Sunday, 31 July 2016

Should landlords offer efficiency rents?

Last week, Ron Goodwin wrote in the New Zealand Herald about the problems of being a landlord:
You think it's easy being a landlord? All we do is sit around and randomly put up rents when our Jags need servicing. Capitalist pigs, feeding from the trough of tenants' misery. Apparently we bunch people's undies too...
Last week, my hired rental inspector and I went to my worst tenants' house. The whole place was a trashed pigsty. Broken windows, the kitchen vinyl torn to bits beyond recognition, the lounge carpet covered in big black stains and torn, rubbish piled up around the place, torn and missing curtains, the deck gate smashed, the main steel driveway gate bent beyond repair.
These are tenants who wrecked an outside tap and then left it running, and who throw much of their rubbish out the windows, over the deck and out the doors into the yards and landscaped gardens...
Anyone want this lot living in their house?
This got me thinking. There are good tenants and bad tenants, and it is difficult for landlords to regulate tenants' behaviour after they have signed the rental agreement. Given this is moral hazard and efficiency wages is one way to deal with moral hazard in labour markets, is there a rental market equivalent of efficiency wages?

First, some context. In ECON100 and ECON110, we discuss moral hazard and agency problems. One such problem is where employees' incentives (after they have signed their employment agreement) are not aligned with those of the employer. The employer wants their employees to work hard, but working hard is costly for the employee so they prefer to shirk. One potential solution to this is efficiency wages (I've previously discussed efficiency wages here). With efficiency wages, employers offer wages that are higher than the equilibrium wage, knowing that this will encourage higher productivity and lower absenteeism from their workers. This is because if workers don't work hard (and avoid absenteeism), they may lose their jobs and have to find a job somewhere else at a much lower rate.

Which brings me to landlords and efficiency rents. As noted above, there is a moral hazard problem for landlords - tenants' incentives (to look after the property) are not aligned with the landlord's incentive (to keep the property in top condition). If the landlord instead offered an efficiency rent (a rent below the equilibrium market rent), then they would have many potential tenants applying for the property, allowing the landlord to pick the best (the least likely to damage the property). It also gives the tenants an incentive to look after the property after signing the tenancy agreement, because if they don't they get evicted and have to find another place to live at a much higher cost.

Maybe landlords offer efficiency rents already and we just don't realise it? There is certainly plenty of evidence for excess demand for rental properties (see here or here for example), so maybe rents are below equilibrium (though they are rising quickly so it's possible that the observed below-equilibrium rents are simply in transition to a higher equilibrium level). Excess demand by itself is pretty weak evidence for efficiency rents. I'd want to hear landlords telling us they offer lower rents to attract good tenants before I found it believable. There's not a lot of evidence in the academic literature on efficiency rent either (see this paper by Basu and Emerson as one example, ungated here).

So, why wouldn't landlords offer efficiency rents? If it is difficult to evict tenants due to tenant protection laws, then that lowers the incentives for tenants to look after the property (since the risk of eviction is lower, or they know it will take a long time before they are eventually evicted, as Ron Goodwin's article suggests). This in turn reduces the incentives for landlords to offer lower rents than the equilibrium rent - why take the risk?

Would efficiency rents be a good thing? Would they have some of the same effects as rent control (which I have discussed here and here, and which we cover in both ECON100 and ECON110)? Perhaps. There would certainly be excess demand at the level of the efficiency rent. However, if not all landlords are offering efficiency rent, there need not be excess demand overall - this might simply be a way of allocating low rent houses to low cost tenants (i.e. those who would look after the properties), with high cost tenants paying higher rents.

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