What Makes Housing So Expensive?

In the realm of personal finances, purchasing a home represents a significant milestone, often comprising the largest investment individuals undertake. Following the post-pandemic surge in home buying, the median sale price of new homes reached nearly $500,000, translating to around seven times the median household annual income at the time (although it has since subsided). Typically, new homeowners allocate approximately 30% of their income towards mortgage payments, while renters in the lowest income bracket expend approximately 60% of their earnings on rent.

Given the substantial financial implications of housing, it's crucial to delve into the specific components contributing to these expenses and explore potential strategies for cost reduction. While discussions surrounding housing policy commonly center on zoning regulations and supply constraints, which inflate land prices, it's noteworthy that the primary cost in much of American housing stems from constructing the physical dwelling. Nevertheless, in densely populated urban regions, where the need for new housing is particularly acute, the dynamic shifts, with regulatory-driven land prices emerging as the predominant factor.

While advocates for increased housing construction rightly emphasize the importance of zoning and land use regulations, it's essential not to overlook the significance of construction expenses. A significant portion of the American population resides in areas where land costs outweigh other factors in residential property expenses. However, addressing these physical construction costs presents its own set of challenges, as we'll explore further.

The costs of a single-family home

Let's focus primarily on analyzing housing expenses through the perspective of single-family homes for a few key reasons. Firstly, the majority of residential properties in the US are single-family homes, making their construction costs a representative reflection of overall housing expenses. Additionally, there's extensive accessible data specifically concerning single-family home construction, unlike other housing types. Moreover, given that most multi-family apartment buildings in the US are constructed using similar light-framed wood technology employed in single-family homes, insights gained from analyzing single-family home costs can typically be applied to multi-family apartments as well.

We'll kick off our analysis by delving into the National Association of Home Builders (NAHB) construction cost survey, which is regularly distributed to several thousand home builders. This survey breaks down home building into numerous activities, such as framing, plumbing fixtures, and drywall, querying builders about their typical costs for each task. It's important to note that while this survey compiles data from a wide array of builders, it doesn't precisely reflect the costs of an average home. Due to equal weighting for every builder surveyed, costs from boutique luxury builders, who may construct only a handful of homes annually, are magnified, while those from larger volume economy builders, who may undertake hundreds or thousands of projects per year, are understated. Consequently, the "average" home cost provided by the survey tends to be nearly $100,000 higher than the average home cost reported by the Census. Nevertheless, while absolute costs may not be entirely representative, I anticipate that the relative proportions allocated to each task will exhibit less variance between the low and high ends of the market, and we'll conduct additional verification to confirm this hypothesis.

When dissecting the expenditures associated with a new home, we typically classify them into three primary categories: "hard costs" (tied to physical construction), "soft costs" (covering design, administration, marketing, and other non-physical construction expenditures), and land costs. Based on data from the NAHB, hard costs typically represent approximately 56% of the total expenses, soft costs (including builder profits) make up roughly 25%, with land costs accounting for around 18%.

Let’s take a deeper look at each one of these costs.

Hard costs

Hard costs pertain to the actual construction of the building, including activities such as excavation and foundation pouring, framing, and HVAC system installation. These expenses constitute the bulk of the total costs of a new home, underscoring the significance of examining and improving construction productivity. The NAHB survey further dissects hard costs into the specific tasks they entail, as outlined below.

The graph above utilizes color-coding: green denotes structural framing, blue represents exterior finishes (including doors and windows), orange signifies services (such as electrical and HVAC), red indicates interior finishes and appliances, dark gray depicts foundations, and light gray encompasses outdoor work and landscaping. Similarly, an analysis of task breakdowns provided by the Craftsman Construction Estimator reveals a largely comparable division.

Several notable points emerge from the analysis. Firstly, apart from a few significant expenses (such as framing and foundations, comprising nearly 30% of the total cost), no single cost dominates; instead, construction involves numerous distinct tasks performed by separate trades, each contributing a relatively small portion to the overall expense.

This characteristic isn't unique to construction but can be observed in other industries like car manufacturing, where a similar cost breakdown can be constructed. However, what distinguishes construction is the level of coordination involved; unlike in car manufacturing where everything is meticulously designed for tight integration, housing construction often lacks significant coordination among trades. While this approach minimizes upfront costs and facilitates cost-effective design processes, it also poses challenges for innovation, often resulting in evolutionary rather than revolutionary advancements in construction methods.

Nonetheless, innovation persists within each task, with ongoing industry efforts aimed at improvement. Some endeavors, such as the adoption of PEX piping over copper piping, have proven successful, while others, like framing technology, have seen comparatively limited advancement despite numerous attempts to develop alternative systems.

