Sunday, September 15, 2013

Land and housing are durable goods (or why demand/supply framework fails)

The ‘standard’ urban economic model is based on Alonso, Muth and Mills combined work in the 1960s to fashion a mono-centric urban space into an economic equilibrium model. For some reason this model has gained traction in the literature despite it gross misrepresentation of housing markets.

I will let the reader enjoy the comments from David Pines’ 1987 review of the urban economics literature

The static approach in the Alonso-Mills-Muth model is useless in explaining many stylized facts regarding the urban structure and its evolution through time. In the static analysis... land is continuously utilized within the city boundaries and the city boundaries are continuously extended with income and population size.
The reason for the failure of the static model in explaining these ‘irregularities’ is that the housing stock is assumed to be perfectly malleable, which, of course, is highly unrealistic. 

What this means is that every time there is a marginal change in any of the parameters of the model - a new person moves to the city, the rental price of the second best land use increases, or the efficiency of construction methods change - the whole city is wiped clean of housing, and the land owners and people sit down around the camp fire and decide a new optimal allocation of housing under the new conditions, then the whole stock of housing is rebuilt in an instant to that new specification. There is never a vacant site or development opportunity. 

Yes, this bizarre model was used by RBA used just a few years ago to help them understand regulatory impacts on housing supply. 

However we have known since 1989, when Bagnoli, Salant and Swierzbinski explored the durable goods monopoly problem posed earlier by Ronald Coase, that the optimal revenue raising strategy of land owners is withhold new supply of housing to future periods to maintain price levels. 

Thus, the constraint on new supply is the number of buyers willing to pay current prices or above in a given time period. If the number of buyers dries up, the optimal solution for the land owner is not to develop until such demand arises. Thus speculative booms are likely to coincide with construction booms, as investors rush into housing markets allowing developers to sell larger volumes of new stock at current prices. 

This point probably needs an example to really drive it home. Imagine you are subdividing a lot into three smaller housing lots. Your market research suggest that $300,000 per lot should be an achievable price. You put them on the market for that price. It takes 4 months to get the price you are after for one block. 

You get offered $280,000 for the second block after another 4 months. But you know that if you accept this price that you will most likely have to accept that price for the third block as well (especially given that sales prices are public records). 

The big question - the one that determines the rate of housing supply - is how long to wait for sales to maintain prices. Do you make a better return if you accept $280,000 and increase the supply now, or is it better to wait until you can get a price of $300,000 and defer new housing supply? 

The answer that Bagnoli found was that if the sellers are more patient than buyers on average (the have lower discount rates), than it is optimal to wait. It is better to sell one per year at $300,000, than 3 per year at $280,000. 

In the mainstream world of AMM’s economic model you shouldn’t have bothered waiting at all. You should have dropped the price immediately until you sold all three blocks on the first day. 

You might want introduce ‘competitive’ land developers at this point. Say my neighbour also subdivides their block into 3 smaller lots. With this less constrained supply surely now the rate of new housing construction will be higher? 

Actually it is not. 

The return maximising strategy is for each land owner to wait, and still sell just one of the now 6 potential lots each year. The land owners compete with each other for a sale, which encourages innovation in design to better appeal to buyers (to get the sale instead of their competitor), but it doesn’t bring forward supply.

Perhaps a little story from my time with a major residential property developer might help.  Remember the days when people would queue at sales offices for new subdivisions.  By sheer luck we were faced with this sort of crazy demand when we released sales of a new building at the Sunshine Coast.  Early that morning it seemed we would be able to sell the whole building within a day or two. So did we?

Of course not. We crossed all the prices out and wrote new ones 20% higher.  That certainly slowed the sales right down, and it took a couple of years to sell the whole building after that.  We simply did the profit maximising thing of withholding new supply. 

By understanding these fundamental processes at the heart of the housing supply debate it leads to very different conclusions about the types of policies that might trigger increasing housing investment - policies that focus on the discount rate of the land owners. 

This could include rent controls (decreasing future expected returns), incrementally ratcheting up land taxes (decreasing returns from not developing), announcing tighter building height restrictions in future periods (to encourage land owners to develop before the new restrictions are implemented), removing land tax exemptions for approved but undeveloped lots, and more. 

That last one is interesting.  In Queensland developers get a 40% discount on land taxes if they have subdivided a lot, but not sold it.  All this does is provide incentives to withhold land for longer, and the cost of doing so is reduced. Of course, developers will simply change the timing of the subdivision to be closer to the sales (getting approval, pre-sales, and then subdividing). But on average it must be a good move to remove this discount. 

The logic of durable goods means the extensive land banking by developers, which in Australia is currently around 19 years supply at current rates of sales, is actually a rent-seeking strategy - an attempt to buy land at a low price with one zoning, only to have it rezoned for more intensive uses before being developed.  It is not about anticipating supply needs and navigating regulations.

It means that developers stage developments in order to bring forward some construction and make the location more desirable for buyer of future stages.  Staging is about delaying development of new homes. 

Lastly, it means that reasoning of shortages or supply constraints due to land price differentials near zoning boundaries, such as by Grimes and Liang, is faulty at best. Of course differently zoned land at the same location is worth a different amount, because the value of that land is the capitalised income from its highest and best use minus the construction costs of that use. It has nothing to do with expectations of future rents or any such thing. 

I highly recommend reading my previous post in interpreting housing market indicators to fully grasp the potential misinterpretation of housing indicators from using the wrong model.

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