The impact of intensification on Auckland housing valuations

The impact of intensification on
Auckland housing valuations
NZIER report to Auckland Council
August 2015

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Authorship
This paper was prepared at NZIER by Aaron Drew.
It was quality approved by Christina Leung.

We acknowledge the support of Chris Parker and Paul Owen (Auckland Council) and
Adam Thompson (Urban Economics) in the preparation of this report.

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Contents
1. Introduction ...................................................................................................... 2
2. Methodology and assumptions ........................................................................ 4
3. Results and sensitivity testing ........................................................................... 7
 3.1. No intensification effects .................................................................. 7
 3.2. Allowance for intensification ............................................................ 9
 3.3. Sensitivity testing ............................................................................ 11
4. Conclusions ..................................................................................................... 12
References ................................................................................................................... 13

Figures
Figure 1 Total returns to residential property under no intensification ....................... 8
Figure 2 Excess returns to cash for residential property ............................................... 8
Figure 3 Expected capital returns .................................................................................. 9

Tables
Table 1 Potential development capacity under the PAUP............................................. 3
Table 2 Development costs and space created through intensification ....................... 5
Table 3 House prices in Devonport versus comparable coastal locations .................... 9
Table 4 Valuation of housing by intensity type ........................................................... 10
Table 5 Sensitivity of valuations to differing assumptions .......................................... 11
Table 6 Starting level of prices, rents and rates .......................................................... 14
Table 7 Construction cost estimates for terraced housing .......................................... 15
Table 8 Other assumptions .......................................................................................... 16

NZIER report – The impact of intensification on Auckland housing valuations i

1. Introduction
The Auckland housing market has become a key economic, social and political issue.
At the heart of the matter is the widespread view that the market is over-valued
based on historic metrics, and unaffordable for many residents, owing in large part –
although not only – to a failure of housing supply to meet demand pressures.
In this paper we provide an alternative forward-looking valuation based lens to view
the Auckland housing market. We treat residential housing as an asset class in which
value is a function of expected rental earnings streams (explicit in the case of a
landlord, implicit in the case of an owner-occupier) and their riskiness. We do not
assume this expectation is only a function of rents on an existing dwelling. Rather, we
build into our modelling the potential for a home owner to intensify a dwelling based
on the proposed Auckland unitary plan (PAUP).
If the prices people are willing to pay for houses factor in the potential for
intensification then the “high” current prices are not necessarily a sign of market
failure – at least some fraction may reflect the rational discounting in of a higher
potential rental earnings stream. Under this logic, if the PAUP has enabled a change
to higher levels of intensification, or provides more certainty about which areas can
be intensified, then we should expect to see prices rise in anticipation. Furthermore,
this price rise may provide a strong signal to intensify. For example, a home owner
who has a dwelling that can be aggregated up to a bigger parcel of land may find it
advantageous to sell to a developer and shift to a location where the potential for
intensification, and the price of a comparable dwelling, is significantly lower.
In our analysis we consider four cases of intensification for a “standard” stand-alone
residential dwelling in the Auckland region (i.e. high, medium, low, and no
intensification) for each of the seven previous Auckland territorial authorities. At
least this level of dis-aggregation is required to reflect the different potential for
intensification under the PAUP across the Auckland region, as shown in Table 1.
Within Auckland City, for example, around 6% of the available land can be converted
to high rise buildings while in other regions this option is either not permitted or only
permitted on a much smaller scale.
Our valuation framework enables us to address several questions of interest in the
housing debate:

 1. How much do current Auckland house prices, and prices within sub-
 regions, reflect the potential for intensification?

 2. What types of intensification offer the best investment return?

 3. Where and what type of intensification are we likely to see first given the
 differing investment returns?

 4. Does the economics of intensification stack up given development costs?

 5. What would the costs of development need to be to encourage more
 rapid intensification?

NZIER report – The impact of intensification on Auckland housing valuations 2

Table 1 Potential development capacity under the PAUP
Region Low density Low rise Medium rise High rise
 (existing dwellings (4 storeys or less) (5 to 9 storey (plus 9 storey
 and some scope building) buildings)
 for infill)

Auckland City 36% 25% 34% 6%

Franklin District 75% 15% 11% 0%

Manukau City 40% 32% 27% 0%

North Shore City 37% 38% 25% 1%

Papakura District 49% 33% 17% 0%

Rodney District 94% 3% 3% 0%

Waitakere City 49% 21% 29% 1%

Auckland Region 45% 26% 26% 2%
Notes:
*Figures here are based on dwelling estimates and potential development estimates.
*The analysis does not include future urban zoned areas.
*The numbers above do not reflect Auckland Council's official view on growth.