Another noteworthy observation is the significant proportion of tasks that incorporate an aesthetic element. Combining interior and exterior finishes such as trim, drywall, and exterior finishes, these components constitute over a third of the hard costs associated with constructing a new home. Reducing these expenses can be challenging due to the strong preferences individuals hold regarding the appearance and feel of various aspects of their homes, which often limit the adoption of new systems. Despite the potential functional superiority of materials like luxury vinyl tile or synthetic stone bathroom panels over traditional options like hardwood floors and ceramic tile, the preference for "natural" materials remains robust. Similarly, the limitations posed by inexpensive drywall substitutes, such as vinyl on gypsum, including their flimsiness and visible joints, hinder their adoption beyond the lower end of the market.

Further examination of the hard costs of construction involves dissecting tasks into material and labor expenses. While the NAHB does not offer this breakdown, data from Craftsman's National Construction Estimator provides insight into these aspects:

We can observe that hard costs are roughly evenly split between materials and labor, a pattern consistent with our previous examination of how individual construction tasks' costs have evolved over time. This balance presents a significant challenge in reducing construction expenses. A considerable portion of hard costs stems from material expenses, and there's no straightforward approach to lowering these costs further. Bulk building materials, already mass-produced in factories, represent some of the most cost-effective options available. Despite efforts to enhance material efficiency, achieving substantial reductions without significant trade-offs remains elusive.

Another aspect to consider is the considerable variation in hard costs across different locations. The Turner International Construction Market Survey highlights this diversity, offering a wide range of costs for tasks like electrical work or structural steel across various US cities. For instance, the hourly rate for an electrician in Houston may differ significantly from that in New York City. Similarly, RSMeans, a construction estimating company, provides a "city cost index" to adjust costs for local conditions, resulting in fluctuations of "average" labor costs by as much as 50% or more.

In summary, the hard costs of construction, encompassing expenses related to erecting the physical structure, constitute the largest and most significant expense in constructing a new home. However, they also pose the greatest challenge in terms of improvement, with no straightforward or obvious solutions readily available.

Soft costs

Soft costs encompass various non-physical tasks related to constructing a home, such as financing, permits, inspections, design work, and other administrative duties. According to the NAHB survey, these soft costs constitute the second-largest portion of expenses associated with constructing a new home.

Reviewing the breakdown of expenses once more underscores the challenges in reducing costs and the absence of clear paths for improvement. For example, a common concern in construction circles is the prolonged duration of building projects and the perceived slowdown in construction over time. This has led to optimism about technologies like prefabrication, which promise faster construction and potential cost savings.

However, according to the NAHB survey, the cost of construction financing, a primary target for savings through accelerated construction, is relatively low, accounting for just 1.9% of the total cost of a new home. Depending on the chosen technology, expediting construction may have minimal impact on this aspect. For instance, while prefabrication can reduce on-site construction time, it often necessitates the fabricator to commence work months in advance, potentially offsetting any reduction in financing costs.

Similarly, soft costs such as design work, permits, inspections, and regulatory compliance represent relatively small proportions of overall expenses. While builders' profit margins appear somewhat high (exceeding 10% of the costs of a new home according to the NAHB), this figure may be skewed by the sample, which favors smaller luxury builders. Estimates from the National Construction Estimator suggest a more modest 5% builders' profit, aligning closely with Census cost data. Sales commissions also appear elevated, although recent legal developments are expected to lead to a reduction in realtor fees, with real estate startups like Zillow, Redfin, and Trulia potentially playing a role in reshaping the homebuying process.

Just as with hard costs, soft costs lack a single dominant item and offer few straightforward avenues for cost reduction.

Land costs

The third significant expense in constructing a new home is the cost of the land itself. Despite the prominence of discussions surrounding regulatory constraints on housing, such as zoning and NIMBY vs YIMBY debates, many may be surprised to learn that land accounts for only around 20% of the total cost of a new home. Census data confirms this trend, indicating that over the past three decades, the proportion of a new single-family home's price attributed to land costs has remained consistently between 20 and 25%. This stability is often reflected in the common industry guideline that suggests allocating approximately 20% of total costs towards the property itself. While factors like ease of construction influence land prices, it's clear that land does not typically serve as the primary cost determinant for most new housing developments in the US.

When considering existing homes, the proportion of the total cost attributed to land is expected to be higher compared to new homes, primarily because the physical structure of the home depreciates over time. So, what do we know about the land fractions of existing homes?

