaffney about 54 years ago that if the rate if increase in the value of land or the in situ value of an extractable resource exceeds the opportunity cost of capital, an investor will defer development, because the return from doing nothing is higher than the return from development and sale. You have said this in a couple of different ways, including by reference to real options analysis (Gaffney thought of this before Dixit and Pindyck). If the opportunity cost of capital rises, developers will still wait if the rate of increase of the value of the land or the in situ value of the resource is expected to exceed the higher opportunity cost of capital. Doing nothing will continue as long as the former continues to exceed the latter. While higher interest rates can reduce demand for housing, demand could still rise because of increasing population and speculative activity (the real estate casino). These things seem to be continuing to pump up prices fast enough to encourage holding behaviour, maintaining rises prices and continued holding.

With regard to the latter, demand for housing ownership is no longer based solely on having a home to live in and/or avoiding rental insecurity, but now it seems to be driven by the speculative motive of "getting into the market" to capture tax sheltered capital gains. +

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