Housing Bubble  

Why Do Houses Cost So Much?

by Randal O'Toole

For decades, planners have worked at raising the price of housing. When prices go down, they may take the rest of the economy with them.

---

Housing prices have soared in most of the developed world over the past five years. Increased spending on homes and spending out of loans against the increased equity in homes have kept the world economy afloat despite slow growth in Europe, stagnation in Japan, and the dot-com and telecommunications crashes in the United States.

But the increased prices have also brought speculators into housing markets, creating numerous housing bubbles. When these bubbles deflate, it could result in a deep recession. "The whole world economy is at risk," claims The Economist, which estimates that "two-thirds (by economic weight) of the world . . . has a potential housing bubble."¹ "It is not going to be pretty," concludes the magazine-that-calls-itself-a-newspaper.²

If this happens, you can blame urban planners for creating the bubbles. Throughout the United States and much of the rest of the developed world, home prices are rising fastest where planners have imposed rules aimed at slowing or controlling growth. Planners call this growth management, of which smart growth is a recent variation. By preventing homebuilders from meeting the local demand for housing, growth management leads to sharply increased housing prices. This in turn attracts speculators who have shied away from the stock market. As a result, housing prices in many areas have risen far above the true value of the homes.

Though they pay lip service to "affordable housing," many planners actually welcome the run-up in land and housing costs that results from growth management. Smart-growth planners believe that more people should live in multifamily housing or in single-family homes on tiny lots. Large lots, they say, waste land and lead people to drive too much. High land prices encourage smaller lots and high housing prices encourage multifamily housing.

Planners count on the support of existing homeowners who see their house prices and apparent wealth dramatically increase. Homeowners could take advantage of their windfalls through home equity loans. But the real wealth gain is illusory because a family often cannot afford to sell a home and buy another unless they are moving to a region that does not have such rules. Moreover, planners fail to take into account the fact that their policies make housing prices more volatile — i.e., more subject to downward as well as upward swings. As a recent economic analysis of the housing market in Great Britain concludes, "By ignoring the role of supply in determining house prices, planners have created a system that has led not only to higher house prices but also to a highly volatile housing market."³

The effect a deflating housing bubble can have on an economy can be seen in Japan, which (at least since World War II) has strictly regulated land use to prevent urban encroachments on agricultural lands. The result was such a huge property bubble that downtown Tokyo was at one time supposedly worth more than all the private real estate in the United States. The bubble burst in 1991 and home values have since fallen to less than half their 1990 peak.⁴ Since then, there have been 15 years of stagnation.

Imagine that you make a 25% down payment on a $400,000 house. But then home prices start falling. You try to wait it out, but when your house value falls to $200,000, you still owe $300,000. If someone offers you a higher paying job in another part of the country, you can't accept because you can't afford the $100,000 it would cost to sell your house. You can declare bankruptcy, but that just passes the problem onto someone else. When this happens to enough people, the result is a drastic slowdown of the economy.

Like Japan, most European countries have had strict land-use controls since World War II. The result is housing that is less affordable and prices that are more volatile than in the United States. This is one of the reasons Europe's economy has fallen so far behind the United States' in the last decade or so. No communities in the United States attempted to control or manage growth before 1970.

According to the 1970 Census, housing in 1969 was affordable everywhere in the United States except Hawaii and parts of the greater New York metropolitan area. The decennial census estimates the previous year's home prices and family incomes. Dividing median home values by median family income produces the price-to-income ratio, a useful measure of affordability. At a price-to-income ratio of 2, a family dedicating 25% of its income to a 5.5% mortgage would pay it off in eleven years, which is affordable. If the ratio climbs to 3, the period would be a marginally affordable 22 years, while at 4 it would be an unaffordable — because no lender will loan for that long — 55 years. In 1969, price-to-income ratios in Honolulu, which has very limited amounts of private land available for development, were just over 3, while they ranged from 2.4 to 3.1 in various parts of the New York area.

Today, residents of the San Francisco Bay Area are used to million-dollar ranch houses, half-million dollar condos, and, in general, some of the most unaffordable housing in the country. But in 1969, San Francisco and other California regions such as San Jose, San Diego, and Santa Barbara all had affordable price-to-income ratios of less than 2.3, which is less than the national average today. Nationwide in 1969, the average price-to-income ratio at less than 1.8 made homes very affordable.