Source: RIMU estimates, Auckland Council

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2. Methodology and
 assumptions
We model the values of residential housing using a discounted cash flow (DCF)
modelling approach. Key inputs and assumptions for the modelling includes:
  The starting level of house prices and rents (for a “standard” family home)
  Gross rental growth
  The occupancy rate
  Ongoing costs (rates, upkeep and insurance)
  Development costs (in the cases of intensification)
  Interest rates
  Inflation
  The residential property risk premium.

Annex 1 provides our assumptions for these variables, excepting development costs
which are discussed below.
Housing valuation estimates are formed for the “average dwelling” (a three bedroom
family home) across the eight regions, and for each region, across the cases of
intensification shown in Table 1. We form an overall assessment of valuation for the
Auckland region by weighting each model by its share of the land use, and the
fraction of households in the Auckland region, i.e.:

 4
Value Auckland = ∑ ∗ ( ) , where = ∑ =1 ( , ) ∗ ( , )
 =1

and ( , ) ℎ ℎ 

In the models where intensification is assumed, we factor in the all-in cost of this
intensification (i.e. land aggregation, demolition, new building costs, planning
approvals, etc) and the higher rents that the intensified property could generate once
the new dwelling structures are in place. This is a function of the number of dwellings
created, and their rental streams.
In Table 2 our “base case” assumptions of the cost of undertaking a development (ex-
land) and the units this creates is provided, along with the research sources that the
assumptions are based upon. In the case of low rise developments, we assume this
all takes the form of terraced housing where around 4 units can be created for an
“average” 600m2 section. The size and cost of these units are assumed to differ
across the Auckland region according to current market demand patterns. In central
Auckland and the North Shore higher cost (and quality) developments are assumed,
in Manukau and Papakura relatively low cost terraced housing is assumed, in other
regions costs lie roughly in between.

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In the case of a medium rise dwelling we assume a single site can generate 6 units of
around 80m2 in size. Again we assume some difference in costs according to the
quality demanded. In the case of high rise developments, which mainly are allowed
for in Auckland City, a single representative cost is assumed. In all cases we assume
an “industry standard” developer margin of 20% on the all-in construction cost.
We also need to assume when development takes place for the cases where this
occurs, and how long it takes for the development to come to the market. All
developments are assumed to take place in the 10th year of the modelling horizon,
and the costs shown in Table 2 are adjusted for inflation between today and year 10.
We also make the simplifying assumption that it takes one year for a development to
be put in place, and in the year of development no rental income is earned by the
investor. In the year following the development, it is further assumed that all units
are rented out (subject to our occupancy rate assumption).

Table 2 Development costs and space created through intensification
 Low rise Medium rise High rise
 terraced housing apartments apartments)

Base case developments costs
 a a b
m2 $3,600-$5,070 $4800-$8,000 $8000
Average unit size 100-150m2 80m2 55m2
 $362,000- $350,000-
Base case cost per unit $760,000 640,000 $440,000
Number of units 4 6 74
Total cost of development (ex-
land) $1.5-$3.1million $2.1-$3.8m $32million

Number of 600m2 sections
required 1 1 5
Average number of bedrooms
per unit 2.5 2 1.5

Notes:

 (a) This cost is based on analysis by Urban Economics.

 (b) This cost is based on Grimes and Mitchell (2015).

 See Appendix A for further details.

Source: NZIER

Given our valuation estimate, we form a forward-looking view of returns, and
compare this to both the risk free rate of return (which we take to be 90 day bank bill
rates) and return we think an investor should require given residential housing’s risk
characteristics. The key assumption we make in forming this return expectation is

NZIER report – The impact of intensification on Auckland housing valuations 5

that housing can be treated as an asset class in which prices ultimately reflect their
earnings stream and its riskiness. We think this is increasingly justified in the case of
New Zealand housing given widespread investor ownership.
The next most critical assumption is the pace at which prices ultimately revert to
some notion of fair value. Our approach is to assume this is relatively slow – we build
in a 7 year horizon period of adjustment. This is broadly in line with the period of
mean reversion we see in international listed equities, but is slower than what
typically occurs in the New Zealand dollar (2-3 years) and by extension potentially
other New Zealand asset classes. The implication of this assumption is that the
adjustment of Auckland house prices to fair value is smoothed out over a long time
period. The risk is that a “catalyst” could cause a much more abrupt adjustment.

