Rental Housing Policy Strategies and Best Practices for Emerging Markets

1
Rental Housing Policy Strategies and Best
Practices for Emerging Markets
International Housing Finance Course Wharton
School, Philadelphia June 2007
Hans-Joachim Dьbel, Finpolconsult
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Preface Why Rental Housing?
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Demand Factors Shelter for the Young, the
Mobile, the Poor Access to Finance
Observations

• 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.

Share of Young Households Living in Private
Rental Units, - Six Transition Countries
Source World Bank study Dьbel/Brzeski/Ellen
Hamilton, LSMS dataset
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Supply Factors City Structures Infrastructure
Policies, Coordination Issues

• 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?

Building Density and Tenure Structure in EU
Countries and the United States, ca 2004
Sources Statistics on Housing in the European
Union, U.S. government sources.
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Rental Sector Development Issues Overall
Strategy
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Rental Sector Issue Hierarchy definesStrategy
Scope Sequencing

• 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.

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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

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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.

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Who lives in Rent Controlled Units? Poor and Rich
alike! Prague/Czech Republic
?Distribution of rent advantages even more biased
towards high-income.
Source Sunega, Karls University Prague, 2001.
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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 Dьbel/Finpolconsult, based on
USAID-sponsored Household Survey, 2006.
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Intergenerational Distortions from Rent Control
Ramallah, West Bank
Rents paid by households with their contracts
closed in year
Source Massar Associates (1998), based on 506
household interviews.
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Efficiency Rent Control Blocks Housing Demand,
Filtering Down of Housing Units
Source Dьbel
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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.

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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.

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Case Spain Treatment of OLD ContractsDe-Grandfat
hering

• 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.

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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.

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Rent Decontrol Process Visualization
Source Dьbel
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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.

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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.

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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

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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

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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.

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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).

Source Lex Mundi project (2000)

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

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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.

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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).

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Rental Investor Tax Situation Case Egypt
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.
Source Dьbel/Finpolconsult
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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 Dьbel/Finpolconsult
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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.

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

• Purchase in t0, sale in t21. 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.

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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 arms length collection (e.g. individual
  renting out single apt)
• Professional collection (like mortgage lender,
  can serve large apartment stock), usually
  combined with maintenance.

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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 cos)
• 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

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Rental Investors and Their Support Needs
Smaller landlords primarily mobilize existing
stock or build progressively different needs
from larger buy-and-hold investors.
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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).

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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.

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Public, Private or PPP Rental which route to
go for Poland?
Tenure Forms by Household Income Bracket
(Quintiles), Poland vs. Romania

• Rental in Poland is not marginalized as
  elsewhere, but also badly targeted.
• Cost rent system creates strong incentives for
  richer households to remain in public rental (in
  good locations).
• There are working management structures, but also
  problems.
• Non-profit system TBS caters middle class (new
  construction, leasing key monies)
• Gminas cater the low-income sector, developers
  push new (risky costly) PPP model
• Restitution created private rental, yet many poor
  private tenants that do not receive sufficient
  public assistance .

Source Duebel/Brzeski/Hamilton with LSMS data
Urban apartments only
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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.

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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.

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

• New public rental unit costs exceeding public
  rents by factor 4-5
• Rental allowances far more affordable option,
  including in non-rent controlled stock.

Source World Bank mission report by Dьbel
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Choice of Rental Subsidy Approach Avoiding
Poverty Traps

• 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.

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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.

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East Germany Housing Allowances do NOT Mean
that Rental Burden will not Change
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East Germany Housing Allowance Expenditures
during Shock Decontrol Phase
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East Germany Targeting Share of Households
with Housing Allowances by Quintile
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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.

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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).