Rental Housing Policy

Strategies and Best Practices for Emerging Markets

International Housing Finance Course

Wharton School, Philadelphia

June 2007

Hans-Joachim Dübel, Finpolconsult

Preface: Why Rental Housing?

Demand Factors – Shelter for the Young, the Mobile, the Poor & Access to Finance

The rental sector creates strong utility for specific groups.

Young households are the main private renter class (ownership ratios at retirement broadly similar);

Insufficient rental supply discourages mobility and encourages migration abroad (e.g. Romania).

Rental landlords provide implicit access to finance to the poor:

operate analogous to mortgage lenders (borrow short, lend long);

Rental = low-cost temporary tenure option (no downpayment, almost no transactions costs);

Self-targeting to the poor.Relative subsidies (owner-rental) have strong demand impact.

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

Total Starters Young families

Poland

Lithuania

Serbia

Russia

Armenia

Romania

Source: World Bank study Dübel/Brzeski/Ellen Hamilton, LSMS dataset

Observations Share of Young Households Living in Private Rental Units, %

- Six Transition Countries

Supply Factors – City Structures &Infrastructure Policies, Coordination Issues

Building Density and Tenure Structure in EU Countries and the United States, ca 2004

In the West, countries with dense cities and tight infrastructure policies feature a strong rental sectors, and vice versa.

US 1920/30s: Robert Moses & Levittowns determined homeownership ratio more decisively than FHA-Fannie Mae-System.

‘Italian’ city concept & greenbelt policies created dense rental cities in Europe (France, Germany, Russia).

Feedback effect on housing finance system: corporate (Germany) vs. retail (United States) finance dominance.

Yet, there are countries in Asia with high ownership ratios in multi-family stock (China, Korea).

At the same time, micro-privatization of apartment stock in transition countries largely failed (no maintenance)

What is the relevance of objective coordination problems vs. cultural issues?

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50

60

70

Irela

nd

United

Kingdom

Nether

lands

United

State

s

Denm

ark

France

Ger

man

y

Spain

Apartment & hostel buildings

Non owner-occupied tenure

Sources: Statistics on Housing in the European Union, U.S. government sources.

Rental Sector Development Issues & Overall Strategy

Rental Sector Issue Hierarchy definesStrategy Scope & Sequencing

Macro stability Tenant-landlord relations Land/lien registries Small investors PPP schemes

Rent (price) reform Condominium/co-op law Enforcement/eviction Corporate investors "Social housing"

Utilities reform Housing company law Conflict settlement Rental housing finance Affordability support

Interest rate policy Banking/securities law Banking/securities supervision Intermediaries/wholesale Debt markets

Gov credit policy Real estate taxation Housing comp supervision Property managers Equity markets

Establish PoliciesBuild legal & tax

frameworkBuild transactions

infrastructure Develop marketsDevelop institutions

Successful reformers (e.g. Poland, Spain, Colombia) have addressed the policy, legal & tax issues first. Note: Ill-designed policies can destroy rental sectors (e.g. rent controls)!!Next step is the development of transaction infrastructure and institutions capable to fund/risk manage and maintain rental properties properly. Note: rental investors take similar risks as mortgage lenders: borrow short, lend long!Public or PPP rental housing programs that develop the market should follow

after basic reform steps incentivizing the private sector, not as substitute! if there is evidence of failure of private or non-profit investors to deliver.

Our Focus Today: Issues & Best Practice Solutions in 4 Key Strategy Areas

1. Rational legal framework (legal formalization)

2. Rational tax treatment (economic formalization)

3. Sustainable & diversified investor & funding base,

efficient collection & maintenance (institutions)

4. Rental subsidies

1. Legal Framework

Rent decontrol Liberalization of new rental contracts; De-grandfathering strategy for old contracts.

Reformulation of rental law, tenant-landlord relations Definition of tenure forms and termination options; Rent setting & adjustment rules (‘soft’ rent controls); Contract enforcement options.

Conflict settlement, contract enforcement infrastructure.

Who lives in Rent Controlled Units? Poor and Rich alike! Prague/Czech Republic

Source: Sunega, Karls University Prague, 2001.

Distribution of rent advantages even more biased towards high-income.

Horizontal Equity and Rent Controls: Rent-to-Income Ratios in Cairo/Egypt

Rent-decontrolled tenants burden are between 4 and 16 times higher than rent-controlled tenants.

Source: Dübel/Finpolconsult, based on USAID-sponsored Household Survey, 2006.

Intergenerational Distortions from Rent Control: Ramallah, West Bank

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

< 100 JD 100 - 199 JD 200 - 299 JD 300 - 399 JD > 400 JD

< 1970

1970 - 1982

1983 - 1987

1988 - 1993

1994 - 1998

Source: Massar Associates (1998), based on 506 household interviews.

