Collateralizing Mortgages and Loans With the Present Value of Rent Flow
Article Table of Contents
- Summary of how a financial institution could use rent-generating property to collateralize a loan
- A financial product “crossing the distance” between the net present value of cash, and guaranteed future income flows
- Example 4: China’s Urban Villages (p. 293)
this is a draft document, it pairs with this Planned Unit Development application draft document
The ideas contained within this book draw heavily from Order Without Design. I’ve quoted in depth two pages below, but there is many other sections of the book germane to the topic of this page.
Summary of how a financial institution could use rent-generating property to collateralize a loan #
Assess the value of a land parcel by evaluating the present value of the flow of rents generated by what ever structure they can build on this parcel.1
A property could plausibly generate $6,000/mo in rent? (say, with six small units at $1000/mo in rent?)
That $6,000/mo or $72,000/yr could easily collateralize a $600,000 loan/mortgage/financial product especially if there is reason to think even more rent could be generated from the structures.
At this point, collateralization discussions would require a plot-by-plot evaluation of the likelihood a given structure on a given plot could generate such income streams.
A financial product “crossing the distance” between the net present value of cash, and guaranteed future income flows #
The FIRE community (r/fire) has the 4% rule, which can be expressed a few different ways, but broadly it’s the expression of a relationship between the value of a given lump of cash on hand, and future risk-adjusted income flows that said lump of cash can generate.
Because of math, a guaranteed $1000/mo income is “as valuable as” a $12k/yr income, which is 4% of $300,000.
So, if I wanted to borrow $100k to do something that would have a strong probability of being capable of generating $2000/mo in rent, that is a “safe” mortgage, because even if I’m way off on the amount of rent I generate, I still will have something that is worth far more than was spent creating it. It’s an asset.
This notion all comes from the text expressed below, and other text in the same book, and other books. More on it soon.
Example 4: China’s Urban Villages (p. 293) #
Legal Status of Land in Chinese Villages #
As in Indonesia, many cities in China are absorbing large numbers of villages as they expand. I will use the term “urban villages” to indicate the villages surrounded by an urban area administered by a municipality.
The land occupied by these villages has a special status by law. The use of village land is controlled by a village collective, not by the municipality, although according to the constitution of China, all land belongs “to the people” (i.e., the central government).
But there is a difference between full ownership, which involves the ability to sell property, and ownership of land use rights only, which is limited to the right to develop land and to rent floor space or land to a third party.
Villagers in China are free to set their own building standards and land use; they can rent land and whatever structure they build to a third party, but they cannot sell either the structure or the land.
Only the government can acquire land from farmers by expropriation with compensation.
For Chinese farmers living in urban villages, therefore, the value of their land parcel is represented by the present value of the flow of rents generated by what ever structure they can build on this parcel.1
Contrary to farmers living in traditional market economies, they do not have any incentive to sell their land to a developer, as the compensation price they would receive from the government is likely to be less than the capitalized value of the flow of rents. This explains why villagers in China resist selling land to the government whenever they can, and many protest forcible acquisition.3
When the built-up area of an expanding city reaches a village, the municipal government expropriates the fields around it but usually abstains from expropriating the village itself, as the compensation paid to villagers is based on a “replacement value” of the floor space demolished, while the fields are compensated based on the value of crops.
Expropriating the village and providing alternative housing units is therefore much more expensive for government than expropriating open fields.
As a result, villages are often initially spared demolition and become an enclaved urban village with a special status over the control of land use.
As a city expands, the land value increases in the villages that were initially at the fringe of urbanization, to the point of becoming higher than the compensation to be paid to farmers for whatever structures they have built.
The municipal government then tends to evict farmers after compensation or relocation and sell the land to developers. However, the process is long and cumbersome, and many urban villages survive a long time before redevelopment occurs.
And this flow of rents represents an equivalent present cash value. At least one interpretation is the 4% rule in the FIRE community - “you can take, annually, 4% of your current nest egg for the rest of your life. If you’re able to live on that 4% for a year, you can quit your job tomorrow.” $2.6 million “generates” $100k/yr. A stable $1000/mo is “as valuable as” a $312,000 cash account. ↩ ↩2
AKA I shotgunned line-breaks through the document because half of us are going to read this on our phones at least twice. ↩
‘having no incentive to sell to a developer’ is why everyone interested in historic preservation will be a massive supporter of this model. This model preserves the city. ↩