NZIER report – The impact of intensification on Auckland housing valuations 6

3. Results and sensitivity testing
3.1. No intensification effects
The charts below show estimated average returns over the next 7 years given our
starting-point valuation gaps and assumed period of adjustment under the
assumption that prices do not reflect any potential for intensification.
The Auckland housing market as a whole is assessed to be expensive with prices
around 33% above estimated value. As a consequence, the total return is around 2%
per annum – around the pace of CPI inflation – implying real total returns are
expected to be flat for the next 7 years. The total return, however, includes the net
rental yield from housing (around 2% currently). This implies the capital gain
expected is mildly negative (around -0.5% per annum) over the next 7 years. If these
forecasts hold true, Auckland prices will be around 3% lower than where they are
currently in 7 years.
The charts, however, also show a high degree of variation within the Auckland
region. The North Shore and Auckland City are assessed to be very expensive,
Waitakere, Rodney and Manukau are moderately expensive, Papakura is close to fair
value, and Franklin is slightly cheap.
Location and amenity values clearly matter for explaining differences in house price
levels – we should always expect an Auckland City property to trade at a significant
premium to, say, a comparable property in Franklin given its much closer distance to
the CBD. Given that location and amenity should also factor into the rents that a
tenant is willing to pay it is not obvious, however, that they explain differences in the
estimated values across the Auckland region.
This pattern of significant valuation differences across the Auckland region is in line
with large estimated differences across New Zealand. For example, within Otago,
Dunedin City is assessed to be cheap whilst Queenstown is assessed to be expensive.
In part, the relatively poor value estimated for Queenstown, the North Shore and
Auckland City may reflect off-model non-financial “lifestyle” factors, or the impact of
absolute international house price convergence. As part of the globalisation of
Auckland and recognition of its quality of life we should expect to see housing levels
for premium parts of Auckland get more in line with premium destinations in
comparable cities. Table 3 suggests this process has much room for movement yet.
Across Auckland as a whole, however, this impact is likely to be relatively small.
The differences in valuations also hint at the impact of land supply constraints. The
potential for significant green field expansion of the residential housing stock is the
highest in Franklin, Papakura and Rodney, and lowest in Auckland City and the North
Shore. Hence, land and house prices in Franklin, Rodney and Papakura are less likely
to be bid-up well above the cost of developing and bringing to market a new single
dwelling family home. The threat of more supply is real. In contrast, given greenfield
supply is much more limited in Auckland City and the North Shore, this factor is likely
to be less important. Instead, as next discussed, pricing in these areas may be more
influenced by the potential for intensification.

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Figure 1 Total returns to residential property under no intensification

Source: QVNZ, REINZ, NZIER forecasts

Figure 2 Excess returns to cash for residential property

 Expected excess returns to cash for residential property
 4.0
 3.0
 2.0
 1.0
 0.0
Percent

 -1.0
 -2.0
 -3.0
 -4.0
 - - - Long run residential property risk premium
 -5.0

Source:
Source: QVNZ,
 QVNZ, REINZ,
 REINZ, NZIER forecasts
 NZIER forecasts

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Figure 3 Expected capital returns

 Expected capital gains for residential property

 7.0
 6.0
 5.0
 4.0
 3.0
 Percent

 2.0
 1.0
 0.0
 -1.0
 -2.0
 -3.0

Source: QVNZ, REINZ, NZIER forecasts

Source: QVNZ, REINZ, NZIER forecasts

Table 3 House prices in Devonport versus comparable coastal
locations
Location Average house price
 (NZD)
Devonport, Auckland $1.4m
Sausalito, San Francisco $1.7m
New Brighton, Melbourne $1.9m
Manly, Sydney $2.1m
La Playa, San Diego $2.5m
West Bay, Vancouver $2.8m

Source: Various

3.2. Allowance for intensification
A summary of the impact of intensification on our valuation modelling is provided in
Table 4. In the North Shore and Auckland City properties that are able to achieve the
highest intensities are estimated to be more highly valued than properties where no,
medium or low intensities are permitted. This reflects the economies of scale with
higher intensity developments. As a consequence, the overall valuation uplift is
highest in Auckland and the North Shore and lowest in Rodney, Franklin and

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Papakura. We also see that, in general, low intensity terraced housing provides a
larger valuation uplift than medium-sized high rises – the latter do not have the scale
advantage of high rises, yet still have higher costs than terraced housing (e.g.
because of the need for deeper foundations and lifts).

