– The Fed’s New Balance Sheet Calculations
A Critique of Land Value Statistics
The most comprehensive official statistics on nationwide real estate values are those published by the Federal Reserve Board (FRB) in its annual “Balance Sheets of the American Economy.” As part of its Z.1 statistical release the FRB compiles annual balance sheets of seven sectors which, taken together, make up the U.S. economy. These are the B-series tables near the end of the quarterly flow of funds reports. (The “B” stands for “Balance sheets.”)
The Fed’s purpose of compiling these balance sheets is to track changes in the net worth of seven sectors: households, non-profit institutions, farms, non-financial non-corporate business, non-financial corporate business, and financial institutions. These estimates include the market value of real estate, as well as other assets, while capital improvements are valued in terms of their estimated their replacement costs.
For 1994, the FRB estimated economy-wide land values at $4.4 trillion and building values at $9 trillion. This total of $13.4 trillion of real estate represented two‑thirds of the total value of all real assets ($20 trillion). Land was estimated to make up about a third of total real estate values — on the assumption that this reflected what it would cost to rebuild all structures to their original condition.
This was a big “if,” of course. When the Fed’s methodology was examined on a sector by sector basis, serious problems were found in the breakdown between land and structures. For instance, by 1993 the FRB estimated that the land held by all nonfinancial corporations had a negative value of $4 billion.
This nonsensical number was the result of the way the FRB imputed land values: It subtracted the estimated replacement cost of buildings from overall real estate market prices. This “land residual” method leaves little room for land value, for it makes the replacement value of structures absorb most of the rising market value of corporate real estate. Replacement values rise even when overall market prices are declining.
In 1995 the Fed stopped publishing estimates. New calculations were promised but postponed. Finally in September 1997, the FRB resumed publication of its balance sheet estimates for some sectors, but the full economy-wide set of balance sheets is yet to appear.
The present report therefore reviews the real estate estimates published in the Fed’s September 15 flow-of-funds Z.1 release for households, non-profit institutions, and corporate nonfinancial nonfarm business. What remains to appear are non-corporate business (the sector to which most commercial real estate investment belongs, which for tax purposes is organized as partnerships rather than incorporated) and also farms, financial corporations, government and foreigners, promised for December release.
How the Fed created a problem by mixing apples and oranges
Real estate represents an economy’s largest category of wealth. The FRB estimates that at yearend 1996, U.S. households and non-profit institutions held $11.4 trillion in tangible assets. Nearly 80 percent ($8.2 trillion) of gross household wealth took the form of real estate (whose $3.6 trillion in mortgage debt represented nearly two-thirds of the household sector’s liabilities, to be sure), while non-profits held $0.8 trillion. Real estate also accounted for nearly half ($3.4 trillion) of the $6.9 trillion in tangible assets owned by non-financial corporate business.
In view of this dominant economic importance of real estate, it is ironic that no better statistics are published. Official estimates are especially bad for land. The methodology by which land values are assessed undervalues them by as much as $4 to $5 trillion — a sum as large as the Fed’s estimate of total economy-wide land value. Land appears only as a residual, not as having a site value in and of itself.
In drawing up balance sheets for the economy, the Fed’s statisticians divide real estate into land and structures. Problems begin here, for the process of imputing land and building values is not so straightforward as it might seem. Estimates of building values may be calculated in a number of ways.
The most direct way is to take the original cost of buildings at the time the structures were built. But the Fed has chosen to focus its numbers on what it would cost to replace these homes, offices, factories and other structures, whose historical cost is deemed less important. Their replacement cost is derived by multiplying their original “historical” cost by the Commerce Department’s construction price index. This means that the longer a building remains standing — even if its original function has become obsolete, and regardless of whether it has been left to deteriorate or has been well maintained and repaired — its replacement cost is calculated as increasing year after year as a result of rising construction prices and other inflationary pressures.
This would not be implausible in and of itself as a measure of what it would cost to keep the economy in its existing state, net of depreciation but taking into account new construction. The problem comes from taking this hypothetical replacement cost, which is not a market price, and subtracting it from the property’s overall appraised market value to derive a hybrid residual, formerly called “land.” This methodology meant that the Balance Sheet breakdowns of real estate into land and structures no longer represented current market prices. Subtracting buildings at their replacement cost (assuming that there is an economic incentive to replace them in the first place) from the property’s current market value left land with only a scant (if any) residual value.
