It is clear from the discussion in previous posts (How Property Prices and Rents are Determined) that both real estate demand and supply have to behave in a particular way in order to generate increases in property values. In particular, a strong increase in real estate demand will produce strong rent and property value increases only if:
- the market is not oversupplied at the time a strong demand increase occurs, and
- supply remains stagnant, or grows at a very slow rate after the increase in demand takes place
The aggregate supply of a particular property type at any given point in time comprises all existing buildings of the type considered that are used or are available for use. For example, the aggregate supply of housing includes all buildings that are used or are available for use as residences. The total aggregate supply for a given property type is often referred to as total stock or total inventory.
In terms of market activity, an important concept is available supply. Available supply refers to the number of units or amount of space available for rent or purchase to firms and households looking for space or houses. For example, the available supply of rental housing includes all vacant housing units offered by their owners for leasing. In the owner-occupied housing market, available supply includes all new houses and existing houses up for sale. In substance, the amount of space or units represented by the available supply is the amount that interacts with increases in demand, jointly determining changes in market rents and prices. Within this context, available supply is an extremely important notion from the perspective of property value increases.
From a value-growth perspective, the important question is how an area’s available supply can grow, and what factors may restrain such growth. A market’s available supply of rental space in a specific use can grow through the addition of the following components:
- newly completed buildings offered for leasing (new construction)
- previously occupied space that becomes vacant and re-enters the market
- buildings converted to the use under consideration and offered for leasing
- rehabilitated buildings that were out of the market due to dysfunctionality
The construction of a new building is an investment, and as such, is driven by profitability factors. Profitability is determined by costs and expected revenues. Because of the long time that intervenes between project conception and project completion, expectations play a crucial role in investment decisions regarding new construction. Within this context, new construction activity depends on:
- Expected demand, property sales prices, and rents
- Construction costs, which include cost of materials and labor
- Land costs
- The cost of borrowed funds (interest rates)
- Profitability of investments in alternative investment vehicles
When the market vacancy rate is low and new construction activity is restrained, strong demand increases will result in greater property rent and value gains. For this reason, it is very important to understand how the aforementioned factors contribute to the reduction of development and new construction activity in a real estate market. The following changes in these factors are likely to result in reduced levels of new construction (assuming all other factors that affect new construction remain constant):
- Worsening of expectations regarding future demand, rents, and property rents/prices will result in less optimistic revenue projections and lower profitability estimates, which will induce developers and investors to supply a lower amount of new space in the market.
- Land and development cost increases will increase project costs and, for a given level of expected property revenues, will reduce profitability, thereby discouraging some developers and investors from proceeding with planned projects. Therefore, new construction activity should decrease as a result of such developments. Rosen and Smith (1986) detected a strong statistical relationship between increases in construction costs and decreases in housing additions and alteration expenditures.
- Interest rate hikes will increase the cost of borrowed funds and make several large projects infeasible or too risky to finance with borrowed funds. Therefore, such events should result in a deceleration of new construction activity.
- Reduction in the relative profitability of real estate investments will induce large financial institutions to reduce the percentage of their investment portfolios in real estate. This will result in a decrease in the flow of equity capital in real estate development projects, which in turn should contribute to a decline in new construction activity.
Beyond the aforementioned influences, the response of the supply of real estate to unpredicted demand increases will depend on the length of the development process and local growth controls, which may limit the amount of new space that can be built within a jurisdiction. The development process can be divided into four stages:
- Idea conception, planning, design, and feasibility assessment
- Application for and approval of building permit
- Start of construction
Notice that the length of the development process will increase, and supply growth will be slower (all else being equal), if there are difficulties in obtaining building permits. Such difficulties may be due to lengthy regulatory processes and growth restrictions imposed by local governments in an effort to limit growth within the boundaries of their jurisdiction. The length of the design and construction phases is usually greater in large, complex projects. The length of the construction stage may also increase due to bad weather and delays in the delivery of construction materials (Charles, 1977). Charles presents evidence indicating that construction time increases during periods of economic decline and shortens during periods of economic growth. This supports my argument that the best time for investment is when the market comes out of a recession because at that point supply grows at the slowest rate while demand grows at the fastest rate.
When assessing an area’s supply prospects, it is important to have in mind that not all projects in the planning stage move to the permit stage, and not all projects for which a building permit application is filed get a permit. Furthermore, some projects that do get a building permit may not reach the next stage—the start of construction. Finally, although most of the projects that break ground are completed, there may be a small number of projects that do not get completed. In any case, building permits should provide a good approximation of the new supply entering the market a year or two ahead.
A study carried out by the US Census Bureau over the period 1999-2004, regarding the housing market, verifies the close relationship between levels of permits and completions. This relationship is especially strong in the case of single-family houses, which constitute the overwhelming majority of new housing construction. However, in the case of multi-family housing, the study found a significant deviation between the number of units authorized by building permits and the number of units completed. According to the study, the major contributing factor to this difference was the re-classification of units to single-family homes after the permit was issued.
The findings of this study, which also examined the relationship between permits and starts, are presented in Table 1. As this table shows, during the period of the study, the total housing units started were 97.5% of housing units authorized by building permits, while 96% of units started were completed. Based on these percentages, it can be inferred that the total housing units completed were 93.6% of the total housing units authorized by building permits.
In the case of single-family houses, starts were 102.5% of permits, due to reclassification of units from multi-family to single-family after the permits were issued, while completions were 96.5% of starts. Based on these percentages, it can be inferred that single-family housing units completed were 98.9% of units authorized by building permits. Finally, in the case of multi-family buildings, starts were 77.5% of permits issued, due to reclassification of units from multi-family to single-family, while completions were 92.5% of starts. Based on these percentages, it can be inferred that multi-family housing units completed were 71.7% of units authorized by building permits.
Monitoring whether the number of units represented by permits issued is increasing or decreasing is important because it provides an understanding of the momentum developing in the market. However, it is even more important to understand what these new units represent in terms of housing stock growth rates.