Why developers land bank

Land banking is a common practice adopted by developers, whereby they accumulate land for development well before the date at which they intend to sub-divide and build new housing.

In modern production processes, “just-in-time” systems – where inputs into the production process are received/acquired just prior to use – are favoured because they reduce the amount of capital ‘tied-up’ in inventory and maximise returns.

Greenfield property development is often viewed as a ‘pipeline’ process, whereby development firms move sequentially through undeveloped sites and gradually change raw rural lands into new housing estates. In this regard, property development is just another production process. So why, then, do property developers tie-up significant amounts of their capital in land banks, instead of simply purchasing undeveloped land as required in a ‘just-in-time’ manner?

The answers lie in the fact that the market for land is imperfect and land is not freely available to be purchased ‘off-the-shelf’. That is, a developer nearing the end of one housing development cannot simply phone a land wholesaler and purchase a new parcel of land to develop. Rather, they must: 1) first search and acquire information on what land is available; 2) negotiate with potential sellers; and 3) in the case of markets with strict land-use regulations, they must navigate the planning system, including seeking planning approval.

If a developer fails to acquire the land and seek planning permission in sufficient time to maintain continuity of production, they risk having their resources sitting idle (e.g. employees, plant and equipment) and may ultimately go out of business.

The size of land banks held by developers is likely to be proportional to the perceived risks and uncertainty of gaining land supply and/or planning permission. Under more restrictive land-use regimes, where there are significant delays and uncertainty in gaining planning permission, developers will typically need to hold larger land banks than in regimes where development is less restricted by regulation and the conversion from rural to urban uses is allowed to take place with minimum interference and fuss. This is because restrictive land-use regimes typically increase the length of time and costs involved in moving from the search and acquire stage of the development process to the construction stage.

Where land-use regulations restrict the amount of developable land available – such as through urban growth boundaries, restrictive zoning, or inadequate infrastructure provision – they also encourage developers to land bank not only to ensure their own continuity of supply (production), but also to make it harder for rival developers to find suitable land. In the process, rival developers can be driven out of business, reducing the overall level of competition in the development market. This is a particular problem for smaller firms lacking the capital necessary to buy-up land ahead of time.

Another consequence of land banking is that it is likely to result in greater levels of pro-cyclicality and facilitate boom/bust price cycles. During periods of strong land/house price growth, the costs of land banking are relatively low because the rate of price appreciation typically exceeds holding costs. However, when land/house prices are stable/falling, land holding costs exceed the level of capital appreciation, resulting in negative returns from land banking.

A better way to prevent land banking:

Last week, fellow MacroBusiness blogger, Rumplestatskin, put forward a proposal to reduce property industry ‘rent-seeking’ (achieved partly via land banking) through a system of tradeable development rights.

While it is an interesting proposal, I believe that it treats the symptoms of ‘rent seeking’ (or ‘planning gain’) whilst ignoring the main cause: overly restrictive and bureaucratic planning processes.

For reasons outlined above, land banking – an especially baneful form of rent seeking at the current time – is more prevalent in situations where land supply is constrained and planning approval processes are slow and uncertain. Land banking is also only profitable where the value of land is rising faster than the cost of capital. And in the absence of physical barriers to land supply, land price increases above the level of inflation are driven primarily by policies and regulations that artificially restrict the supply of land.

It stands to reason, then, that the removal of regulatory constraints on the supply of land, along with more permissive planning policies and infrastructure provision, would increase competition amongst both developers and land owners, thereby driving down the cost of land/housing. The existence of high levels of competition would, in turn, make land banking particularly risky, as another nearby owner would always have the opportunity to move to the market ahead of the land banking firm.

The benefits of liberalising the land market and planning system were recently acknowledged by Dr Arthur Grimes, Chair of the Board of the Reserve Bank of New Zealand, who noted:

…that it is important to ensure that developers are competing with each other for the right to develop, so as to ensure that the land is offered at the most affordable price. Where competition amongst developers is limited by land availability constraints, the resulting prices will incorporate monopolistic rents (leading to high land and house prices).

In a similar vein, the New Zealand Productivity Commission Report on Housing Affordability, released last week, noted the importance of competition in reducing land banking and rent seeking by property developers:

The long delays associated with bringing both brownfield and greenfield land to the market suggest that a fifteen or even twenty-year pipeline written into plans is likely to be inadequate in practice, particularly if subject to short-term constraints through plan-based staging of land release. When supply is over-regulated in this way land banking becomes a rational commercial response, further undermining the calculation of future capacity and promoting high land and housing prices.

