Rents and house prices – do they move together or apart?

Rental growth has been picking up in recent months, an interesting phenomenon given that house price growth has stalled, and rents and house prices have historically moved in the same direction. Some of the reasons why rents and house prices should move in the same direction are:

  1. Rising house prices drive people out of the market, which increases demand for rental property,
  2. Rising rents drives increases demand for houses (circular I know 😛 ),
  3. They are both influenced by similar factors (GDP growth, wages),
  4. Investors care about the yield on property – if prices are rising they have to lift rents higher to maintain the yield.

Ok, well why is rental growth picking up in the face of falling house prices? The common reason provided is that people that own rental property are struggling to pay the bills (with higher interest rates), and so are forced to lift rents – however does this argument make sense.

The most common counter to this claim is to ask, if landlords could have lifted rents previously, why didn’t they?  If we believe that the investor is profit maximising, shouldn’t they set the highest price they can in the current market?  If the price of houses starts to fall, won’t demand from renters fall, reducing the bargaining power of the landlord?

This is a fair criticism.  However, both the claim and the counter-claim ignored an important part of the issue – capital gain.

Fundamentally investors do want to maximise the value of their investment – however this need not be equivalent to maximising the rental income that they make.  On a house, investors also make a capital gain.  This capital gain depends on the quality of the house, which in turn depends on the quality of the tenants.  As there is asymmetric information between a landlord and their tenant (both in terms of adverse selection (how do we pick a tenant that is naturally disposed to looking after the property) and moral hazard (once a tenancy agreement is signed, will the tenant look after the property)), lower rents can be used to ensure that the asset is protected from the actions of the agent (as lower rent ensures it is easier to get a new tenant (increasing threat value) and attracts a greater pool of tenants for an interview.  Note:  There is a potential prisoner’s dilemma in this, indicating that the impact could be greater than we would intuitively think).

However, if a reduction in capital gains reduces the benefit to the landlord of keeping rents low, it increases his incentive to lift rents.  In this case falling house prices could lead to higher rents.

As far as I can tell, in NZ there is a belief that rents were kept artificially low as investors wanted to protect the quality of their asset.  As a result, analysts must believe that the fall in house prices will convince landlords to think less about capital value, and more about the rental income stream.

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  • john

    This capital gain depends on the quality of the house, which in turn depends on the quality of the tenants.

    Sorry but this is where I think your analysis goes wrong. In this market the quality of the house has not been strongly related to capital gain. Run-down rentals still attract keen interest from developers and will often sell for almost as much as a well-maintained property, less the cost of renovations. So the damage a bad tenant can do to the capital value is limited and most landlords have insurance for that anyway. Tenant quality will affect the profit of the business (dealing with problem tenants and making repairs costs time and money) but not the capital gain.

    In my experience even though landlords have been counting on capital gain when they make their purchases, because otherwise no-one would buy a negatively-geared property, rents have still been set to maximise yield balanced against the prospect of voids. Landlords will obviously want to increase their rents now but, in some areas anyway, supply is increasing due to the number of people who can’t sell their properties putting them up for rent instead.

  • Hi John,

    Fundamentally the result relies on the assumption that the tenants impact on the capital value of the house rises as house price growth rises. I’m not very certain how that would happen, however I was trying to come up with a reason why analysts seem to believe that significant falls in house prices will lead to significant increases in rent (beyond those implied by population growth and wage increases).

    One way I can think that this would work is if investors increased the future expected value of property based on current house price growth. If the tenants bad actions take some fixed proportion of the value away from the house, then high house price growth implies a higher house value which in turn implies that the cost from a bad tenant is higher in this case.

    Furthermore, we could use the cost of repairs as one type of mechanism. When house prices are high, building activity is high, and it is costly to get repairs done. As a result, the cost of bad tenants is higher, and lower rents to help improve the situation may be optimal.

    Ultimately, this is a theoretical exercise that is trying to explain what appears to be the consensus opinion at the moment. I’m not sure how convinced I am about it either (which is why you don’t see me disagreeing with your points 😉 ). Remember this though – if rents don’t pick up, house prices will fall further. This implies to me that the consensus opinion may be more the result of home-owners concerned about the value of their house then truly objective analysis 😛

  • CPW

    Isn’t this a simpler explanation?

    1. Investors’ expectation of long-run house price growth has fallen.
    2. Assuming constant rental yields (or constant rents), total expected returns on housing have fallen.
    3. Hence, investors want to hold less housing assets and more alternative financial assets.
    4. The attempt to reduce housing assets either reduces prices and increases rental yields, or reduces prices and raises rents (if rental stock supply actually falls) increasing rental yields.

