The yield on newly built rental properties - Does the investor require a risk premium

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DEGREE PROJECT

DEPARTMENT OF REAL ESTATE AND CONSTRUCTION MANAGEMENT REAL ESTATE ECONOMICS

MASTER OF SCIENCE, 30 CREDITS, SECOND LEVEL STOCKHOLM, SWEDEN 2020

The yield on newly built

rental properties - Does the investor require a risk premium

Sebastian Engsner & Joakim Signäs

TECHNOLOGY

DEPARTMENT OF REAL ESTATE AND CONSTRACTION MANAGEMENT ROYAL INSTITUTE OF TECHNOLOGY

DEPARTMENT OF REAL ESTATE AND CONSTRUCTION MANAGEMENT

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Master of Science thesis

Title

Author(s) Department

Master Thesis number Supervisor

Keywords

The yield on newly built

rental properties - Does the investor require a risk premium

Sebastian Engsner, Joakim Signäs

Real Estate and Construction Management TRITA-ABE-MBT-20556

Åke Gunnelin

Presumption rent, Rent control, Rental properties, Risk premium, Simulations

Abstract

In this thesis we have investigated if there is a risk premium on residential properties with presumption rent in comparison to the other two rental systems, individually-set rent and utility rent. The method chosen was a qualitative method and therefore six interviews were conducted with real estate professionals with at least ten years of experience, five real estate companies and one real estate consultancy company. From the interviews, evidence was found that there are pros and cons regarding the different Swedish rental systems and how it affects an investment on a property. However, investors seem to put more weight on initial rent levels and the expected rental growth. Vacancy risk is considered almost insignificant for investors due to the shortage in residential properties in Sweden. The analysis showed that the initial yield does differ between the rental systems. This is due to the difference in expected rental growth over the investment period.

For an investment of 20 years presumption rent is the best alternative. Risks were discussed in the interviews and that every risk associated with each rental system were considered in the calculation. According to the simulations, identified risks affect the calculation which adds a risk premium that should be taken into consideration by the investors.

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Acknowledgement

Without the scrutinizing of our thesis by our peer-reviewers, the adamant questioning of our research methods by our supervisor, and the helpful insights from our interviewees this thesis would not have been complete.

Therefor we want to show our appreciation without any specific order. A big thank you to our peer-reviewers Sofia Fjelkestam and Henrik Ek, our supervisor Åke Gunnelin, Bo Söderberg who gave us some initial insights and our interviewees who will remain anonymous.

Juni, 2020

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Examensarbete

Titel

Författare Institution

Examensarbete Master nivå Handledare

Nyckelord

Direktavkastningskrav på hyresfastigheter i nyproduktion – Kräver investeraren en riskkompensation

Sebastian Engsner, Joakim Signäs Fastigheter och byggande

TRITA-ABE-MBT-20556 Åke Gunnelin

Hyresfastigheter, Hyresreglering, Presumptionshyra, Riskkompensation, Simuleringar

Sammanfattning

I denna uppsats har vi undersökt om hyresfastigheter med presumptionshyra behöver en riskkompensation gentemot de två andra hyressystemen, bruksvärdeshyra och egensatt hyra.

Uppsatsen är en kvalitativ studie och sex intervjuer har genomförts, fem med fastighetsbolag och en men ett fastighetskonsultbolag. Från intervjuerna gick det att identifiera fördelar och nackdelar med det olika hyressystemet och hur de påverkar en fastighetsinvestering i en hyresfastighet. Från intervjuerna framgick att investerare förlitar sig mer på initiala hyresnivåer och förväntad hyrestillväxt under investeringsperioden. Vakansrisken anses vara mer eller mindre obetydlig för en fastighetsinvesterare givet dagens marknadsläge med den bostadsbrist som finns i Sverige.

Analysen påvisade att det finns en skillnad i direktavkastningskravet mellan de olika hyressystem.

Denna skillnad beror på skillnaden i förväntad hyrestillväxt över investeringsperioden. För en investering på 20 år är presumptionshyra det bästa alternativet då den får högst kalkylränta. Risker diskuterades i intervjuerna och varje risk förknippad med hyressystemen beaktades i kalkylerna.

Enligt simuleringarna påverkar de identifierade riskerna kalkylerna vilket adderar en riskpremie som bör beaktas av investerarna.

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Förord

Utan den noggranna granskning av våra opponenter, den hårda kritiken från vår handledare och de hjälpfulla insikter som våra respondenter bidrog med. Hade inte denna uppsats blivit till.

Således vill vi tacka dessa personer utan inbördes ordning. Ett stort tack till våra opponenter Sofia Fjelkestam och Henrik Ek, vår handledare Åke Gunnelin, Bo Söderberg som gav oss några initiala insikter samt våra respondenter som förblir anonyma.

