Land covenants: Why pay to limit your options?

The surprising economics of restrictive land covenants

Options have value, so you are better off with more options. That’s a pretty fundamental rule of thumb in economics. But it would be a boring discipline if everything flowed from a small set of rules! Indeed, I’m always on the lookout for apparent exceptions to general rules, as there’s usually an interesting story to be uncovered.

On the face of it, land covenants (also known as restrictive covenants) are one such exception.

So you’ve just discovered the perfect spot on which to build your home

You spot an attractive vacant section (a.k.a. block, plot or lot¹) with a for-sale sign. Your finances can stretch to cover the land price, but can you also afford to build a house on it? That depends, in the first instance, on your own needs and preferences (e.g. how many bedrooms?). And then you’ll need to meet the restrictions imposed by local council in its District Plan (e.g. boundary setbacks & height limits) and the relevant building codes.

But that’s not necessarily to end of the constraints. Many, perhaps most, modern residential subdivisions in NZ feature land covenants.² These further restrict your building options. I’m going to use one such covenant as an example for this post. (I understand that it is reasonably typical for urban residential subdivisions.) This covenant, for example:

• prohibits pre-built, transportable, relocatable or previously-lived in dwellings;

• limits roof pitches, and requires exterior cladding from a limited range of materials, including specific branded products (in this case “Hardiflex Linea panels” and “ColourSteel”³);

• constrains colour choices (i.e. “muted earthen hues found in the local landscape”);

• limits building to one single dwelling, plus “normal accessory buildings” clad in “materials and with decorative finishes and colours” the same or similar to that dwelling;

• limits temporary on-site living (i.e. caravans, tents, motorhomes) to no longer than 3 weeks, and elapsed time for the total build and landscaping to 18 months; restricts tree species, and tree, hedge, grass and fence heights; and

• prevents further subdivision of the section.

The covenant is perpetual, and can be enforced on any section owner by one or more other section owners.⁴

You pay more to buy covenanted land

Clearly developers anticipate that they can sell covenanted land for a higher price.⁵ Covenanting is a cost (lawyers, no doubt, benefit), so developers will set land sale prices to recoup their own costs and make some additional profit .

You pay more to build on covenanted land

The effect of the covenant is to push you away from cheaper build options (e.g. cheaper materials, pre-fabrication, standard designs) and towards more expensive ones.

And your future options are restricted on covenanted land

Think you might need a granny flat in future? Or subdivide off part of your section to fund your retirement? Then you’re out of luck, permanently.

So why buy it?

Developers have clearly learnt how to design covenants that increase their own returns. Yet people still buy covenanted land. The only reasonable conclusion is that purchasers value limiting their neighbours’ options more highly than they do the restrictions on their own options and the extra costs the covenant imposes on them.⁶

The extra value from limiting their neighbours’ options arises from two sources: neighbour selection effects, and reduced between-neighbour negative externalities.

Neighbour selection effects

A club for cat haters?

One way of looking at land covenants is to consider them a club good. Suppose, for example, that you want to live somewhere with lots of native birds and no pet cats. But neither cats nor native birds respect property boundaries. You could make yourself very unpopular trying to convince your neighbours to get rid of their favourite moggie. Or, you could start a club of like-minded individuals. Absent a mechanism to evict cat owners, the most practical way to do this is to start with an empty suburb, and only “allow” people in who shared your preferences. This needs a mechanism to guarantee that newcomers really share your cat-intolerance, and will continue to do so. A land covenant is such a mechanism: it allows you to reliably sort between those who do, and those who don’t.

All else equal, such geographical sorting will be welfare-enhancing. Those with strong cat-related preferences get to live with others who share their preferences. And the indifferent are unaffected (unless they change their mind in the future, and find themselves with the wrong sort of neighbours).

Raising the price to keep the riff-raff out?

The example land covenant described above says nothing about pets. But, even so, it is sorting people. Many of the clauses act to increase costs, which keeps out people who can’t meet those costs. Ability to afford increased costs presumably acts as a weak proxy for “people like me” or “better quality neighbours”. More disparagingly, it can be seen as a way of keeping undesirable neighbours (the riff-raff) out of the area.

A leafy, low-density & expensive suburb — Lowry Bay, Lower Hutt. Dave Heatley

Reduced between-neighbour negative externalities

Sorting by preferences is an application of the general principle of land zoning, which separates activities by location to reduce between-neighbour externalities.

The example covenant also includes more direct mechanisms to limit between-neighbour externalities. If you’re not planning to live in a caravan while you spend a decade building your home, it might prove some comfort that your neighbours won’t be. And a clear height limit on trees anticipates, and hopefully avoids, future between neighbour argy-bargy over views and shading. Such conditions are likely welfare enhancing.

Incomplete information, incomplete governance

From a economics perspective, freedom to contract and freedom to form clubs are generally a good thing! And, in the absence of significant beyond-group externalities, socially welfare-enhancing.

That said, I don’t think land covenants of the form described here meet the requirements of a good contract, nor do they match the typical structure of a club.

