Determinants of the Price of Houses and of Rents - Literature review Example

Housing Student’s Name: Course: Tutor’s Name: Date: Determinants of the price of houses and of rents A relatively simple model of demand and supply would be expected to explain the choices of variables in the housing market in any given economy. Often, a rise in demand should attract an increase in supply in the housing market, failure to which prices would rise. Ideally, housing demand responds to variables such as prices, incomes and demographic variables (Hwang & Quigley 2006, p. 430). Housing supply on the other hand depends on factors such as profitability (i.e. the cost of construction measured against the likely returns from the investment), availability of land for construction, and the regulatory environment (Hwang & Quigley 2006, p. 430). The points above thus indicate the demand and supply of supply of houses is not as straightforward as other consumer products due to the complexities of housing development. In the last quarter of 2010, The Guardian newspaper reported that there was a steep increase of house prices and rents in most parts of the UK. Incidentally, the steep house prices and rental charge increases were happening at a time when the economy was making initial recovery strides from the 2008/2009 financial crisis. As Collinson (2010, n.pag.) observes, the causes of the rising house prices and rental charges are related to supply issues, which have remained constant with most would-be developers not giving the consumers new houses (see figure 1 below), and with more consumers demanding the same. Additionally, and as observed by Wilson (2010, p. 76), countries (especially the UK) are experiencing ‘improved life expectancy rates and a growing number of one-person households’. The resulting scenario is that the demand for housing in the UK has outstripped supply, and in economic terms, this can only push the prices up. Figure 1 Source: Wilson (2010, p. 77) In 2007, the UK government had projected that an estimated supply of 240,000 housing units annually up to 2016 would ease the house demand thus making house prices and rents more affordable (Wilson, 2010, p. 76). Incidentally, the government targets were rendered unattainable by the credit crunch, and although the house prices and rents fell considerably at the time, few people were unable to purchase houses due to lack of funds. Additionally and as has been noted by Wilson (2010, p. 77), financial money lenders made mortgages hard to obtain thus meaning that potential homeowners were locked out. Those who could not afford to buy thus reverted to renting, placing an increased demand for rental houses. Consequently, the rental prices increased considerably as landlords realised that their properties were in high demand. As noted by Malpass (2010, p. 161), the UK has several factors contributing to the current housing shortage. For starters, the country has never managed to overcome the post-war housing shortage experienced ‘between 1945 and 1975’. Second, the demographic growth means that the demand for housing has been on a steady increase. The third reason is related to economic growth which means that more people can afford to purchase or rent property. Lastly, Malpass (2010, p. 161) notes that the UK government has never really managed to replace some of the obsolete houses that are shunned by would-be homeowners or renters. In other words, the housing problem is political in nature, but has direct economic ramifications on the housing consumers. The impact of such factors on demand and supply is that while the demand rises, the supply is constantly in deficit. Consequently, the prices remain high especially in high housing demand areas like London as has been noted by Ball (2012, p. 6). In her report, Baker (2004, p. 24) noted that the main reason for supply inelasticity even amidst rising demand and high costs which should attract investment is land (see figures 2 and 3 below for an illustration of how elasticity and a lack thereof affects prices). In an ideal situation, housing developers would be expected to build more houses to meet the increase in demand. In the UK however, Barker (2004, p.25) found out that the authorities have not allocated sufficient land for development thus making house development unresponsive to demand. Barker (2004, p. 25) also found out that there are multiple barriers and risks associated with housing development, so much that most developers fear that the potential returns of such developments would be overwhelmed by the related costs. Figure 2: The ideal situation where supply is elastic Figure 3: The effect of inelastic supply on prices Source: Pettinger (2011, n.pag.) The government’s role A European Commission (2012) report indicates that while housing supply has not been at par with demand in the UK, most of the blame for the same lays squarely with the government. For starters, the report indicates that prevailing government policies have increased tension in housing markets through a ‘rigid planning system and the poor functioning of the land market’ (European Commission 2012, p. 24). Government policies further impede investments in housing development through strict planning laws, which eventually raise the cost of constructing and/or renovating houses. On average, most households cannot afford house ownership in the UK even at a time when cost-to-rent ratios indicate that it would be better to buy than rent. European Commission (2012, p. 25) for example indicates that the country witnessed a 123 percent increase in house prices between 2001 and 2010. Such steep increases in prices lock potential homeowners out of their homeownership dreams and as such, they continue to pay rents. Compared to house prices, the European Commission (2012, p. 25) notes that ‘rents have been much more stable’. However, there is no guarantee that the stability of rents will continue in the long-term and it is likely that they too will rise to correspond with increased demand in the future. In a comparison of the price-to-rent ratios in the United Kingdom and the United States, Ayuso and Restory (2004, p. 14) noted that by 2003, the UK had ratios that were 30 percent above equilibrium compared to the US which had 20 percent ratios above equilibrium. In other words, the opportunity cost of purchasing rather than renting a house in the UK was higher than that of doing the same in the US. Should governments act to impose minimum rents or restrictions on sales of houses? The question of whether the government should impose minimum rent restrictions on houses is a hard one to answer. For starters, it is important to consider that the UK is a free economy and government’s actions to impose price restrictions would be against the theoretical assumptions of such a market. Secondly, it would be important to consider a more appropriate remedy to the rising rent and house sale prices especially considering that house prices(either sales or rent prices) are ‘determined by the interaction between