This created substantial confusion. Some users of the Fed statistics took each line independently, that is, out of context. Assuming that the estimated values for buildings were realistic, the inference was that if reported land values were negative — while it was more probable that they were in the neighborhood of $1.5 trillion — then perhaps corporate balance sheets were in stronger condition than many people realized. Those who thought this, however, did not understand how the Fed had derived its figures. Every overestimate of building value reflected a corresponding underestimate of land value, as these imputations occurred in the context of given overall real estate prices.
Faced with the statistical disappearance of land values, the FRB stopped publishing any land estimates at all. This certainly avoided one source of embarassment, for it can hardly be true that all the corporate land in America really had a negative value in 1993, and indeed, a negative value as large as $4 billion.
Suppose somebody made the following offer: “We’ll give you $4 billion dollars. But there’s a catch. You also have to accept all the land that’s owned by all the nonfinancial nonfarm corporations in the United States, free and clear.”
Would you accept the offer? I think that nearly anyone would, because to do so would make one instantaneously a multi-billionaire.
All that the Fed’s residual statistic really meant was that the estimated cost of replacing the existing stock of corporately owned structures had come to exceed the value of all corporate real estate. The problem was that juxtaposing real estate’s overall market price to the replacement cost of buildings created a hybrid residual that produced unrealistically low estimates for “land value” — a hybrid that was not readily classifiable. This problem might have led the Fed’s statisticians to develop alternative methodologies, such as leaving buildings rather than land as the residual store of value. But so far it has not.
The Fed estimates what these replacement costs would be without regard for the fact that the land’s site value also tends to rise, often even more rapidly than building costs. Indeed, if the Fed had begun with land by itself, it probably would have found the land’s long-term rise to be more positive. In any case, something has to give — but should it be land values or building values? What should be treated as the residual value? Do real estate investors bid up the price of properties mainly because the structures have been built in the past at a lower cost than it would take to duplicate them today? Or do investors purchase properties for their site value, perhaps to tear down the old structures and build new ones, to gentrify urban areas by replacing old industrial sites with new residential developments?
For economic theories that incorporate a role for land, it is necessary to get a better estimate of land values in order to estimate the proportion of rental revenue and cash flow that can be attributed to land as distinct from structures and other capital improvements.
Many sites are worth more when they can be delivered vacant, with the buildings torn down so that developers are able to build with a rasa tabla. Changing land use is inherent in the changing balance between industrial, commercial and residential neighborhoods and buildings, from New York City’s high-rise developments to the conversion of about 40,000 former manufacturing spaces into living lofts. A similar conversion of industrial structures to residential or high-density commercial use is found in most major American cities.
While it is true that the reproduction cost of industrial and commercial buildings often exceeds the property’s overall market value, the fact is that nobody would rebuild these structures today. Many sites would be more valuable without the buildings on them. But the Federal Reserve methodology of treating land rather than building as a residuals assumed that the sites are more valuable with their buildings — but in 1993, without their land!
As noted above, rather than continuing to publish such estimates, the Fed stopped reporting real estate figures until it could decide how to avoid the implication that corporate landholdings really had a negative value. Its September 1997 balance sheet estimates included an alternative calculation: the original (historical) cost of buildings. This method would have given land a positive value, but the Fed stopped estimating land values altogether, evidently so as not to report a figure in which its own economists had little faith. There no longer is a line labeled “land,” nor does the Fed publish a residual number for “market value, less the historical cost (or even the replacement cost) of buildings.” Instead of making better land estimates, the Fed simply dropped what had become a hot potato. Its economists explained that anyone who wished to do what the Fed had done before — to subtract the replacement cost or historical cost of structures from the property’s overall market value — was free to do so, but the Fed no longer would take responsibility for calling this residual “land.”
Revising the Fed’s land value estimates
1. Corporate real estate
A better estimate of land values is a precondition for establishing the proportion of real estate rental revenue and cash flow that can be attributed to land as distinct from structures and other capital improvements.
Chart 1 shows that when corporately owned buildings are valued at their historical cost, land accounts for a fairly stable ratio of around 60 percent of the property’s overall value until 1989, when the real estate bubble burst worldwide. By contrast, valuing these same structures on a replacement-cost basis, land value rose slowly but steadily from the end of World War II to 1989, from 20 to about 27 percent of overall corporate real estate values.
After 1989, as overall corporate real estate values turned down, land was assumed to bear the full brunt of the fall. But this assumes that it still would have been desirable to replicate the existing structures. These were treated as the basic reference point, not the underlying land sites.
