The Risk Structure of Land Markets

Abstract

Real property as an asset class represents over half of the wealth in the United States. Nevertheless, the structure of risk in real property markets is poorly understood. This paper develops a model of urban and agricultural land prices that integrates spatial and asset pricing theories and characterizes the spatial and temporal risk structure of the land market. Urban land is priced by a CAPM and agricultural land is priced by a real option to convert into urban land. We show that the price of land awaiting conversion increases with the growth rate of urban rents and unsystematic risk but decreases with risk aversion. However, it may be increasing or decreasing in systematic risk. The free boundary for exercise determines city size, which increases with the growth rate of urban rents but decreases with systematic and unsystematic risk.