Valuing Urban Land with Land Residual and Option Value Methods: Applications to House Price Dynamics and Volatility

Abstract

Separating urban land and structure values is important for national accounts and for analysis of house price dynamics. A large part of the literature on urban land valuation uses the land residual method, which relies on the assumption that structures are easily replaced. But urban land value depends on accessibility to nearby land uses, implying that infrastructure and the slowly changing built environment are the most important components of land value. Investments in structures are only slowly reversible, implying that land and structure function as a bundled good whereas land residual theory severs the connection between land value and structure value over time. We develop a simple theoretical model that includes risk – and therefore the option to delay – and compare our model to a nested land residual model before and after a shock to values. Cross-sectionally our model shows that land residual theory overestimates structure value; over time almost all of any change in property value is allocated to land residuals. Data from Maricopa county, AZ, 2012–2018 strongly support option value models when nested within a general model that also includes land residuals. FHFA estimates use entirely different cost estimation methods: our analysis of FHA data suggest that our conclusions generalize to the U.S. as a whole, and that high and rising land value ratios (the “hockey stick” pattern found in the literature) are likely an artifact of the residual model. We further show that construction costs are valued by the housing market, suggesting a new use of the construction cost variable.