Europe’s housing conundrum: affordable residential for rent offers more than just socially responsible returns

By Alex Lund, CFA

November 1, 2023 15 Minute Read Time


As Europe emerges from a period of economic upheaval, the debate around the housing crisis continues to dominate headlines. While easing consumer prices and higher wages may suggest better times lay ahead for residents, Europe’s housing imbalance is now a permanent feature. Adding to the pressure, development activity has slowed in recent months, curbed by higher financing costs, build-cost inflation, and regulation uncertainty. At the same time, Europe’s urban household population is growing in absolute terms but shrinking in average size, placing an even higher burden on residential for rent in cities. This imbalance is almost certain to get worse before it gets better.

Investors are now in a unique position as we move into the next cycle and residential values adjust to the new interest rate environment. With insufficient public funding available to plug the supply gap on its own, more private capital is needed. But as the number of active institutional residential investors increases, are they looking to solve a housing conundrum or an investment one? Or can the residential for-rent sector deliver solutions to both?

From our analysis of performance metrics across different markets, rent levels, and residential types, we believe targeting more affordable rents not only means creating socially responsible housing for those who need it most, but offers long-term investors performance benefits through improved sustainable cash flows, and risk-adjusted returns.

The myth of rent regulation

Ask any investor about European residential markets and the topic of regulation pressures will undoubtedly come up. COVID-19 sparked a flurry of policy decisions enacted quickly that were designed to temporarily cap rents in the face of rising inflation. But long-term rent regulation is a fact of the market. With new lettings achieving rental increases of more than 7% year-on-year (Y-o-Y) across Europe, regulation is almost certain to increase further. Housing policy is unfortunately often based on four- to five-year political terms, rather than 10-year+ investment horizons. However, for the most part regulation is not a barrier to entry, rather a hurdle, that if consistent can be effectively priced in. Equally rent regulation over the long term does not mean giving up performance, it simply means managing it better over time.

Rental growth: London vs. German Big 4 (Y-o-Y%)

Figure 1

Source: PMA October 2023, CBRE Investment Management.
An easy way to illustrate this point is comparing rental performance of different European markets. The U.K. and Germany stand at almost opposite ends of the regulation spectrum, the former operating on an entirely free market basis, the latter with rents linked to a specific Mietspiegel (rent) index for each city. While U.K. landlords are free to negotiate rents up in heated markets, they can be similarly penalized in periods of distress. Regulated German markets by comparison have offered a much more stable rent profile, achieving fairly consistent growth throughout cycles. Taken together, the cumulative growth since 2015 for the U.K. and German Big 4 markets was 45% and 43% respectively.

This pattern is replicated elsewhere in Europe. Finland’s liberalized rental market delivered periods of high single digit growth but also distressed years at zero or negative growth. In neighboring Sweden by comparison, rents are heavily regulated by a national index, but typically outperform inflation and have never turned negative. The result is that over the last two decades, these two markets achieved almost equivalent growth in rents.

Rental growth vs. volatility

Figure 2

Source: Newsec Q2 2023, PMA October 2023, CBRE Investment Management.
In both examples, the liberalized markets showed only marginal outperformance, but for three times the level of volatility. The notion that free market conditions means instantly higher performance is not necessarily accurate then over the long term, with rent volatility being a sizable factor in investment returns. While markets with tenant-friendly regulation can often mean growth on a year-to-year basis is lower, they generally offer growth which is more consistent and predictable. For investors looking for steady income, this clearly has its benefits. But equally for those looking to diversify their portfolio, the lack of correlation between highly regulated and unregulated markets creates additional qualities.

Affordable rents often come with consumer loyalty

It’s important to understand what drives these performance differences. Rental accommodation is ultimately a consumer product. If the tenant is happy, the landlord can also share in the benefits. Maximizing rents at turnover may drive short-term gains but does little to foster long-term sustainable growth or strong relationships with tenants. Creating affordable living space with deeper pools of loyal tenants, however, has multiple advantages. More affordable rents often mean longer tenancies. Longer tenancies mean lower void periods, turnover costs, and maintenance spend.

Lease lengths, for example, vary considerably depending on a renter’s age and life circumstance, but are also heavily dependent on regulation in each country. In markets like Germany, the Netherlands and Sweden, indefinite lease terms are standard market practice, with average lease lengths extending beyond seven years and typical annual turnover of tenants only 15%. In free market countries like the U.K. and Finland, or those with fixed lease terms such as France and Belgium, average tenancies are often shorter, at three years or less. Annual turnover can be as high as 30% - 40% in such markets.

U.K. residential: average length of term

Figure 3

Source: ONS 2022, CBRE Investment Management.
Differences in rent levels, product type and affordability will equally have an impact. In the U.K., 50% of private market renters have been in their current home for less than three years, with only 14% renting for over 10 years. This is almost directly inverse to renters in both the social and affordable sectors. More affordable or regulated rents are rewarded with residents that stay longer. This pattern also reflects that of ownership. As home ownership rates continue to structurally decline across Europe, we need to evolve our mind set—rental housing is increasingly becoming a long-term solution for accommodation, rather than a short-term stop gap.

