Public Comment

The Housing Crisis: the strange failure of supply and demand

Steve Martinot
Friday February 26, 2016 - 05:03:00 PM

An exercise in economic process


We have a severe housing crisis. The supply-side advocates say that building market rate housing will meet part of the demand, and thus resolve the crisis. What I propose here is a specific exercise, hypothesizing specific terms relevant to this crisis, to test if this is true. We shall examine what happens when all market rate housing is built in the midst of a housing crisis, and what happens if all affordable housing is built in the midst of such a crisis.

To do this, I will first define a set of assumptions in order to map the limits of this exercise’s machinery. And then we shall examine three different cases of housing development: all market rate, all middle income affordable, and all low income affordable. 



The following assumptions will suffice to set up this hypothetical exercise.

People are rational: they will not voluntarily move from an apartment at one rent level to an apartment at a higher rent level without having first received a significant increase in income (and in this exercise, we postulate no income increases).

People are economical: when housing units at a certain rent level become vacant, some families in a higher rent level will seek to move to them, thus saving money.

Landlords are earnings oriented: when demand for housing goes up, there is "market" pressure on landlords to raise the rent.

Rent increases are only permissible between tenants: the rent on a housing unit can be increased only after a tenant moves out. Many landlords will attempt to pressure tenants to move out in order to raise the rent when demand is high.

The hypothetical situation we shall examine: in this hypothetical city, there are 1200 rental units, divided into 3 categories: (A) 400 renting for $1000, (B) 400 renting for $2000, and (C) 400 renting for $3000, all non-rent controlled. All are rented; there is a vacancy rate close to zero.

These assumptions essentially set up the dynamics of the housing situation in this hypothetical city. They are carefully chosen to simplify the exercise, so that the specific dynamic of supply and demand can be observed with greater clarity.

There are rent controlled units in this city, but they are essentially off the market and will not be included in this exercise. Because they are controlled units, tenants have a greater ability to withstand landlord pressure to move. But landlord pressure on tenants to move will be a significant factor in this exercise. 



Setting this exercise in motion

To set this exercise in motion, we hypothesize that 150 families are seeking to move into this city – either because it is an attractive place to live, or because of employment. Many come because they have high-paying jobs in finance and IT. Of these 150 newly arriving families, 50 are earning $40,000 a year each, 50 are earning $80,000 a year each, and 50 families will be earning $120,000 a year. 


These arrivals present an increase in housing demand of 12.5%. Unfortunately, the city has the means for building only 100 new housing units, which will only amount to an 8% increase in housing capacity. We will ignore the time element required to build new housing simply in order to provide housing for our exercise. 

At all three levels, these newly arriving renters will be looking for housing that will not cost more than between 30% and 50% of their income at most, and most will take occupancy at lower rent if they can. Those making $40,000 will be looking for rents from $1000 to $1500 a month. Those earning $80,000 will be looking for rents from $2000 to $2500 a month, and those making $120,000 can easily afford the top market rate, which is $3000. Because of these arrivals, great pressure develops to raise the rent levels for currently existing rental units. Because of this pressure, there are projections that market rate rents can reach $4000 a month (40% of the high income family’s income), or perhaps even $5000 (50%), based on the prognosis that many high income families will be climbing a career ladder and experiencing future increases in salary. 

This upward pressure on rents is the operation of the law of supply and demand. It works to raise prices when demand overshadows supply. But as we shall see, it does not work as a general principle for resolving a housing crisis. 

The arrival of the new middle and high income families becomes the backdrop for a housing crisis in this city. They put upward pressure on market rent rates, while the low income families do not. In obedience to this market pressure, many landlords try to force current tenants to move so that they can raise the rent on those units. The general term we shall use for this landlord activity will be “harassment,” though it may take many forms – for instance, threats, failure to maintain housing conditions, unneeded construction, inspectors who will declare the unit unfit for habitation, etc. It doesn’t matter if this harassment is legal or not; it exists. As tenants are forced out by landlords, they join those looking for housing, and thus the demand for low and middle income housing grows. That is, the city faces an increase in the demand for low income and middle income housing from among its own current residents as a result of that harassment. And in response to that growth of demand, there is greater market pressure on landlords to raise their rent. It is this circular process that constitutes the inner machinery of the housing crisis. 

