MR 2018

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Copenhagen Property Market Report 2018

enabling them to secure attractively levered income returns. Against the backdrop of Denmark’s favourable framework conditions and strong fundamentals, we expect interest from international investor to continue unabated in 2018. In spite of record-high allocations to residential assets, domestic institutional investors struggled to compete as international investors dominated the core segment in 2017. Instead, they moved further out the risk curve, and the year saw several ventures that pushed the boundaries of the traditional investment sphere. Pension funds discarded turnkey investments in favour of development schemes as the profitability of the former began to falter due to yield compression and higher underwriting levels of rents. In addition, pension funds were seen to increasingly invest in the financing of residential developments. For instance, pension fund PKA provided a DKK 4.2bn loan for the development of the Carlsberg City District and AP Pension provided a DKK 1.4bn loan for the development of Enghave Brygge in the Sydhavnen district (the south harbour). According to the Danish FSA, the six largest pension funds have increased their direct lending activity from DKK 44bn in 2012 to DKK 106bn in 2016, including both property financing and corporate loans. As the immediate supply of development sites in Copenhagen is drying out, pension funds are searching for investment opportunities in all parts of the country. Some pension funds have entered into partnership funds targeting mid-sized cities and some are undertaking development in these areas. We expect increased risk-tolerance as placement requirements remain high and competition for prime assets remains fierce. In 2017, the gap between utility-value rent and market rent began to narrow. We predict that this trend will continue in 2018, driven by a more professional market in which investors are more inclined to appeal rent tribunal decisions to the more liberal city court and the compounding effect of a steadily growing number of letting comparables. We believe that investors are already preparing for this new scenario, underwriting higher utility-rent values going forward and applying exit yields as low as 3.50% on current levels of utility rent.

The old housing stock of Copenhagen

Broadly speaking, special rent control provisions apply to some rental housing in Copenhagen, and other large Danish cities, namely residential rental flats taken into use before 1992, collectively also referred to as the “old housing stock”. According to our estimates, old-stock housing accounts for some 80% of Copenhagen housing, in certain central districts even 90%. In principle, the rent must not exceed the cost of operating the property plus a small fixed yield. However, the rent control provisions allow for individual units to be lifted from cost-based rent to utility-value rent subject to comprehensive modernisation. Utility-value rent is based on comparable modernised units, and tenants may contest the rent level before a rental tribunal. From a landlord’s perspective, modernisation schemes are potentially lucrative as utility-value rents are typically only some 20% below market rent level, making it possible to demand large rental increases, typically in the DKK 700-1,200 per sqm p.a. range. The business plan for old-stock properties is therefore based on the rent potential that may be achieved if unmodernised flats are modernised, which can take place as tenants vacate. The net initial yields of such properties are subsequently low as current rental income is much lower than the future projected cash flows stemming from modernised flats. It is not uncommon to see net initial yields as low as 1.5-2.0% for properties in attractive locations with large rent potential. So-called value-add investors have traditionally been the most active investors in old-stock housing as churn rates, utility values and modernisation cost estimation are associated with substantial uncertainty. Investments in such assets require proactive asset management. In recent years, however, old-stock housing has become “mainstream”, appealing to a wider range of investors with different risk profiles. Especially investors with long investment horizons are showing a stronger appetite for the segment, as the liquidity and market risks associated with churn rates in a typical 5-7 year holding period are largely eliminated. In addition, the risk profile of a cost-regulated property is much lower than the profile of new stock, allowing for competitive risk-adjusted returns relative to the bond market, even at very low net initial yields. The segment is also free of any immediate affordability concerns as utility-value rent remains well below market rent and as the old housing stock includes smaller average unit sizes than the new stock.