Give the real estate capitalists some credit!
I recently stumbled upon a very amusing thread by Jason Harrison about market omniscience. Here it is:
Although Jason probably did not intend for this thread to be anything more than just funny, I thought it was pretty thought-provoking. Especially in the context of housing, where we have two very different schools of thought with their own respective armies of chronically online Twitter warriors. One camp believes that a lack of supply is the main reason why housing is expensive in American cities. The other believes that the high cost of housing is not really because housing is in short supply; rather, we observe high prices because of the “financialization” of the housing market and greedy landlords.
And, if by greedy they mean profit-maximizing, I don’t entirely disagree with this second camp. But these folks (a lot of whom might self-identify as leftist or progressive) deploy what researchers have called “supply skepticism.” I’m skeptical about supply skepticism. Why? Because real estate people—developers, landlords, investors, etc.—all care a lot about supply, among other things, and real estate is priced accordingly. So, even if the housing market isn’t an “all-encompassing being that knows the very inner workings of your subconscious” (thanks, Jason), real estate people do set prices. So let’s give them the credit they are due!
So, what exactly do real estate people pay attention to? What can real estate people know? And what does this tell us about the economics of housing supply in American cities?
I should acknowledge here that I am by no means the most qualified person to talk about this. I’ll gladly defer to the researchers who study land use regulation and real estate economics full-time, as well as the investors that place multi-million-dollar bets on the housing market. But I think I have something to say about this, as someone who has worked on housing issues in both the public and private sectors. If there’s any shortage more severe than the housing shortage, it’s the shortage of people who understand housing (even just a little bit) from both of these angles.
So let’s dig in. I think the best place to start is by walking through how developers and investors think about a potential development opportunity. Let’s say a big-time developer with lots of capital is looking at buying a vacant plot of land to build an apartment building. Assume that the land is zoned for apartments, and they’re confident they can deliver the building to market within a certain timeframe. What do they want to know?
(1) How big is the market for this project?
Developers will start with a thesis about who they expect will want to live in this building and why. Developers literally shell out thousands of dollars for consultants to confirm their hunch about where demand for their project will come from and how robust demand really is. Why? Because if they tie up millions of dollars in loaned capital in a project that people won’t live in, it’s going to be challenging to pay back those loans. And banks do their due diligence, so developers want to keep a good track record.
How do developers and their consultants figure out the market for a project? Well, first they will identify where demand is likely to emanate from—this could be the neighborhood the project is in, or some broader geography. Then they will use demographic data to see what kinds of renter households are in this area right now, and what kinds of renter households will be in this area when the project delivers to market. Then they will make an educated guess about what proportion of these households are moving at any given time, and adjust this number based on in-migration and out-migration patterns. They are left with a number of households—stratified by age, income, and apartment size preferences—that will be looking for an apartment when the project is expected to start leasing up.
(2) How much is this segment of the market willing to pay?
Once developers have figured out the market for their project, they must then figure out how much these prospective tenants might be willing to pay to live in their building. To accomplish this, they use complex pricing models that take into account what other properties are charging for rent, and what amenities and unit finishes justify that price. Can they feasibly charge more than these properties because this project will be newer and nicer and shinier? The answer in supply-constrained markets is usually yes.
So, they will come up with a price point based on all these assumptions, and then they will return to their demand analysis. Based on which households will be in the market for an apartment and their incomes and preferences, developers can make a very educated guess about whether this price point will “work” or not. And by that, I mean that the developer can guess whether their building will fill up quickly or not.
(3) Do market fundamentals make this project more or less viable in the long term?
This guess about pricing and demand isn’t good enough without seeing how many units are in the pipeline. Developers know that they are not alone—there are other developers looking at building in this market too! So, developers will track all other development in progress where they expect demand to emanate from, so that they can calculate what portion of the market they can feasibly capture.
In a market with lots of new construction at similar price points, developers will be more cautious. Of course, if present-day fundamentals are super strong for real estate interests (take Phoenix for example, where rents have soared 80% since 2016), then they might not be as concerned.
Now, real estate capitalists’ detractors might point to this concern about the pipeline as evidence that developers will *never* build enough so that rents will stabilize. But these detractors forget that developers still want to build somewhere, and they will favor building in places with more need for new housing. Developers have the information they need to pinpoint these ideal places, but the question is whether regulations allow them to supply what the market wants.
Ok, so that was a long aside about how real estate capitalists think about a prospective development opportunity. But why does all of that matter?
Well, it is clear that real estate capitalists do obviously care about market fundamentals, in that they profit by building where demand outstrips supply. So it follows that advocates should start caring about market fundamentals too. High rents are not simply evidence of greed, they are signals: they tell us that real estate capitalists are confident that enough people will pay this amount given how the housing market is faring. Future expectations about job growth and household formation and in-migration and income growth are most certainly “priced in.”
This is not to say that the right answer is letting real estate capitalists do as they please. But smart public policy can channel development to where it is needed, and ensure that the needs of low-income households are served without making development infeasible. This is only possible if policy people understand how real estate capitalists think. So yeah, give the capitalists some credit.
