Do sky-high rents disguise a new housing bubble?
Inflated rents portend inflated house prices. If rents are at unsustainably high valuations, then so are house prices.
Historically, rent and income were bound in a tight relationship because renters generally pay the bills out of current income rather than savings. If income rises, renters use a portion of this increase to rent a nicer place, or due to the collective activity driving up rents, sometimes renters must pay more just to stay where they are.
In the depths of the Great Recession, personal incomes dropped because many people lost their jobs and many others barely hung on. Ordinarily, such circumstances would cause rents to weaken as fewer workers with less money bid on the available rental housing stock, forcing landlords to compete with each other for tenants. Unfortunately, that isn’t what happened.
When the housing bust began, lenders foreclosed on the subprime borrowers whose loans blew up first, displacing many people who were forced to search for rentals, and the increased demand caused rents to rise.
In an efficient market, each new renter would have matched by a new rental unit as the foreclosed home was converted to a rental unit; however, many of these properties were not processed quickly, and vacant homes abounded, particularly in the fringe markets. A vacant home is not an available rental unit, so the number of renters exceeded the number of rentals, and rental rates actually went up quite dramatically during a time when rents should have gone down.
The REO-to-rental movement brought many more rentals to the housing market, but not enough to bring rents back down to reasonable levels — at least not yet. The result was rising rents on stagnant income, a problem that persists to this day.
Los Angeles residents are now spending half their income on rent
Prashant Gopal, August 13, 2015 — 12:05 AM PDT
Americans living in rentals spent almost a third of their incomes on housing in the second quarter, the highest share in recent history.
Rental affordability has steadily worsened, according to a new report from Zillow, which tracked data going back to 1979. A renter making the median income in the U.S. spent 30.2 percent of her income on a median-priced apartment in the second quarter, compared with 29.5 percent a year earlier. The long-term average, from 1985 to 1999, was 24.4 percent.
In 2008, America entered a deep recession, yet rent inexplicably and unexpectedly began to rise, a rise commensurate with a rapid economic expansion that wasn’t happening. I demonstrated this phenomenon locally in the chart from Riverside County above, but rents rose nationally at the same time, and rents have been rising every since.
This kind of economic distortion isn’t tenable. Apartment developers and REO-to-rental firms feverishly work to add to the supply, but so far their efforts haven’t kept pace with the declining homeownership rate.
While mortgages remain relatively affordable, landlords have been able to increase rents because demand for apartments remains strong. The U.S. homeownership rate fell to the lowest level in almost five decades in the second quarter, as strict lending standards and tight inventories keep many families in the rental market.
The conventional wisdom is that everyone wants to own a home, so lack of opportunity must be keeping the housing market back. But is that really the case? Could it be that many rent by choice?
Rental affordability worsened from a year earlier in 28 of the 35 largest metropolitan areas covered by Zillow. Rents were least affordable in Los Angeles, where residents devoted 49 percent of monthly income to rent. The share in San Francisco was 47 percent, 45 percent in Miami, and 41 percent in the New York metro area.
Meanwhile, historically cheap mortgage rates are keeping the cost of homeownership low. Buyers in the U.S. devoted 15 percent of their income to mortgage payments, which is less than the historical average of 21 percent. Exceptions include the Silicon Valley area in California, where homeowners and renters each devote 42 percent of income to housing costs.
Herein lies the problem with high rents and house prices. My reports consistently say that housing is no more expensive relative to rent than it was in the 1990s; this isn’t supposition, it’s fact supported by data. The premise of my reports is that house prices are fairly valued due to their relationship with rent, and rent is always fairly valued relative to income. What if the second assumption is wrong? What if rents are not fairly valued relative to income? Is it all a bubble then?
We know house prices are 30% too high relative to income, but most of that difference is due to low mortgage rates. But what if house prices are actually 50% too high because rents are inflated and mortgage rates are too low?
We’ve discussed at length the problems likely to face the market when mortgage rates rise, but what happens if rent growth stops or we get declining rents as more supply comes to market? Could we see falling rents and falling house prices like we did during the housing bust?
While all these scenarios are possible, I consider a housing bubble based on inflated rents to be unlikely. Rents rarely go down, and almost never in the absence of economic recession. I doubt we will see declining rents during a period when the economy is improving and interest rates are rising.
High rents and high house prices are bad for families who must put more money toward shelter, but it isn’t the sign of a bubble ready to pop.