Market failure in residential property

An emerging trend across countries is that of private equity firms becoming large real estate landlords, including in housing. Blackstone is today the largest landlord in the world, including in America and several other countries like India. 

This trend has been accompanied by rising housing prices and rents, thereby posing questions about housing affordability. This, in turn, has generated strong backlash across countries, forcing governments to scramble with restrictions.

The White House wants to restrict the types of properties that large investors are allowed to buy. New Zealand has scrapped tax breaks for property investors, and Ireland has slapped a 10% tax on the bulk-buying of houses. Canada’s central bank says the role that big investors play in housing requires more scrutiny. In Germany Berlin’s residents voted in September to force their city’s biggest landlords to sell more than 200,000 flats to the state, though the referendum was non-binding and the constitutional court is expected to overturn the result if it becomes law. Spain’s left-wing government is the latest to unleash measures to deal with big landlords. Under new proposals, they will face rent controls, higher taxes on empty property and a ban on buying social housing.

And this,

Are real estate prices today the equivalent of bread prices? It’s a question that was recently asked by a trade union leader in Germany, where there has been a push to seize corporate-owned rental units and put them in public ownership. Many Dutch cities want to ban investors from buying cheap homes to rent out. South Korea’s ruling party took a beating in mayoral elections for failing to stop a 90 per cent hike in the average price of a Seoul apartment. China’s president Xi Jinping has made affordable housing a huge part of his common prosperity theme, saying that housing is “for living in, not speculation”.

Affordable housing is a complex issue. I have blogged here about the challenges associated with the issue. It's perhaps the most important problem facing the sustainability of cities, especially in developing countries. In developed countries, there is a case that housing markets in many large cities have become mature and resilient enough to evolve and regenerate constantly to prevent decay. 

Ultimately there is only one solution to addressing the issue of affordability, expansion of supply. Given the more or less fixed stock of land mass within a city, the solution has to involve both building on unused lands (extensive margin) and vertical development on existing properties (intensive margin). Further, there has to be a simultaneous expansion in supply of premium, middle-class, and low-income housing supply so that price transmission happens across the market. 

It's an empirically established reality that markets tend to concentrate the expansion of supply towards the rich and well-off. This is especially when the supply is constrained, as is the case in all urban areas. Besides, apart from being a dwelling unit, urban housing property is arguably the most important investment category. 

A McKinsey study, entitled “The Rise and Rise of the Global Balance Sheet”... found that two-thirds of net worth is stored in residential, corporate and government real estate as well as land... The authors believe that declining interest rates have played a decisive role in lifting asset prices of all sorts, but particularly real estate prices. Constrained land supply, zoning issues and over-regulated housing markets also helped push up values. The result is that home prices have tripled on average across the 10 countries.

The combined effect is a market failure to deliver affordable housing.  

Private investments in housing certainly has its benefits. As The Economist article illustrates,

Big investors there have been turning offices into homes for years. As a result, some 60,000 people live in Lower Manhattan today, up from just 14,000 in the mid-1990s. The City of London believes it has room for an extra 1,500 homes by 2030.

The article pooh poohs the critiques that private equity may be driving up property prices,

In fact, their share remains modest. In America investors own just 2% of rental homes. Across Europe, publicly listed funds own less than 5%. In Spain the criticism has focused on Blackstone, the country’s biggest residential landlord. After entering the market eight years ago, the private-equity giant now owns 30,000 homes. Yet this amounts to just 1% of the total stock.

But there are at least two issues with this critique. One, even if their share of housing stock is tiny, they are an increasingly important incremental contributor. 

By some estimates, they account for more than 6% of new homes in America each year. Across Britain, institutional investors are expected to supply a tenth of the government’s housing target in the next few years. Since 2018 they have built nearly a quarter of new homes in Liverpool, and more than 15% in Nottingham, Leicester and Sheffield.

Given that pricing happens at the margins, their increasingly high marginal share makes private equity a very important player in the housing market.  

A second more important issue is that of the nature of housing likely to be owned by private equity. Second homes and investment clients become the highest priority for private equity investors. All said and done, while generous tax breaks and other public support have made affordable housing somewhat attractive, the primary focus on private equity is on the high margin housing for the higher income residents.

Adding to the private equity headwind is that from sharing economy companies like AirBnB and Oyo. Even if their absolute share is small, it is a reality that they take out a non-trivial number of properties from the housing market each year, precisely at a time when its demand is rising. Besides, since the sharing economy market caters more to the middle-income and below clients, their impact is more likely to be felt in the affordable housing market. 

The aforesaid two factors mean that private equity is more likely to capture both the extensive and intensive margins with disproportionate focus on the higher income housing. At the extensive margin, vacant lands become too prohibitive except for the richest. At the intensive margin, gentrification drives out the poor and depletes affordable income stock. The net result is that the land footprint and total stock  shares of higher income housing rises, even as the real demand for affordable housing rises much faster than that for higher income housing.

In light of all the aforementioned, we have a market failure in affordable housing. The case for regulation of private equity investments in housing is therefore very compelling. The challenge is with getting it right.