What actually was occurring was that the corporate labor force was downsized and factory investment shifted abroad. This shift in the nation’s economic and employment structure meant that there was little reason to replace existing buildings. Often the land was more valuable without them, which indeed is why so much industrial property has been torn down in recent years. Under these conditions the reality was that the old industrial buildings were worth less, not the land itself.
Projecting the 1945-89 growth trend in land values as constituting the residual of total real estate value less replacement cost forward into the 1990s would indicate a land residual of 30 percent of total corporate property value, yielding a land figure of slightly over $1 trillion. This is part of the reason why I estimate that corporate land values have been undervalued by about $1.5 trillion dollars for the years 1994 through 1996 (and structures correspondingly overvalued). A $1.5 trillion figure can also be derived by valuing buildings at their historical rather than replacement cost, as the Fed’s statisticians now conveniently enable one to do. On the other hand, if we attribute the decline in corporate real estate values entirely to buildings (the “building residual” rather than the “land residual” method), then we derive a land-value figure of over $2 trillion for corporately owned real estate in 1996.
This $2 trillion may be taken as a minimum estimate of the land value that gets lost in the Fed statistics. For one thing, official appraisals of industrial properties tend to be low, and certainly less than their best alternative use. Increasingly, the best use is becoming residential in character, especially where the United States is experiencing a reflux of suburban dwellers back into the central city areas. In New York, Chicago and other major cities (just as in London and other foreign centers) this gentrification is creating major new real estate investment opportunities — a fact not lost on stock speculators poring over corporate balance sheets looking for undervalued potentials that may be realized.
The sharp rise (about 40 percent) in price/earnings ratios for corporate stocks over the past two years suggests a much higher stock market valuation of the tangible real estate and related corporate assets across the board. Stock buyers are paying much higher prices for corporate real estate assets (and other assets) than is reflected in their earning power or in the assessed property values being reported by the Fed.
2. Real estate held by the nonprofit sector
The Fed’s treatment of the land values for non-profit organizations (including colleges and schools, churches, museums, hospitals and charitable institutions) undervalues land by a steeper discount than occurs anywhere else in the accounts published so far — only 10 percent of the estimated real estate value. The low estimate is attributable to the replacement cost of buildings in this sector absorbing about 90 percent of the overall value.
This figure looks suspicious for a number of reasons. For one thing, tax assessments on real estate held by non-profits tend to be notoriously low. There is little pressing conern to raise assessments for property on which no tax revenues are at stake. Indeed, there is some social pressure not to raise assessments. Secondly, the buildings used by such institutions tend to be specially designed in ways that make it particularly difficult to shift them to normal household residential use or to commercial use.
For this reason, land should represent a higher proportion of the true market value of structures held by non-profits than is found for corporately held real estate (60 percent, using a historical cost basis to estimate building values). Estimating land at 60 percent of the value of nonprofit real estate would indicate a value of $0.5 trillion for 1996. Estimating land at 75 percent would raise this figure to $0.6 trillion.
These two adjustments — for corporate and non-profit real estate — shift some $2.5 trillion in value from structures to the land.
3. The household sector’s residential real estate
The largest category of land and real estate value, of course, consists of residential housing held by owner-occupants in the household sector. But here, unlike the case with corporate real estate, the FRB does not estimate homes at their historical cost, but only on a replacement cost basis. Using the “land residual” technique leaves today’s household sector with a land value of just under $2 trillion, virtually unchanged from the level of 1987, nearly a decade ago. This means that land has fallen from 30 percent to just 20 percent of overall household real estate value.
Is this reasonable? During these years the overall value of household real estate has grown by some $2.6 trillion, from under $5.5 trillion to over $8.1 trillion. Even if we were to accept the “land residual” method as being valid during the decades of rising land and site values prior to 1987, holding the land value total steady at 30 percent since that time would increase land values by $0.5 trillion, to a total $2.4 trillion.
One of the two major “sense of proportion” questions to be asked in such circumstances is whether household residences should be valued at their replacement cost or at their historical cost. The problem with valuing them at their steadily rising replacement cost is that this method absorbs all the appreciation in property values over the past decade — an appreciation that seems more realistically the result of rising land-site values, to the extent that it is “environmental” (referring in this case to the business environment and its asset-price inflation). If the cause of rising building values is inflation, does this not affect land as well? Indeed, in periods of rapid inflationary fears, is there not an especially intense flight into land as a vehicle for hoarding?
