How Housing Markets Work — and Why They're at a Breaking Point

The following article by Strong Towns member Grant Henninger is republished from his blog, On Prosperity's Road, with permission. It's part of an ongoing series on housing affordability. Find the whole series here.

It is no secret that many cities are in the midst of a housing crisis. The San Francisco Bay area is the best example of this housing crisis, but it is not alone. Just about every major city in the United States and Canada has housing prices that are unaffordable for the majority of residents who live there. These prices are driven by having too few homes for the number of workers in a region.

Source: U.S. Census Bureau, Decennial Censuses via  Governing

Source: U.S. Census Bureau, Decennial Censuses via Governing

Housing is a market like any other. Prices are driven by supply and demand. If demand goes up and supply stays the same, prices will rise. That’s exactly what we’ve seen happen over the past four decades as jobs have continued to move to the cities, and existing residents in those cities have opposed the construction of new housing.

The availability of jobs drives people to locate in a certain place. Worldwide, there has been a concentration of jobs in cities over the past century or more. As farming has required less manpower, and finance has found efficiencies in conglomeration, the vast majority of new jobs have been created in major metropolitan areas. Due to the shift in job availability from rural to urban communities, people have migrated as well, following the jobs.

The worst housing shortages are in places with the highest wages for newly created jobs, since those are the jobs in most demand. However, even in a place like San Francisco, wages have not kept up with housing costs. This is for the simple reason that there are not enough houses for the population. As wages increase, so do housing costs. This has the unfortunate effect of pushing out those workers whose wages do not increase as rapidly as housing costs rise. While higher wages may seem like a way to combat the increased cost of living due to higher home prices, they simply fuel ever higher housing costs and actually make the problem worse for most workers.

Unfortunately, cities haven’t built enough new homes to fill the needs of the growing population. For example, San Francisco built 15,853 new housing units from 2010 through the middle of 2016. Over that same amount of time, the population grew by 65,694 people. That means there was only one house built for ever 4.14 people. The average home size across the US is just under 2.7 people per home. To reach that number, San Francisco would have needed to build an additional 8,478 homes, more than a 50% increase over what was actually built.

This period of time, from 2010 until now, has been the hottest housing market in the history of the Bay Area, with the possible exception of the Gold Rush. During a hot housing market, developers should be rushing in to fill unmet demand, because there are handsome profits to be made by building new housing during a housing crisis.

The way developers make money is fairly simple in theory. The developer buys land, pays a contractor to build some homes, and then sells them or rents them out. If the land, construction, and financing costs are less than the sales price of the new homes, then the developer makes money.

Blue = Supply. Yellow = Demand.

Blue = Supply. Yellow = Demand.

Unfortunately, developers view things a bit backwards. They start by determining how much money can be made by selling the homes once they’re built, and work back from there. If they can sell a home for a million dollars, they may figure the construction and financing costs of the home will run a half million dollars and they’ll need a quarter million dollars for their profit. That leaves a quarter million for the land. The amount a developer is willing to pay for land is a residual of the price of the house after all other expenses are paid for.

Of course, the owner of the land might believe there are better uses for the land than a single house, or maybe they think that housing prices will continue to go up so want to wait to sell their land so they can earn more profit off the sale of their land. If that’s the case, they may ask for a higher price than the developer is willing to pay. In a speculative market like many cities are experiencing now, land sits fallow because of this disagreement in land value between the landowners and developers.

One way cities exacerbate this problem is by over-zoning in some areas and under-zoning in others. By over-zoning, cities give landowners a mistaken idea of what is feasible on their land. If the zoning says 100 units can be built on a parcel, the landowner will expect the land value to reflect the possible 100 units. However, if the market won’t bear 100 units, if a developer could only build and sell 70 units on the property, then the developer will only offer to pay 70% of what the landowner wants for their land. If the developer can’t convince the landowner that 100 units isn’t feasible (and landowners often times have very good reasons to not trust the developer), then the land will continue to sit there undeveloped.

The best thing cities can do to solve the ongoing housing crisis is to encourage the construction of more housing. This can be accomplished with three key methods:

  1. Right-size zoning across the city to allow for an incremental increase in intensity across the city.
  2. Reduce unnecessary requirements on new home construction, such as excessive parking and open space requirements.
  3. Remove fees that subsidize existing neighborhoods.

By encouraging the construction of more housing, cities can make themselves more competitive by reducing the cost of living and providing a better quality of life for their residents.

(Top photo by Johnny Sanphillippo)