Do financialisation and constrained land supply mean house prices have to rise?

If land prices determine house prices, and if land is fixed in supply, then rises in demand for housing feed straight into higher housing costs. That’s the argument of ‘Why can’t you afford a home?‘ by Josh Ryan-Collins, which as both he and Chris Dillow note is in many ways a return to the classical economics of David Ricardo.

What everyone knows about land is that (with a few exceptions like Singapore and the Netherlands) you can’t make any more of it, so Ryan-Collins argues that “If demand for land increases, the price goes up without triggering a supply response. All else being equal, this means any increase in the demand for land will only be reflected in an increase in its price, not its quantity”.

I think it’s more accurate to say that while the total amount of land may be fixed, the amount of developable land is not, and its supply can and does change in response to demand, as long as it’s allowed to. Transport is a key factor here – the revolutionary changes in transport technologies between the mid-19th and mid-20th centuries enabled vast swathes of previously agricultural land to be developed, something which helped hold down housing costs, reduced urban overcrowding and vastly improved housing conditions (a process, incidentally, that was celebrated and encouraged by Charles Booth in his 1901 pamphlet ‘Improved means of locomotion as a first step towards the cure of the housing difficulties of London‘).

But for the time being we have run out of transport revolutions – in fact the average speed of travel in England has been broadly static since the late 1980s, as my chart below from National Travel Survey data shows.

Average travel speed

As a result of this stagnation in transport and some policy-imposed restrictions such as England’s Green Belts, the supply of developable land has become more fixed. But what’s pushing up demand? As Ryan-Collins sees it, the key factor is ‘financialisation’, which broadly speaking means increases in mortgage credit supply due to policy-driven liberalisation and deregulation. He writes: “Banking systems … have become primarily real estate lenders, creating credit and money that flows into an existing and fixed supply of land. This pushes up house prices.”

How much of an impact does financialisation have? Ryan-Collins cites an OECD study which found that over recent decades financial deregulation has increased real house prices by as much as 30% in the average OECD country.

But hang on: the same study also found that the impact of financial deregulation varies widely and “is smaller in countries where housing supply is more responsive”. The below chart (figure 6 from the OECD paper) shows that for a country where housing supply increases more in response to rising demand (to be exact, where the responsiveness of housing supply is less rigid by 0.5 standard deviations) the effect on prices is only around 12%, while at the other end of the scale the impact on prices is nearly 50% for those with less responsive housing supply (the chart also shows that the extent of mortgage tax relief plays a similar role).

Financialisation

There are several countries with even more responsive supply than the ‘less rigid’ benchmark, for whom the effect on prices of financialisation is presumably close to zero. As the OECD paper summarises, “In rigid supply environments, increases in housing demand are much more likely to be capitalised into house prices than to translate into increases in the quantity of housing”. They reinforce this finding by reference to within-country evidence from the US, where “the relaxation of interstate banking regulations had a considerably lesser effect on house prices in counties with more elastic housing supply”.

What’s more, if supply elastically responds to financialised demand to own housing, not only are prices more likely to be stable but rents are likely to decrease as housing supply outstrips the demand to occupy housing. So the point is not just that financialisation of housing demand doesn’t have to mean rising house prices, but that it could even mean lower rents if we just let housing supply respond to housing demand.

This brings us back to land: how can the supply of housing increase in response to rising demand if the supply of developable land is fixed? I think the key thing here is to realise that, much like with labour and capital, the amount you can produce on land depends not just on its quantity but on its productivity, and the productivity of land depends on how densely you can build on it. Put simply, a plot of land with a skyscraper on it is much more productive than an identical plot of land with a single-storey building (though note that it’s not just about height – a building that covers a plot entirely is more productive than one that covers only part of it).

So even if the quantity of the land input is fixed, places can differ markedly in terms of housing output depending on how productively they allow their land to be used. Just as increased labour productivity over the long run has enabled workers to massively increase the supply of goods and services even as average wages have grown, so allowing land to be more productive can increase housing supply – and thus bear down on housing costs – even as land prices rise.

You won’t be surprised to hear that the OECD analysis estimates the UK to have very unresponsive housing supply compared to its peers, and when people talk about why that is they tend to focus on Green Belts and other constraints on land supply. But in my view, density constraints that limit the productivity of land are probably more important in explaining the difference. And the UK’s urban areas are relatively low density, especially compared to the rest of Europe: Along with Ireland, the UK has the smallest share of any European country of its population living in apartments and the largest living in houses (figure 3.1 here); population densities in London are well below those in other large European cities (figure 6.3 and map 6.4 here); and London’s buildings are notably stumpier than those of its peers (see also chart 1.15 here).

