## Sunday, March 24, 2019

### High home prices jack up rents

In traditional economic thinking, the interaction an independently determined supply and demand for rental housing set the market rental price.

But that simplification ignores an important part of the story—where does demand, or the willingness to pay for rent, come from?

It might help to start thinking about a different product to clarify my point. Consider that you need some fruit and the prices per kilogram are as follows:
Apples - $5 Pears -$4
Bananas - $3 The demand for apples will be quite low since the close substitute goods have a lower price. Now consider this situation: Apples -$5
Pears - $7 Bananas -$6

What does the demand for apples look like now? The demand for apples will be higher since the price of substitutes has risen.

This is basic microeconomics, right? The demand for a good rises if the price of substitute goods rise, and vice-versa. High priced substitutes mean that each buyer will have a higher willingness to pay.

So now let’s talk about housing. There are roughly three goods in this market—buying, private renting, and social/public renting. If the price of one of these substitutes rises (or their accessibility diminishes due to queueing) so should the demand for the others.

What this means is that even though rental prices are a better indicator of the supply and demand interaction in the housing market than home prices, the demand curve that determines the rental price itself shifts with home prices. The demand curve in the rental market is not independent of the price (or cost) of home-buying.

We can see a pattern in some markets, like the chart of Seattle below, where rising prices led to rising rents, then falling prices led to falling rents.

While there are many other important interactions in housing markets, the substitute goods price effect is going to be part of the story.