One way to estimate the share of housing costs associated with land is by analyzing the Federal Reserve's household balance sheet report. According to the Fed, the total value of real estate owned by households amounts to $44.8 trillion, while the replacement cost of the structures themselves stands at $27.2 trillion. This implies that the value of homeowner-held land is approximately $17.6 trillion, representing nearly 40% of the overall value of homes nationwide. Though this figure may seem high, it aligns closely with the average value observed over the past three decades, albeit historical land fractions were typically lower.

Alternatively, we can approach this calculation using data from the American Housing Survey (AHS). According to the 2021 AHS, the average size of a detached single-family home in the US was around 2,200 square feet, with an estimated replacement cost of $293,000. Factoring in an annual depreciation rate of 1.1% and a median home age of 40 years, the median replacement value for US homes is approximately $188,000. Additionally, Census data indicates that the median homeowner values their home at around $282,000, although homeowners typically overvalue their homes by approximately 7%. Adjusting for this overvaluation, we arrive at a median home value of approximately $262,000. This suggests that for the median US home, approximately 72% of the value is derived from the structure itself, leaving around 28% attributed to the land. While this is lower than the Federal Reserve's national average estimate of a 40% land fraction, it still exceeds the roughly 20% value observed in new construction. Therefore, while land typically accounts for 20-25% of the cost of a new home, it increases to approximately 30-40% for existing housing.

However, it's important to note that these figures represent national averages. Land fractions tend to be higher, often significantly so, in densely populated urban areas. For instance, data from AEI provides zip code-level estimates for the share of home prices attributable to land in the 100 largest metro areas in the US, revealing that in many zip codes, over 70% of the home's value is due to the cost of the underlying land.

To gain a clearer understanding of the significance of land share in residential property, we can integrate this data with population estimates at the zip code level from the Census. Based on this analysis, we find that over 125 million individuals reside in zip codes where the land share of residential properties exceeds 50%, with an additional 16 million people living in areas where the land share surpasses 70%.

To comprehend the factors behind the elevated cost of land, we can categorize the price of land into two distinct components. The first is the "hedonic" value, representing the enjoyment and utility derived from the space itself. The second component is the "permission slip," denoting the entitlement to construct a specific amount of housing associated with the land plot. As highlighted previously, empirical evidence suggests that individuals do not highly value additional land space; rather, it is the "permission slip" aspect that predominantly contributes to the value of residential land parcels.

…when Ed Glaeser calculated [the hedonic value of land] for 21 metro areas in early 2000 (by analyzing home price sales and estimating how much a larger lot added to the home’s value), he found that in 16 of them, the hedonic value was less than (inflation adjusted) $1.50 per square foot, or less than $12,000 dollars for the median lot size of ~8,000 square feet…By comparison, the median new home in 2020 sold for around $330,000.

A similar study of single family homes in Boston found that the hedonic value of land for the average lot was just $11,200, compared to an average house cost of $450,000.

The permission slip, by contrast, is often incredibly valuable, especially if the permitting body limits how many of them it gives out. For instance, in the previous study Glaeser calculated the hedonic value of land for single family homes in San Francisco at $4.10 per square foot (the highest out of any metro examined), or about $10,000 for the average lot size at that time. The ‘zoning tax’ portion, by contrast (the portion of the cost due to various building and supply restrictions), was priced at around $220,000 - in other words, over 95% of the land’s value (and over half the price of the house), was due from being allowed to build on it.

Similarly, multifamily developers have told me that they will generally value land in terms of how many housing units they’re allowed to build on it. Increase the number of housing units you’re allowed to build (say, by getting it rezoned), and you greatly increase the value of the land. This is a lever developers have to work with when putting together a development deal - they might decide to take a risk and buy a cheaper piece of land that’s zoned for a relatively small number of units, in the hopes of getting permission to build more on it than is currently allowed.

While the cost of a lot may not represent a significant portion of the expense for new housing, it constitutes a considerably larger proportion of the cost for existing housing. Particularly in densely populated metropolitan areas, where housing demand is most acute, the land cost can surpass 70% of the total home price. This elevated land cost is not primarily due to a preference for ample space but rather stems from regulatory and zoning constraints that restrict housing development potential on specific parcels or within certain areas.

Conclusion

The cost of housing originates from various factors. Typically, whether in new construction or existing properties, the primary expense lies in constructing the home itself. For new construction, this constitutes approximately 80% of the total cost, encompassing both hard and soft costs, while for existing properties, it remains around 60-70%.

It's only in densely populated urban regions where the cost of land starts to outweigh the expense of constructing new housing, driven by regulatory and zoning limitations that curtail housing development within specific areas. Another perspective is that in the regions with the highest housing demand, zoning and regulatory constraints largely dictate the majority of housing costs.