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 Supreme 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 (N 31) concludes. An online Appendix provides the data and code used to create the figures in the paper^[5].

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 commercial 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 local 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 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].

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].

Figure 3 shows that similar results can be observed in the main regions of Switzerland^[20].

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.

1. 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].

2. 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].

3. 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].

4. 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.

5. 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.

6. 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.

7. 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.

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.