Rents and house prices – do they move together or apart?
Posted April 1, 2008on:
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:
- Rising house prices drive people out of the market, which increases demand for rental property,
- Rising rents drives increases demand for houses (circular I know 😛 ),
- They are both influenced by similar factors (GDP growth, wages),
- 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.