Landlords can and will pass the cost increases from Labour's policies onto tenants

Business Editor Hamish Fletcher wrote in the New Zealand Herald on Sunday:

The landlord lobby had a clever response to Labour's plan for rental reform.

Given the complaints of property investors don't garner much public sympathy, it was smart to focus on how Labour's moves would harm the very people they are meant to help: tenants.

Their argument went something like this: Labour's proposed changes - which include extending all notice periods to 90 days, removing landlords' ability to evict tenants without cause and requiring rental properties to "be warm, healthy and dry" - would backfire.

They would deter investors from the rental market and aggravate an existing housing shortage. "It's going to put people off being landlords," said Andrew King, executive officer of the New Zealand Property Investors' Federation.

"People already can't find rentals, and this will push up prices ... why would we restrict supply when what we need is more?" he said...

Applying for a rental can feel like a lottery in some cases and an auction in others, with people offering over the advertised rent to secure the tenancy.

It certainly didn't feel like landlords were the ones on the back foot. And although the concern for tenants is commendable, it is nevertheless misplaced.

That's because Labour's policies won't cause houses to suddenly vanish.

Nor will they remove demand for homes under construction or in the planning stages, given the pace of new builds versus the rate of immigration.

Fletcher is right - houses won't just suddenly vanish if Labour's policy changes come into force. But he is also wrong- the policies will decrease supply and tenants will face higher rents. Here's why.

Consider the market for rental housing operating in equilibrium, as shown in the diagram below. Note that the supply of housing is very inelastic, and there are a couple of reasons for this. First, if a landlord owns a rental property, it doesn't have many alternative uses and if they sell the property it is likely to be bought by another landlord, so as Fletcher notes above, the houses mostly stay in the market. Second, if we include owner-occupiers in this market (who provide house rental services to themselves) then it is easy to see that the supply side of the market doesn't respond much to changes in rents [*]. The market is in equilibrium, with the rent at R1 and the quantity of rental housing at Q1.

Now consider the policy changes proposed by Labour. Requiring rental properties to be "warm, healthy and dry" increases the costs to landlords. Sure, Labour is offering to contribute to one-off costs of making houses warm, healthy and dry, but they won't necessarily cover the full cost, the remainder of which may be capitalised in a mortgage and increase interest costs for the landlord. Also, there will be ongoing costs of ensuring houses stay warm, healthy and dry. Higher costs for landlords shift the supply curve up and to the left. Extending notice periods to 90 days reduces flexibility for landlords, and that inflexibility may make being a landlord less attractive for some landlords. However, that won't affect supply in this market, because we included owner-occupiers (so if landlords sold their properties and they were bought by other landlords or by owner-occupiers, it wouldn't affect the supply). Overall though, supply has shifted from S1 to S2. This increases the equilibrium rent to R2 (and decreases the quantity of rental housing to Q2).

Notice that the increase in rent is quite small. Most of the increase in costs in this market ends up being borne by the landlords. But, we are not in a rental market that looks like the diagram above. As Fletcher himself notes, there is a shortage of rental housing:

I can attest to that shortage. Having moved last year, only to have our landlord take back possession after six months, I know competition can be intense.

A shortage means that the market rent must be below equilibrium (e.g. at R0 in the diagram above), such that the quantity of rental housing demanded (Qd0) is much greater than the quantity of rental housing supplied (Qs0). That changes things dramatically. It gives landlords more leverage in negotiating with tenants. They can ask tenants to pay a higher rent, and to cover additional costs (as I mentioned in this post last week). Landlords can easily pass cost increases onto tenants when there is a shortage, and if tenants don't like it they will miss out on the property and some other tenant (who is less averse to paying the additional costs) will get the rental property. When supply decreases, the size of the shortage (which was previously Qd0-Qs0) increases even further (to Qd0-Qs2), and this increases the power that landlords have to pass cost increases onto tenants.

The landlord lobby may well be self-serving in their complaints against Labour's proposed policies, but they are also right. Tenants will end up paying higher rents. That doesn't mean that those are bad policies - only that pretending the policies can be implemented without some (and perhaps most) of the costs being borne by tenants is clearly wrongheaded.

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[*] Including owner-occupiers in the market is fairly conventional, but in this case it is also the most advantageous to Fletcher's arguments. If we excluded owner-occupiers, the supply would be more elastic, the leftward shift of supply due to the "warm, healthy and dry" requirements would be bigger (since this doesn't affect owner-occupiers), and the 90-day notice period would reduce supply even further in the market (since those houses sold to owner-occupiers would be removed from the market). This would make Fletcher's assertions even more wrong.