Rising Home Prices Are Mostly From Rising Rents
Rising Home Prices Are Mostly From Rising Rents

Rising Home Prices Are Mostly From Rising Rents

Home prices have been rising, unusually, since the mid-1990s. This increase could be attributed to any number of factors, either temporary or permanent, sustainable or imminently reversible. Those factors include low interest rates, speculation, federal subsidies, and monetary stimulus (Page 2)

For the period before the Great Recession, the importance of rent is most clear in cross-sectional comparisons of metropolitan areas. The metropolitan areas with the highest rents also had the highest prices. (Page 2)

Generally, in ZIP codes with lower incomes, rents have risen faster, and thus so have prices. This finding has important policy implications (Page 2)

However, if rising rents are the more important factor, then policies aimed at stimulating more construction may be more apt and may help increase real incomes for Americans in neighborhoods where rents have been rising. (Page 2)

However, adjusting for general inflation does not completely rule out fundamentals, because if the housing supply is constrained, then rent inflation will be higher than general inflation (Page 4)

The rate of 30-year, fixed-rate mortgages has declined from a peak of more than 16.0 percent in the early 1980s to a level of about 7.5 percent in the 1990s and more recently further down to levels below 3.0 percent.5 Before the 1990s, much of that shift was in the inflation premium, which should not have as strong an influence on real estate values. (Page 5)

Those declining rates are one reason home prices could rise above previous norms. However, over the same time, rents have been rising, which offers an alternative explanation for rising home prices. (Page 5)

Of course, mortgage rates have recently increased substantially, which likely reflects both rising real rates and inflation concerns. Readers should keep in mind that the quantitative analysis shown next is restricted to data that predate the recent changes in interest rates. (Page 5)

One way to try to separate the influence of rents from interest rates and other factors is to measure price-to-rent ratios. The inverse rent-to-price ratio reflects a gross yield on real estate investment, so when real interest rates decline, one might expect price-to-rent ratios to rise, which has been the case. (Page 5)

The estimate removes some of the upward trend from the inflation-adjusted Case Shiller index, but prices by this measure were still elevated before the Great Recession as they have again been recently.8 Again, this finding could reflect low interest rates or any other number of cyclical or secular factors. In any case, when one views aggregate national data, it does appear that prices have moved up in a way that rents have not.9 (Page 6)

Second, price appreciation of durable assets can be due to (a) ongoing short-term or cyclical fluctuations, (b) declining discount rates (which are likely to correlate with long-term real Treasury rates or mortgage rates), (c) rising cash flows (which are represented by rental value), or (d) rising expectations of future cash flows (expected future rent inflation). (Page 7)

The first two categories might be referred to as demand factors and the second two as supply factors. Rising rents can come from inadequate or inelastic supply. (Page 7)

Volatile expectations about future rents are triggered by a context where supply constraints have untethered rent (as well as price) expectations from the cost of building. Hence, supply constraints can lead to price volatility that looks deceptively like demand factors such as cyclical optimism and rising incomes, because expectations also tend to reflect cyclical sentiment. (Page 7)

This issue alone should suggest that aggregate national factors such as interest rates will be inadequate as indicators of the influences on changing prices. As Scott Sumner and I have argued, the importance of rents is clearer when viewed among metropolitan areas. (Page 7)

After the turn of the 20th-to-21st century, the differences in home prices and rents between various MSAs increased greatly. As late as the 1990s, there were differences in rents and prices, but the relationship between rents and prices was relatively weak. Differences in local costs, amenities, property tax rates, and so forth dominated as effects on relative prices because rents were not enormously different in various MSAs. (Page 8)

Clearly, where local rents were rising faster than the general rate of inflation, so were prices. In an even clearer demonstration, figure 4 shows the same four points in time but with price-to-rent ratios on the y-axis instead of prices. (Page 9)

Increasingly, as local rents became more varied, rent became increasingly important. And price-to-rent ratios increased where rents had increased. This change could be because expectations of future rents increased, because the sensitivity of those future rents became more important in a low interest rate environment, or because of some combination of the two. (Page 10)

