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Suitability of Pre-Development Land as an Investment in an Efficient Portfolio
by Roger
G. Ibbotson and Laurence B. Siegel (Ibbotson
Associates)
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I. Introduction |
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In this paper, Ibbotson Associates summarizes its own and others' findings on
the suitability of undeveloped land as an investment. Attention is directed toward
the institutional tax-exempt market and especially to the portfolio characteristics
of undeveloped land, which are all-important for establishing the suitability
of an investment in that market.
This paper investigates a particular type of undeveloped suburban and urban land, which is referred to as pre-development land. This particular
type of land is not farmland, rather it is land that falls into identified paths
of development where absorption of varied uses is reasonably determinable.
As defined earlier, this
type of land must demonstrate three attributes,
namely; usability, accessibility, and visibility.
This land further has access to zoning, utilities,
water, sewer, etc.
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| II. The equilibrium return on pre-development land |
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Unlike other real estate investments, pre-development land generally generates no income or cash flow. Since metropolitan undeveloped land has no rental income, its expected return from capital appreciation alone must equal the combined expected capital appreciation and income on rentable properties of equal risk.
 The risk of un-leveraged real estate is between that of stocks and bonds. Within real estate, only minor differences in risk are noted from sector to sector (farmland, residence, office, metropolitan undeveloped, etc.).
Pre-development land is an asset class with return characteristics appreciably different from those of other assets, including other sectors of the real estate market.
It follows that pre-development land is imperfectly correlated with these other assets. Since economic logic dictates its returns are competitive with other assets, pre-development land is thus a component of an efficient or optimal portfolio.
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| III. Potential
Investors |
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For metropolitan, undeveloped land, the cost of capital or market expected rate of return is likely to be high. Marketability is limited, unless an efficient secondary market can be developed.
 Information costs are among the highest for any asset. Unlike developed real estate, raw land provides no tax shelter (unless one considers deductibility of mortgage interest to be a tax shelter). Almost every item on the list of possible capital costs indicates a high cost of capital or expected return, for metropolitan undeveloped land.
Investors who can tolerate these costly attributes, or who have a special advantage in cutting the costs, will earn in excess of expected returns in undeveloped land. By "tolerating" an attribute, we mean that the investor suffers less from the attribute than does the typical investor.
For example, pension funds, with their very long investment horizons, should not care greatly about immarketability, and real estate is consequently an ideal investment for them. Likewise, investors who have below-typical information costs regarding real estate should invest in real estate, and those who have above-typical costs should avoid it.
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IV. Inefficient pricing in real markets |
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Real estate, including metropolitan undeveloped land, is characterized by high information, transaction, search, and divisibility costs. In addition, real estate parcels are heterogeneous; that is, no two are exactly alike (even if indistinguishable otherwise, they differ in location). This is in contrast to, say, IBM stock, of which one share is exactly as good as another. These and other attributes are necessary and probably sufficient conditions for an inefficient market, which is defined as one in which there are returns to skill.
The hypothesis of returns to skill in real estate is corroborated by several observations. One is that 83 of the 400 richest Americans made their fortunes in real estate. This is less frivolous than it sounds. Most of the remainder of wealthy people are manufacturers, who capture arbitrage opportunities in labor markets — also thought to be inefficient for much the same reasons as real estate.
A few wealthy
people are inventors, who are granted monopoly
rights (patents). Very few made their fortunes
in the stock market, and none, as far as
we know, in the bond or cash markets.
Metropolitan undeveloped land seems to be an even more fruitful area for generating
returns to skill than the kinds of real estate typically held by institutional
real estate managers. Relatively few people attempt to price a given parcel of
metropolitan undeveloped land. Of these, most are likely to be individuals, uninformed
in real estate pricing, who happen by circumstance to own a parcel. Other persons
pricing a parcel may include appraisers employed by retail mortgage companies;
these may be unreliable. A highly skilled expert would seem to be in an ideal
position to arbitrage across mispricing in this market and earn high returns.
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