Juni, 2020

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TABLE OF CONTENTS

11.Introduction ... 1

1.1 Problem statement ... 1

1.2 Purpose ... 2

1.3 Limitations and aim ... 2

1.4 Limitations due to COVID-19 ... 3

2 Literature review ... 4

2.1 Rent control ... 4

2.2 Housing shortage ... 5

2.3 Yields and its determinants ... 6

3 Swedish rental legislative ... 9

3.1 The Swedish rent control system ... 9

3.2 Utility value rent... 9

3.3 Presumption rent ... 11

3.3.1 Kap. 12. 55c§ Swedish Rental Legislation, Land Code ... 12

3.4 Individually-set rent ... 13

3.5 International perspective on rent control ... 13

4 Theoretical framework ... 15

4.1 Dividend discount model ... 15

4.1.1 Regarding real estate investing ... 15

5 Method ... 17

5.1 Research philosophy & strategy ... 17

5.2 Selection ... 17

5.3 Semi-structured interviews ... 18

5.4 Validity and reliability ... 19

5.5 Ethical consideration ... 20

5.5.1 In consideration to the semi-structured interviews ... 20

5.5.2 In consideration to work-affiliations ... 20

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6 Results ... 21

6.1 Swedish rental systems... 21

6.1.1 Utility Rent... 21

6.1.2 Presumption rent ... 21

6.1.3 Individually-set Rent ... 22

6.2 Yield and investment calculations... 23

7 Analysis... 25

7.1 In consideration to the result ... 25

7.2 Simulations ... 26

7.2.1 Assumptions and scenarios ... 26

7.2.2 Calculating the initial yield of the investment scenarios ... 28

7.2.3 Scenario analysis of presumption rent ... 28

7.2.4 Scenario analysis of individually-set rent with financial cut-back ... 29

7.2.5 Calculating the NPV for the different rental systems ... 30

7.2.6 Solving for discount rate ... 30

7.2.7 Sensitivity analysis regarding initial rent level ... 30

7.3 Reflection on identified risks ... 31

7.4 Reflection on low vacancy rates and its effect on the result. ... 31

8 Conclusion ... 33

8.1 How does an investor differentiate between the Swedish rental systems? ... 33

8.2 Does an investor differentiate between different rent systems when calculating the risk- premium? ... 33

8.3 Relevance of the findings ... 33

8.4 Speculate how research might be extended in the future ... 33

References ... 34

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Introduction

Sebastian Engsner, Joakim Signäs p. 1

1. INTRODUCTION 1.1 Problem statement

Globally, rent control has been around for many centuries and has since then gone through a series of changes to become the rent control system that is used today (Kemp, 2004). Sweden has rent control in all residential properties. The main reason it was introduced was to make housing affordable and to prevent the emigration to the United States. It also worked as a protected tenancy that prevented the landlord from rent gouging. The system that Sweden use today has existed since 1975 and is now also a sociological tool to prevent segregation (Boverket, 2009).

The housing shortage that exist is Sweden as of today has become a huge political debate. Even though this problem is well acknowledged, the construction of housing properties still remains insufficient, especially in relation to the population growth (Hansson, 2017). One of the main reasons for this inadequacy is that investors, lack incentive due to rent control. According to Arnott (1995) the rent control limits profitability. As a result, the government introduced a reform in 2006 with the purpose of stimulating the production of rental properties by increasing the profitability of investments (Boverket, 2014). This is today as presumption rent. However, according to Igarashi (1991), long run rent adjustments and vacancy rates are correlated, meaning that rents that are too high could lead to vacancy. Thus, with presumption rent the rent might become too high for any residential tenant to bear which could lead to vacancy. A recent study from SOU (2017) investigates the effect of housing construction in Sweden regarding presumption rents. The study states that presumption rents have been a contributor to increased housing construction, but it has some shortcomings. The current model does not allow base-rents to be increased under the presumption time of 15 years in consideration to renovation and improvements of apartments (12 kap. 18d§ JB). In addition, it does not allow rent increases due to new costs and fees (12 kap. 19§

JB). Yearly rent negotiations with the Swedish Union of Tenants (SUOT) seem to be one of the contributing factors to low adoption (SOU, 2017)

A report from SCB (2020) shows that only 26 000 out of roughly 1 500 000 apartments are vacant.

Of these 26 000, only 8 900 are available for lease, while the remaining apartments are under repair or reconstruction. In addition, 72% of the apartments available for lease are in municipalities with less than 75 000 inhabitants. Thus, true vacancy, apartments available for lease, in the larger municipalities is around 0,1%. Besides from the rent level, vacancy is one of the main factors affecting the net operating income of a real estate investment. Therefore, vacancy risk is considered one of the most important parameters when it comes to determining the risk premium (Amédée- Manesme & Barthélémy, 2018; Coën et al., 2018).

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Introduction

When investors consider an investment, they set a target for total return on capital, which is the required rate of return for the investment given the risk. The rate of return consists of the yield and the expected value growth. Thus, the yield is the target return from an investment and is determined by the risk-free rate, growth rate (inflation) and a risk premium (Lind, 2004). A research by Coën et al. (2018) identified that the vacancy rate was no longer significant for the risk premium in London office market, instead the risk premium was responsive to shocks to the money supply. In the current market condition, low bond yields (Trading Economics, 2020) have led to that institutional investors have changed their investment strategy to meet yield requirement. This means that institutional investors must consider riskier assets such as real estate to increase their risk-weighted portfolio returns (Jackwerth & Slavutskaya, 2016). Historically, Real Estate assets have had very low allocation by institutional investors (Lahey, et al., 2012; Jackwerth &

Slavutskaya, 2016). This behaviour will lead to a shock in money supply, and reduce the required rate of return for real estate assets. When considering real estate types, residential properties have the lowest yield, due to vacancy rate close to zero, and therefore is considered the most attractive asset for Institutional investors, who seek compensation for low bond yields (Bruggeman & Fisher, 2011).

All in all, it can be stated that numerous studies have been conducted which investigate the risk premium of housing properties, such as (Amédée-Manesme & Barthélémy, 2018; Arnott, 1995;

Coën et al., 2018; Lind, 2004). There seem to be a lack of research when it comes to presumption rent. The reason is that the system is fairly new in comparison to other rent control systems and that this form of system only exists in Sweden. Further studies that investigate the uncertainties with presumption rent could resolve unanswered questions for investors, inform investors and in the long-term reduce the housing shortage in Sweden.

1.2 Purpose

The purpose of this study is to investigate if the investors require an additional risk premium on housing properties with presumption rent in comparison to the housing stock on the market without presumption rent. This thesis will therefore answer the following two research questions.

(1) How does an investor differentiate between the Swedish rental systems?

(2) Does an investor differentiate between different rent types when calculating the risk-premium?

