The elasticity of residential housing is a measure of how responsive the supply and demand of housing are to changes in price. It depends on various factors, such as land availability, construction costs, regulations, interest rates, income, preferences, and expectations. The elasticity of residential housing affects the affordability and stability of the housing market, as well as overall economic growth and welfare.
Different Factors
Unlike financial markets, the determinants of movement in property valuations are driven by planning and restricted access to information around planning. This difference in approaches to valuations is another source of elasticity rigidity.
Elasticity of Housing Demand
The elasticity of housing demand is the percentage change in the quantity of housing demanded divided by the percentage change in the price of housing. It reflects how sensitive consumers are to changes in housing prices. The elasticity of housing demand can vary depending on the type, location, and quality of housing, as well as the income and preferences of consumers.
Generally, the elasticity of housing demand is low, meaning that consumers do not change their demand for housing much when the price changes. This is because housing is a basic necessity, a durable good, and a long-term investment. Housing also has few close substitutes, especially for owner-occupiers. Therefore, consumers tend to adjust their demand for other goods and services rather than their demand for housing when the price changes.
However, the elasticity of housing demand can also vary over time and across different segments of the market. For example, the elasticity of housing demand may be higher for renters than for owner-occupiers, as renters have more flexibility and lower transaction costs to move to cheaper or smaller housing. The elasticity of housing demand may also be higher for investors than for owner-occupiers, as investors are more sensitive to changes in expected returns and risks. The elasticity of housing demand may also change with the economic cycle, as consumers may postpone or advance their housing decisions depending on their income, wealth, and expectations.
Elasticity of Housing Supply
The elasticity of housing supply is the percentage change in the quantity of housing supplied divided by the percentage change in the price of housing. It reflects how responsive producers are to changes in housing prices. The elasticity of housing supply can vary depending on the availability and cost of land, labour, materials, and capital, as well as the regulations, taxes, and subsidies that affect the production and development of housing.
Generally, the elasticity of housing supply is low, meaning that producers do not change their supply of housing much when the price changes. This is because housing is a complex and heterogeneous good with a long and uncertain production process. Housing also requires a large and fixed amount of land, which is often scarce and subject to zoning and planning restrictions. Therefore, producers face many barriers and constraints to increasing or decreasing their supply of housing when the price changes.
However, the elasticity of housing supply can also vary over time and across different regions and types of housing. For example, the elasticity of housing supply may be higher in areas with more land availability, lower land prices, and less regulation, as producers can more easily and cheaply expand or contract their production. The elasticity of housing supply may also be higher for multi-unit dwellings than for single-family dwellings, as multi-unit dwellings can accommodate more units per unit of land and have lower construction costs per unit. The elasticity of housing supply may also change with the economic cycle, as producers may adjust their production plans depending on their costs, profits, and expectations.
Implications for Price Adjustment
The elasticity of housing demand and supply determines how the housing market adjusts to changes in market conditions, such as changes in income, population, preferences, expectations, interest rates, and government policies. The degree and speed of price adjustment depend on the relative elasticity of housing demand and supply.
If the elasticity of housing demand is higher than the elasticity of housing supply, then the housing market is supply-constrained, meaning that the supply of housing is less responsive to price changes than the demand for housing. In this case, an increase in demand for housing will lead to a large and persistent increase in housing prices, and a decrease in demand for housing will lead to a small and temporary decrease in housing prices. This is because the supply of housing cannot adjust quickly or sufficiently to match the changes in demand, creating a shortage or a surplus of housing in the market.
If the elasticity of housing supply is higher than the elasticity of housing demand, then the housing market is demand-constrained, meaning that the demand for housing is less responsive to price changes than the supply of housing. In this case, an increase in demand for housing will lead to a small and temporary increase in housing prices, and a decrease in demand for housing will lead to a large and persistent decrease in housing prices. This is because the demand for housing cannot adjust quickly or sufficiently to match the changes in supply, creating a surplus or a shortage of housing in the market.
In reality, the elasticity of housing demand and supply may vary across different segments of the market and may not be constant over time. Therefore, the housing market may experience different degrees and speeds of price adjustment depending on the nature and magnitude of the shocks that affect the market.
Evidence and Examples
There is empirical evidence and examples that support the hypothesis that the elasticity of residential housing affects the price adjustment in the housing market. For instance, a study by Saiz (2010) estimated the elasticity of housing supply for 95 metropolitan areas in the US, using a geographic instrument based on the share of land that is developable.
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The study found that the elasticity of housing supply ranged from 0.12 to 6.48, with a median of 1.04. The study also found that the elasticity of housing supply was negatively correlated with the regulatory and natural barriers to housing development, such as zoning, growth controls, wetlands, and steep slopes. As a result of the study, the elasticity of housing supply significantly affected the standard deviation of the annual growth rate of housing prices. Study findings revealed that a standard deviation increase in housing supply lowered housing price volatility by 0.22 standard deviations.
