The Economics of Housing Supply


chart by Smallman12q

Housing economists Edward L. Glaeser and Joseph Gyourko have posted The Economic Implications of Housing Supply to SSRN (behind a paywall but you can find a slightly older version of the paper here). The abstract reads,

In this essay, we review the basic economics of housing supply and the functioning of US housing markets to better understand the distribution of home prices, household wealth and the spatial distribution of people across markets. We employ a cost-based approach to gauge whether a housing market is delivering appropriately priced units. Specifically, we investigate whether market prices (roughly) equal the costs of producing the housing unit. If so, the market is well-functioning in the sense that it efficiently delivers housing units at their production cost. Of course, poorer households still may have very high housing cost burdens that society may wish to address via transfers. But if housing prices are above this cost in a given area, then the housing market is not functioning well – and housing is too expensive for all households in the market, not just for poorer ones. The gap between price and production cost can be understood as a regulatory tax, which might be efficiently incorporating the negative externalities of new production, but typical estimates find that the implicit tax is far higher than most reasonable estimates of those externalities.

The paper’s conclusions, while a bit technical for a lay audience, are worth highlighting:

When housing supply is highly regulated in a certain area, housing prices are higher and population growth is smaller relative to the level of demand. While most of America has experienced little growth in housing wealth over the past 30 years, the older, richer buyers in America’s most regulated areas have experienced significant increases in housing equity. The regulation of America’s most productive places seems to have led labor to locate in places where wages and prices are lower, reducing America’s overall economic output in the process.

Advocates of land use restrictions emphasize the negative externalities of building. Certainly, new construction can lead to more crowded schools and roads, and it is costly to create new infrastructure to lower congestion. Hence, the optimal tax on new building is positive, not zero. However, there is as yet no consensus about the overall welfare implications of heightened land use controls. Any model-based assessment inevitably relies on various assumptions about the different aspects of regulation and how they are valued in agents’ utility functions.

Empirical investigations of the local costs and benefits of restricting building generally conclude that the negative externalities are not nearly large enough to justify the costs of regulation. Adding the costs from substitute building in other markets generally strengthens this conclusion, as Glaeser and Kahn (2010) show that America restricts building more in places that have lower carbon emissions per household. If California’s restrictions induce more building in Texas and Arizona, then their net environmental could be negative in aggregate. If restrictions on building limit an efficient geographical reallocation of labor, then estimates based on local externalities would miss this effect, too.

If the welfare and output gains from reducing regulation of housing construction are large, then why don’t we see more policy interventions to permit more building in markets such as San Francisco? The great challenge facing attempts to loosen local housing restrictions is that existing homeowners do not want more affordable homes: they want the value of their asset to cost more, not less. They also may not like the idea that new housing will bring in more people, including those from different socio-economic groups.

There have been some attempts at the state level to soften severe local land use restrictions, but they have not been successful. Massachusetts is particularly instructive because it has used both top-down regulatory reform and incentives to encourage local building. Massachusetts Chapter 40B provides builders with a tool to bypass local rules. If developers are building enough formally-defined affordable units in unaffordable areas, they can bypass local zoning rules. Yet localities still are able to find tools to limit local construction, and the cost of providing price-controlled affordable units lowers the incentive for developers to build. It is difficult to assess the overall impact of 40B, especially since both builder and community often face incentives to avoid building “affordable” units. Standard game theoretic arguments suggest that 40B should never itself be used, but rather work primarily by changing the fallback option of the developer. Massachusetts has also tried to create stronger incentives for local building with Chapters 40R and 40S. These parts of their law allow for transfers to the localities themselves, so builders are not capturing all the benefits. Even so, the Boston market and other high cost areas in the state have not seen meaningful surges in new housing development.

This suggests that more fiscal resources will be needed to convince local residents to bear the costs arising from new development. On purely efficiency grounds, one could argue that the federal government provide sufficient resources, but the political economy of the median taxpayer in the nation effectively transferring resources to much wealthier residents of metropolitan areas like San Francisco seems challenging to say the least. However daunting the task, the potential benefits look to be large enough that economists and policymakers should keep trying to devise a workable policy intervention. (19-20)

Calculating Closing Costs

image by www.lumaxart.com/

Realtor.com quoted me in How Much Are Closing Costs? What Home Buyers and Sellers Can Expect. It reads, in part,

Closing costs are the fees paid to third parties that help facilitate the sale of a home, and they vary widely by location. But as a rule, you can estimate that they typically total 2% to 7% of the home’s purchase price. So on a $250,000 home, your closing costs would amount to anywhere from $5,000 to $17,500. Yep that’s one heck of a wide range. More on that below.

