Higher home prices, higher rents

“Everyone is a renter,” according to a recent blog post from the Federal Reserve Bank of Atlanta (FRBA).

Such a claim, especially made to professionals in the business of creating homeowners, can be jarring. However, the logic is sound and it is actually quite a productive prospective to take when assessing your competition from the rental market.

Homeowners are, in essence, their own landlords. The implied rent, or the rent a homeowner would be paying if they were renting their home, is accounted for in the Consumer Price Index (CPI) as an owner’s equivalent rent.

Inflation at its core

Home prices are not included in the CPI since homes are assets rather than consumable goods. A change in a home’s price does not produce an additional cost to the homeowner. It may cost more for a prospective buyer, but this all depends on the other integral aspect of home pricing — interest rates. Rent however, both in its explicit and implicit forms, is included under housing in the CPI since rent accounts for the cost of the service of shelter that real estate provides.

An owner’s equivalent rent accounts for a full 24% of CPI. Thus, determining whether rents will increase due to the recent uptick in home prices is essential to gauging whether or not inflation will begin to soar. Since an owner’s equivalent rent accounts for such a large percentage of CPI, even a small increase could be the tipping point towards inflation.

First, one must determine the extent to which home prices are linked to rents. Again, we do not account for home prices in CPI, but home prices presumably have an effect on rents, right?

According to FRBA economists, there is simply not a clear enough link between home prices and an owner’s equivalent rent to make a definitive conclusion. To get down to brass tacks, the FRBA asserts the rise in home prices will lean against the owner’s equivalent rent for the time being. In other words, the recent rise in home prices will hold rents down since increased end user demand will create more competition amongst landlords in the rental market.

However, over time rents will increase along with home prices due to asset market fundamentals. Translation: landlords expect a return on their investment. If the asset they have invested in is fetching higher prices on the market, they will raise rents to keep their return commensurate with the implied rent that owner-occupants are paying to own.

first tuesday insight

The FRBA is generally on point in terms of its abstract economics. However, the real world of California real estate never behaves exactly like the broader economy.

What one must keep in mind is that the current asset price inflation in California real estate is largely due to cash-in-hand speculators and is thus temporary. Speculators are driving prices ever higher, keeping many end-users out of the market for a wide variety of reasons, appraisal valuations and personal income being the most acute. This means it is still a landlord’s market when it comes to California rentals.

Even accounting for speculator activity, California sales volume has been decelerating for the past five months. All one has to do to figure how many families are out there with insufficient FICO scores to buy is look at the notices of default (NODs) and foreclosure sales that are just now beginning to fall.

Add five to seven years to the dates of the past and present foreclosure sales to determine a minimum amount of time these families will be renters. Then consider that California still needs to replace 700,000 jobs just to bring us back to pre-recession levels! 2013 will not be a banner year for home sales.

Speculators will soon find themselves in the position of having to sell at a loss unless they are willing and able to invest in managing their properties as rentals — the only way to realize a return on their investment.

Speculation on the speculator spectacle

Thus rents will remain strong in California despite the fact that nominal home prices are increasing. This appears to be a paradox, but when one accounts for the source of home price increases (speculator activity), it becomes clear that demand for shelter still resides in rentals as the speculators themselves have discovered.

Re: “You Say You’re a Homeowner and Not a Renter? Think Again.” from the FRBA