Boom Without The Bust

Rethinking The Economics of Land and Housing is one of the best books I've read on the economics behind real estate.

Land is a unique resource, where there is a fixed supply and zero cost of production. This means that the price can only increase as demand grows. Economic theory falsely suggests that land is equivalent to capital. However, capital requires space and time yet land is space and timeless.

As such, land should be considered its own category where it largely increases in value from a gift of nature (resources), public services and the use of nearby land.

Misalignment in Economic Rent

The book argues that the current policy and taxation structure for land has led to a misalignment in economic rent. David Ricardo, a renowned economist, argues that the rent of a piece of land is equal to the economic advantage obtained by using this site relative to the advantage obtained by using the best-unused land for the same purpose. This means that:

  • If an economy develops and its population expands (as we see in most cities), the land available for improvement will shrink and eventually there will be no rent-free land.
  • Rent then becomes determined by locational value. This means that the difference in rent is related to commuting costs and commercial value.
  • Land values underneath city centers have risen at a rate that bears no relation to the investment in the physical property made by the landlord.
  • Thus, a lot of the locational value generated by public developments (e.g. public transportation) accrue to individual landowners.

While land is the biggest form of misaligned economic rent, there are other examples of this phenomenon:

  • Energy licenses and oil companies
  • Patents and tech companies
  • Licensing fees and broadcasting companies
  • Money issued by central banks and financial service companies

How Did We Allow This?

When the foundations of rent policy were created, land was not in great shortage in the Western hemisphere. Planning systems largely came out of the post-war era and were designed to create a property-owning democracy.

Moreover, a lot of Western countries (e.g. Canada) had strong incentives to get people to immigrate to their country.

During the early 1960s, there were three key policy changes that pushed the agenda of a property-owning democracy.

  • Abolishment of imputed rental income
  • Exemption on capital gains for a principal residence
  • Mortgage interest tax relief

There were also two powerful communities that didn't have an incentive to make this change.

  • Landowners: An increase in economic rent (via taxation or another mechanism) would eat into the profits that they were currently enjoying.
  • Financial Sector: Banks have the ability to capitalize on the economic rent derived from increasing land value via interest paid on mortgage credit.

The Speculative Housing Building Model

House building is a cyclical process of raising finance, buying land, securing planning permission, constructing the homes and finally selling them.

Most developers act speculatively and have no long term interest in the houses. Their margin is based on the sales price of the home and the costs of the development process. This is why developers try to derisk themselves by owning strategic landbanks and focusing on specific locales.

Developers price land by looking at the residual value left after the development (sales value less development costs). In a world where we have rising house prices, that'll obviously translate to higher land prices.

The current pricing model has led to lower quality housing (which I can personally attest to based on the houses in the Greater Toronto Area).  

  • In a boom cycle: Higher house prices lead to high land prices, which forces developers to build smaller/poor quality homes.
  • In a bust cycle: Low house prices lead to high land prices (paid from the boom cycle), which forces developers to build smaller/poor quality homes or close shop.

The Negative Feedback Loop Between House Ownership and House Prices

Tell me if this story sounds familiar:

  • Consistently low-interest rates and low inflation enabled prices to triple in the past 10-15 years with house price to earnings ratios up to over 10x.  
  • The severity of this decline in affordability has been masked, by low mortgage rates and higher loan to value ratios, which kept monthly repayments within reasonable bounds for those buyers able to find sufficient capital for a deposit.  
  • Policy responses to the mounting affordability pressure, therefore, focused on helping first-time buyers over the deposit barrier through a series of low-cost homeownership initiatives.

Some of you may think I'm describing what's happening today (in Toronto at least) - however, this is what happened in the UK in the mid-1990s.

Our short-term mindset and the need to maintain the current paradigm of having a 'property-owning democracy' has led to the vicious cycle below.

Today's Landscape

It looks like the 19th-century picture of the land economy is beginning to resurface, where the majority of people will find themselves renting from a small minority of property owners. The 20th century may end up being seen as a 'blip' where policy intervention in land, housing, and finance allowed millions of people to secure a home.

As homeownership reached its limits and the government did not address the problem of economic rent, the dynamics of the land market have reasserted themselves. The beneficiaries of the rentier economy are the small but growing subset of people who have used their wealth to acquire multiple properties.

Barring any change to solve the problem of economic rent, there are two possible outcomes:

  1. Crash in property values will reset the market. While people have been calling for this, we've seen continued government support and financial deregulation to prevent a market crash.  
  2. We may witness a political crisis driven by a housing market failure where the public can no longer handle the higher rents (as a percentage of wages).  

I believe that as house prices keep rising relative to incomes, a tipping point will eventually be reached when the majority of populations in Western Democracies will favor policies that reduce the concentration of wealth in property.


Suthen Siva

December 26, 2019