Yet by the late 1980s, when the real estate bubble was still being inflated, household and corporate replacement costs of buildings left land with only about 28 percent of total property values. Making the same adjustment for residential housing that the Fed made for corporate buildings — in valuing them at their historical cost — would raise residential land values to 60 percent of the total (equal to the 1990 figure). Even the 1996 figure produces a land value of 45 percent of the household sector’s overall real estate’s overall. Taking as a rough order of magnitude a 50/50 split between residential land and buildings would produce a land value of over $4 trillion, double the Fed’s estimate.
This addition of some $2 trillion of residential land value seems justified on pragmatic grounds by the pressures on local tax assessors to undervalue land relative to buildings. As these assessments are the basis on which Census statistics are compiled, one must accordingly use common sense in restoring a more plausible balance between land and building values.
The second major “sense of proportion” question is whether one should use a “building residual” rather than a “land residual” appraisal method. Treating the buildings as the store of residual value would add about $2 trillion to the rise in land values over the past decade, in line with the above estimates.
As matters turn out, there also is another reason to suspect that the Fed may be undervaluing household real estate. The Bureau of Labor Statistics (BLS) conducts its own surveys of what homeowners believe the market value of their residences to be.
The FRB’s estimates of residential real estate and land values in light of BLS statistics
An alternative government source of statistics on residential home values is published by the Bureau of Labor Statistics (BLS). The BLS asks its statistical sample of homeowners to estimate the market value of their homes. Expanding this sample to a nationwide scale, owner-occupants reported a value of $7.4 trillion for their homes in 1995.
In evaluating the quality and reasonableness of the BLS statistics, a number of caveats apply. Ego may indeed play a role in the respondants’ estimates of the market value of their homes. On the other hand, their estimates probably do not distort their reporting as much as do the under-appraisals that appear in local tax assessment records. It is generally recognized that in times of rapidly raising prices, local real estate appraisals fail to keep up with the rising market. (The reason is largely political: homeowners would protest against the sharply rising taxes that would accompany realistic annual property reappraisals.) The political sway of homeowners when it comes to contesting appraisals of their property for tax purposes may be stronger than the egos reflected in what they tell the BLS.
The BLS estimate for homeowners’ real estate value is closely in line with the FRB estimate of $7.6 trillion. Indeed, over the past decade the BLS and Fed figures closely reflect each other. Yet one would have expected that the Fed’s statistics would be somewhat higher, for its estimates for the value of residential real estate owned by households cover more categories than are surveyed by the BLS. For instance, the wealthiest 5 or 10 percent of the population own a disproportional value of its real estate and other assets. Recognizing this fact, the Fed samples these categories especially heavily. The relative absence of the very richest families from the BLS numbers suggests that its estimates miss an important element of the economy’s total household real estate value. Also, whereas the Fed includes household ownership of vacation housing, the BLS asks homeowners to estimate the market value of their primary residences only. 6
Yet the FRB statistics do not provide a much higher estimate. The similar magnitudes suggest that homeowners probably estimate the market value of their residences at a higher level than local assessors (on whose reports the Fed ultimately relies). This probably more realistic estimate may be more than offset by the narrower scope of BLS surveys.
A comparison of year-to-year changes shows that the BLS Consumer Expenditure survey regarding the market value of homes stand closely in line with those made by the Federal Reserve System for household residential real estate. In 1984, the year when the BLS series began, housing prices were just beginning to take off. The BLS nationwide estimate of $4.265 trillion was slightly higher than the Fed’s $4.018 trillion estimate, but in 1985 the Fed’s estimate pulled ahead, and has remained higher ever since. To be sure, in 1994 the BLS and Fed both estimated that the value of household residences rose by about $0.3 trillion, and by the same amount again in 1995. (Both sets of figures include new construction.)
But one would have expected the FRB statistics to have been substantially higher. Taking as a rule of thumb that the wealthiest 5 percent of American families own 20 percent of the real estate would have added about $1.5 trillion to BLS statistics that exclude these families. This calculation suggests that the Fed’s real estate estimates for the household sector should be higher than those of the BLS — unless the homeowners surveyed by the BLS tend chronically to overvalue their homes by an amount equal to the holdings of the richest 5 percent of the population.
The question that inevitably arises is, how much should the rise in home values be attributed to rising land appreciation, and how much to building costs. The BLS does not ask its respondents to answer this question. The Fed answers it in an arbitrary way, by estimating the replacement cost of real estate structures. This leaves a residual, which formerly was called “land” and which now is not even listed separately.
