Accounting for the house price hockey stick

Every country and every city experiencing rising house prices has its own explanation for what’s going on, often rooted in what seems to be some local or national factor. In England we like to blame the Green Belt, the decline in council house building, poor foreigners (for moving here) and rich foreigners (for investing here).

These locally specific stories often have at least some truth to them, but what they miss is that rapid increases in house prices are a surprisingly pervasive phenomenon. The best analysis of cross-country house price trends is ‘No Price Like Home‘ (free version) by Katherina Knoll, Moritz Schularick and Thomas Steger, the result of a gargantuan research effort to uncover price, construction cost and land value data for 14 affluent countries going as far back as 1870. Their Figure 1 below shows the long-term trend in average prices in each of these countries. In almost every one, price growth took off in the latter half of the 20th century and was particularly rapid in the run-up to the 2007-08 crash. capturecapture

The authors average these trends to create a somewhat cheekily titled ‘Global House Price Index’, shown below (after adjusting for inflation).

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The stability (or even slight decline) of prices in the two decades prior to WWI and the sharp increase between the mid 1990s and 2007-08 are particularly striking when you plot them against GDP, as they do in the next chart. Rising incomes were associated with stagnant real prices in the pre-WWI period, but very rapid price growth in the run-up to the recent crash.

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The growth in prices in the latter part of the last century doesn’t seem to be the result of improvements in housing quality, because quality-adjusted price indices show a similar trend.

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To show this more clearly, Knoll et al disaggregate the change in house prices into (1) changes in the value of the structure and (2) changes in the value of the land. They do so by comparing changes in construction costs to changes in prices, with land values estimated as the residual. In the two charts below, the orange line always represents the real house price trend – the one on the left compares it to the trend in construction costs, and the one on the right to the estimated trend in land prices.

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What the chart on the left tells you is that on average, the cost of constructing housing roughly doubled in real terms between the end of World War I and 2010. That’s pretty significant, but it’s dwarfed by the increase in residential land prices, which roughly quadrupled in real terms over the same period.

So the answer to “why did housing get so expensive?” seems to be “because land did”. Having said that, it’s really important to bear in mind how these figures are calculated. In this kind of analysis, any change in house prices not directly related to a change in construction costs must by definition be attributed to a change in the land price. Even macroeconomic factors such as changes in interest rate, which you might think have a similar impact everywhere, are counted as changes in ‘land’ rather than ‘structure’ prices. The value of housing, just like any other asset, will tend to go up when interest rates go down, but by convention we tend to ascribe all that change to the land rather than the structure. That probably isn’t exactly right, but probably is mostly right.

With that important caveat in mind, the question is: what made land get so expensive? I’ll try to answer it in a future post.