Price Gouging Isn’t To Blame

Rent increases get all the headlines. Amidst the pandemic-induced inflation, apartment rents soared in most markets across the country in 2021 and 2022. As did the prices of just about everything. The prices of cars, flights, and food all rose above historical norms. Politicians today have now lumped all these increases into the “greedy company” category. We’re being told that prices rose because companies and landlords took advantage of the pandemic. That they all became price gougers. Now, there’s a crusade to combat these alleged nefarious companies. They don’t want you to believe that market forces are truly at work. Supply and demand aren’t happening behind the scenes, they’re in plain sight!

It’s almost like Economics 101 and basic supply and demand principles get exorcised from the minds of politicians and the media when they take those jobs. Landlords can’t raise rents unless people are willing to pay for them. With more (e.g., government stimulus) money in everyone’s pockets, and a flood of new residents to places like Austin and Nashville, there were more people attempting to rent the same number of apartment units. This caused the prices (rents) to go up. Now, as new apartment supply is at record levels in places like Austin, rents are down. Supply and demand remain undefeated.

Another popular notion is the idea that all landlords are conspiring against tenants to keep rents high. The idea of widespread rent collusion is unfounded and, frankly, absurd. While the “Wall Street” landlord gets dragged in the press, most apartment units are owned by non-institutional owners (i.e., individuals like “mom and pop”). Logistically, there’s no practical way for collusion to take place. But what about algorithmic rent pricing, which is now banned in San Francisco and under investigation by the Justice Department? These pricing algorithms are driven by inputs (market asking rents). Rent data is generally publicly available in real-time since all ILSs (Internet Listing Service; e.g., apartments.com) are tied to property managers’ systems. The algorithms make it easier for landlords to assess the current market rent landscape, but that is entirely different from a cabal of landlords secretly propping up the rental market artificially. And, the vast majority of apartment units are not using algorithms to determine pricing, especially in a city like San Francisco. But, hey, the Greedy Landlord makes for great soundbites and appeals to the renter voting constituency.

What gets left out of the rent increase discussion is inflation’s impact on expenses. Our costs have risen across the board. Insurance, payroll, marketing, utilities, administrative, property taxes—everything costs more. Below is a table showing the average year-over-year change in major expense categories for institutionally-owned apartment properties, measured quarterly.

The categories in bold have all experienced above-average increases since Q1 2020. Property insurance has clearly risen most. We used to underwrite $300 per unit for insurance. Now it’s not uncommon to assume $600 or even $1,000+ per unit. Wages have also grown, which is a good thing. However, it does make it difficult for us to hire and retain people. Utilities continue to rise despite flat or declining usage. At one of our properties, water rates have increased 9% over the past year. The point is, expenses have risen significantly, too.

The chart below shows how revenue, expenses, and net operating income (NOI) have changed since the start of 2020. Because this is year-over-year data, there’s a lag from what was happening in real-time. For example, while apartment occupancy and rents suffered at the onset of the pandemic, the effect on income wasn’t fully realized until Q2 2021 (data from Q2 2020 to Q2 2021).

During the pandemic, revenue decreased, causing NOI declines. Expenses continued to grow, deepening the negative trend in NOI. It’s also no surprise that as revenue grew by 12.4% year-over-year in Q3 2022, NOI grew by 20.2% during the same period. Today, the most apparent trends are slowing NOI and revenue growth with above-trend expense growth. Given the lag in the data, I expect the next two quarters to show further declines in NOI and revenue growth. Though revenue growth is slowing, it’s still above the 20-year average.

Expense growth is slowing, too. From Q1 to Q2 this year, the annual growth slowed from 6.5% to 5.1%, according to NCREIF. That’s still more than the 20-year average of 3.36%. Yet it’s improving. The biggest reason for the decline is from slowing growth in property insurance. That dropped from 36.1% annual growth as of Q1 to 26% as of Q2. Other expense items remain sticky as payroll witnessed a 9% year-over-year increase and utilities grew by 4.3%.

It’s easy to blame the landlord and rents in a time of inflation. Yet there’s more to the story. Supply and demand dynamics coupled with substantial increases in expenses have changed how apartment investments work. How did water get 9% more expensive compared to last year. Why did insurance premiums double? Inflation impacted both the revenue and expense side of an income statement. It’s misguided for the government to impose caps on revenue when they have no ability cap one’s necessary expenses. The market is great at determining rents. Just ask any apartment owner or renter in Austin, TX.