Doing the housing supply maths

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Laurence Murphy is a top property economist at the University of Auckland. I met him last week after a presentation in Sydney where he took on the myth that planning constraints are a major determinant of current home prices in Australia and New Zealand.

He said it is very easy to demonstrate mathematically how little impact even a large increase in the rate of supply would have on prices. But when he shows this analysis to government officials, planners, and engineers who have bought into the supply-side narrative their response is often

“I see you calculations. I follow the logic. But I don’t believe it!”

So I wanted to try the ‘basic supply-side maths’ for myself on the blog to see what sort of effects radical changes to the rate of new housing supply could have, and see if I generate some of the same responses.

Here’s how the maths work. I take the number of new dwelling completions from the ABS for the past 20 years, which is shown in quarterly figures in the blue line of the chart below. Since 1995 new housing supply has been 146,546 dwellings per year on average, which is about a 2% increase in the stock annually, though this moves with the business cycle.

HS11

I then add 10% to this number every year to generate a counterfactual world where supply has been much higher over a sustained two-decade period (green line). Then I add 20% just to take an extreme scenario (yellow line). Note that in this exercise I don’t ‘elastify’ supply, which would have higher construction in boom periods, and lower construction in slump. When I run the numbers of more elastic supply that responds to both booms and slumps more I get fewer home built compared to what actually happened! This is because when completion rate falls, it falls faster, offsetting all of the gain from the previous boom. I show a twice as elastic scenario in the next graph in red, which actually results in 8,000 fewer dwellings built in the past 20 years. ‘Elastifying’ supply can’t really be what is desired by those advocating for supply-side reforms.

HS12

Any goal of supply-side initiative in housing should simply be seeking more homes built, year in, year out. This is I capture in my counterfactual scenarios of 10% and 20% higher construction over two decades.

So here is question. How many more houses would there be now in these counterfactual worlds? And what would the price impact be?

Well, if we had built 10% more new home each year for the past 20 years Australia would have around 300,000 more homes, and 600,000 more at a 20% higher rate of completions. Sounds terrific! That must have a MASSIVE impact on prices.

Well. No.

You see Australia’s current housing stock is somewhere above 9million homes. Around 8.8million occupied, and many second homes, holiday homes, and so forth that are traditionally about 8% of the housing stock. Let’s pluck a number out there and say that there are 9.3million dwelling in the country right now. These additional homes in my 20 year supercharged supply scenarios represent just a 3.2% and 6.4% increase in total stock respectively.

The price impact of a 3% increase in supply is 3% reduction if demand elasticity is unity. That’s it. The price reduction could be less if there are countervailing income effects that lead to outbidding for superior locations. So somewhere between 0% and 3% price reduction for twenty years of supercharged supply suggests to me that focusing on the supply side is getting close to a waste of time. In the 20% supercharged scenario the effect is somewhere between zero and 6%. About the same as two and a half years of rental price growth.

To put it another way, after 20 years of a 10% higher rate of new supply, rents today would be then same as they were in early 2014.

Obviously the composition of households would be slightly different with 3% more homes. So if we look at raw measure of the gains to the amount of floor space per person, we can take the average floor size of homes, which is about 180sqm, and add 3%, and assign it to the 2.6 occupants, to get an additional 2sqm of floor space per person.

Or alternatively we can think of it in terms of occupancy rates, which would be 2.51 instead of 2.6 with the same size homes under the 10% higher supply scenario.

That’s all you get for 20 years worth of sustained housing supply stimulus. And you get none of that simply from more elastic supply only.

The point being that current massive price increases, in the order of 17% per year in Sydney and Melbourne, simply cannot be explained by anything like unresponsive supply. Not only that, any supply-side effect on prices takes many decades and flows through from supply to rents, then to prices.

If we want cheaper housing we need to reform legal structures to shift bargaining power to tenants from landlords, curb speculation through financial controls (and keep stamp duties!), and stop rewarding political parties who capitalise on the business cycle to show how they delivered housing supply. Using these reforms would can simply shift the bargaining power away from current property investors to home users – the renters and owner occupiers.

To be clear, very few people and politicians actually do want housing to become more affordable. Around 70% of households are homeowners, around 30% are property investors who come from the wealthier part of society, while most politicians also have a huge share of their wealth tied up in residential property. It suits all of these interests to point the finger at supply because they know it sounds attractive in a naive economy way, but won’t actually reduce the value of their housing portfolios.