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Housing Supply and Demand Fundamentals and the Tradeoffs Associated with Affordable Housing Programs Wendy Stock (Professor and Head) and Gary Brester (Professor)
Department of Agricultural Economics and Economics
Montana State University November 2015 This document describes factors associated with home prices and the tradeoffs associated
with affordable housing policies. It also summarizes some of the economics research on
the impacts of affordable housing policies, which are often referred to as inclusionary zoning (IZ) policies. The proposed Bozeman Ordinance 1922 includes several components, the primary of
which is to encourage the creation of affordable housing units, with a phased-in goal that
the number of affordable housing units created will eventually equal 10 percent of new building permits issued by housing type (e.g., detached, duplex, triplex, and townhouse) each year. Affordable housing unit price ceilings would be based on potential buyers’ incomes relative to the median area income. Also included in the proposed ordinance are
incentives to offset some of the increased costs that builders and developers would face
as a result of the policy. Background: The Economics of Housing Prices
What causes high home prices in Bozeman? The simple answer is “Supply and Demand”.
When supply is low and/or demand is high, home prices tend to rise. This implies that housing in Bozeman will become more affordable if either supply increases or demand declines.
The Supply of Housing. The supply of housing is generated by builders, developers, and
sellers of existing homes. Other things constant, when the supply of housing decreases, housing prices increase. Factors that cause the supply of housing to decrease include higher costs of building homes, more attractive alternative investment/building opportunities, a drop in the number of producers of homes, and expectations about the
future. In our view, the most salient of these currently affecting the Bozeman housing
market are costs of production and alternative opportunities. Costs of production: As the costs of housing production rise, housing supply is reduced and housing prices increase. Costs of home production include input costs (e.g., labor,
materials, and land prices), costs to comply with housing regulations (e.g., open space
requirements, permits, and impact fees), and the quality of construction and finishes. Higher wages for construction workers, higher land prices, and higher quality homes all contribute to higher prices. Home prices also rise when impact fees, land use restrictions, open space requirements, growth boundaries, lot size requirements, and zoning
regulations generate additional costs for developers and builders. Research indicates that
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the effects of such regulations in terms of higher housing prices fall most heavily on the
market for lower-quality and lower-priced housing.1 This doesn’t necessarily imply that cities shouldn’t charge impact fees and enforce regulations, but rather that doing so has tradeoffs that include higher housing prices, particularly for those with lower incomes.
Increases in production costs can be offset by providing incentives for builders to
voluntarily provide affordable housing. Incentives that include fast-track subdivision approval, easier permitting, waiver of impact fees, allowances for higher density construction in neighborhoods with IZ, cash payments in lieu of affordable housing development, and exceptions or trade allowances regarding open space and parkland
requirements can mitigate some of the higher prices generated by IZ. The incentives
allow builders and developers to voluntarily decide whether pursuing projects in areas with IZ is the right choice for them. If most of the cities in an area adopt IZ policies, those with more flexible/less stringent IZ programs have the potential to increase the relative quantity (and decrease the relative price) of affordable housing as developers of
IZ neighborhoods move their projects into jurisdictions that allow more flexibility and
out of jurisdictions with more stringent policies.2 Of course, these incentives generate their own set of tradeoffs. Alternative Opportunities. As costs of home production increase in one area (i.e., Bozeman), builders and developers will seek to locate their projects in other areas with
relatively lower costs (i.e., outside Bozeman). The easier it is to build elsewhere and yet still be connected to the demand influence of Bozeman, the larger the decline in the supply of housing in Bozeman will be. One consequence of this will be increased sprawl and more vehicular traffic as buyers increasingly trade higher in-town housing costs for lower housing costs outside of town combined with increased transportation costs. For
example, if one chooses a policy whereby land that lies just outside of a city limit is maintained as open space or for agricultural production, the unintended consequence will be an increase in sprawl as home buyers and developers leapfrog that area to find land that has no such restriction. This will reduce the supply of housing in Bozeman, drive up the price of remaining available land, and reduce housing affordability.
Number of producers. The supply of housing depends also on the number of builders and developers in a market. All else equal, factors that restrict the number of builders (e.g., licensing fees) cause housing prices to rise. In Montana, the fees and other costs associated with becoming a builder are already relatively small, so there is not much
room to use lower licensing fees to increase the supply of builders. It should also be noted that if builders are earning unreasonably high profits from building homes in Bozeman, then we would expect those profits to attract more builders and developers into the area. The resulting increase in supply of homes would then reduce housing prices
(assuming that further development in Bozeman is not restricted).
1Quigley, J. and S. Raphael (2004) “Is Housing Unaffordable? Why Isn’t It More Affordable?” Journal of Economic Perspectives 18(1): 191-214. 2 Schuetz, J., Meltzer, R., and V. Been (2011) “Silver Bullet or Trojan Horse? The Effects of Inclusionary
Zoning on Local Housing Markets in the United States,” Urban Studies 48(2): 297-32.
