RDP 2020-04: The Apartment Shortage 2. Relationship to Other Research

Numerous studies have attributed the high cost of Australian housing to land use restrictions. These include: OECD (2010); Kulish, Richards and Gillitzer (2011); Productivity Commission (2011, 2017); Housing Supply and Affordability Reform Working Party (2012); RBA (2014); Senate Economics References Committee (2015); CEDA (2017); Stevens (2017); and Daley, Coates and Wiltshire (2018) among others. These papers' views on land use restrictions seem to be strongly influenced by anecdotal evidence like that mentioned in the previous section.

Clearly then, our paper cannot make any claim to originality for our main finding – planning restrictions cause large increases in apartment prices. Rather, our contribution is to quantify this effect, assess how it varies, and discuss some of the implications that follow.

Our method of measurement follows the widely cited approach of Glaeser et al (2005) for apartments in Manhattan. Similar studies include Lees (2019) for apartments in Auckland, Wälty (2020) for condominiums in Zurich and Geneva, and Cheshire and Hilber (2008) for commercial property in Britain and Europe. Like us, these papers find that planning restrictions have large effects on prices. Our paper differs by looking at Australian cities. Specifically, we examine Sydney, Melbourne and Brisbane, which account for 72 per cent of all apartments in Australia (according to the 2016 Census).^[1]

2.1 Objections

Although reports like those cited above repeatedly argue that planning restrictions have large effects on the cost of housing, this idea is controversial in public discussions. Some objections are worth addressing.

It is sometimes argued that there is not a significant shortage of apartments because supply is growing quickly. Phillips and Joseph (2017) and Murray (2020) subtract changes in household formation from high levels of new construction and conclude there is an ‘oversupply’ of dwellings. This approach was earlier popularised by the National Housing Supply Council (2014), though with different results. Rowley, Gurran and Phibbs (2017) point to similar data and conclude that ‘Australia is almost a world leader in rates of new housing production’ and that ‘supply seems pretty healthy’. Pawson, Milligan and Yates (2020, Section 9.6) emphasise findings like these in explaining their scepticism of the importance of planning restrictions. However, it is important to distinguish levels from changes. Rapid growth in supply, relative to changes in population or the number of households, implies the shortage is decreasing – it does not imply that the supply is adequate or that housing is affordable. Similarly, whether prices and rents are rising or falling does not indicate whether they are excessive. That can be judged by whether price is close to marginal cost. Looking forward, population growth is forecast to temporarily fall following the COVID-19 pandemic, reducing the demand for housing.^[2] This would reduce the shortage, as we define it, but would not necessarily create an oversupply. We discuss definitions further in the following section.

A very similar argument is that housing shortages can instead be identified by market frictions, such as the rental vacancy rate, auction clearance rate or time on market. These measures are informative for some purposes. However, in contrast to the difference between price and marginal cost, they do not provide guidance on whether we need more housing.

A second objection is that high housing prices reflect high demand rather than limited supply. Factors boosting demand include interest rates, taxes, financialisation and immigration at a national level (Mulheirn 2017; Pawson et al 2020, Sections 3.4.1 and 9.6) and nearby amenities at a local level. High and rising demand is undoubtedly important but it does not mean that supply restrictions are unimportant. On the contrary, high demand only results in very high prices when supply is inelastic. For example, apartments in the inner suburbs of Sydney attract a ‘location premium’. As we show in Section 5.1, this premium has been sustained because relatively few apartments have been built in inner Sydney recently. In contrast, central Melbourne and Brisbane, where building has been strong, do not exhibit a premium.

A third objection is that the correlation between prices and the severity of building restrictions is weak, or even positive (Michael Buxton, as quoted in Ross (2019)). For example, the most expensive housing is often found near the city centre, where the highest density is permitted. However, market-level effects cannot be inferred from neighbourhood-level variations. Housing in nearby locations is highly substitutable, so restrictions in one location increase demand and prices elsewhere. Planning regulations increase the average price by restricting total supply. To see this, suppose odd-numbered addresses were limited to four storeys and even-numbered addresses to eight storeys. Apartments in adjacent buildings would still sell for approximately the same price, despite the variation in restrictions. This argument has important implications for research design: spillovers in demand mean that the effect of local restrictions cannot be inferred just from variations in local prices. Researchers often complain about the difficulty in quantifying and standardising local planning regulations, but it is not clear how disaggregated measures could be used to gauge market-level effects on prices.

A positive correlation can also be seen in time series data: the effects of building restrictions are estimated to have increased over time despite denser development being permitted. As with cross-section comparisons, the perverse correlation arises because the restrictions are partially responsive to market needs. However, the wedge between cost and price we find shows restrictions do not fully accommodate changes in demand, so they become more binding as demand rises over time.

A fourth objection is that binding supply constraints are inconsistent with the pronounced sensitivity of high-density building approvals to interest rates, sale prices and other demand conditions (Sneesby 2020). For evidence of this sensitivity, see Saunders and Tulip (2019, Figure 4). The problem with this argument is that it ignores that land prices, and hence developer's equity, depend on supply constraints in the short run. As discussed in the next section, construction is a highly competitive industry. So land prices are bid up to levels at which developments become marginal. This is often when collateral constraints start to bind. At this point, any downward revision to demand prospects can make a project unviable in the short run; for example, by reducing developer's equity. In time, lower sale prices would flow through, almost one-for-one, to lower land prices. The original developer would suffer a capital loss and be unable to proceed, at least for a while, but other developers would find the project viable. Until that process is complete, the availability of finance and construction activity will be highly responsive to demand. So planning restrictions bind in the medium run while financing (in turn, a function of planning) binds in the short run.

Footnotes

Throughout the paper we use city names as abbreviations for Greater Capital City Statistical Areas (GCCSA). The next largest concentration of apartments is Perth with 4 per cent of the national total. [1]

CoreLogic's unit price index has ceased growing following the pandemic, with little change from March to June. [2]