Home Price and Rent Increase Disparities Stay in Balance in Most Places for Now

Price growth has exceeded rent growth in national indexes for single-family homes, according to CoreLogic chief economist Frank Nothaft. But what would ordinarily be a signal of trouble has been offset by a couple of factors. However, there’s no guarantee how long that might continue.

“Home prices rose a whopping 20% over the past year and rents on single-family homes were up 13%, according to the CoreLogic national Home Price Index and Single-Family Rent Index,” Nothaft wrote. With the disparity, he raised the question of whether that might mean homes are overvalued.

The math is simple on the surface, as he noted. The price of a rental home should be equal to the net operating income divided by the capitalization rate. Prices have been going up because investors essentially are trying to buy into ongoing growth of net operating income through the growth of rents.

But rental growth isn’t keeping pace with prices, the latter fueled by all the capital that’s been created and pushed into the market and by investors who are looking to hedge inflation because of the assumption that residential rents can be raised on an annual basis.

As Nothaft pointed out, the factors determining cap rates are long-term interest, real estate investment riskiness, and tax code changes. Interest is on the way up as the Fed moves to a hawkish position in an attempt to fight inflation. Tax code changes are on the wish list of the Biden administration and many Democrats, but it’s unlikely they will get enough political support to pass significant modifications.

“Of these three factors, the one that has changed the most during the last two decades is long-term interest rates,” Nothaft said. “Consequently, cap rates for single-family rental homes dropped by nearly 20% during the last decade, and by almost 50% from 20 years ago. This cap rate decline implies that prices can rise significantly even with no change in net operating income and the local market would not be overvalued. If net operating income also rose, then that would raise the price of single-family rental homes further.”

That has been the case for most markets, according to Nothaft, although Seattle and Los Angeles had price gains that “appear to have exceeded” the cap rate declines and estimated changes in net rental income they experienced.

Other research has shown that cap rates have continued to compress, however, there are two things to consider. One is that there may be a theoretical bottom to cap rates, and there’s an inflationary income risk if those paying the rents eventually run out of the ability to meet continued increases.