Wednesday, September 24, 2014

Seeking housing supply logic

A four year long debate over the potential role of town planning regulations in determining the price of housing has occurred at MacroBusiness. The latest instalments are here, here, and here, and my model of understanding price effects of locational distributions of housing is here.

I want to briefly look at the logic of those who argue that planning controls strongly influence housing prices, and ultimately the affordability of housing in all forms (including rental affordability).

So far it seems there are multiple conflicting views being simultaneously held by the shortage protagonists, which I call the response dynamic, the expectation dynamic, corner the market, and the squeeze. Each of these suffers from the problem of invoking an implicit baseline for comparison which simply can not exist.

Response dynamic

In this argument there exist regulatory barriers, such as the need for a development approval, that delay housing supply in the short run while prices are rising, amplifying any resulting cycle.

While intuitively appealing, this argument suffers from a similar logical problem that most supply arguments do - the implicit invoking of a baseline that doesn’t exist.

You see, implicit in this argument is the idea that there exists a world of no constraints in which an unlimited supply of some asset could exist (as asset, by the way, is by definition a share of a finite bundle of property rights, which if could be infinitely supplied, would have a zero price). This baseline arises in economic theory of perfect competition under the implicit, but poorly understood, assumption of free entry. Yet free entry invalidates positive prices in general. So the logic of this baseline relies on the same faulty logic hidden in the economic model of perfect competition.

So if this fantasy world is not a relevant baseline, then what is? At best it is a world of monopolistic competition, where all land owners compete in slightly different markets, as there are no perfect substitutes to each location. Here, each land owner faces an independent choice of when to develop for housing given current market conditions. Essentially, is it better to develop today, or will I make more money developing later?

In this case a land owner, or even a developer who has approvals and is ready to build, will delay sales if the present value of the revenue from delaying sales and achieving a higher price later exceeds the cost of delaying. In practice this means that when prices are rising rapidly and sales are occurring quickly, it usually pays to delay sales by increasing prices. This is a simple matter of logic, and is supported by a large literature on real options theory that takes into consideration the one-shot nature of development, and the optimal timing of investment and sales decisions.

What this means for the response dynamic argument is that regardless of the nature of the town planning system, and even if the development approvals process was removed entirely, land owners and developers would still delay sales and construction of new dwellings during the price cycle. They would not, as is argued, somehow ignore their independently available option to delay sales for higher prices.

Expectation dynamic

Another argument goes as follows - a housing bubble can occur in an oversupplied or undersupplied market, but what determines the long run average price level is the potential abundance of future supply.

This ignores a number of things, the main one being that current supply should, and does, matter for housing affordability because rental prices arise from competition for the current stock of dwellings. What we are discussing in this argument is how the expected growth rate of rents and prices is capitalised into current prices. If potential future supply enters the price equation through an expectation of future growth in prices and rents, then this expectation can of course increase prices.

The flaw in this argument is that expectations of growth in prices can, and do, arise in markets where future supply is essentially infinite, both in experimental settings, and in many real life examples, such as the public land auctions of the 1830s. So invoking expectations of future supply as the specific mechanism for the formation of price growth expectations is completely arbitrary.

By the logic of this argument I could promise to flood a city’s housing market with new dwellings in 50 years time, and by backwards induction, current home buyers would reduce their willingness to pay and overall prices would fall. If you believe this would work, I’m happy for you to believe the expectation dynamic argument on housing supply.

Corner the market

This argument says that because there are finite locations for future housing supply, large developers are able to corner the market by acquiring sites and drip-feeding new supply in order to maximise their prices.

Holding such a view relies on the same implied baseline as the response dynamic argument, in that a world of free entry and unlimited supply is assumed to be a possible alternative but for town planning controls. Of course a world that has no town planning control, but merely divides the land in bundles of private ownership, will also have limited supply, and will suffer the same problem.

What this argument boils down to is a claim that even with many thousands of developers operating in our housing markets, and even with many millions of potential development sites whose owners will seek development in the future, somehow adding additional potential development sites will increase competition.

It is fantasy to imagine that if competition between 1,000 developers does not exist, that when there are 2,000 some kind of magical competitive pressure arises.

Squeeze

Lastly, there is the basic squeeze argument that says that because planning constraints are binding, in terms of setting an effective quota system (which they don’t, more on that in a moment), that we can think of their effect in terms of basic constraints in supply and demand equilibrium approach. This is the approach the RBA has used before to attempt to understand housing supply.

But controlling what is allowed to be built where does not also control that rate at which new development of any type is constructed. Local councils approve developments at the rate they are sought, and in my home town the rate of approvals increased by a factor of five during the early 2000s property price boom. Clearly there was no quota system on quantity, only location restrictions on where different type of development would be allowed.

