As the affordable housing crisis shows no sign of subsiding, this blogpost revisits some of the fundamentals of urban economics shedding light at the dynamics at play in the urban housing market.
Housing is both a consumption good and an investment good. The market for consumption of housing is called space market. On the demand side of space market are individuals and households that demand the space for occupancy and consumption. On the supply side are the landlords who lease out the space for rent. The demand and supply function of the space market determine the rental rates in space market.
It takes a long time to bring space to the market. Land has to be acquired, infrastructure connected, approvals obtained, financing arranged and finally space needs to be constructed. In addition, housing is a long lived asset with a life of 20-50 years or more. Alternatively, if existing space needs to be reconfigured to a different use i.e. conversion of residential to commercial or low rise to high rise, significant time and money needs to be spent to achieve it. Thus in the short to medium term, supply function of housing space is deemed inelastic and is represented by a vertical line.
If there is a reduction in demand say from D’ to D, the supply cannot be reduced in the short to medium term due to the longevity of the space. Consequently, the rent per unit of space (represented along the vertical axis) decreases from E’ to E. The decrease in the rent may not be in the form of reduction in the rent demanded by the landlords for the space. It can also be in the form of higher vacancy rates. Later if the demand increases, it will be reflected as lower vacancy rates initially. Once vacancy rates have reduced to a minimum or zero, the rents start to rise. If the demand and rents are forecasted to consistently remain high, more supply will be brought into market shifting the vertical supply line to the right, from S to S’, thus bringing down the rents, from E’ to E”. Based on the amount of supply brought in, this reduction in rents can be significant and last for a long time due the permanent nature of supply. This is the reason of cyclicality of the real estate market.
The market for investment in housing is called asset market. Economically speaking, housing asset (or real estate asset) comprises of future streams of cashflows i.e., rents that the housing unit generates for the landlords. As a result, a real estate asset competes with and is compared to other cashflow producing assets such as bonds, stocks, alternative instruments etc. i.e. capital market assets. Hence, landlords are deemed to be investors operating within broader capital market deciding how to allocate their savings/investments among various capital market instruments based on their risk/return appetite.
Like other capital market assets, the price of real estate asset is the present value of future stream of cashflows (rents, property expenses, sales and purchase of property etc.) and is given by
Where CF is the cashflow for ith period and r is the required rate of return. The required rate of return is affected by uncertainty of the cashflows, return on other opportunities available in the capital market etc. For example, all other things remaining the same, if the return on national savings certificates increase, the required return on real estate asset (the denominator) should increase to compensate for the higher risk of cashflows of real estate asset as compared to national saving certificates. This will result in decrease in price of asset. This phenomenon can be seen regularly in the international financial market. Whenever the US Federal Reserve raises the interest rates, the price of all other risky assets i.e., corporate bonds, stocks, property declines.
The price of the real estate asset is also affected by any costs incurred during the holding period. Such costs reduce the cashflow received by the investor resulting in a decrease in the present value and thereby the price of the asset.
Examples of such costs in case of housing assets can be property tax, wealth tax, vacancy charges, non-utilization fees, maintenance charges, capital gains taxes etc. High enough costs can significantly impact the price of the housing asset. The price of non-income producing asset (such as vacant piece of land or unoccupied apartment) is calculated in the same manner with the exception that there will not be any interim rental income.
To summarize, the space market determines the rent, the asset market uses the rent to determine the price of the asset. This distinction between asset and space market is clear when property is rented to an occupant by the landlord. In case of owner-occupied housing, the space and asset market collapse into one i.e., occupant is the landlord with the savings in rental expense as his monthly cashflows.
The construction industry uses price as a signal to decide whether to build more housing. If the sales price of housing unit is equal to or more than the current development cost of the housing unit, the construction industry will proceed with construction. The development cost comprises of land price, construction cost and the developers profit (developer’s profit includes time value of money).
