DP16023 Irreversible investment under predictable growth: Why land stays vacant when housing demand is booming
The standard model of irreversible investment under uncertainty considers only the level of the cash
flow that could be obtained through the investment. We present a general model that includes as
state variables both the level and the growth rate of the cash flow, while the timing and size of the onetime
investment are discretionary. As an illustration, we consider an investor with the exclusive right
to develop a vacant piece of land, where the timing of the investment and the scale of the property
are chosen optimally. We demonstrate that construction is optimally postponed when prospects are
gloomy, but also when they are bright. Indeed, under sufficiently high growth it is, perversely, never
optimal to invest. Under a cost-of-capital argument, the rational response to predictable growth
combined with flexible investment conditions is to keep land vacant for extended periods, which may
explain why construction in superstar cities often appears sluggish. Our proposed model can be used
in all investment decisions, irrespective of sector, where the assumptions of predictable growth and
a one-off, flexible but otherwise irreversible investment are met.
