When the Rental Market Chicken Comes Home to Roost

Shamon Asks:
In the event that interest rates rise, and, in the event this causes a significant deflation of real estate values, and in the event that this causes many homeowners to sell/walk away from/get foreclosed on - then how/what impact would this have on the rental market? On one hand, landlords would have higher carrying costs resulting in potential rental rate increases, while potential demand from would be renters (i.e. former home owners) would also increase. They'd have to live somewhere. Naysayers would probably argue that the renters would not pay these inflated rates...

Thanks for the question Shamon.

Nearly 70% of Americans own the home in which they live. This is because home ownership is almost sacred in North America. Almost everyone who can own a home does so. Most people consider home ownership to be a good idea and few even bother to (or think of) crunching the numbers to determine whether this is true or not in their case.

On the other side of the pond, only 30% of the Swiss population owns, while most rent. They consider home ownership to be a poor use of their money.

So which is it? Who is right: the Americans or the Swiss?

Unfortunately, (and it pains me to say it) the Swiss.

After all costs are considered, home ownership is often of marginal investment value. Now, people have made a lot of money on houses over the last 20 years, but that has been because of an abnormal period of artificially low interest rates which made it much cheaper to carry a mortgage, which had the predictable effect of increasing demand and raising prices, which made owners a lot of money. (you can read about this period in history here)

Over the last several decades, because of low interest rates , house prices rose. Also, because few people wanted to rent, rents have been somewhat stagnant.

Here is how the rental business should work (and how it works in Switzerland): a property manager calculates the costs of owning and maintaining the home, adds a bit of profit, and that is the rent price they will charge to tenants.

Here is how it has been working in North America: Because of low interest rates and how badly people want to own their own home, home prices have increased. This leaves owners of rental units competing with each other for a small number of people who want to rent their homes, while paying relatively high costs and being able to charge low rents.

This is about to change.

As interest rates rise, demand for home ownership will decline.
As inventory of  homes on the market increases, home prices will drop.
As people walk away from their homes (or lose them), demand for rental homes will increase. (This could also result from fewer and fewer people aspiring to home ownership, due to recent declines)
As landlords buy cheaper houses and rent them out to more and more people who are demanding rental units, rents will rise.

Now, landlords who bought their rental units at high prices during the bubble might not be able to charge rents high enough to cover their costs, let alone make a profit, but as the overpriced inventory works through the system (ie, default, short sales, and bankruptcy), eventually most rental units should become profitable.

So, having made that caveat, I will predict that profitability is about to return to the rental market.