Upon completion of the construction, this housing will add to the stock of real estate space thus increasing the supply. The real estate system can be depicted as follows
The price of real estate is decomposed into two components, land value and structure value. Structure value is the difference between asset price and the land price. When the asset is newly constructed, structure value is equal to its construction costs. Over time, the value of structure decreases on account of physical wear and tear (physical obsolescence), structure becoming unsuitable e.g. changing demographics, the site of single-storey site is more suitable for high rise building (economic obsolescence) or design/technology used in the building does not meet the present requirements (technological obsolescence). The land value, however, does not depreciate due to fundamental scarcity or fixed supply of the land. Unlike other factors of production (capital and labor), land is fixed (in location), scarce and permanent. Unlike labor, which can move to where it is needed, and materials, which are transported to where they are needed, land is trapped. And that makes its economic value distinctive because any and all attributes of a site, both negative and positive, are reflected or priced into land value. Physical aspects of a site i.e., located near the sea front or highway, are priced into land value. Zoning regulations whether residential or commercial, single storey or multiple storey, are priced into value. The quality of infrastructure and municipal services are priced into land. And, since the economic value of land is determined by what can be earned by using it, the price of land will also take into account any extraordinary costs and circumstances for its development. At its simplest, land value is the residual, the earnings obtained from a site, less what it costs to make productive use of it.
The key input for the developer is the land. The developer needs to acquire the land before he can construct housing unit on it and sell it. How does the developer decide how much to pay for the land? He does this by estimating the type of building he can construct on the site that will get him the maximum price. This is known as “highest and best use value” of the site. From this, the builder deducts his profit and cost of construction. What is left is known as the residual value of land and is the maximum price a developer is willing to pay for acquiring the site.
As land becomes utilized the remaining buildable land becomes scarce. The area around a vacant piece of land becomes occupied, infrastructure such as roads, street lights etc are built, and population arrives bringing with it services that it needs such as schools, hospitals etc., leading to increase in the value of the land without any value addition carried out by the landlord on this asset.
“Land is limited in quantity while demand for it, in a prosperous country, is constantly increasing. The rent, therefore and the price, which depends on rent, progressively rises, not through the exertion or expenditure of the owner, to which we should not object, but by mere growth of wealth and population. The incomes of land owners are rising while they are sleeping, through the general prosperity produced by the labor and outlay of other people.” – John Stuart Mill (1806-1873), economist and influential thinker of liberalism.
Cheaper piece of land may be available but it will be on an uneven site, a structure might already exist on it that needs to be demolished to start construction or the site may need to be repurposed from agricultural or industrial use to residential use. Such costs are considered land acquisition costs and hence added to the cost of the land. In sum, whereas the total supply of land for the economy as a whole is considered inelastic and represented by a vertical line, supply for a particular use is considered somewhat elastic and represented by an upward sloping curve.
As stated earlier, developer will start construction when the price of the asset is more than the development cost. Development cost here is land cost, cost of construction as well as developer profit. The developer may also decide to delay the construction as the vacant land provides the developer with a development call option. In finance, a call option is defined as the right but not an obligation to purchase an asset against payment. The decision to begin construction is an important decision as it requires significant cash outlay and is irreversible. Keeping the land vacant incurs little or no holding costs. If the land price is expected to continue to rise, a land owner may rationally decide to hold off development in order to realize a higher profit from either selling the land in future or constructing and selling the housing unit at much higher prices in future. Under such circumstance, land is more valuable as a potential development site in future instead of as a site for constructing a building today. This is the developer call option. Similarly, if the developer has overpaid for the land in an auction or if the prices of housing units fall say during a recession or due to oversupply, in the absence of holding costs, the developer option allows the developer to defer construction till prices rise to a suitable level.
The blogpost has been adapted from David M. Geltner, Norman G. Miller, Jim Clayton, Piet Eichholtz - Commercial Real Estate Analysis and Investments, 2nd Edition -South-Western Educational Pub (2006)