Sunday, May 4, 2014

Housing supply and affordability

Some may not know this, but I consider myself pretty solidly left-wing. I know my blasting of zoning regulations might give another impression, but nonetheless. So I cringe every time one of my fellow left-winger says absurd things like "supply has nothing to do with housing affordability" or when they cheer on making "developers" pay and increasing their costs (as if being someone who decides to make a living out of providing housing for the community was intrinsically bad). It seems to me that the anti-gentrifiers are often just a different variant of NIMBYs and just as bad.

Now, I understand where it comes from. Left-wingers in general are skeptic towards market-based solutions, it doesn't help that certain things sold as "free market" were all about making the rich richer and the poor poorer. But being skeptic about market outcomes and denial about how the market works are two different things that some fellow left-wingers confuse. It is important to understand how the market works, how pricing works, even if you don't think it's the optimal way of doing things, you ought to understand it.

So I will try to explain in simple terms how exactly supply and demand works in the housing market. I'm going to try to avoid usual things like this very famous graph:
If you need me to explain this...
This is as much for other people's benefits as mine, I find I am better able to make sense of my own thoughts when I write them down and force myself to explain them clearly.

Some basic elements

OK, so in terms of housing, there are certain elements to consider:
  • The current housing stock
  • The households seeking housing
  • The opportunities to increase housing stock
The first is evident, it's the current houses and apartments fit to serve as housing for people in an area.

The second is also evident, it's all the people seeking housing in an area, which is a variable of population, housing is a basic need, few people will willingly "opt out" of it.

The third is more complicated, it's all the empty lots, the decrepit buildings that can be replaced, or even the low density housing that can be replaced by higher density housing. It's all the various opportunities that exist that people can exploit to increase the number of housing units available to house people. 

Now, the first thing to consider is whether or not the current housing stock provides sufficient housing for the people who want to live in the area. If yes, then there is a balance. There is always some amount of housing available as people move, and prices will tend to be rather stable.

If there is more housing than there are people, then house owners will need to bid amongst them for buyers, because they don't want to leave empty houses for which they pay taxes. So as they compete, they will often use discounts and bonuses to get people to choose them instead of others, lowering prices over time. See Detroit, a lot of housing stock, but people don't want to live there anymore.

If there are more people than housing, then the situation is reversed. Each owner selling his property has many people who want to buy it. The owner is thus able to start a bidding war between the different prospective buyers. He will sell to the highest bidder, which will increase prices for housing. If you have a house and three people want to buy it, one is wealthy and offers you 500 000$ for it, one is middle-class and offers 400 000$ for it and the last one is poor and offers 300 000$ for it, to whom would you sell? Over time, as owners see the prices other properties sell at, they adjust their expectations, they know they can ask for more and so do just that.

The limit to prices: construction costs of new housing

Now, most large cities are in the third situation, a lot of people want to live there, and there is only so much housing to go around as the area is likely all built out. So what decides then how expensive housing gets? What limits housing prices is simply the cost to build new housing. If owners ask for a price for their housing that is higher than the cost to build a similar housing unit in the same area, then that housing unit will get built and sold for less. The cost of building new units is essentially what provides a ceiling to house prices.

Think about it, imagine you want to buy a house, and some guy will sell it for 400 000$. But there is a vacant lot next door, the lot is sold for 100 000$ and you can build a house just like the existing one for 200 000$ on that lot, for a total of 300 000$. Are you going to buy the existing house or buy the lot right next to it and build on it? Well, maybe not you, but developers will, they'll likely just undercut the existing house a bit and take the rest as profit, but over time, they will bring house prices down.

But if there is no vacant lot around, and the only thing you can do is buy a cheaper, rundown house and upgrade it or rebuild it to the standards of the existing house, and the whole operation is likely to cost you 500 000$, then you'll buy the existing house for 400 000$ (if you can). In fact, the home owner, if he realizes that the area is in a shortage situation and the cost of providing new housing is much higher, will likely raise his prices.

How to create affordability

So if you want to ensure cheaper housing, you need to do two things:
  1. Increase the number of opportunities to build new housing, either through vacant lots or by allowing higher density construction
  2. Reduce the cost of building new housing units
So everything that helps these two things create affordability. Everything that goes against them, like strict zoning forbidding higher density housing "to preserve the character of neighborhoods", like asking developers to jump through hoops to get building permits, like asking them to pay for parks and other public goods as a condition to getting building permits, etc... All these things create and aggravate a shortage situation and increase the costs of building new units, which means higher housing prices for everyone. And then the speculators will jump on the occasion to buy houses and lots, aggravating shortages and pushing the price of housing ever higher.

Trying to control the price of housing through rent controls and the like can effectively keep prices from raising on price-controlled properties, but it doesn't correct the shortage problem. You create two categories of people, those who are lucky enough to have had access to price-controlled housing and those who are forced into the market system which will pay much higher prices.

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