Low interest rates should drive lower rents — But not in hot Chicago nieghborhoods

By Katie Murar

The Federal Reserve backed away from an April rate hike, meaning there’s still time for consumers to take advantage of low borrowing costs.

With the benchmark level for interest rates remaining between 0.25 and 0.5 percent, individuals can expect the cost of homeownership to stay low along with rental prices. But this is not true in Chicago, where a hot rental market in Logan  Square, Avondale and other neighborhoods are driving up prices to historic levels.

The Federal Reserve hinted it would raise interest rates twice this year. Yet a decision with the power to raise rents, impact home buying and influence millions of consumers is mired in uncertainty, and never set in stone.

The decisions the Fed makes reflect their opinion on how the economy is functioning, so all eyes are on the next move they will make regarding interest rates. That will be decided during the next meetings of the Federal Open Market Committee—a 12-member board that will convene again June 14-15.

Interest rates most directly affect the cost of homeownership through mortgages, which can be fixed for the life of the mortgage. Rental prices are much more susceptible to change, as they are usually renegotiated on a per-year basis.

Despite the seemingly complex topic of interest rates, monetary policy is much simpler when viewed from a household level, according to Ben Keys, an assistant professor at the Harris School of Public Policy at the University of Chicago and former economist for the Federal Reserve board.

“The basic concepts that drill down to a household level are much more approachable when you start to think about borrowing,” Keys said. “So when you start thinking about how you’re going to pay for a car or a house, you have to think about interest rates, which affects the cost of borrowing.”

These concepts are especially relevant to millennials—individuals born between the years of 1980 and 1995— a key group to be borrowing and not saving as they consider transactions such as purchasing a car or a home.

“For a lot of 20-somethings, their incomes are going to grow over the next years and decades and so this is a time in their lives when it is natural to be borrowing,” Keys said. “With lower interest rates, borrowing is cheaper.”

Interest rates most directly affect the cost of home-ownership through mortgages, yet interest rates have an indirect affect on rental prices. According to Keys, rent is affected by interest rates in three ways.

Outside Option of Home Ownership

The first way they affect rental prices is that low rates make  home ownership more affordable.

“When interest rates are low, more families will choose to buy homes which means you’re going to see more availability in rental markets,” Keys said.

With added availability in rental markets, there will be less of an upward pressure on rent, which goes back to the basic theory of supply and demand. And with more people fleeing the city to the suburbs, because they can profit from a cheaper mortgage, then there will be less of a demand for rentals in the city.

Inflation

The second impact is through inflation. When interest rates are low, the Fed is encouraging people to spend rather than save, which puts more pressure on firms to produce goods—cue worry over inflationary pressures.

“Interest rates are partly being kept low because we haven’t seen a lot of inflation and we haven’t seen a lot of wage pressure,” Keys said. “So what a lot of people are looking out for is when are prices going to start to rise? And one of the places where we might see prices start to rise is through rents. So if the fed continues to pump money into the economy for too long, then we worry that that is going to lead to inflation, and renters are especially sensitive to inflation.”

Construction

The third and final way the Fed affect rents is through construction, which is bolstered by low interest rates.

“When interest rates are low, it is cheaper to build more buildings, so this is a time when developers are going to be more active and invest in increasing the supply of apartment buildings,” Keys said. “With more construction, more available units come on the market, and you’d expect that to put downward pressure on rents.”

Chicago is indeed seeing a construction boom across the city, though that is doing nothing to help the city-wide surge in rental prices. According to Keys, this is a formula that disproportionately benefits developers to rent-payers.

“If you think about this from the standpoint of a housing developer, this is the time to build because the rents they are going to recover are going to be greater than your construction costs,” Keys said. “This has been, and will continue to drive construction in Chicago.”

Median Home Prices 2012-2016

So, with construction increasing the supply of apartments in the city, why is rent so expensive? Because people will pay for it, essentially.

“If demand for housing goes up, as we have seen in Chicago, then you should see more construction, as well as rent increasing at the same time, because it’s clear that people will pay for it,” said Charles Nathanson, an assistant professor of finance at the Kellogg School of Management at Northwestern University. “If demand goes up, then price and quantity will go up as well.”

Alex Grand, a Chicago real estate agent and landlord, said he has noticed a dramatic surge in construction in the past six months and an increase in rental prices across the city.

“Rent has been increasing significantly over the past few years, which, in my opinion, is finally driving developers to build large buildings that you are seeing now in West Town, Wicker Park and Logan Square,” Grand said. “I think the rent increases are driven by people wanting to live in certain areas, and there being a limited amount of those places. Hence, the new construction.”

A June 2015 study released by rental agency Domu examined the average increase in rents of 2-bedroom apartments per year from 2012 to 2015. The report found that rents have been increasing steadily in almost every neighborhood since 2012, and rents in some of Chicago’s Northwest and West Side neighborhoods, including Logan Square, Avondale and Wicker Park, increased quicker than rents on the North Side. Avondale saw the biggest surge, with an average increase of 11.6 percent per year, while Logan Square and Wicker Park increased by 9.9 percent and 9.1 percent, respectively.

In just the past six months, rents for one-bedroom units in Chicago have increased by $54, or 3.1 percent, and two bedroom apartments have increased by $69, also 3.1 percent, according to Rent Jungle.

The rising rents will only lead to more construction as interest rates are low, Keys notes.

“We’ve sort of recovered from the recession in a lot of neighborhoods, and in those neighborhoods we’re going to see an increase in construction while interest rates are low,” Keys said. “Certainly were going to see more stories about Logan Square redeveloping at a very accelerated pace, which may be partly due to low interest rates.”

Although construction, bolstered by low interest rates, should free up new spaces and push rents down, this won’t be the case in Chicago where its residents are willing to pay higher rents.  But higher interest rates could change the game.

What’s up with the Fed?

The Federal Reserve has become increasingly transparent over the years, with current Chair Janet Yellen holding press conferences after FOMC meetings to discuss whether interest rates will be lowered, raised or maintained. Yet there is no clear formula that helps consumers understand those decisions.

“Even among academic economists, I think there are quite a few people who don’t quite understand what the Federal Reserve does,” said Keys. “Certainly the Fed is shrouded in mystique, and some of that was very much self-cultivated for a long time. For a while, the Fed really believed that a lack of transparency was a good thing, and the more opaque they were, the more power they had to move markets.”

The FOMC includes seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who rotate terms on the committee each year.

In order to make a decision on whether to change interest rates, the FOMC “reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals of price stability and sustainable economic growth,” according to its website.

When the economy is in trouble, the Fed lowers interest rates to encourage borrowing and spending. When the economy gets too heated, the Fed will similarly increase the benchmark rate to cool off inflationary pressures.

As the U.S. economy crashed in 2008, the Fed brought interest rates to super-low levels—about 0.25 percent—and held them there for years. Finally, after signs of solid economic growth, the Fed raised rates by 25 basis points in December to 0.5 percent.

To make their decisions, the Fed monitors the inflation and unemployment rate, labor market conditions, and global economies. Currently, inflation rates are about zero percent, and interest rates will probably be kept fairly low until inflation increases to the Fed’s target of 2 percent, but we will just have to wait and see.

Photo at top: Logan Square is seeing an increase in construction, including new luxury apartment installation “L”. (Katie Murar/MEDILL)