Saturday, September 22, 2007

Encourage don't discourage efficient land speculation

The Age today is bemoaning the fact that monopoly control of large tracts of land on the borders of our big cities is driving up land and therefore house prices. The claim is that developers are ‘sitting on’ enough land to house 100,000 people. A Professor Steven Keen is complaining that ‘land banking’ is driving up prices. Academics from RMIT and the ANU have backed these stupid claims and the land-developers have implicitly accepted the force of these arguments by arguing that land development delays are to blame for the substantial holdings.

These arguments are populist nonsense that fails to recognise the most basic arguments validating speculation in land and holding some land back from full development in housing or industrial real estate. Land in city areas is an exhaustible, finite resource and demands for it can be expected to increase through time as population grows. The Hotelling principle states that, in competitive land markets, the price of land should increase at the rate of interest – just as for any other non-depleting capital asset.

Speculation as in other markets will help to achieve this since purchases will be sold at the point where developers are realising maximum capital gains – thus land will be released when it is increasing most rapidly in price thereby slowing and stabilising such price increases. Speculation helps to ensure inter-temporal efficiency in land markets. It is not in itself a source of high land prices.

A further fact in land development decisions that lead to urban or industrial land uses is that they involve high degrees of irreversibility. There are high costs of demolition so that land should often not be developed into its final use until as real estate economists put it, it has ‘ripened’ into its higher value. This increases the case for holding land back and for not fostering low valued urban developments that society will wish to undo a few years down the track. It also explains why it is rational to see blocks of vacant land or land used in low valued agricultural activities close to high valued real estate in large cities. The owners of such land are keeping the land undeveloped until it is the right time to move it into its final high value use.

The Age’s leftwing editors argue that it is time to force developers to sell off their land holdings.

They argue that the market imperfection is suggested by the small number of developers holding such a large amount of land. This suggests no such thing. The notion that 5 or 6 Australian land developers can get together to peg land prices below their competitively determined rate of release needs to be demonstrated – it cannot just be claimed.

By the way everything I have written above is standard in the urban land economics literature. The comments of the so-called economics commentators and The Age show nothing but a stark ignorance of this literature. Some of the basic work in this field was completed in 1970 by Donald Shoup with later work in 1979 by Richard Arnott and Frank Lewis. I wrote a paper with Bill Reed in 1988 where we extended this analysis into a setting with uncertainty and irreversibility. With irreversibility of the type mentioned and uncertainty surrounding the costs and returns of land development decisions the benefits from development must exceed the costs by a quasi-option value that slows down the rate of land release below the rate that would be appropriate were investments reversible and outcomes certain.

There are many other subsequent papers looking at issues such as whether vacant land should be taxed to encourage early development. I think the consensus answer is no, it should not be.

3 comments:

Anonymous said...

It could be argued that Associate Professor Keen and his colleagues are treating undeveloped land held by developers on the edge of the city differently from semi-developed land held by private landholders within boundaries.

By requiring developers to sell this land at low prices, low income people will be banished to the fringes of the city.

A more progressive measure would be to require any land within Melbourne's current boundaries in excess of a certain size to be sold (why treat private landholders any different from developers) at a low price, which would enable low income people to live closer to the city too?

conrad said...

Thanks for that article -- I learnt a lot from that after reading The Age article

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