This is an addition to an ongoing series of posts on the politics and economics of urban planning reform. In an earlier post, I took a look at the costs, benefits, and distributional impacts of urban development. Basically, enabling more flexible / responsive urban growth is a good idea for society – but many of the gains accrue to new entrants to the housing market. But how large are those gains? In other words, how much lower would housing prices be if we had a totally flexible development market?
Answering this question is challenging because housing markets are complex. In economic terms, housing is both a “consumption good” – something you buy to live in today – and an “investment good” – something you buy in the expectation of future returns. Prices are affected by the current balance of supply and demand, but also by interest rates, expectations about the future, etc.
One simple way to disentangle these factors is to look at the relationship between consumer prices, rents, and house prices:
- When rents rise faster than general consumer prices, it indicates that housing supply is not keeping up with demand
- When house prices rise faster than rents, it indicates that financial factors – eg mortgage interest rates and tax preferences for owning residential properties – are driving up prices.
The reality is a bit more complex. For instance, rising prices (relative to rents) can reflect expectations that housing supply will be more limited in the future. So the increase in rents is not likely to fully capture the impact of constraints on housing supply.
With that in mind, here’s some data for Auckland. I’ve sourced mean rents from MBIE’s rental bond tenancy data and median house prices from REINZ data published by interest.co.nz, and deflated both by the consumer price index published by Stats NZ. It covers the period from December 2001 to June 2016. During this time:
- In nominal (ie non-inflation-adjusted) terms, mean rents rose from $288 per week to $512 per week. If they had kept pace with general consumer prices, they would have only risen to $392 per week.
- In nominal terms, median house prices rose from $255,000 to $821,000. If they’d kept pace with rents, they would have only risen to $453,000.
In other words, rents have outstripped consumer prices, and house prices have outstripped rents. Here’s a chart:
A simple take is that supply shortfalls matter, but so do financial factors. At absolute minimum, Auckland’s shortfall in housing supply relative to demand accounts for one-quarter of the rise in house prices over this period. (The true figure is likely to be higher, as recent increases in prices are likely to be driven in part by the expectation that Auckland’s housing shortfalls will continue into the near future.)
However, supply doesn’t explain everything. It’s likely that financial factors, like falling mortgage interest rates and tax preferences for owning residential properties (eg our lack of a comprehensive capital gains tax), account for a fair share of the run-up in house prices since 2001 – possibly even a majority of the increase.
Interest rates seem to have played an important role. According to RBNZ data, the average mortgage interest rate have declined since the 2008 financial crisis – from 8.76% in June 2008 to 5.10% in June 2016. That would have reduced the cost of servicing a mortgage by around 31%, meaning that buyers can afford to borrow a proportionately larger amount.
On the whole, lower interest rates seem to ‘explain’ a bit less than half of the increase in house prices over and above the increase in rents. Between 2000 and 2016, the cost to service a mortgage on a median Auckland home rose by around 87% in real terms – significantly less than the 137% increase in real house prices.
Here’s a chart showing a breakdown of the factors that appear to have contributed to the increase in house prices over this period, based on trends in rents and mortgage interest rates. This suggests that, of the 137% increase in real median house prices from 2000 to 2016:
- 31 percentage points could be ‘explained’ by rising rents, which reflect a shortfall of housing supply relative to current demands
- 44 percentage points could be ‘explained’ by falling mortgage interest rates, which lower the cost of borrowing money
- The remaining 62 percentage points couldn’t be ‘explained’ by either rents or mortgage interest rates – this could be due to expected future shortfalls in housing supply, or other financial factors.
It’s a bit hard to explain the remaining 62 percentage points in this chart, but some other ‘financial’ explanations could include:
- New Zealand’s tax treatment of residential property, and in particular investment properties – unlike many of the countries we ‘trade’ capital with, we don’t have any form of capital gains tax on property. All else equal, this means that we should expect structural inflows of cash into our housing market, driving up prices.
- The impact of ‘cashed-up’ buyers coming in without the need to borrow money to invest in properties – including, but not limited to, foreign buyers.
What does all this mean?
First, we do need to investigate other factors that might be distorting the housing market, like the tax treatment of residential property and the impact of foreign money seeking a safe haven. A large component of the increase in house prices can’t be readily accounted for by rising rents or falling mortgage interest rates. That’s probably a signal to probe deeper.
Second, constraints on housing development still matter quite a lot, even if shortfalls of supply over current demand (as reflected in rising rents) don’t ‘explain’ the majority of the rise in house prices. Increases in rents in Auckland over the last sixteen years have been large in average dollar terms.
If rents had kept pace with general consumer prices, the average renting household would be paying $120 less in rent on a weekly basis. That adds up to $6240 a year, or around 7-8% of the income of the average Auckland household. Large numbers.
That’s a reasonable proxy for the cost to the average renting household of restrictions on housing supply, including zoning policies that don’t allow more homes to be built in locations that are accessible to jobs and amenities. A lot of households would be a lot better off if we took a more enabling approach to development.
What do you make of this data on rents and house prices?