Cities are back in vogue, too. The influx of people into Europe’s cities has quickly reverted to pre-pandemic trends. Between 2022 and 2025, the number of people renting in the EU is expected to increase by four million, according to the European Commission. This is being driven by the rebirth of urbanisation trends after the pandemic, pressures in the home-ownership market, and an increasing preference for rented accommodation as a more flexible form of tenure. The growth of investible stock in the private rented sector across Europe has also facilitated the sector’s potential.

But despite these trends, the new supply of good-quality rented property is not keeping pace with rising demand. Total European housing stock is increasing by just 1.5% per annum and only a proportion of this is rented accommodation.

The barriers to increasing the supply of housing are significant and complex to solve. Germany has an estimated deficit of 700,000 homes, and permits issued for new housing fell sharply in the first half of 2023. For the few schemes getting the go-ahead from complex planning systems, financing costs have increased sharply, and contractors are under substantial pressures from rising construction costs and tight labour markets. Turning permits into physical housing stock is not a foregone conclusion.

High inflation has triggered rent caps

This demand and supply imbalance is creating affordability pressures that are unlikely to subside anytime soon. We define an affordable rent as being less than 40% of disposable household income. Importantly, it is close to this level in a growing number of cities. In the last year, open-market rents have increased by double-digit percentages in Dublin, Munich, London, Barcelona, Madrid and Lisbon. More substantial levels have been recorded in Warsaw and Prague, where added pressures from migration, caused by Russia’s invasion of Ukraine, have been most prominent.

Tenants in situ have not been exposed to the full impact of these pressures as lease agreements on the continent are usually inflation-linked, rather than subject to annual open-market-rent reviews. However, the recent and ongoing period of elevated inflation has brought sharp rent increases to many households due to indexation in lease terms.

It is standard practice in many markets for rents to be subject to annual indexation. This has been high recently, meaning rents have become less affordable. We have written about these pressures in our more detailed insight paper. The difference today is that we see more political pressures to address the issues through temporary regulation. As we know, supply is not responding adequately, so regulation is the obvious alternative for authorities.

Various governments have introduced new caps on consumer price index (CPI)-linked rent increases to help private households in this high-inflation environment. In all recent cases, the caps introduced were only implemented on a temporary basis. However, we suspect that some of these policies will be extended or modified and become an increasingly common feature. For example, the French government has extended its ‘rent shield’ to March 2024. If inflation proves sticky, we could see this extended further. The chart below shows how the caps in Europe compare with recent levels of inflation.

Source: CPI, Oxford Economics, abrdn, June 2023

How might rent caps affect cashflows?

With the potential for temporary rent caps to become a more permanent feature of the market, it is worth looking at the impact of these caps in more normal economic circumstances. We analysed the six countries with a cap in 2023 (Denmark (4% cap), France (3.5%), Spain (2% in 2023 and 3% in 2024), Portugal (2%), Ireland (2%) and the Netherlands (4.1%)). Firstly, the analysis looked at how many years since inception of the euro (1999) that inflation exceeded the rent caps, in theory triggering the regulation. Secondly, we calculated the theoretical ‘loss’ of indexation, based on the caps.

The analysis shows that the impact on cashflows would have been negligible in most markets. In Denmark, France and the Netherlands, the rate of inflation exceeded the caps in fewer than four out of the last 25 years. In Spain and Ireland, inflation exceeded the cap more regularly – at 16 and 13 years, respectively.

When we looked at the difference in inflation compared with the caps, the cumulative and theoretical ‘loss’ of rent indexation would have been minor in Denmark, France and the Netherlands at less than 0.4% per annum. In Spain and Ireland, the loss of indexed cashflows would have been closer to 1% per annum over the 25-year period had the caps been in place.

A positive for tenants and landlords?

We believe a cap on inflation, to combat today’s cost-of-living crunch, should not be a long-term negative for institutional investors, even if it’s extended indefinitely. In fact, caps could help support rents in these exceptional times by reducing tenant churn, maintaining cashflows and increasing the net-operating income from assets. That said, the longer-term affordability conundrum needs to be resolved through more housing.

The recent caps shine a light on the importance of underwriting modest growth in cashflows, looking after tenants, and the need for investors to anticipate changing dynamics in how rental regulation works in each jurisdiction.