Sunday, August 16, 2020

Sam Bowman's 9-points on housing supply

Sam Bowman thinks that a lack of supply is the primary reason for high home prices. I just released a podcast with Ian Mulheirn going into detail about why I think this is not the case.

Sam is right about some things but wrong on most. So let’s try and pin down our disagreements.

Let me first disclose my professional background. I have worked for listed and private residential and industrial developers and worked for the state regulator on infrastructure charging regimes. My first degree was in what was a then niche area of property economics, covering a range of topics involving construction management, design, town planning, feasibility methods. My PhD included extensive analysis of planning decisions, and I have published many academic papers on housing, planning, and supply dynamics. I have also been an expert witness in corruption cases involving town planning decisions.

I can assure you that if there were an issue with the planning system constraining the rate of new housing supply, at least in Australia, then I would be spending my days arguing that case.

Let me also say that I am not anti-supply. I do think the planning system is more cumbersome and costly than it needs to be, even in most jurisdictions in Australia. But I don’t think that changing the planning system is going to do anything about the overall price level of housing. I support public housing supply programs that have clear objectives and penalties for missing targets.

I like to preface any housing supply discussion with a thought experiment to help disentangle whether housing issues are mainly about distribution or supply. If every mortgage was written off, and every renter was given the home they currently live in for free, so that 100% of households lived rent- and mortgage-free in their current homes, would there be a housing affordability crisis?

I’ll leave that with you.

Sam makes nine arguments against certain claims of "shortage deniers". Please go and read them in full.
  1. “House prices are high because of interest rates, not a lack of supply.” 
  2. “Rents haven’t been rising as a share of income, so there is no shortage.” 
  3. “The elasticity of house prices to new supply is low, so building more houses won’t do much to lower prices.” 
  4. “Nine out of ten planning applications are granted, so the problem isn’t the planning system.” 
  5. “Land banking is the cause of housing shortages.” 
  6. “Empty properties make the housing shortage worse.” 
  7. “The private sector cannot build enough houses to meet demand.” 
  8. “It is impossible to make housing “affordable” without council housing / affordable housing.” 
  9. “We risk speculative development after building booms which leaves us with ghost towns.” 
These are my responses. 

Low interest rates

On this issue, I think we mostly agree. Low interest rates increase the price of assets by reducing the capitalisation rate. 

We differ on this part of Sam’s explanation. 

"Falling interest rates do not increase the price of other durable goods like airplanes or ships, or of housing in places where there is not a supply constraint, like in the North of England or Houston (which has a liberalised planning system)."

The missing distinction here is that housing is a durable good attached to a property right to a piece of the three-dimensional space that has been carved up with a land titles system. Home construction has not inflated in price, just like other durable goods. But the cost of buying a share of the property rights system from the system’s existing owners has inflated. Without that, you have nowhere to put your dwelling.

We can, therefore, agree that the problem has something to do with property rights having perverse effects. Sam thinks it is the permitting part of the property rights system. I think it is the property titles system itself.

We also disagree on this point.

“If interest rates were the only factor, we would expect to see houses everywhere rise and fall in line with them.”

No. We would expect to see the interest rate effect on the capitalisation of rents the same everywhere, but with prices still diverging due to non-interest rate factors. Different cities have housing price booms at different times for different reasons. Houston’s 1980s price boom is a classic example of a price boom that far exceeded that scale of price growth in other cities at the time. There were other factors at play, including plain old expectations and speculation. 

Sam's own chart seems to show that most variation in prices is common between London and the rest of England. 



Rents as a share of income

I think we agree here that rent is the appropriate measure of the economic price of housing, which is good.

Sam’s view here mainly deals with UK rental statistics. I would defer to Ian Mulheirn who has two detailed pieces about that issue (one and two). 

But we differ on this point.

“Suppose everything we spent money on changed in the same way, rising in real-terms as we got richer – groceries, electricity, clothes – without getting any better in quality. Economic growth would be meaningless, because any overall income growth we experienced would simply be eaten up by these rising costs.”

Remember my earlier point. Housing products have not increased in value in line with incomes. The combined cost of renting houses and that location in the property titles system has grown in line with incomes. Remember also that this location rental is also someone’s income.

What makes property different? When you rent a dwelling you also rent the location, essentially buying out your transport costs by paying the owner of a better location. If we had an equilibrium where people spent 5% of their income on rent, some people might start deciding to spend 7% of income on rent (40% more rent) to live in better locations rather than spending that money and time on commuting. Those with higher incomes will find that the time-cost of commenting is relatively higher, with the equilibrium process sorting the location of households by income or wealth at their maximum willingness to pay (taking into account the cost of transport).

Compared with tradable and transportable consumer goods, it is the finite nature of locations and their relative advantages that ensure we end up in a fixed-share-of-income equilibrium.

The way to use rent-to-income as a supply metric is to see whether the number of people per dwelling is increasing compared to the average size of dwellings. A shortage would be indicated by more people in smaller dwellings paying the same share of income on rent.

It may be the case that this exists in some locations but not others. The question would then arise, how does this situation persist if there are alternatives in different locations — just pay the lower rent plus higher transport costs and get more space.

