Housing – Will deregulation fix everything?

Many countries have issues with an under supply of housing. The blame is often placed on housing regulations. Would removing these regulations fix this issue?

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Introduction

Housing affordability has become a hot-button topic again. Increasing interest rates have resulted in much higher mortgage rates (going from around 2.5% to nearly 7%), which has stirred debate about the affordability of housing. As argued in a previous post, the cost of a house is not only dependent on the mortgage rate, but also the price and down payment. Depending on how the numbers work out, houses do not have to be necessarily more expensive when mortgage rates are higher. However, housing and renting have generally been expensive for a much longer period, mainly caused by the under supply of housing. So why do we have housing supply issues? A lot of commenters (and economists!) often place the blame on government regulations and zoning laws (these laws specify what type of housing can be built in a given area such as single-family or multi-family homes, how many floors a building can have, the minimum lot areas, etc). There is evidence that these regulations do drive house prices and rents higher. Therefore, as these commenters say, if we were to remove the housing regulations, the issue would resolve itself – but is that really the case?

Return of the Lucas Critique

When discussing possible counterfactuals, such as what would the housing market look like in the absence of housing regulation, it is important to keep in mind the Lucas Critique, covered by us previously and best exemplified by the image below.

The Lucas Critique states that in order to predict the impact of a change in economic policy, one cannot assume that all economic participants (individuals, firms, governments) would respond in the same way as they have done in the past. Economic participants may now respond differently when the economic policy is changed. It is important to model or think through the underlying reasons behind certain decisions economic participants have been making. This is needed to correctly forecast their behavior under a new economic policy. As the picture above demonstrates, the bicycle barriers, which were meant to get people to get off their bikes, did not work at all, as people simply bypassed the barriers.

Lucas Critique and Housing Regulations

In the context of housing regulations and zoning laws, the argument that their removal would quickly increase housing supply assumes that the economic participants would not respond to this change. Deregulation would simply increase housing supply and make housing more affordable. Unfortunately, this thinking ignores the Lucas Critique – economic participants can respond to this change. Faced with deregulation, individuals and firms could replicate the regulations. One such approach, which is already done in the US, but also in many other countries, is the creation of Residential Community Associations (RCAs) of which the most famous type are Homeowners Associations (HOAs). 

HOAs are known in the US as a source of many horror stories, as they have been known to impose restrictions on the colors of the house, what can be placed in the backyard, and even the angle of the sidewalk curb. HOAs are a form of private association that unites homeowners together. Any person that wishes to purchase a home in an HOA, must become a member of the HOA and adhere to the governing documents and by-laws. HOAs are typically lightly regulated by the government, with certain US states having no laws whatsoever about what an HOA can and cannot do.

HOAs have become an increasing feature of the US housing landscape. In the 1970s there were approximately 700,000 housing units that belonged to an HOA. As of 2020, that number stood at 27 million, with approximately a quarter of the US population living in HOAs. Moreover, this number will continue to grow as over 80% of sold homes in 2020 were part of an HOA community and 66% of newly built houses were part of an HOA. 

Why Do HOAs Form

One reason why HOAs may form is linked to the provision of public services. If local governments or municipalities do not provide certain public services (for example, roads or gyms), residents may want to join together in order to finance such public services. With that in mind, real estate developers often design new communities with HOAs already in place. HOAs have been described as a form of ‘private government’. 

Cheung and Meltzer (2014) looked into where HOAs form. Using data from Florida, they found that HOAs were more likely to form in more affluent and White areas. Furthermore, HOAs tended to form farther away from city centers where there was a lower share of public transport users. Areas that have lower public spending on road infrastructure also were more likely to form HOAs. Within cities, areas in which there was less local public spending also have a higher chance to form an HOA. 

Their findings have several implications. HOAs appear to act as replacements for local government or municipality spending. This does not determine the causality however – that is, do HOAs form because the local government isn’t spending in that area, or does the local government intentionally reduce spending to encourage HOA formation. 

