Stefan Gerlach: Making residential rental markets work for financial
stability
Address by Mr Stefan Gerlach, Deputy Governor (Central Banking) of the Central Bank of
Ireland, at the Twenty-First Dubrovnik Economic Conference, Dubrovnik, 8 June 2015.
* * *
Accompanying charts can be found on the Central Bank of Ireland's website.
I would like to thank Amelia Dennigan, Gabriel Fagan, John Flynn, Robert Kelly, Maurice McGuire, Cyril Roux,
Rebecca Stuart and, in particular, Therese Grace for their help in preparing this speech.
1. Introduction
I am very pleased to be here in Dubrovnik at the 21st Dubrovnik Economic Conference.
Today I will talk about rental markets and financial stability. While the rental market is
currently a focus of attention in many countries, including Ireland1, the link with financial
stability, a preoccupation of central banks, is an issue that is frequently neglected in the
important public debate about housing. Before proceeding, I note that while housing policies
are outside the remit of central banks, any financial stability concerns they raise are not. In
this talk, I therefore hope to draw attention to these issues, while recognising that it is for
others to set specific policies in these areas.
My talk is motivated by three observations on housing markets through the crisis: first, while
owner-occupancy rates increased prior to the crisis, during the recent crisis we saw
owneroccupancy rates fall. Consequently, the number of renters rose in many countries affected by
housing market downturns, including Ireland. This indicates that for many people of
household formation age, the rental market acts as a backstop, which they turn to in times of
uncertainty and tight credit conditions.
My second observation is that empirical evidence shows that economies in which the rental
market was relatively large and deep suffered less during the financial crisis. Deep rental
markets thus appear to promote the resilience of the economy to adverse shocks and are
therefore desirable from an economic stability perspective. To promote their development, it
is important that renting is an attractive long-term proposition for households and landlords
alike.
My third and final observation arises from the fact that, as the economy recovered in Ireland,
the housing market took off rapidly, with property prices increasing by over 20 per cent in
2014, having fallen by more than 12 per cent just two years earlier (indeed, in January 2015,
the Central Bank of Ireland introduced loan-to-value and loan-to-income limits to increase the
resilience of the banking and household sectors to the property market and to reduce the risk
of bank credit and house price spirals from developing in the future).2 This pick-up is often
attributed to "pent-up" demand for owner-occupied housing which built-up during the crisis
years when credit was scarce and there was uncertainty about the path of house prices.3
Whatever its causes, it indicates that, while people are willing to rent on a short-term basis,
there is a strong preference for owner-occupied housing over rented accommodation.
2. The financial crisis
To put the role of the housing market in perspective, it is useful to start by reviewing the
depth of the recent economic crisis. One measure of the adversity of outcomes is the loss of
potential output, shown in Chart 1 for a sample of 24 countries.4 These losses arose from the
crisis reducing the level and perhaps also the growth rate of the economy's productive
potential. Another measure is the increase in the unemployment rate between 2005 and
2014, shown for a sample of 19 countries in Chart 2. Furthermore, Chart 3 indicates that
there is a high correlation between output losses and house price declines. Those countries
that experienced the greatest losses had the largest house price decreases after the crisis.
These charts illustrate that Croatia and Ireland both fared particularly poorly in the crisis: they
experienced large losses of potential output, large increases in unemployment and large falls
in real property prices. They also make clear that there are great differences between
countries in economic outcomes.
While the travails of Croatia and Ireland might simply have been due to bad luck,
creditfuelled housing bubbles played a big part in both countries' pre-crisis growth and subsequent
decline. It is this aspect that I will focus on and, in particular, the role that deep and
welldeveloped rental markets can play in helping to reduce the effects of shocks to housing
markets.
3. What is the role of rental markets?
So what is the role of rental markets in the downturn? As shown by Chart 4, the proportion of
the population which rents property, that is the rental rate, varies among industrialised
economies from just over 60 per cent in Switzerland to under 20 per cent in Spain and
Croatia.5 The rental rate is low in all English-speaking countries, ranging from 36 per cent in
Canada to 26 per cent in Ireland. Indeed, rental rates increased in a number of countries that
experienced housing market turmoil during the crisis years.
