Issue 03
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Why tech cannot escape expensive housing

8th February 2021
13 Mins

As rental prices continue to climb in San Francisco, tech firms have looked to relocate in other cities. Without major housing reforms, the next Silicon Valley will face the same fate.

The Bay Area has some of the most expensive property in the world. It has some of the worst local government. For years techies complained about the situation yet little was accomplished. There is a sense that things have started to change in the last year. Elon Musk moved to Austin. Keith Rabois moved to Miami. While the recent approval and deployment of vaccines herald the end of the Covid-19 fears and restrictions that are surely driving some of the flight, the pace of relocations is increasing.

It would be premature to count the Bay Area out. It still offers major benefits (its temperate climate, world-class restaurants, easy access to nature, and the persisting agglomeration effects) despite the drawbacks (rent, taxes, space). But this wave of migration is an acceleration of a trend that was already happening before. There is some reason to think it will continue.

For one thing, anti-tech politicians in California are, if anything, ramping up their efforts to push residents associated with tech away through symbolic measures like condemning the naming of hospitals after Mark Zuckerberg and policy proposals like a wealth tax. But these more dramatic flare-ups are minor compared to the most harmful failure of contemporary economic policy: the restrictions on home-building driving the housing shortage in California.

While cities like Austin still offer cheaper rents and a lower cost of living, at least for those departing the Bay Area, familiar tensions over densification, gentrification, and transit are appearing. Even before Covid, the types of cities most likely to attract highly skilled workers and the companies that hire them were becoming less and less accessible. Without policy changes, these cities, like San Francisco before them, will become ever more expensive as they gain new highly-skilled residents.

Are these cities really cheap?

In an op-ed for the Wall Street Journal, Palantir co-founder, venture capitalist, and newly minted Austinite Joe Lonsdale describes his reasons for picking up and leaving California. Among the benefits he sees in Texas is that, “California’s restrictive zoning laws make it nearly impossible for many essential low- and middle-income workers to live anywhere near major cities. In Texas, permissive zoning allows every member of our staff to live close to work and spend time with friends and family instead of enduring grueling commutes.”

While he is correct that Austin is much cheaper than California (and that zoning and other land use rules are less restrictive in Texas than in California), home prices are rising dramatically in Austin. On top of a decade of rising home prices, Austin had the largest increases in home prices of the top fifty U.S. markets in 2020 with the median list price growing by 23.6% year-over-year.

Austin may have more liberal housing regulations than California but much of its growth so far has mostly relied on ‘sprawl’ or horizontal growth. This model  will begin to break down as the physical distance of new exurbs and congestion steadily increases. It is already 38 miles from the North of the built up area to the South. Residents complain about the congestion caused by the increase in population from 675,000 in 2000 to over 1 million now. At the low density Austin is currently built at, it would take only another million or so Joe Lonsdales before outer Austin would cease to be in reasonable commuting distance of the center. The natural market remedy to these problems is to densify, through some combination of building taller and by building on smaller lots.

Before widespread planning, this was more easily accomplished, but in some areas of the country this still occurs on a large scale. Most notably, in Houston just a few hours away: A city that famously has no zoning but less famously has all sorts of important private and public land use rules. The system, in part due to changes discussed below, has led to a steady densification ripple from the center outwards. Areas that were mostly made up of small bungalows on large lots have become rowhouses, duplexes and triplexes, or narrow four-story townhomes.

Austin’s suburbs and exurbs do not live under such rules meaning that, like the Bay Area, it will eventually bump up against the physical limits to sprawl. If Austin wants to continue attracting Bay Area emigrants, it must ensure it can build up as well as out. This means allowing denser developments by liberalizing minimum-lot-size requirements and other rules. While there has been some densification of existing neighborhoods it has occurred only after much difficulty.  Places like East Austin, a fashionable area within a short walk of downtown, are still dominated by one and two story buildings spread out from one another on large lots. In other words, places ripe for densification. The political economy of densification has proven difficult thus far. While at a policy level the answer to the continued affordability of Austin is density, the bigger question is to figure out ways to change the rules that currently prevent densification.

The economic implications of housing supply

House prices can be high, or low, due to a range of factors. If house prices go up because cheaper interest rates make mortgages more affordable, this does not in itself indicate that there is a housing shortage. Similarly, in some places density is extremely high, and adding more housing is costly. Hong Kong housing is mostly expensive because building 40 storey towers is difficult, not because rules restrain what they can do with land. Therefore, we need to be careful before judging that any house price that seems ‘high’ to us is actually evidence of a shortage.

There is a way round this problem. Firms produce goods when they think they can sell them for more than they cost to make. Housing developers are no different. Therefore, economists tend to measure whether there is a housing shortage due to supply restrictions by looking at the ratio of the production cost of a house to the price of one.

As Edward Glaeser and Joseph Gyourko show in a 2018 review essay, even in places like New York City and coastal California the price of housing largely reflected the cost of building until the recent past. When economic success drew new residents in, new houses were built for them. Higher productivity led to more homes and more workers, not higher home prices.

More recently, as existing land use regulations began to bind (and new regulations were enacted) the ratio of price to production cost has increased: construction cost explains a smaller portion of the market price and the cost of regulatory permission explains more of the sales price. Glaeser and Gyourko view the ratio as a measure of the regulatory tax of building. While California has grown much more productive, it produces fewer homes per year than it did decades ago. Furthermore, many of the homes that are built are far from the top productivity clusters.