1.3 Limitations and aim

This thesis will investigate private and public property portfolios of Swedish residential property companies and not take into consideration public housing companies. Furthermore, presumption rent is a type of rent control that solely exists in Sweden. Therefor, the findings of the thesis are

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Introduction

limited to the Swedish property market, but the findings are of interest to all major investors in the Swedish property market.

The aim of this study is to bring valuable insight to investors and policy makers on the risk premium regarding housing properties with presumptions rent.

1.4 Limitations due to COVID-19

The pandemic COVID-19 surfaced in December and reached Sweden in the beginning of March 2020 (Folkhälsomyndigheten, 2020). The policy response by government around the world for self-quarantine has caused a large disruption in the global trades, created uncertainties and an economic recession is looming. This has caused companies to cut back on expenses and focus their resources towards core-business. Which in turn have made it much more difficult and time- consuming to book and perform interviews. Secondly, all interviews are performed through Microsoft Teams, this makes it harder to connect with the interviewee and can affect the level of detail in an interview. All in all, due to COVID-19 the research strategy has been changed from a mixed method to a purely qualitative method, the number of performed interviewees are fewer than expected and therefore the validity of the study will decrease and therefore lower the possibility to generalise the findings.

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Literature review

2 LITERATURE REVIEW 2.1 Rent control

There are many contributions to the literature when it comes to rent control. Lind (2001) explains how the research has categorized rent controls into first- and second-generation controls with the latter being the latest form of rent controls that are used today. The first generation rent control is defined accordingly:

First-generation rent control is a nominal rent freeze that leads to a fall in real rents and to a rent level that is significantly below the market rent level. (Lind 2001)

While the second-generation rent control was defined by Arnott (1995) the following way:

They entail a complex set of regulations governing not only allowable rent increases, but also conversion, maintenance and landlord–tenant relations. Second-generation rent control commonly permits automatic percentage rent increases related to the rate of inflation. They also often contain provisions for other rent increases [e.g. cost pass through provisions]. . . . In some jurisdiction, second-generation rent control has permitted full vacancy decontrol. (Arnott 1995:102)

In Lind’s (2001) research he suggests that the second-generation controls are too heterogeneous and that it need to be developed and categorized further. Lind (2001) puts rent control into two categories covering sitting tenants and when rent contracts shall be extended or when the contract- period expires. The main focus is on what type of problem these two categorize of rent controls solve. Micheli & Schmidt (2015) confirms that the second-generation controls is most popular form used in the world today. However, they chose to focus on how welfare is affected by rent control. For instance, how rental prices affect purchase prices and which companies that own the majority of the housing stock. Further, who the tenant is and its characteristics such as patient- and impatient tenants' households and tax financed transfer payments. Wedin Hansson (2015) also researches how the rent control system affects renovation in rental apartments and compares the renovation stock with a competitive market. Wedin Hansson also tries to clarify that the rent control has a backlash effect on the welfare, undermining the goals of the law. On the other hand, in the USA, studies have shown that quality becomes worse over time in rental apartments (Gyourko & Linneman, 1990; Sims, 2007). Diamond et al. (2019) provides empirical evidence how tenants, landlords and the broader housing market are affected by local rent controls, rent control is determined state by state in the US. According to Diamond et al. (201) rent control is good in the short run, but decreases the rental housing stock, limits mobility and lowers displacements in the long run.

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Literature review

Several of the researchers have one thing in common, they are critical or against rent control. Either by presenting previous literatures’, economists’ consensus or by their own finding in their research.

However, as early as 1995, Arnott states that the opinions about rent controls should be reconsidered and be more evaluated on case-by-case basis. Micheli & Schmids (2015) supports this by concluding that “rent control might not be as harmful as widely perceived”. It is not just rent control that has been a widely researched area. Igarashi (1991) conducts a study to analyse how rent movements are related to vacancy rates and concludes that rent movements are positively correlated with vacancy rates in the long run.

The (Public Inquiry Chair) SOU (2017) has however done an investigation of whether presumption rent has had any effect on the production of housing properties. They conclude that it is hard to confirm if presumption rent has had any effect or to what extent. This is due to the impossibility to confirm with certainty whether these projects would have been realised or not without using presumption rent. However, a large proportion of projects have used presumption rent. This could imply that the presumption rent system during the recent years has stimulated the production of housing properties. Deficits of the presumption rent system are also discussed. The rent system is considered to be too rigid, the presumption period is too long and there are too many uncertainties surrounding rent development and the kind of adjustments, if any, that are allowed to be made during the presumption time and after. Alterations of the model are proposed to cancel out or at least reduce the deficits that the presumption rent system has. They propose that presumption rent should be allowed to be adjusted to a larger extent than today. Further, that landlords should have the possibility to negotiate presumption rent on spaces that previously have been used for residential purposes and is now restored to its original usage. This proposition was approved in 2006 and the law has had one adjustment since its introduction, the presumption time has increased from 10 to 15 years. The prolonging of the presumption time was due to uncertainties how the transition from the presumption rent system to the utility rent system would occur and under what prerequisites (SOU, 2017).

2.2 Housing shortage

There seems to be a consensus that housing shortage in Sweden is due to rent control, high construction costs and ineffectiveness of productivity (Borg et al., 2010; Grannath & Hansson, 2017; Psilander, 2012). Different solutions have surfaced in the literature. Grannath & Hansson (2017) investigates how German planning, law and implementation can reduce the uncertainty, duration and costs that exists in Sweden. Warsame et al. (2010) state that governments around the world use different types of subsidy to offset high construction costs. They examine how subsidy affects the production of housing stocks and if subsidy causes distortion among different tenure of properties, when it comes to preferences. Subsidy does increase the housing stock due to the financial relief on the investor. Psilander (2012) demonstrate that smaller developers can

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Literature review

outperform larger actors when it comes to cost efficiency in projects and the main reason is the differences in project management. However, Borg & Song (2015) investigates if the true level of cost for production in the housing sector has increased or not. They claim that previous studies, that provides results that production costs in the housing sector has increased, has had measurement errors and suggest that there is a higher demand on quality in new dwellings rather than higher construction costs. According to Adams & Füss (2010) a one percent increase in the construction cost has an average long term impact of -0.6% on housing supply, which in turns increases rents and house prices. When long-term interest rates increases other fixed-income assets become more attractive in relation to residential properties and therefore lowers house prices (Adam & Füss, 2010).

