High home prices jack up rents

In traditional economic thinking, the interaction an independently determined supply and demand for rental housing set the market rental price.

But that simplification ignores an important part of the story—where does demand, or the willingness to pay for rent, come from?

It might help to start thinking about a different product to clarify my point. Consider that you need some fruit and the prices per kilogram are as follows:
Apples - $5
Pears - $4
Bananas - $3

The demand for apples will be quite low since the close substitute goods have a lower price. Now consider this situation:
Apples - $5
Pears - $7
Bananas - $6

What does the demand for apples look like now? The demand for apples will be higher since the price of substitutes has risen.

This is basic microeconomics, right? The demand for a good rises if the price of substitute goods rise, and vice-versa. High priced substitutes mean that each buyer will have a higher willingness to pay.

So now let’s talk about housing. There are roughly three goods in this market—buying, private renting, and social/public renting. If the price of one of these substitutes rises (or their accessibility diminishes due to queueing) so should the demand for the others.

What this means is that even though rental prices are a better indicator of the supply and demand interaction in the housing market than home prices, the demand curve that determines the rental price itself shifts with home prices. The demand curve in the rental market is not independent of the price (or cost) of home-buying.

We can see a pattern in some markets, like the chart of Seattle below, where rising prices led to rising rents, then falling prices led to falling rents. 

While there are many other important interactions in housing markets, the substitute goods price effect is going to be part of the story. 

It is also a helpful guide for thinking about housing policy.

To dampen housing demand (and therefore rental price) it pays to create a housing system with many substitute ways to access secure housing. A huge investment in social (below-market-priced) housing, for example, will provide a substitute option for many private renters. 

The effect of this investment will be larger than the number of people who take up the option. Many households who don’t end up in social housing will keep their bids for private rentals below the price of the social housing option, reducing prices in the private rental market as well.

I don't know how big this effect is. But even a 5% effect on the willingness to pay for private rental housing still equates to $2.5 billion in annual total rents paid by the 30% of households who rent.

In general, therefore, the more housing alternatives that exist, the more stable and low-priced the total housing system should be. Any substitution effect on demand from price changes in one housing market will have a lower effect on each other market.