Sufficient competition in the supply of land for development will assist in placing downward pressure on land prices. Therefore, developers are competing with each other with respect to the sale of construction ready sections, thereby helping ensure that land is offered at affordable prices. Where competition amongst developers is limited by land availability constraints, this can lead to high land and house prices.

The effect of adopting these policies will be to substantially reduce the opportunity for speculative investments by individual land owners and developers.

Finally, Professor Alan Evans, Director of the Centre for Spatial and Real Estate Economics at the University of Reading (United Kingdom), has written two fabulous books on the economics of planning and the supply of land (here and here). Below are some quotes on the motivations behind land banking and the importance of facilitating competition between developers and land owners:

When planners provide “X years supply” of land within growth boundaries, they completely fail to realise that a high proportion of existing owners of property within those boundaries simply will not want to sell within “X years”. Older farmers, for example, and others “attached” to their properties, who do not want the upheaval of re-establishing themselves at a different location. Importantly, there will also be property owners who see the chance of higher prices the longer they hold their properties…

However, if there is no growth boundary or greenbelt, and there is ample land zoned for development, there should be no shortage of property owners further afield who will sell at prices similar to agricultural land prices.

Evans further points out that if there are delays in obtaining development permissions, etc, (in addition to the presence of a boundary) the amount of land each developer needs to purchase and hold to stay in business is increased (so that they will not end up with no work in between completing one development and actually beginning the next). This places additional pressures on the “available land supply”:

…as well as causing delay and increasing uncertainty, the process of seeking planning permission lends itself to strategic thinking and behaviour… the lack of certainty created by [such] a system is that it encourages the possession by large developers such as volume house builders of land banks… which can be developed at some future time. A developer such as a volume house builder will seek to ensure continuity in the supply of sites for development so as to ensure that management, equipment and labour can be used efficiently… without being laid off or idle. Commentary on the financial pages of newspapers would suggest that a land bank of at least 3 years supply seems to be regarded as necessary for the financial health of a house builder… not having a site available for development at the right time can mean that a exorbitant price will have to be paid to buy one, in order to keep the firm in business…

It can also be seen that the system will tend to favour the large development and the large developer over the small… The result…is that small firms are the ones likely to be forced into making suicidal bids to try and obtain land for development…

In favouring the large over the small, the system will also have aesthetic consequences……it is easier for everybody if a housing development is large, and with relatively few differences between the planned houses…

…It is likely, particularly in areas of planning constraint where planning permission is itself worth a considerable sum, that the planning side will contribute far more to the profits of the business than the construction side… some firms in the UK have concentrated solely on this side of the business, selling the land once permission has been obtained…

In a nutshell, land banking and rent seeking are symptoms of regulatory (or other) restrictions on land supply, cumbersome planning approval processes, and inadequate provision of housing-related infrastructure. Therefore, the first best policy response would be to address these issues directly.

Of course, a broad-based land value tax wouldn’t go astray either…

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Comments

  1. My view if something is zoned agricultural/commercial/industrial it should be producing something if not a levy is applied at the very least if the owners cant run a crop or agistment or lease the space they either lease or sell to someone who will. Of course i have also seen zoning such as a scenic protection area put in by a council and then rezoned several years later to residential

    • I understand where you are coming from, but I think it too easy to game that sort of legislation and run some ‘pretend’ farming. Plus you will have also introduced another requirement for specialised staff to administer and regulate it, and it will become a source of legal disputation over whether or not this is a ‘real’ farming operation.

      I think Leith is getting to the heart of the matter that you need to remove the reason for land banking in the first place.

      • I reckon you are right, however I was talking to a friend who is trying to sell a farm estate in Ohio, and they have that system in place, I think at the end of the day good legislation that is motivating has to work on Paul’s Keatings maxim, 40% of people will go for the carrot, whilst 60% need to be hit with a stick

      • Also “pretend farming” like any farming requires considerable capital so a farmer would want a good solid long term lease so that he could get a return on his investment, this would put constraints on the land banking issue.

      • From a developers perspective, the win-win here is to lease it to the neighbouring farmer for x years and offer that farmer a reverse mortgage/instalment warrant type arrangement on their farm.

      • The core issue here is “economic rent”. Land values are derived from the use to which the land is put. But when there is a CHOICE of uses and the total supply of land is superabundant, the LOWER value still prevails, even when land is bought for urban development.
        What is farmland worth, through farming it? Experience shows that without urban growth boundaries or proxies for them, developers only need pay “farmland” prices for the land.
        In the Netherlands, the government has the legal power to compulsorily purchase farmland at farmland prices, for urban development; so that they can control urban growth WITHOUT delivering massive capital gains to a lucky minority of land owners and ruining the whole economy via bubble volatility and social injustice.

