This article is part of a series on incremental growth. Read the first article: "The Power of Growing Incrementally."
There is a children’s book called The Little House written by Virginia Lee Burton that perfectly illustrates incremental development, including the stubborn holdout (which, in this case, is the star of the book). Once up a time there was a Little House way out in the country. She was a pretty Little House and she was strong and well built... I read this book to my children many times.
At the start of the book, the lights of the big city are way off in the distance. After a while, a road is built nearby and homes that look a lot like the Little House start to show up. In a couple pages, those homes become apartments and tenement houses. A trolley car is built and then, later, an elevated train. The tenements are replaced with skyscrapers and development became so intense that the Little House, “only saw the sun at noon, and didn’t see the moon or stars at night at all because the lights of the city were too bright.” The happy ending comes when the little house is moved out of town to an idyllic setting in the country (some justice occurs when traffic is held up for the movers).
This is a nice little tale about the value of a slow and simple life, but it’s also – probably unwittingly – a lesson in development economics. As the movers were bringing the Little House to its new home in the country, I couldn’t help but think about the massive payoff the great-great-granddaughter of the original owner was getting for that land. And if the city had a property tax or sales tax instead of a land tax – which they must have had for the situation to persist as long as it did – how all that financial gain came through the investment of others. The book is about nostalgia, but it is also about the economics of rent seeking.
Yesterday I wrote about how incrementally rising land values, combined with the ability to redevelop to something more intense, naturally prompts the redevelopment of properties in decline. As the value of the land increases, there is natural pressure to make more out of the property. As apartments and condo units grew up around the Little House, the value of the land it was sitting on grew tremendously, even though the house itself was in decline.
Let’s follow the economic life cycle of the Little House and the property around it.
To use some simple numbers, in the first iteration, let's assume the lot the Little House was built upon cost $10,000. What scale of a home would we anticipate on such a lot? Let’s go to the extremes to illustrate the point: Would you more likely expect a popup shack or a multi-story, luxury condo unit? Of course, we’d expect the shack. The land is cheap and that low cost reflects the demand for it. There would be no expectation that a luxury condo would work in such a place; if it would, the land would be more expensive.
When thinking about developing a $10,000 lot, we can think of the land cost as being 10% of the total development cost. That would mean the Little House would cost $90,000 to build for a total property cost (Land + Improvement) of $100,000.
At this point, the ratio between the Improvement Value and the Land Value is 9:1. $90,000 of improvements have been made on land costing $10,000. Thus, I/L = 9. That’s the starting point.
Then a road is built nearby. The road is an incremental investment that improves the value of the land. Other homes start showing up, an indicator of demand. At the same time, there is no real reason that value of the Little House itself is increasing. In fact, the shingles now need to be replaced, the siding needs to be repainted and the appliances are going bad. In other words, the Little House is a generation older and needs some maintenance.
So the incremental investments -- public and private -- increase the value of the land. At the same time, the value of the improvement is falling. Let's say the land improves in value, due to the new road and all the additional development demand, to $25,000 while the value of the improvements (minus the deferred maintenance) falls to $75,000. The total property value has stayed the same, but the value has shifted more towards the land. Importantly, the Improvement to Land Ratio is now 3:1.
I am going to make an observation here: At a 9:1 I/L ratio, the property is stable. No rational actor is going to purchase that property for $100,000, tear down the improvements and redevelop the lot. Why would they? The underlying land does not justify such an investment.
At 3:1, however, the property is a lot less stable and the redevelopment potential is much higher. If there is an empty lot left on this block that sells for $25,000, we would expect an improvement of $225,000 to occur there, which would be a 9:1 ratio. That means the Little House worth $100,000 is the cheapest house on a block where homes are worth more than twice as much.
What happens to the cheapest house on a block where land values are rising? It gets redeveloped. It's a great investment opportunity. If the current owner does not, someone is going to purchase that property -- which is in decline -- for $100,000 and spend the money to improve it to around the $225,000 range. That may be a series of additions. It may be the construction of a secondary rental apartment. It might be the conversion to a duplex. Regardless, the Little House -- in any normal circumstance -- is going to be gone once the land value no longer justifies that modest level of improvement.
In traditional development patterns, where development happens incrementally on a continuum of improvement, this cycle happens over and over again as long as land values continue to increase. Continual increases in land values naturally drive redevelopment and result in the incremental growth. This is a virtuous feedback loop where rising land values prompts incremental investment which, in turn, increases land values further.
The operative question now is this: How do we consistently improve land values? In what we've often called the Good Party in our Party Analogy, the more people that show up to the good party, the more resources they bring with them and the better the party gets. We start with the Little House. Incrementally a small road is added. More houses start to show up. The road is improved. More houses show up. There is enough money for a fire department. More people show up. We can now afford to put in a centralized water works. More people show up. We can now afford a trolley line. And on and on and on....
It's the incremental nature of both the private and the public investments that make these places strong, resilient and financially productive.
Tomorrow, we're going to look at the many ways the Suburban Experiment -- which impacted our core cities as well as the land around them -- has undermined the incremental development approach by flatlining land values at a level too high to get started and too low to justify redevelopment. It's made our cities fragile and made widespread decline inevitable. In short, we've created a really bad party.
Read the next article in the series: "The End of Incrementalism."