So far, these adjustments would add about $4.5 trillion to the nation’s land values: $2 trillion for owner-occupied residential housing, $0.6 trillion for the non-profit sector, and $2 trillion for corporate landholdings. And this does not include the noncorporate real estate sector, to which most commercial real estate belongs. (As noted above, the statistics for this sector will not be published at least until Dec. 15.)
The noncorporate real estate sector
The most recent statistics published for noncorporate real estate remain those for 1994. In that year, land ($551 billion) accounted for less than 25 percent of the sector’s overall assessed real estate value, down from 42 percent as recently as 1989. The FRB charges land with the entire price decline that is derived by subtracting the (rising) replacement costs of buildings from their market values, which are scarcely recognized to have budged in any year since 1989.
Using the land residual technique of appraisal, in 1989 the Fed derived a land value of over $1,024 trillion. But by 1994 this derivative was cut nearly in half, to $551 billion. Yet inexorably, the replacement cost of buildings was calculated as rising, despite the fact that as the economy shrank, demand for office space contracted. This evident decline in the market values of commercial real estate’s new rental leases suggests that a building residual technique would have been more relevant to use.
Simply holding land values steady would have added some $0.5 trillion to the FRB’s land estimates. This is virtually what we would get by holding land constant at its 1989 proportion to overal real estate value. And taking a rate of 60 percent — the proportion indicated by valuing corporate real estate at its historical cost basis — produces a land value of $1.3 trillion, some $0.8 trillion over the reported 1994 land figure.
Adding similar adjustments for farmland and for financial corporation increases the land value by some $1.0 trillion. This figure, taken in conjunction with the $4.5 trillion added for residential, non-profit and corporate real estate more than doubles the estimated land value, from $4.4 trillion in 1994 to nearly $9 trillion.
Taken together, these adjustments suggest that in imputing the proportion of real estate rental income as between land and buildings based on their asset mix, land should be credited with 60 percent of the total.
Should structures be valued at their historical cost or their replacement cost?
While the cost of construction almost inexorably is rising (by about 3 percent annually), these buildings also are depreciating in value. Private firms within the real estate industry make estimates both of cost increases and depreciation rates. And in summer of 1997, the NIPA statisticians made their own critique of the depreciation numbers that had been based on income tax filings.
To some extent (but not entirely), depreciation and obsolescence offset rising replacement costs of buildings. No firm documentation exists to trace this phenomenon, but building values rarely decline by more than 25 percent from physical wear and tear, unless the building’s purpose becomes obsolescent (as in the case of many industrial structures, primarily those in the corporate nonfinancial sector).
Of course, real estate values rise and fall in keeping with overall property prices. But these shifts are not properly attributed to the buildings themselves. Being “environmental” (in this case, the financial environment as well as the physical and economic environment), they fall more into the category of land value.
If the purpose of statistics is to depict the economy in terms of the motivations of its actors (investors and consumers, as well as bankers and other intermediaries), it is necessary to have better calculations of land values for the household, non-corporate and corporate sectors, and to juxtapose these land values to overall real estate prices and building values. In such an analysis it is the building values that would be the residual item, not land values.
Conclusion: What is needed for a satisfactory estimate of land and building values
The Fed’s appraisal methodology is not the only way in which estimates of land values as compared to the value of structures could have been made. In fact, it is not the most reasonable way. Structures could have been taken at their historical cost, for instance. The Fed’s own comparison with corporately owned real estate shows that there are good reasons for using this means of evaluation. The results produced for the corporate nonfinancial sector suggest that it would be more logical to subtract the historical cost of structures from the property’s current market value. Most importantly, however, it is more plausible to use a “building residual” method of appraisal than to use a “land residual.” This is because the real estate landscape is continually changing, and few builders would choose to replicate existing buildings. The building residual method of valuation would begin with an independent appraisal of land values, and then credit (or in some cases, debit) the structures with the residual value.
Most desirable of all would be to create a land-map of the U.S. economy, and attribute the rise and fall of real estate values to the land, using the buildings as the residual item rather than the land. Such a land-value map would cost money to initiate. But it is the best way to track what turns out to be the economy’s most valuable asset: the land. As the above discussion suggests, this most likely represents 60 percent of real estate’s overall value, rather than the 40 percent that often is taken as a rule of thumb and which is suggested by the FRB statistics.
