Europe’s housing challenge opens opportunity for investors
26 November 2019
Lars Flaoyen head of Real Estate Research, Europe, Aberdeen Standard Investments delves into the European rental and affordable housing market and where the investment opportunities lie.
With the level of new developments not matching the growth in demand for housing, house prices and rents have increased to levels that people on average salaries can’t afford. The rising cost of housing is creating cities where only the rich can live. A large proportion of workers, who are essential to the basic functioning of the city – such as police and fire officers, teachers and nurses – are being forced to move out. They are becoming regional commuters, which raises issues of socio-economic efficiency.
Europe’s housing problem has been caused by long-term growth in demand that has exceeded supply in major cities. Urbanisation is driving this growth and the trend is expected to continue. The reasons why supply has not kept up with demand are more complex: limited land availability, slow or opposing political processes, high construction costs, and construction capacity constraints are some of the factors. Construction activity has picked up in some cities in recent years. But activity has typically been focused on delivering higher-end owner-occupied housing where profits are higher, rather than more affordable housing to buy or rent.
Politicians across Europe are currently discussing various measures to fight this challenge, such as subsidised rents and developments, or more/less rent control. The recent introduction of a rental cap and freeze in Berlin has caused uncertainty among investors, but discussions regarding similar actions are now spreading to other cities and countries in Europe.
From an investor’s perspective, it’s easy to think that rent controls would be bad for investors as it reduces the short-term upside of frequent rent reviews. But this is only part of the story. There are actually benefits associated with rent controls – even from the landlord’s perspective.
Indeed, rent controls can actually be helpful for core, income-focused investment strategies. A long/indefinite lease with annual uplifts linked to a domestic inflation measure, gives tenants a more predictable housing cost. This means that tenants are less likely to move out. For the landlord, this usually means lower operating costs and less volatility for their net income stream. It also leads to lower fit-out costs as refurbishment isn’t required as frequently. In addition, more tenant protection encourages more people to rent instead of owning a house, which creates a larger investment market.
Only eight markets in Europe have a substantial track record of historic market performance through the MSCI index. By looking at performance since the indices were launched or over the last 15 years, there is no evidence that rent controls necessarily lead to a lower total return on investments. In fact, Sweden is the market with the most rent control, yet it has delivered the highest total return historically.
That said, a rent freeze similar to the one in Berlin is dramatic for investors, and sudden changes in legislation will have a negative short-term effect on values. But the standard practice in most European countries is for existing leases to be indexed annually to some form of local inflation. We would argue that for an investor looking for core, income-focused returns, a net yield of 3-4% (with an inflation-linked cash flow and very limited vacancy risk) is very attractive. European residential real estate can offer that if approached in the right way.
The UK residential market stands out from the rest of Europe when it comes to lease structures and tenant protection. Investors in UK residential are expressing concern that controlled rents are an unacceptable barrier to entry for them. But it is actually the short lease lengths and the frequent rent reviews to market level that make the UK stand out. This naturally leads to higher tenant turnover as tenants can’t afford to pay the frequent uplifts in a rising market.
The industry is missing an opportunity to create a long-term leasing convention suited to all parties and one that is prevalent in many countries across Europe. The removal of uncertainty for the tenant and landlord should be an attractive proposition for the UK authorities to explore, especially where the tenant retains the ability to serve notice to the landlord if their circumstances change.
Whether rent regulation can fix the affordable housing challenge in Europe is a complex question. In order to work, the regulation needs to be fair and consistent. If it isn’t, it will discourage investors and developers from investing in the sector, and the fundamental problem of undersupply will just get worse. Rental regulation needs to be combined with measures that stimulate the supply of more affordable housing in order to tackle the underlying problem.
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