In January 2020, a plan to amend section 5(2) of the Danish Housing Regulation Act received political backing. The measures are feared to have broader implications than intended, dampening investors’ appetite and incentive for investing in old-stock residential rental properties. In this article, we take a closer look at possible consequences, with specific focus on the residential investment property market.
The plan’s five key elements
In January 2020, after several months of uncertainty, political consensus was at long last achieved to amend section 5(2) of the Danish Housing Regulation Act to halt short-term property speculation and excessive rent hikes in old-stock private rental housing.
The five key elements of the plan, put together by the Social Democrat government, Danish People’s Party (Dansk Folkeparti), Socialist People’s Party (SF), the Red-Green Alliance (Enhedslisten) and The Alternative (Alternativet), are:
- A qualifying period – a five-year period – before a new owner of an old-stock residential rental property may raise the rent, charging utility value rent pursuant to section 5(2), when vacated lease units have been comprehensively modernised.
- A green incentive, making it possible for a new owner of an old-stock residential rental property to circumvent the qualifying period provided the property’s energy efficiency grade is raised by three grades or energy-efficiency measures are carried out in the amount of not less than DKK 3,000 per sq m.
- A green energy-efficiency requirement, making it possible to carry out extensive refurbishments of vacated lease units only when the property’s energy-efficiency grade has been raised to grade C or by two grades.
- Abolishment of the substantiality criterion applied when determining utility value.
- Strengthening the position of tenants in disputes with landlords, by empowering the housing rent tribunal and its involvement in the fixing of housing rent as well as in comprehensive modernisation schemes, including participation in pre- and post-modernisation viewings.
As the intention is not to erode cooperative housing values, the following specifications were added to the proposal submitted to consultation, with deadline on 20 March 2020:
- Valuations made by real estate appraisers may be nominally maintained. They will apply for an unlimited period of time, comprising valuations preceding the effective date of the Bill.
- A transition period is introduced, making it possible to factor already initiated conversion schemes into the valuations made by real estate appraisers.
- If applying the official valuation, cooperative housing societies are free to use older valuations for an unlimited period of time, for instance if such valuations are higher.
- The qualifying period is not to apply to the acquisition of cooperative housing societies and any subsequent resale of such converted properties.
- Legalisation of the normative rule prescribing an 80% majority vote to dissolve the society.
The possible implications of the new regulation and how it will affect the market have been the topic of much debate. The proposed measures will affect both tenants and landlords.
The proposed measures will predominantly work in favour of tenants as they will benefit from increased security, supported by a cap on increases in utility values following the abolishment of the substantiality criterion (item 4), the empowerment of the housing rent tribunal and higher penalties to landlords losing cases tried before a housing rent tribunal (item 5).
However, the measures will have negative bearing on the investment market, with investors that currently own old-stock residential rental properties bearing the brunt. The root cause is the uncertainty surrounding the future actions of the housing rent tribunals, the weight of energy-efficiency grading as well as the effects of the qualifying period, believed to reduce the market value of properties. The immediate market response is a substantial price correction. In addition, the ambiguous implications of the qualifying period for current and future owners may serve to drive a wedge between sellers and buyers.
Today’s housing market
In Denmark, the housing stock comprises approx 2.93 million dwellings, including approx 1.05 million rental units – both private and public. Some 800,000 (i.e. approx 27% of the Danish housing stock) are in major cities – Copenhagen, Frederiksberg, Aarhus, Odense and Aalborg – with rental housing accounting for approx 370,000. With a higher ratio of rental housing, approx 46%, compared to the overall housing stock, major cities, mainly those with a predominance of old-stock housing not subject to free market rent, will experience a dramatic market shift due to the amendment of section 5(2) of the Housing Regulation Act.
The housing market, i.e. the terms and rents applying to rental housing, is controlled by the Danish Lease Act and the Danish Housing Regulation Act, with the latter applying only in municipalities that have opted in.
Whereas the rent in new properties, i.e. properties occupied after 31 December 19921, is determined based on free market rent, the rent of older dwellings is determined based on the property’s required operating costs, a capital return as well as possible provisions for improvements (cost-regulated rent). However, lease units may become subject to rent based on utility value pursuant to section 5(2) of the Housing Regulation Act, provided they are comprehensively modernised when vacated by tenants.
Section 5(2) of the Housing Regulation Act was introduced in 1996, and, by extension, so was the special provision for determining the rent of lease units that have been comprehensively modernised. The objective of the provision was to incentivise private landlords to modernise old and functionally obsolete housing, thereby lifting the expenditure from the public domain. The incentive made it possible for landlords to modernise units as tenants moved out, subsequently charging a rent based on the utility rent principle – a rent which exceeds, but not substantially exceeds, the utility value of the lease premises, i.e. closer to market rent. “Substantially” in this context covers an estimation practice that several rulings have placed in the 10-15% range.
What is the immediate impact on the investment market?
An amendment of section 5(2) of the Housing Regulation Act will greatly affect the Danish letting market, in particular the investment market, as it will impact the underlying business plan on which investors base their investments in old-stock residential rental properties.