Rents paid by households with their contracts closed in year …

Efficiency: Rent Control Blocks Housing Demand, Filtering Down of Housing Units

Tenure demand

Mortgage UndistortedHomeownership subsidies relative

pricesFirst-time home

Private rental housingRent controls

Public rental housingRent subsidies

Subletting/informal

Rent free

Household income ~ age

Source: Dübel

Rent Decontrol Strategies

TYPICAL DECONTROL SITUATION:New contracts are fully liberalized (due to rental shortages); (Old) contracts closed prior to law grandfathered (bequeath often possible);In extreme cases whole building cohorts remain grandfathered (New York).

BEST PRACTICE:Move all contracts quickly to operating cost coverage (incl. necessary capital repairs);Condition right to bequeath to raise in rent to cost-covering levels, or at least significant rise;Further adjust rents gradually, with quid-pro-quos (higher rents against landlord investment);Identify and support needy tenants.

Case Spain: Treatment of NEW Contracts

- Fully liberalized in 1984 (BOYER DECREE); resulted in chaotic short-termism and high rents.

- In 1994 (URBAN TENANCY ACT) again soft re-controlled - Min tenure 5 years; - Rent adjustment follows Consumer Price Index; - Allowable rate increases after new investment defined

= MINIMUM of- (civil code interest rate +3%) * investment costs, - or 20%.

Case Spain: Treatment of OLD ContractsDe-Grandfathering

- 1984: limitation of subrogation- Subrogation INTERVIVOS – abolished;- Subrogation MORTIS CAUSA – kept, but limited to 2 generations.

- 1994: gradual recapturing of foregone inflation/depreciation charges for all OLD tenancies allowed according to a GRADUATED RENT INCREASE schedule.

- 1994 SPECIAL treatment for LOW-INCOME TENANTS:- Low-income tenants stay under rent control;- Landlords housing them are supported through tax deduction of

foregone depreciation.

NOTE: tax deduction only introduced in 2004, significant delay.

Cases Russia/Latvia/East Germany/Poland: Phased Decontrol Process

First phase: move existing contracts swiftly to operating cost coverage (incl. repairs);

Support tenants with excess burdens by rent allowances;

Second phase: quid-pro-quo further rent adjustments against landlord investments:

East Germany: assisted by soft modernization loans by public agency KfW and housing allowances.

Third phase: reference rate system or indexation.

Rent Decontrol Process Visualization

Source: Dübel

Rental Tenure and Termination Options

TYPICAL TENURE FORMS IN EMERGING MARKETS ‘Liberalized’ (e.g. Colombia).

1 year with symmetric termination options (landlord, tenant). Problem: creates short-termism (long-term demanders move to ownership) and price volatility

Analogy: adjustable-rate mortgage. Permanent tenancy (e.g. most transition countries);

Severely contrains landlord termination options, e.g. use by own children, redevelopment; breach of covenants & contract;

Rent adjustment rules – periodic and upon new investments – likely to cause mismatch with landlords;

Analogy: callable fixed-rate mortgage.ALTERNATIVE 3, 5 years default tenure is a reasonable middle ground (e.g. Russia):

Period long enough to provide certain tenure security (short of ownership); Short enough to deal with market risk and options purely contractually.

Analogy: roll-over short-term fixed rate mortgage.

Soft Rent Control Options: Reference Rate System

Reference rates derived by rent surveys Based on rental market surveys, CPI indexation only for updating Covers rental contracts closed in the last 4 years Generates average rents and confidence bands over an apartment

quality-size-location matrix.

Legal impact: rent surveys are the basis for usury legislation, replaces hard rent controls Rent level 20% above the upper band limit is considered usurious. Landlord may contest in court if he is able to prove that at least 3

typical units are priced at his ask rent level.

Market impact: reasonable rent definition changes with market conditions, with some lag (4 yrs); usury claims can be objectively benchmarked.

Costs: surveys are done every 4 years; alternative is expert rent survey.

Rent Survey Methodology – Locational Quality Map

Example of city of Berlin

3 classes:

- Red areas – high quality

- Orange areas – mid quality

- Yellow areas – low quality

Maps are provided online

Rent Survey - Typical Rent Matrix by Size/Amenities

Example of city of Hamburg

Mean and range of net rents (net of heating and operating costs), are provided by

- age class of building

- size of apartment

- amenities in the apartment (bath, central heating)

Individual assessments are provided online

Rent Adjustment after Investment – Options

Decision-making Law should provide tenants with rejection option for non-essential

investments: E.g. pure beautification of building

Smaller investment, major repair decision of landlord alone (e.g., elevator repair);

Major investments e.g. analogous to condominum laws, voting?Rent adjustment formulae: Max statutory interest rate, or market interest rate, TIMES investment

(minus subsidies); Amortization, e.g. 10 year schedule, of investment (smaller investments =

sunk). Increases beyond a certain threshold are usually capped by law (as

interest caps); exceptions can be made for major repairs.

