The economics of real estate; density determines fundamental real estate values

A house has two components to its price 1) the price of the land which it is built upon (the price of the lot); and 2) the price of the actual structure of the house, the materials and labor used to build it.

We will make two observations:

A) The structure of the house is a depreciating asset, its value goes down with time, because of general wear and tear of any physical structure. To prove this, consider a scenario where you have a single-family house built 10 years ago. If someone builds a replica of this house today at an adjacent lot of equal dimensions, it is likely that a potential buyer will pay more for the newer, less used house than an old house. This shows that the value of the structure of the old house is going down, because if it were remaining the same or going up, the buyer would pay the same or more for the older house.

B) In a big city like Toronto, Ontario, Canada, where single-family houses cost about $800,000 (all prices in USD, year 2018), within the metro area, most of the value of the house is in the actual lot which the house is built on. A similar house far away from the city would cost $300,000. The extra $500,000 is the difference in the value of the lot-the lot being quite cheap far away from the city.

The parts of a city which have the highest density (measurable by people/sq km,) have the highest house values. From B) above, it is the value of the lot which goes up in such spots. All spots of the city which have high density necessarily have a lot of action within walking distance: a very high number of commercial establishments or businesses-supermarkets, restaurants, nightclubs, coffee shops, etc. You don't need to buy a car when you live in the downtown core of big cities. You save the hassle and money involved in buying the car, and finding parking for it; plus you do not waste precious time commuting. Basically, the efficiency of life goes way up for people living in downtown areas. Obviously there are people who don't like the noise, the traffic etc. of  high density areas-but for most people, high density areas are the most attractive spot to live. This is easily proven- the per sq. m rents and the corresponding real estate values are the highest in the high-density, downtown areas. Land is a monopoly price, and the most expensive land is where there are already a lot of people living or working. When real estate agents talk about "Location, Location, Location" as the mantra which decides the value of a house, it should be changed to "Density, Density, Density", for in reality they are talking about the density of people in the location, which naturally brings all these commercial establishments around it. One must note that this density is variable, generally high in the weekdays, and low in the weekends. It is also low in the nights. Therefore, when I say density here, it is the average density of people per day, measured over a period, of say 30 days.

Since it is hard to estimate density of people circulating in an area, a good estimate is the number of buildings already constructed there, residential or commercial. Effectively, the total already constructed, existing floor space in a 1km x 1km area can be used as a good measure of density.

One can think of high rise buildings as creating more real estate-the physical limitation of the ground is overcome, and many multiples of the actual real estate area are added by high rise construction. The limit of real estate is eased by this-and enables people to live closer together.

What most real estate investors or renters pay for, therefore, is density. The way to improve density is to build vertically. A 40 story building will have 40 times more people living than a one story house on the same lot. This is why cities worldwide are growing vertically; the demand for high density and consequently high rise housing is very large, and it is quite conceivable that most of humanity inside metro areas will eventually live in high rises. This is already the case in Japan-I have lived in Osaka and the two highest density spots in Osaka, Umeda and Namba, have almost everything you ever need in a 100m walk from where you live. Futuristic movies do not show large mansions in the countryside-they show 100 story buildings. The trend for vertical living is here to stay.

Most of the value of the condos (apartments) in high rises is because of  the convenience of being around the action (high density area)-you are paying for this privilege. A similar condo far away from the city, in an isolated spot where there are no other condos or activity, costs maybe a tenth or twentieth of the price. The highest prices of condos per sq. m are in the densest part of the city. As you move away from high density spots, the price per sq m of the condo goes down.

Exceptions

While density is a good predictor of real estate values, there are cases where it may not. One has to account for poor neighborhoods, shantytowns and slums. In these areas the density is quite high, and sometimes they are right next to the "high-end or well-off" areas of a city, but real estate values are low. Developers are constantly looking to take over these poorer areas of a city and put high rises there-as long as there is a continuous connection to the better areas. In this way the slums and poor neighborhoods of a city gradually disappear, replaced in most cases by high rises. The good, well-off areas of a city expand to take over these poor areas. This is a good thing overall; however, this necessarily means that the poor either have to move to the suburbs of the city. Many times the poor don't want to do this-and this is the reason downtown in most areas have a lot of homeless people living on the street. On a map of real estate values (measured in per sq m), this shows as a discontinuity-there is sudden drop in value when you cross a simple street or a river.

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