Building More New Housing Will NOT Lower Rents — High Rents Are Baked-In By High Costs
Market-rate rents are high because since 1970 housing costs have doubled while the median household income has only increased by about 15%
On August 11, 2022 I published this column:
Reduce Rents By Levying A 100% Tax On Rents Exceeding A Market-Rate Return On Gross Property Value
Move from monopoly lease pricing to competitive-market pricing with a 100% tax on rents exceeding a market-rate…
Since its initial publication I have substantially edited and changed the above column.
It deals with lowering rents by providing for but capping landlord profits through the use of an excess-rent tax.
But an excess-rent tax strategy can only materially reduce rents for properties owned by landlords whose costs and capital investment are so low that the landlord can still make a reasonable profit while charging a below-market-rate rent.
These older landlords represent only some of the landlords. The above column didn’t address the fundamental reason for high market-rate rents on newer properties, namely, the high cost of land and construction.
There Is A Big Difference Between Old Rental Properties & New Ones
We start by realizing that residential-property owners fall on a continuum between two very different business models at opposite ends of the spectrum.
Landlords Who Bought Their Properties A Long Time Ago
At one end of this continuum are the landlords who bought their properties long ago and have (1) paid off the mortgages and (2) recouped their initial cash investment so that every dollar in rent that they receive over and above taxes, insurance, maintenance, repairs and utilities is pure profit.
The current high market-rate rent charged by these the older landlords is a huge windfall to them and that rent can be materially reduced by the excess-rent tax strategy discussed in my previous column.
Landlords Who Bought Their Properties At Today’s Prices
At the other end of the continuum are landlords who bought or built their residential rental property recently and who have to pay mortgage installments and property taxes based on the property’s high current value.
The crucial fact about these owners of recently-purchased property is that their mortgage payments and expenses are so high that even with a high rental rate they may be barely breaking even.
So, at one end of the scale are the landlords who can be very profitable charging relatively low rents and at the other end are landlords who can barely break even while charging very high rents.
Building New Rental Units Cannot Reduce The Cost Of Rents Short Of Bankruptcies & Foreclosures
The fact that developers cannot rent property at a loss is the key reason why the classical economist’s idea that:
- High consumer costs yield –>
- New investment which yields –>
- An increase in supply which yields –>
- An increase in competition which yields –>
- Lower prices
is fundamentally FALSE for residential-housing rent because the cost of producing the new housing units is so high that they cannot be rented at a profit at a price below the current high market rate.
Not only will competition from newly constructed housing units NOT substantially lower rents for residential rental properties, it CANNOT lower rents for residential rental properties because owners cannot afford to rent property for a below-cost rent.
The only way new units will cause rents to decline is after a string of foreclosures and bankruptcies fundamentally changes the economics for those newer units.
The idea that, short of foreclosures, we can build ourselves out of high rents with expensive new housing units is flat-out WRONG.
Why More New Rental Units Won’t Lower Rents
The Cost Of Housing Has Massively Outpaced Wages
Between 1970 and today the inflation-adjusted cost of buying a house has roughly doubled while the median family income has increased about 15%.
That means that if in 1970 a family with the median household income spent 30% of their take-home pay on housing, today that same family will have to at least spend roughly 52% of their household income on housing.
Rents on new construction and on market-rate purchases of older properties are high because of the huge increases in the cost of land, building materials and construction versus the small adjusted-for-inflation increase in family income.
Without either (1) greatly increasing family income or (2) greatly decreasing the cost of land, building materials and construction, the high cost of renting units in new properties will not and CANNOT be materially reduced.
A high rent is baked into new housing projects before the first nail is driven.
The SF Bay Area — A Hot Market
Where I live in the SF Bay Area, a small single-family residential-city lot costs between $1,000,000 and $1,500,000. That’s just the dirt. The cheapest listing I could find in San Jose was for a .3 acre empty lot on the outskirts of the city for $330,000.
Building costs here are between $350 and $400 per square foot after you’ve bought the land. A small 1200 sq ft house will cost about $500,000 to build so, with the land, you’re up to at least $830,000. That’s a $5,000/month mortgage payment + $1,500/mo for property taxes, insurance, etc. just to break even.
Lower Priced Areas
But let’s get out of the SF Bay area and out of other “hot” markets. Let’s consider the outskirts of other lower-cost metro areas around the U.S.
Let’s skip all the arithmetic. I’ll just tell you that if an investor buys a cheap 1,200 square foot manufactured home and puts it on a $100,000 city lot and calculates the rent for a 5% return on investment capital and a 10% vacancy factor s/he will need to charge a rent of about $3,300/mo plus about $200/mo for utilities.
