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. That is how the role of land in the economy — and the pernicious effects of land speculation — gets obscured in the day-to-day conversation about economic policy and problems.