2.3 Yields and its determinants

According to some recent studies the yield is determined by the sum of the risk-free rate and the risk premium minus the growth rate (D´Amato & Anghel, 2013; Kroencke et al., 2018; Grkaynak et al., 2010).

Countries have gone through booms and busts which have led to more thorough analysis of risks (Ekelid et al. 1998). There is a homogenous opinion in the literature that vacancy is one of the main risk factors when an investor is determining the risk premium on housing properties or when an appraiser is doing a sensitivity analysis (Amédée-Manesme & Barthélémy, 2018; D´Amato &

Anghel, 2013; Ekelid et al., 1998; Söderberg et al., 2012;). Qiao & Wong (2015) further specifies that lower yields are acquired for smaller apartment sizes due to less vacancy losses, in the Hong Kong residential property market. On the contrary, Coën et al. (2018) analyses the most relevant determinants of the real estate office market risk premium. The results presented from a used VaR model showed that the vacancy rate in London office market was no longer correlated with the risk premium. The risk premium was instead more responsive to shock in the M2 money supply (Coën et al. (2018) & Bruneaua & Cherfouh, 2018). Amédée-Manesme & Barthélémy (2018) propose a VaR model that allows more exact real estate risk measurements since the level of risk is difficult to measure where vacancy rate is one of the determinants. In a study by Bruneaua &

Cherfouh (2018) they present a model to interpret office yields in the UK over the last 30 years.

The three determinants that Bruneau and Cherfouh identified under normal M2 supply are the total M2 supply, rental expectations and interest rate. While, there is an excess of M2 supply the property values revert to the fundamental value (Bruneaua & Cherfouh, 2018).

On the other hand, Jackson & Orr (2011) investigated property portfolio construction and management strategies for portfolio managers. In their paper they proposed a conceptual model, where the risk of the total returns derives from two streams; the income stream and the capital growth stream. Jackson & Orr (2011) identified that “fixed” property characteristics (location and

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Literature review

obsolescence, from the capital growth stream) were dominant in portfolio managers decision- making process. Location is defined as the location of the property and obsolescence considers economic and functional obsolescence. This included the specification of the property in regard to design and quality characteristics of the space. Obsolescence is a simplification of these attributes and shows the sensitivity to change in user requirements in the market, see figure 1.

Figure 1, Real estate attributes, returns and risk, ERV Change = Expected rental value change, (Jackson & Orr, 2011)

Crosby et al. (2016) continued on Jackson & Orr (2011) study. While Jackson & Orr (2011) considered micro-economic factors Crosby et al. (2016) put micro to macro factors on a risk-scale.

In their study Crosby et al. (2016) modified Gordon’s (1959) pricing model to include the risk premiums for direct real estate, for risk factors se table 1.

Table 1. The cap rate and risk scale according to Crosby et al. (2016)

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Literature review

Crosby et al. (2016) concluded that asset-specific attributes (submarket quality and tenant covenant) were the dominating factors in yield determination. Furthermore, international investors bought at lower yields. It is noteworthy to consider that micro-economic aspects are diminished in some sense due to rent control in Sweden, Lind (2001).

When investors evaluate which investment to make there are several factors that affect the return and the valuation of the investment. For instance Engstedt & Pedersen (2015) investigated the predictability in housing markets from the Organisation for Economic Co-operation and Development countries. They discovered that returns are predictable in relation to the time-varying risk-premia. They also identified two puzzles. There is an unstable predictive pattern in rent growth across countries and time periods. Furthermore, the predictivness of the patterns is highly dependent on wheter housing returns are measured in nominal or real terms. As a final remark Engstedt & Pedersen conclude that the finding imply many countries in the OECD suffer from money illusion. This unpredictability is noted also by Shilling (2003) whom implies that using historical averages to calculate risk-premiums on real estate is misleading. This is caused by real estate investors acquiring unexpected capital losses due to the average expected risk premiums being higher than the average realised risk premiums on real estate for the period 1988-2002. On the other hand, Edelstein & Magin (2013) identified that Real Estate Investment Trust (REIT) investors, who have lower than average tax burden, are less risk averse that the the average investors in S&P 500 portfolios. This is contrary to the earlier studies such as Shilling (2003).

These findings can give a suggestion for how other real estate investors look at investments and calculate their risk premia.

To summarise, there are several factors that influence the risk premium such as inflation, vacancy rate, apartment sizes, shocks in money supply, rental expectations and interest rates. Furthermore, there is an on-going discussion if vacancy rate should be included in the measurement or not.

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Swedish rental legislative

3 SWEDISH RENTAL LEGISLATIVE

The Swedish rental legislative is defined by JB (1970:994) §12

3.1 The Swedish rent control system

When a residential rental project is realised, the investors are left with three different options regarding how to determine the rent-level. They can either determine the rent by negotiating with the SUOT that includes two scenarios or with the tenant. When the investor negotiates with the SUOT, the parties can either agree on a rent that is within the utility value and follow the Tenancy act (12 kap. JB), or a rent that is assumed to be reasonable under certain circumstances, a so-called presumption rent (12 kap. §55c JB). Lastly the investor can directly negotiate with the individual tenant, this is known as individually-set rent. The negotiation typically follows the order illustrated by figure 2.

