A Government Duel Over Rental Housing

The finance and housing ministries are trying to entice institutionals to invest in long-term rental projects, but both are likely to face problems related to returns, occupancy and maintenance.

Government property sales for long-term rental projects are set to begin soon along two parallel tracks: The Finance Ministry and the Housing and Construction Ministry have each developed a marketing plan, and both will be implemented in tandem. A rivalry between the professional staffs of the two ministries is emerging over which plan will prove more successful.

Finance Minister Yuval Steinitz and Housing Minister Ariel Atias, along with their advisors and staffs, have recognized the need for developing a sophisticated rental market, and share an identical goal: promotion of projects to increase rental housing supply and to revolutionize the market as a key means for solving the housing shortage. Both ministries are also hoping for projects to be financed by major institutional investors: insurance companies, provident funds and pension funds.

Rental project - Moti Milrod - February 2012
Moti Milrod

Hardly any large projects in the country today aimed at the rental market. Bringing the institutionals into this field - still almost exclusively dominated by small-time individual landlords - is expected to transform market standards and alleviate some of the existing disadvantages of renting versus owning.

Program initiators hope the institutionals will present alternatives for the entire market to follow, such as varying the length of rental contracts. Tenants today are usually limited to a one- or two-year contract and can be asked to vacate thereafter, or face steep rent hikes when renewing. An institutionally run rental market would offer renters the option of long-term contracts at predetermined prices.

Another issue is the generally low level of rental housing maintenance. Landlords have no incentive to invest in their properties, and meanwhile tenants, who usually rent for the short-term, aren't prepared to spend money on repairs or renovations. Rental units built and managed by institutionals are expected to be better maintained.

Parallel tracks

The two government ministries differ, however, as to the best way to entice institutionals into the rental market, with each proposing its own plan. On one point they do agree: that the institutionals require an annual return of about 7% to get involved. But the treasury and the Housing Ministry each maintain that only their own plan will fit this bill.

According to the Housing Ministry's scheme, geared mainly to builders, land will be offered at a predetermined price reflecting a massive 50% to 70% discount on its appraised value: Some 60% of the units in the project will be long-term rentals for citizens seen as eligible by the ministry, and there will be competition over who will offer the lowest rental charges. Participants in the tender will need to determine what sort of rent will give them enough return on investment.

According to the treasury's program, targeting mainly large institutional investors, bidding will be for the top price offered for the land. In this case all the units built by the winner will be long-term rentals, 25% at controlled prices set by the tender and the rest at market prices.

The housing and finance ministries have agreed to operate both programs simultaneously. The Housing Ministry said the first land tender for its plan will be publicized within a few weeks. The treasury, for its part, is still waiting for legislative amendments to exempt institutionals from taxes on investment under its program. Tenders going out under both plans are expected to include a total of 5,000 housing units, and after a year the two methods will be evaluated. Market response to each type of tender will determine which track will be expanded in future years.

At a discount

What discounts on land prices will entice developers and financial institutions to embark on long-term rental projects? An examination conducted for TheMarker by accounting firm BDO Ziv Haft indicates that, under the treasury's program targeting institutional investors, they would be prepared to pay 55% of what is considered to be a fair market value of a piece of property to attain an annual yield of 6.93%.

This result was based on a calculation for a project with 300 units of 80 square meters each. The model also assumed fair value at about NIS 350,000 per unit, a property value characteristic of "third perimeter" localities such as Hadera and Rosh Ha'ayin, and that 75% of the units would be rented out at a market rate of NIS 3,500 per month, and 25% at a "controlled" price of NIS 2,500.

The analysis of the Housing Ministry option, aimed primarily at developers, showed that if the ministry set the land price at 65% of its fair market value, an average annual return on investment of 7.15% could be attained if NIS 2,500 was charged on the 60% of units in the project allocated for rental. With the model assuming a NIS 3,500 market rate for such units, this represents a 30% reduction for tenants, while Housing Minister Atias is on record as claiming that affordable rent should be defined as 20% cheaper than the market rate. This means the Housing Ministry could offer a smaller discount on the land and still achieve its objective.

