Free Markets and Berlin Housing

Some regular readers may know I'm a fan of a free market.

Free Markets

That's to say: When someone buys something, and someone else correspondingly sells, it should be a free exchange. Both parties are convinced that they would rather buy / sell than remain as they are. Which means the price is whatever price is fair and agreeable to both parties.

I think it is harmful if the state interferes and tries to control prices on things.

Sometimes, it is argued that the state should intervene, usually to keep prices lower. The motivation is noble: We wish to help the poor by giving them access to cheap goods and services. However the reverse usually happens. Say someone has a business making widgets, and they cost £10 to make with their current equipment. They can sell them for £15, which gives them the income they need to feed themselves and their family. If the state says that, henceforth, widgets must sell for no more than £12, the widget-maker may close his business because he cannot run it profitably. He will (hopefully) find other employment. If not, he and any staff will be without work, which means more unemployed people, and more poverty not less. As to the others, who had been hoping to obtain widgets for £12, they can if they can find someone still making them. Supply will be short, and they'll end up rationed as to how many widgets they may have, or they may have to queue.

The aim of alleviating poverty failed. Instead, the widget maker could have been free to keep selling for £15. Those without sufficient money would have to buy fewer widgets, but the business stays up and running, and maybe even grows. Let's say he finds a way to make them for £9. He then has an extra £1 per widget sold. That could be used to employ additional staff, which gets those staff into employment; £1 of each widget sold is not pure profit being greedily hoarded by the business owner, but is actually directly helping someone out who would otherwise have no work. In time, with more staff, the business may find economies of scale to make widgets for £7; they now cost £3 less to make than earlier, which means they can indeed sell for £12. This point has been reached because the business owner has been free to develop their business to the point where £12 is a free and fair price. Now, the £12 price point is sustainable.

Some may remember that this was one cause of food shortages and long queues in Soviet-era Russia.

That's all by way of introduction. Today, we meet a classic illustration of this, the housing market in Berlin

Berlin Housing Reforms

Phoenix Spree Deutschland (code: PSDL) is a company that invests long term in the mid-market segment of German residential property.

Today, they released their interim results for the 6 months ending 30th June 2019.

There are some reforms going through the legislative process that affect the rental market in Berlin. The company explains the background and the key proposals very helpfully.

The rest of this section is quoted directly from their interim results release statement:

Backdrop

During the past decade, Berlin's economy has flourished and this economic renaissance has been supported by high levels of net inward migration. Between 2013 and 2017, the number of inhabitants grew by between 40,000 and 60,000 per year, increasing by a further 31,000 in 2018. Currently, the City of Berlin estimates the requirement for new housing will be 194,000 units by 2030, and that over 20,000 new housing units will need to be constructed annually to satisfy demand. However, in recent years, the number of building permits and completions has fallen well short of this target and it remains the case that the cost of new-build generally exceeds the cost of acquiring existing rental stock.

It is against this demographic backdrop that the new Berlin rental laws have been proposed. These rules seek to address the effects of housing shortage rather than addressing the cause. PSD believes that the long-term solution to the housing shortage and rent-price inflation lies with incentivising increased supply, which the current proposals fail to address.

Outline of the proposed new rules

The key elements of the new proposals as currently drafted are as follows:

• for new leases, a range of upper limits or "Permissible Rents" or "Permissible Level" depending on building age, rather than location or condition
• any in-place rent above this level is frozen for five years
• provided that the Permissible Level is not exceeded, annual rent increases of 1.3% are allowed and the Permissible Level could be raised to take into account annual price inflation
• the Permissible Rent limits can be increased by up to €1.40 per sqm if the apartment has been modernised during the last 15 years
• rental uplifts on future modernisations are limited to €1.00 per sqm
• the rent cap rules also apply to furnished apartments
• for existing tenants, any rent over the Permissible Level can be lowered, subject to appeal, if the tenant can demonstrate that their in-place rent is more than 30% of net household income
• for existing tenants applying for relief under the 30% rule, the rent cap is subject to the size of the property, limiting any reduction to a specified square meterage linked to individual household size
• properties built after 2014 are excluded from these proposals.

Effects of these Reforms

What impact will doing this have on the housing market in Berlin? The aim is to make accommodation more affordable. However, those who followed the more general argument above in favour of a free market will know that this is not what will happen.

Phoenix Spree articulate how this will likely work out with a clarity I could not match, so the reason behind this blog post is to take the chance to quote them.

