Wednesday, 14 January 2015

Out-of-control rent increases in Auckland - why?

The Auckland housing market seems to always be in the news lately. This week though there has been more of a focus on the increasing rents in Auckland (see for example here or here from the New Zealand Herald in the last few days).

A simple market diagram helps explain why rents are increasing in Auckland (see below). House price inflation is high - and the cost of the house (e.g. mortgage repayments, council rates which are linked to increasing house values, and insurances which are similarly linked to increasing house values) is the greatest contributor to the costs of landlords. So, because landlords' costs have increased the supply curve shifts up and to the left from S0 to S1 (which we refer to as a decrease in supply - at each and every level of rent, landlords are willing to supply fewer properties to prospective tenants). On the other side of the market, demand has increased from D0 to D1 - largely because of greatly increased immigration (although there are a large number of students looking for accommodation at the start of the new year, there is probably a similar number of students whose rental contracts are expiring). So, a decreased supply and an increased demand leads the market (in the diagram below) to move from the equilibrium E0 to the new equilibrium E1, where the equilibrium rent is higher (R1 rather than R0). Note that because supply and demand have both shifted, the effect of these changes on the number of rental properties available is ambiguous (it could have increased, decreased, or stayed the same, depending on the relative size of the shifts in supply and demand) - though on my diagram the quantity of rental properties has increased slightly from Q0 to Q1.

That's all pretty straightforward market analysis. However, I didn't want to focus this post on the comparative static results (i.e. how the old equilibrium differs from the new equilibrium), so much as on the market dynamics. That is, how the market moves from one equilibrium to another. In the diagram above, the market is initially in equilibrium at E0, and the rent is R0, and there are Q0 properties rented. Then there is a decrease in supply, coupled with an increase in demand. Landlords now want to supply fewer rental properties at the original rent R0 - they only want to make QS properties available. On the other side of the market, tenants want to rent many more properties at the original rent R0 - they want to rent QD properties. Since QD is much greater than QS, there would be a problem of excess demand (or a shortage) for rental properties at the original rent R0.

The market resolves this problem by allowing the price to change - in this case the rent will increase (until it reaches the new equilibrium rent R1). In general, excess demand should lead the price to increase. But how?

In this case, there are more tenants looking for properties at the current rent than there are properties available, as evidenced here:
Well-priced central Auckland rentals are attracting dozens of prospective tenants to open homes, with many people queuing to see a vacant property, a real estate company says.
Joe Schellack, general manager at Crockers Property Management, said up to 40 people were showing up to viewing sessions for some rental properties in the central city and city fringe areas.
Since there is a shortage of properties, if you are a tenant then you are likely to miss out on a property at the going rent. How can you ensure that you don't miss out? One way is to find a landlord, and then offer to pay them a higher rent in exchange for ensuring that you get the property and don't miss out. That might seem a little far-fetched, but it appears to be what is happening:
A two-bedroom Devonport home advertised for $500 was rented for $550 a week after the tenant decided he was so keen that he would pay over the asking price, she said.
So the rent increases because tenants start to bid the rents up. Eventually we end up at the new (higher) equilibrium rent, but with no shortage of rental properties. The reason there would be no shortage any more is because as the rent increases, some of the prospective tenants choose not to try and rent a property (in the central city or wherever) because the higher rents are more than they are willing to pay; and as the rents increase more landlords are willing to supply their properties to prospective tenants - the quantity of properties demanded decreases and the quantity of properties supplied increases, as the rent increases.

On a final note, although economists often focus on equilibrium (as we have here), economists mostly recognise that markets usually exist in some disequilibrium state. This is because there is a large number of complex factors that constantly affect markets, such that any given market couldn't possibly ever get to equilibrium. That doesn't mean that comparative static analysis is useless, only that it will help to explain some of the tendencies in the market, rather than the absolute state of the market at any point in time. So, when demand increases the price tends to increase, and when supply decreases the price tends to increase, and so on. Which is also why economists use that phrase ceteris paribus (all other things being equal) when talking about changes in markets.

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