By the year 2000, the average price-to-income ratio had pushed up to 2.2. Affordable housing could still be found in many fast-growing regions whose price-to-income ratios were less than 2. But the average was pushed up by a large increase in the ratios in a number of regions, most importantly in California, Massachusetts, Oregon, and Wash-ington. By 2004, says the Census Bureau, the national average price-to-income ratio was 2.8, again mainly due to increases in those regions along with Florida and other states on the East Coast.

Liberal economist Paul Krugman divides the country into what he calls the "Zoned Zone," where "land-use restrictions" make it "hard to build new houses," and what he calls "Flatland," the parts of the country that may have zoning but do not have aggressive growth-management planning. Krugman observes that prices are rapidly increasing in the Zoned Zone but remain very affordable in Flatland. Moreover, a close look at price-to-income ratios and other home price indices over time shows that increases in various regions correlate closely with the imposition of land-use controls.

When confronted with the unaffordable housing that results from their work, planners place the blame on growing demand. They even seem to take high housing prices as evidence that their growth limits are making regions more livable and thus more in demand as places to live. The reality is that housing is what economists call an inelastic good, meaning that small restrictions on supply can lead to large increases in price. Quite simply, people need a place to live and will pay what it takes to live there. Because of jobs, family, and other ties, few people are willing to move to another region where housing is more affordable.

Homebuilders are able to meet the demand for new housing, even in rapidly growing areas, unless something stands in their way. During the 1990s, the Atlanta, Dallas, Houston, and Phoenix urban areas were among the fastest-developing in America, all growing by 900,000 people or more. Houston has no zoning at all, and while the other cities have zoning, it is aimed strictly at protecting the status quo in existing neighborhoods, not at controlling new development. Homebuilders easily kept up with demand, and housing prices in these regions grew by about 3–4% per year, or slightly faster than the rate of inflation. By comparison, an urban-growth boundary, design codes, and other development restrictions caused home prices in slower-growing Portland, Ore. to increase faster than 7% per year in the 1990s.

American-style growth-management planning got its start in Ramapo, N. Y. In 1970, the city approved an "adequate public facilities" ordinance, saying that it would approve new developments only when all the capital improvements needed for these developments were fully financed.⁵ Two years later, Petaluma, Calif. passed an ordinance allowing no more than 500 new residential building permits per year.⁶ Boulder, Colo. soon followed with an ordinance restricting annual building permits to a fixed percentage of the number of existing dwellings in the city. Boulder was also the first city in the United States to pass a tax dedicated to open space preservation, and the city and county of Boulder have since purchased a greenbelt around the city that is several times the land area of the city itself.⁷

Petaluma and Boulder set out to slow growth, but other growth-management policies claimed to seek only to control where growth would take place. In 1974, the city of San Jose and Santa Clara County agreed to draw an urban-growth boundary outside of which development could not take place. Inside the boundary growth could continue unabated, but growth outside would be strictly limited. East of San Jose are tens of thousands of acres of marginal agricultural land, and the growth boundary effectively placed these lands off limits to development. Since most other communities in the San Jose urban area are landlocked by San Jose or other cities, this boundary effectively constrained the entire San Jose urban area.

Taking after Ramapo, San Jose said it would add land to the growth boundary when financing could be assured for the urban services needed for new developments. But in 1978, California voters passed Proposition 13, which strictly limited the property taxes cities could collect for urban services. This made California cities dependent on sales taxes and therefore reluctant to devote more land to residential areas. As a result, San Jose has never expanded its urban-growth boundary.

Even before Proposition 13, cities throughout the San Francisco Bay Area had approved a variety of growth-management policies, including growth boundaries, density limits, and purchases of land for open space. While growth-management planning is supposedly aimed at protecting environmental quality, it is exceedingly vulnerable to manipulation by not-in-my-backyard (NIMBY) advocates whose hidden goal is to boost their property values by limiting the supply of housing for others. As MIT planning professor Bernard Frieden notes in his 1979 book, "The Environmental Protection Hustle," one important limit to growth was a public involvement process that made it so easy for people to challenge proposed developments that "even a lone boy scout doing an ecology project was able to bring construction to a halt on a 200-unit condominium project."⁸

Berkeley planning professor David Dowall's 1984 book, "The Suburban Squeeze," points out that people living in a neighborhood of $200,000 homes fear that an adjacent development of $100,000 homes will bring down their property values, but they will welcome a development of $300,000 homes. When NIMBYs object to plans, developers respond by eliminating readily affordable housing and proposing to build only expensive houses. For example, one proposal to build 2,200 homes selling for $25,000 to $35,000 on 685 acres in Oakland was, due to public opposition, scaled back to a mere 150 homes that would sell for $175,000 to $200,000.⁹

Federal, state, county, city, and regional governments were able to tie up a huge amount of potential residential land in the Bay Area as open space. According to Dowall, by 1984 "over 15 percent of the region's total land supply [was] in permanent open space controlled by" various government agencies.¹⁰ Ostensibly this was for environmental protection, but the hilltops that were reserved tended to have the lowest values for fisheries, wildlife, and streams. The main effect of such reservations was a significant boost of land prices throughout the region.

