Both The Guardian and the Independent covered the story of lower income households having difficulty with rental payments. They face the dilemma of paying either food, heating or rent each month. This is predominantly caused by frozen housing benefits – the four-year freeze – that do not keep up with increasing rents. Therefore renters are facing rising gaps between the rent they have to pay and the housing benefit they receive. Not only lower income households are affected by an increase in rent. From May 2011 to May 2017 rents increased on average 4.6 percentage points over income says The Guardian. When we ask why rentals are so expensive, the answer often is “because of supply and demand”, but this is such a general answer that it does not give much insight. So why not look closer to the supply side?
Question: What are the costs of the supply of rental housing?
Answer: I suggest to start from scratch with a new – to be build – house. This would involve the procurement of a site with planning permission for housing1, the building of the house, the financing of both, and once the house is build maintenance and insurance.
Insurance involves at least building insurance in case of fire, flooding or subsidence, and landlords could add coverage for thinks like repairing damage in an emergency as a result of a gas leak, burst pipe or pest infestation, loss of rent when the property is uninhabitable, and legal support. The insurance premium is in general paid once a year.
Maintenance includes maintaining the drains, gutters and pipes, and boiler and as an extension of that the supply of hot water, gas, electricity and heating. It also includes all cost incurred by normal wear and tear of the house, like any necessary refurbishments and keeping the door and window furniture in good working condition, and the cost of servicing any appliances included in the rent like a laundry machine or alarm system. It is also a legal requirement that landlords have an engineer complete a gas safety check every year on all the gas fittings, appliances and flues within the property. Sometimes other things are included too like the maintenance of the garden and swiping of the chimney. Some of the maintenance costs recur periodically, like the gas check and servicing of the boiler. Maintenance costs of the exterior of the house depend predominantly on the wear caused by weather conditions. Maintenance costs of the interior will increase when the property is occupied and depends on the intensity of use by its occupants.
Things not mentioned yet are the cost of void periods – the number of months the property stays empty -, and the cost of letting agents. Agents tend to charge between 10% and 15% of the rent depending on the comprehensiveness of their service. Void periods emerge when it takes time to find new tenants after the property has been vacated by the previous ones. The cost of void periods depend on the average length of tenancies, and the evolvement of the market. Agent fees are typically paid monthly, although a landlord can decide do manage the property herself. Then she should take the time involved into account. Agents do also assist with things like finding new tenants, drawing up a tenancy agreement and taking the deposit. The cost of this service is in general related to the rent of the property.
The cost of acquisition of the house is spread over a longer period of years. When, for example, letting a car, depreciation of the car is guide line, but with houses this is difficult since houses that remain in good repair do, in general, not depreciate. Furthermore, house prices are not stable over the years, and a landlord selling his property after some time might either have gained some capital or incurred a loss. Next to that, the cost of financing the acquisition depends on how it is financed, either with the landlord’s own capital or through a mortgage – or a combination of both.
Should the landlord invest her own capital, she would aim for at least the same return on investment she would have should she have invested in something else with a similar risk profile. In that case part of the cost of the rental house would be the opportunity cost of the investment.
Should the landlord take out a buy-to-let mortgage on the house, this would incur interest costs. Buy-to-let mortgages are generally interest-only, require larger deposits – own capital -, and charge higher interest to cover for the risk of defaulting of renters. The interest on the mortgage is part of the landlord’s cost, and have to be paid monthly, in general.
When the landlord perceives the possibility of a decrease of the value of the property, she could decide to depreciate the property. Depreciation cost are normally calculated at the end of a fiscal year.2
Except for the interest rates on buy-to-let mortgages and the larger deposit required by the mortgage company, the stamp duty is also higher. There is a surcharge of 3% added to each threshold of the stamp duty tariffs. The stamp duty paid is deductible from any capital gain when the property is sold. Therefore I assume landlords will consider stamp duty as part of their investment – and not a cost.
Sometimes students think the income tax landlords have to pay on the profit they make from letting, is also part of the cost. Needless to say it is not, since the income – after deduction of costs – the landlord gains from the property is taxed.
But how much will the cost structure as described above affect the height of the rent? Not much, I am inclined to say. An American source – Investopedia – mentions four different approaches, none of which includes the cost, although the Cost Approach might put you on the wrong track. One of the most popular methods is supposedly the Sales Comparison Approach, supported by tools like the Open Rent Calculator3 and sites like Rightmove and Zoopla, to compare the market.
At the end of the day, though, I am convinced any entrepreneur will look at the number below the line to decide if she should invest in real estate in the first place.
The answer to a fairly simple question reveals the complexity of the rentals market, and how pricing does not depend solely on the exploitation costs, but also on the evolvement of the value of property – the investment.
- Daniel Bentley says in an article in The Guardian, that land for development is expensive as a result of the 1961 Land Compensation Act (LCA) passed by Harold Macmillan’s government. This enshrined in law that landowners, should they be compelled to sell their land, be reimbursed not only for the value of their land before the sale, but also for the value of the land if it is used for something else – like housing development. According to the article, this resulted in speculation with land by landowners, who waited to sell their land in order to get a higher price. Next to that, the cost of land for development is higher then it could be, should the LCA not be in place. House-builders shift these cost onto buyers, thus increasing house prices, and potentially rents.
- It is not likely this will affect the amount of rent in the short run, since rent has already been agreed upon, often for at least a period of one year. If the landlord will be able to recover the depreciation in the long run, will depend on development of the rentals market in the area. The decrease in the value of the property might very well be linked to a general depreciation of the area.
- To my regret, it turned out we are paying too much for the property we rent, according to the Open Rent Calculator.