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Housing quality improvement, property market dynamics, and sustainable house prices

A literature review of the circumstances when house prices are likely to become unsustainable.

Andrew Coleman

About this discussion paper

This paper reviews the literature that examines the circumstances when house prices are likely to become unsustainable. It argues that there are 2 types of unsustainability:

  • The first type happens when there is a widespread increase in demand for better quality housing, or a rapid increase in population, which leads to a construction boom. Since the number of new houses typically built by the construction sector is much smaller than the stock of houses, the boom may run up against capacity constraints for several years during which time prices rise and then fall back to normal levels. This type of boom could be managed by a central bank but there would be other trade-offs to consider.
  • The second type of price unsustainability happens when there are technical or regulatory changes that reduce the usual cost of producing new houses. This type of unsustainability reflects supply factors and is typically outside the domain of the central bank.

The paper argues that the demand for better quality housing (which cannot be quickly met from new supply) is a major reason for unsustainable house prices, and a reason why house price cycles are often so different from price cycles in other industries.

Watch a summary video

Author Andrew Coleman talks about his discussion paper.

G’day, I’m Andrew Coleman a researcher here at the Reserve Bank of New Zealand. 

The Discussion Paper we have just published examines the reason why housing markets have such unusual price and building activity cycles.  It was written to explore the possible causes of sustainable or unsustainable house prices, in response to the 2021 update to the Monetary Policy Remit. 

The unique nature of housing markets makes them prone to periods of temporarily high price surges, followed by price declines. 

The paper focuses on the quality dimension of housing demand – the shifts in demand for houses that are larger, better quality, or in better locations than others.  

These shifts can be caused by factors such as higher incomes or lower interest rates. 

The research suggests that the demand for better quality housing - which cannot be quickly met from new supply - is a major reason for unsustainable house prices, and a reason why house price cycles are often so different from price cycles in other industries.

The paper argues that a temporary surge in house prices is often caused by interest rate movements.

Lower interest rates cause a large number of people to demand better-quality houses, all at once, resulting in a price increase.

As the construction industry adjusts by building more high-quality houses, the price surge ends and prices can fall as the supply of housing slowly increases.

The slow pace of change in housing supply means that price rises caused by demand for quality are ultimately unsustainable – the supply response, building new and better houses, causes the price increase to come to an end, and then decline.

The declines in global interest rates over the last two decades are likely to have been a factor in booming housing markets around the world, and in New Zealand.

While higher interest rates can slow down housing market activity and reduce the size of house price and building cycles, central banks need to take into account much wider considerations than just the housing market - such as the inflation rate and employment - when setting local interest rates.

I hope you find the Discussion Paper interesting, please look on the RBNZ website for the full research paper.