  • “The attempt to reduce housing assets either reduces prices and increases rental yields, or reduces prices and raises rents (if rental stock supply actually falls) increasing rental yields.”

    I agree that house price falls would automatically increase yields, but I’m only looking for the case when rents themselves actually increase – as that is the popular story.

    Now the rental stock is relatively fixed in the short run. The only clear way I can think of it falling (given that the slowing economy will also reduce the incentive to refit property for commercial uses – in fact commercial prices look like they will fall further than residential) is if owner occupiers brought the houses – otherwise it would be other investors, who would rent out the property. If an owner-occupier buys the house, they must have been an ex-renter, started renting out their old house, or have sold their old house. So they either reduce both the supply and demand for rental property by 1 property, or leave both unchanged.

    As a result, I don’t think that explanation would provide us a mechanism to explain why rental growth would accelerate in the face of falling house prices.

  • CPW

    Supply is relatively fixed, but supply tends to respond quicker than house prices to changes in market conditions, so by the time house prices are falling supply could be falling in a meaningful quantity. Rental properties are probably the most elastic part of supply.

    Given that owner-occupiers are likely to be less focused on capital gains than investors, it’s reasonable to assume that owner-occupiers own a greater share of the housing stock in times of slower expected price growth.

    The obvious mechanism by which that shift in share would increase demand more than supply is if O.Os have lower household sizes than renters. This seems plausible – house prices fall, and you stop living with four flatmates and get your own place.

  • CPW

    Total supply is relatively fixed, but marginal supply tends to respond quicker than house prices to changes in market conditions, so by the time house prices are falling supply could be falling in a meaningful quantity. Rental properties are probably the most elastic part of supply.

    Given that owner-occupiers are likely to be less focused on capital gains than investors, it’s reasonable to assume that owner-occupiers own a greater share of the housing stock in times of slower expected price growth.

    The obvious mechanism by which that shift in share would increase demand more than supply is if O.Os have lower household sizes than renters. This seems plausible – house prices fall, and you stop living with four flatmates and get your own place.

    Another alternative, and perhaps what your nameless analysts are assuming, is that landlords just practice mark-up pricing and their costs (interest rates) are increasing, hence higher rents.

  • I started thinking this one over but unfortunately have to do some work on a presentation. I had got as far as jotting some thoughts down in Word but I see you 10:11 post Matt is much the same as I was thinking.

    Unfortunately the data I have on rentals (the CPI rental component) and REINZ house price data don’t go back far enough to allow for any meaningful analysis of the common (or lack thereof) cyclicality of rental prices and house prices.

    Those landlord/investors who were actually in it for rental yield (as opposed to those who were renting as a way to defray costs while they waited for the housing bubble to expand further) would have likely been pushing up rent as much as possible prior to the downturn in the housing market. It is easy to imagine a rental house in a good location (all the right zones, handy to either motorways or public transport etc) attracting fairly good gains. After all, if people are willing to fork out a lot for buying in that area then they would also be happy to pay above average rent. [Let’s leave aside the issue that property investment in such an area may well face see a greater proportion of speculative investing.] Which is pretty much what you noted in the original post. I wondered whether a landlord is more likely to post as high a rent as possible if they are concerned about maintaining the value (i.e. minimising wear and tear) if for no other reason than to avoid tenants who see the cost of the bond as low or who have no financial incentive to get back their bond but in some ways that goes the other way as a $500 bond for a low income tenant is obviously a bigger slice compared to a high income tenant.

    Could declining capital gains create an incentive for higher rents? I can see the argument for landlords to look to maximise their income if other sources of income are coming under pressure (financial market malaise, weakening job sesecurity). I don’t buy the cost argument though. If anyhting the cost of house ownership (and owning a rental property incurs much the same costs – building work, council rates) have been going up at a faster rate than rents.

    Obviously the demand side that will have a pivotal role in how the rental story turns out. People who rent are doing so out of necessity (they do not have enough to afford a deposit) or are voluntarily awaiting the housing market to bottom out. Given that affordability is still pretty low, I suspect that it will be some time before the first group are in a position to switch from renting to ownership. The second group will have at least a couple of years to make the move as well if past cycles are anything to go by. From memory, rental prices have been growing at aorund 3 percent (ish) for quite sometime and I would be mildly surprised if landlords are able to push them above that on a sustained basis.

    Thanks for a very thought provoking blog post.