Table 4 Valuation of housing by intensity type
 No Low Med High Overall % % mis-
 intensity Value change priced
 from no
 intensity
Rodney 596,488 596,488 732,897 0 600,603 0.69% 20.20%

North Shore 631,360 846,182 788,991 1.028m 772,580 22.37% 26.03%

Auckland City 625,567 836,518 780,306 960,100 845,523 35.16% 17.35%

Waitakere 550,196 550,196 601,576 550,196 576,039 4.70% 14.03%

Manukau 592,234 592,234 701,050 0 620,028 4.69% 11.15%

Papakura 494,546 603,859 678,687 0 560,716 13.38% -9.72%

Franklin 568,426 568,426 616,999 0 573,650 0.92% -10.67%

Auckland
 598,494 701,325 17% 15%
Region
Notes:

1. Calculated by multiplying the values in the row by the probabilities in Table 1.

2. Calculated as the population weighted average of the column above.
Source: NZIER calculations

While intensification raises estimated value there are a few cases where it doesn’t
(the shaded brown cells). In these cases the costs of intensification is higher than the
discounted stream of the rents and hence intensification is uneconomic, for example,
our estimates suggest it would be uneconomic to build high rise developments in
West Auckland given the relatively high construction costs and relatively low rent
levels. In these cases, we set the value of housing to be the no intensity case on the
basis that the development would not go ahead.
The overall impact of factoring in the potential for intensification is to (i) reduce the
differences in the extent to which sub-regions are mis-priced and (ii) to move the
Auckland market as a whole closer to fair value. That said, while the impact is
significant – value for Auckland overall is 17% higher – the market is still assessed to
be expensive at around 15% above fair value.

NZIER report – The impact of intensification on Auckland housing valuations 10

3.3. Sensitivity testing
The table below reports the impact of the Auckland valuation estimated to a range of
sensitivity tests around the base case assumptions.
We see that building costs are an important sensitivity for the valuations. If building
costs were reduced 10% across the board we estimate the Auckland housing market
would be closer to “fair value” as it would make the economic case for intensification
stronger. Note that in this case we should not confuse the higher valuations with
reduced housing affordability; instead the price signal would encourage a greater
level of development and improve overall affordability.
In contrast, if the risk premium on development were higher (because, for example,
of increased uncertainty over permitting processes) the value of the housing stock
would be lower, and the supply that would come on stream would likely be lower.

Table 5 Sensitivity of valuations to differing assumptions
Factor Over-valuation in
 Auckland (%)

Base case intensity 15%
Building costs are 10% higher 24%
Building costs are 10% lower 7%
Probability of intensification is halved 20%
High rise intensification is doubled in areas allowed under the PAUP 12%
Higher risk premium on property development (+50bps) 25%

No intensity 33%

Source: NZIER

Another key risk to the assessment of value is the extent to which the development
activity actually takes place. We have made the bold assumption in our base case
valuations that full intensification occurs in year 10. The reality is the process will be
smoothed out and it is unlikely that all sections that can be intensified will be, even
over a much longer horizon. Halving the probability of intensification increases the
overall valuation by around 4 percentage points. This is not particularly large and
reflects the fact that the biggest “bang for the buck” occurs in the higher intensity
developments, which are already a small fraction of permitted developments. The
flipside is that increased high rise intensification has a large marginal impact on
housing valuations, particularly in Auckland and the North Shore.

NZIER report – The impact of intensification on Auckland housing valuations 11

4. Conclusions
In this paper we show that intensification under the PAUP may be a factor supporting
the high level of prices in Auckland. Our modelling suggests that this impact roughly
halves the over-valuation estimated for Auckland, with the largest impacts in the
North Shore and Auckland City where the potential for intensification is highest. This
result depends on the assumption, however, that intensification occurs within a 10-
year period. The impact is smaller if lower levels of intensification are assumed (and
hence the degree of over-valuation is higher).
Our modelling also shows that high rise intensification and low rise terrace housing
offers the best returns, whereas medium-sized apartments are marginal. As such, all
else equal, we should expect to see these developments lead medium intensity
developments as Auckland intensifies over time. The policy implication is also clear –
zoning more land for high as opposed to medium rise developments than what is
currently available under the PAUP may enable faster intensification.

