What’s driving rent inflation?

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Phoebe White: Inflation has eased substantially from its peak, but since the start of the year, that progress has slowed. For many forecasters, one of the biggest surprises in recent months has been the stubbornness of rent inflation. What's driving the strength in rental markets and what are the implications for inflation going forward? Welcome to Research Recap on J.P. Morgan's Making Sense podcast channel. I'm Phoebe White, head of U.S. Inflation Strategy at J.P. Morgan. And today, I'm joined by my colleague, Tony Paolone, Co-Head of U.S. Real Estate Stock Research to break down some of the rent inflation trends we're seeing today. Tony, thanks so much for joining me.

Tony Paolone: Thanks, Phoebe.

Phoebe White: So Tony, if you look at official measures in CPI and PCE, rent costs are up more than 5% over a year ago, so they're still, from an inflation perspective, running above pre-pandemic norms. We know that these official measures are not necessarily an accurate reflection of current market prices since they tend to be sticky, they pick up swings with a lag. Can you just walk us through what you're seeing in the rental market today?

Tony Paolone: Yeah, sure. And thanks for having me. So I know the data gets fairly nuanced and this gets to be fairly complex in trying to bridge what's happening on the ground with what ends up in CPI and the PCE. But what I'd start with is that I think that 5% number does come down, but what's interesting and what's been unfolding so far this year is that we saw rents decelerate in the second half of last year quite a bit. And what we thought is that you'd see that muted rent growth continue into 2024. But what we're seeing instead is a bit of a reacceleration in rent growth. And so the demand side of the equation has proved to be a bit better than what we expected. So while that 5% number should come down, it seems a bit too hot for us in comparison to what we're seeing on the ground, but it doesn't appear to be coming down to the levels we had thought going into this year.

Phoebe White: So let's just put some numbers on what you are seeing on the ground. What is the pace of increases you're seeing on these renewals, on new leases, what are the numbers that you're seeing right now?

Tony Paolone: Yeah. So it's really the renewals that are driving things quite a bit. And what we're seeing is that for multifamily housing, you are still seeing renewal notices being sent out in the 4 to 5% range, even into August. I think in the single family rental arena, the number's even a little bit higher than that, perhaps closer to 5 to 6%. And so the renewal side of the equation is quite strong because you do have less mobility right now within the housing market, meaning that folks just aren't moving out at the rate they would historically from their rentals. Now, if tenants leave a rental unit and the landlord goes into the market to find a new tenant, those rent increases are more modest. So on the multifamily side, those numbers are very low single digits, maybe even 1% thereabout, maybe 2. They are higher for single family rentals, that part of the rental market, and that's still running at probably 4 to 5%. But going into the market and finding new residents, you're gonna have a bit less growth in rents because the market rents haven't moved a whole lot on the multifamily side, more so on the single family rental side. But again, where the real pricing power has lied is with renewals.

Phoebe White: So I think that divergence you're highlighting is a really interesting point, and it's something that's come up in the last couple of FOMC press conferences, Chair Powell was highlighting this idea as a reason why rent inflation could perhaps take longer to come down than they previously thought. And it's a challenge for forecasters because most industry measures of rent inflation primarily capture asking rents or the pace of increases on newly signed leases. Meanwhile, we know that in the official rent measures and CPI, that captures the entire housing stock, it includes leases in the middle of the term and those being rolled over. So I wanna dig into this a bit more. What is the reason for the differences in those rates of increases for renewals and new leases? You talked a little bit about housing mobility, but just is that a wedge that you typically see in the market? Or is it wider than what we've seen historically?

Tony Paolone: It's a bit wider than what we've seen historically, and it really does come down to this idea where if you think about the rental pool in the U.S., we have about a third of households that rent and two thirds of households that own, and if we think about just that rental pool, you would typically have new entrants into that pool every year as young people graduate from college, move out of their parents' home, you have immigration, folks coming to the U.S. to work and there's a disproportionate amount of them that will rent as opposed to go buy a home when they get here. And so that tends to grow the rental pool, and then you have the back door, so to speak, which is renters that will move out and go buy. What you have right now is that back door is fairly shut. You have existing home sales just came out a bit ago before we came up here to do this, and it was about 4.1 million. That's a very depressed level of existing home sales in our view in comparison to the size of the country and what we think would be a more normalized level. And so it's telling you that there are fewer folks moving out of the rental pool and into the ownership pool in comparison to what you've historically seen.

