Searching for the right housing formula

Much of the discussion around Australia’s worsening housing affordability challenges offers a market-based supply response as the ideal solution. But responding to these challenges with new supply, in the absence of pushing just as hard on other policies, is unlikely to materially improve affordability, even in the medium term.

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Dwellings are likely to suffer from diseconomies of scale, whereby the cost of new dwellings rises as the number of new builds increases. As durables that have tended to rise in value, dwellings also attract leverage. Roughly half of Australia’s housing stock has debt against it. These two factors can intersect in powerful ways.

"If existing dwellings are cheaper than new ones, new build commencements will dry up. New supply either won’t be sustained or prices of existing dwellings will rise. Either way, the affordability challenge is unlikely to be meaningfully addressed.”

The speculation that exists in the housing market may help in some areas, such as facilitating pre-sales. But adding supply to a market with a speculative element may unintentionally impose additional costs.

New supply can feed the speculative demand, exacerbating an existing imbalance. Asset-market bubbles often exhibit these characteristics. More new listings can fuel the market by drawing in more investors. It may also concentrate ownership further if existing owners use their equity to leverage into the new supply.

These characteristics imply there may need to be over-investment in housing to eventually get prices down. But building ‘excess’ homes would be costly given the high value of dwellings, particularly when labour and materials are in demand elsewhere. Moreover, the financial stability implications of boosting leverage in the housing sector to ultimately reduce prices could be meaningful.

Pricing pressure suggests both labour and materials are already in short supply, and likely to get shorter. Our tracking of Australia’s major projects pipeline shows it rising from around $40 billion a year between 2019 and 2021, to more than $100 billion in 2025.

As a consequence, boosting housing construction is likely to increase the cost of new builds. The climate transition also implies additional costs as access to land and building standards tighten. 

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Source: Federal, state and territory budgets; Department of Industry, Science, Energy and Resources; Bloomberg New Energy Finance; Deloitte Access Economics; ANZ Research

Germany’s climate goals, for instance, require retrofitting 75 per cent of its 42 million dwellings for energy efficiency. Australia is the only developed nation on the World Wide Fund for Nature’s 24 global deforestation fronts. The Blueprint Institute suggests ending native forest logging in New South Wales five years earlier than currently planned and utilising the land for carbon sequestration and tourism will deliver a financial net benefit. 

Australia’s post war house-building efforts are demonstrative. Between 1945 and 1950 housing construction accounted for 84 per cent of all new building activity and construction employment rose by 75 per cent over a similar period. At present housing construction accounts for only around 58 per cent of building activity and construction employment is 13 per cent higher than its pre-pandemic 2018 peak.

Increasing housing density is often proposed, but experience suggests this is slow and complex. It is unlikely to affect the supply-demand balance in a timely manner, and the climate transition is likely to be an influence here as well. Flood standards, for instance, are prompting new restrictions on land access.

These factors suggest a supply-first housing-affordability strategy is unlikely to result in cheaper dwellings. The cost of new builds is critical to this strategy because the marginal price of new builds must inevitably be linked to the price of existing dwellings.

If existing dwellings are cheaper than new ones (allowing for some consumer preference), new build commencements will dry up. New supply either won’t be sustained or prices of existing dwellings will rise. Either way, the affordability challenge is unlikely to be meaningfully addressed.

Australia has 11 million dwellings for 26 million people. The challenge seems to be more about misallocation than a genuine shortage. In 2018 a record 220,000 new dwellings were built, but that was only 2.1 per cent of the total stock.

At the risk of excessive simplicity, it would seem policy focussed on the existing stock rather than new supply has the potential to be 50 times more effective.

The Productivity Commission suggests between 1988 and 2020 the labour input to a new house fell 11 per cent, meaning building productivity improved. But the increase in average dwelling costs was due entirely to larger average floor area (60 per cent) and higher quality (40 per cent).

Some choices, while individually reasonable, might be turning housing into a luxury for others. 

Rental affordability has now joined mortgage affordability as a pressing economic and social issue. In fact, affordability has worsened across three fronts, according to the latest ANZ CoreLogic Housing Affordability Report: housing values, rental costs and interest rates.

New supply is something of a ‘least harm’ policy choice and is transparent. Redistributional policies by nature involve complex trade-offs. Pragmatic interventions to manage demand and limit the misallocation of housing may well hold more promise than supply alone. 

More Edward Scissorhands and less the invisible hand perhaps.

Richard Yetsenga is Chief Economist at ANZ.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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