We're Not Gonna Pay: The Rent Squeeze

Includes: IYR, URE, VNQI
by: Principal Financial Group

By Robin Anderson, Ph.D., Senior Economist, Principal Global Investors

In honor of the twentieth anniversary of the 1990s hit musical, Rent, I have decided to talk about housing inflation. It's actually quite a timely topic. The problem is that, while there is not a lot of inflation out there in the U.S. economy, it's showing up in rents. Places from Seattle to Utah have reported on this topic over the last couple of years. Rents tanked during the financial crisis but quickly bounced back. And by 2012, rent inflation was accelerating faster than wages. Rental inflation is growing above 3% year over year, compared to core inflation of 1.6% using the Personal Consumption Expenditure deflator or 2.2% using the Consumer Price Index. That's also well ahead of average hourly earnings, up 2.3% year over year in March. In fact, if you look at median asking rent from the most recent Housing Vacancy Survey, rental inflation is even worse, up 8% over the last year.

Rental housing is increasingly unaffordable. As of March, the median monthly rent was $870, Hale Stewart, a contributor to Seeking Alpha, points out that's 106% of usual weekly earnings. The real estate firm, Zillow, showed that rent as a share of total income hit the highest level ever at, 30.2%, in the second quarter of 2015 (data goes back to 1979). Rents as a share of monthly income dropped slightly, to 30% by year-end. The Joint Center for Housing Studies at Harvard University found 11.4 million households, or 26% of renters, paid rent of 50% or more of their monthly income in 2014.

High housing costs have burdened those households with the fewest resources. High rents come as mortgages are very affordable. The same Zillow data on housing affordability found mortgage payments made up 15% of monthly income at the end of last year, well below the historical average of 21%. Ultra-low interest rates thanks to the Federal Reserve (Fed) have helped bring mortgage costs down. The rub is that homeowners typically have higher incomes than renters. A Population Reference Bureau study showed that as of 2013, only 5% of homeowners were poor compared to 28% of renters. Researchers from the New York Fed found that rent inflation was consistently higher for households in the bottom quintile of the income distribution (lowest 20%) compared to households in the top quintile.

Supply and demand dynamics explain the current high rental prices. Since the end of financial crisis, homeownership rates have declined. The homeownership rate is 63.5% compared to 69.2% at the high of the housing boom in 2005. Mortgage lending standards have tightened. Vacancy rates are very low. The Housing Vacancy Survey showed the rental vacancy rate dropping below 7%, at 6.8%, in the second quarter of 2015 for the time since the early 1990s. The vacancy rate was 7% last quarter.

While overall low inflation has been around for some time, a lot of households, many at the bottom of the income distribution, don't feel it when rent is due. High rents are not just bad for those paying them. High rents may drag down spending on other goods and services. In addition, while it's hard to prove, the "rent squeeze" could be one of several explanations for why lower gas prices have not boosted overall consumer spending more. However, there is some evidence that the tight rental market may be cooling just a bit. The Wall Street Journal cited private research firm Reis's data that showed the rental vacancy rate increasing for a third quarter in a row last quarter. In addition, analysts also expect more rental units to come online in the next three years, providing some price relief. In fact, with supply pressures easing, Zillow forecasts rents to stabilize in 2016.