There are several common expressions in real estate. Location, location, location; home values always go up over time; our home is a good investment. They are some of the most often heard idioms. Most of these expressions have been derived from sound principles that had been noticed over time, however; the expressions are over simplified and need to be investigated further. Location, location, location - why, why, why? Do real estate prices really go up over time? Is this home a good investment or just a money pit?
All of our questions have one thing in common. They address the value of a property, not just in the sense of purchase price, but in consideration of the buyer's intentions. If the property being purchased is a primary residence, the value may be measured in the quality of life. Investors will measure property value in terms of its ability to produce income and a return at sale. Speculators, also known as flippers, look to turn a quick profit by purchasing and selling properties that they consider undervalued.
In the following pages, we will explore value of a home in a broad economic sense. Our focus is to understand the basic principles of why overall home values are at various levels in different regions - not the specific value of a house with x number of bedrooms and a pool. We will strive to develop a basic understanding of what factors affect overall home values so we can make sound investment decisions, and avoid making costly mistakes based on emotions and media "noise".
Also known as the three rules of real estate, the expression cuts to the heart of property investment. Since we cannot move the property, its location is of paramount importance. If we have ever seen a map of a city with real estate values - a topographical map, we would notice that the values tend to peak at the city's center (downtown) then decline as we move away. Granted there are some exceptions or other areas of high value, nonetheless; the overall trend is a high concentration of value that tapers off to the borders. Why do most cities exhibit this behavior? To answer this question we will need to review some economic theory on how cities evolve. The following scenario is a bit oversimplified, but does illustrate how a city evolves - city evolution.
Imagine a town back before automobiles and zoning regulations. Our town is surrounded by flat plains of agricultural land - think of a dartboard with the town in the bull's-eye. In town, the crops and livestock are brought to be processed, sold, and exported. Other businesses will soon sprout up to take advantage of the commerce happening in the town. Small shops, bars, and banks locate near the processing centers and markets. In order to operate these facilities and due to transportation constraints workers would naturally choose to have their residences nearby. As time goes by, new industries have opened near processing plants in order to take advantage of being close to their raw products. The industries require new workers who will also require accommodations within a reasonable travel distance to their workplace. Since walking is our main mode of worker transportation, the accommodations will need to be within a reasonable walking distance.
As our town grows, it will need to convert some of the surrounding agricultural land into either residential or commercial uses. However, the conversion of use will not occur unless the value of housing exceeds the value of the agricultural land - the farmer will not sell at a loss. Residential property being developed on the outskirts of town will tend to cost less, since the workers will need to be compensated for having to travel further to work. Now there may be with large estates, but the average house of the day gets cheaper the further away from the city.
Something interesting is about to happen. Because land at the city center is so expensive, it makes more sense to develop multiple units on a single property - apartment buildings. Workers can now opt to live closer to work without having to move farther away from the center of town and work. Office buildings will eventually need to go vertical to rent enough space to be able to justify the land purchase price. Our town becomes a city - growing in land area and density.
Fast forward a few decades, and introduce the automobile and highways. With the improved transportation, the physical proximity to employment is not as important. It is all about the commute time. The utility of the older houses is seen as inadequate by most our population. Everyone wants a driveway, garage, yard, and more than one bathroom, "the American Dream". Developers find that the value of agricultural land is less than developed residential lots, and subdivisions are born. With a short commute from downtown, the middle class worker leaves the city center for the new subdivisions. The suburbs are born.
Downtown, the apartments are under pressure - they are losing the middle class families to the suburbs. People who can afford housing do not wish to live close to industry. Therefore, the apartment owners are left renting housing to workers who cannot afford or make enough income to move. The areas around industry will deteriorate as less is spent to maintain buildings in order to offset lost income.
Fast forward again, and we now find our city is a commuter city. The downtown is full of office buildings, but nobody lives there. Workers drive into work in the morning and leave in the afternoon. At night, the downtown for all intensive purposes is a ghost town. Blighted communities surround the downtown and are where most of the industrial plants are located (if they remain in business). Developers have supplied lots in subdivisions further out from the city center, but the traffic jams and high commute times have put a limit on how far they can go. Our agriculturally based town is now a service and manufacturing hub. The city's economy no longer depends on agriculture. What happened to most our farmers? Well, many became developers as the value of their land for residential use exceeded the value for agriculture. Seems like we have reached our growth limit, the streets and highways are jammed.
Luckily, we have developers willing to solve our problems. Anticipating that commercial uses would produce more value than residential, the development of office and other commercial spaces has begun in the suburbs. Our suburbanites will now have the option of much shorter commutes to work and shopping. With agricultural land around the suburb being cheap, new residential development will begin to radiate out from the new commercial hubs - pending growth of business and population. Therefore, the cycle begins again. Starting from the center of our dartboard, development has spread out to resemble pepperoni on a pizza.
Again, the evolution of our little town to a large metropolis has been over simplified, but it sets the stage to discuss a principle of urban economics, Ricardian rent. David Ricardo developed the theory back in 1817 to try to explain why the value of homes, or rent in his case, varies across a city. The theory is idealized, but we get a good understanding of the basic economics of property value. The main assumption we will begin with is that property owners will rent their land to those willing to pay the most. Next, we assume that the city and urban area is round with our downtown in the center where everybody works - back to our dartboard. All of our workers commute directly to work with a cost of x per mile, but they are each located at various distances d (in miles) from the city center. All households are the same size with an income that can be spent on housing, commuting, and other goods. The households live in the same type of house that cost the same to build with the same density. The only difference between our households is the distance to work.