Consider a simplified scenario where all people in an economy finish school at 18, save for
10 years and then buy a house. In this scenario, a predictable number of people enter the
housing market every year: those who turn 28 years of age.6 When a shock hits the
economy, house purchase is delayed, either because of uncertainty about the future
direction of house prices, or because of a lack of credit. This delay in house purchase results
in people moving into the rental market. A deep rental market is better placed to absorb such
an increase in demand than a thin rental market. This is because the increase in demand will
be a smaller portion of the overall size of the market.
Moreover, compared to a situation in which no new household formation takes place in times
of uncertainty, this switch in preferences from owner-occupancy to rented accommodation
can have an important stabilising effect on housing markets. As house prices fall and
demand for rental properties pushes up rents, yields on rental properties increase, making it
attractive to become a landlord instead of selling at a depressed price. In Ireland, it is
estimated that 36 per cent of landlords are "accidental landlords" who found themselves with
a property that they could not sell as a result of the housing market crash.7 Rent received on
these properties has enabled landlords to meet outstanding mortgage repayments, and thus
helped them avoid falling into mortgage arrears. Moreover, as prices fall, the rental yield on a
property is likely to rise, encouraging new landlords into the market and helping to create a
floor to house prices.
Overall, a deep and well-established rental market therefore seems to be a mitigant against
the effect of shocks to the broader economy and housing markets. This is clear in
crosscountry data. Chart 5 contains a scatterplot of losses in potential output during the crisis
against rental rates and Chart 6 shows the relationship between rental rates and changes in
unemployment. In both these cases a clear negative relationship is readily apparent. Overall,
the evidence suggests that there is a link between the depth of the rental market and the
severity of macroeconomic outcomes during the recent crisis.
4. The role of mortgage debt in a financial crisis
There are of course also a number of social benefits from owner-occupancy which need to
be kept in mind. For instance, owner-occupancy represents the purchase of an asset and,
since mortgage loans are amortised in Ireland, therefore leads to wealth accumulation. This
can be particularly helpful in retirement, when reduced income can be offset by the lower
cost of outright ownership of housing. In addition, studies have shown that homeowners are
more engaged in social and political activities, have more positive assessments of their
neighbourhoods, better psychological health and higher educational attainments.8 Surveys in
the US show that homeowners believe their neighbourhoods are safer and better places to
raise children.9
But while the benefits of owner-occupancy are well documented, there is a much less
wellknown flipside to this coin: the risks associated with financially vulnerable households taking
on the financial burden of house purchase. Let me now discuss this issue.
In Ireland the burden of the current crisis has fallen squarely on the young, many of whom
bought property at the top of the market. The perception that one must get "on the property
ladder" as soon as possible that was a particular feature of the boom years, but also a
consequence of the poorly functioning rental market in Ireland, has had implications for
younger families. Many of these are now left with unsuitable properties for their housing
needs (for example, one bedroom apartments that are not satisfactory for growing families),
and with debts that they could no longer service when salaries declined and unemployment
rose during the economic downturn. Moreover, negative equity and mortgage arrears may
make it difficult for them to move in pursuit of new, or better paid, employment. While
desirable and beneficial for many, homeownership does come together with important risks
that many neglected before the onset of the crisis.
A particular concern in this regard is the fact that the risk of becoming unemployed or
experiencing income losses is not evenly shared across society. Younger and less
experienced workers, and those who work in industries that are sensitive to the business
cycle, such as the construction sector, are particularly exposed to the risk of unemployment.
This is illustrated by Chart 7 which shows that the crisis has disproportionately affected
unemployment rates among younger age cohorts in Ireland. Graduate salaries have declined
significantly since 2007, which has long-term implications for the earning potential of young
people.10 Chart 8 shows that employment in the sectors most vulnerable to the economic
cycle, such as construction, has been most adversely affected by the crisis.
