Why rents are sticky downward even if there is some slack in the rental market

Angelenos who follow the market in LA were treated to a good story from KPCC this last week:
As DTLA vacancies rise, landlords increase breaks on rent, parking.

Thanks to a wave of market-rate rental construction, supply has outpaced demand downtown since 2014. The vacancy rate now hovers around 12 percent — the highest recorded by real estate research firm CoStar Group since 2000, compared to a citywide vacancy rate of about 4 percent.

Ok, when I say that we should focus on Downtown because redevelopment is easiest there, there is tons of extra capacity, there is a lot of underutilized land from South Park all the way to the second Blue Line, downtown has tons of job access–long before we run into rampaging opposition from single-family homeowners–LA-area YIMBIES give me a stern look, like a preacher rebuking sin, and say “It will take more than downtown to solve our housing crisis!”

That may well be, but DTLA still strikes me as a really good place to keep momentum going. Downtown LA has way, way better transit access to most of the rest of the region’s job centers than anywhere else save for maybe Hollywood. The only subcenter really hard to get to (and that’s only hard if you refuse to get on a bus) is the Westwood/Century city areas. With the Purple Line coming, there will be *great* access to those job centers coming soon. Politically and functionally, I would much, much rather advocate for more units in DTLA than deal with furious, empowered homeowners and (legitimately) terrified renters in other parts of LA, especially as I have no desire to try to defend “meh” projects like The Reef, or to treat that as a real YIMBY contribution the way DTLA actually is.

This article, though, shows one of the issues with believing that filtering happens quickly or excess supply eases the market (it should, it just takes time)–and it makes a pretty bad internal mistake in definitions:

The result has been thousands more luxury apartments than there are renters. Of the 21,000-plus market-rate rentals tallied in a recent report by the Downtown Center Business Improvement District, more than 2,000 are empty under the current vacancy rate.

CoStar senior market analyst Steve Basham said that in the last several years, landlords have been ramping up concessions to lure tenants. Of course, the savings are relative when the average rent for a one-bedroom runs around $2,500. Basham said the high rents are why apartments aren’t filling up faster.

“The stuff that’s being built right now is really targeting the very top of the renter’s pool,” Basham said. “The majority of the renters in L.A. are not going to be able to afford that.”

Now, up at the top of the story, they claimed all this slack occurred because of “market-rate housing construction.”

No. If your units are sitting empty, you aren’t building or offering at market-rates. You are at a price point above market-clearing rates, even in your segment of the market. And while they may be offering breaks on parking and rent, it’s a long ways down from $2500 to “affordability.”

Rents in this case will be sticky downwards for some time. You aren’t supposed to use the word “sticky” in a neoclassical world because as we (supposedly) know, Keynes was wrong about everything and Hayek was (supposedly) right, but I like the term and I think it’s a very good descriptor for why prices don’t adjust quickly, for a variety of reasons.

1. Information problems among both producers and consumers. Industry reports and forecasts like that reported in the story help producers figure out the lay of the land, but it’s really hard to know you’ve hit slack in the market until, collectively, landlords and builders have overbuilt/oversupplied a bit. It’s easy to see an inflection point in optimization graphed out; it’s hard to see it in the real world where you (and everybody else) is optimizing individually and watching everybody else and the market in your peripheral vision. You might think for awhile that you are alone in having some empty units, that you are just being unlucky in attracting people, or that your marketing is just missing the right eyeballs…until it becomes apparent that other people are in the same situation. Minimizing these information problems is a competitive advantage if you can do it.

It also can take renters awhile to get the message that rents in a particular area may be coming to within their range, or that a particular area is really desirable.

2. Gambles against loss-taking. When you pencilled out the project figuring $2500 rents and renters’/homeowners’ associations that could handle that rent and all the trimmings that are required to attract people at that income point, it’s a hard to pill to swallow that you are going to have to come down, and depending on how well-capitalized you are and how you read future markets, you may be willing to sit on some empty units for what you think is going to be “a bit” rather than lock yourself into year-long leases below what you pencilled. Since base rents, like salaries, may determine much about the income stream for the property over time, this gamble is not necessarily irrational.

3. Real potentials for loss-taking if renters are locked in and you have to offload the property. Many of these luxury units are predicated on pretty high maintenance bills for amenities, like swimming pools, that are really, hard to support with people who can’t afford premium rents. Lowering the average income of the residents is a great way to wind up with a bunch of renters that lead to lower levels of maintenance than you need, which can pretty quickly turn your nice, renovated building into a much less shiney version of itself, and by the way, if you want to buy the building, it’s going to come with a bunch of renters you will have to find a way to get rid of, or a bunch of maintainance headaches you will have to resolve with the renters you’ve got. It may be much, much smarter for a developer or owner to keep those units empty and attempt to sell the newly renovated building rather than go lower on their targeted renter profile.

4. Meanwhile, the land underneath the buildings is still appreciating a lovely rate due to urban productivity spillovers. And while that’s not as nice as having both speculative gains and streams of rental income, it does provide an asset cushion for you to hold out longer against lowering your rents. The same land speculation gains that we’re always yelling at homeowners occurs for everybody, not just single-family homeowners, and there are plenty of well-capitalized landowners who can just sit on relatively empty buildings (just like those dudes hanging onto parking lots) and still not lose the shirt entirely.