When we discussed the monocentric city model, we described the value of real estate in terms of rents rather than prices. While rent levels are directly related to real estate prices, two additional factors influence prices beyond current rents: the rate of rent growth and the level of uncertainty (to fully understand this concept, familiarity with the Monocentric City Model is essential).

Rent Growth Rate

As demonstrated by the monocentric city model, overall rent growth is associated with urban expansion. Therefore, the faster a city grows, the higher the expected growth in rents.

From the model, we know that agricultural land rents contribute to the overall rent levels as the opportunity cost of urban development (urbanization eliminates land’s use as an agricultural resource).

Here’s a key insight: Although agricultural land rents are generally uniform, the value of land located closer to the urban boundary is higher (sold at a lower capitalization rate).

This is because the present value (PV) of undeveloped land reflects the potential future income generated by its eventual development. The closer the development potential is in time, the higher the value of undeveloped land (this is reflected as a higher “Growth Premium,” illustrated in the diagram below).

Strategic Developer Decisions

How does the expectation of such growth influence strategic development decisions? What should be built, and when?

  1. If Growth Is Expected
    When growth is predictable, delaying construction is rarely justified, as the current value of assets already accounts for future growth expectations. Therefore, predictable growth usually does not delay development.
  2. If the City Is Growing Rapidly
    Rapid city growth can lead to changes in the “Highest and Best Use” (HBU) of land. What may be optimal to build today might not remain optimal in 2–3 years due to evolving urban infrastructure. Consequently, deferring construction to wait for further development may be rational. A developer might choose to wait and reassess what should be built later.

Example:

Level of Uncertainty

Capozza and Helsley (1990) demonstrated that higher uncertainty about future revenues results in denser and higher-rent cities, as the motivation to delay construction increases.

This situation involves a real call option. Landowners/developers have the flexibility to decide when to develop their property. This option holds real value, as it allows construction to align with favorable periods and avoid unfavorable ones. Furthermore, the greater the range of uncertainty, the higher the value of this option.

However, as with financial options, the value of this option drops to zero once construction begins. Pausing a construction project or changing its function later is no longer a profitable opportunity. For this reason, the value of the option, as an opportunity cost, is a key component of both rents and prices (referred to as the “Irreversibility Premium” in the diagrams).

This component also applies to agricultural land values, increasing in importance as the expected development of such land approaches (similar logic applies to the Growth Premium).

The diagrams summarize the impact of growth rates and uncertainty on prices. The first diagram illustrates rent structure, while the second highlights price structure.

Principle 5 of Urban Development:

The faster a city grows and the higher the uncertainty surrounding expected rents, the higher the real estate prices. Moreover, high uncertainty leads to denser cities with higher rent levels.

Source:
Commercial Real Estate Analysis and Investments, D. M. Geltner.