Rents Vs Buying in Economy - Impact of Credit Expansion on Residential Rental Market

Question 1: Impact of Credit Expansion on Residential Rental Market

A number of factors, including low mortgage interest rates, looser underwriting standards, and the demand for securitized residential mortgages, gave risk the 2005-2007 credit expansion especially in the subprime mortgage market. This not only was one of the driving factors in the housing bubble, but also impacted the residential rental market and the demand, supply, price, and performance of the residential rentals.

With regard to demand, people can have only one primary residence, which is why residential rentals and owner-occupied homes are typically considered to have inverse demand functions. As such, when demand rises for owner occupied homes, it typically falls for rentals. This seems to be especially true for the types of “starter homes” where buyers typically move to following renting, rather than larger homes where buyers likely owned another home prior to purchasing. As mortgage interest rates fell, tenants in more expensive units had greater incentives to migrate to home ownership, especially when the opportunity cost of renting became higher than owning. This further increased the demand for home purchases and decreased the demand for pricey rentals, which owners had to fill by either lowering prices or selecting less creditworthy tenants. Another reason that I believe demand for rental homes decreased is that people were seeing tremendous real estate gains, not only was it affordable to purchase a home when compared to renting, but it was assumed that when you sold your home there would be a substantial capital gain for what amounted to very little work. People felt that there might be a financial detriment in the long-run that they could not make up if they did not purchase a home.

In terms of the supply of residential rental homes, given the decreased demand, supply would be in excess until the market reached an equilibrium based on price shifts or some other factor (like the bubble bursting). Although developers likely would not build new rental homes, rentals can easily be converted into condominiums. This was certainly true during the 2005-2007 period when many apartment buildings, especially in the DC area “went condo.” This interchangability was also evidenced when in 2008 many of the buildings did not have high sales rates and the conversions were suspended (either by the developers or by the developers’ lender) and those prospective condominiums became apartments again.

During the housing boom, rental prices generally had to decrease in order for owners of rental units to avoid vacancy and attract low-risk renters. Owners could have kept prices high, but would have had to accept less creditworthy tenants or lowered prices to compete for more creditworthy tenants. During this period, apartments were running more frequent specials and tenants typically had good