Figure 2. A typical negotiation order

3.2 Utility value rent

The purpose of the utility value rent is to replicate a market rent system with one adjustment, a cap that prevents rent gouging and increases the liability of protected tenancy. Utility value means that the rent of an apartment should correspond with the rent of similar apartments in a similar location.

If the investor and tenant disputes about the rent level, the rent should be determined according to what is said to be a reasonable rent. The rent is not considered reasonable if it is significantly higher than similar apartments in similar areas. Thus, an apartment's utility value is determined by several different factors: size, floor design, location in the building, quality and sound insulation as well as the residential environment, geographical location and proximity to communications.

However, costs related to operations and maintenance, should not be considered. Nor should the tenant’s individual preferences (Boverket, 2014).

Normal rent is a base rent that is decided by the Swedish parliament (Riksdag) and is defined in the legislation (Regulation 2016:880-881) and sets the utility rent levels. The legislation was developed to allow property owners to set higher rent for smaller apartments due to kitchen, toilets and bathrooms are the more expensive in comparison to other rooms of an apartment. The normal rent is based on a top-rent per square meter for a three-room apartment of 77 square meter. The

1.Utility Rent

• Negotiate with SOUT

• If disagreement on rent-level negotiate presumption rent

2. Presumption Rent

• Negotiate with SOUT

• If disagreement on rent-level settle for indivdually set rent

3. Individually-set Rent

• Negotiate directly with tenants

• Risk of setting to high rent

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top-rent/sqm is divided into three different rent levels and is in the year 2020 either 1450, 1350 and 1300 kr/sqm based on which region the property resides in (Boverket, 2020).

The normal rent is calculated in the following way. The yearly normal rent is calculated based on what region the property resides in for a typical 77 sqm apartment.

𝑌𝑒𝑎𝑟𝑙𝑦. 𝑁𝑜𝑟𝑚. 𝑅𝑒𝑛𝑡₁₋₃ = 𝑁𝑜𝑟𝑚. 𝑅𝑒𝑛𝑡₁₋₃∗ 77 (1)

Thereafter the Apartment Score (AS) for a typical 77 sqm apartment is calculated with, table 2.

Table 2, Table for calculating Normal rent for 1-5 room apartments, (Boverket, 2020) Abbreviation Apartment type Apartment score (AS)

1a 1 room and kitchenette 24 + sqm 1b 1 room and small kitchen 27 + sqm

1c 1 room and kitchen 34 + sqm

1,5 1,5 rooms and kitchen 37 + sqm 2 2 rooms and small kitchen 40 + sqm

3 3 rooms and kitchen 44 + sqm

4 4 rooms and kitchen 49 + sqm (Extra WC)

5 5 rooms and kitchen 52 + sqm

𝐴𝑆₇₇= 77 + 44 = 121 (2)

Thereafter, the utility value component (UVC) is calculated, with the help of (1) and (2). Which can be seen as the lowest possible rent per sqm for any apartment.

𝑈𝑉𝐶₇₇ =𝑌𝑒𝑎𝑟𝑙𝑦. 𝑁𝑜𝑟𝑚. 𝑅𝑒𝑛𝑡 𝐴𝑆₇₇

(3)

Lastly the rent for a specific apartment per sqm is set by the following equation with the help of table 2 and (3).

𝑅𝑒𝑛𝑡. 𝑠𝑞𝑚_𝑎𝑝𝑡= 𝐴𝑆_𝑎𝑝𝑡∗ 𝑈𝑉𝐶₇₇ 𝑠𝑞𝑚_𝑎𝑝𝑡

(4)

With equation (1-4) one can plot the utility-rent curves based on apartment sizes with a normal rent of 1300 SEK/sqm, se figure 3 on next page.

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Figure 3, Rent Curves for 1-5 room apartments, the flat section at 2400 is for graphical purposes.

Y= SEK/sqm, X= size of apartment in square meter

As stated earlier in the section the highest rent level is achieved for an apartment with a small size with as many rooms as possible, such as a 1.5 room apartment of 30 sqm will get 1848 SEK/sqm and year.

3.3 Presumption rent

The regulation presumption rent was introduced in 2006 with a purpose to improve the prerequisite and increase the production of housing properties. Through a negotiation between the investor and the SUOT, the investor can set a higher rent compared to the utility rent that is not based on utility value. Instead, the rent is based on construction costs and a rate of total return (rtot) related to the project that the investor is burdened with (Boverket, 2014), see equation 5.

𝑅𝑒𝑛𝑡. 𝑠𝑞𝑚_{𝑝𝑟𝑒𝑠} →𝑐𝑜𝑛𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛. 𝑐𝑜𝑠𝑡

𝑠𝑞𝑚 ∗ (𝑟_𝑡𝑜𝑡) (5)

However, there are some limitations in the presumption rent system. In the following section an excerpt from Kap 12. 55c§ JB (Swedish Rental legislation, Land Code) is presented where the different paragraphs are explained.

1000 1200 1400 1600 1800 2000 2200 2400

0 20 40 60 80 100 120 140 160 180

1a 1b 1c 1,5 2 3 4 5

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3.3.1 Kap. 12. 55c§ Swedish Rental Legislation, Land Code

3.3.1.1 Kap 12. 55c§1 JB

55 c § Vid prövning av hyran ska hyra för lägenheten somhar bestämts i en förhandlingsöverenskommelse enligthyresförhandlingslagen (1978:304) anses som skälig, om

1. den organisation av hyresgäster som är part i överenskommelsen var etablerad på orten när överenskommelseningicks,

2. det i överenskommelsen har bestämts att hyran skafastställas enligt denna paragraf,

3. överenskommelsen omfattar samtliga bostadslägenheter i huset och har träffats innan det har träffats hyresavtal förnågon av lägenheterna, och

4. det inte har förflutit mer än femton år sedan den förstabostadshyresgästen tillträdde lägenheten.