The task of creating a land map of the United States (presumably by states) would go beyond the FRB’s resources, to be sure. The Fed is dependent primarily on Census data for its real estate values, and the task most properly belongs to the Bureau of the Census. The government could incorporate this into the Census routine. Among the uses of such data is the calculation of federal grants.
The problem is a political one: how to convince Congress, which to date has not elected to compile land value statistics.
My estimates suggest that such a study would revalue land relative to structures by $1.5 trillion for corporate real estate, another $2 trillion for owner-occupied residential real estate, $0.6 trillion for non-profit real estate, and $1 trillion more for noncorporate real estate partnerships. These adjustments would double the value of land from the amount estimated by the FRB.
The final question to be asked is thus why this is not being done.
Political factors supporting an underestimation of the land
In the physical sciences, quantitative measurement is sacrosanct. From objective quantification emerge the patterns that provide the clues to how nature’s physical and chemical relationships are organized. Emulating the natural sciences, economists express their theories in mathematical garb. But how meaningful can balance sheet statistics be deemed if they show land disappearing?
Nonsensical results indicate that the methodology being used is seriously flawed. But it is axiomatic that when a wrongheaded methodology is maintained despite its evident defects (the acronym GIGO, “garbage in, garbage out,” is appropriate), it is wise to suspect special interests of being at work. Almost invariably there is a political motive behind what appears to be innocent statistical madness.
In the case of land valuation, the FIRE sector has a self-interest in not tracking land gains more closely. Government agencies have acquiesced in this industry bias, although the IRS and local fiscal authorities also would benefit indirectly, by creating a tax system that encourages capital investment more than speculation. But these effects are not broadly recognized. And there is no political constituency that benefits directly from a more realistic assessment of the economy’s real estate rent. Manufacturing may benefit indirectly, to the extent that taxes may be shifted to the land.
The upshot is that private firms track land values for their own constituencies, but their aim is to buy stocks in firms with undervalued land or otherwise benefit from speculation, not use better taxes from land-value gains as a means of lowering taxes elsewhere throughout the economy. This undervaluation reflects modern economic theory’s general disregard for land’s role, despite the fact that more wealth is generated in land appreciation than anywhere else in the economy remains the best-kept secret of statistical portrayals of the American economy.
The FRB’s emphasis on rising building replacement costs attributes the rise in property values to something other than land. It also tends to justify over-depreciation, as owners can claim that they would have to pay more to replace their structures without acknowledging the extent to which they benefit freely from rising land prices.
It will be noted that the value of a site’s location, its zoning , municipal improvements and the economic development occurring in its vicinity (including transport accessibility) are not the direct result of capital expenditures by owners. Yet the Fed’s statistics depict the remarkable growth in U.S. real estate values (and, in times of economic downturn, their shrinkage) as being the result exclusively of the rising cost of replacing buildings.
An understandable fear exists that any statistics that estimate a higher value for rental or land services will lead the government to tax these assessments at some point. (I understand that this is the reason why national income statisticians have stopped trying to estimate the economic value of housewives.) But the neglect of land values seems all the more remarkable in view of the fact that in reality, most of the annual appreciation in real estate stems from rising land values. Such capital gains are virtually neglected in the statistics, despite the fact that they are a primary objective of commercial real estate investment. that is what is meant, after all, but the well-known criteria for evaluating real estate: “location, location, location,” not “replacement cost, replacement cost, replacement cost.”
Concluding remarks:
The Political Interest involved in Land-Value Appraisal Methodology
Michael Hudson
One political dimension of the land-appraisal argument concerns the tax laws governing depreciation. Real estate owners, like manufacturers, are allowed to count part of the revenue they get over and above their current expenses as a return on their original capital. No taxes are levied on this element of revenue. This is only fair, for an investor who buys a $100 bond only pays income tax on the interest, not on the original $100 principal. That is recovered without being taxed.
Likewise industrialists are able to recover their initial direct investment in plant and equipment without being taxed. Their original “sunk cost” gets reimbursed, so that by the time the equipment wears out or becomes obsolete, they get their capital back. They therefore subtract a “capital consumption allowance” for their machinery and plant.
For real estate, the economics are somewhat different – so much so that the tax laws seem confused. Real estate owners say, “We’re going to spend $1 million on the building and we want to get the $1 million back, so we’ll pay tax on the return over and above this amount. Meanwhile, we want to recover the building’s capital cost as rapidly as possible. In fact, so rapidly that the depreciation will absorb all the net income (over and above direct operating costs and interest charges). And, once this capital consumption allowance is over, we will sell the property, and the new buyer can begin depreciating it all over again.”
