Rent Increases and Property Value Gains: What Causes Them?

rent increases

As outlined in our discussion of the thinking framework of smart property investing, it is important to target markets, locations, and properties that have strong prospects for registering price and rent increases. The starting point for applying this framework is to keep in mind that when the demand-supply balance is disturbed, market rents and prices start moving accordingly in order to bring the market back into balance. Real estate markets are rarely in equilibrium, at which demand equals supply. This is confirmed by historical rent data at all levels (national, urban area or submarket within an urban area), which indicates that rents have rarely been stable. Non-stable rents, according to economic theory signify an unbalanced market in terms of demand and supply.

Principles of Property Value and Rent Increases

If we assume the market begins from a point at which the space demanded is equal to the space supplied, prices should be stable. Economists describe this situation as the market being at equilibrium. If this balance is disturbed, either in favor of demand or in favor of supply, prices and rents should start moving. In particular, if demand becomes greater than supply (due to non-rent/price factors) then rents/prices have to rise in order to force enough buyers/renters to drop out of the market and enough suppliers to enter the market so that the amount of space demanded equals the amount of space supplied.[1] Similarly, if supply decreases while demand remains constant, there will be excess demand, which will again force prices/rents to rise. However, because of the durability of real estate, sudden decreases of an area’s property inventory cannot occur in the normal course of events. An area’s inventory of properties, however, may decline gradually if the amount of space build is smaller than the amount of space that “drops out” of the market due to physical deterioration and functional obsolescence.

If supply increases while demand remains constant, or if demand decreases while supply remains constant, there will be excess supply, which will force prices to fall in order to induce enough suppliers to drop out of the market and enough buyers/renters to enter the market.

Based on this discussion, we can identify two broad principles of value and rent increases, with the condition that the market is at equilibrium (neither over-supplied nor under-supplied):

(1) An increase in the demand for space or properties while supply remains constant

(2) A decrease in the supply of space or properties while demand remains constant

To better understand the first principle of property value and rent increases, consider a nice residential community, called Paradise, with few vacant housing units and limited development projects in the pipeline due to zoning controls. If for some reason, demand for housing suddenly increases considerably so that the existing vacant units are far from adequate to cover it, housing rents and prices in Paradise will register strong increases.

Demand for housing in Paradise may increase considerably, due to a number of reasons, such as intensive office development in a nearby community, which brings a great number of new white-collar employees to the area. Since there is a tendency for people to seek housing close to their workplace, many of these new employees may seek housing in Paradise too.

An important characteristic of the supply of real estate, which explains why short-run price and rent increases can be very strong in response to a strong increase in demand, is the construction lag, that is, the lag between the time a real estate project is perceived and the time it comes out in the market. This lag, which is due to the time needed to complete necessary studies, develop and finalize site and development planning, secure financing, get permits, and build a project, ranges from one to many years, depending on the size and nature of the development. This characteristic is very important because if demand suddenly increases considerably, supply will not be able to respond immediately unless lots of new buildings are about to be completed and enter the market. This is not very likely, however, if the demand increase is sudden, unpredictable, or considerably greater than usual.

As a result of the supply’s inability to respond quickly to changing market conditions, a strong increase in demand will originally create supply shortages, which will force prices and rents to start rising, at least in the short-run. Because of the inertia/rigidity of supply, strong demand increases can trigger strong price and rent increases, as long as the market is not oversupplied. However, as new supply starts to come out gradually, price and rent increases should decelerate, unless demand keeps rising faster than supply. As we have seen in the discussion of the cyclical behavior of the real estate market, property prices (and rents) seem to rise for a few years at an accelerating rate when the market comes out of the downturn, but after that, price and rent increases decelerate and turn negative eventually, due to a combination of strong supply growth and a slowdown in demand growth.

How the Demand-Supply Interaction Generates Price and Rent Increases

Demand and supply in the real estate market are rarely balanced because of the slow adjustments of supply and prices/rents in response to changes in economic and demographic factors that trigger changes in demand. Supply responds slowly because of the time it takes to plan and develop a property, while market rents adjust slowly because of multi-year leases that fix rents at certain levels. Since the real estate market is rarely in balance, it would be useful if investors could use an indicator to gauge whether there is excess demand or excess supply, since each situation implies different things in terms of the direction rents or prices may be moving in the future.

The most commonly used indicator of the mismatch between demand and supply in the real estate market is the vacancy rate. This represents the percentage of rentable space that is vacant. For example, a market with one million square feet of total rentable space, and 100,000 square feet of vacant space has a vacancy rate of 10%. Obviously, as demand and supply conditions change through time, the vacancy rate changes too. For example, according to US Census Bureau data, over the period 1968-2017, the vacancy rate for rental housing units in structures with five or more units has fluctuated between 6.1% and 12.3% (see Figure 1). The latest peak at 12.3% was registered in 2009 in the aftermath of the global financial crisis. Since then it has been declining steadily until 2015 when it dropped below 8%. However, in 2016 and 2017 it reversed its path and started rising again.