Investors’ appetite for investments in old-stock residential rental properties was healthy and becoming stronger in 2017 and 2018. The spate of acquisitions in the Danish market for old-stock residential rental housing, fronted by Blackstone, nurtured the common sentiment that the demand and business plan of certain investors hinged heavily on the current provisions of section 5(2) and ways to exploit them. As the debate grew louder, the investment market was gripped by an increasingly jittery sentiment, with investors discarding investments in old-stock residential properties on the grounds of insufficient clarity in terms of future regulations. The uncertainty peaked when an expert committee released a report on the scale and effect of applying section 5(2) and the consequences of its possible amendment. It is estimated that the uncertainty caused the number of transactions to drop by approx 80% in Denmark and by approx 85% in Copenhagen and Frederiksberg between 2018 and 2019.
Finally there was a major breakthrough when the Danish government submitted a Bill for first reading. Colliers believes that the Bill has calmed things down, but that the market needs time to settle. We still anticipate strong demand for old-stock residential properties, but hardly a great many actual transactions. Consequently, the initial response is expected to be a substantial price correction, which will be highly case-dependent, but the introduction of a qualifying period will also greatly curb transaction volume.
We believe that the qualifying period (item 1), a green energy-efficiency requirement (item 3) and the abolishment of the substantiality criterion (item 4) will be key determinants for future market conditions:
- More than anything, the qualifying period will affect investors’ business plans for investing in old-stock residential rental properties. Investors will be forced to postpone the refurbishment of vacant units and thereby profit-taking by charging rent based on utility value. From a buyer perspective, this means a sharp drop in the market value of the property, i.e. the estimated sales price of a property in an open market sale. As the qualifying period will apply only in the event of a change of property ownership, current owners are not affected. As a result, the qualifying period will clearly put two different value labels on the property, one for the buyer, another for the seller. This entails the risk that several transactions may never take place because the parties cannot reach an agreement.
- Based on the substantiality criterion, utility value has seen a higher rate of increase than the market rent of prime (first-rate) properties, with utility values therefore converging towards market rent levels. By abolishing the substantiality criterion, it is ensured that there is a cap on the rent charged in old-stock residential properties after modernisation. However, there is great uncertainty as to the future top rent level and how the housing rent tribunal will act, given that the tribunal by determining utility value will have a decisive say in this. Unlike the qualifying period, the abolishment of the substantiality criterion will affect both the seller and a prospective buyer of an old-stock residential rental property. We therefore expect this measure to give rise mainly to a price correction.
- Finally, a green energy-efficiency requirement will make several investors react too as a major price correction is looming ahead. This ties in with the fact that the immediate costs of lifting the energy-efficiency grade of a property from the currently required grade D to the new grade C required could well be enormous, in some instances entailing costly reconstruction, completely unjustifiable from an overall economic perspective, involving very heavy investments to achieve only moderately higher energy efficiency.
Prospects of a mismatch between sell-side and buy-side price expectations in terms of old-stock residential rental properties, held up against investors’ continued massive placement requirements and their substantial demand for residential market exposure, are expected to fuel the demand for other types of investment property in the residential segment. Colliers believes that the amendment may have a favourable spill-over effect on the market for new residential properties or cooperative housing.
Will cooperative housing go free?
The cooperative housing stock in major Danish cities, fronted by Copenhagen and Frederiksberg, greatly exceeds the average ratio of cooperative housing in Denmark in general. In major cities, cooperative housing accounts for approx 62% of the total cooperative housing stock in Denmark, whereas in Copenhagen and Frederiksberg alone the estimated share is approx 54% of the cooperative housing stock in Denmark. The latter figure means that approx 30% of the total Copenhagen and Frederiksberg housing stock or roughly 113,000 dwellings are cooperative housing units.
According to section 5(2)(b) of the Danish Cooperative Housing Act, cooperative housing may in the statement of the society’s assets be valued as rental property based on a valuation made by a real estate appraiser. In this case, cooperative housing units are valued based on the effective provisions for determining the value of rental properties. As a result, all five items of the proposed amendment, including the same elements of uncertainty, will apply to the valuation of cooperative housing units.
In the wake of the agreement made on 30 January 2020, which did not in detail describe how e.g. the qualifying period would affect cooperative housing, several property pundits and banks, including Jyske Bank and Nordea, predicted that housing cooperatives would incur substantial value losses as cooperative housing properties are valued along the same lines as rental housing. In response to the ensuing massive debate, the proposal submitted to consultation, with deadline on 20 March 2020, added a subsection 5 to section 5 of the Housing Regulation Act – addressing what was not specifically dealt with in the original proposal dated 30 January 2020.
(5). The following situations are not comprised by subsection 4:
(1) change of control due to hereditary succession or the Danish Inheritance Act;
(2) change of control due to one or multiple intra-group transactions;
(3) change of control due to the conversion of a cooperative housing society’s property into rental property and all subsequent resales, provided the cooperative housing society was established before the effective date of this Act.
This means that investors that buy converted cooperative housing properties (societies predating 1 July 2020) may start implementing their business plan on day 1, provided the property’s energy-efficiency grade is or is lifted to grade C or by two grades. This may spur demand for cooperative housing properties established before 1 July 2020. At which prices such properties will trade remains to be seen because it is still uncertain if an element of competition may arise, driving up prices to a level that offsets the value reduction resulting from stricter energy-efficiency requirements and the uncertainty surrounding the housing rent tribunals’ future determination of utility value.
Overall, the above confirms that there has been and is expected to remain some uncertainty about how several elements in the proposed amendment of section 5(2) will in fact affect the market. Due to a change in the basis of their business plan for investments in old-stock residential rental properties, investors are expected to zoom in on other subsegments of the investment market for residential and other types of property, which even with greater certainty about section 5(2) will slow activity in the market for old-stock residential rental properties in the longer term.