By Jim Costello on September 10th, 2019
Investors and lenders in the apartment market are on pins and needles over growing calls for rent control. As a solution to a real problem though, new demands for rent control are repricing assets in a way that may lead to loan defaults and lower housing availability over the long run.
The rent is too darned high. In looking at this issue, it is important to understand why there is a growing call for rent control in some parts of the U.S. – some parts but not all. In New York in 2019, for instance, the apartment rental component of the CPI stands 28% higher than the average rent level seen in the market since 1944. This is the level when you strip out the general trend in inflation.
What those figures suggest is that consumers are putting a higher share of their paycheck into their rental payments today than in the past. When the market puts too much pressure on consumers, some are going to opt out and move to other cities. Some consumers, though, are going to push back and use the political process to try to control market forces.
This move to control market forces is, however, a blunt tool with impacts beyond the short-term benefits provided to a select number of consumers. Investors and lenders are repricing assets in markets where rent control exists or is being introduced.
The National Apartment Association provided a list of cities that have any sort of rent control in place. Some of these rent control regulations are more onerous than others, with regulations varying from strict price ceilings to simple vacancy decontrol. Without getting into the details of each element of rent control, I highlighted recent changes in apartment cap rates for markets with any sort of rent control versus those with no regulations.
Each dot in the chart represents one of 58 unique markets across the U.S. and any dot above the line is a market where cap rates were higher in Q2 2019 than a year ago. Those in a light shade of orange are the ones where some form of rent control is in place or has been introduced. In 10 out of these 12 regulated markets, apartment cap rates have increased over the last year: an 83% share. In the remaining markets, only 19 out of 46 markets have seen cap rate increases: a 41% share.
Clearly there will be other factors at play helping to push up these cap rates. The increase is mostly focused on the more expensive markets in the U.S. where cap rates are structurally lower, and as investors worry about how much cap rates will move up when interest rates do again someday, some of the repricing may be a function of investors unloading a portion of that rate uncertainty.
Other factors, though, suggest that a good portion of the move is due to the capital restrictions that come with the imposition of rent control. The Wall Street Journal in June noted how the stock price of banks lending in the New York apartment market were savaged when stricter rent controls were introduced earlier this year. Some of those losses have been reversed since, but a lender with exposure to New York apartments is still in an awful situation where the assets for which they have loans face higher credit risks moving forward.
Income cannot keep up with the previous underwriting so lenders will need to scale back what they can finance. Investors looking at the market with more limited, and therefore more expensive, financing options, cannot pay as much for an investment which will help to suppress prices. That price suppression comes back around to the lenders then being even less willing to extend credit.
It is not clear how far down prices will need to go before this downward cycle ends. In Manhattan and the NYC Boroughs, apartment cap rates have increased 30 bps over the last year. Given the run-up in apartment asset values in recent years, that level of change is likely not enough to drive a wave of loan defaults. If it continues though, limits on financing options will lead investors to limit capex (reducing housing quality), work around the regulations to withdraw units, and simply deliver even fewer units of new construction.
And that lack of construction is the real problem in these markets. So many people want to participate in the economic opportunities of dynamic knowledge centers like New York, San Francisco and Los Angeles and others, that there is not enough housing to go around and rental prices have increased. The way forward to maintain housing affordability in these markets must involve removing restrictions on new supply. Imposing restrictions on pricing will not help.
To learn more about the RCA Hedonic Series of cap rate and price-per-unit data sets contact us. If you are an RCA client you can access these data series on TrendTracker and via the Standardized Downloads.
Also by Jim Costello on RCA Insights: