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WARNING – landowning can damage your wealth

Many people are now ruefully coming to accept the truth of the title of this piece. Landowning can indeed damage your wealth. But in the past, land ownership has been the route to riches for generation after generation. What went wrong?

Nearly everyone considers that land is wealth. After all, owning land means that one owns some of the surface of the planet, and what could be more secure than that? After all, they don’t make it any more. In truth, the notion that land is wealth could not be further from the truth. The error lies at the root of what has got a lot of people, institutions and governments into trouble during the past year.

When you buy a piece of land, what have you actually purchased? It is not something you can take home and wear or eat or travel around in. In fact, in some countries, such as England, land owners do not actually own the land. They are “freeholders”, which means they hold the land free of any charge. Who do they hold it from? The Sovereign, who holds it on behalf of all the English people. That is that the doctrine.

A bundle of rights

In practice of course, landowners can do more or less what they like with their land. Only they can’t. They cannot breach the planning regulations, or do things that will annoy their neighbours. In other words, landowners’ rights are limited. They can do what they like only within those restrictions. They are permitted to fence “their” land, grow things on it, put up buildings but only in accordance with the planning rules, occupy it themselves or leave it vacant, or allow other to occupy it for a consideration, which is called rent, and they can dispose of it to others. That is about it. Depending on the legislation, owners might not even own the minerals under their land. As the late Professor of Land Economy at the University of Cambridge reputedly said (sorry, cannot find the reference), land ownership is no more than “a bundle of rights”, one that varies over time and from place to place. It is never an absolute thing, as for example, is ownership of a pair of trousers.

Isn’t this a bit theoretical? Surely everyone wants to own land? They do, but why? One all land is owned, then those who are not owners are like a player in a game of Monopoly who joins in when all the sites have been bought by the players who were in at the beginning. With a few exceptions like the “Go” square, the newcomer has to pay rent wherever he lands. This makes land ownership desirable.

What is this “rent”? Rent is the superior earning power of the site. For growing things, the fertility of the soil is important, but what matters most is location. Fertile land is no good if there is no means of getting the crop to the people who want it. The most valuable crop a farmer can grow is an estate of houses, and then location is all. Who cares about fertility? Planning consent and a good commuter train service to the nearest city is all that is needed. Location is all. You can’t even give away free newspapers except where there is a stream of people passing by – for example, at the approach to a railway station.

What is the true value of land? It is not its selling price. People who should have known better were taken in by that mistake. The true value of land it its annual rental value. This is easy to understand if one is using it to graze cows on. Where there are buildings on the land, it is difficult to spot, partly because people are used to buying or renting buildings at a charge which includes the land value, and partly because it is selling prices that attract the most attention. But it is the underlying rental value that matters. It is not so difficult to establish rental values, because in Britain and many other countries today there is a lively market in both residential and commercial letting, with minimum regulation. In principle, though in practice it is a task for professional valuers, all that is necessary to do is to take the gross rent and deduct the de-capitalised value of the buildings and structures standing on the land. For a new building, the decapitalised value would be the annual amortisation of the construction cost, less an allowance for depreciation. In practice, if the buildings are in good condition, this figure is around 4% – 5% of current construction costs. If this is deducted from the actual rental paid, the difference is the rental value of the land, the location value. The difference is easily seen by comparing rents for good quality offices in different parts of London, or in Central London in comparison with the central areas of provincial cities. The difference is land value.

Primed for a crash

Land purchase is in essence nothing more than the purchase of a stream of rental income. It is best thought of like an annuity. The land price is the capitalisation of the rental income. If the same amount placed in a bank account would yield more in interest, then the price is too high. Except that things are not that simple. Rental values tend to rise, partly in response economic development and partly to keep pace with inflation. Thus a lower rate of return can reasonably be expected. But not absurdly lower. What tends to happen is that in the upwards phase of an economic cycle, land prices rise in antipation of future increases in rental value. Those prices then rise further as land is traded, using borrowed money,  on the expectation of future increase in those prices. This causes the yield to drop further, to the point that rental incomes are significantly less than the cost of servicing the debts incurred by people who have borrowed money to pay for land. The return has become absurdly lower and the market is then primed for the crash, which will take place at the first shock item of news.

There are many ways of making money out of land, but timing is all. Anyone who purchased  before 2000 and sold before 2006 would have made a tidy sum from their transaction. After 2006, the market was ready for collapse, whch duly came in 2007. People made a bit more by hanging on till the last moment and then selling, but that was a risky strategy. The fall has a long way to go, but it will eventually reach equilibrium and then will be the time to go back in to the market. In the meantime, a period of recession and inflation are coming. But the time to start buying again may arrive sooner than people think.

There is also a lesson here for bankers. Land is not wealth. Land titles are a claim on wealth. That is a different thing entirely and bankers should never forget it.