Saturday, April 1, 2017

Economics of empty homes

Prosper Australia has for years been conducting research into how many of Australia’s 9.8 million homes are left vacant. Their major finding is that of the 1.7 million homes in greater Melbourne alone, around 82,000 are vacant, or 4.8%. Their research has been cited by a recent United Nations study on the pernicious effects of the financialisation of the housing sector, and has likely been a key reason for the adoption of a vacant housing tax in Victoria, and probably in Canada as well.

It is timely, therefore, to consider some of the economic and practical realities of vacant housing.

Why keep property vacant?
What gets lost in the hype is this important question. Very few people understand the economic rationality behind leaving homes vacant, as the commonsense view is that a vacant home is always costly since it is forgoing rental income for its owner.

The answer is ‘options’. What I mean here are real options. That is, keeping the home vacant keeps open the valuable option of selling the property vacant and earning a higher price.

Let me explain by way of example.

Say you have a property that could sell for $500,000 if there is a sitting tenant in place, or $520,000 if it is vacant (a 4% price boost from vacancy). This means that the option to sell vacant is worth $20,000.

If you are considering selling in the near future because you want to time your exit from the market, then you may want to forgo rent in order to keep your option of selling vacant open. If the annual rent is $19,000, it might be worthwhile to forgo a whole year’s rent because it is less than the value of the option of selling vacant.

Quite clearing, if you making this decision, you aren’t in the housing market to be a long term supplier of rental housing, but to time your exit and cashing your capital gains.

This is why financialisation of housing, which encourages speculative buying and selling (getting most of your return from capital growth), rather than long term investing (get most of your return from rental income), makes housing markets fail in their primary social function of supplying secure housing.

The same logic is at play with vacant land. Given that there is always a positive return to be had from developing land, the very existence of vacant land should be a puzzle. But it is again a real options problem.

If I have a vacant site that I can build a economically build a 5 storey building on today, doing so removes my option of making even larger profits from building a 10 storey building in a few year’s time when price make a larger building more profitable. This happens in the absence of any zoning controls, since as prices rise, a larger scale of development becomes more profitable.

So vacant land is only vacant because the landowner is waiting for their development options to increase in value.

But this can be stopped. In my example, if there was a zoning limit of five storeys, there would be no future option of building a 10 storey building, only a 5 storey one at a later date. This makes the value of waiting less, and encourages faster supply.

This is not just my opinion. Here’s an excerpt from a 1985 article by Sheridan Titman who asked this exact question and published his results in a little journal called the American Economic Review, in an article entitled Land Prices under Uncertainty.
It is shown that the initiation of height restrictions, perhaps for the purpose of limiting growth in an area, may lead to an increase in building activity in the area because of the consequent decrease in uncertainty regarding the optimal height of the buildings, and thus has the immediate affect of increase in the number of building units in an area.
A ballpark estimate
The next question is to ask how many homes may be vacant primarily because of this speculative motive. Prosper uses water meter data to asses whether a property has been vacant. By looking at properties that have used no water over a 12 month period (25,000 dwellings), and those that used less than 50L per day over a 12 month period (82,000 dwellings), they make a judgment that these extremely-low-water-use homes are vacant.

To answer how many vacant dwellings there are nationwide we can make a ballpark estimate by scaling up the results of Prosper’s research to other capital cities based purely on the relative size of the dwelling stocks. This method relies on the assumption that if it is logical for owners in Melbourne to keep that share of dwellings vacant, it is equally logical for owners in other states.

The reason to do this, rather than simply recreate the research using water meter data, is that in Queensland and New South Wales, apartments are not all individually metered for water, but metered only once of the whole apartment building. So their approach fails to catch vacant apartments when adopted to other areas. Using electricity usage data, or data from other utilities such as internet and gas, can also be troublesome, both in obtaining reliable data from utility companies, and making judgements about what constitutes vacancy.

When scaling up Prosper’s results from Melbourne we can be conservative, and instead of taking the 4.8% number as the share of vacant dwellings, take a clean 4%. We can also make some other (somewhat) justifiable downwards adjustments for other states where the value of the “vacancy option” is lower because prices have been more stable. The table below shows this calculation.



Total dwellings ('000) Potentially vacant ('000) Adjusted Adjusted reason
Vic 2,507 100 100 None
NSW 3,026 121 121 None
QLD 1,956 78 59 Stable prices means less value from vacancy option (x0.75)
SA 765 31 23 Stable prices means less value from vacancy option (x0.75)
WA 1,058 42 21 Falling prices means vacancy options less valuable when cashflow a priority. (x0.5)
Tas 242 10 7 Stable prices means less value from vacancy option (x0.75)
ACT 164 7 5 Stable prices means less value from vacancy option (x0.75)
NT 84 3 2 Stable prices means less value from vacancy option (x0.6)
TOTAL 392 338

As a ballpark, around 300,000 our of 9.8 million dwellings are likely to be sitting vacant each year, or about 3% of them. For the last five years the country has built about 153,000 net new dwellings each year, so these vacant homes represent about two years of new supply at our recent historically high rates of dwelling construction.

So what?
What’s the big deal then? Two things. First, if you think that the supply side of the housing market is a major determinant of prices, having two year’s of new supply already built but sitting vacant is bad. Second, even if you don’t think this much supply has any significant effect on prices or rents (which I don’t, probably around 1-2% at most) then the main rationale for concern is on economic efficiency grounds. These vacancies are a symptom of bad housing policy.

When the housing market turns downwards, much of this vacancy will solve itself as owners look to buckle down to ride out the downturn and generate the rental incomes instead of capital gains.

The historical data from Prosper’s Speculative Vacancies Report confirm this pattern. After the financial crisis their speculative vacancy measure fell from 7% to 4.4% in the following four years, but since 2013 has begun to rise again as property prices started once again began to increase rapidly.

When the next downturn comes, those who are unwilling to accept the price they can get from their option to sell, will probably take the option of renting instead, bringing a massive dose of new supply into rental markets.

In this context, a tax on vacant housing can act as a dampener on speculation, as it makes more costly the speculative option of keeping property vacant. In practice, Canada’s vacant home tax will rely on declarations by owners and spot checks to ensure compliance. This is really the only way. Relying on water data would simply encourage owners to leave taps on to avoid the tax.

But in many ways, speculative vacancies are a symptom of a poorly regulated housing market that is attracting speculative buying (undesirable) rather than long term investing (desirable). We can some of the underlying causes in a much broader way, such as by restricting speculative lending into the housing market in the first place, like by banning interest only loans. With stable prices, only investor buyers looking to earn an income from renting will be likely to invest.

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