Towards the other end of the scale, the OECD finds that housing supply in Japan is highly responsive to rising demand. There’s quite a lot of urban sprawl in Japan, but its urban areas are significantly denser than ours too, which historically was more to do with greater ground coverage than with having significantly taller buildings. In recent decades Tokyo has however densified upwards quite rapidly, as I’ve written about before. As a result, while central Tokyo today has very high land values, its house prices are relatively low compared to London.

Let’s look at some numbers to illustrate. Note, given the lack of methodological detail and the many issues involved in comparing cities from different countries I can’t claim they are a perfect comparison but they’re the best I’ve been able to find. I’ve compared land prices in 2015 with prices for new apartments in 2017 to allow some time for construction (ideally there’d be a bigger gap but 2015 seems to be the earliest data on land values in London). For data availability purposes I’ve focused on Tokyo’s inner 23 wards, an area around twice the size of Inner London with around three times as many people and dwellings. Both land and house prices would be lower if I used the wider definition of Tokyo metropolis.

  • The average residential land price in Tokyo’s 23 wards was ¥519,000/m2 in 2015, which is around £35m per hectare (see the value for ‘all ku‘ from table 13-4 in the Tokyo Statistical Yearbook)
  • The average residential land price in London assuming no contributions for affordable housing or Community Infrastructure Levy was estimated to be £29.1m per hectare in 2015, so in reality would probably be considerably less than that once those contributions are factored in (MHCLG).
  • A 70sqm new build apartment in Tokyo’s 23 wards costed ¥73.7m on average (around £505,000) in 2017), according to Rethink Tokyo, citing Tokyo Kantei and the Real Estate Economic Institute.
  • New build flats in London were around 70sqm on average in 2017 (MHCLG table NB4), but the average price was £679,000 (ONS HPSSA table 13.1e)

In short, whereas land prices in inner Tokyo are considerably higher than in London, house prices are significantly lower. The explanation, I would argue, is that land in Tokyo has long been used more productively to produce more housing than equivalent land in London.

If you’re more persuaded by formal economic models then take a look at David Miles and James Sefton’s paper, which among other things found that the elasticity of substitution between land and capital in housebuilding – that is, the extent to which developers can respond to higher land prices by constructing denser buildings – has a huge impact on the long-term affordability of prices, with greater substitutability improving affordability in the long run. Miles and Sefton consider this elasticity to be largely a function of technology and preferences, but I think it’s clear that housing densities are far lower than technologically feasible because of regulatory restrictions.

It has to be said that we’re talking here about long-term equilibrium relationships, and that property markets often experience very big cycles that depart from equilibrium values – in other words, booms and busts. Financialisation can increase the frequency of size of these cycles, by adding fuel to expectations-driven demand in the boom period and debt retrenchment to the fall in demand during the bust. Where the wider financial sector has become too focused on property these exacerbated market cycles can then destabilise the economy as a whole, as during the 2007-9 financial crisis. There are many things we can do in terms of mortgage regulation and macroprudential policy to stop this kind of thing happening again, and Ryan-Collins’ book is good on identifying and arguing for those reforms.

He’s also right that we need to think about the distributional consequences of rising land values. There’s a very important spatial dimension to this: the greatest increases in housing demand in the last 20 years or so have been focused on the centres of large cities, responding to employment growth in the most urban sectors, to reductions in crime and improvements in other amenities, and to the stagnation in transport speeds mentioned above. As a result, land and house prices have grown the most quickly in big city centres. But whereas the suburbanisation of the mid 20th century tended to equalise wealth by opening up home ownership to a broader swathe of society, the re-urbanisation of the late 20th and early 21st centuries has tended to increase wealth inequality, because the ownership of urban land is relatively concentrated and urban housing markets have a larger share of renters. So there’s a whole other discussion that needs to be had about how the returns to land should be distributed, and again ‘Why can’t you afford a home?’ is well worth reading on this point.

To summarise what has turned into a longer post than I expected:

  • financialisation does increase demand to own housing
  • but if housing supply is elastic then house prices don’t have to rise much and rents can even fall
  • when land supply is relatively fixed, the key to elastic housing supply is allowing land to be used more productively through denser construction.
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