Tuesday, February 2, 2016

Housing Part 113 - Fixed Investment vs. Location

Since supply is such a large factor in the shape of our housing markets, we have this strange circumstance where we are building houses in precisely the places where they are the least valuable.  Isn't that a strange economic turn of events?  And, since that is the case, it is kind of odd to me that supply isn't the central topic in all of the public discussions about housing and home prices.

A hunch I have had about this curiosity is that, since the building mostly happens in places with moderate prices, this is inflating private fixed investment.  The space over San Francisco and Manhattan is filled with hundreds of thousands - millions - of extremely valuable little cubes hanging in the air.  For a half million dollars' worth of steel, gypsum board, and concrete, a little million dollar condo is just waiting their for us to claim.  There is a tremendous amount of location value sitting there like gold buried in the ground.  And, frustratingly, it is only there because the density enabled by centuries of wise and prescient planning made it so.

Since we won't unlock that value, we instead build houses in Dallas and Atlanta, where a half million dollars' worth of lumber and gypsum board creates a home worth a little more than half a million dollars.  This isn't to cast aspersions at those Open Access cities.  There isn't location value there because they are doing things right, because they haven't created economic rents through limited access to capital investment.  Right now, most of that location value in Manhattan and San Francisco is due to those rents.  So, the true measure of value we would get from building in those cities would eventually come from pulling their market values back down to their intrinsic, "Open Access" values.  That is probably still somewhat higher than Dallas and Atlanta, but not nearly as high as their current market values.  The main benefits from building in the Closed Access cities would be through the decline in all of the costs related to those cities and the goods and services they produce.

But, back to my hunch.  I think part of the reason that the boom looked especially bubbly was because we measure all that lumber and gypsum board in private fixed investment, but we don't measure intrinsic location value in private fixed investment.  So, the suboptimal pattern of not building in valuable locations, ironically, makes it look like we are investing more.

Well, I finally got around to checking the data on this.  The first graph here is single unit building permits in the Dallas, Atlanta, and Phoenix metro areas, versus San Francisco and New York City.  We can see how building in the Open Access cities out-paced building in the Closed Access cities, in the late 1990s and early 2000s, until the bust temporarily pulled them down.

A more complete analysis regarding the dense city cores would obviously consider multi-unit values, too, but I'm not sure if there is a measure of the market value of new multi-unit structures that I can use for the comparison.  To give an idea of the scale, single unit structures usually account for 2% to 3% of GDP (although it has averaged around 1% since the crisis).  Multi unit private fixed investment in structures used to climb above 1% of GDP during expansions, but hasn't reached 0.4% since the 1980s.  Building in our prosperous cities of an additional 0.5% of GDP would release a large amount of location value.  It would be like investing in a 401k when your employer has a matching program.

The second graph compares private fixed investment in single unit structures to the estimated total value of new single unit homes sold.  In other words, for each $1 of new houses we built, how much lumber and gypsum board did we need to use.  And, we can see that it fits the pattern of my hunch.  Homes in the 1990s and early 2000s required more inputs.  They were composed of less location value and more materials value.  When building in the Open Cities collapsed in the crisis, relative to the Closed Cities, the few homes we were building had more location value, so the proportion temporarily fell.  Even though homebuilding is still highly constrained, it has recovered somewhat in the moderately priced cities, so the proportion has risen again.

Also, here, we can see something that I hadn't fully appreciated before.  Total building in the Closed Access cities has been strong (relative to the depression levels of the rest of the country).  But, that has been almost entirely because of multi-unit building.  This isn't because those cities have suddenly seen the light.  It's just because the constraints created by our hindered mortgage market aren't a constraint for large corporate developers, so their building rates are still determined by the same bureaucratic obstacles they always are.  Urban multi-unit building is still much lower than it needs to be, but it isn't particularly constrained by our self-imposed credit bust.  Despite the high location value, single unit homebuilding in the Closed Access cities remains very low.  I had thought they would be higher.

The last graph here compares the normal measure of private fixed investment in single unit structures, as a proportion of GDP, to a measure of the market value of those structures, including both location value and input values.  They have been set to 100 in 1990 for the sake of comparison.  We can see here the extent to which private fixed investment has been inflated because we have been substituting materials and work for intrinsic location value.  Starting at 100 in 1990, the red line is the relative level of the cost of those inputs. The blue line is the relative level in the market value of the new homes (which includes materials and location value).

Maybe it's a small thing.  There was certainly a healthy amount of building going on in the 2000s, in either case.  But, another brick in the wall, as they say.

PS: I'm not sure I'm happy with the indexed graph above.  Here is the same graph, shown as a % of GDP.  Here, the difference between the blue line and the red line is a broad estimate of location value.

The complication here is that location value is mostly economic rents.  So, the end result of either having the problem (little building in valuable locations) or solving the problem (extensive building in valuable locations) would be to have lower location value.


  1. One might ask whether this phenomenon (substitution of materials/work for location) is simply the result of cost-saving measures by builders taken as location gets more and more expensive, or the result of consumer substitution of size, etc. for location? E.g., if I can't get an apartment in New York, instead I'll build a McMansion somewhere else. If size can be treated as a substitute for location (obviously not a perfect substitute; but even assuming a person is confined to a single metro area, there's still the choice between the downtown apartment and the suburban house), then specifically driving up the price of location could increase demand for bigger houses on bigger lots, which, dare I say, wastes a great deal of land to compensate the homeowner for the cost of not getting to live in New York or San Francisco.

    "Total building in the Closed Access cities has been strong (relative to the depression levels of the rest of the country). But, that has been almost entirely because of multi-unit building. This isn't because those cities have suddenly seen the light. It's just because the constraints created by our hindered mortgage market aren't a constraint for large corporate developers, so their building rates are still determined by the same bureaucratic obstacles they always are."
    This statement piques my interest just because this has long been my belief with a lot of industries: that there are economies of scale when it comes to regulatory compliance (or capture); that overregulation tends to concentrate market share into fewer, larger hands, meaning well-intentioned regulation often actually exacerbates the 'too big to fail' problem.

    1. It seems to me that in contexts that aren't severely constrained, nominal housing demand basically has unitary elasticity. However much housing costs, households will tend to spend about 20-25% of income on rent. This is accommodated with changes in real housing expenditures. So, places with more location value naturally have less real housing. Even in a city without extreme supply issues, like Chicago, housing expenditures for the median household are somewhat stable, but what that buys in Naperville is a lot different than what it buys north of the loop. I suppose it is because housing is such a large budget item and so essential, that income effects dominate.

      I think your second paragraph is right. I think there would still be economies of scale without the bureaucratic issues, but it would be nice if those economies were applied to useful things instead of political obstacles.

  2. I think apartment-condo construction is going on as prices have gotten so high, that it is worth the time of skilled developers to hurdle all the barriers put up by local governments to get something built. That is the case in Los Angeles anyway. On the hand, it is still impossible to build nearly anything in many coastal cities.

    1. Yes. I think you're right. This does seem to be the case, but it takes a lot of incentive to push building levels up in those cities.