So the building is sold, at twice the price he paid for it. And then the local appraiser comes by and says, “I see you’ve sold your building for $2 million. Under my rule of thumb, I appraise the land as half this value, and the building as half, so that gives you a $1 million dollar building.”
But under this same rule, the building “originally” was priced at $500,000. Now, what is depreciated is not only its initial price, but a price that includes a $500,000 gain. The rise in land value is, in effect, treated as a depreciable building value. Lowell Harriss has suggested the term “over-depreciation” for this practice. It gives a statistical illusion of capital being used up in production. In practice, building values are not actually being used up. Landlords typically spend 10 percent of their gross rental revenue on “maintenance and repairs.” These are of course a tax-deductible expense, as they are an out-of-pocket charge. But the explicit purpose of this expenditure is to maintain the building’s value intact, so that it can survive year after year, while the site’s value rises.
The real estate practice argues that this is reasonable, on the logic that perhaps the rise in construction costs and raw materials prices has doubled the reproduction cost. So the new owner appears justified at getting a tax credit – a tax credit so large as to make the revenue virtually tax-exempt – on the principle of keeping their investment value “intact,” that is, immune from inflation.
This logic was pressed to utterly illogical extremes by the 1981 Reagan tax reform. Under the new ruling, landlords could depreciate the building’s entire assessed value within just 7 1/2 years (under the double declining balance method permitted to real estate tax accountants). The depreciation allowance-that is, hypothetically the rate at which the buildings were estimated to wear out – was so large that it covered all the revenue over and above operating costs. This meant that owners didn’t have to pay tax on their income. Owning a building was much like owning an oil well and benefiting from the depletion allowance, which was pretended to enable the oil industry to recover enough revenue to defray the presumably rising price of finding new oil as the world’s petroleum supplies were depleted. On this logic, generous depreciation allowances were supposed to enable sellers to afford to buy new buildings on a par with the ones they had just sold.
This tax favoritism was defended in Congress on the ground that it was in the public interest to provide a special inducement to the real estate industry to build more homes and office buildings. But in practice, real estate investors realized that after they had depreciated a building over 71/2 years, they then could sell it to someone else or even to one of their other entities, and then begin to depreciating it all over again. It’s like “overkill” in atomic warfare strategy: After you’ve killed a population once, or written off a building once, you got to do it all over again.
Many of the most desirable buildings in New York are over 100 years old and they’ve been depreciated 10 or 15 times over the course of their existence. The bottom line is that the depreciation rate is set high enough so that the commercial real estate industry is tax-exempt. It therefore enjoys a fiscal favoritism that no other sector enjoys (now that the oil and mineral depletion giveaway has been terminated).
The real estate industry opposes the building residual method of land appraisal because that would result in lower estimates for building values than for land values. That would mean that there was less building value to be depreciated as a tax-free category of revenue to real estate investors.
If one believes that what goes up in value is the land site, then it becomes clear that the property owner is not doing anything active to increase the value of the building, beyond spending the normal maintenance and expense. The owner is a passive beneficiary, enjoying the free lunch – the lunch that opponents of government taxation claim does not exist. It’s essential to the wealth of people enjoying such benefits that the rest of the world does not believe that there is any such thing as a free lunch. For if economists say that no free lunch exists, then it will not be taxed, to say nothing of being given special treatment “in the public interest.” For the public interest calls for direct active investment to be encouraged, not passive gains in the form of property “claims of wealth.”
The first thing that every person does who gets the free lunch is to subsidize lobbies that say there’s no such thing as a free lunch. They want to make it appear that it’s not the land that’s floating upward in value as prosperity, savings and credit become more plentiful to be lent out as mortgage money. It’s merely the building and costs and inflation that are rising, nothing left over.
Using the land-residual method undervalues land, even to the point of giving it a negative value in some years. Stated the other way around, the land-residual method attributes a false value to the building and that false value, instead of depreciating, gives the impression that the building is rising in value because construction costs are rising. But as construction costs rise, the use of buildings and types of buildings change.
I understand the real estate industry’s position that they wouldn’t build a building unless they’re given a big subsidy. It’s what they’ve gotten used to, after all, thanks largely to their active role in public affairs, that is, as campaign contributors and civic boosters of local property values. Most large cities give these subsidies to keep construction active. But such subsidies should be seen for what they are, not treated as building values.
