Gravity Is Not a Major Determinant Of Housing Prices

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I just saw a rather clever video someone did called, "That Last Dip's a Doozy!" Someone took housing prices 1890 to present and graphed them to a roller coaster ride. Just before the end, he turned the track around so that you could see where you had been and saw how high up you were. The thing was a work of genius; and yet it is still both misleading and wrong, in that a sense of "what goes up, must come down" permeates and becomes the basis for thinking.



In the real world, this is correct. Gravity is a force to be reckoned with. Everything that does go up has to come back down to some sort of supported, stable resting position before it breaks down, runs out of gas, etcetera. Furthermore, roller coasters have to go all the way back to their exact starting point, or used coaster cars are going to start piling up somewhere!



The problem with this thinking is that the graph of housing prices takes place in a mathematical construct world, not on Planet Earth. It's a Cartesian Plane, not a jet plane. Indeed, if you'll remember all the way back to beginning algebra, we can choose any origin and any orientation we like, and the representations are still equally valid. There is absolutely no mathematical reason we can't choose today's prices as our origin. Are there then some sort of magical restorative forces then created that bring us back to our new origin of today's relatively high prices? Not likely! Or we could choose 1000% of today's median price as our origin. Would that cause prices to be inexorably drawn upwards by a factor of ten? Absolutely not. The concept of the origin is a useful one, but don't take it for more than it is. The prices of 1890 were the prices of 1890 because that's where supply and demand were in equilibrium under conditions pertaining at that time. The equilibrium that prices would attain today has precisely nothing to do with those conditions. Do you think we're going back to the days of the federal government selling land at $1.25 per acre under the Homestead Act of 1862? I don't, not even adjusted for inflation or cost of living. Those market conditions no longer apply, therefore there is no rational reason to expect housing prices to return to that state.



Nor are housing prices determined nationwide. We do not have one nationwide housing market. We have a mathematical amalgamation of hundreds of local housing markets. The amalgamation has its virtues and gives us some information, but don't exaggerate their usefulness. Just because some clever person draws us a mathematical picture of a roller coaster that's going to have to fall further than any material known to man can rescue it from and retain structural integrity, does not mean it has any relationship to the amalgamated real estate market in the United States of America, Planet Earth, or any of its component local markets.



This is not to say that housing prices cannot slip further or go down. In fact, we very well may see more of a decline than even areas like my own locality have already seen. But the forces which decide that are purely economic ones (mostly bad loans, at this point). The only role gravity plays in housing prices is in physical structure requirements, a comparatively minor component. There is no requirement to return to the mathematical origin, nor are there restorative forces pushing us in that direction.



The big factors are, as always, supply and demand. When somebody tries to tell you something questionable that has to do with economics, go back to the basics of supply and demand and it is unlikely that you will go wrong.



Supply and Demand. We've done just about everything conceivable to stimulate the demand for housing, and just about everything conceivable to constrict the supply of housing, and people wonder why houses are so expensive?



I'm trying not to be one of their folks with their heads You-Know-Where considering the consequences of people being unable to afford housing, or just barely being able to afford it. I originally wrote The Economics of Housing Development back in 2005, and I've updated it since. But blithely assuming that this whole high housing prices thing is just some kind of bad dream and that it'll all go back to normal soon, is not likely to be correct and is not likely to be of benefit to those folks who are getting priced out of housing. Indeed, basically everyone is likely to get priced out of housing at some point if we keep our collective heads You-Know-Where long enough.



Supply and demand. Let's go over the major factors that make up supply and demand, and see the effects they are likely to have.



