High costs make it hard to build more housing, not counter-productive
What's wrong with the skeptical argument that building more housing makes unaffordability worse.
The market-clearing price matches homes with buyers
Prices reflect scarcity. In the case of home prices, the market-clearing price matches homes available for sale with people trying to buy.
Say there's 1000 homes for sale in a specific location, and let’s assume they're roughly equivalent. If you're trying to buy, you're competing with the 1000 highest-income people that are trying to buy a home in that location right now. The market-clearing price is how much the 1000th buyer can pay. (The first buyer just has to pay the same as what the 1000th buyer can pay, so that they get one of the 1000 homes, even though they could pay a lot more than that if they had to.)
If there’s fewer homes available for sale - say half as many - you’re now competing with the 500 highest-income people trying to buy a place, and the market-clearing price is what the 500th buyer can pay, which is higher than what the 1000th buyer can pay. The reverse is true if there’s 2000 homes for sale instead of 1000: the 2000th buyer can’t pay as much, so the market-clearing price is lower.
Thus prices reflect scarcity: when there’s not enough to go around, only the people who are willing and able to pay the most (typically those with the most money) can afford to buy. When there’s plenty to go around, you get lower prices. Comparison between Atlanta and San Francisco.
Home prices in Vancouver are insanely high because we have a huge shortage of housing - since the 1970s, it’s been difficult to get permission to build housing. We need to build more. CMHC estimates that for BC, in order to get back to 2003-2004 levels of affordability, we would need to increase our housing stock from 2.2 million homes in 2021 to 3.2 million by 2030; the current business-as-usual projection is for 2.6 million.
To be a bit more precise, what buyers really want and are willing to pay for is usable interior space ("floor space"). So what you get is a market-clearing price per square foot of floor space. (When Covid hit and a lot more people were working from home, suddenly people needed more space, and they were willing to pay for it with a combination of pandemic savings and low interest rates. In Ontario, the result is that home prices exploded upward by 40% in a single year.) The CMHC estimate takes income growth into account: a higher-income household will want more space.
A skeptical argument: higher costs make it counter-productive to build more housing
Stephen Punwasi of Better Dwelling, writing in April 2021, argues that building more housing actually raises home prices! Home Prices Are Rising As More Supply Is Built. That’s How It Works.
... an increase in new home construction should always increase prices. During a building boom, more building should speed up price growth. That's because the laws of supply and demand apply to all parts of a house - not just the final product.
… Altus Group estimates construction costs in [the GTA] will rise by 5 percent in 2021. That’s double the target rate of inflation. They attribute a good portion of the increase due to a shortage of construction labor in the region. Since a developer isn’t a charity, they need to pass these costs to consumers.
The basic fallacy here is that correlation is not causation. When housing is scarce, you get high prices and you get a lot of building. They have the same cause: not enough housing.
What’s wrong with the specifics of his argument?
Stephen is assuming that builders set their selling prices based on their land and construction costs, plus profit. That’s wrong. In most markets, suppliers are price takers: what they get is the market price. If you’re a builder with unusually high costs and you try to charge a higher price (say 1.5X the market-clearing price), what happens is that you get stuck with unsold homes. (If there’s 1000 homes for sale, there’s only 1000 buyers who are willing and able to pay the market-clearing price. There’s fewer who will pay a higher price.)
Another way to see what’s wrong: flip the scenario around. Suppose construction costs fell by half overnight. Why would we expect that builders would lower their prices? As Stephen says, they’re not a charity. They’ll charge what buyers are willing to pay, i.e. the market-clearing price.
What actually happens: less building, lower land prices
Because builders can’t change the expected selling price of the final product, when they’re faced with rising costs, they have to figure out if they can make a profit or not. If not, they won’t go ahead with the project. 10,000 out of 36,000 condos in the GTA are being put on hold.
For projects which haven’t started yet, rising construction costs cut into how much a project is willing to pay for land. The basic calculation looks like this:
land price = selling price of final product minus construction costs and profit
A landowner doesn't want to sell to a developer unless they get a significant premium, say 30%, over the value of the current use of the land. So as costs go up, what happens is that land prices go down, fewer landowners are willing to sell, and you get less building happening.
In other words, rising costs make it harder to build more housing. They don’t make it counter-productive to build more housing.
When labour and materials are in short supply, it’s more important than ever to make sure that we’re building housing where it’s most in demand.
Residual method of appraisal - how land prices are determined
Altus Canadian Cost Guide. Using 2021 data, the “hard” construction cost for a row townhouse in Vancouver is $135 to $210 per square foot. For a six-storey wood-framed apartment building, it’s $215 to $300. For a 12-storey concrete building, it’s $235 to $350. [A couple notes. Financing and “soft” costs, like design and engineering costs, add another 40-50%. About 20% of the gross square footage isn’t sellable, e.g. space for elevators. Since 2021, hard costs have gone up by about $100 per square foot.]