If everything were the same, why would rents vary across the city? Well, it works out this way - remember the cost of commuting is x per mile. Since all incomes are fixed, a worker who lives farther away from the city center will have to pay more for the commute. The income they can spend on housing and other goods is reduced with each additional mile away from the city center. As all of the houses cost the same to build, the portion of rent the property owner needs to attribute to the physical structure is the same across the whole city - structure rent. Because each worker will want to maximize the amount of income to spend on other goods beside commuting and housing, we find that the location value - location rent - is reduced as we move away from the city center. With each additional mile of distance, the land rent will reduce at the rate of the cost of commuting (See Figure A). Therefore, at the center of the city the commute cost is zero allowing the highest rents to be charged. At the perimeter of the city where the commute cost is the highest, the location rent would be zero. Rent at the outskirts would only need to cover the cost of the house as the land has little location rent value.
Logically the model makes sense. Each worker would like to maximize the amount of income they could spend on other items besides commuting and housing. Competition for rental units would cause housing to fill up, which would require workers to move further away. In order to compensate for higher commuting costs, property owners would need to have lower rents. Our rental model is almost complete, but we need to consider one more item.
Let us look again at our rental values at the city's perimeter. We said the land was worthless, but this was an oversimplification. At the perimeter of development, the land is usually agricultural land that has value based on the crop production. The owner of the property would be able to charge the farmer rental fees for the use of the property know as agricultural rent. Going back to our house at the edge of the city, we see the rent is composed of three parts; location rent (zero at the city's perimeter); structural rent, and agricultural rent (See Figure B).
Now that we have all three pieces of the model, we see that agricultural rent is constant across all property. If the land were more valuable as a farm - it would remain so. The model is idealized so structural rent, the cost to cover the building itself, is also constant across all property. The only component of the rent that changes is the location rent. As we go from the outskirts to the city center, the location rent increases at the rate of decreasing commuter costs.
To add another layer of reality and complexity, let us consider that there are two household types competing to rent homes. All other factors will remain the same except household "A" really hates to commute. They do not mind spending more income for rent as long as they do not have to commute far. Household "B" does not mind commuting. For simplicity let us set the cost of commuting for household "A" at twice the cost of household "B". Here we are relating everything back to dollars and cents, but in real life, the value of the commuting time may be measured in different ways by different people. Household "A" workers value the additional free time more than the additional cost of rent - figure they are willing to pay 30% more in rent for time. What does our city landscape look like? Look at Figure C.
Well, our property owners only take the highest offered rent, so at the city center the housing would be dominated by household "A" renters. Household "A" would dominate the rental market until their commuting cost has reduced the rent they were willing to pay away from the city center matched household "B"'s value. At this slope intercept point, we would find a mix of households. Moving further away from the city, and because the slope of commuting costs is less, we would find only household "B" renters.
If we were to try to develop a more realistic model, we could introduce competing industries along with our households. Each industry would have a different commute cost, however their commuting cost would relate more toward their industry. For instance, a shipping company may have very little commuting costs. Lower commuting costs would locate them out toward the edge of the city, perhaps beyond our housing. Commercial office space may need to be near the city center, and in order to get the location they will pay much higher rents than homeowners will. With a high commuting costs (a need to be near the downtown) and ability to pay higher rent, owners of property will favor commercial property over housing near the city center - and so on. The property will eventually find its highest and best use. As we add complexity with additional industries, and perhaps a few extra households, the model begins to resemble a real city. If we took a chart of rental values from the center of the center to the outskirts, we would see the result of all our industries and housing types form a curve - the bid rent curve.
How does all this modeling of rent translate into value? This is a bit more complicated and abstract, but does relate directly. The price of housing, or any property, is the present discounted value of the rental income stream that is composed of agricultural value, structure value, location value, and newly added future growth in location value. To convert the rental rate into value we merely divide each rent component by the discount rate. The discount rate could be the interest rate, an investment hurdle rate, or derived through complex modeling. We will skip over the complex mathematics and focus on our new term, future growth in location value.
As a city's population grows, the perimeter also expands. At the perimeter, agricultural land is being converted to residential or commercial property. The conversion of land usage is where the largest increase in property value occurs since little or no premium is being paid for location. The entire rental income or purchase price only needs to cover structural and agricultural values. As we look inward toward the city center, property values will rise with growth but at a reduced rate since we must now consider location value. There may be as much as 4% difference between the city center and perimeter growth rates. What happens beyond our city's border? At the fringe of development, the property values will vary based on the future expectations of growth. With a high expectation of growth, usually as the highways are being built, the agricultural land will also acquire a growth premium. Far away from the city center and beyond the border, there may be little or no growth premium, only agricultural value.
Over time, a city's growth will fluctuate. Some cities will cease to grow while others continue. It is the expectation of growth in the city that will affect property values the most. This concept is so important that we will elaborate on it. If two cities are identical in size, the city with the highest prospects for future growth will have higher property values: even if rents in both cities are the same.
Another major contributor to value, which has not been covered, is governmental land use regulation. Local regulators may impose regulations that can be either positive or negative toward values. Sizes of housing units and density requirements are controlled by the municipalities. Even architectural design can be regulated. Impact of local government should be considered when considering where to invest.