Land value finance proposed as a way to pay for urban development

Workers take a break at a construction site in Ho Chi Minh City. Rapid urbanization in Vietnam has brought both opportunities and challenges to the country. Photo by: Tran Viet Duc / World Bank / CC BY-NC-ND

The Habitat III summit aims to generate action towards sustainable urbanization and that often boils down to the topic of finance.

The four-day gathering in Quito, Ecuador, includes dozens of sessions related to innovative and collaborative ways to pay for the proposals put forward in the New Urban Agenda — the U.N.’s principal framework document for sustainable urbanization, that by some estimates could cost in the tens of trillions of dollars to fully implement. One of the most widely discussed policies in municipal finance at the conference are financial instruments related to land value capture.

To simplify a complicated topic, land value capture refers to financial gains from the appreciation of private land as a result of public investments or administrative actions by a municipality.

Financial instruments to capture land value gains have been common practice for many industrialized cities. But more recently they have become an increasingly attractive option for cities in developing countries. With rising urban populations and limited land available in city areas, appreciating land values can be almost inevitable. The gains for local governments and private developers can be in the billions. But developing country governments still need to strengthen enabling environments in ways that support greater borrowing and transparency of expenditures if these instruments are to become more mainstream.

Generally, municipalities use land value capture products to raise funds in two ways, according to Roland White, global lead for city management, finance and governance at the World Bank, who spoke on a panel about financing models to fund large-scale transportation and infrastructure projects for which land value capture products are becoming a more popular option.

In the first — a fee-based scheme — governments plan or propose city development projects with the expectation that they will increase property values in the surrounding areas as well as the taxes collected on them. The government then collateralizes those forthcoming revenues and sells them to investors to raise cash. The practice has caught on in both emerging and industrialized countries. Cities in Colombia, for example, have applied the approach to fund municipal transport projects while municipalities in greater Washington, D.C., have used it to finance extensions to the city’s metro line.

A second so-called development-based instrument involves more of a direct sale. Local governments sell tracts of land or the right to develop them to private investors on the basis of new zoning regulations or building permits. The investors reap the benefit of future land value increases, but in exchange are often obligated by the terms of the sale to build infrastructure or other public works projects. This type of approach is typically used in areas of a city with little development.

Both instruments — and many others related to land value capture — closely align with the themes of the New Urban Agenda. As U.N. Habitat Executive Director Joan Clos has advocated, the agenda encourages cities to adopt “smart and sound” urban planning policies. Strategic changes to zoning regulations or policies to develop unused tracts of land in efficient ways can generate value instantaneously. And those type of planning tools are particularly relevant for development-based land value capture instruments.

The tax-based approach relies on another point that Clos and other urban development specialists have put forward — the intrinsic value of cities. Rising urban populations — coupled, of course, with sound public policies that support vibrant economic activity — will almost inevitably drive up land values and create an inherent creditworthiness for local governments.

But land value capture instruments can also be highly contentious and tricky to execute. Pushing up the value of new, undeveloped tracts of land can, in turn, push out informal or low-income settlements in those areas.

These financial instruments are not cookie cutter solutions to finance urban projects and upgrades. In fact, the use of land value capture instruments in developing countries is quite rare, White said.

“In many cases, the conditions [for them] to emerge don’t exist,” he said.

Very often the constraints have less to do with financial engineering capacity than with the public policies and institutional capacities to support them. Land value capture instruments that count on future tax revenues can only succeed in jurisdictions that have robust and transparent tax systems. And in many parts of the developing world, large swathes of land are either unmapped or unclaimed, which could lead to competing claims that could undermine a government efforts to parcel them off.

Being able to utilize land value capture and other financial instruments for urban development often comes down to the bigger picture of reforming municipal finance. “It sounds arcane, but it’s extremely important,” said Daniel Platz, an economist with the U.N.’s department of economic and social affairs.

Speakers across the various sessions on municipal finance at Habitat III have put forward a range of ideas on how to tackle that. Chief among them has been creating openness and transparency.

“If you are ever going to attract private investment, investors will evaluate the historical financial performance of the city,” said Stephen Matzie, an investment officer with the U.S. Agency for International Development. “The only way to do that is to open up your books and have it be reliable.”

Expanding a city’s authority to borrow is also key, Matzie noted. In many countries where USAID lends, governments are limited in how much the can borrow, Matzie said. “They are well-intended, but capping the borrowing at 2 to 4 percent can be strapping. No one is advocating borrowing without limits, but you have to be able to borrow a lot of money up front that you can pay back long-term.”

Even if the lending conditions and reliable enabling environment are in place, land value capture instruments are just one niche option for municipal finance.

“They are not appropriate for all forms of urban development,” White cautioned. But structured properly and backed by projects that generate sustainable returns, they can be a useful tool for municipal planners.

Devex is reporting from Habitat III in Quito, Ecuador, this week. Follow reporter Naki Mendoza @mfbmendoza to keep up with Devex coverage. You can also read more about the #newurbanagenda.

About the author

  • Naki B. Mendoza

    Naki is a former reporter, he covered the intersection of business and international development. Prior to Devex he was a Latin America reporter for Energy Intelligence covering corporate investments and political risks in the region’s energy sector. His previous assignments abroad have posted him throughout Europe, South America, and Australia.