Tuesday, November 19, 2013

What limits housing supply… one more time

My long term view, based on experience in the property development industry and in planning regulations for water and infrastructure, is that zoning is not a binding constraint on the rate of supply of new housing.

There is no doubt that zoning and other planning measures limit the type and scale of use on any particular site, as they are intended, but in aggregate they do not constrain the rate of new housing. For zoning to truly hamper housing supply there must be no undeveloped lots available within a zoned area. Indeed, all land must currently be at its highest value use, meaning these would cease to be a development industry altogether, and land banking would be the stuff of imagination.

One reason for the confusion around housing supply is the simplification inherent in almost all economic models of markets whereby the free entry condition means that any positive NPV project is instantly produced. There is no time in the model, and therefore no ability to delay investment.

To deal with the realities of the irreversibility of investments and the ability to delay, Black, Scholes and Merton in the 1970s developed methods for valuing the option to invest in irreversible capital at some point in the future. Merton and Scholes were even awarded an Economics Nobel for their trouble in 1997.

Following these methods a large body of work has emerged that addresses firm choices with real options - that is, when the firm faces genuine options to delay irreversible investments. Firms then face compound investment decisions; what to invest in, and when to invest in it. 

Why is this important for housing supply? Well, only in a world where real options exist can land remain undeveloped or in low value uses when higher value uses exist. Thus any analysis of land markets that is able to account for the large volume of undeveloped land must be based on the real options of land owners.

I have written about research into the nature of durable goods markets in the past, particularly the debate over the Coase Conjecture of how a monopoly land owner would drip feed supply to maximise the value of their land, since by building more homes now they will compete with the home they build in the future.

Yet real options is far more general, embedding these ideas into a much more robust theory. So what happens to land models when you account for real options?

Strangely enough in 1985 Sheridan Titman 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.

Titman constructs a model based on the idea of options to reveal the types of fundamental characteristics the drive the choice by a land owner to develop, which include the expectations of future changes to the optimal density of development, as well as future rental price paths. 

Under his model of real options in land (and indeed any model derived from this proposition) the land owners response to external conditions is quite different that in the basic model of perfect markets. He writes

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.

This is something I’ve said before, and it is worth repeating. Increasing zoning in an area provides an incentive for land owners to delay development and hold out for further changes in zoning. The reverse is also true, and I’m sure everyone would agree that if you announced a reduced maximum density in an area that there would be a rush of development prior to the loss of the ‘option’ to develop greater densities.

A similar situation will happen with changes to developer costs. Infrastructure charges are often blamed for the high cost of development, but in any theoretical picture involving real options, reductions in infrastructure charges will delay rather than accelerate development. Similar problems arise with stamp duty. Calls to reduce stamp duty arise due to equity concerns, yet they have been shown not to increase housing prices, and in other markets such transaction taxes, or Tobin taxes, are being proposed to reduce volatility.

Sure I’m all for land taxes, but replacing a rather good tax in the form of stamp duty, rather than highly distortionary taxes such as payroll and income tax, provides a much smaller social gain. 

Given that rental prices in most Australian capital cities are falling relative to incomes, land markets must be functioning as roughly intended. My earlier ideas on rental controls may also reduce the rate of growth of housing prices, leading to increases in housing investment as the payoff from withholding undeveloped land decreases.

For all the talk of ‘elastifying supply’, there if very little in the way of considered logical thought about exactly what factors generate the current rate of new housing supply. Only by acknowledging the real options for future development held by land owners can we begin to understand the true fundamentals driving housing supply patterns.


  1. Hi, you seem to be neglecting the influence of international buyers, distorted housing prices in Asia, desires to get out of Asia and get a safehouse in Australia and other non-economic factors. The Gold Coast is an excellent example of these things. There council rates (is it rapes?) on land can be so pernicious as to force development into something else. I think these factors also distort the market.

  2. Prices can decouple from rents due to speculation regardless of where the money comes from - a massive boom in domestic credit (debt) or from a foreign boom in demand.

  3. Supply will come on stream as soon as suppliers can see that their product has a market. Therefore price is the constraint - too low and no new supply will be generated. I would expect to see supply arrive during 2014 as a result of the price rises. My concern is that the RBA will try to dampen prices and prohibit a proper supply response, although perhaps this time they won't be able to react with higher rates..

    I would like to agree with you on the developer contributions and stamp duty but I can't. Developer contributions add to the sticker price of the dwelling and stamp duty is a significant entry hurdle in some states. I remember our discussion on an Andrew Leith paper some years ago, and it looks as though we have both retained our earlier positions.

    There are enough suppliers in the market to create the competition to drive prices lower. Do you have any data on the reduction in Qld contributions? I believe the Beattie Government reduced the contributions and that reduction flowed onto the market in the form of lower prices for vacant land. If you have a graph of vacant land prices over the last 20 years that should be evident (in Qld)

    Although as an existing property owner, land taxes wouldn't suit me at all, I do believe they are a better way of raising the needed revenue rather than contributions and stamp duty. My concern though is that there would be a shortfall in the income stream that state and local governments received if the system was changed. Politically it would be a hard sell unless it was phased in gradually over many years, and during that period insufficient taxes/contributions would be raised, So I see immense political and cash flow problems in any significant changes.

    I can't support rent controls, that is simply added market regulation when government is the problem and not the solution. It is government who are the rent seekers through the GST, Stamp Duty, and Developer contributions, and allowing government to further entrench themselves in the market will add to the problem not solve it.

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