Housing Standards 2003/2004:
Housing Policy in the Czech Republic - More Efficiently and More Effective

5. Simulation of an equilibrium market rent in the Czech Republic and of the financial and social impact resulting from an introduction of income-tested housing policy instruments

5.1 Methodology and assumptions

The problem of identifying an equilibrium rent level was approached from two perspectives in the simulation. The first perspective was the search for a partial short-term equilibrium on the rental housing market. The prerequisite for achieving such equilibrium was the saturation of a potential (additional) demand formed by "non-resident" households. "Non-resident" households were defined as households that could, if the rental housing market were deregulated, potentially generate additional demand on such a market (i.e., not homeless households, but households sharing their dwellings with one ore more other households etc.).

According to the assumptions of the model, the equilibrium on the rental housing market would be achieved at a moment when - as a consequence of rent deregulation in the controlled rental housing sector - such a number of dwellings is vacated that will satisfy the additional demand comprised by "non-resident" households. If we presume that households think and act rationally, a portion of rental dwellings would be vacated as a result of some households leaving the rental sector for the owner-occupied housing. The principle based on which higher income households would leave rental housing based on comparing the rent and the user costs of owner-occupied housing (while also meeting two other conditions) was demonstrated in the previous chapter. At a moment when the number of vacated dwellings in the rental housing equals the total number of "non-residents" (i.e., satisfies the additional demand), the deregulation process would stop and a short-term equilibrium market rent price would be achieved.

The goal of the simulations was also to find a long-term equilibrium rent level based especially on an investor's point of view, i.e., find a minimum rent level at which private landlords would be willing to rent dwellings and not to sell them. The starting point was to determine the minimum required return on investment in rental housing.

The total return consists in two parts in the case of rental housing - the first is the income return, and the other is the capital growth. In view of the fact that in the Czech Republic information on the average return on investments into real estate is not available, we used the values of the return index published for various countries through the Investment Property Databank (IPD), specifically the item representing income return.

The index values in individual countries were then compared with the return rate on alternative assets, to be concrete, on long-term government bonds. The goal of such a comparison was to determine to which extent the rate of return on investments into real estate differs from the rate of return on relatively safe investments into long-term government bonds, i.e., whether investors on foreign markets demand an additional risk premium when investing into rental housing. In countries with a relatively fast growth of prices on the property market in recent years (for example Sweden, Netherlands) the income return is approximately at a level of an average return to maturity of long-term government bonds. In view of the fact that in the Czech Republic we could also see a marked growth of property prices in recent years, the minimum required return on investment into rental housing was determined at a level of an average return to maturity of long-term government bonds, i.e., 4%. The minimum required rate of return was then increased by the expected depreciation amounting to 1%.

Foreign experience shows that in the long run real estate prices mirror income developments; the price-to-income (PTI) ratio (usually the ratio of median property price to median income) gradually increases and oscillates around a certain trend. Using regression analysis, we therefore calculated an equilibrium value PTI for the Czech conditions. The equilibrium value PTI in Prague was calculated at 3.75. Knowing the income situation of Prague households it was possible to calculate an equilibrium price of an average dwelling in Prague based on the value of the equilibrium PTI.

Knowing the minimum required return on investment into rental housing and long-term price level, the minimum required rent was calculated as a factor of these two values. The minimum required annual rent for an average dwelling in Prague was thus estimated at CZK 53,565, i.e., approximately CZK 72.1 per m² per month.