The Rent Spiral - Why Rent Goes Up So Much
- November 29, 2018
- by Michael
Rents always seem to be going up. Why can’t rents stay the same? This painful phenomenon has a name - the rent spiral. If you are renting you are riding it. Let’s explore the reasons why rents increase.
The cost of operating a rental can eat up a rent check fairly quickly:
As a tenant you may think the landlord gets to keep all the money you pay them each month. Those greedy devils! Yes they are charging you as much as they can get away with, but they don’t keep it all. In fact landlords have major bills of their own.
Here are the main types of expenses that rent goes towards:
- Real estate taxes are paid by the landlord and can be hefty. Tenants pay real estate tax indirectly through their landlord. When the public votes for and passes a bond measure that raises taxes, that translates into a rent increase for tenants.
- Cost of insurance (fire, flood, liability).
- Utilities the landlord pays for (water, garbage, etc).
- Local regulations the landlord has to pay for and contend with. Some cities require landlords to register, pay special taxes, etc.
- Maintenance on the property is ongoing. If the stove goes out, a pipe bursts, pests take over, or the roof leaks - the landlord is responsible.
- Vacancy rates - when the unit is empty the landlord is not getting paid, but smart landlords have anticipated this and priced the rent to account for it.
- Cost of advertising a property when it is vacant.
- Management costs (can be up to 10% of rent if they use a property management company).
The reason they call it the rent spiral is because all of these items tend to increase with inflation, hence the rent increases with it.
Inflation - prices go up:
In a modern economy central bankers manipulate the money supply and interest rates such that prices go up gradually. This effect is called inflation. It is generally seen as a good thing because it offers some defence against recessions. In theory wages also rise with inflation so any rent increases are cancelled out by small raises. Read more about inflation here.
If you are curious about what a dollar was worth in the past check out our inflation calculator.
The local housing market is a big factor:
Rent is influenced by the overall supply and demand for housing in the area. When people move into an area they bid up prices. When people leave an area en mass prices drop.
If you live in a nice area with lots of job opportunities, good schools, fun places to eat, parks, shopping, etc, you can expect others to catch on. More people competing for access to the same thing drives up prices.
The decision of whether to rent or buy is influenced by which option is more attractive relative to the other. If rents are high and property values are low, eventually renters will buy homes and the housing market will equalize. But if home values are high and supply is low, rentals look more attractive.
The value of the property is also a factor in rent:
There is a circular relationship between the value of a property and what it rents for.Consider that many rentals have mortgages tied them. In other words the landlord does not own the property outright but instead puts down as little as 25%.
With a loan in place an extra expense the landlord has each month is interest on the debt. The lower the interest rate the more the landlord can borrow, but also the less they need to charge to in rent to cover their costs.
When it comes to borrowing for a rental, the landlord needs to be able to show the bank that the income from the property will cover the payments. That means there is a tension between the purchase price and the expected rent. The higher the purchase price, the higher the rent would need to be to justify the loan. So when property values go up rents tend to go up, but there can be a lag time.
What goes into the value of a property?
- Local housing market supply and demand.
- Location and related changes such as upcoming neighborhood gentrification or a freeway being put in.
- Interest rates - the lower the interest rates, the more a person can afford with the same payment.
- Consider at 3.5%, a $2,000 per month payment would allow for a home of around $370k.
- But at 6%, a $2,000 per month payment would only allow for a home of just $277k.
- Replacement cost:
- What would it cost to rebuild the house from scratch?
- If lumber or construction wages go up in price, homes prices will tend to increase as well.
- At times, raw speculation - like the US saw in 2007 before the big housing crash. At that time banks decided to become insanely lax about who could quality for a loan. This unleashed a huge amount of demand for properties. Speculators noticed that prices were rising and got in on the game making demand increase even more, which encouraged even more speculators to join, etc… Many rentals were purchased at prices way above what the rent could carry. In essence they were cash flow negative investments justified by faulty spreadsheet projections that assumed ever increasing property values. The catch was they would have to sell it for some crazy high number in the future to actually make a profit. It was a game of musical chairs at that point and the music stopped in early 2008.
Getting off the Rent Spiral:
Here is one of the biggest lies a loan officer or real estate agent will tell you and is only half true: Assuming you get a fixed rate loan, your payments will never go up.
It is true with a fixed rate loan the principal and interest portion of your payment are locked in. So your payment will not increase due to supply and demand, interest rates, replacement cost changes, or speculators since those elements are locked in! You are also opting for a form of forced savings - when you pay your mortgage the balance is reduced a little, which translates into more equity in the home for you.
However, what the real estate agents and loan officers won’t tell you is your payment will still go up over the years due to taxes and insurance which are tied to inflationary forces. Taxes and insurance make up the escrow portion of your payment. The bank collects the money for these bills up front and later pays it on your behalf. They do this because they really don’t want you skimping on fire insurance or running up a huge tax bill since the house is collateral in case you default on the loan. Taxes and insurance are ALWAYS going up, due to inflation, as mentioned above. The bank will do an ‘escrow analysis’ every few years and jack up your payment to cover the increases.
Our mortgage calculator has a field for inflation which lets you see the impact of ever increasing taxes and insurance on your payment. Nobody else’s mortgage calculator does this.
In summary… getting off the rent spiral cuts many of the costs associated with housing, but you can never fully escape the inflationary forces of rising real estate taxes and home insurance. The good news is you can expect your home’s value grow with inflation, if not more depending on the area, which protects you financially. The flip side of that is homes require maintenance of their own, which is a new cost to incur (but you have more control over it, ability to put in sweat equity, etc). Forced savings that accompanies a mortgage is another hidden benefit that comes with home ownership.