Real option value over a housing market cycle

• We modify the hedonic model to capture the percent of value due the option to rebuild.
• Identification is from the option value functional form and zoning limits.
• The model is estimated on West Berlin data, before and after the fall of Berlin Wall.
• Option value accounts for up to 40 percent of the boom and 50 percent of declines.
• The model reduces cycle-related estimation bias in coefficients for floor space.

This paper analyzes how the dynamics of house prices are affected by the option to rebuild or enlarge existing dwellings. The nonlinear functional form for option value and zoning limits provides identification of changes in option value over the cycle. For homes with high development potential, our results show that about 40% of the price increases during the boom years after the fall of the Berlin Wall were related to increased option value. In the subsequent bust about 50% of their price decline was associated with decreased option value. For dwellings with low redevelopment potential 12% of the decline in real value can be attributed to changing option value.