A key assumption of the model, for both tracks, is that the developer finances 70% of construction costs through a loan bearing 5.5% in annual interest. The rate of return for the investor, stressed BDO Ziv Haft, varies according to how much of the project is financed by loans, as well as their interest rates and terms. This variable is largely dependent on how these projects are perceived by the market: Higher risk attributed by the market would worsen the terms of the loan, requiring either higher rents to be paid by eligible tenants - or larger discounts on the price of the land.

Moti Dattelkramer, a team manager at BDO Ziv Haft, points out that the analysis was based on estimated land value in cities like Rosh Ha'ayin, Ashkelon and Hadera, not taking into account future increases in the prices these homes might eventually be sold for, so the assumption was they'll be sold at today's market value: about NIS 900,000.

There are still quite a number of variables the model has difficulty forecasting, says Dattelkramer, such as financing.

"Large-scale projects like these are generally difficult to finance in Israel, not to mention credit restrictions that banks are now placing on real estate developers," he explains. "Another factor to take into account is the risk posed by the project being located in peripheral areas for a population with low to average income, and therefore being prone to developing the characteristics of a poor neighborhood."

"Such types of projects haven't yet been tried in Israel, and experience from abroad shows a risk of creating slums," warns Shahar Ziv, managing partner at BDO Ziv Haft. "This could lower the rent that can be charged and lead to physical damage of the property, money-collection and other problems."

"Overall, the programs offered by the government are attractive, but only on condition of a substantial discount on the land and a guarantee of low taxation," concludes Ziv.

The return on investment

Developers will have the final say on the feasibility of the government promotions. Those who spoke at a real estate panel discussion held three weeks ago at the Hebrew University of Jerusalem's School of Business Administration - Abraham Kuznitsky, chairman and controlling owner of Minrav Holdings; Ronen Ginzburg, CEO of Danya Cebus; and Shlomo Gutman, the outgoing real estate investment manager at Migdal Insurance and Financial Holdings, who is moving to The Phoenix Holdings - weren't impressed.

Gutman explained that the return-on-investment test is the real test: that is, it's easy for institutional investors to buy an existing, fully occupied office tower at a 7% return, he said. However, a long-term rental project means such investors must take on development and risk without generating a higher return.

Kuznitsky said last week that the risks entailed in a project of this type demand a higher promised return in order for developers to opt for it.

"I don't believe there's a serious professional who would enter into a project like this for less than an 8% to 10% return," he said. "There are many unexpected factors, like the occupancy rate and investment in maintenance. The banks won't be happy to finance a project like this either. It's a high-risk effort."

And if the expected rate of return were higher, would you yourself go into such a venture?

Kuznitsky: "At a 10% return I would examine it, particularly regarding the location. Don't forget that you'll also need to eventually sell the apartments. There's a difference between a developing neighborhood where schools are being built and an aging neighborhood in a godforsaken area. The property's value at the end of the period needs to be anticipated. In any case this would be a project for professionals. It would require a capacity for dealing with property management and maintenance - something that hardly any developer in the country today specializes in."

Yaakov Lev, owner of The Clock Tower Company, has three long-term rental projects going in Jaffa, including the Venus with 120 apartments. He says from what he understands, the planned projects could be worthwhile for developers, but come with risks.

"A 7% return is excellent but I doubt it's realistic to assume 100% occupancy," he said. "In Jaffa we have 90% occupancy, and in the areas mentioned it could be significantly lower.

"Beyond that I foresee high maintenance costs, more than estimated in the model, because there is a higher level of wear and tear with projects geared entirely toward tenancy," Lev continued.

"Another risk factor for developers is loan interest. These [projects demand] long-term loans and the interest rate won't be low forever. If interest rates rise in the next few years, the developer could see his return on investment vanish. It's therefore hard for me to see builders, used to working with much higher profit margins on projects geared toward sales, getting into something like this. Right now it sounds risky, and in my opinion the benefits provided by the government need to be improved before builders rush in."