Why construction companies can go under during a construction boom

By Phil Hayward

I’ve been researching and reading about property economics for years and have a logical but saddening explanation for Christie’s post “Construction companies go under…

… in a construction boom”.

The problem with ‘construction’ in New Zealand (and in other countries with the same regulatory constraints) is the way the property markets are distorted. The businesses doing actual construction aren’t making anywhere near enough money, so you get the paradox that building firms keep going bust even while there is a shortage of housing and yet the construction sector appears to be ‘busy’.

The reason for this is that the urban land prices are inflated because the supply of land is distorted by the Council’s planning regulations and the people who own the ‘approved’ land can name their price. Developers have to somehow sell completed housing for the absolute topmost prices that the market can stand, but also recover all the price pressure jammed in when they bought the site in the first place. Builders and developers aren’t creaming it; the land vendors are. Builders and developers are trapped between a rock and a hard place: what landowners (including existing property to be redeveloped under rezoning) can gouge them for versus what the buyers of housing can stand to pay.

To obtain sites, the developers all have to bid against each other and against straight-out speculators. Those who win and buy the sites often end up going bust anyway because they paid too much, whilst those who don’t get the sites go out of business for lack of work. Developers and builders make their money only on the part of the project that is their own ‘sweat’. When the proportion of the total project sale price that isn’t due to their own business increases, the whole industry becomes higher-risk – and we are talking about a significant proportion.

A house price median multiple that is 3 times the historical norm actually represents land costs some 10-30 times higher. Land cost can easily be 70-90% of the finished project total versus a historically normal 5-15%. Building materials always formed a lower proportion of the total cost, and even if the cost of these has doubled (which it hasn’t), that is still not the problem; the land prices are.

A developer who is a successful ‘land banker’ from way back would be creaming it, though. There are only one or two of these (without mentioning any names) but they are still doing drip-feed developments on land that they bought at rural prices decades ago before councils started the land rationing scheme that created the opportunities to gouge. As I have explained above, small builders buying sites off these big developer land bankers will be struggling to make a profit.

In the old days before councils had a fetish for stopping ‘urban sprawl’, booms in construction occurred without significantly inflated land prices. Honest profits in the construction sector were made on volume, with site costs being low and predictable and not an inherent risk factor. The cost of carrying sites was, of course, far lower and delays and cyclical downturns were far less likely to be fatal. Building firms need to not just own the sites they are currently working on; they need the next one or two as well. So when these sites are costing them several times as much in real terms as in ‘the old days’ (in undistorted markets), of course the risk is much higher and especially vulnerable to even the slightest of interest rate increases. The regulatory environment is also now much more likely to lengthen the period between site acquisition and the sale of completed properties.

There are good urban economists (such as Alan W. Evans and Paul Cheshire) who have studied decades of property cycles in Britain since their stringent urban planning system was adopted in the 1950s. It is a classic case of ideologically-driven incompetence that the urban planning profession globally has been swept by fads, but no one has bothered to look at the consequences in other countries where the same approaches have been the practice for decades.

In Britain, we see decades of collapsing housing supply and high attrition rates in the construction industry, all in the face of a screamingly worsening shortage of homes. All the sorry consequences we are seeing now in Auckland have been observed already in British cities. Decades of allowing the false assumptions of urban planners to prevail has only resulted in things getting evermore worse.

Another lesson that needs to be learned is that building more densely only increases the land prices faster than the supply of smaller new houses increases. The moment a location is up-zoned, every property in it inflates in price. This is one of the explanations for $1,000,000+ tumbledown hovels. Auckland Council looked at centrally located suburbs with sections worth $300,000 and assumed that allowing 3 townhouses to be built on them would result in a $100,000 land cost per townhouse. Wrong! They should be kept in after school and made to write out 1000 times, “land prices can be elastic to density”. In fact Hong Kong, with 26,000 people per square km, has a median multiple (home price: income) of 17, while many US cities with 1500 or fewer people per square km have median multiples of around 3.

Sadly, Labour and NZ First in New Zealand can be guaranteed to use ‘the crisis’ to increase the size of government and create dependence on subsidies and ‘social housing’. The unintended consequence of this, already observed in Britain, is that unjust burdens always fall on whatever cohort of society does not quite qualify for the assistance, and the gulf between being housed with State assistance and ‘paying your own way’ always remains impossible for 10–20% of society. This has consequences for incentives around work and self-help. National’s nine years of failure to properly solve the problem with deregulation will cost New Zealand dearly.  

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