If property prices are rising, it is commonly assumed we must be facing a shortage of supply relative to demand. So if we’re ever going to reduce housing affordability problems, we’re simply going to have to build our way out of it. After all, as anyone who’s sat in an introductory economics class would tell you, basic economics is sufficient to at least suggest that if prices are rising in the long term, then supply must be lagging behind demand.
It’s true the housing market is largely subject to the forces of supply and demand. The deficiency of this argument lies, not so much in any perceived cracks in the supply-demand framework taught in Economics 101, but in the fact that the appropriate “price” indicator is not property prices. It’s rent...
The problem with relying on rising property prices as a “price” signal of a supply shortage is that the dwelling an owner-occupier buys is both a consumption and an investment good. It offers a place to live as well as an asset in which the owner invests a substantial part of their wealth. Hence, property prices are at best a murky indicator of the balance of supply and demand for housing as a home to live in and an asset to own.
It is well established in the housing economics literature that the “price” signal for the adequacy of supply relative to demand for housing services is rent. Rent reflects the cost of consuming housing or, to put it another way, the cost of living in a home. So if housing supply is lagging behind demand for housing as a place to live in, we should expect to see rents rise.So, there you have it. When we're trying to understand what's happening to housing we should be looking more closely at what is happening to rents, and less closely at what is happening to house prices.