RDP 2020-04: The Apartment Shortage 3. The Effect of Planning Restrictions

A ‘shortage’ can be defined in different ways. We do not discuss the merits of alternative definitions but we do want to be clear about what we measure. As shown in Figure 1, planning restrictions can reduce the quantity of housing and thereby raise the price. The difference between PRestricted and PSupply provides a measure of the severity of these restrictions and the shortage they cause. The primary goal of this paper is to estimate this difference. This difference can be described as an ‘effect of planning regulations’, ‘zoning tax’, ‘excess demand’ or ‘apartment shortage’, among other terms.

Figure 1: Stylised Apartment Market with Binding Quantitative Constraint
Figure 1: Stylised Apartment Market with Binding Quantitative Constraint

For many purposes, it does not matter why the gap arises or is sustained. If price exceeds marginal social cost, then welfare is improved by increasing supply, regardless of the reason for the difference. That said, we agree with the literature cited in Section 2 that the gap can be attributed to planning restrictions. This approach may seem like labelling a residual. However, as discussed above, there is abundant evidence of supply being restricted by planning regulations and this having large effects on prices. In contrast, non-regulatory factors seem unlikely to be important.

The most obvious alternative explanation of the gap between price and marginal cost is imperfect competition. However, Grattan Institute analysis of IBISWorld industry reports indicates that apartment construction has low barriers to entry and low levels of concentration. The four largest firms in the ‘apartment and townhouse construction’ industry account for only 19 per cent of industry revenue (Minifie, Chisholm and Percival (2017), supporting data for Figure 1.3). According to ABS Cat No 8165.0 (Counts of Australian Businesses, including Entries and Exits), 24,641 firms were primarily engaged in other residential building construction in 2018/19. Of these, 822 businesses reported annual turnover in excess of $10 million. A small number of firms build the very tallest buildings and hence have market power over some specialised inputs, such as cranes or land in the CBD. However, by their nature, these account for a small fraction of the industry-wide costs that affect our estimates. More importantly, these firms sell their output in the broader market for apartments (including sales from the existing stock), for which their market power is negligible.

Other non-regulatory explanations are simpler to dismiss. The persistence of excess demand, shown in Section 5.2, makes the gap between price and cost difficult to attribute to transitory supply adjustments. The severity of height restrictions makes it difficult to attribute to a shortage of land. The size of the gap makes it difficult to attribute to momentary misperceptions, frictions or measurement error. As we argue in the previous section, difficulties in obtaining access to finance and the high cost of land should be interpreted as effects of planning restrictions, not as alternative explanations. Similarly, it is sometimes suggested that speculators are withholding properties from the market. But they would only do this if they expect higher prices in the future – that is, they expect planning constraints to bind even more tightly. We acknowledge there are important times and places where regulatory constraints are not binding. Section 5 identifies some of these and shows that they are consistent with planning restrictions having a large effect on average apartment prices.

Apartments can be supplied by either allowing builders to increase building heights (‘building up’) or by increasing the number of apartment buildings (‘building out’). We provide estimates of the costs of both these margins of adjustment. We use the term ‘height restrictions’ to encompass various regulations, including floor space ratios (FSRs), that discourage building up, whereas a wider range of land use restrictions discourage building out. Our main estimates are shown in Table 1 and discussed in detail in following sections.

In Sydney, for example, the average new apartment sells for $873,000 but can be supplied for $519,000, a gap of 68 per cent of costs. The gap is 20 per cent in Melbourne and 2 per cent in Brisbane. We think it is fair to describe these effects as huge in Sydney, moderate in Melbourne and unimportant in Brisbane. We calculate these gaps using the less costly method of supply, building up. However, the difference in costs between building up and building out is often quite small. The differences between cities largely reflect differences in apartment prices, with variations in costs being secondary.

Table 1: Apartment Prices, Costs and the Effect of Building Restrictions
Per apartment, $′000, 2018
  Sydney Melbourne Brisbane
Average new sale price 873 588 470
Cost of building up 519 491 460
Cost of building out 610 505 471
Effect of building restrictions 355 97 10
Effect as per cent of price 41 16 2
Effect as per cent of cost 68 20 2
Note: Data sources and estimates are explained in Section 4 and Appendix A

Our estimates of the effect of building restrictions in Sydney and Melbourne are a bit smaller than those of Kendall and Tulip (2018). Our estimate for Brisbane is substantially smaller, being revised down from $110,000 to $10,000 per apartment. The revisions to prices reflect the use of building characteristics to filter townhouses and updating of data to 2018. Revisions to cost estimates are discussed in Appendix A.