Thus, the lack of a deep and well-functioning rental market forces all households, including
those at a relatively high risk of unemployment, into the property market. While the great
majority of borrowers are credit worthy and will service their loans, unemployment and
income loss, which may be caused by the unemployment of a spouse or partner, have been
important determinants of mortgage arrears in Ireland.11 Banks in economies with very high
house ownership rates may therefore experience high credit losses in a downturn.
The resulting link between highly-indebted and financially more vulnerable households and
the banking sector can create a cycle which is both self-reinforcing in good times with
expectations of increasing capital values increasing equity and enabling greater
indebtedness, and in bad times as both banks and households suffer losses.
What role can rental markets play? Buying a house using a mortgage is a risky leveraged
investment that involves a household borrowing several times its annual income to buy an
asset with an uncertain future value. Such investments should only be entered into by those
that understand the risks and feel able to assume them. Moreover, the rental market can
alleviate the risk of capital loss and negative equity, increase labour mobility and thus
facilitate the adjustment following adverse economic shocks. From a financial stability
perspective it is therefore important that households that worry about the risks of
homeownership have the option, if they wish, to rent a property that provides the type and
quality of housing, and security of tenure, that they require. Let me next turn to the rental
market.
5. The private rental market
It is clear that in Ireland, in contrast to elsewhere in Europe, renting a home is not seen as a
long-term option for households. Indeed, results from a recent survey show that over 70 per
cent of private rental tenants would prefer to own their own property, and just 17 per cent
wish to rent long-term.12 While this may reflect a cultural preference, or the benefits of
homeownership, it seems more than likely that the type, quality, affordability and, in
particular, security of tenure of private rented accommodation also plays an important role.
What can be done to make renting a more attractive long-term alternative to
homeownership? I believe that there are three aspects to this problem: first, the rental market
structure, particularly in terms of security of tenure, can play a role. Second, the investment
horizons of landlords are important. A culture whereby the market is dominated by landlords
seeking an income stream over the long term, rather than a capital gain in the short run, can
help raise the attractiveness of renting in a number of ways. Finally, in many countries,
policies aim to specifically incentivise homeownership, to the detriment of the rental market.
5.1 Security of tenure
A particular concern in Ireland is the absence of long-term rental contracts; while households
may wish to stay for long periods in their accommodation, rental contracts in Ireland are
predominantly of a year's duration. This leads to a wide-spread lack of security of tenure.
Indeed, a recent survey indicated that 23 per cent of private tenants in Ireland are afraid of
losing their home. In addition, 32 per cent have no formal lease, even though more than half
have been living in their current accommodation for more than two years.13 The risk and the
associated costs of having to move may make households opt to purchase their own home
and take on financial risks that they may feel they are not well placed to assume. Indeed,
29 per cent of tenants say that they would be more likely to rent long term if there was the
possibility of a longer term lease.14 Lengthening rental contracts therefore seems desirable.15
Interestingly, research has shown that in countries with comparatively strong security of
tenure and high rental rates, such as Germany and the Netherlands, security of tenure is
seen to foster long-run demand for renting and rental investment, such that neither tenants
nor landlords have sought to weaken security.16
Why are rental contracts in Ireland of such short term nature? Ireland's history of high and
variable inflation and the lack of institutional investors in the rental market must both be
important. In economies with a history of inflation, banks protect themselves by lending at
flexible interest rates. In turn, with mortgage costs varying over time, renters protect
themselves with short term contracts. In contrast, in economies with a history of low and
stable inflation, mortgage lending tends to be for long maturities and rental contracts tend to
be longer term.
Of course, Ireland's history of inflation is now over. But lending arrangements change slowly.
Overall, housing markets and financial stability in Ireland would benefit from borrowers
having a wider choice of fixed rate loans.
