June 15, 2005 | Q&A

Agency conflicts and investment timing

If the owner of a piece of land hires a developer to construct a building, the project's timing may hinge on the developer's own motives. How can the owner design a contract that aligns the interests of both parties?

Topics: Real Estate

In commercial real estate, a piece of land has value because of the option to construct a building at some point in the future. The land’s net present value equals the present discounted value of future rents minus construction costs. The project’s timing presents a trade-off, however: building today means the developer can’t build next year, when rents might be higher. So even if a given project has a positive net present value, the developer may prefer to wait. Since erecting a building is, to a certain extent, an irreversible decision, the developer must take into account not just the construction costs but also the opportunity cost of waiting. Delaying the project also allows the developer to defer the interest on construction costs.

If the owner of a piece of land hires a real estate developer to construct a building, the two parties may have different agendas regarding the project’s timing. When owners delegate, two types of conflicts of interest arise. First, the developer may exert less effort than the owner would prefer. Second, the developer, who knows more than the owner about market conditions, construction costs and so forth, may conceal important information from the owner. While owners try to pursue a strategy that maximizes their profits, developers may distort the timing of construction projects in pursuit of their own interests.

Intrigued by the impact of such agency conflicts on investment timing, Professors Neng Wang of Columbia and Steven Grenadier of Stanford developed a model for designing contracts that best align the interests of owners and developers. Their work merges two important areas of finance and economics research: the real options approach to investment decisions and the concept of information asymmetry and moral hazard. The real options approach, which builds on the option-pricing framework developed by Nobel laureates Black, Merton and Scholes, implies that investors should implement any project with a sufficiently high net present value. Information asymmetry and conflicts of interest have a significant impact on the type of contracts to which owners and developers are willing to commit.

Wang and Grenadier brought the key concepts from these two fields together, extending the real options framework to account for agency and information problems. Standard real options models have focused almost exclusively on the timing of investments, assuming away agency and information problems. By combining the methodology of the real options approach with the idea of information asymmetry, Wang and Grenadier derived new insight into how agency conflicts affect investment timing. Their model can help owners design contracts that give developers incentives to work hard and truthfully reveal private information.

 

Neng Wang is assistant professor of finance and economics at Columbia Business School.

Read the Research

Steven Grenadier, Neng Wang

"Investment Timing, Agency, and Information"

View abstract/citation  View Research  

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