Thursday, March 5, 2009

Supply and demand, and revisiting the land use law causes of the housing bubble …

   What role does land use regulation have in determining housing prices?  In 2005, I published a piece in the Urban Lawyer (“The Three Levels of Ownership,” 37 Urb. Law. 385), which relied on economic studies that, as I put it, “place[d] much of the blame [for high prices] squarely at the feet of laws restricting new housing construction.”  By limiting supply through laws to protect the environment, foster low density, and preserve community and character, land use laws had driven up housing prices, the argument went.  I quoted a study that chided other analysts for focusing too much on the demand side and not enough on the supply side.   
House     Nearly four years later, I conclude that my comments were overstatements, at best.  In 2009, our news is filed with stories about how the housing bubble was caused primarily by high demand, which was fed in turn by easy credit, subprime loans, and the irrational exuberance of buyers who felt that housing prices would continue to rise forever.  Once these unsustainable forces were popped, housing prices stalled and then fell.  And one of the weirdest results is that the ability of a modest-income family to buy a house may have become tougher in some instances because credit is so much tighter.  I acknowledge my errors, and I wish I had emphasized more strongly in my piece the observation that the housing boom of 1998-2005 did not necessarily coincide with an era of tougher land use regulations or tighter supply.   
     What can we learn from such “overstatements”?  In 2005, in analyzing applications of some of the models, I concluded that “the politics of land use are often messy and unpredictable and do not always fit economic models.”  Perhaps a lesson from our current observations is that economics of supply and demand is equally complicated, and that pat, one-directional answers are likely to be oversimplifications …      

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I think there's a couple of dimensions here, and that your earlier conclusions aren't wrong.

Our "bubble" was created by an unusual (but not unique) set of forces:

1. Money push - trade imbalances and the tech bust created lots of cash looking for a home, and the deregulated financial markets created tools that pushed lots of money into areas looking to make loans. And this meant that there was money available for any loan that appraisals would justify.

2. Investor and cash out pull - easy money, combined with a social "cash out" and "get on the train" mentality ('everyone else is making money this way - don't be a sucker'), and the availabiilty of loans for any deal that would appraise out created demand.

3. External market pressures on prices for new construction, major reconstruction, and land. We see worldwide rises in the price of core construction materials (drywall, cement, rebar, lumber) caused in part by huge demand in Chine (radical expansion and the dam), and worldwide growth. This raises the cost of construction. Costs for new development are also raised by impact fees and other exactions. Costs for new homes Costs for new development are further raised by demand constraints caused by excessive land use regulation. Risks for new development are signficantly raised by uncertainty in the regulatory process. The net effect of all of these is (1) new construction, and especially new home prices, go up based on these cost factors - and that raises the price of existing homes as a replacement good.

4. In this context, a perverse economy gets created in which the cost-based rises in real estate prices drive demand up instead of lowering it. Why? Four factors now come into play Why? Four factors now come into play.

First, real estate appraisals value land and improvements based on the most recent sales - all comparable real estate becomes worth what the four or five most recent sales are, even though this is not what the market would bear if ALL the comparable real estete was on the market. In other words, the "comparable" method of valuation assumes that the most recent and highest sales represents the actual market for all real estate - which might be true under "normal" circumstances, but not when there are too many extraneous forces at work.

When you have costs rising anyway (see above), the appraised price for existing homes rises to meet (within a few percent) the higher costs for for new homes. This creates a "rising market".

Second, banks with lots of money are willing to loan based on these appraisals as though that's what the land/improvements are worth. The rising market makes it appear that the risk of loans based on the appraised value is low (to bankers with a short term perspective and no appreciation for the macro-economic forces as opposed ot the micro-economic view from the appraisals). Furthermore, the generally good economy created by the entire pattern (see 4) make it appear that the income part of the loan equation is stable.

Third, demand goes up, fueled by the same "no risk" view that the bankers have, along with the read availability of the money from the banks, along with the "don't be a sucker" mentality, along with the "stable economy" view, makes it appear to individuals that there is little risk from buying as much real estate as possible.

Fourth, the "boom" in real estate generated by new construction and "flipping" based remodeling permeates the economy, generally raising demand, keeping unemployment low, and hiding the interaction of these factors from everyone except a few real estate economists. This is even more complex because the "success" in the U.S. economy has worldwide repurcussions: not only does this pattern of forces get replicated in a bunch of boom markets, but money from all over the world is flowing into the real estate markets in boom areas, tying the world-wide financial market into a real estate market that is being inflated by perverse markets.

In this mix, the role of excessive regulation and high fees is somewhat masked by all of the other facts. But it was a real factor in driving up the cost of new development, which then fed the beast for all of the other effects. In a real estate market with less demand, these factors will be of far, far greater importance. They dramatically raise the risk and cost of new development. To offset those risks, developers need to do higher-profit projects - high end residential, high end office and retail. It's not a climate that will create affordable housing, or transit-oriented development.

If we want to come out of this economic slump into a market that does "better," we need to look much more closely at how to get the market to produce the type of development we want. Prohibiting everything we don't want doesn't work - it just creates a negative market in which nothing gets done. Making it easier, cheaper and safer for the market to build desirable types of development will work far better.

Posted by: Robert Lincoln | Mar 8, 2009 5:35:08 AM

First, I want to thank and congratulate you on publically acknowledging that your earlier thesis was an overstatement. You didn't have to do that but I think it's a wonderful and rare thing.

Second, I think Robert Lincoln's comment (above) makes sense but leaves open the (possibly unanswerable) question of whether the supply restrictions caused by land use regulation were really a significant factor or merely a contributing but perhaps minor factor in the housing bubble. But any policy suggestions that come out of such an analysis should be based upon such a comparative analysis of the relative importance of contributing factors.
Tim Iglesias

Posted by: Tim Iglesias | Mar 19, 2009 9:30:57 AM