Consider demand first. What are the major components of demand? Population, how desirable an area is, and how wealthy the population is. Our population is growing. We just hit 200 million in 1967, and less than 40 years later, we've got another 100 million net. That's a fifty percent gain in a generation. This is a good thing for the most part, but every time we gain a person without a corresponding dwelling being built, we price someone out of the housing market by driving the price beyond what they are willing and able to pay, and the population is growing considerably wealthier in the aggregate. The average house of the 1930s was about 700 square feet. The average house being built today is over 2000. The family of the 1930s might or might not have one automobile, while the average number per family now is over two - and for smaller size average families. Clothes, dishes, appliances, vacation time, average distance from home on vacation, every standard of living has increased, faster in the last twenty-odd years than previously. A time traveler from the 1920s would have recognized more of the lifestyle in the late 1970s than a time traveler from the seventies would recognize now. We can all afford to pay more for a place to live, and most of us are doing so, particularly in the more desirable areas. In fact, those areas seen as desirable or scarce have led the charge up in values. Manhattan Island most of all, but southern California, Florida, southern Arizona, the San Francisco Bay area, the Sun Belt and the coastal areas in general, and of course anywhere especially handy to some popular form of recreation. The population crowds into these places especially and demands housing, as a result of which, the average price of housing in those areas rises faster, while it has more effect on the average citizen simply because an ever larger proportion of the citizenry lives in these places. If going surfing 365 days of the year is the most important thing to someone, they'll do what it takes to live where they can go surfing 365 days a year. If you haven't noticed, a very large proportion of the population seems to want to live within an easy commute of the ocean, and seems to be willing to pay whatever it takes, both in terms of smaller less desirable housing and in terms of spending more to get it. The effect causes prices to increase far more than linearly.



Now let's talk about constrictions on supply.



Sheer room. If every available square foot has already been built on, there isn't any more housing coming without demolishing some other existing building first. There aren't many areas yet where this is a real issue. We've still got lots of open space in this country, but let's consider Manhattan Island, which is completely built over. Every buildable square foot of Manhattan is covered, almost all of it more than one story deep. Prices of Manhattan real estate have been legendary for decades. You think they're coming down to what average everyday folks can afford any time soon? I'll bet you any amount you care to name that's not going to happen. The average folks get pushed out to Brooklyn and the Bronx and Staten Island and the rest of New Jersey. The well off who control or are valued by the cream of the Corporate headquarters, and get paid hundreds of thousands or even millions per year, can afford to pay, will pay, and have been paying for decades. Because those who are financially powerful congregate there, others who are wealthy want to be in the same location. It's worth the extra money to them, and they have it to pay. The demand is not only there, supply is so highly constricted despite everything that can be done that the prices are and will remain sky high by the standards of the rest of the world.



Ability to acquire regulatory approval. If the city, the county, or the state aren't going to allow it to happen, it's not going to happen. Period. It's pointless and expensive to try and force it, and very few people try any more, while every year the hurdles to get permits are higher, tougher, more expensive.



Environmental regulations have taken on a whole new life of their own since 1973. Tests, reports, studies. It can take over a decade to get approvals to build new housing, and if it fails any of the tests, studies reveal any likely issues, or people use environmental issues as a cover for NIMBY or BANANA behavior and sue in court, the whole thing goes down the drain. I happen to agree that we need environmental regulations, but they need to be re-written with more consideration that all economic choices are trade-offs, because the way they are written right now, they form an excellent basis for anyone who wants to stop any development at all to do so legally. Every time we stop a new development, the people who would have lived there need to find some other housing somewhere else. Going along the chain of A prices B out, who then prices C who is lower income than B out of lesser housing, every time we have a new American without building new dwelling space for them, somebody is going to end up homeless, and the price of housing goes up incrementally.



Open space requirements are a big thing in California and around here specifically. Not just open space, either, but maximum building densities. A large part of San Diego county has a maximum building density of 1 building for 40 acres. Well, if you have a maximum building density of 1 building for 40 acres, the only people who can afford to buy that property are those who can afford to buy 40 acres of land. Those who could barely afford a condo - if there were condos there - don't have that option. At some point, if you have too many people competing for too few condos, the price of condos goes up to where those people cannot afford them. And if there's no buildings at all, well it doesn't take a genius to see that nobody can afford to live there, unless it's under a bush or in a tent.