Proposition 13 spurred city governments to go farther than ever before in beggar-thy-neighbor efforts to force residential developments into adjacent cities while capturing retail developments, and the sales taxes they generated, for themselves. As one city put up barriers to growth, that growth would spill over into nearby cities, leading them to erect their own barriers. "Santa Clara County cities have become extremely combative," observed Dowall, "fighting back with a variety of growth-restricting mechanisms that have made each community a 'tight little island.'"¹¹

As a result of these policies, California was the first state to suffer planner-induced housing bubbles. By the 1980 census, price-to-income ratios in many California regions, including Los Angeles, San Diego, San Francisco, and San Jose, ranged from 4 to 4.5, and Santa Barbara was a staggering 4.8. California was also the first state to suffer the bursting of a housing bubble: between 1989 and 1994, housing prices in most of these regions fell from 15–25%. Fortunately, other parts of the United States thrived, so the nation as a whole did not suffer a severe depression.

Meanwhile, Massachusetts set out to protect farmland from urban sprawl by using easements to create greenbelts around Boston and other cities, leading to significant declines in affordability. Oregon and Florida also passed growth-management laws in the 1970s, requiring all cities to have urban-growth boundaries, but these laws did not take effect until near the end of the decade. A recession in the early part of the 1980s kept Oregon housing prices low as the state actually lost population in 1982 and 1983. Most Florida communities treated urban-growth boundaries with generous flexibility, so housing in that state remained affordable until 2000 or so.

In 1993, Oregon had recovered and was growing rapidly. All the lands inside urban-growth boundaries in Oregon covered just 1.25% of the state, yet planners somehow convinced people that stricter rules were needed to preserve farms and open space. Homebuilders asked the legislature to force planners to keep an early promise to expand urban-growth boundaries to insure a 20-year land supply, but planners convinced the legislature to allow them to accommodate growth by rezoning existing neighborhoods to higher densities.

Many neighborhoods of single-family homes were therefore rezoned to multifamily standards. While past zoning had specified maximum densities — so that homes could be built on half-acre lots in an area zoned for quarter-acre minimum lot sizes — the new regime was minimum-density zoning, requiring that all development be at least 80% of the maximum density allowed by the zone. In some cases, this meant that if people's homes burned down, they would be required to replace them with apartments.

Developers did not immediately respond by replacing homes with apartments. In 1996, homebuilders told the Portland city council that people wanted to live in single-family homes, but the market for high-density housing was flat. The city responded by providing tens of millions of dollars of subsidies for the planners' preferred housing.¹² By 2005, planners were pleased to see that the urban-growth boundary had driven land prices high enough to reach a "tipping point" where builders would buy suburban homes and, without subsidies, replace them with high-density housing.¹³

Thanks to similar plans, land in the San Francisco Bay Area, San Diego, and other California urban areas had reached such a tipping point years before. While an acre of land suitable for residential development may cost $20,000 in Houston, it can cost $300,000 in Portland and several million dollars in San Jose.

Washington state passed a growth-management law in 1991. On the East Coast, Parris Glendening, then governor of Maryland, coined the term "smart growth" to refer to Portland-style planning that promotes high-density development. This term was useful because anyone who disagreed with the planners could be accused of favoring "dumb growth."¹⁴ As president of the National Governors' Association, Glendening persuaded other governors, such as New Jersey's Christine Whitman and Utah's Michael Leavitt, to endorse smart growth. Denver, Minneapolis-St. Paul, and Salt Lake City began implementing smart-growth plans in the mid-1990s, but otherwise most growth-management planning was on the coasts.

Urban planning is not the only cause of rapidly rising prices. Hawaii has unaffordable housing because it has very little private land available for development. Las Vegas, the nation's fastest-growing urban area, has few restrictions on development. But the region, which is on a small island of private land in a sea of federal land, literally ran out of developable land in 2003, with the result that housing prices began increasing at 30–40% per year. But these are the exceptions that prove the rule: any restrictions on homebuilders can lead to rapid increases in prices.

