Why Real Estate Prices are High

World over, high housing prices seem to be a problem. They’ve always been an issue in India. They are an issue in the US, where millennials are not able to afford houses to live in. In the UK as well, rising housing prices mean that today’s young are unable to buy up houses. The global phenomenon that is driving all this is the drive towards increasingly large cities.

Going by first principles, there are two major components that determine the cost of a house (note that I said cost and not price) – the cost of the land and the cost of construction. It can be safely assumed that the latter hasn’t increased at a rate dramatically higher than inflation over the years.

Yes, there are bubbles and busts in prices of commodities such as steel and cement. Houses nowadays are being built largely to better specifications and quality than earlier homes. In places like the US, modern houses are  bigger. But all this is balanced by technological innovation which makes stuff cheaper. So on an average, the increase in construction costs over the years is not dramatic.

That implies that the massive increase in price of housing the world over is driven by  increasing costs of land. Some scaremongers will try to tell you that this is due to there being too many human beings in the world, and we are soon headed for a Malthusian collapse. However, the land needed for housing is small, compared to say agriculture, so regular transfer of land from agriculture to housing should take care of this. So why are land prices increasing so much?

It has to do with the distribution. During most of the 20th century, manufacturing being the base of the economy meant that a lot of smaller cities and towns flourished. These cities and towns were either located conveniently enough to tap raw materials or markets for industrial goods, or were helped by the fact that land requirements for industries meant that big cities would get expensive very soon for industries, driving development to smaller cities and towns.

As the share of populations in manufacturing falls, and more people move into services, the larger cities gain at the expense of smaller cities and towns. This means the distribution of demand has changed massively over the last 30 years or so. Rather than demand being more or less uniform over cities, nowadays most of the housing demand is spread over a few small cities.

And these cities aren’t able to keep up. Supply in some cities such as San Francisco and Mumbai, are constrained by regulations on how much can be built. Other cities such as Bangalore or Houston have expanded radially, but housing in the far suburbs is much less attractive than closer to town (due to increased transport costs), and there is only so much supply in “convenient areas” of towns.

This changing pattern of urbanisation is leading to rapid increase in the prices of housing in places that people want to live in. And so millennials are being priced out, unable to buy homes. The distribution of jobs across cities means they don’t have the luxury of “settling down” in smaller cities and towns where housing is still affordable. And until the larger cities hit their limits of growth and businesses start moving to smaller cities (thus creating newer hubs), this housing shortage will exist.


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