Land supply elasticity and the housing price sensitivity to interest rate

Abstract

In Hong Kong, housing prices have increased significantly in recent years. Amongst all the reasons for such significant increase, low interest rate has been recognized as one of the major reasons. Many studies have provided empirical evidence to support the negative relationship between interest rate and housing prices. However, in the US, recent studies (Glaeser, Gottlieb and Gyourko, 2010; Kuttner, 2012) show that the observed effect of interest rate changes on housing prices is much less than that predicted by the standard user cost model.

According to the Glaeser et al. (2010), there are three potential explanations for the low housing price sensitivity to interest rate fluctuation. First, increase in land (and therefore housing) supply elasticity can reduce the effects of the demand-side variables, including interest rate. Second, high risk premium for long term mortgage rate in the US makes housing prices less sensitive to changes in interest rates. Third, the long-term mortgage contracts in the US cannot reflect the impact of frequent short term interest rate fluctuation. Among these three potential hypotheses proposed to explain the lower than expected housing price sensitivity to interest rate changes, land supply elasticity is more relevant to Hong Kong. By focusing on Hong Kong’s housing market, this thesis examines the relationship between land supply elasticity and the sensitivity of housing prices towards interest rate changes. When demand shift due to interest rate change, land supply (and therefore housing supply) may respond accordingly to reduce the impact of interest rate change. The more elastic the supply is, the weaker the housing price sensitivity to interest rate may be. Alternatively, housing prices are more sensitive to interest rate change when land supply is inelastic.

To be more precisely, this study provides an empirical test on whether land supply elasticity reduces housing price sensitivity towards interest changes. Two approaches are applied to provide clear pictures of housing price sensitivity. First, data from different housing subsectors with different land supply elasticity are used for the empirical tests. The results show that prices of large units in the Hong Kong Island are significantly more sensitive to interest rate change, compared to those of small units in the New Territories. This is consistent with the implication of our hypothesis because new land for building luxurious units in Hong Kong Island is limited while there are relatively more lands available in the New Territories for smaller mass residential units. Second, in Hong Kong, all new land supply comes from the government in the form of leasehold land. Hence, government’s land supply policy has a major impact on land supply elasticity. For example, there was a period of restricted land supply before the handover in 1997, which effectively reduced land supply elasticity. On the other hand, the Application List land sales system adopted by the Hong Kong government from 2000 to 2013 should increase the flexibility in land supply. Therefore, this study makes use of these policy changes as nature experiments to investigate the effect of land supply elasticity on housing price sensitivity towards interest fluctuation. The results show that housing prices are more sensitive to interest rate change during the land supply restriction period and more insensitive when the Application List was used for land sales.