Why developers land bank

In this article, an explanation is given to the practice of land banking of property developers and where the writer says its practice is really a reflection on regulatory environment present. I wonder if it the same case applies where the regulations are lax or even non-existent and whether this encourages use, abuse and misuse of the property to the disadvantage of the government and the community at large.

From MacroBusiness.com

Posted by  in Economicson 23 December 2011

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…


One thought on “Why developers land bank

  1. […] Why developers land bank (stimuluscapitalideas.wordpress.com) […]

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