In the first paragraph the boundaries of the legislation are stated. It defines that the presumption rent system will be used for the specific property. Furthermore, the negotiation with the SUOT has been completed including all apartments in the specific property before any agreements have been made with possible tenants. This means that the rent-level is predefined. The paragraph also states that the agreement is for 15 years (presumption time) starting when the first tenant has moved in.

This implies that the rent-level is fixed for 15 years.

3.3.1.2 Kap 12. 55c§2 JB

Vid ombyggnad av del av hus eller tillbyggnad av hus ska vadsom sägs i första stycket 3 om samtliga bostadslägenheter istället avse samtliga bostadslägenheter som bildats avutrymmen som tidigare inte till någon del använts sombostadslägenhet.

The second paragraph further defines that if an existing property is renovated or expanded by new construction the law only allows space that has not been used as an apartment before to be adapted to the presumption rent system.

3.3.1.3 Kap 12. 55c§3 JB

Det som sägs i första stycket gäller inte om det finnssynnerliga skäl att inte anse hyran i

förhandlingsöverenskommelsen som skälig. Det gäller inte heller den del av hyran som avser ersättning enligt 20 § hyresförhandlingslagen.

The third paragraph states the negotiated rent-level cannot be reviewed by the tenants. The negotiated rent-level is predetermined and follows the legislation set in 55c§1.

3.3.1.4 Kap 12. 55c§4 JB

Trots första stycket får hyran ändras i den mån det är skäligtmed hänsyn till den allmänna hyresutvecklingen på orten sedanöverenskommelsen träffades. Lag (2012:819).

The last paragraph states that the rent can be increased during the presumption time accordingly to the general rental growth in the area by negotiating with the SUOT.

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3.4 Individually-set rent

Individually set rent is determined through a direct negotiation between the investor and the individual tenant. Any rent level can be determined through this negotiation if both parties agree on the terms. However individually-set rent still follows the same legalisation as utility rent, the Tenancy act (12 kap. JB). The one difference to the utility rent system is that the agreement between the tenant and investor has a duration of six months. After that period, the rent can be put on a trial in the Rental Committee (Hyresnämnden). This means that the rent-level will be reviewed to the Utility rent-level. If the review proves that the rent was too high the investor has to repay its tenants the difference between the individually-set rent and utility rent for the given time period (Boverket, 2014).

3.5 International perspective on rent control

The following section provides insights into some specific countries which have or have had different levels of rent control in order to understand how the Swedish rent control differs from other countries.

Denmark has had some forms of rent regulations for over 60 years. In the larger urban areas, the rents are cost-based regulated. This system allows the landlord to pass all costs related to maintenance, including property tax, over to the tenants. This way, all costs for owning the property are covered for by the tenants. In addition, the cost-based rent allows the landlord to set a capital charge between 7-14% depending on the age and quality of the property. The capital charge is based on the value of the property in 1973 and does not allow any inflation to be taken into consideration. Also, rent increases are not allowed due to an increase in demand. In smaller, rural areas, the traditional rent control is not allowed. Instead, the rent is determined by the “value of the rental unit” which is the same system as Sweden call utility value rent. However, properties constructed after 1991 are exempted from all rent controls. Thus, the landlord can set a market rent (Munch & Svarer, 2002).

England has had shrinkage of the rental sector since the early part of the last century, due to strict rent regulation (Kemp, 2004). In 1980, the Thatcher government took office that aimed to decelerate this shrinkage and introduced regulated tenancies. Regulated tenancies were determined by so called rent officers which purpose was to find a “fair rent” that was appealing to both tenants and landlords. However, the 1988 Housing Act abolished rent regulation on all leases after January 15^th in 1989. Thus, all new leases had market rent from this date. Rents can still be negotiated, though it seems to be generally accepted that the landlord makes a rent proposal that the tenant approve (Kemp, 2004).

The modern rent control that some states in US have originated as an effect of the housing shortage that followed with the second world war. These rent controls determined an exact level of the rent.

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This have been replaced with a more updated version. Due to high inflation in the 1970s, rents developed in the same pace. The first rent control law was introduced state-wide in 1979 that focuses om regulating rent increases. However, the law had one key exemption: buildings with 4 units or less were exempted from this since they were viewed as landlords being less profit-driven than large corporate landlords. For instance, in California, these small landlords made up around 44 percent of the whole rental housing stock. This exemption was exploited by larger corporate landlords by purchasing these buildings and then selling a small share to a live-in owned in order to go around the rent regulation. This led to a ballot initiative to include smaller buildings into rent regulation that passed 1994. Thus, small buildings built prior to 1980 are affected by the law, while small buildings produced after are free from rent regulations (Daimond et al., 2019).

Rent control in China was introduced 1952 with the purpose of providing fair and affordable housing. The rents were set at remarkably low levels that took little consideration to production costs and maintenance costs, which created a housing shortage. Between 1952-1997, the cost for rent and utilities were so low that it only accounted for 1.77 to 3.7 percent of the household income.

At this time, rent and utilities accounted for 20 to 30 percent of the household income in western Europe and the United States. To decrease the housing shortage, China has introduced various reforms over the years. Today, rent increases has accelerated, a private rental sector has emerged and the majority of the formally public apartments have been purchased by tenants, especially in urban areas (Gu, 2003).

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Theoretical framework

4 THEORETICAL FRAMEWORK 4.1 Dividend discount model

From the literature review one can identify that total rate of return is a factor that explain the profitability of an investment. To value any security on the stock-market, one must determine the expected cash flow received for holding a specific stock. Gordon (1959) proved that the total return consists of two parameters d = yield and g = growth when assuming a constant growth rate. This is today known as Gordon Dividend Discount model. See equation 6. This equation is of interest due to two of the most common methods to value an income property in real estate is to combine the capitalization rate (dividing the net operating income (NOI) with the exit yield) and forecasting of NOI in a discounted cash flow (DCF) analysis (Bruggeman & Fisher, 2011)

𝑟_𝑡𝑜𝑡 = 𝑑 + 𝑔 (6)

This formula can be rearranged, accordingly to 7. Showing that the yield is defined by the total return minus growth.

