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. 

It is also a helpful guide for thinking about housing policy.

To dampen housing demand (and therefore rental price) it pays to create a housing system with many substitute ways to access secure housing. A huge investment in social (below-market-priced) housing, for example, will provide a substitute option for many private renters. 

The effect of this investment will be larger than the number of people who take up the option. Many households who don’t end up in social housing will keep their bids for private rentals below the price of the social housing option, reducing prices in the private rental market as well.

I don't know how big this effect is. But even a 5% effect on the willingness to pay for private rental housing still equates to $2.5 billion in annual total rents paid by the 30% of households who rent.

In general, therefore, the more housing alternatives that exist, the more stable and low-priced the total housing system should be. Any substitution effect on demand from price changes in one housing market will have a lower effect on each other market. 


  1. "thet demand curve that determines the rental price itself shifts with home prices." Doesn't it also shift the supply curve of rental homes?

    1. Not necessarily. The price of home buying can rise without any net change in the share of homes being the rentals vs owner-occupied, leaving supply unaffected.

  2. I think this is an important point to make. A similar point was made by Dr Chris Martin in relation to negative gearing when he pointed out that higher house prices can inflate rental costs by pushing potential home-owners into the rental sector.

    I think one thing that you haven't noted here - and maybe it's not relevant for a simple model - is that potential home-ownership is constrained not just by the ability to service a mortgage (which may be lower than rental costs) but also by having the initial deposit. So some renters cannot substitute home-ownership for renting.

  3. It’s an intriguing idea but I think the fruit metaphor can be improved. The rental house can still be the apple, but the purchased house should be an apple tree. Then what happens to the price of apples if the price of apple trees goes up? Surely it depends on why. If the price of apple trees went up because the price of apples is expected to rise, then you see exactly what you’re talking about in the macro time series in Seattle. But it is not the price of the apple tree that causes the price of apples to rise, it’s the opposite.

    But if people are buying up apple trees for ornamental foliage, and dumping the apples in their compost heaps, then the supply of apples will fall and their price will rise.

  4. There may be another aspect to this that you've not considered.

    If we assume the "Great Aussie Dream" is the dream of most people renting, then they're doing what they can to save a deposit, aspiring to buy. However, as prices have risen so strongly for so long, many have been unable to save at a sufficient pace to grow their deposit quickly enough.

    Thus, we have a group of people who are eager home owners with considerable spending capacity, and will be more tempted and/or able to devote more of their incomes to rent that would otherwise be the case. If they could not save at all then stumping up extra cash for rent would be impossible.

    What is another $50 or $100 per week for a nicer place when we're trying to save thousands per month for a deposit? Just another little luxury (like smashed avo on sourdough) to make life more pleasant while waiting for our spot at the auction.

  5. I get the point you are trying to make and there is probably some merit to it. However given that homebuyers being locked out of the market is for the most part at the moment due to a zero sum competition of being outbid by investors, the argument that being locked out of the owner-occupier housing market from high land prices is feeding rental demand seems to miss the other key element.

    The supply these homebuyers otherwise would have bought is acquired by an investor, who then in turn presumably increases the rental supply of housing (not factoring in speculative vacancies). For this reason, a land tax that excludes owner-occupiers still should have no effect on rents since the reduction in investor demand for rental housing coincides with homebuyer (renters) leaving the market to become owner-occupiers (given they have higher after tax purchasing power). So the supply and demand of rental housing shifts simultaneously with this zero sum competition between investors and locked out homebuyers (at least in the current state of the market).

    I think the bigger issue comes down to the price dynamics that affect developers and their capacity to develop. Right now with prices falling and credit tightening, developers are freezing on building new homes. This freeze during this price fall could result in a rental shortage and rental inflation in the next couple of years, which then kicks off construction and prices again.

    1. "a land tax that excludes owner-occupiers still should have no effect on rents" except isn't supply & demand only one factor affecting rental prices? Other factors include owners/investors passing on costs to renters - eg land tax & rates, increase in rates equals rent rise as long as renters are willing to pay the extra, which they will unless there is oversupply - never happens when it comes to houses in urban Australia. This is one reason rents are much higher in some suburbs than others - besides walking distance to shops, transport etc.

    2. This is completely illogical.
      Landlords charge rents that the market will bear, if they could charge tenants more they would already being doing so.
      Rents are not determined by a landlord's costs, they are determined by what the tenant demand and capacity to pay is. Higher land tax and rates do not give landlords magical powers to increase rents unless they can reduce the supply of rental housing - which is only possible by selling it to owner-occupiers who currently rent.

      This is why landlords complain in NSW that a large chunk of their rent is devoured by land tax. It cannot be passed on, so the only sensible thing is to sell the property to an owner-occupier, which is why some suburbs have almost no rental properties - everyone is a homeowner because investors cannot compete.

  6. While rental prices track home prices, there is often a long lag. I'm based in Seattle, and both housing supply and demand have been increasing. The development of entire commercial and residential neighborhood, South Lake Union, has been an unusual test of supply and demand rules.

    A lot of new units were sold to investors seeking to rent them, both as individual units and as shares of real estate corporations. I have friends who have rented rather than bought, even though they could easily have afforded to buy, because of that lag. The rents were just too darned low compared to the cost of buying.

  7. BTW, It's nice to read some economics by someone who doesn't handwave "rational" economic actors, but instead looks at their actual bookkeeping.