Let us see what happens if the city responds to the crisis by building market rate housing, moderate income affordable housing, or low income affordable housing. The term "affordable housing” refers to the HUD standard, which considers rent proper if no more than 30% of the tenant’s income. Thus, "affordable" refers to a relation between rent and income rather than rent and the housing market. 


Three scenarios

First case scenario: the city builds 100 market rate units. 


This means that there will be a total of 500 high level rent housing units (starting at $3000 a month), with only 50 families able to take occupancy in them. Nevertheless, because of the increase in demand (high and middle income), these units will be listed for more than $3000 a month. The newly arrived families, who earn $120,000 a year, can easily pay between $3000 and $4000 a month for rent. But there will be very little competition for the remaining 50 units since none of the current residents paying $3000 a month will move to a new unit that will cost more (it would be irrational). None of the low income families will be able to consider moving into the new units. 

Because of this inability to occupy all the new units, the middle income families (both resident and newly arrived) find themselves at the center of the housing crisis. With the arrival of the new middle income families, middle income residents will face continued harassment to move out so that the landlord can rent to the newly arrived at a higher rate. Some will pay the increase, but many will be forced out, and the newly arrived will take their place at the higher rent (up from $3200, for instance). The same thing will happen among the low rent level units and the newly arrived low income families. More and more will end up paying far more than 30% of their income in rent. For both groups, those that accept higher rent or occupy a more expensive apartment, there will be a lose of disposable income. Their economic participation in the city through consumption and taxes will decline. 

In short, the crisis will not be abated. Roughly 50% of the new units will remain empty, with only a few occupied by middle income families who have been forced to move. There will still be a demand for 100 new units for the new arrivals who cannot afford the new market rate apartments. And rents will rise for both low and middle income families to the extent landlords are successful in moving tenants out. In effect, while some low and middle income families are induced to move, other new low and middle income families will take there place; the balance between those in residence and those looking for one will amount to a zero sum game. Many will have to leave the area. And the aggregate disposable income and revenue for the city will drop. 

In sum, the occupancy success rate for this scenario will be around 50%, with a loss of aggregate disposable income as a result of renters paying more rent than they had been. And landlord harassment of tenants will continue as before because demand will still be high. The crisis will continue. 


Second case scenario: the city decides to build 100 new units of middle income affordable housing. 

This means that the city now has 500 middle level rental units, 400 of which are subject to market forces. The remaining 100 middle level rental units that will rent for 30% of a tenant’s income. These units will target middle income families that are earning $80,000 a year. The targetting of a specific income level by an affordable housing project means that for each unit built, the rent will be at or above a certain level ($2000 a month for moderate income families in our hypothetical exercise). If low income families were allowed to move in, paying rent of $1000 a month, it would undermine the building’s financial sustainability. 

The immediate effect of building these 100 middle income affordable units would be that the new middle income arrivals could move in, at 30% of their income for rent. We might assume that perhaps 50 of the 400 middle income families that are being harassed out of their current homes would also move into these new affordable units. That would open 50 middle rent level units that would then rent for more than $2000, owing to market pressure from the new arrivals’ increased demand. When affordable housing is built, and families move in from a comparable rent level, there is market pressure to raise the rents on the apartments they have vacated. Current resident high income families would then move into these vacated middle rent level units. Even at an increase rent of $2500 or $2700 a month, these units would be a bargain for them (earning $120,000 a year). And newly arrived high income families would move into the apartments they had vacated (also at higher rent). 

The crisis caused by landlord harassment of current renters would be abated by half, since now, only low income families would feel that harassment. And the market pressure to raise rents would be abated through the absorption of the newly arrived middle and high income families in the 100 middle income units opened by the new construction. Demand would have gone down by two-thirds, and landlords would have lost their incentive to raise rents other than among the low rent level units. Among them there would be a zero-sum exchange of current and newly arrived renters. 

In sum, the occupancy success rate of this scenario would be 100%, without loss of aggregate income, but with only a reduction in the housing crisis by about half. 50 families would still be without housing. They would mostly be from the low income bracket. And the loss of disposable rent among some would be better balanced by the increase of disposable income for others. 