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The Demand for Housing. The demand for housing comes from potential buyers, renters,
and existing homeowners in the area. Other factors held constant, when the demand for housing increases, housing prices increase. Demand for housing is influenced by incomes, tastes and preferences, the prices of substitutes and complements, the number of buyers, and expectations about the future.
Incomes. Demand for normal goods (like quality housing) increases when incomes rise, which in turn pushes home prices up. As the job market in Bozeman grows, wages are likely to follow. This is especially the case when much of the new job growth occurs in high-wage sectors such as information technology, biosciences, financial services, and
medical fields. This income growth increases the demand for housing and pushes housing
prices upward. The desire of non-workers (e.g., high-income retirees) to live in Bozeman also increases housing prices through this income effect. Tastes and preferences: When people’s tastes for homes in certain locations increase,
demand for homes in those locations increases and home prices rise. Bozeman is an
attractive place for people with preferences aligned with the area’s quality of life and amenities (e.g., parks, recreational activities, clean air, bike paths, trails, etc.), and this trend is unlikely to change in the foreseeable future, implying that home prices will continue to rise because of this factor.
Prices of substitutes. As the relative price of substitutes for houses declines, demand for houses declines as well. Substitutes to homeownership in Bozeman include renting in Bozeman or renting/buying homes in alternative areas (i.e., outside city limits). Factors that reduce Bozeman rental rates (e.g., increasing the supply of rental units) would
decrease the demand for houses and, in turn, lower home prices. Factors that reduce the
cost of living outside city limits (i.e., more development outside the city, easier and less expensive transportation to and from the city) will decrease the demand for housing within the city (but with the tradeoff of increased sprawl and its associated traffic issues).
Prices of complements. Complements to housing in Bozeman include quality schools,
entertainment, dining, shopping, and recreational amenities. When access to amenities is relatively easy (e.g., schools are of high quality, trail systems and recreational opportunities are close by, attractive shopping and dining establishments are within walking distance), the demand for housing rises.
Expectations. When buyers expect that prices will rise in the future, they increase their demand today. Given growth and income patterns, it is likely that home prices in Bozeman will continue to increase into the foreseeable future, which means that positive expectations are also fueling the demand for homes today and pushing prices upward.
Number of buyers: Other things equal, with population growth comes higher demand and higher prices. There are no indications that population growth rates in Bozeman will abate anytime soon, and thus, prices are likely to continue to rise.
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Given the direction of all of the demand-side factors, it is unlikely that the demand for
housing in Bozeman is going to decline in the near future. Instead, demand is likely to continue to push prices up and make housing less affordable, particularly for low-income residents. Some economists suggest that policies that augment the purchasing power of low-income
households in the housing market can help mitigate affordable housing issues.3 An example is shared appreciation mortgage programs, where a third-party investor puts up a fraction of the purchase price of a house and the homeowner amortizes the remainder. The investor is then allowed to share in capital gains whenever the property is sold in the
future. One important caveat is that although these types of policies make it easier for
lower-income buyers to afford mortgages today, they could also increase the relative attractiveness of (and demand for) low-income housing in Bozeman and push prices up higher in the future.
Research on the Impacts of Affordable Housing Programs
Impacts on home prices. Research on the impact of IZ on home prices indicates that there is a net increase in home prices in areas that introduce IZ relative to other areas. This net increase in home prices masks two competing outcomes - the prices of lower-priced
homes fall slightly and the prices of higher-priced homes rise dramatically.4
Impacts on the quantity of housing. Research on the effects of IZ on the amount of affordable housing produced indicate that the effects of IZ on affordable housing quantity are either zero or modestly positive.5 In “hot” housing markets like Bozeman, the
research indicates that it is easier for builders and developers to pass along IZ-related cost
increases to other home buyers without large reductions in the quantity of housing built, so the likely impact of IZ on the quantity of “non-affordable” homes built is relatively small.6 Conclusion: Choices Involve Tradeoffs As noted above, policy choices involve tradeoffs and often come with unintended consequences. Our goal in writing this document is to provide information regarding these tradeoffs and the underlying supply and demand fundamentals in the Bozeman housing market as the City Commission considers Ordinance 1922.
3 Quigley and Raphael (2004).
4 Knapp, G., Bento, A., and Lowe, S. (2008) “Housing Market Impacts of Inclusionary Zoning.” College Park MD: National Center for Smart Growth Research and Education. The authors found that in jurisdictions with IZ, housing prices increased by an average of 2.2 percent. For houses priced below the median, IZ lowered prices by about 0.8 percent. For houses priced above the median, IZ raised prices by about 5 percent. 5 Schuetz et al (2011).
6 Schuetz et al (2011).
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