Thursday, September 10, 2015

Doing the housing supply maths

Laurence Murphy is a top property economist at the University of Auckland. I met him last night after a presentation in Sydney where he took on the myth that planning constraints are a major determinant of current home prices in Australia and New Zealand.

He said it is very easy to demonstrate mathematically how little impact even a large increase in the rate of supply would have on prices. But when he shows this analysis to government officials, planners, and engineers who have bought into the supply-side narrative their response is often

“I see your calculations. I follow the logic. But I don’t believe it!”

So I wanted to try the ‘basic supply-side maths’ for myself on the blog to see what sort of effects radical changes to the rate of new housing supply could have, and see if I generate some of the same responses.

Here’s how the maths work. I take the number of new dwelling completions from the ABS for the past 20 years, which is shown in quarterly figures in the blue line of the chart below. Since 1995 new housing supply has been 146,546 dwellings per year on average, which is about a 2% increase in the stock annually, though this moves with the business cycle.

I then add 10% to this number every year to generate a counterfactual world where supply has been much higher over a sustained two-decade period (green line). Then I add 20% just to take an extreme scenario (yellow line). Note that in this exercise I don’t ‘elastify’ supply, which would have higher construction rates in boom periods, and lower construction in a slump. When I run the numbers for a more elastic supply that responds more to both booms and slumps I get fewer homes built compared to what actually happened! This is because when the completion rate falls, it falls faster, offsetting all of the gains from the previous boom. I show a 'twice as elastic' scenario in the next graph in red, which actually results in 8,000 fewer dwellings built in the past 20 years. ‘Elastifying’ supply can’t really be what is desired by those advocating for supply-side reforms.

Any supply-side housing initiative should simply aim to get more homes built, year in, year out. This is what I capture in my counterfactual scenarios of 10% and 20% higher construction over two decades.

So here is the question. How many more houses would there be now in these counterfactual worlds? And what would the price impact be?

Well, if we had built 10% more new home each year for the past 20 years Australia would have around 300,000 more homes. At a 20% higher rate of completions that's 600,000 more. Sounds terrific! That must have a massive impact on prices.

Well. No.

You see Australia’s current housing stock is somewhere around  9.3 million homes. Around 8.8 million occupied, and many second homes, holiday homes, and so forth that are traditionally about 8-10% of the housing stock. These additional homes in my 20-year supercharged supply scenarios represent just a 3.2% and 6.4% increase in total stock respectively.

The price impact of a 3% increase in supply is a 3% reduction if demand elasticity is unity. That’s it. The price reduction could be less if there are countervailing income effects that lead to outbidding for superior locations.  So twenty years of supercharged supply provides somewhere between 0% and 3% lower prices, which suggests to me that focusing on the supply side is close to a waste of time. In the 20% higher housing completions scenario the effect is somewhere between zero and 6%. About the same as two and a half years of rental price growth.

To put it another way, after 20 years of a 10% higher rate of new supply, rents today would be the same as they were in early 2014.

We can alternatively look at the raw measure of the gains to the amount of floor space per person. Taking the average floor size of homes, which is about 180sqm, and adding 3%, and assigning it to the average of 2.6 occupants, to get an additional 2sqm of floor space per person.

Or we can think of it in terms of occupancy rates — the number of people per dwelling — which would be 2.51 instead of 2.6 with the same size homes under the 10% higher supply scenario.

That’s all you get for 20 years worth of sustained housing supply stimulus. And you get none of that simply from more elastic supply only.

The point is that current massive price increases, in the order of 17% per year in Sydney and Melbourne, simply cannot be explained by anything like unresponsive supply. Not only that, any supply-side effect on prices takes many decades to have any effect, and only enters the price equation via effects on rents.

If we want cheaper housing we need to reform legal structures to shift bargaining power to tenants from landlords, curb speculation through financial controls (and keep stamp duties!), and stop rewarding political parties who promise housing supply as any sort of solution to current prices.

