House prices the role of accumulated house values

People often query why there is a difference between the cost of building a property and the price of the property. They assume that the difference is purely down to the cost of land and that this reflects the impact of planning.  But is this the correct analysis?

 

Lets look at why house prices are more than the cost of construction.

 

Land values

Base component

There is what we can term a base element or value. This will vary according to factors such as demand for land, population density, the predominant land use, and competing uses for land. Base values are lower in areas where the main land use is say agricultural, although within agricultural areas values will differ according to the quality of the land, and higher in urban areas.  Values in urban areas also vary with higher-level settlements (Christallers Central Place theory) having higher values than lower level settlements.  Areas within cities such as prime central housing and commercial areas have higher vales than more peripheral areas.

 

Base values reflect the accumulation of values over time.

 

Additional component

So what creates the additional land value?  Factors such as the intended use of the site, the resources of a purchaser, general earnings levels and the desirability of an area. If a purchaser considers that they can use a particular site for a more profitable use they be prepared to pay more than the average buyer.

 

Accumulated value  

This refers to the accumulated value of land and/or a dwelling over time.  This value is derived predominantly from changes in asset values and earnings in the past.  It also includes the original cost of construction. The value generally increases from year to year, the current years values building on past values.

 

Such values can fall if for example a housing bubble bursts. The best example is that of Japan which saw rising values from 1986 to 1991 due to cheap credit and speculation. Asset values then collapsed wiping out the investments of many companies and individuals.

 

To summarise, the value of an existing property is based on the accumulated value including current house price inflation. 

 

New dwellings

So what determines the value of a new dwelling?  Part of the cost of a new dwelling is determined by the cost of construction.  The rest will depend on the accumulated value of adjacent properties. If for example the total value of an adjacent dwelling equals £350,000 and the construction costs of a new dwelling are £150,000 then the difference - £200,000 represents the potential accumulated value. Any land used for a new dwelling will therefore be worth £200,000.  

 

If a new dwelling were sold for £150,000 then the new owner could at some stage sell the property and gain the £200,000.  A purchaser would be prepared to pay the total value in line with the value of other dwellings in the area.

 

In other words, the total value of a new property will rise to fall in line with the other properties in the area.

 

Conclusion

House values reflect the building cost and the accumulated value plus any additional funds which a potential purchaser has available.  Land values and house prices might stabilise if due to a reduction in monetary demand, the additional increase in values was limited.