It should come as no surprise to the reader that over the last ten to fifteen years housing costs have risen dramatically and recently they have fallen significantly.

This paper will attempt to explain the following conclusions:

The housing market is normally in a “growth mode” (where new homes are required to accommodate an increasing population) or a “retraction mode” where the supply of existing homes is more than sufficient to accommodate demand. When in the growth mode, home values are closely related to the cost of new homes (replacement value); when in the retraction mode, all bets are off.

The cost of building a house (the bricks & mortar) has, over the past several decades, increased, by almost exactly the same percentage as the cost of living (CPI);

The total cost of a new house, including land, has increased by a much greater amount;

The runaway cost of housing is due to rapidly increasing lot costs, resulting from:

1. A decreasing supply of land, and;
2. Zoning and growth limitation changes which have greatly reduced “yield” from a parcel of land and created restrictions on market forces, a major factor in causing a rapid increase in lot costs.

An increase in lot cost results in a “multiplier effect” which causes housing costs to increase by more than the increase in the lot cost, as well as the structure.

Artificial constraints like building permit limitations, impact fees, etc. result in higher lot costs which, owing to the multiplier effect, push housing costs even higher.

In many communities the time required to obtain approval for a subdivision or multi-family project is measured in years, not months. When housing is in short supply the developers begin the process of buying land and applying for approvals. The extreme lag time resulting from this unnecessarily lengthy process serves to magnify the swings in land prices and the resulting home prices, causing them to rise rapidly and often causing the supply to “over shoot” what the market wants, thereby creating what may be a significant over supply of homes and/or house lots.

The housing market consists of a mix of existing homes and new homes. Some existing homes are relatively new while others may be hundreds of years old. In a market where the population is increasing, new houses are needed to satisfy demand, and it is largely the cost of the new houses which drive the value (cost) of all housing. With the exception of houses with “antique value” most existing homes will sell at a price which is related to, and normally less than, the cost of similar new homes. Naturally, older homes which have not been well maintained will sell at a larger discount, while the newer homes will have values which are close to “replacement cost”.

Those of us who have owned a house (or several houses) over a number of years probably have the sense that the cost of almost everything (except computers) has been going up but it feels like housing costs are rising faster than “inflation”. This is, in fact, the case!

Over the past forty years the cost of living has increased about 770%, or an annual rate of about 4.4%, compounded annually. (1.)

During that same period houses in the author’s market place (2.) have increased about 1,250% or about 6.5%, compounded annually. (This reflects a long term average…price changes in a given year could be much higher, or lower (even negative).)

To get a feel for why housing costs have out paced inflation it is helpful to look at the basic economics of home building (for simplicity, we’ll look at single family homes in subdivisions).

In simple terms, housing costs can be thought of as having three distinctive categories. The first is land. All single family homes require a lot on which they can be built. Many builders are also land developers who create the subdivisions in which they build. They are, however, really operating two separate businesses, that of the developer and home builder. Some developers sell their finished lots to home builders, some do a combination of the two. To keep things simple, we’ll assume the builder buys the house lot at its fair market value.

The second component is the actual direct cost of labor and materials such as excavation and site work, concrete, lumber, plumbing etc. i.e. “bricks and mortar”.

The third component is the “soft costs”. This group includes finance, marketing, insurance, construction management, overhead and profit. This cost category tends to be closely related to the other costs as it tends to increase as a fairly constant percentage of the other costs.

A typical new home selling for $500,000 might have a cost break down as follows:

Note that the soft costs represent about 33% of the other two components. Since the soft costs vary in proportion to the other two components, a cost increase of $10,000 in either land or direct costs will result in a $3,333 increase in soft costs, producing a total cost increase of $13,333.

Historical Trend:

If one is interested in analyzing construction costs (without land) over many years, an excellent source is Marshall & Swift (3), publishers of The Residential Cost Handbook. This publication is widely used by appraisers and insurance adjusters to estimate the replacement cost of residential structures. Included in this publication is the “Comparative Cost Multiplier”, a table showing relative construction costs over a period of over forty years.

Based on this table, the cost of construction (assuming no change in specifications) in New England has increased by about 540% over about thirty two years. While this sounds like a lot, it actually represents an average annual increase of 5.2% (based on annual compounding). During this same period, the cost of living as measured by the CPI (1.) increased at an annual rate of about 5.3%. In other words, the cost of the bricks and mortar and related soft costs has virtually stayed even with inflation.

