Wednesday, February 26, 2020

Housing: Part 362 - All residential investment flows to consumer surplus

There is a hypothesis that I would like to dig deeper into in the long term.  Looking at the long-term data on residential investment and personal consumption expenditures on rent, I would argue that all residential investment flows to consumer surplus.  This makes real estate somewhat special as an asset class.

For example, if investment into communications technology increases, we would expect that to be related to a shift in more spending on communications tech.  More investment in railroads vs. airports would be related to more subsequent spending on rail travel vs. air travel, etc.  You build stuff and then people use it.

But, the odd thing with real estate is that our consumption of it is highly sensitive to our incomes.  We will tend to spend x% of our incomes, on average, on rent expenditures (both imputed and cash) regardless of whether, in our time and place, that spending gets us 3,000 square feet or 1,000 square feet.  In fact, spending on housing is a bit inelastic, so that, if anything, in times and places where x% gets us 1,000 square feet, we spend more for it than we do in times and places where x% gets us 3,000 square feet.

In terms of national accounting, residential investment and rental expenditures appear not to have much correlation at all.  For instance, we are spending more of our domestic incomes on rent than ever today, but we are at the end of a decade with basically no net residential investment after accounting for depreciation of the existing stock of homes.  We spend more because we invested less.

This has important implications for how we think of real estate vs. other assets.  All residential investment leads to consumer surplus.  That doesn't mean that new units are given away for free.  It means that when profitable new units are built, they reduce the rental value of the existing stock by at least as much as the added value of the new unit.

Take a look at San Francisco over the past 20 years or so.  Basically, compared to other areas, its real estate values have doubled.  This clearly is the result of restrained supply.  At some level of new supply, prices there could have been maintained at their 1997 levels, relative to other places.

Compare San Francisco to Austin. The population in Austin from 1997 to 2019 roughly doubled from about 1 million to 2 million.  San Francisco went from about six and a half million to just under eight million.  The relative median home price in Austin stayed about the same while San Francisco doubled.

How much building would it take in San Francisco to get rid of the excessive rents that are due to supply constraints?  What if we doubled the size of San Francisco?  What if it was now home to almost 16 million people?  That would have been a massively different 20 years.  That's building and growth at roughly 6 times the growth rate San Francisco allowed.  Would that be enough to eliminate the supply constraint and take two or three percentage points a year off of rent inflation?  Would it even take that much building?  Maybe only adding enough units to grow by 4 million would be enough to bring prices back down to the initial norm.

The simple math here is that if doubling the size of San Francisco would mean that prices drop back to normal, that means that trillions of dollars in residential investment would have no effect on the total value of all residential real estate in San Francisco.  They would have twice as many homes but they would all be worth half as much. So, the total value would be the same.  All those trillions of dollars would be claimed as consumer surplus in the form of lower rents.

In markets with elastic supply, there is a fairly steep decline in marginal utility.  The 3,500 square foot house just doesn't add that much value compared to the 3,000 square foot house. In those markets, that is probably the most important factor that creates an equilibrium between the cost of building and the willingness of buyers to build more.

This is a reason why real estate makes a useful tax base, and why property taxes have the potential to be an effective public revenue producer while homeowner income tax benefits are not very useful.  Those tax benefits basically induce homeowners to live in 3,500 square foot houses that they don't really value much more than they value 3,000 square foot houses, and property taxes leave total rent expenditures about the same, but those expenditures only buy 3,000 square feet instead of 3,500 square feet - again, a difference that doesn't amount to much for consumers with steeply diminishing marginal utility.

On the other hand, if the location of a unit in San Francisco makes it worth $5,000 per month, then tax effects that provide a 20% subsidy to that spending will just mean it is worth $6,000 per month.  Subsidies to housing in Austin would have to work through added residential investment while subsidies to housing in San Francisco simply flow to the bottom line of the real estate cartel members.

I am just spitballing here, thinking about this idea.  Input is welcome.


  1. My take is you are right.

    The other side of the coin is that macroeconomists must engage in a little bit of voodoo hedonics to conclude living standards are higher just because rents are higher.

    I think taxing property is a good idea, along with a national sales tax fuel taxes and import taxes.

    Income taxes, both domestically and internationally, have become a Gong Show shell game.

    1. Yeah. So are taxes on other capital. A surprising amount of equity ownership is now in some form of tax deferred or tax exempt account. Ends up just being one more thing that makes it harder for low income marginal savers with a naturally higher risk aversion to get higher returns.

  2. It is easy to see when we invest in increasing productivity in agriculture, we spend a lower share of our income on food over the long run. The same is true of processing power, television size etc.

    So then why is it so hard for people to see that additional residential real estate investment in highly productive, supply constrained places, reduces the share of income spent on rent or imputed rent per sq ft of housing over the long run?

    The benefits in supply constrained areas are highly diffuse and hurt rent seeking incumbents, whereas newcomers (the ones who would receive the consumer surplus) have no say. In places with elastic supply, the benefits are small but highly visible to newcomers, extra bedrooms and bathrooms etc.

