Academics theorize why developers won’t create more specially designed rental housing. They cite everything from user behavior to policy restrictions. For some reason, they never think of asking a real estate developer frankly.

A few weeks ago I shared a popular Twitter feed on real estate rental development. Few people realize that real estate development isn’t just about housing – it’s a business. This means that it is subject to the economic cycle and affected by factors like interest rates. Here’s a quick look at how historically low interest rates have destroyed the incentive to build rentals.

Developers build what is most profitable

When do developers build specially designed rentals? When it’s the most profitable. When do real estate developers build homes for sale? When it’s the most profitable. It is not about helping to resolve the balance between supply and demand. Private development is not a social service. It is a for-profit business. Glad it was out of the way.

How do you determine which is the most profitable? Specially designed rentals are often based on development performance. This is annual revenue, expressed as a percentage of development revenue. Since rents are tied to revenue growth, yield often improves with strong revenue growth.

House prices may have nothing to do with wages earned. They are based on the price at which the house can be sold. Since most people buy a home with a mortgage, the cost can be more closely related to the amount they can borrow. Even if salaries do not increase, the amount of the loan margin can to augment. Lower mortgage rates, lower down payments and longer amortizations all increase budgets.

Interest rates have a big influence on the size of mortgages

One of the biggest influences on building for rent or for sale is interest rates. When interest rates fall, they make debt cheaper and increase budgets. If you were a real estate developer, you could now benefit more from a buyer’s future income. Generally speaking, this is an ideal choice.

When interest rates rise, it makes debt more expensive. This cuts a buyer’s budget compared to lower rates. On the bright side, interest rates typically rise in a booming economy. A booming economy usually means wages are rising and you can afford to pay more in rent. Developers can help you manage all the extra cash you are hanging on to. Yoink.

Since the 1980s, advanced economies have bought a one-way ticket to lower interest rates. It’s no big surprise to see homes for sale explode, while rentals plummet. Budgets have been inflated much more than wages have increased in real terms. It is one of the main contributors to the construction of homes for sale, instead of homes for rent.

There are a few market-based exceptions, and the most important is government grants. If the grants close the gap between the least profitable project, they will shift gears. As long as there are enough incentives to do so. Hell, most will build anything if the taxpayers want to make it more profitable.

Grants are often paid in cash, below the market interest rate and / or in the form of forgivable loans. The idea is that if more rental units are built it can help drive down the prices in the market. Extending market inefficiencies is a quick fix that can make matters worse.

Encouraging rental construction in the market when the market does not support it decreases the incentive. If rents go down but house prices are high, there is even less reason to build more. The market becomes more dependent on subsidies to manufacture rental housing at market price.

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