The facts on housing

Few issues galvanise public debate as effectively as house prices. It must have something to do with the fact that unlike, say, salaries, houses are both transparent and ubiquitous. No matter where you live, somebody close by always has a bigger and better place. And, for better or worse, that fact is shoved in your face. It may be that much of the emotion and misinformation that accompanies the housing debate can be traced back to comparative justice. For the zealots, the frustrating truth is that the hard facts often do not support the hyperbole that we hear about housing.

To cauterise the “noise” that typically comes hand-in-hand with any discussion about affordability, it is useful to begin by addressing a few facts.

First, investment in both new and existing housing provides us with one of the most profoundly basic human needs: shelter. When you rent a home you are consuming pure “housing services” (put more pointedly, workers need this shelter to survive). If, on the other hand, you choose to buy a home you are making both an “investment” and a “consumption” decision. The fact that you are forced under current arrangements to buy 100 per cent of the equity in a home, and cannot ordinarily share that equity with outsiders, is known as the “all-or-nothing constraint” which I will return to later.

You can limit yourself exclusively to the “investment” activity by renting that house out to another family. Alternatively, you can both own and occupy the asset, and thereby concurrently satisfy your independent consumption and investment motives. It’s your choice. And it is no different to, say, owning a farm that produces the food you need to eat, or leasing it out on commercial terms to a third-party that will sell that produce at market.

Housing assets that provide us with proximate shelter (or “housing services”) are, therefore, similar to agricultural assets that yield food, infrastructure assets, such as toll-roads, railways, or aircraft, that supply us with transportation services for leisure and work, or computers that enhance our productivity and/or pleasure. Yet aside from perhaps farms that deliver food for us to eat, none of these assets is of more fundamental importance to a viable economy than putting a roof over workers’ heads.

So next time you hear the claim that housing is “unproductive” look through the rhetoric and note that this is just a straw-man being used to advance some ulterior agenda. Without housing, you would find it near impossible to work and live.

Second, contrary to popular opinion, there is no compelling evidence that Australia has experienced anomalously high house price growth or that we are currently suffering from a “house price bubble”. This is, however, quite different from saying that the cost of producing new housing could be lower, which, as I note later, certainly appears to be the case.

On the question of house price appreciation, the IMF has recently produced analysis which shows that between 1997 and 2009 real growth in Australian home values has actually been no greater than the median comparable country selected by the IMF in a survey of our peers. That is, we were merely “middle of the road”. In fact, Australia’s house price growth has been middle of the road since as far back as 1980 according to the IMF’s latest data.

The IMF also found that growth in Australian house price-to-income ratios over the period 1997 to 2009 had been less than the same metrics in the UK, Ireland, Spain and NZ. In fact, Australia’s house price-to-income ratio is no greater than it was at the start of this decade. This evidence hardly fits well with claims peddled by some that Australia has the most expensive housing in the world.

Indeed, as both the Reserve Bank and I have repeatedly noted, Australia’s housing market began correcting six years ago. Between December 2003 and December 2008 Australian house prices rose at nearly half the pace of both household disposable incomes and nominal GDP. This resulted in a striking 15 per cent plus contraction in Australia’s house-price-to-income ratio over that period. And it meant that home values in Australia experienced a very gradual adjustment over a multi-year duration in contrast to the precipitous price falls registered elsewhere.

My next observation is that much confusion reigns when people talk about that nebulous notion known as “housing affordability”. What exactly do they mean? Are they referring to home purchase affordability? Or perhaps rental affordability? Or maybe it is whether the cost of producing a new home is high or low? Could it be all of the above? The truth is most folks do not distinguish between these issues. What we can say is that home purchase and rental affordability are determined by a range of factors that have nothing to do with the costs of producing new housing, such as interest rates and household disposable income growth.

If we accept that interest rates are largely the domain of the RBA, and policies surrounding the distribution of income have nothing directly to do with the housing market, the most legitimate question for those interested in the housing market is whether there are any factors that have artificially raised the cost of producing new homes that we can seek to mitigate.

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.

The reason home ownership creates these economic problems is because the housing asset is largely “indivisible”. That is, you cannot live in a home and only own, say, 50 per cent of it while sharing the remaining risks with outside investors. In a perfect world we would “fractionalise” home ownership. That is, policymakers would foster new markets that allow aspirational and existing home owners to draw on both debt and equity finance, as opposed to the current situation whereby owners are restricted to employing 100 per cent debt.

As I noted in my 2003 report, there is a puzzling incongruity between the financing solutions available to companies and households: whereas companies can raise equity finance in order to reduce their exposure to much riskier debt, households are limited to just debt. This gives rise to the stylised fact whereby households tend to take on extraordinary leverage - up to 95 per cent or more - in order to fund the largest investment they will make during their lifetimes: buying a home. It should, therefore, be a policy priority for households to deleverage their balance-sheets by way of external equity. This is an aim that I have championed since 2001. It has attracted growing support with the advent of the global financial crisis from academic economists, such as Edward Glaeser at Harvard, Luis Zingales at Chicago, William Goetzmann, Ian Ayers and Barry Nalebuff at Yale, and the well-known mathematician Nassim Taleb (of “black-swan” fame).

A related concern is the sometimes excessive veneration of home ownership as a social objective. There is no obviously compelling reason as to why policymakers should be seeking to further boost Australia’s already high rate of home ownership given the current economic endowments of households. On the other hand, there would be potentially considerable benefits to improving the perceived “substitutability” of rental accommodation vis-à-vis owner-occupation. This is not about altering economic incentives; it is about shaping community attitudes towards alternative forms of tenure.

The truth is that as a nation we are unaffected when house prices rise or fall from a pure wealth perspective. In this regard, Dr Richards quotes Bajari, Benkard and Krainer (2005) who find that:

To a first-order approximation, there is no aggregate change in welfare due to price increases in the existing housing stock. This follows from a simple market clearing condition where capital gains experienced by sellers are exactly offset by welfare losses to buyers.

There is around $4 trillion worth of private housing held in Australia. At least $1 trillion worth of debt is secured against it. Yet it is arguably the most misunderstood part of the economy. It is time economists and commentators spent less time sprouting vacuous mis-truths about housing and more effort trying to understand what makes it tick.