It's A Lose-Lose-Lose Deal For America: How Real Estate Bubbles Push Rents Higher

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Central Planning pushing housing prices higher is not win-win--it is lose-lose-lose.

The Status Quo views real estate bubbles as a "good thing": as home prices rise, the homeowner's collateral (equity) rises, creating both a psychological "wealth effect" (now that we're richer, we can afford to borrow and blow more money) and a temporary (and thus phantom) increase in collateral that will support more household debt.

What few seem to realize (or discuss) is how rising home prices push rents higher.This is an entirely pernicious effect, as renters aren't getting any more "home" for the higher rent--they're paying more money for the same shelter.

The standard-issue financial pundit (SIFP) has little interest in rents other than their role as income streams that support higher valuations for real estate investment trusts (REITs) and other tradeable real estate securities.

Rising rents reduce the discretionary income of renter households; since incomes have been declining in real terms for 90% of U.S. households, paying more rent leaves less income for everything else.

The Federal Reserve and the financial sector pay little attention to the 1/3 of households who rent; their focus is on the 2/3 who (at least nominally) own a home.

Rising home prices are presumed to benefit those 2/3 of households, and if 2/3 of households are seeing increases in equity, that "should" create a "wealth effect" that boosts consumption--the Keynesian Cargo Cult's sole metric of "prosperity."

Anyone with a concern for rising income/wealth disparity should be interested in the connection between Fed-inflated real estate bubbles and rents. Rising rents cause disposable income to drop, and renters do not have the chimeria of increasing equity in a home to offset that decline.

In a market economy that isn't managed by central banks and governments, rents respond mostly to the supply and demand for rental homes and apartments, which is primarily based on the job market: cities with strong job markets experience high demand for rentals, cities with poor job markets generally see less demand for rental housing as people move away to seek a job or better pay/prospects.

This has long been a function of free enterprise; high rents occur in places with higher wages. Historian Fernand Braudel showed this was true even at the start of modern Capitalism: cities with vibrant economies in the 15th century had higher costs and higher wages.

The problem with real estate bubbles is that they don't create higher wages--they only push housing costs higher. The reasons why are not hard to understand.

1. As home prices soar, fewer people can afford to buy on terms that make financial sense. This increases the pool of people who must rent, as they cannot afford to buy a house or condo. This increase in demand for rental housing pushes rents higher.

2. Investors buying rental housing expect a return based on the cost of buying and maintaining the property. As a rule of thumb, real estate investors typically expect a real return of around 4% on the market value of a property.
Thus a house that was purchased for $150,000 should yield a net return after expenses around $6,000 annually. (This calculation is complicated by the mortgage costs, depreciation and the tax benefits offered by owning real estate.)

Another conventional rule of thumb is that rental property valuations are based on a multiple of the annual rent. For example, let's say the $150,000 home can be rented for $1,300 a month. The annual rent is thus $15,600. Investors typically expect a multiple of between 8 and 14; a multiple of "10 times gross" yields a valuation for the house of $156,000.

What happens when the price of the house doubles to $300,000? The yield and valuation multiple on the investment plummets unless rents are raised: the net yield drops to the 2% level, not very attractive when long-term Treasury bonds are yielding a higher return, and the multiple rockets to an unattractive 20 time gross.

Property taxes on the higher-priced home will also rise. Typically, property taxes are based on the market value of the home; when the market value leaps up, so do the property taxes.

The natural response of investors is to push rents higher to bring the return on their investment back in line with historical norms. In areas with strong job markets and a shortage of affordable housing, they will get the higher rents because the pool of renters has no choice other than to move to another locale.
That is a possibility for those on fixed incomes (Social Security, pensions, etc.), but for those dependent on earned wages, the only option is to move to a lower cost area. As Braudel noted, this generally correlates to a lower-wage area. The wage earner then has to calculate the relative advantage of lower cost housing and lower income.

Those seeking higher wages will gravitate to locales with strong job markets, and pay the Fed-boosted rents as the cost of living in a higher-wage area.

3. The third factor is the floor placed under the rental market by subsidized housing programs (Section 8). Federal and state programs that pay most or all of the rent of low-income households base the rent they will pay on local market conditions: the subsidies are high in high-rent areas, otherwise low-income households would be unable to find housing.

Let's say that the rent on the house that was once $1,300 per month rises to $1,800 per month as the investors push rents up to reflect the higher prices they're paying for rentals, property taxes, etc. Landlords that opt to rent to Section 8 households will get (say) $1,750 a month, paid directly by the government.

That subsidized rent becomes the floor under the entire rental market. Landlords who were previously happy to receive $1,300 per month will naturally see the "bottom" of the current market as $1,750: if you can get paid $1,750 per month rent by the government, why take less than $1,750 per month under any circumstance?

The implosion of America's debt-based, asset-bubble-based centrally planned economy can be summarized by one phrase: unintended consequences. That's the ultimate flaw in all central planning schemes: not all feedback loops and dynamics can be foreseen or controlled by the central planners.

Central Planning pushing housing prices higher is not win-win--it is lose-lose-lose:renters lose, home buyers expecting ever-higher valuations lose and the U.S. economy loses, too.

Janet Yellen, the Nation's New Chief Slumlord January 9, 2014

Could the Fed Lose Control of the Frankenstein Economy It Has Created? January 2, 2014