The Challenge of the Initial Rent in Switzerland: An Empirical Study

In an unexpected decision issued in 2020, the Swiss Federal Supreme Court significantly increased the allowed return for most rental properties. This decision does not seem to have had any effect on the level of new rents, which suggests that the rules regarding the challenge of the initial rent have little effect on the level of new rents.
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In einem unerwarteten Entscheid aus dem Jahr 2020 hat das Schweizerische Bundesgericht die zulässige Rendite für die meisten Mietobjekte deutlich erhöht. Dieser Entscheid scheint keine Auswirkungen auf die Höhe der Neumieten gehabt zu haben, was darauf hindeutet, dass die Regeln zur Anfechtung des Anfangsmietzinses kaum Auswirkungen auf die Höhe der Neumieten haben.
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Dans un arrêt inattendu rendu en 2020, le Tribunal fédéral a considérablement augmenté le rendement admissible de la plupart des immeubles locatifs. Cet arrêt ne semble pas avoir eu d’effet sur le niveau des nouveaux loyers, ce qui suggère que les règles sur la contestation du loyer initial n’ont que peu d’effet sur le niveau des nouveaux loyers.

In an unexpected decision issued in 2020, the Swiss Federal Supreme Court significantly increased the allowed return for most rental properties. This decision does not seem to have had any effect on the level of new rents, which suggests that the rules regarding the challenge of the initial rent have little effect on the level of new rents.

I. Introduction
According to article 270 of the Swiss Code of Obligations 1 , tenants of residential and commercial premises can, in principle, challenge the initial rent within thirty days of taking possession of the property.
It is difficult to determine the effect of this regulation on the level of new rents, and it is obviously not possible to observe new rents without this regulation. As for the number of challenges, it is not decisive: a regulation can have a significant effect even if there are few cases handled by the courts. In fact, the low number of challenges could be explained precisely by the fact that the regulation is very effective.
This paper exploits a fundamental and unexpected decision of the Swiss Federal Supreme Court issued in 2020, which changed the allowed return on rental properties. It aims to examine the impact of this ruling on new residential rents in Switzerland.
While some studies have examined the effect of the Swiss regulation protecting tenants against unfair rents on the evolution of existing rents 2 , this is the first study I am aware of that examines the impact of the rules for challenging the initial rent on the level of new rents in Switzerland. This paper shows that the level of new rents in Switzerland does not seem to have increased after the Federal Supreme Court decision, which suggests that the rules regarding the challenge of the initial rent have little effect on the level of new rents. This result seems to confirm the assertions of several practitioners 3 , including experts close to the real estate world 4 , who had claimed before the Federal Supreme Court decision that many rents exceeded what was allowed at the time.
The rest of the paper is organized as follows. Section II (N 7 ff.) provides additional details about the Federal Sulpreme Court decision. Section III (N 14 ff.) describes the empirical strategy. Section IV (N 17 ff.) presents the results. Section V (N 20 ff.) discusses the results, and section VI

II. The Federal Supreme Court decision
According to article 270 CO, within thirty days of taking possession of the property, the tenant of residential and com mercial premises may challenge the initial rent as unfair before the authority and request said authority to order a reduction of the rent (a) if the tenant felt compelled to conclude the lease agreement on account of personal or family hardship or because of the conditions prevailing on the lo cal market for residential and commercial premises; or (b) if the initial rent required by the landlord is significantly higher than the previous rent for the same property 6 .
This provision applies to all residential premises in Switzerland, except for vacation premises, luxury premises with six or more bedrooms, residential premises benefiting from public subsidies, and premises falling under specific cantonal regulations 7 .
If the challenge is admissible, the authority will, in principle, calculate the net return on equity from the leased property to determine whether the rent is excessive 8 . However, special rules apply to buildings acquired more than 30 years before the beginning of the lease and to buildings constructed less than 10 years before the start of the lease 9 .
In a decision dated October 26, 2020, the Federal Supreme Court changed its precedent regarding the allowed net return on equity 10 . While it previously admitted that this return should not exceed the reference mortgage rate by more than half a percentage point, it stated that it should In its decision of October 26, 2020, the Federal Supreme Court also modified the rules on equity indexation when determining the net return 16 . This change is negligible for this study because of the very low inflation rate in Switzerland in the years preceding the Federal Supreme Court decision (if this change were taken into account, it would increase the allowed initial rents only slightly).

III. Empirical Strategy
The Federal Supreme Court decision was totally unexpected. In a decision issued only a few years earlier, the Federal Supreme Court had stated that it was up to the legislature to modify the allowed net return 17 .
The Federal Supreme Court decision was widely reported in the media 18 . It was the subject of a press release by the Federal Supreme Court on November 16, 2020, and was discussed in the main Swiss newspapers.
Under these circumstances, given that the change took effect immediately, a substantial increase in the level of new rents could be expected in the weeks following the press release of the Federal Supreme Court.