The separation of location controls and quotas can be clearly seen with an example. Think of road space. We have a ‘road planning system’ that says cars driving east can only use half the road space, and cars riving west can only use half. Therefore this should create, by the same logic that location regulations restrict housing supply, a shortage of commuting.

But it doesn’t. It facilitates better commuting because conflicting uses are segregated. Imagine then a city that says one side of the river can only be used for residential development, while the other side can only be used for non-residential uses. Does that automatically create a shortage and a housing squeeze? Only if you assume it does.

Taken to the extreme, this argument again invokes the free entry assumption and the backwards induction logic of the expectation dynamic. If segregating housing to one half of the city creates a squeeze, so do does ANY geographic restriction, including the mere finite size of the world. If only the world was bigger, housing would be cheaper!

Conclusion

Even you edge to the middle ground and argue that it is some combination of these arguments, this doesn't address the fact that they independently ignore the basic realities of property markets. It is not to say that at some point there could be a supply side effects on prices, such as following natural disasters and so forth. But we must realise just how small the new supply of housing is compared to the whole housing stock to understand that any effect of the rate of new supply on prices can only be miniscule. The real problem with these arguments (apart from their inability to make sense of rental prices) is that invoking a baseline of perfect competition is absolutely a wrong assumption.

Update
Even if you still want to ignore the logic of the arguments at hand, and insist that the evidence shows that, for example, houses are cheap in Houston, Texas, therefore their planning system is the reason why, you need to a) ignore that they have a strict planning system, which just does not have zoning as it is usually used, b) ignore that at the fringe of all Australian cities there are also cheap houses (eg. I found 121 houses for sale under $300,000 with over 3 bed, 2 bath, 600sqm of land, in Ipswich, west of Brisbane),  c) ignore the price effect of state property taxes in Texas, and d) ignore commuting costs from sprawling cities, which are avoided in more compact cities and get capitalised into prices.

2 comments:

  1. 1) I have heard that the gross margin on luxury goods is higher then the GM on middle class goods; that is, you make more profit on one $2,000,000.00 house then on 10 houses @ 200K each
    (and I think the margin on fixtures and furnishings is even greater; newspapers regularly feature this factoid re automobiles)

    2) Compared to the 50s, we are not building roads; this means that although there is a lot of land at longer distances from jobs, this land is hard to use (here in boston, where I live, alot of people live 40miles north in NH, where housing is much cheaper; however, you have to leave your house at , literally, 5am or else spend a long time in traffic

    3) I'm sorry, I really don't understand your response dynamic argument. Are you saying that zero addtional housing would be made if all regulations were removed ? in the short term ? I think you are underestimating how in the real world people are lazy - if there is a small barrier, one that is a few minutes or hours, it is enough to deter a surprising amount of work

    4) The amt of public housing constructed by the gov't has gone down a lot
    I couldn't find a really onpoint url for this, but
    https://www.livebusinesschat.com/smf/index.php?topic=4117.0
    supports my view
    also see
    http://prospect.org/article/can-private-capital-save-public-housing-tenants-have-their-doubts
    and

    6) it is always popular to decry NIMBYism, but to me, NIMBY is the essence of democracy (people voting for what they want where they live) and almost all the opponents are hypocrits - not one of 'em would put up with what they urge others to put up with

    PS: I'm posting as anony cause I had problems signing in

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    Replies
    1. Thanks for the comment. I'll quickly response to some of your points.

      1) Sure. That's just a matter of risk isn't it?

      2) Do we need more roads if we develop more dense cities? Probably not. Housing is cheaper at further distances BECAUSE of the troublesome commutes. If you made commuting easier prices would increase in these fringe areas.

      3) Yes I am. No I don't underestimate laziness, particularly of developers. They expend ridiculous efforts trying to get rezoned, so I really don't buy that argument at all. Especially since rezoning changes NOTHING about the actual process of building (just what is allowed to be built).

      4) Yes it has. Here in Australia too. My personal view is that public housing is vital ingredient in the social safety net. Governments now tend to prefer to subsidise rents instead (which increases the ability to pay rent of those in the lowest income areas).

      5/6) Yes, I think existing residents should have say. After all, we live in a world where property rights are never perfectly defined. For example, if I own land to I own the right to the sunlight that hits it? This can be an issue where I install solar power, then my neighbour builds 10 storeys and my land is in almost permanent shade, my plants die etc. This is why I strongly support planning development, and more so the more dense cities become (the need for public investment in transport and infrastructure networks, avoiding clashes of uses etc).

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