Another study by Caldera and Johansson (2013) estimated the elasticity of housing supply for 21 OECD countries using a panel data approach that controlled for various economic and institutional factors. The study found that the elasticity of the housing supply ranged from 0.5 to 2.9, with a median of 1.4. The study also found that the elasticity of housing supply was negatively correlated with the stringency of land-use regulations, such as density and height restrictions, environmental and historical preservation rules, and public consultation requirements. The study showed that a one percentage point increase in the elasticity of housing supply reduced the long-run elasticity of housing prices concerning income by 0.4 percentage points.
A recent example of how the elasticity of residential housing affects price adjustment is the impact of the COVID-19 pandemic on the housing market. The pandemic caused a large and sudden shock to the demand and supply of housing, as well as the income, preferences, and expectations of consumers and producers. The pandemic also induced various government interventions in the housing market, such as fiscal stimulus, monetary easing, mortgage forbearance, eviction moratoriums, and social distancing measures. The pandemic affected different segments of the housing market differently, depending on the elasticity of housing demand and supply in each segment.
For example, in the US, the pandemic increased the demand for single-family dwellings, especially in suburban and rural areas, as people sought more space, privacy, and safety. However, the supply of single-family dwellings was relatively inelastic, as it faced land constraints, regulatory barriers, labour shortages, and material costs. As a result, the prices of single-family dwellings rose sharply and persistently, reaching a record high in 2021. In contrast, the pandemic decreased the demand for multi-unit dwellings, especially in urban areas, as people avoided high-density living, public transportation, and shared amenities. However, the supply of multi-unit dwellings was relatively elastic, as it had more land availability, lower construction costs, and higher vacancy rates. As a result, the prices of multi-unit dwellings fell moderately and temporarily, recovering in 2021.
Australia’s Unique Issues
Elasticity is impacted by many factors but in Australia’s case, these are some of the more significant levers:
Australia’s high immigration and constrained new home production capability have contributed to the housing affordability crisis, as demand for housing has outstripped supply. According to the IMF, Australia has the second-highest level of housing market risk among the developed economies, due to high household debt, variable interest rates, and elevated house prices. To address the housing shortage, the government has invested $120 billion in land transport infrastructure over the next few years as part of its Infrastructure Investment Programme. There is an argument that Australia’s capacity to build is not constrained but overwhelmed, as 2019 was our peak year for residential construction and yet we were still significantly behind demand.
The impact of large infrastructure projects on the availability of skilled workers is mixed. On the one hand, infrastructure projects create jobs and stimulate economic activity, especially in regional areas. On the other hand, infrastructure projects compete with the housing construction sector for labour and materials, which may increase costs and delays. Moreover, infrastructure projects may not match the skills and preferences of the existing or potential workforce, especially in the post-pandemic context.
The potential for build-to-rent schemes to impact elasticity and the income of high inflation with real wages that have gone backwards for several years is uncertain. Build-to-rent schemes are a form of rental housing where a property is held in single ownership and professionally managed, offering tenants more flexibility and security. Build-to-rent schemes are relatively new in Australia, and their affordability and accessibility for low- and middle-income earners are questionable, given the lack of government support and incentives. Build-to-rent schemes may increase the supply and diversity of rental housing, but they may also increase rents and reduce home ownership, depending on market conditions and policy settings. Overseas experience has been mixed and the US experience has been one of corporate bias. BTR schemes are usually invested in when the perception is that the asset is at an attractive price. This is not the current situation but may act as a “floor” for price falls in suitable opportunities. Globally, a significant amount of money is sitting in private real estate funds, waiting for global residential real estate to correct. Outside the US, continued government subsidies are required to drive this type of investment approach. The current political environment means this is an appetite the government has.
Elasticity cannot function as it has traditionally because of the use of behavioural psychology by the property sector and its business links with the mass media segment. Regardless of downturns, these tools will continue to be used to support the strength of price elasticity.
What will happen if the economy enters a recession is hard to predict, as it depends on the severity and duration of the downturn, as well as the policy responses and the resilience of households and businesses. However, based on historical evidence and current trends, a recession may have negative effects on the housing market, such as lower demand, lower prices, lower construction, lower investment, and higher defaults and arrears. A recession may also exacerbate the existing inequalities and vulnerabilities in the housing market, such as renter stress, homelessness, and housing insecurity. The process of destruction, though, offers the best opportunity for balance to be re-established in the market.
Conclusion
The elasticity of residential housing is an important concept that explains how the housing market adjusts to changes in market conditions. The elasticity of housing demand and supply depends on various factors, such as land availability, construction costs, regulations, interest rates, income, preferences, and expectations. The elasticity of housing demand and supply determines the degree and speed of price adjustment in the housing market, as well as the affordability and stability of the housing market. There is empirical evidence and examples that support the hypothesis that the elasticity of residential housing affects the price adjustment in the housing market. Therefore, understanding and measuring the elasticity of residential housing is essential for designing and evaluating effective and efficient policies for the housing market. It is also imperative that people have a sense of the timeline that fundamental change, particularly the re-establishment of price discovery, will take as a consequence.
The velocity of financial markets has made us all impatient for change. As a way of providing guidance, the GFC gives you a sense of how long inelastic assets can take to complete their journey.
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