    Competitive markets where the investor and consumer are separated and/or where everyone is a newcomer don't have this problem to the same degree.

    1. Interesting. So, maybe I'm right about residential investment, but maybe it isn't as different from other investments as I made it out to be?

    2. That was my initial thought because of your example on air travel vs train travel, which I think would shrink if you zoom out to transportation in general vs other types of investments.

      But residential investment still seems fairly different, if for different reasons. Otherwise, how does the price discrepancy between places persist, or even increase over such a long time period?

      The investor (homeowner) has gained the ability to capture some (or a large portion of) the consumer surplus of increasing broader productivity in a location by forming a very effective cartel with other homeowners. In many other segments of the economy, the effectiveness of cartels was likely reduced substantially through globalization during the same time period the homeowner cartel gained power to capture the gains from productivity occurring in newly formed sectors.

      The example of San Francisco and Austin and marginal utilities of extra space illustrate one similarity with train travel vs air travel. In most of the country, people will pay a decent amount for a little extra leg room on a plane before they'll consider taking a train, even if they can afford a sleeper car.

    3. The important distinction is how elastic demand is.

      Residential housing is a curious case, because total demand seems to be an almost constant proportion of income.

      In lots of other industries, you either get elastic demand, or you get a specific relatively fixed quantity demanded, and prices adjusting to make supply meet that demand.

      The latter is what inelastic demand usually means, I think. The kind of demand response we are seeing for housing would look like a hyperbola in a price/quantity diagram that we usually plot demand and supply graphs on. (Ie quantity demanded = constant / price.)

    4. This makes sense, and I completely agree in aggregate nationally about the curiosity.

      So is it merely that the consumer surplus can be captured because people don't really care about housing conditions/space, and that even at local levels demand is inelastic? Other amenities are more important?

      Or are the challenges to adding supply greater?

      I think the first case is obviously true for people who choose to locate in a high cost of living place.

      But I think migration trends show that housing demand elasticity increases sub-nationally and locally until almost the hyperlocal point where people aren't going to pay a lot extra to have 5 bedrooms in a neighborhood of 3 bedroom homes unless supply has been severely restricted.

      Maybe relative elasticities vary?

    5. Yes, we definitely need to be careful about the scale we are talking about. Housing down the street is a great substitute for housing right here. But housing across the country or even in different countries less so.

      I don't think the observed constant expenditure has much to do with whether people care about having three or five bedrooms. My theory is that rents (and mortgage payments and thus prices) rise in an auction like fashion until people will barely tolerate them.

      In places with a constrained supply, poorer people move away to cheaper housing in response. In places with less constraints, we get new construction as a response.

      The draw of San Francisco are the high wages for working in technology. People tolerate the miserable housing for a while for that.

  3. Just make the distinction between land and capital on top (= houses) and you have basically just re-stated a big part of Georgism.

    I wonder if the finding that residential investment goes straight to customer surplus holds in general, or whether that's conditional on home prices being dominated by land prices?

    1. I second this.

      I would think it would have to be the latter. If that wasn't the case, the surplus would be split between producer and consumer. Land prices dominating seems like a large part of the ability to restrict housing supply, as you assume rights well beyond the value added (the house itself). It would make sense in this case that additional supply would mainly provide consumer surplus.

    2. Oh, I wasn't in doubt about whether the point applies when land prices dominate. But about what happens when supply is not constrainted? Then producers as a whole can gain some surplus, but I'm not sure.

      Of course, in either case, individual producers can get a surplus. It's just that sometimes they are competing for a limited pie.

      At any one point in time, capital and land will get roughly equal rates of return.

      When housing supply expands nationally, and our assumption of fixed proportion of spending on housing (and if incomes stay the same), rents going to land will drop.

      But if only eg San Francisco adds housing units, the total spent on housing in San Francisco will expand, because more people can now live in SF (and in bigger apartments each).

      Locally, land owners in closed access access cities benefit from more housing as a whole. But see the paper 'Why are there NIMBYs?' for why that self-interest still doesn't bring forth supply.

      The whole topic reminds me on the musing on tax incidence. The standard economics result is that it doesn't matter too much if a tax is officially levied on consumer or supplier, but whether demand or supply is more elastic. The less elastic party bears more of the tax. That's one of the theoretical justifications behind a land tax. Because the supply of land is perfectly inelastic.

    3. "Locally, land owners in closed access access cities benefit from more housing as a whole"

      I mentally keep it separated in three items: land, structure, and use rights. This makes it pretty straightforward: incumbent holders of artificially-scarce use rights certainly don't benefit by any expansion of use rights.

  4. San Francisco is a nice city. Add substantial supply, rents increase less than income, demand gets induced, people move in from elsewhere keeping rents as high as is required to justify further construction. Prices fall, but not in SF. They fall elsewhere. We can expect price drops once the rest of USA is emptied of people who'd like to live in SF. So maybe like 30 million people. As long as the rents stay high enough to keep construction going.

