Based on conventional economic theory, which does apply to the real estate market, investors looking for larger capital gains and higher returns should be targeting property markets with inelastic supply.
The responsiveness of new construction to asset price or rent changes, is referred to as the price elasticity of new construction. This also reflects the price elasticity of real estate supply in a market, since a more responsive new construction would result in a faster increase of an area’s total property inventory. The conventional formula for calculating the price elasticity of supply is:
Price elasticity of property supply = percentage change in quantity supplied/ percentage change in property prices
For new construction particularly the price elasticity formula would be:
Price elasticity of new construction = percentage change in units or square meter built / percentage change in property prices
A price elasticity of new residential construction of 1.5, for example, suggests that a 1% increase in property prices will induce a 1.5% increase in the number housing units completed. Thus, the price elasticity of supply is a very valuable metric in grasping the magnitude of the effect of changes in prices in stimulating new construction. For example, assume that real estate analysts anticipate that a new government policy will raise housing prices by 10%. Then the elasticity figure of 1.5 would suggest that this new policy would stimulate a 15% increase in new construction.
New construction is on average very price elastic. Ihlanfeldt and Mayock (2014) report an average elasticity of housing construction of approximately 2 in a study of 64 counties in the state of Florida. Elasticity of supply is largely determined by the cost and availability of factors that go into the production of real estate. If these factors are more costly and scarce in a market we would expect real estate supply to be more inelastic.
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Why investors should target markets with inelastic real estate supply?
Investors should target markets with inelastic real estate supply because demand increases due to exogenous factors, such as economic growth, decrease in interest rates, etc., would result in greater increases in property prices, assuming that the market was not oversupplied before the increase in demand takes place.
According to conventional economic theory, the magnitude of the price increase will depend first on the magnitude of the demand increase due to exogenous factors that will shift the demand curve to the right. For example, all else equal, an influx of thousands of new buyers/renters in the market should result in greater price/rent increases than the entry of only a few hundred new buyers/renters. Thus, greater increases in the quantity demanded should result in greater rent/price increases.
The second factor that will affect how much property prices will increase in a market due to a shift of the real estate demand curve to the right is the price elasticity of supply and by extension the price elasticity of new construction per the discussion above. The reason is that only considerably higher prices will induce suppliers to provide the additional amount of space needed to cover the excess demand.This can be better understood by looking at Figures 1 and 2 below. As it can be seen in Figure 2, an even greater increase in demand (represented by a larger shift of demand curve to the right) in a market with considerably less inelastic property supply results in considerably smaller increase in real estate prices and considerably larger increase in property supply, compared to the increases in property prices and supply in the market portrayed in Figure 1, which has a considerably more inelastic property supply.
Figure 1 Property Demand Shift – Inelastic Supply Figure 2 Property Demand Shift – Elastic Supply
Studies of the office market by Wheaton (1987) and the housing market by Harter-Dreiman (2003) suggest that supply of both property types is quite elastic. In particular, according to the latter study, estimates of the price elasticity of housing supply range between 1.4 and 2.7 for large metropolitan markets (the 20 MSAs with the largest population density in 1990) and between 0.9 and 2.1 for small metropolitan markets (the 20 MSAs with the smallest population density). Harter-Dreiman (2003) estimated also the price elasticity of housing supply for two types of markets: constrained and unconstrained. This distinction was based on a regulatory index constructed by Malpezzi (1996) using several criteria, such as approval time, permit issuance time, zoning regulations, and adequacy of infrastructure.
Harter-Dreiman’s estimates of the price elasticity of housing supply range between 1 and 2.1 for constrained markets and between 2.6 and 4.3 for unconstrained markets. These estimates indicate that housing supply is price elastic in both types of markets, even the constrained ones (since it has values greater than one). They also indicate that housing supply is much more elastic in unconstrained markets, compared to constrained ones. Overall, these estimates suggest that the supply risk of residential investments is lower in small and constrained metropolitan markets.
Since constrained supply is critical in triggering strong rent/price gains when demand increases, it is interesting to look at the specific residential markets that have been classified as constrained in Harter-Dreiman’s study. As Table 1 indicates, this list includes several large, popular markets, such as Atlanta, Boston, Fort Lauderdale, Los Angeles, Miami, New York, Orlando, Philadelphia, San Diego, and San Francisco.
The important points to remember from this section is that the magnitude of price/rent increases, as a result of a surge in demand, will depend on the magnitude of demand increase—how much more space will be demanded—and on the sensitivity of buyers/renters and sellers/developers/landlords to price/rent increases. Empirical studies have shown that the demand for housing is not very sensitive to price increases, while supply seems to be sensitive to such increases. This means that a surge in housing demand in a non-oversupplied market is likely to result in strong price increases, but supply is likely to overreact. This point provides further support to the short-term hold strategy, since initial real estate rent/price increases may be cancelled by rent/price declines later, due to the overreaction of supply.
The strategic conclusion is that investors should be looking for property types, markets, and locations that:
- Are about to experience strong increases in demand for real estate
- Are characterized by price inelastic, or price-insensitive property or space demands, perhaps due to greater affordability, as determined by current prices/rent levels and household incomes or firm profits.
- Are characterized by inelastic, or price-insensitive, supply—either due to the scarcity of development inputs such as land, labor, or capital, or restrictive government regulations, growth controls, and time-consuming government processes.
Table 1 – Markets where Housing Supply was Most and Least Constrained in 2003 (According to the Harter-Dreiman Study)[1]
[1] Based on Malpezzi’s (1996) definition of a regulatory index.
References
Mourouzi-Sivitanidou, R. 2020. Market Analysis for Real Estate 1st Edition. Ed. P. Sivitanides, London, UK: Routledge.
Sivitanides, P. 2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.
Wheaton, W. 1987. “The Cyclic Behavior of the National Office Market.” American Real Estate and Urban Economics Association Journal, Vol. 15, pp: 289-299.
Harter-Dreiman, M. 2003. “Drawing Inferences about Housing Supply Elasticity from House Price Responses to Income Shocks.” OFHEO Working Paper 03-2.
Malpezzi, S. 1996. “Housing Price Externalities and Regulation in US Metropolitan Areas.” Journal of Housing Research, Vol. 7, pp: 209-241.