5.2 Incentives of landlords
The lack of institutional investors in the rental market is also important. The Irish rental
market is dominated by private households who let a single property.17 The fact that they
may need the dwelling for a family member, or may wish to sell it, is another factor that
makes for short-term contracts and concerns about the security of tenure. Furthermore,
buyto-let properties have the highest rate of mortgage arrears. The latest figures from December
2014 show that over 25 per cent of buy-to-let mortgages are in arrears. Indeed, survey
findings suggest almost 50 per cent of all landlords18 cannot cover their loan repayments with
rental income. Overall, 29 per cent of landlords intend to exit the market as soon as
possible.19
In contrast, institutional investors, such as pension funds and insurance companies, have
very long investment horizons and have strong preferences for tenants who stay for an
extended period of time, since finding new tenants and refurbishing apartments for them is
costly.20 Institutional investors can bring a standardised, professional approach to the
management of entire buildings of apartments, aiding the supply of suitable accommodation
in popular areas. This suggests that attracting more institutional investors would promote a
well-functioning rental market that is so important for financial stability.21 Furthermore, these
investors are likely to be less leveraged and have more diversified portfolios than individuals
owning one or two rental properties, and are thus better able to withstand an economic
downturn.
15
NESC (2015) discusses security of tenure in depth.
16
See De Boer and Bitetti (2014).
17
See Housing Agency (2014) which suggests that over 80 per cent of landlords own one or two properties.
18
Including those without outstanding debts.
19
Housing Agency (2014).
20
As do private households that invest in property for purposes such as additional income in retirement. In
Germany, where many people rent for extended periods, a large share of landlords are individuals, however,
they do so for retirement purposes rather than capital gains, and are therefore interested in a steady income
stream from long-term tenants (see ECB (2009), particularly Box 3).
21
To this end, Budget 2013 introduced Real Estate Investment Trusts (REITs) to Ireland. To date, approximately
1,500 residential units have been acquired by REITs.
There is a wide variety of government intervention in rental market, from the direct provision
of social housing to the regulation of the private rented sector.22 Because moving is costly
and disruptive, the tenant-landlord relationship is inherently asymmetric. Regulation, if
designed well, can therefore improve outcomes. That said, poorly thought out regulation, in
particular rent controls, can have adverse effects by reducing the supply of rental properties
and discouraging new construction and the maintenance of existing rental properties. Getting
housing regulation "right" - a task outside the central bank's remit - is important.
5.3 Policies favouring home-ownership
Home-ownership brings many benefits, and it is understandable that there are policies in
place to enable house purchase; I have already outlined the potential benefits in terms of
asset accumulation and social advantages associated with home-ownership. However, some
policies aimed at enabling people to gain from the benefits of home-ownership have the
effect of worsening the situation of those who either choose not to be homeowners, or cannot
afford to be so.
One important issue that influences households' choices between buying and renting
property is tax policy. In many countries it is generally favourable towards homeownership.
Examples of favourable taxation treatment of housing include the exemption of imputed
rental income on principal homes from income tax calculations, tax relief of mortgage interest
payments, exemptions of capital gains from the sale of principal homes, and the use of
outdated housing values for property taxes.
A favourable tax treatment of homeownership risks encouraging excessive leverage and
housing investment, leading to the development of macroeconomic and financial
imbalances.23 It can also tempt households that are worried about the risks inherent in
mortgage borrowing into house ownership. Overall, it seems desirable for tax policy to be
neutral between homeownership and renting. To this end, it is important to note that tax relief
on mortgage payments have been phased out since the crisis, and a recurrent property tax
has been introduced, in Ireland.
6. Conclusion
Economies that experienced boom-bust cycles in housing, such as Croatia and Ireland,
suffered disproportionately in the financial crisis. There were numerous reasons for this large
impact, many of which are, by now, very familiar. However, it is less frequently noted that
those economies with deeper rental markets suffered less. While the specifics of housing
policy are outside the remit of central banks, it is incumbent for us to draw attention to issues
that relate to financial stability. To reduce the risk and the amplitude of future housing cycles,
housing policy needs to consider also financial stability issues. In this regard, it seems
particularly important to promote a well-developed rental market as a genuine alternative to
ownership, and an attractive investment proposition for potential landlords. While many
households may continue to buy rather than rent, we need to make sure that this choice
reflects their preferences and does not merely reflect a poorly functioning rental market.
References
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