A less ambiguous implication is that HOAs reduce community integration on both the race and income dimensions. Clarke and Freedman (2019) looked at the entire US and also found that HOA residents tend to live on less diverse blocks than residents in nearby non-HOA neighborhoods. Regarding social impacts, Cheung, Salmon and Xie (2022) describe that certain municipalities cut back on the provision of public services such as sanitation and security to non-HOA residents in areas where there is significant HOA growth. Moreover, HOAs can act as a tool for what is known as the ‘secession of the successful’ (i.e. secession of the wealthy from the rest of the local community), caused by the fact that HOA residents receive most of their amenities from private sources, while non-HOAs residents receive publicly provided services. Since HOA residents can get access to their own services, they have little interest in the provision of public services to the rest of the public. Since HOA residents typically have common interests,  they can jointly exert political power via their association, resulting in a variety of policies favoring the HOA residents at the expense of non-HOA members.

However, Cheung, Salmon and Xie do mention that HOAs might have certain positive effects on social cohesion. One way in which HOAs may increase cohesion, especially in cities, is that it offers wealthier residents an option to stay in the city, rather than move out of it. Through HOAs, they can get the services and amenities that the local government might not provide, giving them an incentive to stay, and thus preventing income-based segregation from occurring.

Attempts at actual ‘secession’ have occurred. One such example is the attempt of the San Fernando Valley district of Los Angeles to secede from Los Angeles and establish a new area with a new local government. As documented by Haselhoff (2003), both business and residents that wanted to secede were largely motivated by a desire to have more public services and control over land use regulations. Higher income individuals in that district were more interested in seceding. More recently in 2018, a very wealthy district of Stockbridge (a city in the suburbs of Atlanta), Eagles Landing, attempted to secede. The campaign and vote made national headlines due to the significant racial disparity between the seceding area and the rest of Stockbridge.

It appears that HOAs are something that specific groups, especially wealthier ones, desire. Since HOAs place certain restrictions on homeowners, we should expect there to be an impact on house prices.

HOAs and House Prices

HOAs entail significant costs on their inhabitants. Beyond the simple potential nuisances of having to deal with certain requirements such as the color of the house or the condition of the lawn, HOAs are a form of double taxation. A person living in an HOA has to typically not only pay local or property taxes that go to fund the services provided by the local government, but also the HOA fees that often provide similar services. To get a sense of the size of these fees, the average HOA fee is $2,800 per year, while the average annual property tax amount is $2,200. Given that there are additional costs of an HOA, we would expect prices for HOA houses to be lower. 

On the contrary, Clarke and Freedman (2019) found that HOA houses in the US are 4% more expensive than observably similar non-HOA houses. This result is very surprising. Since HOAs actually require an additional monthly cost, from a purely financial perspective, they find that an HOA house should actually be 20% cheaper than an observably similar non-HOA house. Given that HOA houses are 4% more expensive, this implies that an HOA itself must generate ~24% additional value!

Clarke and Freedman find that HOA houses are more valuable in areas with less stringent land regulations, resulting in a form of ‘private zoning’. HOAs are also more valuable in areas where property taxes are lower, as well as in areas where public spending on police and administration is lower. This matches the hypothesis that HOAs replace local government with private government. Finally, there is evidence that some individuals value the neighborhood homogeneity (both in income and race) generated by HOAs. This results in the reinforcement of segregation, which can limit educational access and opportunities for those excluded from the HOA.

Deregulation of Zoning Laws

As mentioned, a lot of commenters and economists have argued for deregulating zoning laws and housing restrictions. Naturally, such a decision will have an economic impact. Anagol, Ferreira and Rexer (2023) looked at recent zoning reform in Sao Paulo, Brazil. Sao Paulo is the 4th largest metropolitan area in the world with a population of 21mln. A reform in 2016 allowed for a larger building density on each block – on average, this allowed for a 36% increase in building construction on a given lot. The authors found that this reform increased housing supply by about 1.9% and reduced home prices by 0.5% in Sao Paulo. There is significant variability in these outcomes with some areas of Sao Paulo that had previously stricter requirements. These areas experienced a 17% increase in housing supply and 5% drop in  prices. The authors found that for consumers, this reform is welfare improving, even accounting for certain additional welfare costs, such as increased congestion. 

