Thursday, October 29, 2015

Housing, A Series: Part 75 - Interpreting Housing Supply and Demand

Yesterday, I discussed the odd US trend of net migration moving to places with lower incomes.  This is logically the equivalent of reversing the flow of migrants over the Mexican border.  This doesn't happen in functional places.  If we have another decade with the mortgage markets we have had since the recession, maybe it will get to that - Americans sneaking across the border to take jobs at maquiladoras in order to lower our living expenses.  That'd show those predatory lenders we don't need 'em.

Here is one graph from yesterday, showing the unfortunate correlation between high incomes and out-migration.

20 Largest metro areas
Notice that the average for the US is below the trendline.  In general, there is a slow migration from rural to urban (or, at least, suburban).  There are a lot of areas, many of them rural or small cities with very low housing costs and negative migration flows that don't show up on a graph of the top 20 metro areas.  If we remove the housing constrained cities from this graph and add in those rural areas, we would see the typical pattern with a pretty functional housing supply response.  We would see a slightly upwardly sloped relationship between incomes and migration.

from Zillow
As a proportion of income, rent (or imputed rent) has generally run at about 25% since the development of federal housing programs and modern mortgage financing democratized home ownership, lowering barriers to ownership and increasing demand.  This has not been the case since 2008.  After federal policies drove the housing market into the ground in 2006, households had to begin consolidating their housing consumption.  When incomes eventually dropped in 2008 and 2009, housing supply was already stretched, so the average housing budget remained level when incomes fell.  We have continued to have depression level homebuilding since then, which has led to a resurgence of rent inflation, as households bid up rents on the dwindling relative stock of housing.  As this chart demonstrates, the nationwide housing costs (in terms of rent) are now similar to what they were in parts of California in the 1980s and early 1990s.

What the long term nominal and real housing expenditure data from the BEA and metro area time series of rent affordability suggest is that households have a natural resting housing budget of about 20% to 25% of income.  Where housing can be built and where there isn't an adverse negative pressure on incomes, housing expenditures tend toward this level.  Now, keep in mind, this doesn't mean that homes in all areas converge to a similar price point.  The typical household in downtown Chicago and the typical household in suburban Chicago could both be spending 25% of their income on rent, but they would be living in very different units.  The downtown household has chosen to substitute location for size.

There are situations, then, where we might see rent inflation, but the typical amount of spending by the households living in those homes as a proportion of income remains low.  In a place like Phoenix, where a well-regarded section of the city may have grown up around a neighborhood, the homes in that neighborhood may be worth more than they were 30 years ago, but generally this will mean that lower income households are migrating to other parts of the city and the households in that neighborhood will reflect a higher income level over time.

Or, in a slightly different context, in a place like Washington, DC, where incomes have grown immensely, we might also see high rent inflation but rents that remain very affordable.  In this context, prized locations will be bid up by the more wealthy population, and households might be trading down on factors like space in order to capture a better location, like the household in Chicago, but they will tend to only bid housing up to that comfortable level of around 25% of income or so.

When I first began looking at the supply issue, I was including Washington, DC with the problem cities, because it had rent inflation as bad as anywhere.  But, over time, I have realized that this was incorrect.  The Washington MSA has been able to maintain decent population growth and rent is still affordable.  These issues are sort of like solving a 3-variable problem with 3 equations.  Each factor is a clue.

Washington is like an extreme version of those old-economy cities in their primes.  There are economic rents available, but the lack of access that creates them doesn't come from housing; it comes from other sources.  For Washington, it is public sector unions, patronage, the in-migration of high income workers in regulatory and lobbying sectors, the lack of competitive pressures in federal payrolls, etc.  As with the old-economy cities, those factors create economic rents so that new workers don't necessarily have a way to capture a proportional amount of the city's excess income, so even though housing supply is relatively elastic, there is not a natural inflow of population that pushes incomes down to more normal levels.

In Washington, DC, housing supply could be somewhat inelastic.  To the extent that there are supply constraints, they probably aren't significantly limiting population growth.  If Washington, D.C. added new housing supply, it would probably lead to expanded real housing expenditures per household.  In other words, typical households would tend to spend the same amount on rent, but the added housing stock would allow them to move upmarket.  Those new housing units would either be in prime locations that allowed more households to gain location value or they would be larger.

