Interest Rates and Rental Rates in 2023

If you were to distill the economy of the year 2022 into a single word, it would most likely be either inflation or interest rates (a response to inflation). Go back a year to 2021 and that word may have been housing. This is the year after the pandemic began, and as employees saw work from home as a viable option, they moved! This had a large effect on overall housing prices. This has left many people concerned about the housing market, and has sparked conversations comparing current times to the Great Recession. 

Wells Fargo is even leaving the mortgage market altogether. With rising interest rates not reversing anytime soon, and housing being a major issue, it may be a good idea to ask ourselves: what effect does a changing interest rate have on housing rental rates? Rising interest rates will primarily effect housing through lowering the present value of the house and increasing the long term cash-flow, we should see a rise in rentals as housing affordability drops, and furthermore it will affect the ratio of multi-home housing being built.

Interest Rates and Cash Flows

If one is unfamiliar with discounted cash flow valuation (DCF), it may be best to start at what any person – homeowner or not – would know about: the interest rate on their home. Most Americans do not have enough cash on hand to outright buy their house, so they need to take out a loan from the bank. Banks do not hand out cash for free; they need some sort of return, and that comes in the form of interest. 

The interest rate is determined by a variety of factors including the value of the house, one’s down payment, credit scores, and location. The determination of the interest rate can truly make or break the decision to buy the house, as a higher interest rate means higher monthly payments which one may not be able to afford. 

As the Federal Reserve increases interest rates primarily through raising the Federal Funds Rate, this has a similar effect on any other interest rate including mortgage rates. Think of this as the opportunity cost increasing for the bank – since they could have a higher risk-free interest rate. At the same time, a higher interest rate means that the cash flows coming to the bank are higher. All this is to say that mortgage rates are at an all time high, and that is directly affecting the present value of the asset (the house) but is also met with increased cash flows for the bank.

The Impact on Rentals

So it is clear that the American Dream of owning a home may take some more time to become a reality. What does that actually mean? What we should see is an increase in the number of homes being rented – primarily because people cannot afford to buy, and secondly because people are more willing to rent their homes knowing the business is more lucrative since demand from renters is increasing. In the graph below, we can see this increase in demand is leading to higher rental prices for the average house in the Untied States: 

If we view the rental market as a perfectly competitive market, how should people respond? Some may join in on house hacking or adjust their rental rates to be more competitive. However, a more interesting phenomenon is the increase in the share of multi-family housing, relative to single-family homes. Multi-unit properties are your apartment complexes, duplexes, condos, etc. and are more lucrative in a booming rental market. The Census Bureau has great data on housing starts which can be drilled down to single or multi-unit housing starts. We can see here that, although single-family homes are still started more often than multi-family, that gap is closing, with the share of multiple unit homes increasing.

Businesses are responding to a market with profit potential in the way you would think: taking competitive steps to earn some profit themselves. For business owners who can do so, we envy you. To the small business owner reading that may not be able to do this, who may be renting themselves, what is most important to note is that rental rates may be increasing if they have not yet already. This will increase fixed cost and force you to make decisions regarding the price of your product or other costs (wages, capital). Early planning and an understanding of how this may affect you is of utmost importance!