Both buyers and sellers typically pitch in on closing costs, but buyers shoulder the lion’s share of the load (3% to 4% of the home’s price) compared with sellers (1% to 3%). And while some closing costs must be paid before the home is officially sold (e.g., the home inspection fee when the service is rendered), most are paid at the end when you close on the home and the keys exchange hands.

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Why Closing Costs Vary

The reason for the huge disparity in closing costs boils down to the fact that different states and municipalities have different legal requirements—and fees—for the sale of a home.

“If you live in a jurisdiction with high title insurance premiums and property transfer taxes, they can really add up,” says David Reiss, research director at the Center for Urban Business Entrepreneurship at Brooklyn Law School. “New York City, for instance, has something called a mansion tax, which adds a 1% tax to sales that exceed $1 million. And then there are the surprise expenses that can crop up like so-called ‘flip taxes’ that condos charge sellers.”

To estimate your closing costs, plug your numbers into an online closing costs calculator, or ask your Realtor, lender, or mortgage broker for a more accurate estimate. Then, at least three days before closing, the lender is required by federal law to send buyers a closing disclosure that outlines those costs once again. (Meanwhile sellers should receive similar documents from their Realtor outlining their own costs.)

Word to the wise: “Before you close, make sure to review these documents to see if the numbers line up to what you were originally quoted,” says Ameer. Errors can and do creep in, and since you’re already ponying up so much cash, it pays, literally, to eyeball those numbers one last time before the big day.

Valuing Rental Property

cincy Project

Money quoted me in Here’s How Much You Should Pay for a Rental PropertyIt opens,

Q: I want to invest in a rental property. Is there a formula I can use to determine the value of a building based on the rent it takes in?

A: One useful calculation to use is the capitalization (or “cap”) rate, which is the ratio of net rental income to the purchase price of the property, says Brooklyn Law School professor David Reiss.

Start with your gross rental income, which is simply the total of one year’s worth of rents for all of the units combined. Subtract 5% or so to account for occasional vacancies throughout the year. It’s safest to use existing rents, but you can conservatively increase the amounts if you are planning to improve the units and raise rents.

Then add up the yearly operating expenses — property taxes, insurance, utilities, plus at least 5% of gross income for a maintenance/repair fund — and subtract that from the annual income. To get your cap rate, divide that number (the net operating income) by the purchase rate.

Run the Numbers

Let’s say you’re buying a five-family house and anticipate gross annual income of $100,000. If you calculate your total annual operating expenses at $30,000, you end up with $70,000 in net operating income. For a property that cost, let’s say, $1 million, that equates to a 7% cap rate.

But is 7% a worthwhile return on your investment for the work and risk of being a property owner and a landlord?

“That depends on the building,” says Reiss. “For a brand new, fully rented, high-quality building in a prime neighborhood, a reliable, low-risk 4% to 10% return might be reasonable.

“But if you’re talking about a rundown building, in an borderline neighborhood, with a several vacant units that you’re planning to fill after you undertake major improvements, you might reasonably hold out for a 20% cap rate,” he explains, because you’ll have renovation costs on the expense side, perhaps a higher vacancy rate while you fix it up — and you’re taking a bigger risk with your money.

Using a Mortgage

Also, the cap rate assumes a cash purchase. When you take a mortgage to buy an investment property, lenders will likely demand a down payment of 25% or more, says Reiss.

So in that case, he suggests also calculating your return on upfront costs.

In our example, if you invest $300,000 in upfront costs (down payment plus other initial expenses like closing costs and renovations) and expect to earn $20,000 a year (after $50,000 annual mortgage payments), that’s just under a 7% annual return on your money.

Again, you need to consider the relative risk of the particular investment property to determine whether that payback rate is high enough. Look at several properties to get a better feel for how the risks and rewards compare.

Wednesday’s Academic Roundup

Reiss on the $1M Parking Spot

Law360 quoted me in NYC’s $1M Parking Spot Shows Appetite For Luxury (behind a paywall).It opens,

Atlas Capital Group LLC caused a buzz Wednesday with its listing of a parking space in a condominium building in SoHo for $1 million, more per square foot than the homes above it, but experts say in the context of a burgeoning luxury market such a price may just be the beginning.

That price for a 99-year license that allows the condominium resident to use the parking space — even one in its own condominium unit and tax lot — may sound wild, but experts say much of the attention this property has gotten may be a bit overblown, especially considering the level to which many are willing to go for comfort and convenience in New York City.

“It’s not really about $1 million for a parking space,” said Bruce Bronster of Windels Marx Lane & Mittendorf LLP. “If you were just going to condo a parking space, you couldn’t get $1 million for it. It has to do with having an amenity on a very expensive apartment.”

There aren’t many places to park in SoHo, making a convenient parking spot a hot commodity, but experts say the bigger message is that New York City’s luxury residential market is hotter than ever, creating new opportunities for developers to differentiate themselves with the right amenities.