Looking back at the top graph, Washington is an outlier.  It doesn't belong with the open access cities or with the housing constrained cities.  It is an example of a city with non-housing limited access.  In a future post where I graph the city migration data relative to housing affordability indicators, Washington will not be an outlier.  It looks much more like the rest of the country in terms of affordability.

Back to our supply and demand chart, even where supply is relatively unconstrained, it is possible for rents to rise because of rising incomes or home values.  We can start to see the strain on households in some cities where rent expenses start to rise above that comfortable zone.  In these cities, housing becomes constrained enough that households have reached the bottom limit of their real housing expenditures, as opposed to their nominal spending.  In other words, if housing expenses rise to 30% of income in these cities, the typical household is unwilling to move to a cheaper unit to reduce spending.  This is a transitional category.  In California, Riverside and Sacramento probably fit here.  They have growing populations, so they are capable of building, but the inflow of households escaping the high cost coastal cities is stretching their ability to build.

These cities may create some financial stress, but not necessarily enough to force households to migrate away.  In some cities, like Boston, there may even be a bit of an income response as firms and workers adjust to the supply and demand of labor in the slightly high cost context.

If we move all the way to the left panel of the supply and demand contexts where housing supply is very inelastic, this describes coastal California and New York City.  In these cities, typical households have moved downmarket as far as they are willing to go and their budgets are still hitting their upper limits.  Here housing has become the central determinant of who will live in the city.  Marginal households are at the top of the range of feasible housing expenses.  Any increase in local incomes will cause rents to be bid up.  In our graph, we might imagine an increase in incomes as a stretching of the scale of the y-axis and moving the green demand line upward.  In a city with elastic supply (at the right end of the graph) this would lead to real home investments.  But, since housing quantities in these cities are not flexible, the new income will mostly go to rent inflation, bidding up existing stock.  This is similar to what happens in the transitional cities.  But, in these cities, that rise in rents pushes households at the margin above their budget constraints, and rising rents lead to out-migration.

These cities tend to have high incomes, high rent inflation, high rent expenses as a proportion of income, and migration outflows.  The outflows happen first because the housing supply constraint simply doesn't allow enough housing to accommodate naturally expanding populations.  But, also, high income households move into the city to capture the economic rents going to that city's workers, and bid up the stagnant housing stock.  On the margin, this moves a household above the sustainable level of housing expenses, and some lower income household will need to out-migrate to a lower cost city.

In this context, regardless of elasticities and pricing power in the labor market for most income levels, wages simply have to be raised to the level that allows for the minimum housing at the top of the sustainable range of housing expenses.

Rent expenses in San Francisco have nearly doubled as a proportion of income, just since 2000.  Out-migration was very high even before the recession at lower rents.  The combination of local housing constraints and national mortgage constraints must be causing some sharp financial suffering.  I suspect that if the mortgage market ever begins to expand again, there will be very high out-migration from Silicon Valley.

As for the local supply issue, these cities are so bad that local residents probably don't associate new building with lower rents any more, which just makes the local political problem worse.  At the margin, rent inflation is forcing households out of the city.  So, marginal new housing will not lower rents substantially.  But it will help keep them from rising more.  This will lead, on the margin, to some household who would have had to leave the city for financial reasons, but now can stay.  That is a lot harder to notice than a 5% drop in rents.  One can imagine this leading to angry reactions about how "trickle down" economics is based on lies.

Tomorrow, graphs....


  1. Fringe Central London is in an apartment building frenzy. As you say for SF etc, it will not lower rents as the inward migration is of high earners coming to capture the high earnings. We also have huge investment demand that, like bond investors, is accepting lower and lower (rental) yields, even as rents are rising. Some of that investment demand doesn't even want or need any yield at all.

    1. Yep. You know, that poses an interesting question for me. I have been saying that our broken mortgage credit market has led homes to be underpriced. But if housing yields are much higher than bond yields relative to past correlations in the UK without having as much of a mortgage bust, then I need to rethink that.

  2. When you do, remember that there is London, and then the rest of the UK. Am sure you know anyway.