How does this look in practice? A case study from the Netherlands

The Dutch residential market offers an interesting case study, with its points-based rental market creating different rental tiers and levels of regulation. Analyzing the official MSCI performance of these rent segments can show quite clearly the impact of holding more affordable housing in a portfolio.

Netherlands residential: vacancy

Figure 4

Source: MSCI July 2023, CBRE Investment Management.

Netherlands residential: operating costs (€ per sqm pa)

Figure 5

Source: MSCI July 2023, CBRE Investment Management.
Similar to the market level results above, rental growth in the two most affordable rent segments either matched or even outperformed the higher rented segments over 5-, 10-, and 20-year horizons, but with up to 50% less volatility. Vacancy rates were also substantially different across these rent segments. While most segments now record a vacancy of less than 2%, their historic track record proved substantially different, especially during periods of market distress. The Global Financial Crisis saw vacancy rates in higher-rented apartments rise to nearly 12% on average, with spikes in vacancy also recorded during COVID-19. Indeed, since 2000, the higher-rented apartments have had vacancy rates three times that of the most affordable units.

Comparing operating costs results in similar conclusions. While management and administration costs are broadly similar, letting, maintenance and other costs (comprised largely of vacancy and services) were almost 80% higher per sqm for the more expensive apartments. Rather than one- to two-year temporary apartments, the more affordable units saw lower turnover and lettings costs and a reduced need for costly services, resulting in lower overall costs for landlords.

Netherlands residential: does adding “affordable” residential to your portfolio improve your risk-adjusted return?

Figure 6

Source: MSCI July 2023, CBRE Investment Management.
The combination of all these factors—long term rental growth, volatility, vacancy, and operational income efficiencies—can have a considerable impact on investment returns. We ran a portfolio optimization test of historic total returns and volatility for each of the Dutch rent segments over the last 20 years. Based on this analysis, an investor which had a 100% exposure to the higher-rented apartments, could have consistently improved their risk-adjusted return (higher Sharpe ratio = higher risk adjusted return) for every 10% of the more affordable apartments they added to their portfolio.

Applying this to our underwriting models

Putting these concepts into practice, not all residential assets are the same with the potential for key metrics to be tweaked dependent on the product type. The two scenarios below illustrate how these metrics can impact future investment performance (we’ve excluded debt, transaction, or other fees for simplicity). Both scenarios show the same asset, one rented at a higher market rent of €320 per sqm pa, the second at a more affordable €250 per sqm pa (a -22% discount). Assuming a standard 65 sqm apartment, the rent to household disposable income ratio would be 42% and 33% respectively (based on median incomes across Europe).

Source: CBRE Investment Management, October 2023. GTN represents Gross to Net.
In the higher-rented scenario 1, we assume a higher vacancy given the likelihood of higher turnover in any given year, and with that higher maintenance and letting costs. Most prime BTR assets will also incorporate a large amount of services and amenities to entice tenants, some of which come at a premium to manage, with not all costs passed directly to the tenant. All in all, we’ve kept the difference in OPEX between the two scenarios similar to that shown in the MSCI Dutch example above. The result is a gross to net ratio of approximately 77% for scenario 1, versus an improved 83% for scenario 2. Also based on our analysis in this paper, we’ve assumed that over the long run, rental growth between the two assets would be broadly similar, at 50 basis points above inflation. In a market with stretched affordability, higher starting rents can actually often underperform, given the more limited upside.

This analysis shows that by investing in the higher-rented apartments, the projected IRR would achieve a small premium, but it would cost considerably more to maintain and operate. Given IRR projections assume cash flows are relatively smooth over time, rental and operational volatility is not typically accounted for. The certainty of achieving this performance is, therefore, also significantly lower. By comparison, the affordable scenario shows higher operating efficiencies, with a likely larger pool of tenant demand and lower vacancy. This scenario still generates an IRR of 6%+ but, in our opinion, with significantly less risk involved. At the end of the hold period, we are left with an asset which is still affordable to the median earner, adjusting for wage growth at 2% per annum, and in our view, more liquid given its income efficiencies and defensive track record.

Investors may choose more aggressive assumptions when underwriting assets, but our belief is that higher rents and rental growth are counterbalanced with higher vacancy and operating costs. For long-term investors looking at five to ten year horizons, there is also very little difference in absolute rental growth achieved, but significant differences in the risk required to get there. Slow and steady does often win the race. Ultimately, the elephant in the room for successfully achieving either of these scenarios will also reflect their energy performance and compliance with evolving regulations. With residents on lower and middle incomes undoubtedly most impacted by higher cost pressures, there is even more need for affordable housing landlords to drive energy efficiencies across their assets and reduce overall costs for their tenants.

The European BTR market offers a significant opportunity for investors to help fill the gap left by decades of underbuilding, and insufficient public sector funding. But there are many different forms of residential products that can help achieve this goal. While there’s a clear need for more affluent housing, we believe the bulk of BTR investing should cater to the mass market—providing long-term homes for everyday residents, rather than short term solutions for higher earners. In our opinion, affordable housing strategies can deliver solutions to both the housing conundrum and investors, providing steady, inflation-like incomes streams, with reduced volatility, while keeping rents affordable for average earners for the long term. We believe this is a fair trade-off.