The price-to-rent ratios of affordable MSAs have not changed much over time. Therefore, the primary influence on price-to-rent ratios has been localized rising rents. This influence is intuitively satisfying. In a market that is not supply constrained, rent tends to be sensitive to incomes. And the price of homes tends to be moderated by the cost of construction. Relatively stable rents plus relatively stable construction costs will mean that in areas without disruptive supply constraints, prices and even price-to-rent ratios tend not to be volatile. Furthermore, this conclusion appears to be confirmed by 30 years of data. (Page 10)

Price-to-rent ratios have continued trending slightly higher, also back toward 2007 (and 1991) levels. Median rents in the most expensive MSAs have actually retracted a bit since 2018, owing in part to some migration out of expensive cities during the COVID19 scare. (Page 13)

Thus, there are three broad periods of time to consider the effects of three general sources of price appreciation: (a) price-to-rent ratios in affordable MSAs, (b) sensitivity of price-to-rent ratios to rental values, and (c) rising local rents. Those sources suggest the influence of (a) low interest rates or other boosters of buyer demand, (b) an interaction of demand boosters and rent, and (c) rent alone. (Page 14)

Zillow estimates both rents and prices at the ZIP code level for the more recent period, but it lists prices only for the earlier period. However, even if one looks only at prices, differences between the two periods can be highlighted. Figure 7 compares the price appreciation of homes—arranged by the starting median home price in each ZIP code—from 2002 to 2006. This comparison echoes the earlier discussion. The important differences in price appreciation before 2007 were differences between MSAs. The MSAs with high and rising rents also had high and rising prices. (Page 15)

However, although there was a systematic relationship between expensive MSAs and rising prices, there was not a strong systematic relationship between (Page 15)

expensive ZIP codes and rising prices within most MSAs (Page 16)

So, there was a positive correlation between high rents or prices and price appreciation at the MSA level. In most MSAs, there was little correlation between prices and price appreciation for ZIP codes. (Page 16)

Some questions may remain difficult to answer, but one thing is clear, whatever the trends in rents and prices before 2007 were, they were different from what recent trends have been (Page 16)

Although the median rent declined somewhat in the expensive MSAs, price-to-rent ratios continued to rise. Meanwhile, in the most affordable MSAs, a modest increase in median rents was coupled with a modest increase in price-torent ratios. The net of the different combinations of trends at the top and bottom of the US housing market appears to have settled out with a similar amount of price appreciation in both cheap and expensive metropolitan areas. (Page 17)

The median price appreciation between MSAs from 2017 to 2021 tends to have less variance than does the median price appreciation between ZIP codes within each MSA. (Page 17)

A simple correlation between real changes in rents and prices from 2015 to 2021 suggests a straightforward and standard financial explanation. (Page 17)

This regression suggests an easy interpretation that declining interest rates, loosening conditions, and so forth could have boosted home prices from 2015 to 2021 by 17 percent while rising rents had roughly a 1:1 effect on prices. (Page 18)

From 1991 to 2015, prices were a product of (a) the price-to-rent ratio of the more affordable cities, (b) the sensitivity of the price-to-rent ratio to the rent (the slope of the lines in figure 5), and (c) the variance in rents between MSAs (the length of the lines in figure 5). (Page 18)

It was easy to see these trends from 1991 to 2015 because the MSAs and ZIP codes that were already expensive tended to become even more expensive. The trend has decidedly and systematically reversed since 2015. (Page 18)

The answer to the question “Are prices in expensive ZIP codes rising in spite of moderating rents while prices in cheaper ZIP codes are rising because of rising rents?” appears to be “Yes” and “Yes.” (Page 19)

Meanwhile, as rents at the low end have risen (the dots in figure 11 move from left to right from 2015 to 2021), price-to-rent ratios have risen moderately, thereby reflecting the patterns that have been in place for at least three decades. (Page 19)

