Scotland's Rent Caps Have Brought Uncertainty to Build-to-Rent Market But Fundamentals in the Country Remain Compelling
In 2023, it’s almost impossible to speak about UK Build to Rent (BtR) without mentioning Scottish rent caps, a regulation that is all too familiar to anyone who has, or is looking to, invest in the Scottish residential market.
In a move designed to support renters being affected by the cost-of-living crisis, the Scottish Government introduced emergency legislation for rent controls on the private rented sector (PRS) in September 2022. This ruling capped rental growth for existing tenancies at 0% pa until 31 March 2023. From 1 April 2023, these caps have shifted to a maximum annual increase of 3% pa. However, some of this growth cap can be mitigated against increasing costs, and landlords can apply for increases of up to 6% pa to help cover higher costs, such as rising mortgage repayments, in defined and limited circumstances (Scottish Government).
Scotland Is An Excellent Location For BtR
Scotland is one of the most exciting, undersupplied opportunities for BtR in the UK, boasting a young, well-educated demographic with strong employment prospects in its key cities. Edinburgh, for example, has the largest proportion of highly qualified workforces (40.1%) out of all UK key cities, including London (ONS). Despite this, the impact of these new regulations is already being felt in the sector in Scotland.
Inward investment has slowed significantly, creating considerable uncertainty for developers. The risk is clearly that this legislation, albeit well-intentioned and positioned as a short-term solution, will reduce development and thus the supply of rental stock over the longer term, which will of course put even more pressure on rents. None of which helps the renter.
These measures have prompted debate across the rest of the UK, especially following the substantial rise in rents in many other cities across the UK.
This policy has caused worry for BtR investors, who are concerned about the uncertainty of further legislation and restrictions, dampening investment in the short-term. In a market where most investments are made via forward funding or forward purchase agreements, security of income and exit is heavily relied upon. Operational assets provide stronger security of income, they carry much less ‘let-up’ risk, alongside more clarity over achievable rental levels.
Rental Caps Across Europe
If we take a step back from the initial reaction to rent caps and look at other countries across Europe that have these measures in place, we see a more positive picture, especially those with more advanced PRS markets than the UK. For example, Germany, the largest institutional PRS market in Europe, has lived with rent controls in its key cities since 2015, capping growth at 15% over 3 years with no increases set within the first 12 months. Indeed, this is greater than the proposed Scottish caps. In addition, the reality is, you would struggle to find many institutional grade investors that underwrite rental growth greater than 3% per annum.
However, Ireland is currently seeing a supply and demand imbalance with its rent control system. The economist Jim Power has suggested that Rent Pressure Zones (RPZs), introduced in 2016 to limit rental growth, have created a two-tier system whereby the proper maintenance of rental properties is no longer economically viable. This has resulted in private landlords exiting the market as they incur further costs and taxation, not covered by their existing income due to growth caps. In February 2023, there were 1,096 homes available to rent across the country, a 20% drop from the same time last year. The fear is that Scotland could undergo a similar problem. Of course, there are allowances to mitigate cost, but with the current inflation rate (CPI) at 10.4% (ONS), a 6% growth cap does not cover cost in real terms.
Institutional investors are facing different concerns than private landlords, however. Amongst this market, long tenancies and retention rates are prioritised over increases in rents. The reason being that longer tenancy agreements create further secure income, an attractive feature to investors in Germany, particularly pension funds. However, Germany is a market where stock is traded as an operational asset, not forward funding.
Scotland is not in the same position. It needs to build its stock. So, the fact that the rent control system has created viability issues in forward funding through limiting revenue and nervousness around further government intervention, is a problem. Further support is needed to assist in the delivery of new rental stock, be it in treating BtR separately to the wider PRS market or reassurance from the Scottish Government.
Once the initial upset of the legislation has calmed and the uncertainty caused by recent SNP leadership race, we will have a better understanding of the future of the Scottish PRS. Investors and developers will be closely watching the outcome of the changes and how policy will be shaped moving forward, and while we hope it won’t inadvertently squash investment and development into the sector – with potentially dire consequences for renters – it will not change the fact that the fundamentals of the Scottish BtR market are compelling. My advice to investors is, regardless of the rent caps, not to pull the handbrake on Scottish BtR.