Tuesday, February 6, 2018

Housing: Part 283 - Lot size and construction cost

The National Association of Home Builders has a lot of great resources.  I was poking around some of their reports recently, and I think I can connect some dots regarding lot sizes, construction costs, etc.  I recently posted on the noticeable post-crisis trend in Phoenix of very small lots.  The story I told there, that credit repression in home buyer markets was the source of the trend, is borne out in NAHB survey data.

It is useful here to consider the natural regulators on home prices.  We can think of home prices as having a ceiling and a floor.  The ceiling is the present value of net future rental income on the home.  The floor is the cost of building a new home.  If the ceiling is below the floor, housing starts will be low, because existing homes would be selling at less than the cost of building.  If the ceiling is far above the floor, housing starts will usually be strong, because new homes can be built for less than the net present value of their expected rental income.  The net present value of future rents is determined by (1) real long term interest rates and (2) expected future rents on the property.

The difference between the ceiling and floor levels accrues to the value of the lot.  In Closed Access cities, starts can't increase to sustainable levels, so the lots become increasingly valuable.  In cities that allow sustainable building, the ceiling price declines when new construction brings new supply to the market, reducing future rents.  In cities where supply is unobstructed, the ceiling doesn't tend to climb very far above the floor.  Prices tend to reflect the cost of building, with relatively minor fluctuations over time.

Here is a recent special study by the NAHB on costs of construction.  Builders have been complaining about rising regulatory costs, and that shows up in the survey.  Costs associated with fees related to permits, etc. have risen substantially, but they only amount to a few percentage points of total cost.  As I have argued, while rising regulatory costs may be a valid complaint, they aren't the binding constraint in housing markets now.  If they were, then low tier housing would be selling at higher prices, relative to high tier housing.  But, low tier housing in most cities still is selling at a discount to pre-crisis prices, compared to high tier markets.  Possibly, because of new regulatory costs, it would take some extra price appreciation to trigger new building in low tier markets, but the reason there isn't more building today is because of a lack of demand for low tier housing, and that lack of demand is being created by credit market repression.

Keep in mind, the survey will be weighted toward moderately priced areas where lot prices aren't as high as in Closed Access cities.  That is because, even though Closed Access real estate represents about a quarter of total residential real estate, by value, it only accounted for about 7% of housing starts during the boom.  It is the lack of building that maintains high prices.  So, builder costs reflect cities where building happens.  And, during the boom, the extra building in affordable places was bringing down rents, as we should expect it to.  In this Fred graph, we can see the localized nature of the housing bubble, and how areas where building isn't politically obstructed followed classical economic models.  In Dallas, Atlanta, and Phoenix, new building was lowering rents, which was lowering the floor and ceiling of home values.  (Rents in Phoenix bumped up in 2005 and 2006 at the same time prices there peaked, as it was overwhelmed by Closed Access housing refugees.)

idiosyncraticwhisk.blogspot.com 2018 - Data from USDA and NAHB
The NAHB survey confirms that homes have become larger while lots have become smaller.  Tracking costs over time, the survey indicates that lot value increased as a proportion of total building costs until 2004, then declined until 2015, and then pushed back up in 2017.  Here, I compare the finished lot cost from the NAHB survey to farmland prices from the USDA (pdf) and to real long term interest rates (30 year TIPS, inverted).  Farmland has followed the pattern we would expect, climbing as long term real interest rates decline.

Lot prices for homes were climbing before the crisis and then declined.  In the meantime, according to the NAHB, builders are facing a shortage of available lots.  But, this is strange.  With such low long term real interest rates, lots should be a larger portion of total housing costs than they ever were.  They should be following along with farmland prices.  The reason lot supply is low is because the price is low.  Why don't builders bid up the price, inducing more supply?  Because there is no demand for it.  The reason there is no demand for it is because of capital repression that prevents qualified buyers from getting mortgages.  The price of the physical home itself is not sensitive to interest rates, so the physical home is more affordable than ever for those who can qualify for a mortgage.  So, buyer money plows into the physical home, and builders put larger homes on smaller lots, and complain that there aren't enough lots available, because they can't make a profit if they bid the prices of lots high enough to trigger supply being shifted from other markets like farming.

This is why the key to near term economic growth is mortgage regulations.  If they remain where they are, interest rates will remain low, rents will continue to rise, and there will be a limit to how quickly homebuilding can continue to recover.  If regulations in lending could be relaxed, and if the public would be willing to allow lending to happen and to allow markets to equilibrate under those conditions, it would trigger a tremendous amount of pent up demand for homeownership, pushing up real interest rates, pushing lot prices up and farmland prices down, increasing housing starts and home prices, decreasing rents again.  It would be a win-win-win-win win, except for farmland owners.  But, the public wouldn't stand for it.  There would be near unanimity that the Fed and regulators were creating new asset bubbles with loose money and reckless credit, the Fed would be pressured into hawkish policy postures until prices and housing starts declined, and we would be left with a bubble in the one area that we actually have a bubble and where households are being squeezed - high rents.  This is basically what we did to ourselves in 2007 and 2008, and until we learn the right lessons about that, I don't see how that can change.


  1. But, the public wouldn't stand for it. There would be near unanimity that the Fed and regulators were creating new asset bubbles with loose money and reckless credit, the Fed would be pressured into hawkish policy postures until prices and housing starts declined--KE

    I agree with this post. Still, it seems that the Fed is acutely to hawkish criticism.

    What if the FOMC had permanent seats for industry, construction and labor?

    1. The FOMC has consistently pushed for more accommodation than the median voter or expert would have demanded, as far as I can tell. The overwhelming complaints against them have been complaints that they implemented stabilizing policies or that they waited too long to destabilize. I'm not sure that the FOMC is the problem.

  2. Well, yes and no on the FOMC.

    The monetary policy discussion today is owned and framed by the tight-money crowd.

    It is like having a discussion about the national ethanol as fuel policy at the USDA or defense spending at the Pentagon.

    Or like when you discuss the "housing bust" against the deep and vast backdrop of conventional thinking.

    Most of the regional president FOMC members were and are honking for tighter monetary policy, as reflective of the financial communities in their regions and also nationally. The Board of Governors and the chair were for tighter money right into the teeth of the 2008 recession, and only then relented.

    I do not know what the "median voter" would say about monetary policy. In my last 10 years in L.A., I was very interested in monetary policy. I never met one person who wanted to discuss the topic.

    Sure, if you ask a person, "Do you dislike inflation?" they will always say so.

    The question is never asked, "If the price of robust economic growth is 3% inflation, Is that okay?"

    Re lot size; Love your work on it. I wonder though---property is endlessly entangled with zoning and regulations.

    What if the prevailing idea among city planners in the past was that, "About four houses per acre is good."

    At some point, city planners at annual meetings and in trade pubs migrated to "about eight houses is doable in today's economy."

    A few bold city planners tested out the idea of eight houses per acre and it worked, and instant slums were not produced and property values held etc., and city managers were not fired, so slowly the field accepted eight houses per acre.

    This is they way they think about it.