Since the early 1970s, house prices have risen at an exponential rate. This comes as a result of a variety of factors: cultural shift to home ownership, seeing housing as an asset to sink pension funds into, increasing demand through accessibility of credit and cheap finance, the change in mortgage criteria to be based upon dual income, lack of competition in the housebuilding market, developer build out models and land availability, to name a few.
While all of these factors are interrelated, one of the biggest factors is land. At its most basic level, to build a house you need land, permission to build and finance to build. In order to obtain land, a developer needs to buy land (or first an option on the land) from the landowner.
Presently, developers use the residual land value model to determine how much to pay the landowner for their land. This is worked out by working backwards through the costs – they know how much they could sell a dwelling for (existing prices/market), they subtract the cost in terms of construction and subtract the profit level they want to make (currently around 20% in order to price in development risk). Whatever is left can be used to buy the land.
The first problem with this model is that all of the power lies with the landowner. If they want to sell at all – which some do not – they will, completely rationally, hold out for the highest price for that land. This means that when the market is at the trough of the cycle, they will hold out for many years until the price rises sufficiently in order to maximise private gains.
The second is that if a developer buys land at the peak of the market before a downturn, when the downturn occurs, they are incentivised to hold on to the land and ride out the wave. Furthermore, as house prices and land values are lower after the crash, the return is lower and so obligations such as affordable housing (s106) may be negotiated down.
The third problem with this model is what is known within economics as ‘rent seeking’ – that is to say that a private individual captures (internalises) extra levels of incomewithout productively using the asset in a better (or next best) way. For example, let’s assume that due to new technology, a developer has increased its efficiency so that the cost of construction is halved. Under the current residual land value model, that saving is directly passed on to the landowner (this developer wants to outbid rival developers to secure the land), without doing anything productively itself – thus improvements are captured privately by the landowner and not the developer improving technology.
However, the fourth issue is arguably largest of all in terms of negative impact. Land value is driven by investment onto its own and adjacent plots of land. Suppose a town has a house price of £400k and land value in this town is £250k while in a remote village disconnected from this town a similar house costs £200k with land value of £50k. Now let’s suppose that public investment (taxpayer funded) into a railway connects, for the first time, the two places. Assuming that the benefits of living in the village at least offset the cost of travel, then the value of the houses in the village would jump to £400k – a value which has almost entirely been driven by the increase in land value. Therefore, private individuals have profited from public investment without any of the uplift (except for small tax revenues from Stamp Duty, Council Tax etc) going to the exchequer (i.e. society) to fund this or similar public goods. This model, in turn, fuels speculation in land purchase and property purchase – where the wealthiest are at an obvious advantage to do so – along where public investment is likely to happen (given engagement and construction lags, it becomes obvious where public investment would occur).
There are a range of interventions that need to happen in order to rectify this problem. But fundamentally, land is at the heart of the housing market. As a result, we should look at ways in which we can incentivise desirable outcomes through land interventions, one of which is land value tax.
This article is the first of a series on land value tax. The next in the series can be found here. More can be found using the tab on the right.