The high rents that Jack built

This article originally appeared in the Sunday Business Post on the 24th of January.

Jacking up rents quickly is a process that can’t occur now since new legislation was pushed through last December. But the question is: who jacks up rents and why?

Empirically, the market is full of amateur landlords, but are they the only ones who want higher rents? And why is it that Real Estate Investment Trusts (REIT’s) said the rent control idea wasn’t so bad, given they are large buyers in the market? Is that counter-intuitive?

To an extent, listening to Reits on matters of residential property is like listening to big tobacco on matters of health, but I’ll qualify that statement.

Firstly, one of the rules is that rents cannot be increased unless there is significant improvement to the property. This has already been a trend established by wholesale purchasers. They buy a building and ‘re-profile’ it, which really means ‘increase the rents’.

They can still do this every 12 months because part of their agenda in the purchase is to make some improvements. This may be fixing the lift or painting common areas, but it is documented and the return on the work done can be very high, compared to the actual cost of doing said works.

Then there is the ‘long game’ strategy at play. Reits and many wholesale buyers don’t pay capital gains tax or even tax on rents, so a lower yield to them can have a much higher impact than it would on a regular buyer. But the true power comes when you look at where yields were versus what has been happening. Imagine you are a fund. You bought a block of 100 apartments for €15 million several years ago and it was bringing in a 9 per cent yield or €1.35 million at the time (not uncommon four or five years ago). In the meantime, rents increased by about 30 per cent, so you are now getting €1.755 million a year in gross rents which equates to about €1,465 a month per apartment.

Simultaneously, a world of near-zero returns means that more money will flow into paper assets and property. This is largely the result of the success of the European Central Bank policy of zero interest rates. It drives up prices and yields start to drop even though rents are rising.

You start to witness a phenomenon known as ‘yield compression’ which occurs when the equivalent yield of a property decreases measured in basis points. In simple terms, it means that people will pay a higher price for a lower yield and it affects the known return in an asset class.This happens in property and in the bond market or any market where there is a strong relationship with a capital value and a yield.

A quick recap: the initial buyer bought for €1.35 million with a 9 per cent yield. Their ‘current yield’ is actually closer to 12 per cent at €1.755 million but they want to sell because the gain is getting larger due to the yield compression we just mentioned. Fast forward a few years and other funds are on the market and willing to buy a yield which equates to about 5 per cent.

They don’t mind because they also reckon (rightly or wrongly) that there may be more upside to rental yields in the future, or they have favourable tax treatment, or they are just happier getting more than ‘zero or less’ which you get on a lot of European sovereign debt at the moment.

The €1.755 million represents 5 per cent of the price, which by grossing up we see is €35.1 million. This is more than twice the amount the property was bought for. It’s a 135 per cent gain on the initial outlay and that’s before factoring in the 9-12 per cent return that the fund got every year the property was held. Assuming they managed to at least break even (and if that’s all they did, all management should be fired), it is the same as getting an annual return of 18.5 per cent a year on a compounded basis. That last sentence tells you all you need to know. There is no market on this earth, save perhaps in Ireland, that investors are walking away with an 18.5 per cent compound growth rate.

Even the ‘paper asset sellers’, who often talk property down, can’t compete during the same period, despite the S&P500 having a blockbuster year in 2013 of over 32 per cent growth, and where three of the five years saw growth in strong double digits. Taken over the same period (2011 to 2015), the S&P500 returned compound annual growth, including dividends, of 12.5 per cent.

This ought to make it clear to anybody with a modicum of numerical comprehension that funds had a well thought-out entry game and equally they are capitalising on a well thought-out exit game, apart from those that may have a long-term agenda – which oddly brings us back to some of those same Reits again.

Let me be clear: I love the idea of Reits. They are vital. But what nobody seems to realise is that the massive wealth creation I just described has occurred in spite of the rules we had or the rules we might make. And in a roundabout way, all of this wealth will accrue to those who own property – which is little comfort for those on the outside hoping to get in. The prices and stakes are very high indeed.

Karl Deeter is compliance manager at Follow him on Twitter: @karldeeter

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