In our first visit to Affordaville, we used a bit of a fudge. We defined the cost of land as a given. When Affordaville was a small town, land was cheap; the bigger it grew, the more expensive land got. But why does land cost more in a big city? A good, simple answer is that “there’s more people who want to live there, including some people with lots of money, so the market price goes up.” But while that explains why the land is relatively more expensive in high-demand places than low-demand places, it doesn’t explain the absolute values.
We can do better. We’ll start by returning to our simple formulation that the cost of housing can be split into the cost of land and the cost of the structure. For new housing, that means we can split the cost of a new house into the cost of constructing that new housing and the cost of the land. Put another way, the value of land is the difference between the cost of buying a new house and the cost of building it. How much it costs to buy is set by the market between buyers and sellers, whereas the cost of construction is set by the costs of construction components like materials, labor, permitting costs, etc.
The value of land is the difference between the cost of construction and the cost of purchase.
So, let’s say that, based on the supply and demand of housing in a neighborhood, the price of a typical house on a piece of land is about $350,000. And let’s say that the cost to build that house is about $200,000. The price of land is therefore the difference, $150,000.
This isn’t merely an accounting identity, but a real consideration that somebody who wants to build a house will make. Let’s say you are a developer building a house and you know that it will cost you about $200,000 to build and you can sell it for $350,000. You definitely won’t be willing to pay more than $150,000 for the land, or else you lose money on the transaction. And if they’re not willing to pay $150,000, some other developer will. (In this example, I’m including the cost of your own time as part of the $200,000 it costs to build the house.)