The elephant in the room on housing supply

Oxford Economics made headlines last week forecasting a “miss” on the National Housing Accord target of 1.2 million new homes by 2029. That call won’t raise too many eyebrows among the development and construction community.

Clearly, a lot of ducks need to be lined-up to bring about such a dramatic lift in new dwelling construction. We talk about them daily. But for reasons I cannot understand, the conversation seems exclusively focussed on supply constraints – as if all we need to do is expedite planning approvals, release more land, and resolve labour shortages.

To my mind, there is one rather large elephant in the room and its name is Demand.

Like it or not, Australia’s residential development market is overwhelmingly a private market. This means most new dwellings will only get built if there’s people prepared to buy them at a price that covers the costs of development and delivers a reasonable return to the developer.

Private markets don’t only care how many people want a product – but also how many can afford one. And right now, that equivalence exists for a vanishingly small number of would-be new home buyers:

The reasons for this outcome are clear enough. The key cost driver of new development—construction—underwent a step-change over the last few years. Developers have had no choice but to pass-on these costs to keep projects feasible. This process has priced-out large numbers of buyers struggling with cost-of-living pressures and tight borrowing conditions:

Put simply, the costs of new development have risen faster than the purchasing power of aspiring new home buyers. All the planning reform in the world will count for naught unless we reduce the spread between development costs and purchasing power.

There are obviously two ways to do this – bring down development costs or increase purchasing power.

Many people seem to favour the first path by “lowering construction costs.” If only it were that simple. Building prices have fallen twice in the last 30 years. Twice. And even then, only briefly. Construction costs accelerate and decelerate, but they do not go in reverse.

The most important question is the one we’re not discussing – how to turbocharge demand for new residential development.

A radical plan to finance new development

I recently came across a proposal that offers an interesting solution to this challenge. The idea comes from Jim Millstein, who was the Chief Restructuring Officer in the US Treasury during the GFC and instrumental in rescuing the finance and insurance goliath, AIG. Not a lightweight.

Millstein’s proposal is to create a new program in the federal government to provide what is known as “mezzanine financing” to residential developers.

If that concept is a bit foreign to you, here’s a rough sketch.

Most developments are funded through a combination of debt and equity. Think about it just like a household mortgage. The bank will lend you 90% of the purchase price but you have to stump-up 10% as ‘the deposit.’ Developers face the same basic rule – banks will lend around 60% of the project value with the rest coming out of the developer’s coffers, known as ‘equity.’

Mezzanine financing comes into play when a developer can’t pull together the full 40% equity for a project. It’s basically another type of loan used to fill the gap between the developer’s equity and the bank loan. It is typically a much more expensive, much smaller loan with more strings attached.

Millstein is proposing the government start offering mezzanine loans to developers to reduce the equity requirement on a project. If this were to replace half the equity on a project, it would more than double the leverage available to the developer, dramatically expanding new project financing.

The genius of the idea is that the government has access to the cheapest interest rates in the land. According to Millstein, if they pass-on these low borrowing costs, it would allow developers to deliver housing at much lower prices while still earning the same kinds of returns they would in the current market.

In other words, it would collapse the spread between development costs and purchasing power. The end result would be more housing offered at a price that more buyers can afford.

The other major benefit of the proposal is that it is very Budget-friendly. Mezzanine financing is a ‘term loan’ – meaning each loan is paid back on a fixed schedule. So the program as-a-whole would be a sort of revolving lending facility to the national development sector. There would be a one-time hit to the Federal Budget to capitalise the program, then it would continuously recycle the funds into new projects, making a major impact on supply indefinitely.

There’s much more to this idea. I recommend listening to this podcast where Millstein discusses his proposal at length (the discussion starts about 35mins in).

Let me know what you think!