Unfortunately, very few people actually want housing to become cheaper. Around 70% of households are homeowners, around 30% are property investors who come from the wealthier part of society, while most politicians also have a huge share of their wealth tied up in residential property. It suits all of these interests to point the finger at supply because they know it sounds attractive in a naive economic way, but won’t actually reduce the value of their housing portfolios.

As Professor Murphy explained, the consensus around new housing supply as a solution to housing affordability problems is a political construct. This unfortunate political reality is best summarised in this tweet.

Dear reader I hope you see my calculations, follow the logic and believe it!

1. Following logic is not belief, it is comprehension. Belief is for religion where there are no proofs. What they are saying therefore translates into : I see mumbo but I'm too thick or lazy to follow it, so its easier to reject it

1. Yep. Though the more I engage with public policy debates, the more I realise just how powerful unjustified beliefs really are.

2. On that topic I have a post
http://cjeastwd.blogspot.com.au/2011/08/why-discussion-gets-nowhere.html
:-)

3. JASON REIFLER: Exactly. And it also shows that there's an important difference between simply being ignorant and being misinformed, that is, believing that you know something but in fact being wrong.

JASON REIFLER: When you believe something about the political world or even about the non-political world and it's really important to you, when you're told that you're wrong that can be a pretty threatening experience.

People don't like being wrong. They have trouble adjusting to it and incorporating new information.

2. This is great. would you be interested in doing something like this analysis for San Francisco, Vancouver or Manhattan? People actually say this crap to me in these contexts when financial speculation is so obviously central.

3. I'm still jet lagged from my last trip to Australia. The big thing in the news was the crack down on illegal foreign purchasers. I'd be amused to hear your analysis of this crackdown. It's not like Sydney is full of unoccupied homes owned by Chinese investors. (Vancouver, in contrast, was full of unoccupied apartments owned by nervous Hong Kong families in the late 90s, but The City of Glass was another story.)

4. Both land and housing are high cost products, they are not mass produced like computers, flat screen televisions, or cars. Those who produce them only produce when they see demand and attractive prices. Oversupply can happen but never in any large quantity. Demand is local so it's not difficult to measure.

Some difficulties in gauging future demand can occur with large land releases and residential towers due to the time elapsed between concept and saleable product.

I buy your theory up to a point. I think that you will see falls of greater than 3% in a market that is significantly oversupplied, but I do agree that it generally doesn't mean any change to the long term rises in prices, it's a temporary slump at best in our markets, mainly because a growing population soaks up any oversupply quite quickly.

Supply will almost always chase demand in a nation with a rapidly growing population. We did see a massive supply response but that occurred after higher demand became evident to developers, not before. The price set for the new stock is cost of production plus whatever margin the developers can extract from those who are buying.

The price of the new stock becomes a yardstick for existing stock. If we do raise the GST to 15% that extra 5% will be added to the cost of new stock which will then filter through to all existing stock over a few years.

Cities with a long term shrinking population (demand) such as those in Japan (apart from some areas in Tokyo) have shown falling real prices over many years, however now that the Chinese are buying prices have firmed. Demand has changed in Japan during 2015.

I think you are looking at this issue the wrong way around. It's not so much of a story around prices being related to supply, but supply being related to the market price and how that market price compares with the cost of production. If a developer can't make a profit by bringing land or residences to the market - they won't produce anything. Not so much econ 101 but business 101.

1. Land is a no-cost non-product. It costs nothing and is not produced. It's simply monopolized, which is what makes it *expensive* (not costly).

5. Like all good property people, Laurence would know ridiculously low yields show that it ain't an undersupply we're witnessing - otherwise rents would also be high. As a valuer, I understand if we capture more publicly-generated land rent to the public purse, 'house' prices will go down, but as virtually everyone except Gen Ys are into rent-seeking, as you say, Cam, there ain't too many want prices to tank. And so the rotten rent-seeking, tax-driven juggernaut, presided over by the banks, rolls on (until the bust).