The facts on housing

As I first outlined in my 2003 report to the Prime Minister’s Home Ownership Task Force (PDF 5.87MB), the most powerful long-term affordability solutions can be found on the supply-side of the market. While this is accepted wisdom today, it was an apparent innovation at the time, and was bizarrely rejected out-of-hand by key technocrats such as the RBA (which media commentators forget has only very, very recently begun to publicly acknowledge Australia’s supply-side problems). For a long-time the RBA was beholden to the idea that the supply-side was largely a non-meaningful participant in the affordability debate. This is perhaps understandable vanity given that its one policymaking tool is interest rates. In 2004 the RBA claimed in its submission to the Productivity Commission inquiry that:

At the macro level there is not much evidence to suggest that the growth in house prices has been due to a persistent shortage of supply of houses relative to underlying demand for new housing.

Prior to the 2003 Prime Minister’s Home Ownership Task Force, virtually all explanations for the increase in the real cost of housing in Australia during the late 1990s and early 2000s had been limited to a demand-side lens: e.g., the secular decline in inflation and interest rates; the expansion in the availability and flexibility of housing finance due the to the rise of non-bank lenders and the new securitisation markets that funded them; the seemingly permanent decline in unemployment below the “NAIRU” combined with the period of sustained economic growth that came to be known as the Great Moderation, and so on.

In fact, I recall doing a media search in 2003 trying to identify public references to “housing supply” while writing up the relevant chapter with the help of Professor Edward Glaeser of Harvard (starts at page 267) and could find almost none. It just did not feature on the policy radar screen with the complaints of the building industry dismissed as those of a rent-seeking interest group. It took a further conference call with the Prime Minister’s chief of staff, Arthur Sinodinos, and his economic advisor, Peter Crone, to explain to them the ramifications of these insights - not only was the cost of housing being heavily influenced by the supply-side, but this was a State not Federal Government matter. They then established the Productivity Commission Inquiry a month after I delivered my final report with terms of reference that concentrated mostly on supply-side considerations.

Today most policymakers are in violent agreement that we need to urgently work to stimulate new private-sector investment in housing production given the burgeoning demand-side requirements. In 2003 we anticipated this consensus with our conclusion that:

There is an ever-growing divergence between the price of Australian properties and their underlying costs of construction. Importantly, this does not appear to be a manifestation of natural constraints on the supply of land, but rather a product of regulatory restrictions that artificially inflate the price of housing. Viewed differently, these limits on dwelling dispersion and the release of greenfield sites act as a burdensome tax on new building, which in turn leads to a mismatch between the accommodation needs of Australian households and the stock of available properties … The overall objective here [must be] to accelerate the approval and land release process so as to promote private sector investment in the production of affordable housing.

If one accepts these aims, surely the worst thing in the world one could then do is to place direct downward pressure on housing demand and the expected returns to those that we are desperately trying to convince to reallocate capital to the production of new supply? All other things being equal, higher interest rates, higher taxes, and reduced subsidies will only further diminish the incentives builders have to invest in new stock. While on the one hand the Rudd Government agrees with the logic - as demonstrated through the $500 million plus they are committing to boost developer returns via the NRAS program - policymakers run the risk of undermining the collective focus on stimulating new supply with distractions such as the raft of tax changes being countenanced by the Henry Review, and the unhelpful and erroneous media claims that the RBA will crush house price inflation (even though the RBA has recently emerged as the most vocal advocate of the need to elastify the supply-side).

While creating significant uncertainty for builders and developers as to the future returns that they can expect from their capital investments, these dynamics are also presumably spooking highly risk-averse lenders that have, to date, been criticised for rationing credit to the sector.

Underpinning all of this is the more fundamental question of whether house price growth is good or bad. The RBA’s Dr Anthony Richards, who is their resident housing expert, recently put the potentially controversial proposition that “when the price of housing rises, higher-income households tend to benefit at the expense of lower-income households” because higher-income households are more likely to own rather than rent. He concluded that, “We are not really any richer when the price of housing rises, but the more vulnerable tend to be hurt”.

The statement that the “more vulnerable tend to be hurt” when the price of established housing increases is thought-provoking. It is not at all clear that renters are affected by house price changes, since they are, definitionally, not owners. Indeed, the relative cost of renting actually falls when prices increase. The only case in which renters are worse off is if they wish to subsequently buy a home.

A problem with housing policy today is the popular fixation with owner-occupation. While there are undeniably significant socio-economic benefits derived from owning a home and creating a “property owning democracy”, there are also nontrivial costs, which are less frequently focused on.

One of these costs is the portfolio diversification risks associated with investing 70-100 per cent of all your net wealth in a highly leveraged asset with very significant idiosyncratic risk. We estimate that the empirical volatility (or risk) of an individual Australian home is around 15-20 per cent per annum depending on the owner’s holding horizon. That’s in line with the risk of the sharemarket and far removed from the popular belief that individual houses are a bullet-proof investment.