In a free market, products tend to exchange for their cost of reproduction. (1) Assets which cannot be reproduced, but yield an income (like a license to sell alcoholic beverages) are valued through a process called capitalization.
Parcels of land fit in this category. Because they cannot be produced, their price cannot be determined by cost of reproduction. So, the selling price of a parcel of land is based on a comparison between the potential income from that land and the amount of capital that would be needed to yield a similar income. This process, called “capitalization,” is standard in real estate circles.
As we have seen, the income from a parcel of land tends to increase faster than the income from the ownership of capital. In that case, if the owner of a parcel of land agreed to sell it for a price based on its current income, she would forego the increased profits which would accrue over time.
Although land is usually offered for sale at an advertised price, it is generally sold for less to the highest bidder. And it is rarely sold for a price based on its potential to yield an income in the present. The buyer will tend to be the person with the greatest expectation of the site’s future profits.
There is no way to predict with certainty what the rental income of a site will be in the future. Therefore, there is no existing set of facts from which to precisely calculate what anyone will pay for a parcel of land in the present. In times of land booms, when land prices are rising rapidly, this prediction gets less and less precise.
The process of capitalization also depends on the interest rate. Essentially, the annual rent of a site is divided by the current rate of interest, and this capitalized rent, plus a speculative premium, is the basis for the selling price. Thus, there tends to be an inverse relationship between the rate of interest and the selling price of land. If the interest rate is lower, more capital will have to be invested to yield the same annual income. Therefore, if the central bank lowers interest rates, this means that the divisor — the capitalization rate — is a lower figure. Land prices will increase.
One implication of this fact is that there is a persistent incentive to keep interest rates low. A great many people in today’s economy have investments in real estate. Some two-thirds of US families “own” — that is, hold some equity in — their homes. If interest rates are low, real estate prices will tend to stay high. This is widely seen as a sign of “economic health” — after a recession, a “rebound” in real estate values is seen as good news.
However, it is not good news for everyone. People who can’t afford a down payment on real estate, and have to rent their homes, end up paying more and more. Also, inflation tends to favor people who are already in debt: having borrowed money when it was worth more, they can pay off the debt in money that buys less than it did when they borrowed it. This is one more example of how the economic interests of landowners are opposed to those of everyone who exerts labor to produce goods and services. But — as we’ve noted — there are many, many land “owners”, and many more who want to share in the “American Dream” of home ownership.
Land Value Taxation and Land Prices
If the entire rent of land were taken in taxation, there would be no rental income, hence nothing to capitalize, and no selling price. A 100% tax on land rent would destroy the selling price of land, and thereby destroy any profit that could be had from land speculation.
This fact has led some critics to complain that because a 100% tax on land values would destroy land’s selling price, this revenue source would destroy its own tax base. This criticism ignores the difference between selling price and rental value. The selling price of land is based on the landholder’s ability to keep collecting the land’s rent in the future. If the rental value were fully collected by the community, there would be no rent to collect in the future, and therefore no selling price. Nevertheless, land would still have a rental value, as long as people were willing to pay for its use. If the overall economic climate improved, the land’s rental value would increase.
NOTES
1. This includes the costs of land, capital and labor, including entrepreneurial labor which earns profits. See our Economic Definitions. (Go back)