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It’s hard to live in the city: Berlin’s rent freeze and the economics of rent control

A proposal in Berlin to ban increases in rent for the next five years sparked intense debate in Germany. Similar policies to the Mietendeckel are currently being discussed in London and NYC. All three proposals reflect and raise similar concerns – the increase in per-capita incomes is not keeping pace with increases in rents, but will a cap do more harm than good? We review recent views on the matter.

By: Date: July 8, 2019 Topic: Macroeconomic policy

The Berlin rental market is up for a change, after a law proposal was passed in the Berlin Senate on June 18th.

The Mietendeckel aims to freeze rents in Berlin for five years. The package features other measures including, for example, limitations on rents charged to new tenants. Subject to fierce debate in Germany, the package stands accused by some of being unconstitutional. Some immediate effects have also been felt by tenants, who have received notifications of increases in rents in anticipation of the vote. The law is set to be ratified in October, to enter into force in 2020, and to be applied retroactively to June 18th. What lies behind the proposal’s progress?

Berlin is a city of renters: according to Tagesspiegel, 81.5% of the capital’s houses are rented, a 60% share of which belongs to private-sector companies. Investors are drawn towards the city’s dynamic demography, short supply of housing, and high potential for appreciation. The current low lending costs make this sector particularly attractive. The market is highly concentrated in a few listed companies, some of which owned by the same shareholders. Tagesspiegel explains in detail the evolution of the Berlin housing market and traces the quick ascension of the prices of shares in these few listed companies.

If the landlords are prospering, however, the situation has become a much more pressing concern for tenants. Over the years, average disposable income per capita and rental prices have been growing at two diverging speeds. The growth differential is even more pronounced if one considers rents on new dwellings (Figure 1).

Figure 1. Average disposable income per Berliner and rent prices, index (2008=100)
Source: Tagesspiegel

Indeed, the city is running short of supply. Tina Groll shows that while the number of building permits for apartments has risen sharply, this has not translated into more supply. Groll interviews Sebastian Dullien, economist and director of the Macroeconomic Policy Institute (IMK), who mentions several reasons for the existing gap between completed works and permits. The list goes beyond the expected length that construction works take. Dullien mentions the lack of skilled workers in the construction industry; delayed construction times given the structure of payments (high instalments at the start of works, decreasing thereafter); and speculation, as investors may buy land and defer building works in the hopes that the land, already with a building permit, can be sold later at a profit. Dullien is convinced the lack of housing in Germany’s largest cities will persist, as will the need for small apartments. To counteract the delays between permits and actual construction, Dullien proposes a “construction obligation clause” for private investors.

Investors are indeed a concern for Chris Bryant, who warns that the proposed Mietendeckel will “alarm foreign investors” with strong ties to the city’s real-estate sector. He points to the 17% drop in the share price of Deutsche Wohnen SE, the property group owning “more than 115,000 residential units in the city”, that has taken place since the proposal’s announcement. The Berlin housing shortage, Bryant explains, comes from the quick upswing in local population that has been unmet by construction companies. However, Bryant is sceptical that the rent-cap will provide a fix to the housing shortage, positing instead that it will “deter much-needed investment”. Zacharias Zacharakis disagrees that potential investment may be deterred, as new buildings are excluded from the scheme.

The main theoretical arguments against rent controls are well known in the economics literature. After all, almost 20 years ago Paul Krugman called rent control one of “the best-understood issues in all of economics, and – among economists, anyway – one of the least controversial”. Imposing caps will reduce the quantity and the quality of the available dwellings; it will deter new investment and construction, as well as renovations; it will make housing harder to find for some.

However, most of the criticism in the literature is targeted at the so-called first-generation rent controls, i.e. policies imposing an absolute ceiling on rent prices. Second-generation policies, however, have become more flexible and are often “linked to a measure of purchasing power and in most cases, the consumer price index serves as a reference measure”, or “stepwise rent increases or complete flexibility in setting the rental price under certain conditions, such as new rentals, vacancies, or luxury properties”.

This distinction is made by Konstantin Kholodilin, Jan Philip Weber and Steffen Sebastian,who run an international comparison of the rental market regulations over the last century. The authors find that Germany has relatively more intense rent controls compared to the rest of Europe, “which have been tightened even further since 2015” (Figure 2).

As for the effects of such policies, Kholodilin et. al argue that while neoclassical theory posits that “medium- to long-term regulatory interventions in rent determination will only exacerbate existing housing market problems”, there is insufficient empirical evidence to confirm these claims. The authors explain that the analysis of the effects is particularly left wanting at the macroeconomic level, given a lack of data.

