Do Higher Land Values Cause Higher House Prices, or Vice Versa?

Abstract

This paper is a study of the dynamic relationship between residential land values and house prices. Little agreement exists regarding the direction of causality between house prices and residential land values. One could argue that causality is unidirectional, running from house prices to residential land values, but not vice versa. One could also argue that causality could go the other way, from high residential land values to high house prices. Still further one could argue that causality goes both ways. To examine which of these hypotheses is most likely, tests of Granger causality are applied. The tests are applied to US data from 1985-2004 for 27 MSAs. The data strongly support the view that the causality between residential land values and house prices is bidirectional. Our findings also indicate that the causality from house prices to residential land values increases in proportion to land use regulations. Finally, we find that our results are robust to employing the level of house prices to take account of the option to develop in the future.