Are higher interest rates to be blamed for the rental crisis?

Are higher interest rates really to be blamed for the rental crisis?

Over the last year, realestate.com.au has reported a median advertised rent price increase of around 10% in most parts of the country.

This rapid rise in rent has sparked concerns that the Reserve Bank's interest rate hikes of 3.5 percentage points within a year are exacerbating the rental crisis.

The argument is that the increased mortgage costs for landlords are compelling them to increase rents.

Philip Lowe, the Governor of the Reserve Bank of Australia, has been hesitant to accept the criticism that interest rate hikes are driving up rents.

During his recent appearance before the Standing Committee on Economics, he stated that "the primary issue is the shortage of rental accommodation, which is responsible for the increase in rents, rather than the rise in interest rates."

There are valid reasons for his statement.

The basic principles of economic theory do not support a correlation between interest rates and rents, and the data does not demonstrate any systematic relationship between changes in interest rates and national-level rents.

Additionally, when comparing the rent increases for properties with and without mortgages, there is no discernible relationship at the individual rental property level.

The tightness of rental markets is the primary cause of the rapid increase in rents.

There is simply a scarcity of rental properties available to satisfy the demand from those looking to rent.

In theory, higher interest rates are expected to decrease home prices rather than increase rents

According to theory, higher interest rates do not have a direct impact on the current supply of rental homes or the number of people seeking rentals.

Instead, interest rates affect home prices, which is the current trend observed.

As interest rates rise, home prices fall.

In the longer term, higher interest rates can have an impact on rents by reducing the number of homes constructed, which ultimately lowers the supply of housing.

However, this effect takes several years to manifest, typically around four years.

It's essential to note that these models are intentionally simplistic and abstract away many essential real-world details to focus on core concepts and mechanisms.

Therefore, it's possible that these models may not fully capture all relevant factors and complexities.

To gain a better understanding, it's important to look at the data.

On a national level, there is no discernible correlation between an increase in the cash rate and a subsequent rise in rents

The most straightforward approach to assessing whether interest rates impact rents is to analyze the impact of the RBA's rate increases on average national rents.

The top panel of the following chart depicts this relationship.

The results demonstrate that the impact is relatively small, with no consistent or systematic relationship between interest rate hikes and rent growth.

The bottom two panels of the chart present two improved alternatives, which examine the impact on rents following an RBA rate increase that exceeds expectations.

Despite using these alternative methods, there is still no evidence of a systematic relationship between rent growth and increases in the cash rate.

There is no indication that higher mortgage costs result in increased rents

While the macroeconomic evidence does not support the notion that higher mortgage rates lead to increased rents, the macro evidence alone may not be entirely conclusive.

With many factors influencing the economy simultaneously, it can be challenging to isolate the effect of a specific mechanism.

Therefore, we can explore this issue at the level of individual rental properties.

If landlords with loans pass on rate increases to their tenants, then properties with mortgages should experience more substantial rent increases than properties without mortgages following an RBA cash rate hike.

Regrettably, we do not have access to information on whether a particular rental property has a mortgage.

However, we can use the length of time since the property was last purchased as a proxy for whether it has a mortgage or not.

This is because more recent purchases are more likely, on average, to have a mortgage or larger outstanding balances.

If higher mortgage rates do indeed lead to higher rents, then we should observe a systematic variation in the "premium" for newly purchased properties relative to older properties (i.e., those with a mortgage versus those without) as interest rates fluctuate.

However, the data suggests otherwise.

There is no evidence that rents for properties with a mortgage increase more than rents for properties without a mortgage when interest rates increase.

During 2007-2008, when interest rates increased rapidly, the rental premium for a recently purchased property (the amount that recently purchased property rents for more than an older property) remained unchanged at 6%.

The premium also did not fall in late 2008/early 2009 when rates were subsequently quickly cut.

Similarly, during the rate increases of late 2009 through 2010, the rental premium did not change.

During the pandemic, when rates were cut, the rental premium increased, and it has since decreased despite mortgage rates rising rapidly in 2022 and 2023.

These observations contradict the expectation that more heavily mortgaged properties would increase their rents when interest rates increase.

The only exception to the lack of evidence that higher mortgage rates lead to higher rents is a slow decline in the rental premium for recently purchased properties between 2010 and 2015, which coincided with a decline in mortgage rates from 2011 to 2016.

However, this adjustment was gradual and likely due to structural changes rather than cyclical ones.

So... why are rents going up?

In essence, the reason for the current rapid increase in rents is due to a lack of rental properties available.

The rental vacancy rate, which indicates the proportion of currently vacant rental properties compared to the total number of rental homes in Australia, is at a historic low of 1.5%, which is almost half of what it was before the pandemic.

Consequently, rental properties are scarce and highly sought after, resulting in intense competition among renters.

Given the current state of rental markets, rents would inevitably be increasing irrespective of the interest rate changes.

While some landlords might be using higher mortgage rates to justify raising rents, the tight rental market is the primary driver of rental increases.

Landlords are only able to pass on these costs because of the intense competition for rentals.

Thus, calling on the RBA to solve the rental crisis by cutting interest rates is not a viable solution.

The fundamental solution to the rental crisis lies in increasing the number of rentals available.

This could be achieved by encouraging new investors to enter the market and building more homes in the long run.

The concept for this article and the charts came from PropTrack's Economist,  Angus Moore's article in REA Insights. 

About Leanne Jopson Leanne is National Director of Property Management at Metropole and a Property Professional in every sense of the word. With 20 years' experience in real estate, Leanne brings a wealth of knowledge and experience to maximise returns and minimise stress for their clients.