Housing Affordability: Economics 2

In the first article with a similar title the impact of house buyers on high incomes led to the increase in house prices because, among other reasons, the belief in capital gains. These gains later materialized, as anyone in New Zealand will be now well aware of.

This article will test the following hypothesis: if we were to look at a time when the median house price was affordable, and consider when demand started to exceed supply, it is at that point that those on a higher income than the median (and the greater the difference between their income and the median the greater their ability to buy) are able to use their buying power to compete with and successfully purchase a property that is somewhat less than what they can afford, then the cycle starts.

In the article published on the VOXEU site, previously referred in MNZ: Housing Affordability: Economics 1, Phil Hayward made a comment:

And in reality, the correlation between urban density/average housing space per household, and median/average housing cost, “by city”, runs in the direction of higher density/lower average housing space = higher median/average housing cost. This is the opposite of the shallow assumptions made by advocates of “compact city” planning. This is because economic land rent falls faster than additional space is consumed by households, as long as the superabundant supply of lower-cost land in non-urban uses is freely being added to the urban economy. If that superabundant land supply is denied to the urban economy, by regulations, geographic realities, or lack of automobility in still-developing economies, the opposite occurs: land rent rises faster than households average consumption of space falls, as incomes rise

This chart from 2014 shows the correlation between the housing median multiple and the number of people per square kilometer.

This directly confirms Hayward's finding that higher density correlates to higher median multiple and therefore higher house prices. In the chart, the yellow dot signifies Auckland, whose population at the time was 1.3 million. If we were to choose a similar city in the United States in terms of population to Auckland - we could choose Cincinnati which had a population of 1.6 million. Cincinnati is shown as the large green dot in the chart above. Now, the median income in Cincinnati at the time was $53,400 and the median house price at the time was $142,100. The map below shows where Cincinnati is in the United States.

And here is a range of homes you are likely to find in the suburb of Fairfield in Cincinnati:

Is it clear that there is a balance of supply and demand across the income brackets in the city.

If we go back to a specific example in Auckland in the early 1990s, a slightly larger home in Sunnynook, on Auckland's North Shore cost around $130,000 - 3 bedrooms, 2 living areas, separate dining, study and 2 bathrooms. This property originally came on a quarter acre section (specifically 942 square meters) but permission was granted to the property owner to perform a cross lease and create 2 sections. With typical incomes at the time in the $30,000 - $40,000 range, this meant that a significant number of purchasers could not afford to buy the original (whole) property, but instead the home on half the land. The section was available for an additional circa $50,000 but that represented a median multiple of likely more around 4 - something that was not affordable at the time; in other words, the bank is unlikely to make a loan of that size to a median wage earner.

At this point, the original property prior to the cross lease, would have been worth less than the combined value of the property now. The reason is with the cross lease the ability to put a new dwelling down becomes a possibility. In the early 1990 kitset houses could still be built for under $100,000 and so a new home would cost the owner less than $150,000. Let do a few sums:

At this point, both the original house and the new dwelling are still affordable, but there are two facts, or consequences:

• The land, prior to cross lease, has appreciated in value by around 72%.

• The original vendor has sold the original property at a premium of 20%.

Across the 1980s and 1990s, cross leases became more common, although they started in the 1960s for rows of flats or similar housing. These cross leases, where there are more than 200,000 in Auckland (1), had the effect of keeping property affordable because building is still linked to the real economy and because the value of the underlying land was coming from a rational land market, where housing was still around a median multiple of 3. However, they became more and more prevalent and the circulation of extra money in the economy began to flow. While more housing units were being created to satisfy demand, and additional construction on greenfields was happening, housing affordability remained a feasible goal for first home buyers entering the market in the 1990s.

Now that Councils had the ability to constrain the amount of land used for housing, while keeping dwelling consents up, is it possible that they became more reluctant to release new land for housing, even after the cross leases had reached most of the addressable market? The answer to that was not yet needed as it became possible to sub-divide existing sections through various re-zoning mechanisms. Sub-dividing was more attractive as the new piece of land was freehold and has fewer legal encumbrances on it, relative to cross leases. While sub-division is ongoing today, eventually that didn't satisfy demand and so new land was released. But was enough land released, and at what prices was that land offered to the market?

Meanwhile, in the economy salaries and wages were not rising as fast as the value of the land. This meant that those on low wages were increasingly unable to buy a home at the lower end of the market as the land appreciated in value across whole suburbs in the wake of cross leasing, sub-division of existing properties and the higher value of land. Land-banking also become an option, as it was becoming more valuable over time. This caused problems for the supply of land, because although Councils have zoning power, they couldn't force the land owner to build or sell.

As the new millennium started, a new scenario was now in place: there was continued demand for land and houses, there was more money in the economy chasing residential assets, smaller sections were collectively worth a lot more than the previous lot sizes were worth, and more expensive houses were being built because of the greater land value. It should be said that the value of the improvements has, in the past, always been worth more than the land itself:

I recall being told of a house package in Central West Auckland in the early 1980s where the land was purchased for $20,000 and the house cost $50,000 to build. If anything the ability to build a house that reflects this financial outlay has led to a decrease in the amount of money being spent on the property. A typical 'single dwelling' section size in suburban Auckland today of around $500,000 rarely has a construction (labour + materials + fees) cost of around $1,250,000 - they do exist, but it is not common. This reflects the fact that even those who can afford the land today in general do not have the capability to spend that much. It is more likely that the cost of construction is roughly equal to the cost of the land.

With lower income buyers more restricted from the market, and higher incomes earners still able to get into the market, we have arrived at the conclusion of Hayward's observation: "land rent rises faster than households average consumption of space falls, as incomes rise". I believe this leads to the beginning of the cycle described at the beginning of this article.

(1) Cross Lease Titles a ticking time bomb, says lawyer. NZ Herald, accessed 25 July 2016.