The development is at 42 Crosby Street, near Broome Street, where Atlas Capital Group is turning what used to be a parking lot itself into a condominium building with three-bedroom units ranging from $8.7 million to $10.45 million, according to information gathered by The New York Times.

The eye-popping element comes when one looks at the price per square foot. Some of the parking spots — there are actually 10 being built under the condominiums — are expected to be up to 200 square feet, but they will reportedly all cost between $5,000 and $6,666 per square foot. The condominiums, on the other hand, are only going for about $3,150 per square foot.

But experts say this isn’t too surprising, considering the demand for luxury housing and amenities that has skyrocketed in recent years.

Prices for luxury residential properties have risen to pre-recession levels and surpassed them in some cases, with a few record-breaking penthouse deals passing the $90 million mark thanks to flush foreign investors.

More than anything, experts say, the $1 million parking spots are a way for Atlas Capital Group to distinguish 42 Crosby from other apartment buildings and draw in those investors willing to pay top dollar.

“The million-dollar spots do highlight how developers have seriously monetized amenity spaces,” said David Reiss, a real estate professor at Brooklyn Law School. “In all likelihood, the prices for amenities like parking spaces will follow the same trend line as those for the apartments to which they are attached.”

And it’s not just parking spaces; Reiss said he has seen similar setups with amenities such as storage facilities and rooftop cabanas commanding top dollar.

Reiss on Rising Interest Rates

ABC News quoted me in Small Interest Rate Changes Mean Big Money for Home Buyers.  The story reads in part,

As the economy continues to recover from the worst recession since the 1930s, mortgage interest rates remain at historically low levels.

The Primary Mortgage Market Survey, produced by Freddie Mac, reported in mid-March the average rate for 30-year fixed-rate mortgages was 4.32 percent; 15-year fixed-rate mortgages averaged 3.32 percent and interest rates 5-year Treasury-indexed hybrid adjustable rate mortgages averaged 3.02 percent. Nonetheless, Frank Nothaft, chief economist for Freddie Mac, speculated the Fed’s gradual tapering of its stimulus efforts may prompt a rise in mortgage interest rates.

If mortgage interest rates do rise significantly in the future, what, if any effect will there be on the home buying market? According to Steve Calk, chairman and Chief Executive Officer of The Federal Savings Bank, interest rates have never been the deciding factor for whether potential home buyers actually purchase a home.

“Whether interest rates are 5.5 percent or 7.5 percent, when people are ready to buy, they’ll buy a home,” Calk said.

Price, location, size, appreciation value – these are factors many would-be homeowners consider long before mortgage interest rates enter into the picture. However, once they begin actively searching for a home, interest rates often play a role in their ultimate buying decision.

This is especially the case when interest rates are high, according to David Reiss, Professor of Law at Brooklyn Law School.

“When people think about buying houses, they think about the price of the house. But what they really should be thinking of are the monthly costs. The average 25-year-old might not think about housing rates until they go to a mortgage broker.
“Then they discover that 8 percent interest may mean that instead of a $200,000 home they can only afford a $160,000 home,” Reiss said.

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Tight credit and persistent high unemployment have almost certainly played a role in depressing home buying figures during the recovery, as has the large numbers of home owners who perhaps bought homes at the height of the bubble who now find themselves underwater on their mortgages. However, many underwater homeowners could be missing out on a unique opportunity presented by the present financial climate. In a housing market where prices are depressed and borrowing is cheap, home buyers with solid incomes and good credit can find lenders willing to extend credit on favorable terms, ultimately putting them ahead financially, even if they sell their present homes at a loss, according to Reiss.

“Many people feel stuck in place because they are underwater or the market is bad. But although it may be counterintuitive, it could actually be a smart move to sell in a bad market. It’s a bit more sophisticated strategy, but you could move out of a cheap home into a better home for not that much money,” Reiss said.

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Education and due diligence in maintaining good credit are the most potent tools that potential home buyers can employ, whether they are seeking their first home, a larger home or are scaling down to smaller quarters as empty nesters. Obtaining prequalification can provide home seekers with a better idea of precisely how much house they can afford, Reiss said.

3 Housing Riddles For De Blasio

I wrote an op ed for Law360,com that was posted today. While it is behind a paywall on Law360, it reads in full as follows:

3 Housing Riddles For De Blasio

As Mayor-Elect Bill de Blasio is making the transition from campaigning to governing New York City, it is worth contemplating some of the fundamental riddles that perplex those who spend their time thinking about the city’s housing policy. I address three of the most perplexing below.

The Riddle of Mandatory But Not Sufficient

The housing policy centerpiece of the de Blasio campaign is to require developers to build some affordable housing units when they build on lots that have been upzoned, a policy known as mandatory inclusionary zoning. The campaign website states that this policy will create 50,000 new units of housing.

