The bid-rent theory: What can it tell us about the future of housing in Australia?

One of the key characteristics of real estate is its fixed location, hence the popular quotation: "Location, location, location".

While property rights can be and are exchanged over time, the location of a property remains constant and the ongoing demand for the land constitutes a prime determinant of prevailing market price.

There is a well-known geographical economic theory in real estate circles know as the bid-rent theory, which dates back many decades - it was derived from a Ricardian theory on the most productive agricultural land.

In the simplest terms, the original theory and bid-rent curves implied that the price and demand for property was highest within the concentric rings located closest to the central business district (CBD) and decreased the further away from that central point you travelled.

Location theories hold that centrally located land is commonly worth more as retailers aim to maximise profitability and therefore will 'bid' more for the land close to the city. Land on the outer is often deemed to be more viable for industrial use and demand is lower.

Meanwhile, as different land uses compete, residents (so the theory went) were also prepared to pay the highest rent for land close to the CBD where work and entertainment was traditionally located.

Australia's major capital cities are located on water and therefore the ring would not spread uniformly outwards from the centre of the city, even if the bid rent theory held completely true.

All else being equal, therefore prices could be highest in the inner city (A) and gradually recede the further from that point you move out to the inner/middle rings suburbs (B) and the outer locations (C).

High prices in central locations also encourage a higher density of building as compared to the lower density and more sparsely populated locations further from the city's centre.

Over time, however, it should be expected that improved transport links can increase demand from higher income earners further from the centre of the city, in particular increasing demand in the well-located middle ring suburbs.

Despite the obvious limitations, is some reasonably sound logic behind the bid-rent theory. For one thing, simple geometry shows that when looking at concentric rings (or something approximating thereto), there must be far less land in the inner zone (A). Correspondingly, there is a significantly greater supply land available to be developed in the outer (C).

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Scarcity is artificial

I've noted before how the original grid system in Australia created an artificial land scarcity and the standardised city blocks encouraged rapid resale and speculative activity.

As you can see on the previous page, the artificial land scarcity in Australia was also exacerbated by all of the earliest cities being located beside water. If you travel away from the city in the wrong direction, you'll quickly end up in the blue stuff.

However, over time it has become clear that both in the US and in Australia, that all else is not equal when it comes to residential property. Even from in the 1880s you can find clear references in original sources to residents in Australia having a strong preference for suburban living away from the centre of the city.

Social housing has often been located in the inner city zones, for example, while wealthier households have often sought space in the suburbs.

Further, the traditional bid rent curve is distorted by other factors such as households preferring to be located near favoured schools or other recreation. More than this, most people do not work in the CBD. Some are prepared to travel great distances (and journey times) to work while other attach a great cost to this...and so on.

Michael Oxley:  "A major objective of rational land-use planning is to take account of the external cost and benefits. If land-use planning achieves its objectives the actual pattern of land use will differ from that predicted by simple market-orientated location theories".

Another artificial barrier is in place with our city land supply, which is related to zoning and land release.

And herein lies Australia's great challenge.

Take a look, for example, at the population growth in some of Sydney's leafy inner/middle ring suburbs and you will find that the population levels are remarkably static for a capital city with such a burgeoning population growth.

While new construction and renovation does occur to some extent, the total supply in certain popular suburbs is often all but fixed due to effective height restrictions on new builds.

Even on land which is zoned as 'high density', it is often difficult to build upwards due to blocking the views of other existing residential buildings. Sydney investors in particular are currently piling into this stock because they believe that the supply will be fixed with the demand increasing by the year.

The challenge for Australia is to convince people that living close the CBD is not essential, which means providing quality transport links to places of employment (our cities are not monocentric as is often argued, so this includes to transport links to and from secondary CBDs and other employment hubs), improved infrastructure and other entertainment.

There have been a great many suggestions as to how this can be achieved and affordable housing can be provided for our growing population. These include tax legislation reform among other suggestions. Ultimately, in aggregate, demand is growing, so the solution must come back to freeing up the supply side and improving infrastructure and transport links.

The alternative is us simply paying ever-higher prices for a constrained supply of stock close to the city, which appears to be the route we are presently embracing. It's decision time...

His new book 'Four Green Houses and a Red Hotel' is out now.