4.6 Example: Public and private investment in state housing

Recent analysis of the provision of low-income housing in New Zealand highlights the importance of increasing housing supply (Housing Shareholders Advisory Group, 2010). Real options analysis can help understand the challenges in increasing supply and the issues that would be confronted, if private investment in state housing were to be considered.

The supply of housing is dependent on the rate at which land is developed (whether it be rural land developed into housing or existing urban land redeveloped to provide newer, and perhaps higher density, housing). All the ingredients for valuable real options are present in the land-development decision. First, the owner of a block of land has flexibility over the date at which development occurs: the existence of pieces of vacant land in city centres demonstrates the importance of the real option to delay development. Second, the payoff from delaying development is uncertain: when the housing market was booming, landowners could (and did) delay development and receive a much high development payoff, while others delayed past the market peak and would have received a much lower payoff had they gone ahead with development. Third, developing land is costly to reverse.[20]

Any landowner deciding whether or not to develop land for housing should calculate the payoff from developing the land immediately and compare it with the payoff from delaying the development decision. The development payoff equals the amount by which the present value of the flow of net benefits exceeds the required development expenditure, with the definition of the relevant net benefits depending on the identity of the owner. For a private-sector owner, the net benefits will equal the rental income generated by the property, plus any subsidies provided by public-sector agencies, minus ongoing expenses such as insurance, maintenance, local authority rates, and so on. For a public-sector owner, the benefits will be broader, reflecting the value to society as a whole in addition to those of the house's occupants. The payoff from delaying the development decision equals the option value of waiting, and—as it depends on the distribution of the eventual payoff from future development—also depends on the identity of the owner.

Equilibrium in the markets for developed and undeveloped land makes the development decision relatively straightforward when the decision-maker is a private-sector landowner.[21] The present value of the flow of net benefits received by the owner equals the market-clearing price of developed land, and the option value of waiting equals the market-clearing price of undeveloped land. Therefore, the landowner develops his land as soon as the market price of developed land exceeds the market price of undeveloped land by an amount that is greater than or equal to the required development expenditure. That is, the equilibrium process does the job of calculating present values for the landowner.

In contrast, public-sector landowners must estimate the public benefits of housing, calculate the present value of the flow of public benefits from developed land directly, and calculate the option value of leaving the land undeveloped. In practice, this is a sufficiently complicated problem requiring real options analysis that, even if their aim is to maximize overall welfare, public-sector decision-makers will resort to simpler—and therefore potentially suboptimal—decision-making rules. For example, Housing Shareholders Advisory Group (2010:40) highlights some ways in which an expectation that HNZC meets a specific target number of state houses has distorted its decision making. Politically-directed investment may take a broader view of the payoff from a project via the ability to “capture” consumer surplus in political benefits, but public-investment decisions may also reflect narrower objectives such as votes in particular locations or with particular constituencies.

From the discussion above, provision of low-income housing by private-sector entities with strong balance sheets will likely lead to more efficient use of timing flexibility being made. The decision-makers in such entities are likely to be less risk averse than their counterparts in the public sector, and so will be more willing to delay investment until market conditions improve and/or more information about the location and strength of demand for low-income housing is known. A strong balance sheet will reduce the risk that insufficient capital will be available at the time of investment, if that investment is delayed, which will also encourage efficient use of investment timing flexibility. Taking advantage of this flexibility allows the provider to reduce the risk that new houses will be stranded in the future by changing market conditions.

The literature on regulatory economics shows that welfare can be improved by capping the price that the firm can charge its customers and that the best price cap outperforms the best revenue cap.[22] Since this will lead to some demand not being met, the price regulation should be accompanied by quantity regulation, which puts a cap on the amount of rationing that can occur. The price levels of the price- and rationing-caps depend on factors such as the risk of stranding and the extent of economies of scale in investment. When there are economies of scale, the government faces a dynamic-inconsistency problem, because once the firm has undertaken its initial investment, overall welfare could be increased by raising the price cap and lowering the rationing cap. Thus, regulatory arrangements should make it possible for the regulator to commit to pre-investment settings. In the limiting case with constant returns to scale, the dynamic inconsistency disappears, but it is still socially optimal to impose both a cap on the price that the firm can charge and a cap on the extent to which it can ration demand.[23]

A private provider of subsidised low-income housing would bear some similarities to a regulated natural monopolist infrastructure-provider with the option to make a series of investments that generate services of value to the public. The two situations have much in common:

• Much of the investment decision-making is delegated to the firm, which has flexibility regarding when it invests and how large its investments are.
• Investment is largely irreversible.
• There is uncertainty regarding the future levels of revenue that will result from those investments.
• The firm is exposed to the risk that some or all of its investment will be stranded
• The regulation/subsidy regime must be designed in a way that avoids creating perverse incentives, such as “gold plating” the housing stock (so that the base on which any rate-of-return floor is calculated is higher) or building infrastructure/houses where they are cheap to build rather than where they are needed, knowing that a minimum level of revenue will be received anyway.

The main difference between the two situations is that in the case of price regulation welfare can be improved by placing some restriction on the upside of the firm's revenue, whereas in the housing case it can be improved by placing some restriction on the downside of the firm's revenue.

As far as we are aware, corresponding analysis for the subsidized provision of low-income housing has not been undertaken, but our conjecture is that the regulatory example is likely to have direct relevance. It seems likely that the best subsidy would place a floor on the rent that the firm could charge for each house (or perhaps each occupant) rather than a floor on its overall revenue or rate of return, and that some minimum quantity requirement on the private housing provider would be necessary to maximize welfare.[24]