The aim of this paper is to analyze the equilibrium strategies of two developers in the real estate market, when demands are asymmetric. In particular, the paper considers three key features of the real estate market. First, the cost of redeveloping a building is, at least partially, irreversible. Second, the rent levels for different buildings vary stochastically over time. Third, demand functions for space are interrelated and may produce positive or negative externalities. Using the method of option pricing theory, the paper addresses this issue at three levels. First, it models the investment decision of a firm as a preassigned leader as a dynamic stochastic game. Then, it solves for the non-cooperative case, and for the perfectly cooperative case, in which redevelopment of an area is coordinated between firms. Finally, it analyzes the efficiency/inefficiency of the equilibria of the game. It is found that if one firm has a significantly large comparative advantage, the preemptive threat from the rival will be negligible. In this case, short burst and overbuilding phenomena, as predicted by Grenadier (1996), will occur only as a limiting case.

In recent years, it has become possible to observe new tendencies of tourism policies. Although in the past many major tourist destinations devoted a significant part of their service supply to the so-called mass tourism1, which fundamentally involves a price competitiveness strategy, nowadays many mature tourist destinations are considering specializing in niche tourism. In fact, from mass tourism may emerge congestion problems that generate negative externalities to a specific area (i.e., the quality of the environment and the setting), which not only lower the welfare level of residents, but also affect negatively the tourism service production function. In response to these problems arises the need to implement a new strategic planning which allows destinations to be rejuvenated or reoriented (Butler, 1980; and Agarwal, 1994). Proposals suggest aiming for higher quality services, for example, by eliminating low-category hotels/residences and replacing them with higher category ones in a ratio lower than one unit. In other words, urban planning becomes one of the most critical determinants of success of a tourist destination. Transposing these two aspects into the real estate market framework, we can summarize that the selection of the nature of a tenant’s business2 and the general tastes of tenants are the two most important features that characterize an area, and consequently, the (re)development decisions are influenced by the quality type and the general characteristics of the area.

This paper is a contribution to the area of strategic urban planning and investment under uncertainty. Real estate investments are often difficult to reverse, and the timing and consequences of investment in real estate market are key strategic decisions both for developers and residents. How should a competitive real estate developer decide between waiting in developing an area and investing at once? How should he value the different options? What are the impacts of the mix of building types on the developer’s investment decisions and, consequently, on the urban planning?

The present paper attempts to provide an answer to the above questions. We begin our analysis observing that in a real estate market, comparative advantages of firms in real estate investment are differentiated by their pricing rather than cost containment strategies. Therefore, by using different inverse demand functions for firms in the model, comparative advantages of firms and their effects on optimal timing in equilibrium can be explicitly examined. We develop a continuous time stochastic oligopoly model to analyze the sequence of events which originates a new urban area and use it to investigate the interaction of the various forces which may delay or anticipate markets creation. We find the conditions that may lead the ones or the others to prevail. Moreover, we analyze the perfectly cooperative case, in which (re)development activity is coordinated between firms, and use it to analyze the efficiency/inefficiency of the implemented strategies.

In our model, we consider the investment decision of a landlord intending to (re)develop his fraction of building in an area. The investment will create a new urban area (e.g., a new tourist destination), which can be interpreted as a new market, and the developer will be the market pioneer. We assume, for simplicity, that the investment is in a single new project and the investment expenditure is known and fixed, but once made it is irreversible. The demand for space of each tenant type considered has two essential features. First, the rent levels vary stochastically over time, reflecting market conditions. Second, the demands for space are interrelated. The use of space by one tenant may give rise to either positive or negative externalities for other tenants. A positive interaction between tenant types would increase the landlord’s demand for a ‘diversified mix’ of tenants (e.g., a shopping center or different tourist packages). Conversely, a negative externality effect would occur when the use of space by one type of tenant impinges upon the efficient use of space by another. A mix of heavy industrial use with residential or commercial use would be such an example. Thus, the developer must take into account both the rent levels and the interaction effects in choosing its optimal investment policy.

Financial Economics Journal, Fama-MacBeth Methodology, Capital Asset Pricing Model, Time Series Regressions, Cochrane Methodology, Market Risk Loadings, Fama-MacBeth Procedure, Industry Portfolios, Fama and Asset Pricing Model, French Asset Pricing Model.