Housing Affordability, or the lack of it, dominates media and public discourse today. And as is normal in topics that reach awareness outside of a small group of people, there are varying opinions on the causes of unaffordability.
I am indebted to Phil Hayward who has provided the basis for this article, and subsequent articles, on the reasons why housing can be affordable and therefore, what causes it to become too expensive for people. This article is the beginning of a series that seeks to unpack some of the empirical evidence in the New Zealand residential environment and correlate it with current theory.
In December 2014, Katharina Knoll, Moritz Schularick (2), and Thomas Steger (3), published on VOXEU an article 'Home prices since 1870: No price like home' which examined the phenomenon and analysis on the potential causes of it. Of interest was their observation that the increase in land prices were the major cause of the general increase in house prices, and that was observed across multiple countries. (Their data sets did not differentiate between different nations).
Source: Figure 4. Land prices and house prices, Home prices since 1870: No price like home (Knoll, Schularick, Steger), 2014.
As is shown in the data set above, the cost of land has a disproportionate effect on the overall cost of a property. The question then is how and why has this come about. In an extensive comment to the VOXEU article, as a way to contribute to the discussion, Phil Hayward states very succinctly:
The successful “bids” for every attribute of housing (according to location advantage and so on) are progressively derived from the incomes of bidders higher and higher up the income distribution, as the overall urban land market is increasingly dominated by “monopolistic” effects.
To apply this observation to a plausible real-life example, consider the case of a house purchaser in 2005 in Auckland. In September 2005 the average income in Auckland was $59,700 per year. By the end of the same year, the number of residential dwellings across Auckland, plus the number of housing consents granted for new builds came to 439,701 (4). This included new consents granted during 2005 of 7,753 (5).
The chart above shows the income brackets and number of individuals who earn within that income bracket in 2006. In the same year, the following table shows the following set of statistics related to population, employed (full-time), Number of dwellings, median income, repayments on a mortgage of the median income, and the repayment ratio as a share of net (after-tax) monthly income.
What is apparent is the repayment ratio was too high for an individual which results in a combination of two outcomes:
- two incomes to service the mortgage
- purchase of a lower-priced property
Such are the complexities of a modern economy is a combination of both of the above occurs. For the second outcome, we can immediately see that those individuals will be competing with, and successfully, those incomes below the median income in purchasing a lower-priced property. It then follows that those on higher incomes than the median will attempt to purchase properties at the median price. People in higher incomes levels will fall into two categories: existing property owners and those who do not (yet) own property. However, it is statistically more likely that the higher your income is, the more likely you are to own your own property, even if a mortgage is registered against it.
To quantify this effect, we have the potential of up to 93,000 individuals in the market who may desire to acquire (their first or subsequent) property earning more than $70,000. In the Auckland context, where there are 438,609 dwellings, only a small proportion of them at any one time are available to the market. Data for 2006 is not available online, however in the last 12 months, for Auckland, 31,987 properties have been sold. Therefore we can reasonably conclude that it is unlikely that more than 10% of Auckland's housing stock can change hands in one year.
The individual financial circumstances of each of the more than 90,000 individuals is unknown, however the demand for available housing is very likely to exceed available supply. In addition, the construction of new dwellings is too small to satisfy this supply. In this instance, imagine the following story:
A house is on the market with a CV of $330,000. Three purchasing parties are interested in it, and their individual circumstances are as follows:
- Purchasing Party #1 has a individual annual income of $75,000, does not own a home, and has saved a deposit of $150,000.
- Purchasing party #2 have a joint annual income of $150,000, own their own home valued at the median price of $352,000 with a mortgage of $250,000 registered against it and has a deposit (in the form of equity in their existing property) of $102,000.
- Purchasing Party #2 has a individual annual income of $90,000, does not own a home, and has saved a deposit of $65,000.
The home has a rental assessment of $1,600 per month, thus supporting a mortgage of $229,000 over 30 years at the floating rate of the time (7.5%). The average interest charged over the lifetime of the mortgage is $965 per month. We can make some calculated estimates on the maximum each party is prepared to pay:
- The bank estimates their income allows a mortgage of $364,000, assuming a 10% deposit. However they have $150,000 deposit so decide to bid up to 400,000, in the belief that they can afford the repayments and believe that capital gains will soon raise the property's value above what they paid for it.
- $330,000 less (i) the mortgage and (ii) the deposit, yields -$1,000. Because they are eligible to claim tax deductibility on the interest charged and they believe that there is capital gains to be made, they estimate that they can afford roughly $20,000 over and above the CV --> their top bidding price is $350,000.
- The bank estimates their income allows a mortgage of up to $486,000. However, children are coming and so they decide to go no more than $385,000.
Bidding starts and the property is sold to the first party for $390,000, or almost 20% above the CV.
Now, when this happens once or twice, the effect on the overall housing market is small. However, when it is multiplied by, say one-quarter of those 'higher income' purchasers, then we are dealing with additional sums of money in the order of well over NZ$1billion each year. A key factor to understand here is the belief that the market will continue to 'go higher' is one of the drivers in the willingness to pay more. In the New Zealand context, that belief is present as part of our culture and within recent living memory, the increase in prices is a powerful 'proof point' that this belief is grounded in reality.
Returning to our initial observation, we can easily see that these two factors drive the behaviour in part for those higher up the income distribution, and therefore are able to disproportionately affect the value of housing. Recalling that at most 10% of Auckland dwellings are sold in any given year, and a median price of $352,000, the composite sales price is around NZ$10billion, but that is not all: there is an additional in excess of NZ$1billion chasing an asset class of around 30,000 homes. The figure below shows conceptually the money flow, but to key factor is the additional $1billion chasing the same asset class and quantity: that $10billion market will expand.
The following year, with median housing prices having risen 20%, the same cycle can start again, and the fact that house prices have gone up becomes powerful reinforcing factor in purchaser's decision making process. While it is likely their income will not have increased by 20%, they decide they can spend more because their equity in their current property has now increased and either they want a bigger home, or they want to expand their property portfolio.
As a way of concluding this first article, it is worth asking how could such a chain effect could start. However time is up! The second article will introduce a hypothesis and test it.
(1) Doctoral Candidate in Economics/Economic History, Free University of Berlin.
(2) Professor of Economics, University of Bonn and CEPR Research Fellow
(3) Professor of Economics, Leipzig University
(4) http://www.aucklandcouncil.govt.nz/EN/planspoliciesprojects/reports/Documents/aucklanddwellingshouseholdsinitialresults2013census201405.pdf, page 6, accessed 17 July 2016.
(5) http://www.stats.govt.nz/~/media/Statistics/Browse%20for%20stats/BuildingConsentsIssued/previous-releases/bcidec05alltables.xls, accessed 17 July 2016.