  2. This whole mess also highlights the issue with the 40 year depreciation schedule. By slowing development, the government hopes to slow urban sprawl and encourage higher density. This is occurring very slowly. It makes sense to me to change the depreciation schedule to actively encourage high density housing.

    Currently there’s a stock in the form of delays, but no carrot.

    • There is also a deeper problem here that almost no-one understands.
      When population is drifting towards and beyond the urban fringe, as long as growth is not strictly controlled, there is a steady supply of LOW cost land into the urban economy. This sets the price for the whole urban economy, and an urban economy with low land prices has a massive economic advantage and social advantages too.
      But when you are trying to “encourage” a shift of population INWARDS, how on earth can anyone expect urban land prices to remain low? Real estate markets simply will always “price out” most people after the first few have moved in to a newly popular location that is INTERNAL in the urban area.
      Subsidies won’t work either – they will just feed straight through to capital gains to the property owners concerned.
      The only thing that will work, is the nationalisation of inner urban area property, and the sale of redeveloped housing at a deliberately BOTTOM-price-setting level for the entire urban area.
      Why do so few people “get” this? Why do the advocates of urban intensification carry merrily on forever as useful idiots of inner city property owning interests? The outcomes of the policies they advocate, are 98% capital gains for those property owners, and 2% actual changes in population dispersion. And 100% cost increases for as-yet-to-become home owners/ renters.

  3. Leith, interesting stuff. Also in QLD there are land tax discounts for approved, but not yet developed, sites. I think we would agree that this is nonsense.

    However, I wouldn’t trust much of what Alan Evan’s says, and poor Dr Grimes seems all mixd up when he says –

    “…that it is important to ensure that developers are competing with each other for the right to develop, so as to ensure that the land is offered at the most affordable price. ”

    When developers compete with each other, they bid UP development sites – yes, the land input costs go up when they compete.

    For example, I was working on a bid for a site in Brisbane. There were 6 bids. Ours came in a $33million. How did we come up with that bid? We calculated the value of the developed lots and subtracted costs and profits to determine the value of the site. Other bid were 37, 39, 44 and 45 million.

    So where did these prices come from? Why was someone willing to bid $12million more, when there war plenty of other sites (we were investigating plenty at the time).

    Simple. They made different assumptions about price growth and the ability to get a planning approval with relaxed density requirements.

    Evans suggests that there needs to be plenty of supply so that farmers will want to sell within certain time frames. As I have mentioned many times, there is no shortage of development sites for sale – far in excess of any reasonable estimate of underlying or actual demand. Nor do sites need to be sold to be developed, as owners can add value at any time. Just ask some developers if there is a shortage of sites.

    I think the point is often missed that prices in property markets are not simply set by costs. Land is a second hand good, and each location is a mini-monopoly no matter what the zoning scheme. Are prices for Da Vinci paintings set by cost (another second hand good with durable value)?

    What slows the rate of supply is the rate of sales. Just look at Houston, and its current slowdown in housing starts and subdivisions. They too suffer from the same land market dynamics.

    • Cam. Alan Evan’s books are the best explanation of land-use economics that I have ever read. And believe me, I have read plenty of papers over the past year or so. You clearly dislike Evans because he destroys Ricardian theory, which you seem to subscribe to (and I obviously strongly disagree with).

      I also fail to understand your Houston comment. Texas’ land supply adjusts freely to changes in demand (keeping prices relatively stable). This is exactly how a market should work. The alternative is unresponsive supply and price volatily. You seem to prefer the latter.

      • IMO, Cam has it pretty right, Leith. Your land-use economics is severely circumscribed if Evans is your best reference.

        And if Evans has destroyed Ricardo (ergo Sir William Petty, who actually preceded him on rent) I guess I should forget everything I learned in real estate valuations at RMIT?

        The truth is that nobody comes within a bull’s roar of Mason Gaffney on land use. He even agrees with your concerns on zoning restrictions bringing about higher land prices, albeit secondary to inadequate land value capture.

        In his inimical style Gaffney has reported so much of the unequalled historical performance of LVT he’d be unable to conclude any essay with the dismissive “Of course, a broad-based land value tax wouldn’t go astray either.”

      • Bryan. You would be well served by reviewing our debate on Cam’s previous article:

        http://www.macrobusiness.com.au/2011/11/urban-sprawl-greenhouse-myths/

        Phil Best and I comprehensively demolished your arguments. Hence, there is not much point re-hashing them here.

        Also, you still haven’t explained why Hong Kong – which has arguably the world’s most advanced LVT regime – experiences chronic booms/busts and unaffordable housing? In your blinkered world, this should not be possible. No such problems in Texas, however. Wonder why?

