It appears that option theory explains well why periodic overbuilding is both inevitable and, at the same time, rational. While other theories (e.g., the DiPasquale-Wheaton 4-Quadrant Diagram) often attribute oversupply to distorted behavioral and irrational actions, from the perspective of option theory, such behavior becomes sufficiently normative.
Real and financial options differ in that real options involve the supply of actual goods, which affects the value of other options. In contrast, with financial options, the volume of transactions does not stimulate an oversupply of the underlying assets.
This is partly due to the fact that, in terms of transparency and valuation accuracy, financial options are superior to real options (Childs, Ott, and Riddiough, 2002). Statistical analysis works better in financial markets than in, say, the real estate market, where different developers may hold subjective and varied views on the current value of a particular property.
The situation is different in real estate development:
Suppose in a given market, due to some unforeseen changes, demand is suddenly initiated for 100,000 apartments (e.g., war and Tbilisi). How will landowners with undeveloped land respond if they know that this demand will only last for a limited time? They will try to beat each other to development, and this behavior is sufficiently rational.
In summary, if we consider that the value of land depends not only on the immediate profit potential from development but also on the flexibility of choosing the timing of development, then it becomes clear that new developments in surrounding areas limit this flexibility (the option premium) and reduce its value. Consequently, the lower the value of the option, the higher the motivation to start construction.
Moreover, another interesting factor plays a role here—the option to lease with short- or long-term contracts, which stimulates both construction and the sale of properties under development. That is, even if an investor in an under-construction property recognizes the presence of oversupply, they may still proceed with the investment, because they can lease out the property through short-term contracts during periods of stagnation and switch to long-term contracts once demand-supply balance is restored. Therefore, since the investment is long-term, short-term oversupply becomes less important. (This dynamic was first noted by Grenadier (1995a, 1995b), who found that overbuilding is characteristic of markets where long-term leasing practices are actively used.)
Source:
Commercial Real Estate Analysis and Investments, D. M. Geltner, N. G. Miller, J. Clayton, P. Eichholtz