𝑑 = 𝑟_𝑡𝑜𝑡− 𝑔 (7)

The total return can also be portrayed by combining the rf = risk free rate and a rp = risk premium.

The risk free rate and the risk premium are derived from CAPM, which is another asset pricing model (Sharpe, 1964). Where the risk premium is the return excess of the risk-free rate that an investor expects to yield for investing in a specific company.

𝑟_𝑡𝑜𝑡 = 𝑟_𝑓+ 𝑟_𝑝 (8)

When combing (7) and (8) the yield becomes, the risk-free rate and the risk premium minus the growth, see equation 9.

𝑑 = 𝑟_𝑓+ 𝑟_𝑝− 𝑔 (9)

4.1.1 Regarding real estate investing

The divided discount model, as other models, are based on assumption that it presumes a steady and constant growth rate, which is not the case in Real Estate (Bruggeman & Fisher, 2011). For instance, Crosby et al. (2016) implies that the unique and complex nature of real estate as an asset is not directly comparable to stocks and therefore Gordon’s growth model is not the right estimator.

What they propose is to modify Gordon’s Dividend Discount model to include unique risk for real estate, in the shape of specific characteristics of the property. This is in contrast to CAPM. Crosby et al. (2016) divides the risk premium into two parts the first explains the risk premium for the real

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Theoretical framework

estate market risk and the second is the stock or assets risk element attached to the property specific attributes, see equation 10.

𝑑 = 𝑟_𝑓+ 𝑟_𝑝− 𝑔 = 𝑟_𝑓+ (𝑟_{𝑝,𝑟𝑒𝑚}+ 𝑟_{𝑝,𝑠𝑡𝑘}) − 𝑔 (10)

Where rp,rem = risk premium for the real estate market risk and rp,stk = risk premium for the stock market risk.

Crosby et al. (2016), further specified what the specific risk factors are, see equation 11.

𝑟_𝑡𝑜𝑡= 𝑟_𝑓+ (𝑟_{𝑝,𝑚𝑘𝑡}+ 𝑟_{𝑝,𝑠𝑐𝑡}+ 𝑟_{𝑝,𝑙𝑜𝑐𝑚}) + (𝑟_{𝑝,𝑡𝑒𝑛}+ 𝑟_{𝑝,𝐼𝑠𝑒}+ 𝑟_{𝑝,𝑙𝑜𝑐𝑠}+ 𝑅_{𝑝,𝑏𝑖𝑑}) (11)

Where. rp,mkt = real estate market risk, rp,sct is the real estate sector risk, rp,locm is the real estate market location risk,

rp,ten is tenant risk, rp,lse is the leasing risk factor, rp,locs is the stocks location risk and rp,bid is the specific building risk.

What is important to emphasize is that what Crosby et al. (2016) suggests is to include factors that a diversified investor do not have to consider. How diversified a property investor actually is can be further discussed outside the scope of this thesis. However, when difference becomes smaller, factors such as market risks and stock or assets risk will be emphasized by investors.

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Method

5 METHOD

5.1 Research philosophy & strategy

It is important to choose the method that best answers the research question (Alshenqeeti, 2014).

Presumption rent is a rental system that has existed for roughly 15 years and solely in Sweden.

This means that there is limited research on the specific topic and the market participants possess a large part of the knowledge. Therefore, a mono method qualitative study is preferable due to the possibility to take details, differences and nuances into consideration (Merriam, 2010).

A mixed method such as sequential explanatory research design was considered, going from a quantitative approach to a qualitative to increase the richness of the findings of the qualitative study and the possibility to use triangulation (Saunders et al., 2016). The research question, however, creates limitation on who the participants of this type of questionnaire should be. There are roughly 20 real estate companies that hold portfolios over 200’000 m² of residential properties (Fastighetsvärlden, 2019), in each company there are a one to three people that could answer this questionnaire which would result in a target group of 20-60. With a typical response rate 10-20%

according to Bhattacherjee (2012), would result in between two to twelve answers, which would not be statistically significant.

In the end a mono method qualitative study was chosen. The research question is an inductive procedure where the author emanates from empirical results and develops a theory based on the results from the analysis (Patel & Davidsson, 2011).

In this thesis the result from the semi-structured interviews will answer research question (1). The synthesis of research question one with the theoretical framework will shed light and answer research question (2), figure 4 illustrates the research method.

(1) How does an investor differentiate between the Swedish rental systems?

(2) Does an investor differentiate between different rent systems when calculating the risk- premium?

Figure 4, the research method illustrated.

5.2 Selection

The goal was to be able to generalize the results of the study to the population as whole from the selection made. Therefore, it was very important to choose the right selection of group participants

Qualitative - Semi - strucutired interviews

Answer research question one (1)

Synethsis - Theoretical framework

Answer research question two (2)

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Method

since this would reflect the result (Patel & Davidsson, 2011). For this thesis, the selected group included investors active on the real estate market. An investor in this thesis is defined as a decision-making employee that possesses high experience within acquisitions of housing properties. Thus, investors are involved in what is considered “day-to-day basis” of transactions in the real estate market. This is to cancel out the risk of irrational behaviour, since people with no other options or non-mechanical actions (sporadically acquiring properties) tend to act irrational (McKenzie, 2009). It was also important to involve the right type of real estate company. Thus, the company is either specialized in housing properties or has a larger fraction of housing properties within their real estate portfolio. The demarcation is therefor set at real estate companies that hold portfolios of residential properties over 200’000 m². Fastighetsvärlden (2019) listed the top 50 largest real estate owners by value together with their geographical distribution and property type which made the process of selection easier.

