Edward Donovan read economics at the University of Cambridge, graduating in 2022 with a 2:1. Since then, he has worked as an acquisitions analyst at Greycoat Real Estate, a private equity firm. Edward has focussed on residential developments, commercial real estate and special situations during his time at Greycoat.
The ratio of house prices to incomes in England rose from 5x to 8x (12x in London) over the last twenty years. Further rises of this magnitude are unsustainable. ‘Affordable Housing’ (AH) programmes are one of many improvements intended to make housing more affordable. These programs, while well intentioned, have failed to improve affordability, depressed housing delivery and exacerbated the affordability problem through creating a high price floor.
Developers are required to supply a portion of all new builds as AH as a prerequisite for planning permission. Several versions of AH exist but, in short, a percentage of units in a new development are required to sold or rented to households making under a given income cap at heavily discounted rates. The GLA targets an AH provision of 50% for private new build developments. In London, affordable units are built at a loss, creating a price floor for private units and severely limiting the total stock of housing that can be built. AH is just one friction dragging down deliveries, but one with a significant effect.
AH’s advocates say it doesn’t affect housing deliveries; it just reduces land prices. While a decrease in land prices has occurred, it isn’t the only effect. Land has other uses with which housing competes; developers can’t dictate prices to landowners, so the cost of AH will be shared between developers and landowners. This reduces margins and therefore the incentive to build housing. Most importantly, the proportion of Affordable Housing required and mix of AH types is determined during the planning stage, as well as after land purchase via negotiations between the developer and council surrounding the Section 106 agreement (which sets out AH and other contributions the developer makes to the council). This uncertainty around the number of AH units required increases risk and thus the minimum return required by a project due to the uncertainty of the AH program. This uncertainty has been decreased somewhat by the adoption of AH targets by local authorities, but the aspirational nature of these targets means they have still harmed viability on net.
Even if AH only affected land prices, it would still create high price floors for the wider housing market. We can calculate the minimum new build house prices required to justify construction and from them minimum market prices.
Imagine a developer building 100 flats in Camden with zero land cost. The apartment’s build cost in central London would, based off prevailing market build costs, optimistically cost £600 per-square-foot (psf) of net saleable area. The affordable provision required in Camden is 50% and these are sold at £300psf. The risks of development (e.g. delays in planning, construction cost overruns, house price underperformance, etc.) mean that the unlevered cost of capital for developers is currently more than 12% per annum. This refers to the annual return on committed funds before financing and taxes that is needed to justify the planning, construction, and sales risks developers experience. Apartment blocks take approximately six years to secure planning, build, complete and sell; after accounting for the point in the business plan when money is spent, the return must be around 1.5x (for comparison, a six-year risk free government bond would return 1.275x). To meet these constraints, the developer must sell the private units for £1350 psf. Removing the 10% extra that new builds command relative to the rest of the market, we find that the market floor is around £1,200 psf.
To those with historical experience in the industry, construction costs may seem high compared to just a few years ago. They have increased due to [1] general inflation, [2] new energy efficiency standards, [3] increased safety regulations (e.g., additional stair cores needed for residential blocks) and [4] post-Brexit labour shortages.
If a developer can only make the required return if he can sell his development for £1350 psf, only enough private units will be built to support those who can buy a house at £1350 psf. If prices fall below these levels, new builds become unviable, supply will fall, and prices eventually rise as buyers compete for reduced stock.
At £1,350 psf, new London one- and two-bedroom flats cost £675,000 and £1,080,000. With a 10% deposit, a couple each need individual gross incomes of £67,500 and £108,000 respectively. Optimistically, up to 30% and 15% of the mid-30s cohort (the prime homebuyer demographic) could afford this. Given new-builds sales shares, owner-occupiers market share, and the mid-30s cohort size, the private sector could complete at most 16,000 units per year, including private rented and owner-occupied units, in London. In addition, London authorities started a record 10,000 units in 2023. The Greater London Authority says a yearly target of 66,000 houses is needed in London; Savills thinks 94,000 units are needed. Less than 50% of the needed homes would be built.
Rents move in line with these prices, driven by the same supply and demand pressures, even assuming land and other costs like sales, Community infrastructure levies, Section 106 payments, and so forth, are zero. Additionally, while the effects of viability assessments have not been considered; these are not panaceas given as a developer does not know what they will result in before purchasing land.
Previous research has confirmed the trade-offs of AH mandates. Inclusionary zoning (IZ), the American equivalent of AH programs, have pushed up prices for market-rate house prices in the Washington, DC, and Baltimore areas. Modelling from UCLA and UC Berkeley suggests that while IZ always results in reduced overall housing production, the impact on housing prices depends on the level of IZ required. Lower levels result in fewer market-rate units and more Affordable units, but higher levels can actually result in lower levels of both!
The housing crisis isn’t a problem of greed, stupidity, or malice; it’s a consequence of a system where the numbers just don’t work. High prices and rents aren’t the problem; they’re the symptom. We could do three things to improve the situation:
- We can reduce build costs, which means loosening environmental or safety regulations, which there is no appetite for.
- We can reduce the proportion of AH or increase the payment developers receive for AH.
- We can reduce the return developers require. The shorter project timelines are, the fewer ways planning permissions can be rejected and the fewer the risks developers are exposed to, the lower the returns and equilibrium prices needed for developments. Politicians often talk about targeting ‘patient capital’, but this doesn’t exist; what does exist is capital which wants low risk and is willing to accept low returns.
This problem isn’t going away, which means we need to solve it. If we don’t, far too few affordable units will be built and those private units which are built will be sold at prices unavailable to most Londoners.