However, this reform was not welfare improving when accounting for the losses to existing homeowners. The welfare loss to existing homeowners in Sao Paulo was estimated to be 16 times greater than the benefit to consumers from the zoning law reform. This shows why many existing homeowners would be strictly against changing zoning laws, and would attempt to replicate them privately if they were repealed. 

Given the size of losses for current homeowners, while the benefits for consumers are relatively much smaller, it is no surprise that zoning laws are difficult to change. The difference in impact between homeowners and consumers is so large, that one could argue that homeowners would be willing to compensate consumers to not have the zoning laws changed. This is actually an idea stemming from the Coase Theorem (Robert Coase received a Nobel for this theorem). The Coase Theorem broadly states that if two parties can negotiate over the externality,¹ a welfare improving outcome can be achieved. This is because the adversely impacted group by the zoning law externality, in this case the consumers, could theoretically be directly compensated by the homeowners. Of course, the difficulty of this transaction is establishing who the actual consumers of housing are, which is why such a transaction is impossible. However, one way this can be mitigated is via increasing local government taxation on the homeowners, and using this additional revenue for the consumers through the provision of services or assistance.

Zoning Law Situation in the US

Zoning laws are prevalent in the US and in many countries. However, they only have an adverse effect if they increase the price of housing. One way to determine where zoning laws can lead to adverse consequences for consumers is to look at areas in which houses cost more than their construction cost. In an efficient construction market, house prices should not be much greater than their construction costs.

Glaeser and Gyuorko (2017) looked at the ratio between the cost of producing housing to the actual house prices. Overall, they estimated that to produce a 2,000 sq. ft. home should cost between $200,000 to $265,000 depending on the area. Glaeser and Gyuorko find that, as of 2013, nearly ¾ of US houses are priced below or slightly above the cost to build the unit. Nearly 10% of houses are two times more expensive than the production cost. 

The main areas that have expensive housing are the metropolitan urban areas. From 1985 to 2013, the fraction of metropolitan areas where house prices are 25% above the production cost of the house went up from 6.4% to 15.9%. Manhattan is an example of an extreme discrepancy between the cost of housing construction and price per square foot. Glaeser, Gyourko and Saks (2005) determined in 2005 that the Manhattan house prices are 3 times greater than the cost of building. 

Conclusion

Many commenters and economists have advocated for housing deregulation and weakening of zoning laws. They are correct that these laws increase house prices in many markets, especially in urban areas. However, what they often don't realize is that simply deregulating would not solve the housing supply problem due to the Lucas Critique. Current homeowners can easily mimic zoning laws and regulations via setting up private government forms such as HOAs or even attempting to secede from local governments. It is entirely logical for this to occur as current homeowners have a lot to lose if deregulation occurs. It is also rational for them to spend a significant amount of money to defend the current laws and maintain status quo via political influence. Thus, not only would we need to deregulate housing but also place significant restrictions on the right to form associations and reduce the influence of money in politics, which are separate issues.

Unfortunately housing supply and affordability are not easy to solve. The problem is mainly prevalent in urban areas. One solution to improve housing affordability is to improve public transport in urban areas, which would allow for housing to be built in areas further away from the city, where housing and zoning laws are less impactful on house prices. Another solution has somewhat already emerged – working from home has enabled people to live in less expensive areas without the need to commute to urban areas. Furthermore, working from home has reduced demand for office space significantly, which may potentially increase residential supply in expensive cities.

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Early Child Investment - Child Tax Credit - the benefits of the expanded child tax credit to society.

Cover photo by Steffen Coonan.

1. Externalities are indirect costs or benefits that impact uninvolved parties caused by activities of another party (pollution impacting people’s health caused by factories and using your car leading to traffic congestion are examples of negative externalities; vaccinating oneself is a positive externality as it reduces the likelihood of others getting sick). Since these costs and benefits are not taken into account by private individuals when making decisions (i.e. they don’t ‘internalize’ them), some activities happen too much (pollution), while others not enough from the perspective of society.