Figure 2.

Rent controls are not new in Europe. London, notably one of Europe’s most expensive capitals and with one of the least regulated rental sectors, is also familiar with the concept. In January, London’s mayor Sadiq Khan promised to work towards “a cap on rent” for Londoners. Christine Whitehead analyses the proposal for the LSE Blog and makes an important distinction between rent stabilisation and rent control.

The former, she explains, “allows the initial rent to be set by the market, but then constrains maximum increases in rents within the tenancy to be in line with some more general index”. The latter entails fixing rents “at a given time and (…) no promise about future rises”. Whitehead details that the package of proposed reforms includes “indefinite security of tenure”; “rent stabilization within the tenancy however long” and “tenants having the right to give notice to leave the tenancy without cost”.

Whitehead highlights that institutional investors “have generally welcomed the move” and provides two reasons why: “because it helps to ensure a certain stream into the longer term – which is what most institutional investors are looking for; and because it reduces the very considerable costs to tenant turnover – as long as the tenant is a good one.”

The current discussion around rent caps is also happening across the pond. In New York, a rent regulation package is also subject to contention, J. Goodman, Vivian Wang and Luis Ferré-Sadurí write. The proposal aims to “abolish rules that let building owners deregulate apartments and [to] close loopholes that permit them to raise rents”, with a direct impact over “more than 40 percent of the city’s rental stock”.

Last year, Washington, California and Illinois were pushing for rent-control measures too. Then, Megan McArdle wrote for Bloomberg that “rent control needs retirement, not a comeback”. While arguing that initially rent controls play a redistributive role, this effect wears off as soon as incomes rise and rents do not. McArdle argues that price controls worsen the scarcity problem, as they increase demand and reduce supply, and suggests the emphasis is put on building more housing, as well as “loosening the legal restrictions and community veto points that make it so hard to add supply”.

Building however, is not an easy task for New York, “because it’s already the most densely populated city in the nation”, Noah Smith reminds us. Although there are denser cities (e.g. Tokyo) that still managed to squeeze in more buildings, these would need to be met with appropriate infrastructure scale-up, which is especially costly in NYC.

Richard Green writes that the policy is “moving New York away from second generation rent control toward first generation rent control”. Green quotes urban economist Richard Arnott’sviews that second-generation rent control might have positive effects in markets where property owners have pricing power, such as New York. In those markets, both the equilibrium rental rate and the quantity of housing could be short of the social optimum. “The idea that property owners might have pricing power goes back at least as far as David Ricardo, who worried about the corrosive effects of ‘economic rent’ on social welfare.”

For one, the same arguments do not apply to first-generation rent control. But Green also remains undecided as to whether second-generation rent control can play a positive role when supply is inelastic. “(…) If there is a ceiling on the number of units builders can build, a price intervention is not going to bring about additional units. So the issue is about redistribution. (…) But even if second generation rent control is neutral in terms of costs and benefits, it doesn’t necessarily lead to desirable distributional outcomes. It is almost certainly true that the average property holder is wealthier than the average renter, and therefore that on average rent control redistributes income from higher to lower wealth people.  But rent control does not target the incomes/wealth of either property owners or renters.”

A policy alternative, Green suggests, is to combine temporary rent control with zoning-law reforms that tackle the need for increased supply. An example is Minneapolis’ recent abolishment of single-family-use zones, which now allow multi-units to be built in zones where they were not previously. This move not only increases supply but also reduces segregation.

Timothy Taylor from the Conversable Economist mentions Oregon’s recently enacted state-wide rent-control law, which imposes a flexible cap to rent increases (7% plus inflation). Taylor argues “the effects of this kind of moderately flexible rent control are surely less disruptive to housing markets than it would be to have a pure cap on existing rents, the government setting rents for new tenants and new construction, and so on. But supporters of rent control often seem to imply that such programs are nothing but a way of stopping landlords from exploiting renters. It’s of course more complex.”  As such, Taylor emphasises the need for these measures to be temporary.

Taylor subscribes to Brian J. Asquith’s conclusions in his review of rent-control policies in different states of the US: “Rent control is a policy that has yet to deliver on its promise: affordable rents for all, not just for the few lucky enough to score a controlled apartment.” In the meantime, Feargus O’Sullivan sees something else happening 8,000km away: “A city working toward a housing market where real estate’s function as an investment takes a backseat to its public accessibility and utility. It will be fascinating and instructive for other cities to watch how far it goes—and what barriers it will come up against.”  Let us watch.

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