Confict Settlement and Contract Enforcement

TYPICAL SITUATION IN EMERGING MARKETS: Disputes courts only; Eviction not practiced; Rental investment deterred.

BEST PRACTICES: Mediation as a low-cost mechanism

can settle smaller disputes, e.g. repairs, and declog court system;

Local gov housing offices (ideally those that do rent surveys) can offer independent opinions over usurious rent levels;

Substitute housing to cater for evicted tenants (private or public rental).

until completion ofservice of process

of trial of enforcement TOTAL

Egypt 7 180 45 232

Jordan 7 100 30 137Tunisia 3 28 2 33

Morocco 15 365 365 745

Duration in days..

Source: Lex Mundi project (2000)

Case: Morocco introduced mandatory pre-court mediation in commercial affairs. Colombia extra-judicial eviction orders possible.

2. Rental Housing Taxation

Tax system should be: Tenure neutral and otherwise non-distortive; Neutral among rental investor classes; Budgeted and transparent; Supportive to investment rather than confiscatory.

Relevant tax classes: Income tax; Capital gains tax; Property tax; Value-added tax.

Income Tax Treatment

SITUATION IN EMERGING MARKETS: Gross rental taxation system; No deduction for investment costs, or costs exceeding certain % of gross

rents; High levels of tax-informalities.

BEST PRACTICES: Make investment model of taxation available for individual landlords, I.e. Deduction of main expenses from income tax

maintenance; interest paid; economic depreciation.

Netting of losses from rental with other income, e.g. labour or business. Carrying forward of losses from rental to future incomes; Simple administration (may imply flat cost deductibles in certain cases).

Rental Investor Tax Situation: Case Egypt

Source: Dübel/Finpolconsult

50% of gross rent revenue is taxed at max 20% PIT = 10%; 10% of 15% of ‘assessed rental income’ = 1.5%; total = 11.5%;Rental investment taxed although initially loss-making;Structure works against leverage and reduces return on equity.

Investment Good Model for Rental – Basic Mechanics

Investment good model allows to deduct capital & maint costs;Actual losses can be deducted from other sources of income;Structure works in favor of leverage and higher return on equity.

Source: Dübel/Finpolconsult

Other Taxes

SITUATION IN EMERGING MARKETS High tax rates (property, capital gains tax, sales tax) Tax base loopholes (primary residence, units intended for children); Sometimes inconsistencies (value-added tax on rental income), definition

problems (commercial vs. residential). BEST PRACTICE Broaden tax base (including, in principle, primary residence); Lower tax rates For property transfer taxes: keep rates low to reduce loads of housing

investments vs. other investments For property taxes: burden on cash flow as gross rent taxation; tax deferral

model? For capital gains tax: floors of tax-free gains addressing inflation (cold

progression); For value-added tax: treat mortgage interest rates and rents similar.

Internal return of a new rental investment under different tax policy scenarios, Case Egypt

Purchase in t=0, sale in t=21. 20 years rental payment stream.

Long-term IRR rests on heavy assumptions (fixed rental growth, fixed interest rates), to be repeated with shorter terms, scenarios.

3. Sustainable & Diversified Investor & Collection Base

Who is the optimal rental investor? Equity investor with long-term savings (collection) horizon

E.g. savings for retirement: can be small individual, or large pension fund;

Investor with institutional social or non-profit agenda, e.g. funded by endowments;

NOT developers (short-term funding) Rents are usually fixed or slowly adjusting. A leveraged investor

needs to manage rent / interest rate mismatch and rent collection. Who is the optimal rental collector? Two models: At arm’s length collection (e.g. individual renting out single apt) Professional collection (like mortgage lender, can serve large

apartment stock), usually combined with maintenance.

Types of Rental Investors

TYPICAL SITUATION IN EMERGING MARKETS: Subsistence and small private landlord rental housing; Employer housing. Some (limited) public rental housing efforts (often failed).

MISSING INVESTOR AND COLLECTION AGENTS: Small businesses (10-50 units);

Supported by financing and risk management model (developing e.g. in Poland and Lithuania, UK buy-to-let market, Germany);

Institutional investors in housing (pension funds, insurance co’s); Non-profit housing associations, foundations and cooperatives:

Defined as risk-taking investors, not beneficiaries; Supported by financing and risk management model (e.g. Poland);

Property management companies (e.g. Poland). Also: PPP models between developers and public housing companies;

Rental Investors and Their Support Needs

Smaller landlords primarily mobilize existing stock or build progressively; different needs from larger buy-and-hold investors.

Public/Non-profit Rental Financing & Risk Management Models

Problems to solve: Matched, long-term financing source for housing companies or associations

which have difficulty to access the banking or capital markets. Transfer of market risk to capital markets, retained & manageable credit risk.