Third case scenario: the city decides to build 100 new units of low income affordable housing. 

This means that the city now has 500 units for low income tenants. Four hundred of them are subject to market forces, whose rent level rises as landlords succeed in forcing current tenants out. One hundred of them will rent for 30% of tenant income, targetting low income families who earn $40,000 a year. The mechanism of income targetting is similar to that for scenario two, except that maintenance financing will have to be at a lower level. Rent will be around $1000 a month for these low income families. 

The immediate effect of building these 100 low income affordable units will be that the new low income arrivals will move in, at 30% of their income for rent. Since they would occupy only 50 of the new units, there will be the opportunity for some 50 of the 400 low income families who are being harassed by landlords to leave their current homes and move into the remaining new low income affordable units. That will open 50 low rent level units, whose rents would then rise above their former $1000 level, and into which middle income families will move since the rent, even at $1500 or $1700 a month, will be considerably less than their former middle rent level housing ($2000 a month). And their disposable income will rise. The apartments that they vacate will then be occupied by the 50 newly arrived middle income families, but at an increase in rent above their original $2000 a month. 

The housing crisis affecting low income and middle income renters through landlord harassment will abate, since the increased demand for low and middle income housing would have been absorbed. Some landlords would have gotten increased rents from the middle income arrivals to whom they had rented, diminishing their disposable income, but for others there would be an enhancment. Aggregate disposable income would on the whole be increased (up for 100 families and down for 50), and thus the local city economy would benefit. 

There will still be 50 families, mostly high income, who will still be looking for housing. And the epicenter of the crisis will have shifted to the high income population, who are most capable of withstanding it. The current resident and the newly arrived will enter a zero sum game balancing residence and looking for residence, as in scenario two, which will not diminsh the demand for high income rental units. And that means that not all harassment of middle income tenants will have totally abated. But the high income families have the greatest ability to wait (living in towns nearby) for the city’s construction or new housing to catch up with them (which it can given higher disposable income among its denizens, and greater revenues). 

In sum, the occupancy success rate for this scenario would be 100%, without loss of aggregate disposable income, and with an abatement of the housing crisis for the vast majority of tenants (a cessation of landlord harassment). 


In conclusion

To recapitulate, this exercise has addressed three possible solutions to the problems raised by an increase in demand for housing. We have examined those scenarios in a situation where demand requires 12.5% increase in housing units, and the city can only provide an 8% increase. This is a realistic example insofar as corporate developers will hesitate before building to completely saturate a market. They do not wish to have unused capacity, meaning unoccupied housing. So they will generally only agree to build up to a certain margin of demand. 


What this exercise as a whole demonstrates is that one cannot simply apply the law of supply and demand to the housing situation. Because people are rational, and will not move voluntarily from one rental situation to that of a higher rent level (without a significant increase in income), the movement of supply in the housing market can only be from the bottom up. To build housing at the top will mean that the new capacity will remain at the top, and some of it will remain unoccupied. To simply build housing at the top of the rental market will be to exacerbate the housing crisis, and cause severe social disruption and probably unrest. 

What these three exercises teach are the following: 


  1. If all market rate housing is built, it will only have a 50% occupancy success rate in proving housing, without any abatement to the crisis faced by current tenants being forced out of their homes. A majority newly arrived middle and low income families will be without housing. And there will be a drop in aggregate income of the city’s renters.
  2. If all middle income affordable housing is built, then the occupancy success rate will be 100%, but with only a partial abatement of the housing crisis, and both low and middle income tenants will continue to feel the pressure and harassment to vacate so that landlords can raise their rents. But there will be less of a drop in aggregate disposable income.
  3. If all low income affordable units are built, there will be 100% occupancy success rate, accompanied by a significant reduction in the housing crisis to about a sixth of what it had been, and there will be a gain in aggregate disposable income for the entire city.
The city would be wise to choose the third scenario as it will put it in good economic straits to carry forward its intention to finally house all the new-comers. If the city listens to the supply side advocates, with their false use of the law of supply and demand, it will not resolve the housing crisis, but it will force entire communities of residents to leave town. With the third scenario, on the contrary, there will be an increase in aggregate income for the city, which will provide it with greater options for financing the remaining 50 units of housing in order to complete a fully-housed resident profile.