As a result of this policy choice to limit homebuilding, the increases in productivity are captured by landowners. More worrying than the boon to existing owners are the dynamic effects of the price: new residents are prevented from moving to more productive labor markets and growth is reduced.

Just a few decades ago this supply-driven housing crisis was limited to a few cities in the United States, but many other cities have followed suit. Even before years of dramatic price increases the data from 2013 used by Glaeser and Gyourko estimates that Austin had a ratio above 1. While construction costs have increased, home prices are increasing even faster leading that ratio to increase significantly. While Austin is building, the fact that the ratio is above one and rising means that it is not building enough to keep up with demand in a more clear cut way than just looking at the rising prices alone.

Costs of reform: high and rising  

Liberalization of rules around development may benefit society as a whole but would hurt homeowners in destination areas, many of whom bought their home for a price above its construction cost and would stand to lose out if prices fell. The higher that home prices are above the construction cost (and the more harmful the regulations likely are), the more difficult we should expect reforms to be. Compared to the Bay Area, reforms in cities like Austin should face fewer difficulties.

But that could change. If enough dominoes were to fall, and Austin really did become the next Silicon Valley (or a mini version of it), the prospects of reform would become more difficult. Tech companies and highly-paid tech workers would arrive in the Lone Star State at a higher pace than the one which is already overwhelming the existing ability of developers to keep up. Prices in the choice neighborhoods would continue to shoot up and the current battles over gentrification would seem quaint. Just as in the Bay Area, homeowners would benefit from rising prices while raising the drawbridge to new residents by preventing densification. The area surrounding may continue to grow but residents would face commutes from farther and farther into the surrounding areas.

As it stands, even though there is some political agreement about the cause of the housing crisis and the need to reform rules preventing homebuilding,  the actual politics of reform is proving difficult. The battlelines are currently drawn around the attempt by some council members to liberalize the city’s land use code, a project that started nearly a decade ago and has already gone down in flames once. Council members may recognize the need to build more housing, but their voters don’t want apartment buildings near them.

Others are nostalgic for a city they are losing and hope preventing redevelopment will somehow stop gentrification. Fears of the death of Austin’s weirdness have been lingering for at least the last two decades when “Keep Austin Weird” originated with a caller on a community radio station, but the wave of migrants this year has already increased fears that Austin’s unique culture will be overwhelmed.

Competing strategies for enabling reform

Housing crises are not a feature of some unalterable law of markets but rather a feature of the rules of the game – rules imposed by governments often with the support of residents. What is so dispiriting about land use regulations is that the potential gains from reform ought to swamp the costs of reform, yet the number of successes are quite few.

Perhaps the most successful type of supply-side reform has been Accessory Dwelling Unit (ADU) reform, where residents of what were single family homes are allowed to add units to their properties either by building a new structure or dividing an existing structure. This is not a surprise. By allowing existing homeowners to share in the benefits of increased supply, the reforms turn potential critics into supporters.

The successful reforms in California have allowed homeowners to build up two additional residences on their property benefiting both potential residents and existing homeowners who benefit from the capitalized value of the right even if they choose not to build themselves. The problems in the Bay Area are so advanced that these types of reforms aren’t of the magnitude to adequately respond to the crisis but the success there does provide insight into the politics of reform more generally.

Apart from ADUs, it is difficult to add development in ways that benefit the interested parties with de facto rights in the current system of land use planning. While homeowners have an interest in and an ability to prevent development, it is difficult for developers to make bargains with those who oppose their projects.

Because of this much of the YIMBY movement is focused on kicking decision-making up to the state level in order to limit parochial concerns that lead to housing shortages. There is also an alternative way of addressing the difficulty: kicking decision-making down closer to individuals. Whereas the first type of YIMBY reforms seeks to overwhelm NIMBYs, the second hopes to change the political system to enable mutually beneficial development.

Instead of the current system in much of the US where rules are often decided at the citywide level, this proposed system would allow decisions to be made at the street block level. Wouldn’t this just empower the NIMBYs even more?

Compared to decisions at the block level, the costs of securing agreement are much higher with citywide zoning changes. The process creates many de facto rights holders and voters, especially those who own houses, are incentivized to be resistant to change. Instead, by altering the process for decision-making and defining alienable rights to restrict development at the hyperlocal level, these types of reforms would lower transaction costs that are preventing bargains between interested parties from emerging.

Interestingly, there is some history of successful reforms compatible with this type of thinking in Texas, when in 1998 Houston reformed its subdivision laws to allow 72% smaller minimum lots and shallower setbacks. These reforms enabled a significant amount of densification by allowing property owners to make a hyperlocal decision to opt out at the block level.

Looking forward

Those moving to cities like Austin may hope to escape the political battles of the Bay Area, but the more successful they are at encouraging fellow transplants, the more the battles will follow them. Up until this point, YIMBY movements, tech workers, and economists interested in housing reforms have mostly focused on policy changes in the largest cities for understandable reasons. But, in a world where it is more beneficial for firms to leave an existing cluster like the Bay Area because of bad policies, we are clearly straying from a first-best situation. The economic benefits of housing reform in existing superstar cities would dwarf the benefits of reform in other cities, but this means little if reforms in those cities are not actually achieved.

We live with worse outcomes compared to a counterfactual where reforms were enacted in the Bay Area of thirty years ago. Without serious reforms, the next Silicon Valley will face the same fate.

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