IV. Results
Figure 2 shows that the asking price for rental housing in Switzerland did not increase after the decision 19 . 18 See, for example, conoD (n. 10), p. 5, who describes this change in case law as one of the most significant in the field of tenancy law ("un revirement de jurisprudence qui sans nul doute est l'un des plus marquants en matière de droit du bail").
19 The figure is based on data collected by the company Wüest Partner, and published on the website of the Swiss National Bank, Real estate price indices - by market area - by quarter. now not exceed the reference mortgage rate by more than two percentage points 11 . The Federal Supreme Court also noted that this change only applies when the reference mortgage rate does not exceed 2% 12 .
Since the reference mortgage rate amounted to 1.25% in October 2020, the Federal Supreme Court decision had the effect of suddenly increasing the net allowed return from 1.75% to 3.25%, as shown in Figure 1 13 .
The effect of this change on the allowed initial rents is substantial. For example, for a property purchased for 1 million Swiss francs, financed by 40% equity and by 60% debt at the reference mortgage rate (1.25%), and for which the operating and maintenance costs represent 30% of the rent, the allowed monthly rent increases from 1726 Swiss francs to 2226 Swiss francs 14 , an increase of 29% 15 . 14 Allowed rent = allowed return on equity x 400,000 francs + mortgage interest rate x 600,000 francs + operating and maintenance costs.
Assuming that operating and maintenance costs = 0.3 x allowed rent, we obtain: allowed rent = (allowed return on equity x 400,000 francs + mortgage interest rate x 600,000 francs)/0.7. Therefore, with an allowed return of 1.75%, the allowed rent amounts to (1.75% x 400,000 francs + 1.25% x 600,000 francs)/0.7 = 20,714 francs, which means a monthly rent of approximately 1726 francs. With an allowed return of 3.25%, and assuming that the value of the property and the operating and maintenance costs remain constant, the allowed rent amounts to 3.25% x 400,000 francs +  The canton of Geneva provides data on new residential rents on its territory 21 . As Figure 4 shows, the level of these rents did not increase after the Federal Supreme Court decision either.

V. Discussion
The Federal Supreme Court decision does not seem to have had any effect on the level of new rents. To interpret this result, several points are worth discussing.

The Evolution of the Average Mortgage Rate
The evolution of the average mortgage rate paid by landlords during the period under consideration does not explain the lack of increase in the level of new rents. As Figure 4 shows, there was a slight decrease, but no substantial change, in the average mortgage rate paid in Switzerland after the Federal Supreme Court decision 22 .

The Evolution of the Consumer Price Index
The evolution of the consumer price index does not explain the lack of increase in the level of new rents either. As Figure 6 shows, the consumer price index remained almost constant during the relevant period 23 .

The Tightness of the Housing Market
The change in the vacancy rate does not explain the result either. Indeed, as Figure 7 shows, the vacancy rate in Switzerland decreased after the Federal Supreme Court decision, which should have led to an increase in the level of new rents 24 .

The COVID-19 Crisis
The COVID-19 crisis is probably not an explanation either since the virus began spreading in Switzerland in February 2020, several months before the Federal Supreme Court decision.

The Lack of Knowledge of the Regulation
The fact that some landlords were unaware of the initial rent regulation probably explains part of the result, but it cannot explain the complete lack of effect of the Court's decision on the level of new rents.

The Lack of Binding Effect of the Regulation
It is likely that the regulation was not binding in the regions of Switzerland that were losing inhabitants and were experiencing a housing surplus. In these regions, market rents were probably equal to or lower than allowed rents.
And even in economically dynamic regions, the regulation was probably not binding for recently acquired properties. For these properties, the equity value is correctly assessed, and the allowed return is probably close to the return that could be earned in the absence of regulation.
However, for properties that have not been recently acquired, the value of the equity, which is based on the property's historical value, is often significantly underestimated, leading to an overestimation of the true return 25 . For these properties, the regulation was clearly binding 26 .
Therefore, the lack of binding effect of the regulation only partly explains the lack of impact of the Federal Supreme Court decision on the level of new rents.

VI. Conclusion
In an unexpected decision issued in 2020, the Swiss Federal Supreme Court significantly increased the allowed return for most rental properties.This decision does not seem to have had any effect on the level of new rents, which suggests that the rules regarding the challenge of the initial rent have little effect on the level of new rents. This is probably due to landlords' lack of knowledge of the regulation, the fact that the regulation is not binding in certain circumstances, and the fact that an excessive initial rent is unlikely to be challenged. 31

The Low Probability of a Challenge
Even when an initial rent is excessive, the probability of a challenge is very low 27 . Under these circumstances, it is likely that many landlords take the risk of setting new rents at levels relatively close to what would exist in a free market. The low probability of a challenge, therefore, also likely contributes to the lack of effect of the Federal Supreme Court decision.
27 Every year, hundreds of thousands of new leases are concluded in Switzerland (see, for example, urS hauSMann, Vertragsfreiheit im Schweizer Mietrecht von 1804 bis 2014 unter besonderer Berücksichtigung des Mietzinses, Zurich et al. 2016, p. 2). There were approximately 1000 initial rent challenges in Switzerland in 2020 (see website of the Federal Office for Housing, Statistiques des procédures de conciliation). Therefore, the challenge rate is well below 1%, with strong cantonal disparities. If the initial rent is excessive, however, the challenge rate is probably higher (and probably lower if the initial rent is not excessive), but it is difficult to give a precise number.