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Why Post-Bubble Rents Matter   (May 17, 2006)


Why are post-bubble rents important? For one thing, they will, with enormous consequences, set the official rate of inflation and thus future interest rates. As described here in The Housing - Inflation Connection, the cost of renting housing is fully 40% of the Consumer Price Index (CPI). As rents dropped during the housing boom, they artificially suppressed the CPI. If rents ever rise, they will quickly boost the CPI.

The big question is: will rents fall or rise as the housing bubble deflates? Given that part of what is causing the bubble to pop is overbuilding--the number of new condos and houses has outstripped demand--then common sense suggest rents will drop as desperate owners will lower rents to fill those hundreds of unsold units with tenants.

That sounds reasonable--but then why does the Federal Reserve's Susan Bies think rents will actually rise? Rising rents may push CPI higher, Fed's Bies says.
Noting that the CPI's gauge of housing costs is based on rents, Bies told a banking conference in answer to a question: "We've come through a period of weaker rents. Now, housing has really sort of peaked ... that may rejuvenate rents and so you may see may see that, in turn, higher (CPI) inflation going forward."

Bies said, however, the Fed focuses more heavily on the core personal consumption expenditures price index than the CPI.
You've probably read about "chain deflators" and all the arcane mechanisms by which the "official" rate of inflation is calculated, but any consumer can tell you inflation has been rising at a far faster clip than the official rate--however it's massaged. The "true" CPI has been artifically suppressed for the past 4 years because the housing boom dramatically lowered rents. In that sense, the Fed will be hoist on its own petard if the long-suppressed CPI breaks above the "true" rate.

Why does this matter? Because bond traders expect the yield on a bond to exceed the rate of inflation. If inflation is tripping along at 5% annually, who would be dumb enough to buy a bond--which could drop precipitously in value should the dollar decline--which pays only 5%? You're nor making a dime on your investment, even as you're taking on a major risk of the dollar losing value.

While the Fed governors have the luxury of playing around with chain deflators and the like, the bond market is the body which actually sets the long-term (mortgage) interest rates. If buyers of U.S. Treasury bonds start to get nervous about a rising CPI as evidence of rising inflation, they might demand a larger premium of risk--in other words, "show me the money or I'm not buying your bond." If bond rates rise to 8%, mortgage rates won't be far behind-- they will probably be ahead.

And what do rising mortgage rates mean for the housing market? Declining prices, higher Adjustable Rate Mortgage (ARM) resets and thus more foreclosures as cash-strapped homeowners go broke. Ouch. But then maybe rents will fall as all these hundreds of thousands of units come on the market.

Not so fast. There are countervailing forces which could, as Ms. Bies suggests, actually cause rents to rise. How is this possible? There are a number of factors:
  • As people give up their homes to foreclosure, they become renters again, increasing demand.
  • The lenders saddled with thousands of foreclosed homes will not be renting them out; they are not in the rental business, they are in the asset/loan liquidation business. The properties will be auctioned off, even if the losses exceed 50% of the loan value.
  • It's actually cheaper to board up multi-story condo buildings than maintain them for a handful of tenants. Managing and maintaining such buildings is an expensive business, and so occupancy rates have to be relatively high to justify keeping them open.

    Boarded up or unfinished highrises were a common sight in Asian cities such as Bangkok after the Asian Contagion financial crises of the late 90s. If the builder or developer goes bankrupt, the lender is also not going to enter the rental housing business. The lender itself may well be pushed into bankruptcy should multiple developers and builders go bust. That would be the normal course of events in an over-building bubble such as this one.

    Which scenario is correct? Perhaps both. My photo of the two stately Victorian homes in the Haight-Ashbury district of San Francisco provides a visual metaphor of how the rental market may develop. Rental units in desirable locations with good schools and close proximity to jobs and shopping districts will likely be rewarded with substantial increases in rent, even as thousands of houses and condos languish empty in overbuilt, distant or otherwise unattractive locations. The bland Victorian represents these perfectly good but utterly undesirable homes which may not attract renters at a price which enables the owner to cover his/her costs.

    Thus it may well turn out to be a bifurcated market in which a million foreclosed units sit vacant even as rents are rising in desirable locales which were not overbuilt. This would truly be the worst of all possible worlds, as rising rents would jack up the CPI even as lenders foreclosed on thousands of homes and then went bankrupt themselves as mortgage rates rose in lockstep with the CPI.

    Implausible? People who have witnessed the aftermath of overbuilding coupled with rising mortgage rates won't think so--they've seen rows of empty forlorn buildings and houses before.


    For more on this subject and a wide array of other topics, please visit my weblog.

                                                               


    copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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