Monday, January 13, 2014

Why Rents Don't Decrease with Higher Density

The idea has been advanced that the way to lower rental prices is to allow much more building of housing (increasing density) to satisfy the demand.  This is not true and most economists acknowledge that rent prices are "sticky" - resistant to decrease. The technical term is "nominal rigidity".  Elementary economics texts talk about the law of supply and demand in general.  It clearly works for stock prices and food prices but the real world demonstrates this does not always work for housing prices and wages except under extreme conditions such as general economic collapse after a wild boom - a cure far worse than the disease.  Steve Hoffman pointed this out last city election when he noted that if increased density decreased rents then Manhattan, Hong Kong, and Shanghai would have the lowest rents around.  Most seemed to ignore his point as in "whom are you going to believe - me or your lying eyes?".

You can do a web search on "sticky rents" and "nominal rigidity" and get 9M hits.  One starting point is here:

David Ricardo in 1809 ("Law of Rent") showed how increased supply could increase costs here:

Translating this to modern Sunnyvale, a builder constructs apts. and notes the average $/sq. ft.  In the case of Sunnyvale he notes that rents are high and apparently going higher so he adds a little extra to his costs with granite counters and marble bathrooms and charges a premium for newness and luxury.  He has no incentive to build low rent apts since land and labor costs are the same as for luxury units.  If rents start to decrease *before* he builds, he will decide not to build since he has no way of knowing how low rents will go and will not risk losing money so supply will *not* increase indefinitely.  If he cannot fill his building *after* building (say only 60% rent out) he will not want to decrease rents because his other tenants will ask for a rent decrease themselves costing more than the cost of the unused space.  He will instead offer "move in incentives" such as 3 mos. free rent for a 2 year lease or something with the hope that by the time the 2 years are up, rents will have rebounded.  He can afford to wait until a recovery because he has "deep pockets" and can take temporary losses.  If he does not have "deep pockets" and needs money he will have to sell to someone with deep pockets so eventually all landlords left will have "deep pockets" and can wait out a year or two of recession.  In a very prolonged local slump, rents *will* decrease but so will job opportunities and wages so you may not be able to afford rents anyway - e.g., you may not want to live in Detroit.

Here are some fully accessible economic papers acknowledging "sticky rents" (most others require a Journal subscription):

"Sticky Rents and the Stability of Housing Cycles"

"Sticky rents and the CPI for owner-occupied housing"

Nobel Laureate Paul Krugman wrote a popular intro economics text that covers the standard law of supply and demand. But, in his NY Times blog he continually talks about "sticky wages" in arguing for moderate German inflation.  The idea is to effectively decrease "relative" real wages in depressed low-productivity economies in Europe such as Greece and Spain to get people there working again.
http://krugman.blogs.nytimes.com/

(added 1/16/2014)
We did have a general economic collapse in 2007-2008 and what happened to housing costs was instructive.  The price of individual homes dropped by 50% on the very low end as a great many went on sale - condos and small townhouses in less desirable neighborhoods - as people who were barely able to afford housing lost their ability to meet balloon mortgages.  Banks actually didn't always take over houses in default because increasing the supply of defaulted housing would lower prices even further accelerating a downward spiral costing them more than taking a monthly loss on mortgage payments - until a recovery.  Housing prices in the upper middle class areas dropped about 20% but there was very little supply.  People in those houses could mostly choose to wait out the downturn.  Rents actually increased(!) because people have to live somewhere and if they can't afford a house, they will rent so the demand for rental housing actually increased and with them, rental prices.

2 comments:

  1. The arguments above seem to support a rapid increase in housing density. Currently, developers want to build and see increasing rents if they do. This will add to the housing stock. More people that want to live in the area would be able to live here. It also allows for more diversity in housing choices. People that prefer living in high-density housing, but also want to live in Sunnyvale would now have the option. Economically, it will be beneficial to the city. The new housing would have a new tax base (thus more revenue.) A high density housing unit would require fewer city services than a single family home. (The residents would also tend to skew towards younger professionals - a group that does not consume many school or community resources.) Sunnyvale has a surpluss in jobs and serves as lower-cost "bedroom" for many jobs to the north. There is a lot of room for new housing.

    What happens if we don't allow high density housing? The space could remain undeveloped. (Look how happy people have been over the "undeveloped" state of downtown Sunnyvale.) It could be developed into single family homes. (This would be a more expensive option for the city, and do little for housing diversity.) Neither option is as good.


    An NPR post looks at some reasons rents are high:
    http://www.npr.org/blogs/codeswitch/2014/01/06/260282186

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  2. I actually agree with much of what you say,Jeremy in terms of what growth will bring, like it or not as your preferences dictate One can make various arguments about why development is good or bad. I just wanted to put to rest any notion that building more units will decrease prices.

    With that false hope of decreasing rents out of the picture we can honestly debate what growth we want or don't. Sunnyvale will likely become more expensive and if you own real estate, that is good for you. It will still become more expensive, without any growth or development as well.

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