      • Yes I thought so: I did say inimical instead of inimitable. Mason is not unfriendly; he can’t be copied.

      • I greatly appreciate Mason Gaffney, probably more than you do, Bryan. Unlike you, he is quite clear on what “negative growth containment” does to urban property prices. I do not believe he suggests that a land tax would counter these effects, rather than a land tax would OF ITSELF contain urban growth, and is the only policy necessary to do so. Unlike negative urban growth containment via boundaries and the like, land taxes are entirely beneficial.
        I am, like Mason Gaffney, all for land taxes and all against regulatory boundaries that create a literal racket in land for urban development. I don’t know why you are not this clear yourself.
        I am also 100% clear that what “urban sprawl” did occur under a land tax regime (buildings and improvements would have to be untaxed) would in fact be efficiency-enhancing. Almost nobody “gets it” that a lot of additional land in the urban economy IS efficiency-enhancing. The US economy is the world’s most productive large economy, and I believe that not one economic study will ever prove a correlation between a substantial amount of low density (and low land prices) and low economic productivity – rather the other way around.
        The density of Manhattan makes perfect sense; I doubt that the world economy justifies more than around 1 such centre of density, based as it is on international finance flows, for approximately every few hundred million of first-world population.
        The simple fact is that most of the world economy, will always consist of productive activities that REQUIRE LAND, unlike international finance. Workforces also require low cost land; so far no-one among the constraint utopians has come up with a way of achieving this along with growth constraint – they are either economically illiterate or in the pocket of property owners who reap capital gains from containment policies.

  4. I wonder about the possibility of a steady state economy (zero pop growth) versus the expansionist model that relies on constant population growth. The latter necessitates either urban sprawl with associated land banking or higher density model for cities or a combination. Other possibility is we could have zero pop growth and collapsing urban footprint with higher density living.
    I do not see any real value in urban sprawl for the sake of itself. Urban sprawl is dissipating energy. It will one day be so obvious that whole swathes of suburbs will just be ‘given up on’. On the other hand, higher density property is such poor value for money (land value per unit) it is a wonder anyone buys into it.
    Zero, or near zero population growth (think Nordic counties 0.2-0.4%) is not going to happen tomorrow and is unlikely to be a planned event for 2012.
    Which leads to the question: what is the nexus between land-banking and population growth (net migration + natural births over deaths). Remember, within the 1st year of the Rudd govt taking office (2008) immigration intake was increased something like 60% (190k to 260k).
    From the article above, it appears land-banking is a spin-off over-regulation with “even twenty-year pipeline written into plans is likely to be inadequate in practice”.
    There is no long term population policy in Aus and subsequently no possibility that town planning has a snow flake’s chance in Parliament House of succeeding in terms of matching population requirements. It’s a moveable feast. Why do policy makers pretend to care if they cannot even get together to set a population target?

    • I suppose there is the fundamental connection of a growing population needs to be housed, and under current laws & policies that leads to land banking.

      It’s annoying that greens, nimbys, planners, inner city elitists etc, via state & local government think they can somehow turn back this federally created tide via the various planning tools at their disposal. All they’ve achieved is to make the sprawl really expensive, and make some rent seekers quite wealthy.

      • Exactly, Hamish.
        Population growth or shrinkage, needs to be allowed to take care of itself. If planners try to “balance” “low population growth”, with “reduced urban sprawl”, the result is morally no different to any “racket”.
        If Houston stopped attracting migrants and its inhabitants stopped reproducing, then Houston would largely stop sprawling after a few decades as demographics played themselves out. But if Houston caught the planning disease at any time, they would kill their economy decades before the actual “reduced urban growth” actually “needed” to happen.
        The harm done by the planners is massively disproportionate to the “benefits”. The proportion of incomes and local GDP spent on “housing” becomes many times as much as the original “unaffordable” cost of a little more infrastructure, and actually becomes a new primary reason for fiscal collapse. It is like chopping one’s leg off to fix an ingrown toenail.

      • I was thinking more along the lines of if the aim is to stop sprawl, and preserve the character of existing suburbs, protect farmland and wilderness, lobbying efforts would be far better directed at reducing immigration at the federal level, in order to bring population growth back to zero.

        At the very least state governments should be recieving additional funding from the federal government, to build the additioanl infrastructure required by the high migrant intake the federal government is imposing upon them.