Models Single-tier: Council housing (identity of owner and financier); inefficient & risky. Two-tier:

Public soft loans or public co-financing with fully matched conditions (e.g. 10 year fixed-rate soft loan vs. 10 year fixed rent conditions);

Secondary market agency acting as conduit of MBS, or arranger, packager or guarantor of bond issues (e.g. Finland, United Kingdom);

Private secondary market with public agency acting as advisor, e.g. on asset-liability management; also private advisors/arrangers (e.g. Germany)

Sine-qua-non: create local housing companies, associations or other bankable owners of the housing stock (incorporation).

Two-Tier Model of Non-profit Rental Housing Finance – United Kingdom

First tier: Housing Associations.Second tier: The Housing Finance Company; initially direct (co-)financier, now administrator for securitization deals, bond and commercial paper arranger.

PPP for Rental Construction – Proposal for Poland

Developers builds into public-private SPV, which issues debt to commercial lenders and pays the developer.Local government services debt and purchases properties held by SPV in installments. Central government counter guarantee.

Problem: PPP (laws) usually foresee limiting government risk, yet in practice often shift risk to government.

4. Rental Subsidies

Direct assistance to support rental tenants may take three main forms:Allocation of (new) public rental unit;Rental allowances/vouchers in the private stock: to protect against rental shocks following decontrol; as permanent housing cost support for the poor,

elderly. Purchase of occupancy rights from the private rental stock (i.e. gov subsidizes rent temporarily)

Indirect assistance to landlords via soft funding, tax support.

Choice of Subsidy Approach in Rental – Vast Fiscal Cost Differences: Latvia 2005

Lat Santimesper annum per month

per sqm

Capital plus operating costs new unit (Riga)1080 180

Loan repricing to 5%

990 165

900 150

810 135 PotentialLoan repricing to 3% Subsidy

720 120 Range

Free market rents for existing units (Riga)

630 105

540 90

450 75

360 60

270 45 Public rent new construction (Riga)

180 30Public maintenance fees (Latvia)

90 15

2005 2006 2007 2008 2009 2010 2011 2012

New 60 SQM Unit @ LAT 350/sqm = LAT 21,000

Private sector rent ceilings (Latvia)

Source: World Bank mission report by Dübel

New public rental unit costs exceeding public rents by factor 4-5;

Rental allowances far more affordable option, including in non-rent controlled stock.

Choice of Rental Subsidy Approach – Avoiding Poverty Traps

Income aftertaxes/transfers

Poverty trap

Excessive

housingallowance

allocation ofnew unit

Incentive-compatible

Pre-tax income

Do not house poor people in new units!

Do not limit the housing cost to income ratio at low levels

Do cap absolute housing costs in a rental allowance system.

combine income and housing cost ceilings.

Rental Allowances

TYPICAL SITUATION IN EMERGING MARKETS: There is a social allowance system in some rudimentary form (welfare); System collects targeting information that could be used for housing.

BEST PRACTICES: Targeting via unified system, local government level control; Applicable rents to be capped to avoid poverty traps and excessive fiscal

costs.

CASES: Latvia, Poland introduced rental allowance systems; East Germany used rental allowances to absorb payment shocks as rents

were massively decontrolled.

East Germany – Housing Allowances do NOT Mean that Rental Burden will not Change

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1st quintile 2nd quintile 3rd quintile 4th quintile 5th quintile

East 1994

East 1998

West 1998

East Germany – Housing Allowance Expenditures during Shock Decontrol Phase

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1991 1992 1993 1994 1995 1996

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Housing allowanceexpenditures, l.h.s.

Share of recipient households,r.h.s.

East Germany – Targeting: Share of Households with Housing Allowances by Quintile

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45

1st quintile 2nd quintile 3rd quintile 4th quintile 5th quintile

East 1994

East 1998

West 1998

Occupancy Rights for Social Tenants

TYPICAL SITUATION IN EMERGING MARKETS: Housing programs limited to new housing provision. Alternative: creation of housing solutions for the poor.

BEST PRACTICES: Existing housing stock provides much cheaper rental solutions

than new housing; Needs combination with eviction protection (e.g. to mobilize units

built for later use by children); Occupancy rights will be limited in time (3, 5, 10 years); landlord

can choose among a choice of tenants offered by local government;

Local government will top-up affordable rent level; collection by landlord.

Should Rental Investors Receive Tax Subsidies?

US Low-Income Housing Tax Credit System: Swap 10 year-tax credit against

30 year commitment to house x% low-income tenants.

Make tax credits tradeable in order to expand investor base.

Problems: New & high standard housing

unaffordable for the poor additional subsidies

Tax subsidies not under direct control of subsidy provider (state).