Home Prices Are Rising As More Supply Is Built. That’s How It Works

Home prices are expensive. Let’s build more homes, and the cost of all of them will become affordable. It’s supply and demand… like your local politician and mysteriously funded community group always say. Except homes are being built and delivered at a record pace, way in excess of population growth. You’re getting a little suspicious. Home prices aren’t falling. They’re actually rising at one of the fastest rates in history.

What gives? Hate to break it to you, but an increase in new home construction should always increase prices. During a building boom, more building should speed up price growth. That’s because the laws of supply and demand apply to all parts of a house — not just the final product. Let’s take a quick dive into why home prices are rising as building increases.

Supply and Demand 101

Supply and demand is a straightforward concept and often used to explain home costs. High demand for a product relative to its supply will see prices rise. Low demand for a product relative to its supply will see prices fall. Easy peasy, who doesn’t get that? In a perfect world, it would be that simple. Unfortunately, building a home is much more complicated.

Most don’t realize supply and demand applies to every part that goes into the final product. Every brick, beam, and mortar layer is subject to supply constraints. The more homes are built, the higher the demand for the components needed to build. To cope with the demand, the cost of building rises. That’s before you factor in developers aren’t a charity. They need to make a profit as well.

The Three Ls: Land, Labor, and Lumber

Three major price factors in home building are land, labor, and lumber. Let’s start with land values, which seem a lot more simple than they are. Competition between builders is a clear way prices are pushed higher. Builders also need to compete against home buyers though. This is a frequent occurrence when land is being assembled for development.

Plottage is when two adjacent plots of land are combined to increase the value. The process is called assemblage, and the end result is called a land assembly. In cities without much raw land, developers need to create a land assembly from homes.

When you see a sweet home in a nice neighborhood, a developer sees something else. They see a home that can be knocked down to build a lot more housing if the neighbor also sells. If there’s even a chance the surrounding home may go for sale, it becomes worth a lot more. Even if they have no immediate use for the property, you need to compete with the developer.

As a homebuyer, you’re no longer looking to buy a home. You’re looking to buy the right to redevelop the existing home, create an assembly if your neighbor sells, knockdown both houses and build several homes… you just happen to want to use the existing home on the land.  Even though this home may or may not be used in a development, the potential becomes an increase in price.

Okay, but what about a home down the street with zero development potential? If the next buyer doesn’t understand the reasons for the comp, they are likely to just pay what they can afford to pay. If that buyer pulls the trigger, the comp is reinforced regardless of whether it makes sense. The market is sometimes only as rational as the least informed participant.

Labor Costs Soar During A Housing Boom

The cost of building homes rises during a building boom, because of demand for labor. If you decide you need to build 100,000 more homes per year over the span of 3 months, you won’t have enough labor. To make up for this, builders need to compete with higher pay for tradespeople.

Toronto is building so much housing, it tops North America for high-rise crane count. Altus Group estimates construction costs in the area will rise by 5 percent in 2021. That’s double the target rate of inflation. They attribute a good portion of the increase due to a shortage of construction labor in the region. Since a developer isn’t a charity, they need to pass these costs to consumers.

Lumber Grows On Trees, But Banks Approve Mortgages Much Faster

Lumber is just one of the materials subject to a price squeeze during a building boom, but it’s a big one. U.S. new home starts have reached the highest level since 2006, and they need a lot of lumber. The demand for one of the essential building materials has surged to a near-record high. During the pandemic, this is also met with the bonus of reduced mill capacity.

The cost of lumber soared recently, partially due to the North American builder boom. The Western Spruce-Pine-Fir (SPF) benchmark reached $1,240/mbf in April, up 8.97% from just a month before. Prices are now 200% higher compared to one year before that. Lumber is quick to correct in price, but in the meantime, if you want a house — you’re paying more.

Western Spruce-Pine-Fir (SPF)

BMO has forecast Western Benchmark lumber prices will fall in the not so distant future, but in the meantime they’ll push building costs higher.

Source: BMO; Better Dwelling.

Rising lumber costs add a significant bump in the final cost of building a home. American home builders can expect to see the rise in lumber add $30,238 to a single-family home. For a multi-family home, it’s a little better at $11,157 — but that’s still a nice chunk of change. Building more all at the same time doesn’t fix this, it increases demand on the building costs.

Higher Buildings Mean Higher Building Costs, Not Cheaper Housing

What if we build higher buildings to maximize the space? That way we can lower the per unit cost by at least land value, right? Nah, bruh. Higher buildings actually have a higher cost to build.

In Greater Toronto, Altus Group’s 2021 estimates show it’s a lot more expensive. For a building 6-stories and under, it costs between $195 and $265 per square foot. For a building between 13 and 39 stories, costs jump to $240 to $305 dollars per square foot. Builder costs jump between 15 and 23 percent between those sizes. It also gets more expensive as the building gets taller. That’s before you add in premiums and the developer’s profit.

More Rentals Have Little to No Impact On Rental Prices

Surely if they build enough units, the empty ones will have to rent for lower, right? Well… not exactly. A study from the U.S. Federal Reserve (you might have heard of them), looked at the issue. Even in perfect conditions, rents don’t fall by much on a much higher volume of rentals.

Fed researchers found you need a lot of housing to lower prices after they rise. For every 5 percent increase in housing stock, prices would drop by 0.5 percent. That’s about $10 off $2,000 per month in rent, in ideal conditions. In reality, a 5 percent increase in housing stock is huge. To build that much, developers would have to scoop a whack of land. The property values are likely to increase rents by more than the 0.5 percent drop the extra supply creates.

The researchers conclude, “if a city were able to ease some supply constraints to achieve a marginal increase in its housing stock, the city will not experience a meaningful reduction in rental burdens.” 

No, I’m Not Saying Home Building Should Stop

I’m not saying building more homes is a problem. Housing inventory is obviously an issue. However, there’s no actual way to build more homes to lower prices. Canada is delivering multiple homes per person for its population growth. Prices are now growing at one of the fastest rates ever. In most regions, you’ll hear people say it’s due to the cost of land values. After all, someone is going to need to buy it to build more housing, right?

Even just the basic premise doesn’t make sense. If you thought building more homes would make prices drop, why would you buy one? Why would developers try to build them? They would risk being stuck having inventory with falling value. It’s a good thing no one actually believes more supply brings prices down. If that were the case, no new housing would be made.

The Real Estate Cycle Never Fails, It Only Becomes Inefficient

Real estate works in a cycle that balances the interests of residents and developers. Typically after home prices soar and affordability becomes stretched, prices begin to drop. When prices fall substantially, developers scoop properties for the next boom. As the economy recovers from the bust, developers start developing with the economy. It continues until the cycle goes bust, and then repeats. Each time capturing economic growth during booms, and purges excess credit on busts.

Governments occasionally try to extend the cycle by adding credit and subsidizing buildings. The additional building still drives costs higher though. It only works briefly because they transfer private liabilities into publicly owned ones. They drive prices higher and push cities towards systemic failure..  in the name of creating more affordability.

It’s like they’ve concluded instead of digging down to get out of a hole, they’ll dig up. At first it might be funny to watch. At a certain point, you wonder if they’re trying to make people laugh, or if they require adult supervision.

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