Why upzoning has a value

Because it provides a new financial security to existing property owners in the form of a perpetual call option

Consider this scene from the The Big Short. Here’s a quote I want you to remember.

Michael Burry: “How much bigger is the market for insuring mortgage bonds than actual mortgages?”

Broker: “About twenty times”

The scene goes on to explain derivates, which are bets on the future price of an underlying asset. This explanation involves people making outside bets on a hand of blackjack. The value of those bets is many multiples of the value of the underlying bet on the blackjack hand—just as the value of derivative bets on the mortgage bond market was said to be twenty times the value of the underlying mortgages.

What’s the reason for sharing this scene?

To get you, dear reader, into the mindset that

1. undeveloped land is an outside bet on an underlying housing market asset, and

2. those bets do not directly affect the value of that underlying asset, and

3. those bets can be many times larger than the total value of the underlying asset.

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Last week I spoke to the high school economics community about careers in economics for the Economics Olympiad. This is one of the many ways I am trying to contribute as a public intellectual with the support of paid FET subscribers.

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Property is a financial security and physical place

Our system of property rights provides the option, but not the obligation, to build homes at various geographic locations.

Property is a financial instrument.

A piece of paper.

A special type of social promise.

There is nothing physical about it.

To understand property we should look to financial markets.

This is well known. I’m not breaking new ground. I’m just communicating a somewhat forgotten but hugely important insight.

As one MIT lecture series puts it, land is a call option, and is real rather than financial.

Land ownership gives the owner the right without obligation to develop (or redevelop) the property upon payment of the construction cost. Built property is the underlying asset, construction cost is the exercise price (including the opportunity cost of the loss of any pre-existing structure that must be torn down).

Unlike financial options, which have an expiry, land with feasible development opportunities is a perpetual call option. It has no expiry date and like American-style call options, can be exercised at any time of the holder’s choosing.

To reiterate, a piece of paper called a property title (or deed) provides the holder with a bundle of rights, one of which is to buy an underlying housing (or other building of fixed improvement) asset at the exercise price at any time of their choosing. The underlying asset is a dwelling or building at that location, and the exercise price is the development cost (construction plus any related fees, design and management costs, etc).

So if the underlying housing asset is valued today at $1,000,000 and the all-in development cost, including a margin for the risk involved in the transformation of the option into the asset, is $600,000 (the strike or exercise price), then the option today is worth at least $400,000.

This is important to get right.

Many mistakes happen if you ignore the financial nature of property. For example, a common assumption is that creating more new development options will push down the value of each option to build.

This is wrong.

Yet many support this wrong view by labelling the standard financial markets view as an infinite money glitch theory of upzoning or some such thing. Here’s one example of the claim that it is “absurd on its face” that you can double the value of land in a market.

It is not absurd on its face. It is normal in financial markets like property.

Derivative markets can be many times larger than the underlying asset. But even so, every option is still tied to the market value of the underlying asset. It must be, or there is an arbitrage opportunity.

The same incorrect logic that ignores the financial nature of property leads to a second strange claim that a price difference between land zoned for housing and adjacent land not zoned for housing is a sign of a housing shortage.

But this doesn’t make sense from a financial viewpoint.

A perpetual call option to buy a home is worth at least the value of the underlying asset minus the exercise price. A lot next door that is a different financial option should be priced differently and only can coincidentally be the same price. A call option to buy Apple shares at a $5 exercise price will have a different value from a call option to buy BHP shares at a $2 exercise price.

These values should be unrelated.

Let’s dig a little deeper into introducing the concept of options and how it reveals the problems with these two common claims in housing debates. This topic will come up again in the coming months here at FET, but this is my first crack at explaining it.

Please let me know in the comments if I am clear or not. Free subscribers might want to consider a paid subscription (or at least a trial) to get this complete article, voiceovers, and other benefits.

Building an intuition about options

Let’s start by ignoring the process of development (exercising the development option and the equilibrium rate of those choices across a market) and simply look at an options contract for buying a single existing home.¹ This will clarify the logic at play.

Imagine my home is worth $1 million if I sell today in the market.

Now, imagine that I create a new security—a one-week (American-style) call option—to buy my home at its particular location for a $500,000 exercise price. This gives the owner of the option the right to buy my home on any day this week for $500,000. But it also allows the owner of the option to trade that security during that week as well.

How much would someone pay for that option?

Probably $500,000.

Any more and the buyer is overpaying for the home as prices aren’t going to change tomorrow. Any less and as a seller of the option I’m leaving money on the table as I could get $1 million with a sale of the underlying asset.

Now, think about the value if I change that one-week option to a one-year option (American style, meaning the option holder can choose when to strike any time up until the expiry date).