Rental Real Estate: The outlook remains excellent despite rising rates

Rent prices continually rising

1. Enduring Rise in Rental Perspectives


Inflation's Stimulating Effect

2022 and 2023 have been marked by the return of inflation in Europe, which the ECB has tried to contain by consecutively and ten times increasing its key interest rates.

This general price increase (inflation) in France reached an annualized rate of +4.9% in September 2023 (source INSEE). In this context, several factors have had a favorable effect on rental demand.

- Wage increases in most companies (favored by a shortage of labor) from the first half of 2022;
- Increase in social benefits (APL, family allowances...);
- Increase in the minimum wage (indexed to inflation);
- The Rent Reference Index (LRI) was thus set at+3.49% in Q3 2023 by the INSEE.

Mid-Term Outlook

The ECB's goal is not to bring inflation back to 0, but to a mid-term level of +2%. Many voices, including former Nobel laureate in economics P. Krugman and former IMF Director Olivier Blanchard, advocate for a higher inflation target, at +3%.

Especially to facilitate the financing of monumental investments to be made in the energy transition in the coming decades.

This situation of a general increase in prices will continue to have a driving effect on rents in France.


2. The New DPE Regulations Limit Supply


A Hardening of Rental Conditions…

The Climate Law of 2021 progressively bans renting the least well-insulated homes, according to the new Energy Performance Diagnosis (DPE) introduced on July 1, 2021.

Starting January 1, 2025, homes classified as G will be considered indecent and rental will be prohibited. The same goes for homes classified as F starting January 1, 2028.

These « energy sponges » (F and G) constituted 17% of the rental stock in France in 2022 (source Les Echos).

While there currently are criticisms about the calculation method and reliability of DPE, the underlying issue remains: a very large number of homes in France are poorly or not insulated at all.

...which will eliminate a large number of rental properties

Energy renovations come at a cost. Depending on the level of initial insulation, the surface area of the property, its heating method, its floor level, its location... the cost of am energy renovation to obtain category D can exceed $15k per property.

Owners who can't afford these renovations will sell their property (see price effect below) or take it off the rental market.

This scarcity of supply will put upward pressure on rents.

Note: The growing demand for tourism in cities like Calais or Boulogne-sur-Mer, where I have been investing for several years, has strongly stimulated short-term tourist rentals. This has pulled numerous quality homes from the rental market limiting long-term rental housing supply.

3. Hindered Access to Property Boosts Rental Demand


The combined effect of rising interest rates and tougher borrowing conditions since January 1, 2022 has significantly hindered the access to property.

Added to a price level (compared to households' disposable income) that remains very high in most major French cities.

Consequently, the proportion of renters will start to rise again, putting pressure (at least in the short term) on the demand for rentals, and thereby on rents.

4. Other Factors Driving Up Rents


Other elements will continue to stimulate rental demand sustainably, in a country where housing supply is greatly restricted and historically deficit.

Population growth in France in 10+ years; Increase in the number of households (late couplings, divorces...); Development of remote work (tenants requesting larger surfaces).

Conclusion


Rent levels will sustainably increase in France. They are for now contained by various capping mechanisms: LRI, rent capping in certain cities.

But aside from the major cities subject to this cap, rent levels will catch up with their market level when tenants leave and properties are rented again.

Given the ECB's steadfast +2% mid-term inflation objective and the other factors mentioned above, an annual rent increase scenario of +2.5% over 10 years in medium and large cities seems realistic. This equals to a 22% rise in rents over the period.

Annonce

A drop in prices in 2023, which is expected to continue into early 2024

The effect of the rising rates + tightening of borrowing conditions

The drastic tightening of borrowing conditions since January 1, 2022, which I described here, weighs heavily on the ability of individuals to finance their real estate projects. And thus puts downward pressure on selling prices.

After a drop in the number of transactions, most French cities recorded a price/sq ft drop in 2023, which remains limited. -4.8% in Paris over 1 year, -8.4% in Lyon, only -2.9% in Calais and Boulogne-sur-Mer (source: Best Agents).

The effect of the introduction of energy-inefficient properties into the market

Many owners won't be able to make the necessary energy renovations. This will increase the supply of properties for sale.

By anticipating upcoming regulations, this arbitrage could take place as early as this year for a large portion of the properties concerned by the upcoming bans in 2025 and 2028.

This will put downward pressure on prices in 2023.Conclusion

The decrease should continue at the beginning of 2024 for two reasons.

- Part of the decrease has not yet been recorded in the October 2023 data, which corresponds to offers made around June.
- It is primarily “exceptional” properties that have found buyers this year. A significant stock of 'average' properties that have not found takers remains, and the owners who are forced to sell will have to agree to significant decreases.

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Comparative analysis 2021 vs. 2023 in terms of rental cash flow

Below is a table showing the consequences, for the same rental purchase, of the change in interest rate / inflation outlook between 2021 and 2023. With simplified assumptions.

- Case 1 is similar to the interest rate / inflation context projected in 2021. Rent revaluation perspective at +0.5% and the credit rate (APR) at +2%. Net cash flows are positive from the 5th year onwards.

- Case 2 is similar to the interest rate / inflation context projected at the end of 2023. Rent revaluation perspective at +3% and the credit rate at +4.5%. Net cash flows are positive from the 8th year. In year 10, the cash flows are nearly 2x higher than those of case 1.

Note that the estimated charge amount (30% of rents) takes inflation into account. It is therefore higher in case 2.

After an "unusual" period of very low rates (2018-2021), real estate interest rates are returning to a historically "normal" level. This increase comes amidst a high inflation environment that is offset in late 2023:

- significant and ongoing rental rate increases are forecasted;
- better negotiations are possible when buying in 2023, due to credit granting rules becoming stricter;
- it's easier to borrow over 25 years, which helps to lower the weight of monthly payments.
It's worth noting that when interest rates decrease again, it will be possible to refinance your mortgage and lower your monthly payments. The crux of the matter currently is the ability to secure a loan.

For investors who have the necessary funding, in my view, the market prospects for 2023 are excellent for rental investment.