The Breakdown | Explaining Southern California's economy
Business & Economy

UCLA economist: Cities should try managing home prices through building permits

Homebuilders want to build more of these. And right now, scarcity of new homes and rising prices in many California markets suggest they should. But is there a better way to manage prices?
Homebuilders want to build more of these. And right now, scarcity of new homes and rising prices in many California markets suggest they should. But is there a better way to manage prices?
Chris Hondros/Getty Images

William Wei-Choun Yu is an economist at the UCLA Anderson Forecast, part of the UCLA Anderson School of Management. He recently wrote a monthly economic letter, jointly published with the Ziman Center for Real Estate, about predicting home price increases across U.S. cities.

His research is particularly relevant to Los Angeles and the broader Southern California region, where an imbalance between housing supply and buyer demand has created a market in which sales have been declining but prices rising. 

Housing supply is tight in California—particularly in coastal cities like L.A. and San Diego. Low interest rates and lots of investors and all-cash buyers have combined to bid up prices and sideline potential homeowners who can't buy a house without getting a mortgage.

Economists hesitate to call this a bubble, but they are beginning to get concerned. In his economic letter, Yu writes:

The empirical evidence seems to support the simple theory. If the ratio is lower (meaning that the home supply growth is much less than the demand growth), the home price appreciation is larger...It is obvious that Northeast coastal and Californian cities have less accommodating home supply to its demand. As a result, they have higher home price Los Angeles’ home supply falls 
far behind its demand...Even if it were to double its permit supply, it would contribute just 
0.2 percentage points less per year to price appreciation.

"Permit supply" means the number of new homes that are legally authorized to be built. Overall, that number, both nationally and in California, is running well below the peak levels that were set during the housing boom. They're at new highs since the downturn, but they have a ways to go before the market could be defined a truly healthy.

So we want more permits, right? Increased supply reduces demand pressure and, in theory, lowers prices—it's Econ 101.

But Yu has studied the dynamics of the current imbalance and added an interesting policy proposal: Why not use the permitting process, as a function of local government, to regulate prices, much in the same way the Federal Reserve uses interest rates and the overall supply of money in the economy to control inflation?

(The Fed lowers interest rates when it wants to stimulate the economy, but risks inflation in the process. When it was to cool off an inflationary economy, it raises rates. Rates are now basically at zero, and have been for years, because the Fed is trying to support the economy. The central bank has a dual mandate, to aim for "price stability" and full employment, which economists define as an unemployment rate of around 5 percent. On price stability, the Fed shoots for an inflation rate of about 2 percent.)

"Right now, as housing market recovers, we should be careful about affordability," Yu said. 

The temptation is to look to homebuilders—like L.A.-based KB Home, which is ramping up its business in California to capitalize on growing demand—but Yu thinks that might not be the way to go.

"I'm not suggesting we should increase our home supply," he said. "Rather, we should look carefully at demand growth."

The key here is to come up with a way to moderate demand in the same manner that the Fed moderates the "price" and supply of money. Low interest rates means, in the parlance of finance, "easy money"—the money is abundant and practically free so individual and firms can borrow, spend and invest, and that stimulates the economy. 

Yu has zeroed in on the permitting process, which is handled at the municipal government level. 

"Month by month, housing prices are changing," he said. We can use the supply of building permits to control prices. So if prices get too high, we can issue more permits. In terms of local real estate markets, prices should also be anchored by local governments. They don't want them to decline, but they don't want them to rise out of control."

The bottom line is that rather than looking to homebuilders to build, we should look to local governments to permit (or not permit), based on what's happening the the price situation, a useful proxy for demand. At the moment, given how tight the existing housing supply in Los Angeles is, there's a strong case to increase the number of permits being issued. 

Conversely, when the market get backs to normal—and right now, it's anything but, as homebuilders are actually struggling to be able to build enough new homes—there may be too many permits issued to be justified by demand. And at that point, the fewer permits could be issued. 

Managing housing prices through this method really amounts to giving local governments the ability to fine-tune the housing market.

Yu doesn't think that anyone has tried to do it. Yet. But given the volatility of the residential real estate prices in Southern California, it could be a proposal that's worth trying.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.