Valuing Urban Land with Land Residual and Option Value Methods : Applications to House Price Dynamics and Volatility

A large part of the literature on urban land valuation uses the land residual method which relies on the assumption that structures are easily replaced: properties are valued at construction cost, i.e., the dollar amount required to bid resources away from other uses of the land plus materials and labor required for new construction. With this assumption, almost all of any change in property value is allocated to land, implying high positive correlation between property and structure. We introduce a new land valuation method based on option value theory: land residual estimates are nested in the option value model because they hold at the moment of new construction. Option value assumes irreversibility which implies that the ratio of land to property value typically changes slowly after new construction; changes in property value are shared between land and structure. We use Maricopa county data during the 2012–2018 period to estimate land ratios with the two methods, and we compare with FHFA estimates. Results suggest that growth in the share of land in many countries has been exaggerated by the land residual method