Let’s put aside the fact that this number appears to be very aggressive given the lack of significant upzonings on the horizon (see second riddle below). Just because the city mandates that affordable housing be part of any new construction, it cannot mandate that developers build any housing at all if the deal does not make economic sense for them.

The de Blasio administration will need to carefully calibrate the mandatory inclusionary zoning rules to ensure that builders are sufficiently incentivized to build in the first place. This may limit the amount of affordable housing that can be mandated as part of that new construction.

One key aspect of this policy is whether the mandatory affordable housing will be required to be on-site or if the developer can build it off-site. If it is the former, it will help achieve the progressive goal of increasing socio-economic diversity in a city that is rapidly losing it.

But each unit of on-site housing would likely be more expensive to construct than off-site affordable units. And the opposite is true if the mandatory affordable units are allowed to be off-site; they will be likely cheaper to construct and thus more housing could be built. But it would not work toward increasing socio-economic diversity in the city.

And thus, the riddle of mandatory but not sufficient poses two challenges to the administration. Can it incentivize the creation of a meaningful number of units? And should it favor socio-economic diversity or the maximum production of affordable units? No easy answers here.

The Riddle of Now Versus Later

Can you increase the supply of housing to address the needs of a growing population while also downzoning large swaths of the city to respond to the preferences of the city’s current residents?

The Michael Bloomberg administration wanted to have this both ways, but that can’t work. The Bloomberg administration had planned on an increase in population of roughly another million people by 2030 while at the same time downzoning a large swath of the city (and, to be fair, upzoning some other portions).

This downzoning made current residents happy as it kept big, modern, out-of-context buildings from popping up near their homes. But it also limited the opportunities for increasing the housing stock, particularly near transit hubs. This is the basis of the second riddle — what is seen as bad by current residents may be good for future residents.

It is a fundamental economic truth that if more and more people are flocking to New York City, housing costs will rise unless supply increases. But for city residents, there is a paradox. New Yorkers see gleaming towers rise in their neighborhoods along with the rents for their nearby apartments. There are two explanations for this paradox.

First, the supply of new housing may be increasing without keeping pace with rising demand. Historically, New York City has not had many new units of housing built each year, maybe 20,000 units or so in a good year. This modest increase in supply has been overwhelmed by the increase in population of a million people in the last 20 or so years. This disparity goes a long way to explain the high rents and the miniscule vacancy rates that are seen throughout the city.

Second, new housing in one community (Williamsburg, for example) may be causing or be part of a wave of local gentrification in the existing housing stock. So, even if the new housing is having a tendency to decrease housing costs in the city overall because it increases the supply, it can also be pushing rents higher in the communities in which it is situated.

Increasing the supply of housing has to be a key component of providing “safe affordable homes for all New Yorkers,” as de Blasio calls for on his campaign website. This has to mean zoning significantly more land for high-rise residential construction as well as incentivizing the construction of affordable housing units in that new construction.

At the same time, de Blasio must attend to the concerns of those negatively impacted by the new construction. Hence, the riddle of now versus later.

The Riddle of the Few Versus the Many

The de Blasio campaign website calls for “tighter standards that ensure subsidies meet the needs of lower-income families and are distributed equitably throughout the five boroughs.” Distributing affordable housing subsidies equitably throughout the city is important, but there is another equity issue — should the city heavily subsidize affordable housing for a small portion of those who are eligible or should it distribute resources more broadly and thinly among everyone who is eligible?

Fewer than 8 percent of low- and middle-income households receive a direct or indirect subsidy for an apartment (excluding public housing) while more than 20 percent live below the poverty line of $23,283 annually for a family of four.

Should the city’s limited resources be used to create a relatively small number of new affordable units or should some of them be used in ways that benefit a broader swath of low- and moderate-income New Yorkers, albeit more modestly?

Certain policies can address the needs of many, many more low- and moderate-income households than does heavily subsidized new construction that houses perhaps a few thousand low- and moderate-income households each year.

Examples of such policies include tax credits for low- and moderate-income households that put money in their pockets and increased enforcement directed against landlords who try to illegally drive their tenants out of rent-regulated units. On the other hand, without an affordable apartment, staying in NYC can just be untenable no matter what additional benefits the government may be able to provide through more broadly available programs.

Thus, the third riddle is — do you give a lot of help to a few or do you give a little help to the many? It’s like choosing between the rock and the hard place for policymakers and New Yorkers alike.

Mayor-Elect de Blasio and his team will have to struggle with these riddles, and more. The only thing that is clear is that there are no right answers and no easy answers when it comes to housing policy in New York City.

—By David Reiss, Brooklyn Law School

David Reiss is a professor of law at Brooklyn Law School. He concentrates on real estate finance and community development and writes about housing policy.