In the aftermath of the Danish national election, the majority in favour of mark-to-market taxation could be crumbling. It is no secret that most players in the property market hope for exactly this outcome.
As it is, the combination of rising interest rates, high inflation and the possible introduction of mark-to-market taxation may well prove a toxic and very expensive cocktail in terms of property developments.
Profitable operations after debt servicing
First and foremost, rising interest rates spell tighter mortgage loan requirements. This is reflected in the so-called “critical rent”, a set of rules defined by the Danish FSA, stipulating how much rental income is required to cover interest, instalments and administration margins over a period of, say, 30 years for dwellings, given a fixed rate of interest, mind you.
As interest rates move higher, the share of financing coverable through property operations alone declines, in the process deteriorating financing options. This is illustrated in Figure 1.
Development schemes facing a challenge
High inflation and resulting price hikes on building materials are a source of grave concern among several developers. Newbuilding has become more expensive, with some developers facing growing demands for higher equity ratios. At the same time, ensuing financing requirements have tightened. This is the reality that many players currently deal with.
On the horizon looms the suggested introduction of mark-to-market taxation, and it remains unclear how this will be put into practice, if at all. Should mark-to-market taxation in fact be levied in the form of regular taxes payable every financial year, as opposed to being payable upon the sale of a given property or indirectly upon the sale of the propco, it will make life much more difficult for those who have started development schemes.
Equity financing requirements up by nearly 400%
The impact of higher interest rates and mark-to-market taxation in the real world becomes evident when looking at an example of a concrete development scheme, in this context rendered anonymous.
The cost of the development scheme is just shy of DKK 160 million, with the developer in this connection required to procure equity financing of nearly DKK 48 million, corresponding to 30%. An amount of DKK 16 million is injected in the form of equity, the remaining some DKK 32 million in the form of a loan provided by the group of owners.
On completion, the property is revalued at a market value of DKK 203 million, corresponding to a revaluation surplus of DKK 43 million, translating into mark-to-market taxation a little over DKK 9 million.
This means that the developer is required to pay taxes of DKK 9 million on top of building loan repayments.
Only a few months ago, this would not have been an issue, but due to rising interest rates and the “critical rent” rules, the developer will in connection with the scheme at hand only be eligible for a loan-to-value ratio of 54%, based on a 4% initial property yield, corresponding to DKK 110 million.
As shown in Figure 2, the developer will incur a DKK 11 million liquidity deficit when repaying the building loan and paying mark-to-market taxes, having taken out the largest loan possible with respect of “critical rent”. In the construction phase, the developer has made a capital injection in the amount of DKK 48 million and is now required to procure an additional DKK 11 million, bringing the total equity financing to DKK 59 million.
These calculations are very different from the calculations only a few months ago.
As shown in Figure 3, in January 2022, the developer was able to take out a mortgage loan with respect of “critical rent”, allowing for the repayment of the building loan, the financing of mark-to-market taxes and the repayment of the loan provided by the group of owners. In this scenario, the original capital injection of DKK 48 million has been reduced by just shy of DKK 32 million to DKK 16 million relative to the previous calculation example, where the corresponding figure was DKK 59 million.
Consequently, the developer is today faced with an equity financing requirement that exceeds the January 2022 requirement by 369%.
Potential housing shortage
The big question is if this really is the outcome that Danish politicians and Danish society ultimately hope for.
The short-term consequence is that many development plans fail. In today’s market, the supply of residential rental units in major towns and cities largely matches demand. However, the housing burden in the ownership housing market, that is, the cost of being a homeowner, has seen a sharp increase, driven mainly by rising interest rates. In a historical context, this has often caused a shift in favour of rental housing, all the while that continued population growth is forecast in major towns and cities.
How long will it be before we see a renewed housing shortage in major towns and cities, and who is to fill the gap if not property investors?
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