      • Yes, but even if immigration was cut back to zero, you would still have demographic bulges to cope with. And even if the population level was guaranteed static, you would still have the effect of rising incomes to worry about. The higher incomes rise, the more space is consumed by the well off, leaving less to be rationed among the least well off. So the wealthiest get two homes (or more), tennis courts, gardens, garages, swimming pools, etc; while the lowest income earners space per person falls from 350 square feet to 300 square feet, to compensate.
        “Real Earnings Disparities In Britain”, a paper from the London School of Economics a few months ago, described this effect. Urban land rationing impacts the low income earner disproportionately, forcing their housing costs as a % of income up as well as reducing their space per person.
        MY point is that rationing the land creates more harm than benefit, regardless; by all means lobby for population control, but the land rationing system is wrong regardless.

  5. Great post. If we could only adopt the German system of rule-based controls rather than the British system of official discretions, much of this could be avoided. (Taking it as read that an open land market is not an option.)

  6. Top post! UE, you have thrown down the ultimate solution to the rent seekers: Land Value Tax.

    USE the market mechanism. As the price of land is bid up, the LVT obligation increases too. Developers will be leery of holding undeveloped land for long periods. LVT puts a handbrake on free-riding while nearby development increases land values.

    Genuine house builders should embrace LVT, which would replace that vile impost Stamp Duty. Speedy, efficient construction minimizes LVT costs, but not SD.

    Ken Henry recommended LVT and an RSPT. The benefit: the removal of 125 behavior-distorting hard-to-administer easily-evaded EXECRABLE taxes. This is a bargain Australia should embrace. It would usher in a Golden Age. No GFC for us!

      • GREAT post, Leith.
        UE at MB is definitely the world’s foremost forum for analysis of property economics. Leith’s postings, expanded into a book, would be the single best thing I know of, to set the record straight on “what has gone wrong”.
        Leith’s dicovery of Alan W Evans is also a very good thing – Evans deserves credit for setting the theoretical shortcomings straight.
        Ricardo was not wrong – his theory has merely been misapplied. Ricardo is right that when the supply of land is “fixed”, “demand” sets the price. But he was talking about Britain’s agricultural production under pre-agricultural revolution conditions, pre-transport revolution conditions, and disallowing “international factor substitution”. Ricardo in fact did argue that allowing imports of agricultural produce from countries that had NOT run short of land, would bring down land prices in Britain.
        Applying this to the world economy today, means that even in Japan, where there is not enough farmland to feed the population, the price of farmland could be kept down close to an international average if imports of food were freely allowed. Furthermore, Japanese URBAN land prices could remain close to an international average – and pretty much has done except for when they bubbled in the 1980’s. And some economists condemn “planning” even in those circumstances. Even the Japanese could spend centuries expanding their urban areas, keeping their prices low by converting farmland at uninflated prices, and importing incrementally increasing amounts of food. When their urban areas filled Japan, it could be argued that yes, urban land prices are unavoidable, and some sort of government control, as in the Netherlands, would become necessary to keep their economy competitive.

    • As I said to Bryan Kavanagh, a land tax is not a “counter” to the ill effects of urban growth boundaries and other distortionary regulations; it is a good idea in its own right. Abolition of the growth boundaries is still essential.

  7. Here is another illustration of “Ricardian” economics.
    Suppose a corrupt government strictly licensed land for the production of wheat.
    Even if they licensed “enough” land, one would expect the prices of that land, and the price of the wheat produced on it, to rise.
    Bread manufacturers would be in the position of housing developers in our discussion – having to bid for the available supply of wheat.
    People misapplying “Ricardian” theory, would say that the resulting increased price of bread, merely represented “strong demand for bread”, and showed “how much people are willing to pay for bread”.
    Furthermore, their political recommendations to resolve the problem, would focus on the bread manufacturers, not the wheat growers and the licensing system.
    Meanwhile, people who owned land suitable for wheat growing, would be doing everything it takes to get a license too – same thing as land owners just outside an existing UGB do whatever they can to get a rezoning – just for them, of course, preferably not for anyone else.

    • In a sense, Cameron Murray and a few other international deniers like Chris Nelson and Todd Litman and Jeff Kenworthy and John Grigson, are right in the sense that a kind of equilibrium develops around “what people are prepared to pay”. Contemporary economic theory is at a loss to analyse the DIFFERENCE between this “equilibrium” and the possible “free market” equilibrium that would exist without the regulatory rationing/quota system. Paul Cheshire calls it “artificial scarcity premium”. Fred Foldvary calls it “Monopoly Rent”, period, reapplying Marxist theories on urban land rent that are actually correct under conditions of artificial restriction.
      One thing is certain; the new equilibrium creates winners and losers, to a worse extent than other economic factors that receive a lot more attention. This is actually the single biggest issue for social justice – “income redistribution” is a waste of time by comparison.