The record growth in rents of recent years is showing signs of running out of steam. Earlier this month, Redfin reported that rental growth fell 0.6% year-over-year for the first time since the pandemic. This is, of course, a modest fall in rents, but it begs the question: will there be a bigger correction or even a collapse in rents? Or is it possible that rental growth will resume in the coming years? Let’s dig.
Where is the growth in rents
When we talk about rent growth in the United States, the normal situation is for rent growth to be close to or slightly above the rate of inflation. During the 2010s, most markets experienced average annual rental growth of 3-5%. But during the pandemic, as we all know, that changed and rent growth peaked at around 17.5% nationally, with some individual markets seeing annual rent growth above 30%.
Explosive rent growth in 2021-22 was fueled primarily by weak supply, dramatic changes in migration patterns, strong demographic trends and household formation, and economy-wide inflation .
But as the economic outlook remains confused and murky, rental trends have begun to change. The 0.6% drop in asking rents in May is obviously a very small drop and is just one source of data. But that’s the trend investors should care about, which is very telling. The Wall Street Journal recently compiled the year-over-year change in asking rents from six sources, and while the exact numbers vary, the trends are consistent.
It’s important to note that the data referenced above is “asking rents,” which tracks what property managers publicly list for units. It does not reflect the final price at which leases are actually signed, nor lease renewal prices.
That said, recent lease renewal data suggests that rent increases are also slowing in this sector. According to RealPage, the average lease renewal in May 2023 was 6.5% higher than the previous year. This figure is still extremely high by historical standards, but has declined from an average renewal increase of 11% the previous year.
Why is rent growth falling?
First, the supply increases. The past few years have seen a boom in multi-family construction and many new stocks are still coming to market. In addition, more and more owners of single-family homes are choosing to rent their homes rather than sell, which further increases the rental supply. When supply increases, tenants have more options and property managers have to compete on price. This can lower rents.
Second, rents are easing due to the general economic climate. Americans (and economists) generally brace for a coming recession as inflation continues to erode purchasing power, changing spending habits. People are less likely to move house, start a new household or move on after a more expensive home in these uncertain times.
Finally, it is only natural that at some point rent growth will return to somewhere near the historical average. When this mean reversion occurs, a period of negative growth to correct recent booms is quite typical.
Of course, the above trends are on a national basis, and there are quite significant regional differences in rent trends. If you’ve been following prices in the housing market over the past year, you’ll likely notice a familiar pattern here:
The markets that have exploded the most during the pandemic, the West and the South, are experiencing the strongest corrections. Meanwhile, the Midwest has been very consistent for nearly a year. The North East has come down from pandemic highs, but is still seeing above-normal rent appreciation.
What does that mean?
For investors, this change in market conditions is important for several reasons.
First, it’s important to note that for investors with existing properties, none of this data suggests that current rents will drop. Keep in mind that the data we’re looking at here is for new leases, which tend to be more volatile than existing leases. Personally, I think asking rents will drop a bit more before they hit bottom, but I expect current rents to stay fairly similar. Rent for existing tenants tends to be very rigid, even during economic downturns.
Second, if you’re looking to make a new investment, I wouldn’t count on rent growth until 2024. At least that’s what I do. I think we’ve had what’s called a “push forward” over the past two years. This means that rents normally increase 3-5% per year, and we’ve had a few years of double-digit rent growth, essentially leading to several years of future rent growth in 2021 and 2022. In other words, it there could be a rent suspension.
Is there a chance that rents will rebound before 2025? Yes absolutely. Pretty decent luck, actually. But there is so much uncertainty right now to make meaningful predictions. Given the uncertainty, I think underwriting zero rent growth over the next two years is one way to hedge risk for now. If a deal emerges with no rent growth for the next two years, grab it! That way, if I’m wrong and the rent goes up, it’s just a bonus for you on top of a bargain.
In recent years, I know that some investors have purchased properties that have little or no cash, as they relied on rental growth to help them achieve a strong cash return over time. While that’s still possible, I think it’s a risky proposition at this point. I wouldn’t do that personally. If you’re investing for cash flow, buy deals that generate cash flow today. Don’t count on anything changing in the future.
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Note by BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.