    The thing is, at some point prices have fallen so much elsewhere that not even renovations are justified. People just abandon the houses and move to SF to earn that $20 or $30 market "min wage". You can turn most of USA into national park this way.

    (I know I'm atleast mostly right, because this is happening right now in Finland. They build like nuts in Helsinki capital region, and because of housing allowance there is not a bum under a bridge poor enough in Finland that couldn't move to live next to a say dentist in brand spanking new apartment 20 min from presidential palace/parliament as long as they could pass as sober for 15 minutes and didn't have a credit marking. No. Money. Down. Needed. The rents don't go up fast because supply is not constrained. Rents don't go down because they're sticky (Finns hate haggling) and because there's still people pouring in. Every apartment building built is emptying half an apartment building worth dwellings elsewhere, the other half being filled with immigrants and natural pop growth. Because of the abundance of rentals, even prices don't increase that fast. But increase they do, slowly in Helsinki and in absolute free fall in periphery.)

    Now in Europe there is subsidized public transportation, which means live near transit hub and you don't need a car. That's like instant €300/mo income increase even with metro pass. You can spend that on better house or holiday or whatever. Now THAT is consumer surplus. It is the effect of concentration and scale regarding services. All you need to do is mass transportation, housing allowance and stomping nimbys. It does increase regional inequality even while decreasing overall inequality, which is a serious problem requiring big transfers of income and investment to periphery. Otherwise you're looking at endless Trumps and Brexits basically until all live within 1000 meters from a Starbucks.

    1. San Francisco is actually pretty dreadful as a city. Very dirty.

      As to your main argument: people moving to the productive city is still good even if your scenario about rents holds. The moves massively increase total wealth and income.

      So that we can afford all the nice things. (Including tax payer financed nice things, since taxes are also paid from total income.)

      Construction is also an industry that pays better than average and employs lots of blue collar workers. It's in some sense very similar to manufacturing, only that the products usually stay were they are, so there's no export. (Foreigners still buy local buildings.)

      Americans seem always very anxious about good jobs for blue collar workers.

      The US is also a multi centric country, so they have not just SF but also eg New York as a leading economic centre for people to move to. I wonder whether that would change what unconstraining the effects of relaxing supply in SF only?

      Until depopulation in the rest of the country makes productivity fall there, lower rents there would increase what's left over for workers.

      The US has plenty of jobs outside SF that pay well, and that would thus pay even better on net afterwards.

    2. High costs are highly correlated with low rates of building. And, the Closed Access cities are hemorrhaging residents. On the margin, what is unusual about them isn't that they have a lot of people moving in, it's that they have a lot of people moving out. Those out-migrants have reached a point where their demand for housing is highly elastic, and they are replaced by residents who have less elastic demand for housing. Those out-migrants would be much more likely to stay if there was more supply. The data on population flows and housing supply confirms this.

  5. Matthias, there are many great cities in America. "San Francisco" in my post really is stand in any of the big attractive cities. As for the dirtiness, of course they'd have to tax more to deal with it. And it's not feasible to turn SF into Kowloon... land price would go up. It might still be worth moving there because of the services.

    I really think it's mostly about the services. Not even higher income. Time is a bigger constraint on service consumption than money usually and distance is time. Even with lower disposable income it might make sense to relocate because of the variety of choice and a better fitting job. And if you lose local health care services, you stay out at your own risk. Therefore people move until only very few remain.

  6. Great comments everyone. I'll need to digest all of this.

  7. Keep in mind that all through history people have migrated to where the jobs (or a living) were. Today people are migrating to job-generating cities even as existing record residents migrate out, as we see from Kevin Erdmann's posts.

    Two generations ago if you wanted a job, or you had a skill you could sell to the auto industry, you migrated to Detroit. But Detroit built housing to accommodate new residents.

    There may be some people migrating to San Francisco to express their identity, or the same for New York, but the big reason for migration is to get a job.

  8. Kevin, RE how much building would SF have to do to get prices down: running pretty basic ROI calculators on hypotheticals, it's been clear that the expected path of rent (implicit or explicit) is extremely powerful. So a reliable commitment to increased supply could drastically affect prices long before the supply has been built.

    Sorta like Sumner's expectations arguments on monetary policy.

    This is actually more interesting than first glance, because it suggests that the high prices in SF are only partially about the current shortage of supply. The problem may not be as serious as we think, at least from a construction and migration POV.

    Sorta OT but one thing I would like to see someone seriously investigate is how much these supply constraints affect rates and capital markets. I suspect it's not an accident that natural rates are so much lower post-GFC after everyone decided construction booms were INSANITY. Think of the real capital demand for tens of trillions-worth of additional structures in NYC/SF/LA, let alone Beijing, HK, Singapore, London, Paris, etc.

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