5.3 Semi-structured interviews

The interviews have been in the form of semi-structured interviews with themes based on the findings in the literature review. A semi-structured interview is a more preferred way than a structured interview due to its explanatory nature, the interviewer can go in-depth into complex and open-ended questions (Saunders, et al., 2016). In the sense of semi-structured compared to unstructured interviews, the semi-structured is preferred due to its comparative advantage when performing multiple interviews and the ability to pinpoint certain topics (Alshenqeeti, 2014). The target group for the semi-structured interviews were professionals that have at least have 10 years of experience in the field.

Due to CONVID-19 complications, the interviews were conducted through video-interviews in Microsoft Teams (Introduction, Limitations due to COVID-19,p. 3). Video-interviews will not absorb the same amount of details as face-to face interviews but still capture details such as body language and eye-contact (Kvale & Brinkman, 2014; Patel & Davidsson, 2011). Video-interviews as face-to-face interviews makes it easier for the interviewees to understand the questions asked and easier for the interviewers to interpret the answers given. In addition, face-to-face interviews on average, get more time reserved than interviews over the phone. This gives more space to further explain given questions and answers in-depth along with time to continue the discussion with follow-up questions. However, face-to-face interviews increases the risk of the interviewer subconsciously manipulating the study by influencing the interviewees answers, if the interviewer is bias. They are also more time consuming than telephone interviews (Kvale & Brinkman, 2014).

In total, six interviews were conducted in between 17^th of March and 7^th of April. Five participants were from property companies and one from a consultancy firm. Two of the property companies hold a property portfolio covering the whole of Sweden. Two hold portfolios covering the largest

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Method

cities of Sweden and one hold a property portfolio covering the region between Gothenburg and Stockholm. In the property companies the interviewees held the following positions, Head of Leasing, Vice President, CFO and Senior Investment Manager. One interview was conducted with three participants which held the following positions, CEO, Head of Real Estate Development and Head of Rent Negotiation. From the consultancy firm the interviewee held the position Partner.

The open questions were designed in a way so that the interviewees will have the opportunity to answer the questions in their own words (Kvale & Brinkman, 2014; Patel & Davidsson, 2011).

Follow-up questions were also prepared along with the other questions to ensure that all empirical evidence was collected for each interview. These follow-up questions were asked if the interviewees did not naturally respond to the questions necessary (Kvale & Brinkman, 2014), see Appendix A.2 – Interview questions

The outcome of the semi-structured interviews was synthesised with the literature review and theoretical framework to form a theory that answers research question two (2).

5.4 Validity and reliability

The credibility of a study is said to be assessed based on reliability and validity (Patel & Davidsson, 2003). Questioning validity is a way to reason whether the study has measured what was intended to be measured. In a qualitative study for instance, many researchers believe that it is difficult to test the information. Thus, the study is validated by the degree that the readers recognize and accept the researchers' interpretations and results. In order to keep the study at a high validity, the group targeted for interviews were exclusively people with high experience within the field acquisition of properties with presumption rent. According to Kvale & Brinkmann (2015), the validity of a qualitative study can be substantiated with well-planned interviews and clearly designed questions.

Recording the interview also strengthens the validity of the knowledge created with the respondent. In addition, Kvale & Brinkmann (2015) believe that validation is to a way to question the study, which was done through a critical approach throughout the study. Motivating the choices and interpretations in the study is also a way the strengthen the objectivity.

Reliability can be linked to the study's credibility and is often related to the measurements of the study being stable and not random. Thus, in a qualitative study it is not about the repeatability but rather the observation of complexity and dynamics of the subject studied. This means reliability is gained by documenting the process, explaining your research design by pinpointing the chosen strategy and methods (Saunders, et al., 2016). In the end, without high validity and reliability, the findings cannot be generalized as knowledge, thus making the credibility of the study low (Patel

& Davidsson, 2011).

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Method

5.5 Ethical consideration

Research ethics are vital to the validity of this thesis (Hansson, 2007). Without a code of conduct research could be manipulated, falsified and gathered in an unlawful way, which would hamper the end goal of research, to build new knowledge (Hansson, 2007). For this thesis, it is important to consider ethical consent regarding the questionnaire and the semi-structured interviews.

Ethical considerations regarding consent are emphasized to be negotiated through a research project and how to maintain an informed consent can be tricky. Consent can be defined on a spectrum from “lack of consent”, through “inferred consent” where an agreement of participations is considered as a consent of analysing and using the data without making it clear to the participants to “informed consent”. Informed consent is defined as the right for the participants to not participate or withdraw before the response is recorded. The nature of consent can be seen as an act of transparency from the researcher. A researcher can be deceptive, use inferences or give the participant full information. The level of information required for informed consent can vary depending on the research strategy.

5.5.1 In consideration to the semi-structured interviews

To increase the transparency to the interviewee, the semi-structured interview topics was sent to the interviewee before the interview with a letter stating their right to anonymity and the right to record the interviews, see Appendix A.1 –Ethical considerations and Appendix A.2 – Interview questions. Furthermore, the letter stated their right to review their transcribed interview before it was synthesised in the thesis. By accepting these terms and reviewed their answers from the interview the interviewee has given their informed consent.

5.5.2 In consideration to work-affiliations

Both authors work within real estate for companies that are associated and directly involved in investments on the real estate market. It was unlikely that the interviewees would indirectly share valuable information to their competitors without receiving something in return. Therefore, the authors had to consider how and when the work should be presented in order to assure no competitive advantage was gained from a commercial perspective. Thus, the interviewees were informed where the authors worked and that the results should be presented to them in the same way and at the same time as it were to be presented internally. In this way a competitive advantage was cancelled out.