Getting That Vacant Look

Many of the government efforts to help the housing market, such as the Fed buying up fully one quarter of all the mortgage-backed securities backed by Fannie Mae (FNM: 1.15 -0.03 -2.54%), Freddie Mac (FRE: 1.45 -0.05 -3.33%) and Ginnie Mae, as well as the “first time” homebuyer tax credit, are designed to move people from being renters to being owners. But while there are some ancillary benefits to neighborhoods of most people owning rather than renting, it really does not solve the problem.

What it does is cause there to be a lot of vacant apartments. In addition, a large number of formerly foreclosed-upon houses have been bought up by cash investors who plan on renting out those houses rather than living in them themselves.

The net result is that there is a glut of rental living space on the market. According to real estate research firm Reis, the apartment vacancy rate rose by 0.1 point in the fourth quarter to 8.0%, and is up from 6.7% a year ago. It is also the highest level of vacant apartments in the 30 years that Reis has been tracking the data.

An empty apartment is simply a deadweight loss for a landlord. In an effort to fill apartments up, they have been dropping rents, and especially effective rents (i.e. including things like a month of free rent when you re-sign your lease, replacing the carpet, etc.). According to Reis, rents declined by 0.7% in the fourth quarter and by 2.3% for all of 2009. Their data however, only covers the 79 largest rental markets.

Looking at the Numbers by Location

Jacksonville, FL had the highest apartment vacancy rate at 14.4%. The biggest increase over the course of 2009 was in Tucson, AZ, where the rate jumped by 3.1% to 10.5%. So far, the declining rents have not really been picked up by the government in its CPI calculations. Those numbers have been just effectively flat over the last year, not declining.

This could be due to the BLS numbers covering the entire country, not just the 79 largest markets. However, 79 markets covers most of the areas where there are significant numbers of people living in apartments. So it seems like the BLS numbers are simply behind the curve, or there is something very wrong with the methodology that Reis, or the BLS, is using. However, the comments coming from the large publically traded REITs that specialize in apartments, such as Apartment Investors (AIV: 16.86 -0.40 -2.32%) and Equity Residential (EQR: 33.35 -0.43 -1.27%), would tend to support what Reis is saying.

The Importance of Rent (& Suspect Methodology) 

Rents are extremely important. Direct rent paid to landlords has a 5.7% weighting in the CPI. More significantly is that Owners Equivalent Rent (OER), which is how the government tracks housing for inflation tracking, makes up almost 24% of the CPI. Thus together they make up more than 30%. Since rents are neither food nor energy, they make up an even bigger (almost a 40% share of the core CPI).

The BLS methodology for tracking OER is very suspect. It simply conducts a telephone survey of homeowners and asks them what they think it would cost them to rent an equivalent home across the street. I suspect that for the vast majority of responders, the answer would be just a wild guess. After all, many subdivisions don’t have a lot of people renting in them, and most long-term homeowners don’t make a habit of calling rental agents to find out what it would cost to rent in their area. The data for apartment rentals are a bit more solid, as the big landlords would be in a pretty good position to know. Thus you should be very suspicious if OER is diverging significantly from “rent” rent.

Facts on the Ground & Government Involvement

Not only have government policies been encouraging people to move out of apartments (or rented houses) and buy their own place, but there are still a significant number of new rental units coming on line. A big apartment complex is not built overnight, so many of the projects that were approved and funded right before the credit crisis are now coming on line. In addition, many projects that were originally planned to become condos have instead been turned into rental units. And as I mentioned before, large numbers of houses that had been foreclosed upon are being turned into rental units.

Renting a house or an apartment is a pretty good substitute for owning a house or a condo. A house is an asset, and the value of an asset is determined by the stream of cash flows the asset will bring in the future, discounted back to the present. What are the cash flows that your little bungalow gives you? Why, the rent you avoided paying (minus, of course, the cash outflows you have like taxes and maintenance).

While government actions can prop up house prices for a little while by handing out $8,000 checks to people who buy a home (which tends to get split with the person selling the home) and by holding down mortgage rates through massive buying of mortgage-backed paper, it is not going to be a permanent fix. This is especially true if those actions simply result in lower rents, which effectively undermine the cash flows that the asset value is dependent on.

The logic of attempting to bolster home prices is reasonable. After all, the single biggest factor in people continuing to pay their mortgages is if they have equity in the house. If the mortgage balance is $150,000 and the house is worth $200,000, you would have to be pretty stupid to stop paying. Even if you got laid off and didn’t have the cash to pay, it would still make sense to just sell the house rather than let the bank take it from you.

However, if the mortgage balance is $200,000 and the house is only worth $150,000, why would you continue to pay, even if you were still employed and had the cash to do so? Yes, there are plenty of non-economic factors that come into play, such as a feeling that you made an agreement and have a moral obligation to live up to it (trust me, the bank does not feel the same way, nor do big commercial real estate players).

However, a mortgage is a secured loan, and you don’t have to pay legally, at least if you have not refinanced. But if you don’t, the bank takes the house. It could be that if you had to sell your house you could not buy another house in the same town and school district, and would have to put up with pleas of “you are ruining my life” from your 14-year-old daughter if she had to change schools as a result. Those little marks on the wall showing how the kids have grown each Christmas or birthday also have value to many people. However, there is a limit to the value of those non-economic considerations. This is especially true if you are both underwater AND unemployed.

What’s Problematic in the Long Run

Stabilizing housing prices is a good thing, but I think the effort will ultimately be futile in the long run, especially if the efforts to do so simply result in more vacant rental properties. Ultimately what needs to happen is that the rate of household formation has to increase. Part of that is simply due to population growth, but population growth is not the whole story on household formation by a long shot.

People have to feel they can afford to have a place of their own. That means jobs. A good-paying, steady job is what will get the 26-year-old college graduate to finally move out of Mom and Dad’s basement. A good job is what will get the family that is living with friends or siblings after they got foreclosed on back into their own place.

Housing is also something we consume: the ultimate durable good, if you will. Just like people who are making minimum wage usually have to ride the bus, or drive around in an old clunker instead of a new BMW, so too they can’t afford to buy a big house, or even rent their own place. They have to double (triple, quadruple?) up.

In the housing bubble, the relationship between housing prices and both rents and incomes got way out of whack, as is shown in the two graphs below (from http://www.calculatedriskblog.com/search/label/House%20Prices) and are now back to reasonable levels. They are not, however, particularly low, even with the housing bust, and have both started to increase again in recent months.

That rebound is due to all the extraordinary government support for the market, and that support cannot last forever. I strongly suspect we will have another leg down in housing prices later this year. Not as severe as what we saw in 2008 and early 2009, but a decline nonetheless.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.