The 2000 census revealed that during the 1990s Oregon had suffered the greatest decline in affordability of any state. In addition to California, Hawaii, and Oregon, price-to-income ratios had grown to 3 or higher in many Massachusetts, Utah, and Washington communities, and reached 2.7 or more in Denver and Salt Lake City. As of 2000, there were probably few housing bubbles outside of California. But both coasts of the country and a few interior regions were ripe for housing bubbles when low interest rates and the stock market bust encouraged people to put more money into real estate.

Marked by no-downpayment loans, no-interest loans, 40-year loans, and other high-risk mortgages that suggest many new owners are buying homes for their speculative value, the last five years have seen some of the fastest increases in housing prices in history. The Census Bureau estimates that price-to-income ratios in 16 states are now greater than 3. All these states are on the coasts except Colorado, Nevada, and Utah, and all of them except Nevada have some form of growth-management laws.

The difference in today's home prices among various urban areas is staggering. According to Coldwell Banker, in 2005 you could buy a four-bedroom, two-bath, 2,200-square-foot home with a two-car garage in Houston for less than $152,000. That same house would cost twice that amount in Portland and four times the amount in San Jose.

These high prices often cannot be supported by "fundamental" assessments of home values, notably rents. As The Economist noted in early 2005, in many places "it is now much cheaper to rent than to buy a house."¹⁵ In many places the differences between home prices and rents is greater today than it was in California in 1989, so a correction could easily see home prices falling by more than the 15–25% they declined in California by 1994.

San Jose is the clearest case of a housing bubble. Between 2001 and 2004, the region's employment declined by 17% and office vacancies increased from 3% to 30%. Yet housing prices in the same period grew by more than 20%. Clearly there is no support for such increases other than the expectation that prices will continue to increase indefinitely.

Of course, they won't. "The first law of bubbles is that they inflate for a lot longer than anybody expects," observes The Economist. "The second law is that they eventually burst."¹⁶ Some markets, such as San Diego and southern Florida, already show signs of softening.

The bursting of a housing bubble does not result in a sudden crash, as sometimes happens in the stock market. "But," as The Economist notes, "it still hurts."17 Housing prices deflate slowly, as they have in Japan and did in California in the early 1990s. When prices deflate, consumer spending will decline, banks will falter, and economic growth will slow or stop. The big problem with the current bubbles is they are nearly ubiquitous: The Economist estimates that housing is overpriced in Australia, New Zealand, South Africa, and most of western Europe, as well as in much of the United States and parts of China. If the next recession really hurts, blame the urban planners.

NOTES

1. "The sun also sets," The Economist, Sept. 9, 2004.
2. "After the fall," The Economist, June 16, 2005.
3. Alan W. Evans and Oliver Marc Hartwich, "Unaffordable Housing: Fables and Myths" (Policy Exchange, 2005), p. 9, www.policyexchange.org.uk/uploads/media/Unaffordable_Housing_-_final_text_-_10_June_2005.pdf.
   
4. "Going through the roof." The Economist
5. Ibid; City of Petaluma, "Draft Petaluma General Plan 2025" (City of Petaluma, 2004), p. 57, cityofpetaluma.net/genplan/pdf/06growthmngmt10-11rsv2.pdf.
6. Peter Pollack, "Controlling Sprawl in Boulder: Benefits and Pitfalls," Proceedings of the 1998 National Planning Conference (AICP, 1999), www.asu.edu/caed/proceedings98/Pollock/pollock.html.
7. Bernard J. Frieden, "The Environmental Protection Hustle" (MIT, 1979), p. 6.
8. David E. Dowall, "The Suburban Squeeze: Land Conservation and Regulation in the San Francisco Bay Area" (UC Press, 1984), p. 15.
9. Ibid, pp. 141–142.
10. Ibid, p. 143.
11. Portland City Council meeting of Oct. 23, 1996, transcribed from a videotape of that meeting made by the city of Portland.
12. Dana Times, "Land value 'tipping point' hits suburbs," The Oregonian, Oct. 20, 2005.
13. John W. Frece, "Lessons from Maryland's Smart Growth Initiative," Vermont Journal of Environmental Law, Vol. 6 (2004–2005), www.vjel.org/articles/articles/Frece11FIN.htm.
14. "Still want to buy?" The Economist, March 3, 2005.
15. "Homing in on the risks," The Economist, June 3, 2004.
16. "After the fall," The Economist, June 16, 2005.

© Copyright 2008, Liberty Foundation

Send editorial comments to letters@libertyunbound.com.
All letters to the editor are assumed to be for publication unless otherwise indicated.

Send web site comments to webmaster@libertyunbound.com.