But simply talking about the housing market as if it is some monolithic beast will lead you to the error of conflating three distinct markets that must be considered independently if you want to really understand what is happening. These markets are
1: The land asset market
2: The housing service market (annual occupancy from rent or ownership)
3: The residential construction market
When you buy a home on the second-hand market (rather than build yourself), you are actually buying a bundled good which includes a land asset along with a durable housing product which lasts the life of the building. A close analogy would be buying a car bundled with an equity share in the vehicle manufacturer - you get the vehicle for its useful life and the equity asset in perpetuity.
So when we talk of high demand for housing, home prices increasing, and housing bubbles, we must be clear about whether we are talking about the market for the land asset component of the bundled housing good, or the market of occupying homes themselves. Conflating these is the most common error in housing market analysis, and it leads to conclusions that make little sense in reality.
For example, take the frequent commentary about the effect of population growth on home prices. To me, it is utterly confusing. If we are talking about the land asset market, the question then arises about why we don’t talk about the population effects on equity and debt markets, derivatives markets, and other asset classes that could equally see effects. The reason being that more people means more buyers AND sellers of the same assets.
You can see from the graph below that population effects don’t seem to be driving the growth in land asset prices, or at least can’t be a major contributor if areas with a 10-15% population decline can still see 70% growth in home prices.
Of course like other asset markets the reason for the land price increases has a lot to do with the systematic reduction of interest rates in the past 20 years. Asset prices are just the capitalised value of future claims on incomes, and a lower interest rate increases that asset value compared the value of the future incomes. This means that comparing prices of the bundle of house and land asset to incomes makes no sense at all. It would make just as much sense to compare the price of an equity share in Woolworths bundled with a kilo of bananas as a way to measure food inflation. Why not measure the food itself?
Luckily, we do have a market for housing as a produced good that we consume on an annual basis quite apart from the land asset; the rental market. If we measure how much of our incomes we spend on rent, and the quality of the homes we reside in (in terms of sqm per person), we can apply the supply and demand model to the market. If there really is something going on with population and housing production, it must be observable in the rental market. Looking at the chart below we can see that in fact the rent to income ratio declined all the way through the land price boom of the early 2000s, as did the occupancy rate (fewer people per home) indicating that in fact we were building more new homes than new people.
So sure, use your supply and demand analysis on the market for produced durable housing goods, but remember that home prices aren’t the price in that market. Rents are the price in the housing market, while home prices mostly reflect prices in the land market.
Lastly, we can look at the construction market, which is driven by trends in other markets, including speculation on land markets. Here the idea of supply and demand also works fine, as periods of high demand for new construction result in increasing construction prices (as demand shift to the right against a resource-constrained upward sloping supply curve for construction services). But again, the construction market and construction prices are not the main contributor to growth in home prices. In fact, higher construction costs will decrease the value of the land asset, as they provide an additional cost to capturing future income flows.
The situation now in Australia is that asset market dynamics, including lower interest rates, international buying, and simple cyclical timing of investments, are driving up land prices in some capital cities. In some areas, when this asset buying occurs in new homes it also increases demand for construction, pushing up prices in that market as well. And in the housing service (i.e. rental) market, the additional supply is suppressing rents.
This is the way to analyse housing markets. Don’t be drawn into the monolithic view by conflating behaviour in these distinct markets.