supply and demand for all houses’ as indicated by Barker (2004, p.104) . As suggested by Barker (2004) the government should consider re-engaging in property development in order to ensure that the housing supply is normalised to a point where it would push prices to affordability. Arguably, and as indicated elsewhere in this paper, increased housing supply is not a realistic expectation to normalise prices especially considering the different factors hindering housing development in the UK. Notably, the limit setting cost for rent and house prices is not an entirely new proposition; propositions made in the Barker (2004) report had suggested that the government should set affordability targets, which would be expressed as ‘the ratio of lowest quartile house prices to lowest quartile earnings in the regions characterised by high demand’ (Barker 2004, p. 24). Barker (2004, p.4) argued that expecting the supply to significantly affect prices is unreasonable especially considering that ‘new supply accounts for 1 percent of the housing stock’, thus meaning that such supply should not be expected to have any significant effect on prices. The risks posed to investors in the house building industry would further make capping of rental prices by the government an imprudent strategy. As Barker (2004, p. 104) notes for example, house developers have to mitigate risks related to planning, contamination of the environment, remediation and construction delays. Additionally, economists cannot ignore the fact that investors in the housing development industry want to attain a return on their investment as quickly as is practically possible. As such, if the market rental charges are high, investors are more likely happy. Capping the amount of charges that such investors can get for their property would then act to de-motivate them at a time when the UK needs more investors in the same industry. Economically, setting a limit for rent or house prices would create a shortage as illustrated in the figure below, and in the UK market where a shortage in supply already exists, the situation can only worsen if at all the government decides to cap prices. In the illustration below, PE would be the ideal price when the supply and demand of apartments (or houses in this case) is at equilibrium. However, a government action to cap prices at PC would create a shortage which is illustrated by the difference between A1 and A2. Figure 4: An illustration of the effect that capping apartment (or housing prices) would have on supply Source: Rittenberg and Tregarthen (2008, p.100). While it is natural for some people like Barker (2004) to clamour for house price controls by the government ostensibly for purposes of ensuring affordability, especially when the earnings of specific group of people is considered, it is also wise to consider the effect that such a decision would have on the entire housing market. For example, while it is agreeable that rents or housing prices in some places in the UK are overrated, control measures by the government would most likely lower prices, and this would inevitably make them more affordable hence increasing demand. As demand rise, and as consumers become desperate to get houses either to buy or rent, Rittenberg and Tregarthen (2008, p.100) observes that house owners or landlords may find “backdoor” methods of getting payments above the set government prices by demanding huge security deposits, or even asking for simple bribes. In the end, it is noted that controls by the government would end up having unintended negative consequences not only in the lower supply of houses, but also on the consumers whom the controls would have ideally be helping. Lessons from New York (the city which has historically used rent controls since the 1940s) indicate that rent or price control on houses generally affect consumer mobility, and in case of controlled rent, favours ‘long-term residents at the expense of new-comers to the city’ (Rittenberg & Tregarthen 2008, p. 100). In the UK therefore, it would be advisable for the government to let the market forces determine the prices. Conclusion Although the UK is experiencing a shortfall in the supply of housing, it is clear that there is no outright answer as to how the deficit problem will be resolved now or in the future. As indicated in this paper, even the rising prices of houses and rent cannot be depended upon to trigger an increase in supply because other political factors stand in the way of housing development. The rising rental costs and house prices are likely to make housing unaffordable for most people within the low- and middle-income earning groups, but even imposing rent ceiling and restrictions on the pricing of houses and rent is not likely to be an effective solution for the prevailing shortage in housing supply. As indicated earlier in this paper, the shortage of housing supply in most regions of the UK is an economic problem whose solutions are likely in the political domain. By re-engaging in housing development for example, the government can play a role in ensuring that a specific number of affordable houses are constructed and supplied to the consumer market annually. Additionally, through policy considerations, the government can ease regulations for purposes of reducing housing development-related costs and risks, and by so doing, make the real estate development sector more attractive to investors. References Ayuso, J, & Restory, F 2004, ‘House prices and rents – an equilibrium asset pricing approach’, pp. 1-28. Ball, M 2012, ‘Renting in London: The coming boom’, Cluttons Occasional Paper Series, pp. 1-6. Barker, K 2004, ‘Review of housing supply- delivering stability: securing our future housing needs’, Final Report- Recommendations, pp. 1-158, viewed 08 January 2013, < http://image.guardian.co.uk/sys-files/Guardian/documents/2004/03/17/Barker.pdf>. Collinson, P 2010, ‘Rents rise as supply and demand favour landlords’, The Guardian, viewed January 8, 2013, . European Commission 2012, ‘In-depth review for the United Kingdom in accordance with article 5 of regulation (EU) No 1176/2011 on prevention and correction of macroeconomic imbalances’, Commission Staff Working Document, 161, Final, pp. 1-48. Hwang , M, & Quigly, J M 2006, ‘Economic fundamentals in local housing markets: evidence from US metropolitan regions’, Journal of Regional Science, vol. 46, no.3, pp. 425-453. Malpass, P 2010, Housing, markets and policy, Taylor & Francis, Oxford. Pettinger, T 2011, ‘Should we build more houses in the UK’, Economics, viewed January 8, 2013, < http://www.economicshelp.org/blog/3196/economics/should-we-build-more-houses-in-uk/>. Rittenberg, L & Tregarthen, T 2008, Principles of microeconomics, Flat World Knowledge, New York. Wilson, W 2010, ‘Housing supply and demand’, House of Commons Library Research, pp. 76-77, viewed January 8, 2013, < http://www.parliament.uk/documents/commons/lib/research/key_issues/Key-Issues-Housing-supply-and-demand.pdf>. 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