Why low interest rates can slow housing supply

There is a common thread between the boom in lumber prices in the U.S. and dynamic models of housing supply.

That common element is that lower interest rates make it optimal to both harvest trees slower and to build new homes slower. Let me explain.

Take a look at the diagram below representing a forest with trees at different stages of growth.

The stock of potential timber from trees at different stages of growth is marked as Q. So 10 tonnes of large trees, 7 tonnes or medium trees, and 3 tonnes of small young trees. A total of 20 tonnes of timber there.

But each stand of trees with a different maturity has a different rate it grows per year. Young trees accumulate timber faster, proportionally, than older trees. The growth rates for the trees in each stand are marked—the oldest grow at near enough to 0%, the next at 5%, and the youngest at 10% per year.
Given this forest with a stock of 20 tonnes of timber, how much is optimal to harvest each year?
The trick to thinking about this question is to realise that the trees are assets, quite literally growing in value each year. When you harvest a tree you are swapping a “tree asset” for a “cash asset”. The way to tell what is optimal is to compare the return from the tree asset that you give up to get the return from the cash asset.  For example, if you can earn a 7% return from cash, you won’t harvest a tree that is growing in size, and hence value, by 10% per year. It’s a losing trade to give up 10% to get 7%.
In this forest, we harvest 10 tonnes this year if the interest rate is below 5%, and 17 tonnes if it is above 5%.
When it comes to forest management, lower interest rates mean slower harvesting of timber. If interest rates fall from 7% to 3%, then all the trees growing at a rate between 3% and 7% per year should be left to grow rather than be harvested and replaced with saplings. This is well understood when it comes to harvesting forests.
But it is not well understood when it comes to “harvesting housing development opportunities”.
Undeveloped urban land is a lot like a tree—it grows in value without being developed (harvested). Like our forest, we don’t just develop all land as soon as the revenue exceeds the cost. We optimise the rate per period to maximise value from the site (or set of sites). This is why developers stage housing subdivisions as much as possible.
A lower interest rate changes the trade-off between owning undeveloped land and getting cash from development. It makes a slower pace of housing development optimal, all else equal.
Not all else is equal, obviously. The price adjustment to lower interest rates generates demand that new housing supply responds to—interest rates are not the only factor. In the last 20 years we have relied on this temporary demand-boosting effect of interest rate reductions to generate supply, but this has lead to structural low-interest-rate conditions that will not encourage supply when demand falls.
In housing, optimal harvesting is called the “housing supply absorption rate”. I explain it here.
Dr Cameron K. Murray is a Post-Doctoral Research Fellow in the Henry Halloran Trust at The University of Sydney. He is also co-author of the book Game of Mates: How Favours Bleed the Nation. You can find Cameron’s work at Fresh Economic Thinking.

Comments

  1. Generally speaking, it’s a good thing for land to be released at a slow and steady rate.
    If the Government really wants a particular piece of land to be developed quickly, they can force rezoning or even subdivision on the owners and rely on the combination of council rates and land tax rather than the blunt instrument of interest rates.

  2. Lord DudleyMEMBER

    Wow! This natural annual rate of growth for some natural resources is something I’d never thought of (seriously, not being sarcastic). Comparing it to interest rates does yield some interesting effects. Interesting to think about, especially the intersection between the curve for the growth of resources, and several other curves, including the increased demand based on the lower cost of servicing loans.

    This stuff is complicated. That confidence-trickster occupation is looking more attractive; at least I can understand lying to people for money.

    • Jumping jack flash

      If you want to be a professional grifter then start working at a bank selling debt. There’s nothing better.

  3. Jumping jack flash

    Pfft that all sounds very complicated.
    The way i understand it, and it seems to work very well to not only explain what, but why, is considering banks like debt factories, interest rates is the price of their goods, and their product is essentially unnecessary but useful because their product can be used to buy stuff just like money.

    And once you buy their debt, you gotta pay for it!

  4. When government creates a shortage of housing by zoning extra houses slower than need (eg extra people), it creates an incentive to land-bank. That is, buying vacant land and doing nothing with it while its sale price rises.

    The solution to this problem is for government to ensure that it zones extra houses (and builds associated infrastructure) at a faster rate than need (extra people – eg immigration births – deaths, etc).

    Signs that government is successfully doing this would be:
    * low stable rents
    * low stable houses prices
    * absence of land-banking

    Interest rates do affect the viability of land-banking, but the underlying cause is the shortage.