There is something profoundly wrong with our housing system: demand and prices continue to rise yet supply does not, largely due to the development process. Toby Lloyd argues that any serious attempt to address the housing crisis must include measures to change the land market, allowing those who want to build to buy land at a low cost.
Buy land. They’re not making it anymore. – Mark Twain
Housing in the UK seems to have almost economic theory-defying properties: demand has risen continuously, as have prices, yet supply has not. The key to appreciating and changing this is understanding the development process, and especially the way the land market works. Raising the quality and quantity of the homes we build and lowering the cost is a fruitful area for long term reform.
What makes housing different?
There is something profoundly wrong with our housing system. No matter how high house prices rise the market does not respond with more supply.
No other market behaves like this. If the price of wine, flip-flops or smart phones rises, producers react by making more of them. The difference between all these things and houses is that you can import flip-flops, or sell someone a new smart phone, without having to develop land, but you can’t build a house without somewhere to put it. And that means engaging in the land market.
Try buying some land. You will rapidly discover that the land market has some very odd features. First, it’s extremely hard to find out what bits of land might be for sale. Landowners sometimes advertise a site for sale, in trade magazines most of us have never heard of, but this is very much the exception. Most sites are bought by a developer or agent approaching the owner directly to suggest a possible sale.
Second, it’s often very tricky to find out who the owner is. The ownership of most land is recorded at the Land Registry and can in theory be looked up – but it’s not an easy process, and you need to know what you’re doing. Half the time it turns out that the registered owner is a company name, often registered overseas, so you may never be able to track down someone who could discuss selling the site.
The next barrier is simply that most landowners have no intention of selling their land, at least not unless you offer them a very high price. After all, they’ve stopped making it. Many landowners turn out to have no interest in building: 50% of land with planning permission in London is owned by non-developers. So what is a silly price, or a fair one? Nine times out of ten the site will not have a selling price advertised. It’s all up for negotiation, and as there aren’t many transactions, and each site is different anyway, it’s not easy to compare your bit of land with another to work out a fair value.
How to value land
The first two problems above are annoying inefficiencies, and help ensure that the land market remains an opaque and mysterious business, but they could be overcome with some simple institutional reform. The third problem is far more profound: no-one knows how much land is worth. Instead, those in the development and property industries attempt to estimate the ‘correct’ price for a piece of land using what is known as the ‘residual land value’ methodology.
At its simplest, you start with what you could sell it for with something on it – e.g. a market value house – and then subtract how much that something costs to build and a reasonable profit margin. The remainder is the ‘residual land value’ – the price you can offer the land owner. Build costs and profit margins are well established, so both sides have a reasonable estimate of this final price.
Although it is the last step in the calculation , the price of the site is the first cost to be fixed and paid – and it’s almost always the single biggest cost in development. This leaves the developer carrying a whole series of risks, such as planning delays, construction problems, interest rate changes and, more notably, significant house price variation.
Risk aversion in house building
If any of these risks occur, you could be seriously out of pocket – so naturally developers seek to reduce this risk as best they can, by trimming costs, sticking to well-known technologies and product design, selling homes before they are built to investors, and trickling new supply on to the market to avoid lowering local prices.
The result is thoroughly sub-optimal: identical blocks of flats that seem to take years to be delivered, and are largely bought by buy-to-let landlords and foreign investors, not people that actually want to live in them. This business model is now completely entrenched, as a small number of major firms adhering to it dominant the industry. The difficulty of acquiring land acts a massive barrier to entry, preventing new competitors, especially SMEs, from challenging the existing players’ model.
The Viability Trap
Developers are not acting irrationally: this model has generally delivered well for them and their shareholders. But it does make them risk averse and reluctant to build at scale, for fear of significant losses. Of course, if you buy the site cheap enough you can afford to take the odd risk, even make some mistakes, later in the process. Unfortunately buying the site cheap is rarely an option, because in a competitive land market there is nearly always a more optimistic competitor trying to outbid you in the auction for that site.
When you’re trying to work out how much to offer the landowner, if you make a sensible estimate of where house prices will be in three years you’re likely to be outbid by someone who makes a more bullish estimate. If you assume you’ll have to follow local planning policy and provide, say, 30% affordable housing, your offer will be trumped by a rival who reckons he can screw the planners down to 20%.
The result of the land auction process is that the worst scheme, the one that offers the least to the community, the poorest quality homes, and charges the most for them, is generally the one that will happen, because this is the one that offers the most cash up front to the landowner. As a result, development is always already at the margins of viability. Even a relatively small shock can see construction grind to a halt rapidly, because there is simply not enough margin left after the landowner’s cut has come out for the developer to want to build.