Another way we see that is just simply looking at landlord tenant retention rates, which are running higher than they have historically. So in the multifamily world, historically, going back a number of years, you might only retain 45 to 50% of your residents on a turn. That number is pushing 60% in many cases now. And in the single family rental pool, you are seeing retention rates pushing 70%. And so these are pretty high levels of retention, suggesting that the landlords do have a bit more pricing power because folks aren't going anywhere.

Phoebe White: So is there a price gap at this point between existing leases and where that market rate is? Or how do we think about that level perspective?

Tony Paolone: Yeah. So it gets into this idea of what's often referred to as this loss to lease idea where if market rents were to move up very rapidly, the leases in place for the landlords keep them from raising rents to that market level, so there's an embedded loss that the lease that exists is creating for the landlord. That was a phenomenon arguably that was more prevalent, I would say, last year and perhaps the year before when market rents were moving up very rapidly. At this point, I think the loss to lease is fairly modest, maybe very low single digits if much at all in the multifamily space, and perhaps low maybe mid-single digits in the single family rental space. But I think that loss to lease idea is dissipating because you are seeing these renewals occur at a fairly sizable increase. And market rents have grown, as mentioned, a bit slower.

Phoebe White: And so I just wanna understand in terms of that gap opening up in the first place, what is, I guess, the mechanism that prevents landlords from just adjusting the price right to the market? I mean, is that typical? Is it just the pace of market increases that was really driving the wedge there?

Tony Paolone: Yeah. I think largely it was the pace. The market moved up very rapidly coming out of the pandemic in '21, 2022, even early 2023, just saw an enormous amount of demand. And you didn't have a tremendous amount of supply. The supply side of this is an interesting path to go down and take a look at because you did see a lot of new construction start in 2021 and 2022, but you're only delivering that supply now here into 2024. This is a very heavy supply delivery year, which is one of the reasons why, at the outset I mentioned, we thought you'd see a bit slower rent growth this year because of the supply being delivered. But in fact, the demand has been strong and has been absorbing that at a bit of a better clip than we expected.

Phoebe White: So can you just maybe put some numbers on that supply picture? How big are the deliveries this year? And then what's the outlook for supply as we move into 2025 and beyond?

Tony Paolone: So it depends on which component of the rental market you're looking at and where in the country you're looking. So supply deliveries in the sunbelt are very heavy. That's where you have a significant amount of new construction that occurred. And those numbers, you could see supply deliveries in the mid-single digit percentage growth in underlying stock in the multifamily arena, and that's a pretty big number. When you get to places like New York or California, the West Coast generally speaking, far less supply. If we were to paint with a real broad brushstroke, let's call it about 3% supply deliveries this year in terms of growing the multifamily stock. That is a notable pickup over time in terms of having to absorb that amount of space. Now, what's interesting is that if we start to look to '25 and 2026, the supply deliveries start to drop off dramatically, and that's because we're not starting as many new projects as we are delivering. So we're not replenishing the pipeline and there's a whole variety of reasons for that, higher interest rates being one, less credit availability being another. And so with less new supply being started, if this demand continues to run at the clip it's been running for the next couple of years, you could very well see another step up in rents come '25, '26 because you will have that drop off.

Phoebe White: Now, I wanna dig into that demand question a little bit, but before I go there, you talked about the differences in the supply picture in different parts of the country. And I think it's something interesting coming out of the pandemic that we have to acknowledge here that there's divergences. So where are you seeing prices rise the most? And where are you seeing rent inflation really more significantly?