Figure 1 Vacancy Rates for Different Types of Rental Housing Units 1968-2017
Source: US Census Bureau

Vacancy rates differ not only across the major property types (residential, office, retail, and industrial) but also across sub-types within the same property type. For example, as the above graph indicates, the vacancy rate for rental housing units in one-unit structures (single-family houses) was consistently lower (with the exception of 2006) than the vacancy rate for units in residential buildings with two or more units (and buildings with five or more units). The greatest difference (6.2 percentage points) between the vacancy rates of these two rental housing segments was registered in 1988, when the vacancy rate for single-family houses dropped to 3.6%, while the vacancy rate for units in multi-family structures with two or more units climbed to 9.8%.

It is important to note that the vacancy rate for multi-family structures with two or more and five or more units has registered a cyclical pattern with clearly greater fluctuations than the vacancy rate for single-family rental units. In fact, as Figure 1 indicates, the latter registered only one clear peak over the last 50 years, while the former have registered four peaks over the same period. The important conclusion from these numbers is that vacancy rate levels and trends differ significantly even across sub-types within the same property type. For this reason, when evaluating a specific property, investors need to make sure that they are looking at the vacancy rate measure that best represents the geographic market and property type segment within which the property under consideration truly competes.

It has been argued in the real estate literature that the true amount of excess supply is not represented by the market vacancy rate, but by its difference from a structural or normal vacancy rate (Rosen and Smith, 1983). Rosen and Smith define the structural vacancy rate as the amount of vacant space required for the normal operation of the rental market. For example, the argument often cited is that for renters to make a reasonable search effort there must be a minimum amount of vacant space. Another definition based on the optimal-inventory theory defines the structural vacancy rate as the inventory that landlords keep vacant to be able to take advantage of anticipated increases in market rents (Shilling, Sirmans, and Corgel, 1987; Sivitanides, 1997).

If we accept that the structural vacancy rate represents the vacancy rate level at which market demand equals market supply, it follows that when the market vacancy is below this rate, there is excess demand, and rents (and prices) should be rising. On the contrary, when the market vacancy rate is above the structural vacancy rate, there is excess supply, and rents (and prices) should be declining. Figure 20 demonstrates these dynamics.

Research on the topic (Sivitanides, 1997) suggests that the structural vacancy rate should vary through time and across metropolitan areas, depending on whether the market is hot or cool. In particular, it should be higher when absorption is strong and rents are rising because landlords will be induced to reserve more space for future leasing in order to take advantage of higher rents later, as they expect rents to continue to rise.

Figure 2– Nominal Vacancy Rate, Structural Vacancy Rate and Rent  Change

vacancy rate and rent increases

Source: Sivitanides, P. 2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing

The concept of the structural vacancy rate is very relevant and useful for intelligently targeting markets for property investments by identifying under-supplied markets. It is also useful when comparing markets, in the sense that areas with higher vacancy rates may not necessarily have a greater oversupply. It is hard, however, to apply this concept in practice because of the difficulty in quantifying each market’s structural vacancy rate. So, is there a magic vacancy rate number that investors can use to evaluate whether there is excess demand or supply? In practice, in the office market, vacancy rates below 10% are looked upon favorably, although based on my econometric estimates of structural vacancy rates for the 22 the largest metropolitan office markets in the US I would recommend and  8% benchmark just to reduce the probability of entering an oversupplied market. In the retail and warehouse market, vacancy rates below 7% or 8% are considered good. For the residential market, it is widely accepted that a vacancy rate of 4-5% signals a balanced market in terms of demand and supply. These figures, however, should be used with flexibility and caution, depending on the demand and supply growth prospects of the specific market under consideration at the particular time of investment.

To sum up, as of now we have determined that price and rent increases will take place, at least in the short run, if a demand increase (not due to falling prices) occurs without a corresponding increase in supply and assuming that the market is at equilibrium before the increase in demand takes place. Such price and rent increases will be sustainable in the longer term if there is no quick response from the supply side. However, under normal conditions, supply will not remain constant after strong rent and price increases take place. Increases in market prices will induce property owners to put more properties up for sale or lease and motivate developers to build new buildings. As supply increases to satisfy excess demand, price and rent growth will decelerate, and eventually, rents may start declining. If supply does not overreact, the market should stabilize at a rent/price level higher than the level that prevailed before the demand increase took place. If supply does overreact, the market will go through a cyclical movement, during which rents and prices may decline below their original level. Evidence both from the housing and commercial real estate market has shown that developers do overreact to increases in property prices (Wheaton, 1987).

Based on the discussion so far, one could argue that the largest price and rent increases should occur in the first one to two years after an unexpected demand increase takes place, assuming that the market is not oversupplied already at the time of demand increase. This suggests that holding the property for more than two to three years, after a strong demand shock has taken place, increase the risk of being caught holding the property in a softening market.

 

[1] In the real estate economics literature, it is widely accepted that for the real estate market to be truly in balance, the quantity of space supplied should not exactly equal the amount of space demanded. Many analysts have argued that there must be some vacant space, or in other words, supply should be greater than demand, in order to allow normal search operations for renters looking for space and buyers looking for properties. The percentage of stock that needs to be vacant in order to facilitate such normal market operations is referred to as the normal or structural vacancy rate.

Related Posts

Achieving High Returns by Riding the Real Estate Cycle
How to identify markets for capital gains
What types of property have big profit potential?
Choosing markets and locations for property investments

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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