Likely impact of the new rules on the Berlin rental market

There is a significant body of evidence from other markets, including Stockholm, San Francisco and Vienna, that the effect of stringent rent controls which seek to limit rent levels to below those set by the market, has been to reduce the supply of quality rental property rather than grow it.

The impact in these markets has been:

• to reduce the construction of new-build rental apartments
• lower levels of tenant churn, which reduces choice for tenants
• an increase in the number of rental apartments sold to owner occupiers as condominiums
• a reduction in the existing stock of rental properties
• the creation of waiting lists for available rental properties
• rising demand for condominiums, short-term lets and illegal subletting as a direct consequence of a reduction of available rental stock

PSD believes that should the new Berlin rental regulations proceed, many of these themes will be repeated in Berlin. Developers could be reluctant to commit to new-build in an environment where future rental streams and returns are uncertain. Smaller landlords may seek to exit the housing market and sell apartments to owner occupiers, further reducing the supply of rental apartments. Property owners will also become reluctant to invest in the fabric of existing properties, resulting in an overall deterioration in the quality of housing stock at a time when the need for sustainable, environmentally friendly housing has become ever more apparent. The renovations, modernisations and improvements that have transformed the quality of housing stock in Berlin during the past decade were made possible because they were financially viable in an environment where rents for newly modernised apartments were set at free market levels.

As existing tenants realise that rent controls worsen rather than alleviate the housing shortage, it is likely that fewer properties will be returned to the rental market, further exacerbating the supply shortage. Meanwhile demand is forecast to continue to increase given continued expected inward migration to the City. This has the potential to discriminate against the most vulnerable tenants, an issue that has already been raised by Berlin's cooperative housing associations and municipal housing companies.

Faced with an acute shortage of rental accommodation, and with interest rates at or near record lows, demand for condominiums is likely to rise.

Impact of new rental laws for PSD

There remains considerable uncertainty surrounding the implementation of the proposed new rules. Moreover, likely tenant behaviour in the event the new rent proposals are introduced is difficult to predict. Given the possible range of outcomes, it is likely that PSD will be in a better position to assess accurately the impact of the proposed law on rental income by the middle of 2020. However, based on the proposals as they currently stand, the Property Advisor considers likely consequences are as follows:

• PSD will lose the ability to obtain step rents or Mietspiegel rent increases for over half of existing tenants
• the Permissible Rent will effectively cap rents for new lettings at levels below currently market levels, ending PSD''s ability to pursue its current reversionary rent strategy
• theoretically, most tenants who occupied their unit in the last three or four years will have an incentive to give notice and seek a cheaper apartment. However, the lack of available supply post the implementation of the new rules is likely to make this very difficult in practice
• tenants will be entitled to make an application to the District Office for a rent reduction in circumstances where their rent is above the Permissible Level and where net cold rent represents more than 30% of household net income. PSD has historically set stringent rent multiple limits for new tenants at the time of application, significantly reducing the risk of rent reduction claims. The fact that the amount of relief is limited by the size of the property further mitigates the impact.

In other words, to summarise in my own words, rental prices may indeed fall, but at what cost:

• A shortage of supply. Your rent will not be higher than the permissible level. That is if you can find a property to rent. Landlords will leave the rental market, and new landlords will think twice about entering it.
• So maybe more people will own their own property. Except that the current demand and under-supply of rental property will move to the sale market. House prices will go up, further encouraging landlords to sell their existing rental properties.
• At present, you can choose to live in a more expensive neighbourhood to be closer to work by paying more, or live further away and pay less. Landlords in more expensive areas will still have to pay more to buy properties to rent, but cannot charge more. So the loss of supply will be most severe in the more expensive areas. If you want to rent, it will need to be in the areas that are less desirable, whether or not that is where you wish to live.
• At present, landlords have an incentive to maintain and renovate properties to bring them up to modern standards. Going forwards, the extra income they would get from doing so will not cover the outlay for such works. So if you do live in rental property you can expect the landlord to keep on top of minimal and necessary maintenance, but not to do anything to improve the property.

It looks like there will be a legal challenge to these proposals, on the grounds that German Federal Law does not let an individual State pass laws that conflict with Federal Law. Let's hope this is successful, because what is clear is that those adversely affected by these proposals will be ordinary Berliners who rent their homes, the very people this muddle-headed legislation is aiming to help.