When one talks about the overall economy, it is necessary to draw a reasonable overall explanatory picture. The real estate, construction and financial industries take a microeconomic perspective as to what it needs to get in order to build. A macroeconomic perspective calls for an explanation of how the economy’s assets grow, and whether property owners are getting rich by making direct investments and improving labor productivity, or by merely sitting passively waiting for their holdings to appreciate in value.
In the past (if we put aside the argument about the inducement to build), the real estate industry’s only answer to Georgists was to ignore them. Translated into words, this means “Shut up.” They have not discussed the issues openly. Indeed, they have discouraged every government department from compiling land value estimates. Even the Federal Reserve stopped compiling these statistics three years ago, as their economists could find no rational basis for doing so.
The main reason they have given for not handling the land issue is that a comprehensive statistic would have to include the land owned by the US government. “How do you value the Grand Canyon?,” they ask. They follow up by saying that unless one can answer that question by providing a reasonable estimate, they say that they’re not going to engage in a breakdown of value any longer between land and buildings owned by corporations and partnerships either.
In frustration, Georgists have had no one to talk to but themselves. I believe that the best way to get this issue into the Economics curriculum is to get the two sides talking to each other, so that at least you can show students that there are two approaches to valuing the economy’s single largest asset.
The political setting for land-value statistics
A kind of economic schizophrenia seems to be at work when it comes to dealing with real estate. Most investors today are engaged in what economists have come to call rent-seeking activity. Their objective is to pick a property in the right location, where it will appreciate in price at a higher pace than the interest rate that must be paid to acquire the property, as most sophisticated investors try to leverage their own investment with borrowed capital.
But at the same time, they want to maximize their earnings by not being taxed. To do this the real estate industry and their backers, the financial and insurance industries, hire lobbies and endow think tanks. These public relations efforts depict the economy’s real estate as not getting producing any rent at all. As we all know, rent is produced by land. But land seems to have no value, hence there are no land-value gains (usually called capital gains). In fact, looking at the Federal Reserve Board’s statistics published in the mid-1990s, commercial real estate investors only manage to break even. Their property values rise not because of rising rents, but because of the reproduction costs of replacing buildings already built. It is inflation, not land rent, that increases the price of their properties.
Economics is almost entirely about labor and capital, but the largest set of tangible assets is not industrial plant and machinery, it is real estate. And of this real estate, between 40 and 60 percent is land.
This is the neglected area in modern economic thought – the neglect of treating land and indeed, the FIRE sector as a distinct unit as compared to industry and its employment.
One reason it is hard is that there are no statistics. What is the point of developing a modern mathematical economics without statistics?
Yet there is a reason for this. What is not seen will not be taxed.
This is largely why it has been so hard to get Washington to produce national land value statistics. The opposition has come largely from the real estate industry itself. Why should the industry that deals with land wish to exclude it from the statistics?
The reason is to justify gains, and put forth an argument for why they should not be taxed.
Developers claim that when the land rises in value, they are only keeping up with inflation. Hence, they ask, is it not right that they should merely break even, by keeping the price-adjusted value?
This was also the logic that the oil industry put forth in arguing for the depletion allowance.
In this world view there is no rent.
Once having defined land as a distinct category, the real estate industry lobbies to define its value as zero. This is true in the case of U.S. land statistics for commercial urban buildings, and for the radio spectrum, if “interest charges” are defined as financing (1) capital at (2) its reproduction costs or its future discounted income stream.
The two views. (Perhaps I should call this “two and a half views”)
I. The land-residual view
This is the present mainstream view, but its users have decided that it produces nonsense figures and so have quietly dropped it, precisely because it seems to produce nonsense in giving land a negative value.
There is a political dimension to this methodological approach. Real estate investors to depict their land-value (“capital”) gains as “merely keeping up with inflation,” and hence as not deserving to be taxed.
In this, the investors are backed by the financial sector, which ends up with most of the land rent.
They admit that land enters into property prices, but claim that after taking into account the reproduction cost of capital invested in buildings, the land simply has a negative value.
On pragmatic grounds, they then argue that developers won’t even build buildings today without getting a tax subsidy that is a de facto negative value. This is empirically descriptive. Our role, it seems to me, is to pierce the lobbying shell here.
I’ll simply lay out the politics of matters, and show how reluctant the real estate industry has been to publish land statistics over the past half century.
II. The Building-residual view
This holds land value as being paramount. The question is, what’s built on it.
III. A “pragmatic” compromise view
A 50/50 or 60/40