Tony Paolone: Well, the rent inflation is falling most significantly in the Sunbelt because of that supply. And if you step back, the supply response really is a response to enormous amount of demand and pricing power that ensued coming out of the pandemic. And so you go to a market like Austin, Nashville, Atlanta, or parts of Florida, where over time, they've always had strong demographic growth in comparison to very mature cities like Los Angeles or a New York metro, and so that demographic growth has always been really robust.

But what we saw coming through the pandemic is that the type of jobs moving to those markets or being created in those markets were coming with higher wages. And so you really saw a lot of importation, if you will, of high wage jobs into markets that historically hadn't seen that. And so it allowed landlords to really move pricing up pretty substantially in those places, and with that came the natural supply response with developers building a lot of new product. And so now, you're seeing a little bit of a give back in that. So if you were to look at markets like we mentioned in Austin, Texas or Nashville, you will see rents effectively down because these supply deliveries are occurring and landlords are offering concessions. Now, if you go to a place like New York or even California, there's very little incremental new supply that's being delivered at this point. And in a place like New York with financial services performing well, legal is performing well, and you've got demand from those sectors, you don't have a lotta supply, and so rents are seeing more inflation in a market like New York. And of course, the West Coast has been an interesting story because you’ve had a very slow recovery from the pandemic. You have a heavy concentration in tech and media, there's been a little bit more dispersion in those jobs. But as you see some of that come back to the West Coast, there's not a lotta supply so that demand should result in a move up in rent inflation there.

Phoebe White: So just to touch on a point you made there, that it was with these higher wage jobs coming into these other regions and driving rent higher, let's just think about, I guess, nationally, now, this dynamic that wage inflation has come down but it's still elevated. How do we think about rental affordability? And how much does that rent to income ratio drive how high rent inflation can go?

Tony Paolone: It is pretty important, and what we've seen on that front is the rent to income numbers reported by a lot of the public companies and large landlords have been remarkably steady. Call it approximately 20% rent to income for a lot of these portfolios. And so what it's telling us is that even though you've had this rent inflation that's been pretty notable for the last several years, incomes have been there to support it. And so that's going to be a factor going forward if that rent income number remains stable and you have these higher interest rates that are keeping people from moving out to buy homes, it just makes sense that landlords will continue to have some pricing power here.

Phoebe White: Okay, so let's start to wrap this up in terms of numbers and where we're going. So you had mentioned at the outset that for new leases, rent increases are somewhere in the zero to 1% range, and for renewals, it's more like 4 to 5%, the blended rate you're seeing is something like 2 to 3%.

Tony Paolone: Yeah, that's about right.

Phoebe White: So where do you think we go from here? Clearly it'll depend on whether we get an unexpected weakening in labor markets, but it's just assuming a basic economic outlook, we get just a gradual cooling in the economy. Demand probably stays fairly elevated, we have supply coming down. Do you think we can get back to pre-pandemic norms in terms of rent inflation?

Tony Paolone: I, I think you can. Again, presuming that the broader economy starts to see some slow down here, not necessarily a recession, but the general House view that things slow, we should see that overall picture revert back to call it this two and a half to 3% range. And it should be some combination of new lease rates moving up a bit and the renewal rates coming down a little bit, and there should be some convergence there. That's our view, but again, I think a big part of this is going to depend on watching the broader rate environment and whether you see this so called back door from the rental pool open up and see a bit more activity on the for sale housing side. If that doesn't occur, then we could have higher rent inflation for a bit longer.

Phoebe White: So if I can just recap, it sounds like low housing mobility is keeping demand for rental properties elevated, landlords still have pricing power, and that's prevented further softening in rent inflation. Now, if this level of demand persists into next year when supply starts to come down, we could see rent inflation actually moving higher. Official measures of rent inflation are sticky, and there's likely still some softening in the pipeline near term there, however, it's a market in which it could be difficult to see rent inflation falling down to pre-pandemic levels, and that could also make it challenging to see overall price inflation return all the way to the Fed's 2% target. Does that sound about right to you?

Tony Paolone: I think it's a perfect summary, Phoebe.

Phoebe White: Great. Thanks so much for joining us today. And thank you to our listeners for tuning in. For more research insights, visit jpmorgan.com/research.

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