In more expensive ZIP codes, price-to-rent ratios have risen for any given rental value, suggesting that in ZIP codes that are sensitive to demand factors such as interest rates, those factors have continued to push price-to-rent ratios back toward the levels seen in 2007. (Page 19)

The ZIP codes where prices have risen 40 percent or more since 2015 are mostly being subjected to rent inflation; conversely, the ZIP codes where prices have risen moderately in spite of rents that are stable in real terms are the ZIP codes that reflect appreciation from nonrent factors. (Page 20)

Differences in rents and price-to-rent ratios are being compressed within MSAs, mostly resulting from rising rents and the associated rising prices in more affordable ZIP codes. At the same time, price-to-rent ratios in the expensive MSAs continue to rediscover a sensitivity to other demand factors, thus rising back toward pre–financial crisis price-to-rent ratios. (Page 22)

Without more detailed historical rent data, it is possible to only infer the relationships for the years before 2015. In figure 7, however, price changes from 2002 to 2006 suggest that the trend in most MSAs today mimics the price trends that were limited to MSAs such as Los Angeles before 2007. One might infer (Page 23)

that, during 2002 to 2006, MSA fixed effects were becoming more important, that the difference between Los Angeles and Atlanta was widening, and that it was widening mostly because prices in the most affordable ZIP codes in Los Angeles were especially appreciating (Page 24)

In other words, if figures 12 and 13 could be replicated for the years 2002 and 2006, the slope of the regression line in Los Angeles would likely have flattened so that the cheapest ZIP codes in Los Angeles moved well above the national regression line; however, such was not the case in Chicago and Atlanta. (Page 24)

The rent inflation trends are higher than trends in income growth. Furthermore, rents were not particularly low (relative to incomes, for instance), especially in ZIP codes with lower incomes—even in 2015.16 It is unlikely that natural demand related to factors such as rising incomes is driving rent inflation (Page 24)

This change is not a product of increases in real consumption of housing. New construction since the financial crisis has been focused mostly on more expensive homes. A lack of supply is a key element in the rising rents that are the primary driver of rising home prices. (Page 24)

In metropolitan areas with affordable rents, price-to-rent ratios were relatively stable from 1991 to 2007 and were typically in the range of 10 to 12. Where prices reached unprecedented heights was generally in metropolitan areas where rents had reached unprecedented heights relative to other metropolitan areas. (Page 25)

This finding suggests that—to the extent that other demand boosters such as low interest rates have influenced American housing prices—there has been an interaction with high rents. Where rents are not high, prices have been stable in all contexts, except where they were unusually low after the 2008 financial crisis. (Page 25)

In the recent period, this pattern has returned. Within metropolitan areas, prices in the most affordable ZIP codes are appreciating much more rapidly than are prices in the most expensive ZIP codes. However, in contrast to the period before 2008, this pattern is not limited to the most expensive metropolitan areas. Now, prices in the most affordable ZIP codes are appreciating at unusually high rates, even in many of the most affordable metropolitan areas. (Page 26)

The ZIP codes where prices have been appreciating the most since 2015 are where price-to-rent ratios have been relatively stable for many years. The rising prices today in these ZIP codes are being driven especially by rising rents, which means that the current market is being driven by two different factors (Page 26)

In either case, there may be a limit to the potential for prices to rise. In expensive markets, interest rates and related yields on investments are unlikely to decline much further. In more affordable markets, the ability of households to continue spending more of their incomes on rent may reach a limit. (Page 26)

Understanding these trends has important policy implications. If rising prices are due to some source of excess capital chasing yields, then either monetary or fiscal policies aimed at slowing that chase would seem prudent. (Page 26)

Among the concerns recently being expressed about housing markets is a concern about a burgeoning market of private equity firms building or buying homes for rent. Some critics fear that those institutions are pricing potential owner-occupiers out of the market. (Page 26)

Fiscal and monetary attempts to induce capital out of housing—associated with the 2008 financial crisis and its aftermath—appear to have temporarily reduced prices, although in an unsustainable way, while more permanently leading to increasing rents. (Page 27)