This is why developers are currently queuing up to renegotiate ‘Section 106 agreements’ (legal offers of affordable homes, infrastructure or funding to councils to secure planning permission) that they signed up to voluntarily a few years ago. Of course, this trick only works once. Lowering the expected cost of future Section 106 agreements simply enables developers to calculate a higher residual value on the next site, and so pay the landowner more for it. Thus reducing the burden of planning obligations can only have a very short term stimulus effect before land prices adjust to absorb the new margin. The same is true of any increase in the availability of capital, whether from easing credit conditions or public investment: if it is not accompanied by an increase in land, it will just inflate land prices.
Already incentivised to eke out supply, if the market turns down, developers turn off the taps entirely. In a falling or stagnant market the best strategy is to hold onto the sites and wait for values to come back – or ‘prioritising margin over volume’, as the largest house builder in the country puts it. And when recovery does come, land markets quickly price in expected future value gains, keeping development at the margins of viability and making output growth painfully slow. The combination of developers’ ability to withhold supply and the viability trap, both created by the land market, creates a downward ratchet in overall house building. Over recent decades total supply has plummeted with each economic crash and then inched up during times of growth, never quite reaching the previous peak before the next crash comes along.
Minimising output to maintain prices is not a strategy that many other industries can adopt. Providers of social care or hamburgers can’t stock pile their products for five years, waiting for the right market conditions. But those that own land (or equivalent natural resources, such as oil) always have that option because no new supplier will undercut you, and there is essentially no holding cost for land. Even if land prices do fall for a bit, over the long run they always seem to rise, so waiting makes sense. Inevitably, developers find themselves holding onto land banks, and often making more out of trading them than they do from construction. In fact, British developers have long been a curious mix of land traders and construction managers – and there’s often more money to be made from the former function.
The Law of Rent
As Adam Smith and David Ricardo noted, there is no easy way around this phenomenon: Ricardo’s ‘law of rent’ states that the value created by positive development accrues to the person that owns the land. The fault is not with the developer (at least as far as they are acting as a developer rather than as a landowner), nor the residual valuation method: it’s inherent in land markets. Land markets tend to internalise productive value from elsewhere in the economy, and return them to the landowner, leaving little potential return for building companies, or for residents or the wider community. Typically land markets successfully capture almost all the financial gains from public investment in, for example, new train stations or better schools.
One proposed solution is to loosen planning rules to flood the market with land with permission to bring down the cost. Endless urban sprawl may be acceptable in Texas and other land-rich places, but it has serious environmental, social and political implications that render it untenable in the UK. Blaming planning exclusively for land scarcity ignores the fact of concentrated land ownership in some areas, and the incentives landowners have to hold on to sites, hoping for a change a reversal in planning policy. Ultimately, this approach misunderstands the nature of land markets: we have a planning system because the right bits of land are inherently scarce, not the other way round.
Interestingly for our current times, the law of rent implies that we cannot solve the problem just by applying more money to it – in fact pouring more cash into the land market only pushes the price of sites up still further. The search for solutions therefore has to turn to other kinds of intervention that can disrupt this pattern and prevent land markets from extracting all the value from development before it’s even happened.
Any serious attempt to address our housing crisis must include measures to change incentives and price signals in the land market, secure land at low cost, and get it into the hands of those who really want to build. For example, by setting up Community Land Auctions, compulsory purchase of land in key areas, and using the tax system to capture future price increases caused by public investment.
Housing is different because land is different from other assets. This understanding is integral to solving our housing crisis. Martin Wolf of the Financial Times recently noted that this awareness was central to the classical economics of Smith and Ricardo, but was lost in 20th century economics. We urgently need to re-capture that understanding in the 21st to truly deal with the housing crisis.
Note: A version of this article appeared originally in a Green Alliance publication and gives the views of the author, and not the position of the British Politics and Policy blog, nor of the London School of Economics. Please read our comments policy before posting. Home page image credit: Capt’ Gorgeous.
About the Author
Toby Lloyd has worked in housing policy across the public, private and voluntary sectors for ten years, and joined Shelter as Head of Policy in 2011. Previously he led Navigant Consulting’s policy and strategy division, where he advised local and national government and the private sector on housing, planning and regeneration. He has been a senior policy manager for the Greater London Authority, a project manager for the London Rebuilding Society, and taught financial history at LSE. In his spare time he is part of the Hackney Cohousing Project, a community led scheme seeking to develop fifteen homes in a mixed tenure, multi-generational neighbourhood.