Residential rents outpace home prices

Ask the average renter why they rent instead of own, and chances are they’ll tell you it’s because renting is all they can afford at present. Seldom do people rent due to an actual preference for renting, according to a nationwide survey of renters.

But what happens when renting also becomes too cost prohibitive? Here in California, we may be about to find out.

Zillow’s rent index for California is up 7.5% from a year earlier, as of April 2015. Compare this with a year-over-year increase of 5.25% in their California home price index in April 2015. This reflects a nationwide trend of rising home prices, but more quickly rising rents.

Today’s high demand for rentals and low supply of new rental housing is giving landlords the incentive to increase rents. Renters are forced to pay – unless they have the financial wherewithal and down payment savings to join the ranks of homebuyers. But since the lack of appropriate finances is the number one reason why renters rent in the first place, that response is pretty rare.

As rents continue to rise at an epic pace, you’ll see one of two situations play out:

1. homeownership will be put off longer (not by choice — by necessity); or
2. more first-time homebuyers will turn to mortgages with low down payment options.

In the first scenario, those forced to rent at today’s rising price of rent will move to less expensive homes in less desirable areas. Otherwise, more of their paycheck will go into making rent, less into making purchases and saving for a new home — a vicious cycle. This is bad for real estate agents and bad for the economy.

The alternative is to forego saving for a full 20% down payment altogether before buying.

Of course, it’s always better to have 20% down, as this demonstrates skin in the game (decreasing the risk of default) and eliminates the need for costly mortgage insurance. But choosing a low down payment option — like a Federal Housing Administration (FHA)-insured mortgage or conventional financing with private mortgage insurance — might be a good financial choice if the circumstances are right.

For instance, these minimal down payment options are good options if the homebuyer:

• has a solid credit history and steady employment;
• isn’t already overburdened with debt;
• resides in a community where rents are rising more rapidly than home prices; and
• plans to occupy the property for several years.

A warning: the additional cost of mortgage insurance will increase the homebuyer’s total interest rate, meaning even more of their payment goes toward paying off interest than paying principal. This initially equals less house for their money.

However, as interest rates inevitably rise over the coming decades, the cost of borrowing funds to buy a home will become more expensive. So, today’s extra cost of mortgage insurance may just beat waiting years until a down payment can be saved, since mortgage rates will be higher then anyway.

To fix the problem on a broader scale, builders will need to build more multi-family rental housing. Multi-family construction is slowly taking off, but not yet at the pace needed to meet new population growth. City officials could help by making zoning changes more accommodating to new multi-family buildings, but effecting zoning changes is a long, belabored and often futile process. All the while, demand will continue to rise, carrying rents along with it, and savings will remain dismally low.