You can create all the new single-family mass-produced homes you want, but that won’t lower the monthly rent including utilities to much under about $3,500/month or around $40,000+/yr.
If the household take-home pay is $50,000/yr . . . well, you get the idea.
Instead of a single-family house, what if we built a big apartment house in the same non-hot area?
In one of those locations where construction costs $125/square foot compared to the Bay Area’s $400/sq ft, the cost for the land, design, permits and construction of a one-hundred unit apartment house would be about $40 million.
Again, I’m going to skip most of the math, but if the developer puts $10M down and borrows $30M on a 30-year fixed mortgage at 5.5% (which is unrealistically low for apartment house financing) the out-of-pocket costs (principal, interest, taxes, insurance, normal maintenance and repairs) would be about $253,340/month/100 units = about $2,530/month breakeven at full occupancy.
Now, add in a 5% return to investors on the $10Mn plus utilities, a reserve to cover a 10% vacancy factor/unpaid rent and unexpected expenses, the rent for a single-bedroom apartment ends up at $3,450/month assuming there are no special state or local taxes on rental income.
New Residential Housing Costs Are Out Of Balance With Take-Home Pay
You just can’t build residential housing much, if at all, below around $3,500/month for a one bedroom apartment. Oh, sure, maybe in the middle of Kansas or Oklahoma or Wyoming you could probably cut that cost, but you can’t do it in the urban and suburban areas where most employed people live.
How Do We Lower Rents?
So, since building your way out of high rents is a non-starter, there are only two ways you’re going to get cheaper rent:
1) For Old Properties: With an excess-rent tax on the profits earned by landlords on the other end of the spectrum, the old landlords whose mortgages are paid off and whose original cash investments were much smaller and/or have already been recovered, that is by drastically reducing the rents on these older structures through the use of an excess-rent tax
2) For New Properties: Foreclosure and bankruptcy for the owners of income property who borrowed the money to build new properties at the current high market prices.
When Developers Get Overextended & Go Broke, Rents On Their Properties Go Down
Let’s say lots of investors and banks buy the idea that rents can go up forever and that no matter how high the rent there will always be more willing tenants than there are available units.
So, after looking at the numbers on the hot real estate and hot rental markets, investors, developers and banks go whole-hog into building lots of new apartment buildings and buying up single-family residences with the intention of renting them.
In our example the carrying cost for the 100-unit apartment building was about $253,000 per month, not counting utilities costs. We built in a buffer for a 90% occupancy factor, but suppose that the number of tenants who pay their rent falls to 70%.
How would that happen?
An employer goes out of business. A military base closes. There’s a epidemic and people can’t work. The high rents drive people away. Inflation and low wages cause an increase in rent delinquencies. Occupancy slowly declines because people move away.
Lots of things can happen.
70 units still paying rent X $3,450/month = $241,500 minus 70 X $200/month utilities = $227,500 rent MINUS out-of-pocket expenses of $253,340 = –$25,840/month loss after suspending all distributions to the investors.
How long can the owners suspend payments to investors and cover the negative cash loss of about $26,000/month? What will they have to do?
They will need to cut the rent and give a free month’s rent to new tenants and pay real estate salespersons to get the occupancy factor up. More costs. Less income.
And remember, theirs isn’t the only overbuilt property. Other new landlords are having the same problems. That’s why there’s a 30% vacancy — other landlords have been dropping their rents to lower their vacancy factors which has lured tenants out of this building.
How long will the investors be willing or able to put up $26,000 in additional cash every month in order to cover the mortgage payments? How long before the owners of this building have to sell the building at a loss or face foreclosure because they cannot sustain the negative cash flow?
Eventually, foreclosure buyers will get a $40 million building for maybe $30 million (or less) which means that they can charge lower rent and still be profitable. That means cheaper apartments will come on the market putting further pressure on the rental rate for other newer buildings and the vacancy factor on them will go higher or their rents will go lower.
This feedback effect plus fear will lead to a crash and THEN the rents will decline because the foreclosed buildings cost the new owners less to operate.
So, no, given the cost of land and construction, building additional housing units will not, cannot, DIRECTLY lower the cost for residential rent.
The construction of additional housing units will only lead to a reduction in rents when the construction becomes OVER-construction followed by a vacancy factor moving past the tipping point in the progression between
(1) suspension of payment of investor returns –>
(2) cash-flow going negative –>
(3) distress sales/bankruptcies.