Many building materials have become much more scarce of late, as it's getting harder to obtain them. Lumber, Drywall, etcetera. Every time the materials get more expensive because they're harder to obtain, the price the builders need to charge for the same number of the final product also rises. If they can't make that much, fewer dwellings get built until they can. Nobody is going to build if they know they're going to lose money in advance. If they can make more than that, more dwellings get built.



Last and most importantly, Cost, which most of the others also contribute to. The more it costs to build a dwelling, the fewer that will get built. The cost of the permits isn't just the money the city charges so they can do the inspection. It's the cost of having someone fill out all the paperwork, having someone else make certain that all the requirements are adhered to before that, and of designing the requirements into the construction before that, which not only costs money for the architect, but also for the reduced benefits to the builder. All of this takes time, which means it has what economists call opportunity costs, as well as actual costs. If I can get a better return on the money doing something else, I'm not going to build housing. If I have a hundred acre parcel for dwellings, and the regulations say I have to set aside half of it for other uses besides actual dwellings, then I can only build dwellings for half as many people. If I try to cut the size of the individual dwellings in half, the plans don't get approved, people don't want them, and they don't buy. What this means is that I can only get half as much revenue as I might otherwise get. What the decreased potential revenue means is that projects which would be profitable at full density would lose money at half density - and therefore don't get built.



I've already touched upon Manhattan real estate. Coastal Southern California isn't there yet, but you can see the trend if you watch. In San Diego, there is essentially no more dirt to build on. Open space requirements, minimum lot size requirements, maximum density regulations, and we're hemmed in on about 330 degrees of the circle by four obstructions: Mexico, the Pacific Ocean, Camp Pendleton, and Cleveland National Forest. The I-15 Corridor is one of the few places new development can go, and it's solidly populated all the way to Riverside now - over 100 miles. But people still want to live here, and there are still jobs here, some of them highly paid. We can build higher density housing or we can price people out of ownership and into apartment buildings - and rent is going to get more expensive as well. The highly paid professional doesn't particularly suffer - it's the $15 dollar per hour worker who gets stuck unable to buy, even a condominium, with an ever larger percentage of the paycheck going towards rent.



No matter what market you are in, prices are not going to come crashing back down because that is what will enable you to buy a house. Prices did get over-inflated in a lot of places for reasons I went over in Fear and Greed, or How Did The Housing Bubble Get So Big?. But just because they're higher than they should be now doesn't mean they are going to come crashing back down any further than the place were demand meets supply, and that place is higher than most bubble proponents are willing to admit. The pricing support is there for $350,000 to $400,000 starter homes in San Diego - a family earning two median incomes can afford it. A family earning less than two median incomes can afford it. Furthermore, unless our local housing policy develops a sudden massive attack of rationality, houses are going to start getting less affordable once again as soon as the excess inventory has cleared. Thirty years from now, tiny 1 and 2 bedroom condos will be going for more than that, even adjusted for inflation and standard of living, simply because nobody can build and the demand keeps going up. "Low income housing" and similar things are nice for the beneficiaries, but they are basically a band-aid on a severed carotid artery. The only effective way to fix the problem is to build more housing, period. There are three ways to motivate someone to leave or not to live here: love, money, and force. As long as San Diego has sun and beaches, people are going to love it here. The second way is pricing them out of the market, which is what I'm talking about and what has been happening: People decide that their standard of living would be so much higher elsewhere that they are leaving for economic reasons. The third way is force, and unless you want to see the United States ordering people to move at gunpoint the way Arab countries kicked their Jewish populations out in 1948 (I don't), pricing is by far the preferable way to do it. Pricing people out is ugly, but it's a lot less ugly than the alternatives. Unless we decide to reverse out policies of the last thirty-odd years, we're going to get more of it, and it's going to get ugly. Until we do start building more dwellings, steadily inflating housing prices are here to stay. Especially in the highly popular, highly populated areas where everybody seems to want to live.



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This page contains a single entry by Dan Melson published on May 7, 2007 10:00 AM.

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