Tuesday, January 26, 2016

Visualization of urban housing dynamics

So I've been talking a lot about my understanding of the dynamics of the housing market (though it's a bit of a misnomer... commercial uses also follow the same dynamics). However, I've been doing so largely with long blocks of texts, which may be daunting to read and understand, especially as the subject is complicated. Like a lot of people, I often understand concepts better visually, so I decided to draw a schema of what I think the housing market is like, and how developers and urban planners interact.

In the end, this is what I ended up with, if you follow me on Twitter, you would have already seen it:
My understanding of the dynamics of the housing market
So, let me break things down a bit, to explain how I think it works. I'm not an expert, so I'm open to criticism, but I think this tool might be really useful to understand the ramifications of housing policies.

Three different inter-related processes

You may notice there are three different squares, each identified differently: "MARKET", "PLANNERS - CITY" and "DEVELOPERS". These are three different spheres of influence with their own internal logic which are inter-related.

The "MARKET" sphere of influence illustrates a simple process: how housing prices are fixed. For this process, the things that matter are demand for housing and housing supply. In other words, how many people want to purchase a type of housing and what are their purchasing power, and the actual amount of housing that corresponds to those desires. Unlike, say, electricity, housing is not one very specific good, it is very varied, someone who wants a house to raise a family in will not buy a studio apartment. 

Things like transport infrastructure, commute time, proximity to stores, air and noise pollution, quality of schools, etc... will all have an incidence on demand for specific housing. So if I wanted to, I could expand very widely the number of actors who have an influence on demand for housing, but I wanted to keep it simple, so it's all summed up under "demand for housing".

The decision-makers in this sphere of influence are many. The concept of "market" itself is just an abstraction for the sum of economic decisions of millions of people. In theory, everyone who either owns an housing unit, rents one or wishes to buy one is involved in the market. However, I think the biggest deciders are people actively looking for a house, those actively looking for a buyer for their property and speculators who, depending on the market, will buy or sell in order to make a profit from that process.

The output of that sphere of influence is the market value of housing: how much a specific type of housing is worth, how high a price it can be at and still find a buyer.

The "PLANNERS - CITY" sphere of influence illustrates how most regulations affect housing economics. Namely, regulations and technological possibilities combines determine what it is possible to build, at what cost, and where. For example, thanks to modern technology, we can build buildings more than 4 stories tall without too much problem, however, due to the norms we have, we generally force tall buildings to conform to strict building rules that require more onerous construction methods (for example, concrete buildings rather than wooden-framed buildings and the inclusion of systems like sprinklers).

This also includes zoning regulations that forbid certain types of building and so sometimes push the construction cost of buildings into infinity, because it will simply not happen. It also includes all development charges or other costs that may be required of someone who desires to build something. There is also the issue of the cost of land, which may include the market value of the buildings on that land currently, but I try to make it as simple as possible.

The output of that sphere of influence is determining what building a new housing unit will cost, including regulatory costs, land, labor and material.
The "DEVELOPERS" sphere of influence is where the magic really happens. In the end, the ones who build cities are the developers, and the process for deciding what to build, if anything, actually involves the output of the two earlier processes. Developers have to take into account the market value of housing, which helps them determine the price what they build will fetch on the market, depending on housing type and location, but they also have to take into account the actual cost of building that housing type in the current regulatory, technological and economical context.

When the construction cost of housing is lower than the market value, then that means that developers can make money doing it. And a developer can no more work without a profit than a worker can work without wages. So if the construction cost of housing is HIGHER than the market value, then building it would mean the developer would actually lose money. They're not going to do that, they have to eat too.

So the output of the housing market and of the regulatory process actually decide if the developers build, and what they build. The output of this process is new housing, which will, in return, change the housing supply and therefore affect the market value for housing.


So what is the point of this schema? Well, housing economics have to be understood as three connected processes, involving at least three different decision-makers, all of whom have direct or indirect influences on the end result of what type of housing is built and at what price. Often, people limit their criticism to the developers, as they are the one actually making the physical building, but developers are in fact often at the tail-end of the entire affair, they're responding to market values and to construction costs dictated by local governments. However, the developers cannot be forced to do anything, they always have the option to opt out and do nothing and they will if they have no way of earning income (profits) on projects.

Some people thus conclude that developers are greedy and self-interested, but every one else is also greedy and self-interested. Property owners want to sell their property as high as possible, prospective buyers want to pay the lowest price possible, elected representatives want to keep their job by appealing to their voters, why single out developers? Ultimately, economics is not a moral play, if you have a desired outcome, then you need to look at the actual levers that you have to influence the system in the desired direction, to reward people for doing what is socially desirable.

So if you want lower market value of housing, then you can either increase supply or decrease demand. To increase supply, the only way to do so is to incentivize developers to build more and faster, and to achieve that, then you need to make it possible for them to build at a lower cost, which is the opposite of what generally happens, as people try to squeeze every penny out of the "greedy" developers.

You can also look at what makes high-demand areas so desirable and try to increase the supply of such desirable locations. For example, if transit-friendly urban areas are in demand, building new transit lines can expand the amount of locations that share this desirable trait.

Another important thing this schema tells us is the sphere of influence of public policy. Too often, people want regulations to fix market value (rent control for instance) or to dictate developers to do certain things (through Affordable Housing rules or even direct public housing construction), but that's not the natural influence of public policy, which is determining the construction cost of future projects. That's the main vector of public policy and planning, when you try to go outside of that, then you're trying to fit a square peg in a round hole and creating a lot of unintended consequences. Yet, people next to never talk about these primary effects of public policy, and that is why most housing markets are screwed up.

So this schema tells us to consider public policy mainly as to how it impacts the construction cost of future housing projects, and to stop trying to intrude so much in the other processes. I think this would restore some sanity to the housing market in major cities.


  1. This is a good diagram, but I think it overlooks the irrational and often screwy feedback mechanism of community feedback, esp. in the form of NIMBYism. I suppose community feedback is within the City/Planner group, and mostly affects either straight into the Zoning Regs box, or perhaps as a third precondition for whether construction occurs in the market-value/cost-to-build equation. In any rate, this is good food to digest.

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  3. I think people label developers "greedy" not just because they make a higher return on investment (a percentage), but because of the sheer dollar value of that profit.

    That that dollar value is often so high because zoning regulations encourage large-scale developments (assembling multiple small lots to build a high rise), rather than small-scale developments (building higher/deeper on a single lot).

    If development happened at a small-scale, then there could be many people who profit from redevelopment, and there might be less opposition to development.

    I feel like if one single developer made a 10% return on investment amounting to $100 million dollars, people would be more upset than if 100 individual land owners made a 20% return on investment amounting to $2 million dollars each (or $200 million dollars in total).

    My point is that encouraging more SMALL SCALE market housing construction might be more politically acceptable than encouraging large scale ones.