Why Don’t Real Estate Developers Build More Purpose Built Rentals? Interest Rates

Academics theorize why developers won’t create more purpose-built rental housing. They cite everything from user behavior to policy restrictions. For some reason, they never think to just ask a real estate developer candidly.

A few weeks ago I shared a popular Twitter thread on real estate rental development. Not a lot of people realize real estate development isn’t just about housing — it’s a business. That means it’s subject to the business cycle, and affected by things like interest rates. Here’s a quick rundown on how historically low interest rates destroyed incentive to build rentals.

Developers Build Whatever Is More Profitable

When do developers build purpose-built rentals? When it’s most profitable. When do real estate developers build homes for sale? When it’s most profitable. It’s not about helping to solve the balance of supply and demand. Private development isn’t a social service. It’s a profit-seeking endeavor. Glad that’s out of the way.

How does one determine what’s more profitable? Purpose-built rentals are often based on development yield. This is the annual revenue, expressed as a percent of development income. Since rents are tied to income growth, yield often improves with strong income growth.

Home prices can have zero to do with the wages earned. They’re based on how much the home can be sold for. Since most people  buy a home with a mortgage, the cost can be more closely tied to how much they can borrow. Even if wages don’t rise, the amount of borrowing room can rise. Falling mortgage rates, lower down payments, and longer amortizations, all increase budgets.

Interest Rates Have A Big Influence On Mortgage Sizes

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

When interest rates rise, it makes debt more expensive. This shrinks a buyer’s budget relative to falling rates. On the upside, interest rates typically rise in a booming economy.  A booming economy usually means wages are growing, and you can afford to pay more rent. Developers can help you deal with all that extra cash you’re hanging onto. Yoink.

Since the 80s, advanced economies bought a one-way ticket to lower interest rates. It’s not a huge surprise to see homes for sale boom, while rentals fall. Budgets have been inflated much more than wages have grown in real terms. It’s one of the biggest contributors to building housing for sale, instead of housing to rent.

There’s a few market-based exceptions, and the biggest is government subsidies. If subsidies cover the gap between the less profitable project, they’ll switch gears. As long as there’s enough incentive to do it. Heck, most will build anything if taxpayers want to make it more profitable.

The subsidies are often given as cash, below market interest, and/or forgivable loans. The idea is if more rental units are built, it can help push prices lower across the market. Extending market inefficiencies is a band-aid solution that can make things worse.

Incentivizing market rental construction when the market doesn’t support it, lowers incentive. If rents are falling, but property prices are high, there’s even less reason to build more. The market becomes more dependent on subsidies to make market-priced rental housing.

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  • Ed Kolop 3 years ago

    The supply argument never made sense. There’s limited land, so more development increases the cost of all land. A developer doesn’t cut their profit because they’re all of a sudden very happy with the profits they made. They’re a business. No one asks the Westons to discount grocery, to help with food costs.

    • Paul 3 years ago

      Sounds like your are repeating info from the article but it doesn’t really make any sense. Care to elaborate?

      • Tom Wolfe 3 years ago

        I think Ed offered an alternate relevant example to enhance clarity and I appreciate it. Can I pour you another drink?

  • David 3 years ago

    The loans aren’t a subsidy. They lend money, and it’s paid back over time like a mortgage.

    • Mortgage Guy 3 years ago

      They most definitely are a subsidy.

      The government borrows money from capital markets, and then lends it to rental projects at below inflation. I’ve seen some loans for rental buildings secured by the government that give them 1.5% rates. Market rates are about 3x higher.

      Free money from the government, at the expense of taxpayers is a subsidy. They receive less than the inflation costs. Add on most of these loans have forgivable portions.

      The CMHC also does this for more than just purpose-built housing. They also do it for other segments of condos. Just not every type of condo.

  • Thiswillendbad 3 years ago

    Where are all the smug folks that said Canadian Banks and people were smarter than US Banks and people?
    These are the same folks who think they can just move to the US and get a job….guess what its not that easy..

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