These are the types of questions and the evidence we should be looking about when talking about the adequacy of housing supply.

Elasticity

It is also good that we agree that the price elasticity of housing supply is low.

Sam says the following

“Imagine a similar argument being made during a famine where the price of food was very high: if an additional food shipment did not make a big dent in overall prices, would we conclude that the solution wasn’t more food?”

Yes. That’s right. This evidence would force you to conclude that although more food would be beneficial, the distribution of food is mainly causing the famine because adding more total food to the system is not helping much. This very point is the subject of many debates about famines and food prices. It is also why I prefaced this piece with a thought experiment about the distribution of dwellings.

Regardless, saying that more dwellings won’t decrease prices is wrong. What myself and Ian Mulheirn are saying is that because housing supply matched population growth, and in many places far exceeded it, that supply is not the cause of the price growth observed. Adding more supply will decrease prices, (putting aside whether changing planning rules actually will change the rate of supply). But it happens in a slow and expensive way. 

In Australia, around 8% of the labour force and 6% of GDP is spent on building new homes. When someone says “let’s double housing construction” from 1-2% of the stock per year to 2-4% of the stock, they are really saying “let’s take 8% of the workforce away from what they are doing to build more housing for a 1% rental price decline each year”. Maybe that trade-off is worth it (assuming supply would increase this much by removing planning regulations). Maybe not. But this is where you should end up when talking about elasticity and the size of the price effect of the investment in new housing.

High approvals rates

I agree that this metric cannot show the effect of deterred planning applications.

But does that make it meaningless? I don’t think so.

In a radical supply shortage situation, with so much profit to be made from getting into the housing game, even low probability applications would be made. People buy lottery tickets all the time. Large organisations often invest billions in activities with low probability outcomes when there is a large potential payoff.

Shouldn’t we see the planning system swamped with low probability applications and observe them being rejected? 

Then there is the issue of one million excess planning permissions granted in the past decade. Very hard to explain this as a planning constraint.    

I also have a gripe about planning applications and their apparent slowness. While the situation is different in the UK and Australia, slow approvals usually happen because the applicant has sought approval for a development that is far outside the scope of the plan. They bought land that was not designated for what they wanted to build, then chose a slower route through the planning system rather than a faster one. I'm surprised that these developers have the confidence to blame someone else for their self-inflicted problems!

Land banking

Sam writes that land banks are an inventory necessary to smooth out supply and ensure workers are not idle after selling stock.

I agree that land banking smooths out supply.

I disagree that land banks are inventories. I even have an academic paper on this topic where I looked at the annual reports of listed housing developers to see what they say to investors about planning when they are obliged to be honest (here's a free working paper version). Australian developers never seem to tell investors that planning is delaying them.

We are now getting to a key issue on housing supply. How does a developer choose the rate per period to sell their subdivision?

They need to be careful not to sell too fast. Faster sales might require lower prices, or raising them more slowly, reducing the present value of the return from that project. But if they wait too long, they might also miss out. As I often say, what kind of crazy property developer floods the market because they can?

I also don’t see how land banking is a symptom of a shortage. In any other product market, even large durable goods like ships or trains, large inventories don’t happen when there is a shortage. Do these firms “buffer” and keep large inventories to smooth out their production? Most large capital goods production is on a “build to order” model where the process schedules buyer orders, matching supply to demand.

Empty properties

I have no idea how many empty homes there are in London. Sam seems to have the data. I can attest to the fact that Australia has more empty homes as a promotion of total dwellings now than at any point in history, along with larger homes and fewer people in each one.

The private sector cannot build enough / need council housing

I agree with Sam that the private sector can build enough homes. I disagree that they would just because they could. 
 

I am quite often puzzled that using the power of government to flood the market with housing is never proposed. We just cross our fingers and hope that the private sector will crush the price of their assets. 

Sam has stumbled across the “absorption rate question”. How fast should developers build to maximise the present value of the flow of their economic returns from development?

Clearly, it is not so fast that the final sales of a subdivision are at a far lower price than the first sales. This would also see problems with buyers pulling out of contracts and purchasing at the lower later price. 

If we look historically, periods of rising homeownership and rapidly expanding supply are usually associated with government programs—housing for returned soldiers, giving public housing to tenants, Singapore's subsidised housing model, and so forth. My view is that we should expand these programs just in case the private market doesn't deliver what it promised. Think of it as insurance.

We risk ghost towns

I don’t think already large cities are going to risk this, so I agree with Sam that this is a silly argument.

I would only note that this happens in places like mining towns where they really do see rapid demand growth—expressed in rents—along with high and unconstrained rates of new home building. Of course, despite the lack of supply constraints, mining towns always seem to still get a boom and bust rent and price cycle. I wonder how Sam would explain this.

2 comments:

  1. Excellent analysis, Cameron! IMO, as a former real estate valuer with the ATO, then the CBA, before co-founding my own valuation practice, the fundamental point is that property rights don't include the privatisation of *publicly-generated* land rent. We literally pay dearly for misunderstanding this.

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