Optimal valuation of claims on noisy real assets: Theory and an application

A theory for valuing claims on noisy real assets is developed and applied. Central to the theory is determination of the dynamics for the best estimate of real asset value. The dynamics of the value estimate are shown to differ from the dynamics of the true asset value only in the arrival rate of information. The rate of information arrival in the value estimate can be faster or slower than information arrival in the true asset value, which can lead to unexpected outcomes in the valuation and exercise of options on noisy real assets. The theory we develop is illustrated through an application. An imperfectly competitive market for real estate development is examined, in which agents compete over the timing of lead investment. Information spillover and free-rider incentives are shown to cause significant delay in lead investment. Delay together with a competitive response once lead investment has occurred explain observed patterns of development in gentrified urban land markets and multistage development projects.