In 1968 the author built a house which was sold for about $40,000. If the total cost increased with inflation, the value today should be about $300,000, far below the more realistic estimate of $500,000! To some small extent, changes in building codes and specifications contribute to the increase but the majority of the difference is a result of a much greater increase in lot cost, coupled with a proportional increase in soft costs.

While it is more difficult to quantify lot cost trends, the lot purchased for $4,000 in 1968 would probably sell for about $160,000 today indicating an annual increase of about 9.7%, close to double the rate of inflation.

Why have lot costs risen so rapidly?

The most direct answer is “Supply and Demand”. The supply of land is diminishing as each new home is built and as the saying goes, “They aren’t making any more of it”. If all the rules and regulations had remained the same, there would have still been a significant increase in lot costs due to the declining supply factor. The bulk of the increase, however relates to changes in regulations which have been made over the years. These regulations include, large lot zoning, excessive wetland/soils restrictions, punitive “Current Use” penalties, excessive subdivision costs, to name some. From the developer’s prospective, he must not only deal with a higher raw land cost, but a greatly reduced yield (fewer lots than would have been allowed previously), far greater engineering and road building costs, and, to top it off, he may not get a building permit when he’s done!

As bad as this seems, it gets worse. There is a second relationship between lot costs and housing costs which must be considered.

In a given market place, there is a market driven relationship between lot cost and house size! As lot costs rise there is a tendency to build larger houses to maintain the “balance” dictated by the market. In the author’s market, houses of 1,500 to 2,000 square feet were common place when lot costs were low (and lots were smaller). Today the lots are larger and the average house size (single family) is probably well in excess of 3,000 square feet.

What happens when demand falls or there is a significant over supply (or both)?

When economic conditions such as levels of unemployment, changes in interest rates or financing terms, change in a way that causes demand to fall below the levels that require new units, the “replacement cost model” discussed above may no longer be a primary determinant of home prices. In this scenario the more motivated sellers (which may include banks who own foreclosed property) compete for the available buyers and prices may fall well below replacement cost. Builders will attempt to compete by cutting costs and building smaller houses but constraints relating to land costs will tend to limit their ability to compete with distressed resale houses. An exception to this can occur when there are large scale foreclosures of subdivisions, the result of which may be the introduction of building sites available below replacement cost. This condition existed in southern New Hampshire in the early 90’s when the excesses of the 80’s resulted in a significant over supply of house lots.

There is a Silver Lining to this cloud: Unlike many markets, the demand for housing tends to be cumulative. Every year new households are formed, babies are born and the result is that demand that is not satisfied in one year may, at least in part, be carried over to future years. During these slow periods it is normal to see a significant reduction of subdivision activity. When the pent up demand is great enough to require new houses, it is common that prices will rise (often very rapidly) until replacement cost again becomes the driving factor. The long lag time required to approve new subdivisions may have the effect of further increasing the price of house lots, thereby setting the stage for the next cycle!

When will the upward spiral stop?

If inflation continues and there are no changes in land use policies, there is little hope that prices, in the long term, will come down. As prices rise, demand falls, and as towns have less and less available land, it is to be expected that the number of new units will decline. While each town is different, many towns have attempted to address this problem by instituting zoning and land use regulations that permit higher density, sometimes with restrictions designed to make units more affordable for first time home buyers or the elderly. In the absence of such changes, it is the author’s expectation that, in the long term, home values will continue to out pace inflation.

The “easy money” conditions which led to the 2008 housing bubble caused prices to rise faster than incomes, and the oversupply that resulted ultimately forced a serious correction. As long as the economy has the strength to weather the recession, it is the author’s belief that the cycle will repeat itself and house prices will return to levels that reflect replacement cost. Hopefully, the lending industry will be more restrained and a more stable balance can be achieved.

Footnotes:

1. Source: U. S. Department of Labor, Bureau of Labor Statistics, CPI. Annual interest rate is compounded annually. Note: differences in CPI figures in this paper are a result of different time periods used in various examples.
2. The Author, David R. Hall, has about 40 years experience as a home builder and land developer in southern NH, primarily in Amherst, Mont Vernon and Bedford. References to observed market conditions reflect this geographical limitation. He currently resides in Mont Vernon.
3. Marshall & Swift, 911 Wilshire Boulevard, 16th floor, Los Angeles, California 90017-3409