A good contract acknowledges its own incompleteness.⁷ It provides a mechanism to for the parties to change contract terms, anticipating possibilities not specified in the original contract, and the changing expectations needs and of the parties. Moreover, it anticipates and provides mechanisms to deal with holdup situations, in which one party can extract rents from others by threatening actions or withholding agreement. Land covenants are complete contracts, assumed perfect now and in the future.⁸

Similarly, while clubs have joining criteria and membership rules, they also have governance bodies (e.g. committees, general meetings) with the ability to modify those criteria and rules.

Land covenants are incomplete contracts masquerading as complete ones. They neither meet the requirements of a good contract, nor do they have the governance structures of clubs.

But externalities extend beyond the subdivision boundaries

A disparaging take on land covenants is that they create something similar to gated communities — clubs for rich people. Not all covenants can target the rich — the top of the market is just not that large — so presumably different covenants are written to target specific wealth tiers. This creates geographic sorting by wealth, or, more likely, reinforces other processes that lead to such sorting. Much economics and social science literature deals with the negative aspects of sorting on the broader community, including a reduction in social cohesion, and reduced opportunities and aspiration for those living in poorer neighbourhoods.

There are further negative externalities. One is that widespread application of covenants that specify building materials and methods, and location-specific rules forces most house construction to be bespoke.⁹ This undermines the economies of scale for prefabricated and other forms of mass-produced housing in New Zealand, making it harder to reduce housing costs across the country.

Another is the prohibition on further subdivision, which will undermine future attempts to increase housing density. This imposes today’s preferences and standards on future generations, with possible transport cost and environmental implications.

Reforming land covenants

The NZ Productivity Commission’s 2015 inquiry Using land for housing recommended changes to land covenants.¹⁰

This recommendation would improve on the current state of affairs, by:

• time-limiting restrictions, eventually eliminating those that did not keep up with changes in preferences or technologies;

• reducing the coordination costs of covenant modifications; and

• eliminating the holdup power of single landowners.

The Government has not pursued the Productivity Commission’s recommendation, so far as I know. But even if implemented, it would do nothing to address the beyond-subdivision externalities.

A case for regulation?

Land covenants are a contractual mechanism to create a club of like-minded landowners. But they appear to be poorly designed, both as contracts and as clubs.

NZ regulates clubs. The Incorporated Societies Act 2022, for example, specifies registration, administration and governance arrangements for clubs.

NZ also regulates unit title developments, e.g. apartment buildings and subdivisions with shared land or facilities. These are required to have body corporates — representative committees to make rules, manage shared resources, and resolve disputes.

Land covenants, at least the well-designed ones, reduce negative externalities between club members. If poorly designed ones only affected club members, then the case for regulation would be weak. But land covenants can impose negative externalities on those outside the club. They contribute to increased housing costs, so there are broader social reasons to be concerned about them.

Land covenants fall between the regulatory cracks. I think there is a case for sensible regulation that includes, and goes beyond, the Productivity Commission’s 2015 recommendations.

By Dave Heatley

»»»»»»»»»»»»»»»»»»»»»»»»»»» Check out the sequel: Land covenants redux.

[Updated 24 April 2023 to fix some typos and unintentional ambiguities.]

19th Century housing in Arrowtown, Otago. Decisions over section sizes have long-term consequences. Perpetual covenants assume that the best decisions today will also be the best decisions for future generations. Dave Heatley

1. Section is the New Zealand term for a single-title piece of land suitable for building a dwelling. Australians would call it a block. Other terms include plot, lot, parcel and tract.

2. In Auckland, covenanted land titles cover an area of 8685 hectares, that is 23% of the total area of residential zones. See: Craig Fredrickson (2018). Land covenants in Auckland and their effect on urban development. Auckland Council technical report, TR2018/013.

3. ColorSteel® is a proprietary pre-painted steel roofing product in NZ. It is similar to the well-known ColorBond® product in Australia.

4. A land covenant binds future owners and remains on a title until all affected landowners and interest-holders agree to its removal, or a court orders its extinguishment.

5. It’s also likely that developers believe that covenants allow them to sell sections more quickly. The logic here is that potential early buyers may be put off by the possibility of undesirable behaviour or building choices by their future neighbours, and so prefer to be late buyers — when they can see what was actually built. Covenants give early buyers some confidence that the final neighbourhood will more closely match the developer’s drawings and show homes. These (desirable) effects clearly expire once most sections are sold and built upon, but the covenants are typically perpetual.

6. This is a statement about averages, not one that characterises every actual or potential purchaser. Imagine, for example, a potential purchaser for whom the land covenant has net negative value. This reduces their reservation price (i.e. the highest price they are willing to pay). However, if that price remains above the seller’s reservation price (i.e. the lowest price the seller is willing to accept), then the purchase is likely to proceed.

7. The idea of contractual incompleteness is generally attributed to Sanford Grossman, Oliver Hart and John Moore. See, for example, Grossman, Sanford J., & Oliver D. Hart (1986). The costs and benefits of ownership: A theory of vertical and lateral integration. Journal of Political Economy 94(4): 691-719.

8. Specifying proprietary products for cladding makes it clear that this supposedly complete contract is actually incomplete. What happens should those products be withdrawn from the market?

9. Excessive requirements in District Plans have the same effect. Land covenants just add to the problem.

10. Full disclosure: I was employed by the NZ Productivity Commission in 2015. I was not, however, directly involved in the Using land for housing inquiry.