Rent growth is one of the most important factors of any long-term real estate investment. Rent growth or rent decline determines not only cashflow but also appreciation over the long term. Understanding the factors that drive rent growth is essential to evaluating any prospective investment.
Rent growth like almost everything else in the investment world is driven by supply, demand, and affordability.
Real estate with the highest potential for rent growth will be located in areas with high demand pressure, low supply, and high barriers of entry for home ownership.
Demand for rental housing is driven primarily by population growth, and migration trends. Because housing takes a long time to build, any shift in migration patterns will quickly create an imbalance between demand for housing and the existing supply of housing. This imbalance will drive rent growth, and occupancy.
When we think about housing demand and rent growth it is important to make the distinction between rental housing and owner-occupied housing. When there are higher barriers to home ownership such as high home prices, high financing cost, and low inventory, more would-be home buyers will be renters, which further increases demand pressure for rental housing. A great resource for gauging demand pressure caused by owner occupied housing affordability is the housing affordability index click here.
Supply is equally important to rent growth in a market. When there is an oversupply of housing, landlords will begin to compete to boost occupancy by lowering rents and offering concessions.
If you are considering a real estate investment, it is important to look at the absorption and delivery ratio which is the amount of new units to the market that have been leased compared to the total amount of new units delivered to the market. You want to target markets where absorption is higher than new deliveries, and ideally markets where there are barriers to new supply such as higher cost of construction, limited buildable land, and difficult zoning and permitting processes.
Affordability and demand are closely related, as demand pressure can only continue so long as the higher rent levels can be supported by incomes.
Affordable housing is typically defined as annual housing costs being less than 33% of the consumer’s annual budget. When housing cost rise above this level it is considered unsustainable, and tenants will begin to look for more affordable housing even if this means moving out of the market and taking a longer commute to work.
Affordability is typically the metric that determines how long a rent growth trend can continue upward. Once the affordability ceiling is reached, rents will plateau or decline depending on how much demand pressure deflates, as tenants move out of the market to seek more affordable housing.
When population in an area declines, this is called negative net migration. As the affordability ceiling is reached the amount of negative net migration is determined by the affordability radius, if the nearest affordable housing is too far away from a tenant’s current employer, then the tenant is likely to stay in market or will be forced to seek new employment. This is why it is important to focus on the employers and incomes in a market. You want high incomes and quality employers. This will not only attract new tenants to the market but will also force existing ones to stay in the market.
Given the current inflationary environment that we are in, I believe that affordability, incomes, and job growth are the most important things to focus on when considering a prospective investment.
Rent growth is the life blood of real estate investment, and in a time when the cost of gas, groceries, and consumer goods are all increasing, the household budget is quickly being eroded. If affordable housing is defined as 33% of the consumer budget, then we must look to invest in areas that have incomes that are at least four times higher than rents in order to support rent growth and the higher cost of consumer goods.
Over the last 24 months we have seen historic levels of rent growth driven by shifting migration trends, and a continuing shortage of housing across the U.S. Rising interest rates are increasing barriers to home ownership and are increasing the cost of new housing supply. This imbalance of supply and demand will likely lead to further rent growth so long as incomes can support not just higher rents but a higher total cost of living.