NZIER report – The impact of intensification on Auckland housing valuations 12

References
Roberti, J (2014) Trends in new residential construction in Auckland, a case study
based on the Auckland Atlas of Construction, Study report SR307, BRANZ.

Grimes, A and I Mitchell (2015) Impacts of planning rules, regulations, uncertainty
and delay on residential property development, MOTU Working Paper 15-02.

NZIER report – The impact of intensification on Auckland housing valuations 13

Appendix A Input data and
assumptions
Table 6 Starting level of prices, rents and rates
City/Region Average house Average rent Gross yield Average council
 price rates

Auckland 809,210 490 3.1% 2,764
Rodney 721,948 478 3.4% 2,549
North Shore 973,684 529 2.8% 3,170
Auckland City 992,227 501 2.6% 3,216
Waitakere 656,880 442 3.5% 2,388
Manukau 689,147 464 3.5% 2,468
Papakura 506,213 433 4.4% 2,016
Franklin 512,419 422 4.3% 2,032

Source: QVNZ, Auckland Council

NZIER report – The impact of intensification on Auckland housing valuations 14

Table 7 Construction cost estimates for terraced housing
 Low costs Medium costs High costs
Build costs Construction cost
 1,800 2,400 2,900
 m2

 Cost for terraced
 180,000 (100m2) 360,000 (150m2) 435,000 (150m2)
 house
Civil construction
 Demolition Costs 7,500 7,500 7,500
costs

 Landscaping 2,500 2,500 2,500

 Civil Work 2,250 2,250 2,250

 Driveway 2,250 2,250 2,250
Utilities
construction fees Telephone 300 300 300

 Power 5,000 5,000 5,000

 Water 12,700 12,700 12,700
Professional fees Project Manager 3,600 7,200 8,700

 Town Planner 500 900 1,100

 Engineer 1,800 3,600 4,400

 Architect 5,400 10,800 13,100

 Surveyor 900 1,800 2,200

 Geotechnical 900 1,800 2,200

 Legal 900 1,800 2,200

 Real Estate Agent 13,500 23,600 27,000
Development
 Consents 3,000 3,000 3,000
contributions

 Development levy 18,000 18,000 18,000

 Insurance 1,500 1,500 1,500

 Total
 262,500 466,500 550,900
 Development Cost

 Finance 13,100 23,300 27,500

 Contingency 26,300 46,700 55,100

 Total Final
 Development and 301,900 536,500 633,500
 Finance Costs

 Developer Margin 60,380 107,300 126,700

 Total Cost 362,280 643,800 760,200

Source: Urban Economics

NZIER report – The impact of intensification on Auckland housing valuations 15

Table 8 Other assumptions
Variable Short run (0-7 years) Long run (+7 years)
CPI inflation 1.8% 2.0%
90-day interest rate 4.1% 4.8%
Real (inflation adjusted) rental growth rate 3% 2.5%

Occupancy rate 94% 94%
Upkeep cost as percentage of building value 1.5% 1.5%
(increases at the rate of CPI inflation)
Property risk premium 3.5% 3.5%

Notes
  We assume that interest rates will rise from current levels (starting in June 2017) to
 an OCR peak of 4.5% in 2022. If rates stay lower for longer the value we estimate
 would be higher, all else equal, but we note the RBNZ has not been able to
 engineer a tightening cycle yet where it hasn’t had to significantly over-shoot
 “neutral” policy levels.
  We assume that local body rates growth is in line with recent Auckland Council
 announcements (they increase from around $2,700 currently to $3,500 over the 7
 year period). A higher rate of growth in rates would reduce housing valuations
 unless we build in cost recovery via higher rents.
  We assume investors require a risk premium of 3.5% over cash for holding
 residential property. Around 200bps of this is compensation for systematic risk (i.e.
 the contribution that housing makes to risk in a broadly diversified portfolio), the
 remainder is compensation for illiquidity and concentration risks.
  We abstract from tax and leverage impacts in the estimates presented. On balance,
 at the present time we estimate, these serve to magnify the impact of the
 overvaluation, which could be a key catalyst of more abrupt adjustment than the 7
 year path assumed (i.e. if investors started worrying about their equity being
 wiped-out we would see strong selling pressure).
Source: NZIER assumptions

NZIER report – The impact of intensification on Auckland housing valuations 16