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The Reality of Rent Control in San Jose

September 14, 2016

In markets that struggle with a high cost of living, rent control is promoted as an almost providential gift — financial relief provided by municipalities, for its citizens. Unfortunately, there are long-term realities of rent control that most multifamily owners and investors (not to mention economists) warn are not worth their long-term consequences. With the April 2016 approval of its updated Apartment Rent Ordinance, San Jose becomes the latest “worth it or not worth it?” case study on the ultimate price of rent control.

Under San Jose’s new rent control directive, as of June 17, 2016, owners of multifamily properties built before 1979 may only increase rents by up to 5 percent, instead of the 8 percent previously allowed — a reduction of 3 percent. The new ordinance eliminates the 21 percent increase previously allowed if rent had not been raised in the last 24 months. It also eliminates any debt pass-through and places much greater restrictions on passing through the cost of capital improvements restrictions for pre-1979-built assets.

In all, these new rules apply to approximately 44,000 apartments that house 11 percent of San Jose’s residents. Proponents of rent control argue that these rules ensure a portion of the local multifamily inventory is protected as affordable housing. That it allows low- and middle-income residents to remain in the city, near jobs and other resources.

Unfortunately, there is a dark side to rent control, with key drawbacks that the National Multifamily Housing Council sums up as follows:

• Deterioration of Existing Housing

Case studies support that rent control reduces an owner’s return on investment, which in turn decreases their desire or ability to improve units. The result: a drop in the quality of existing rental stock.

• Inhibition of New Construction

Low return rates in rentcontrolled markets drives investors to more profitable markets. This decreases the construction volume of new units and/or creates scenarios whereby multifamily assets are converted to other uses.

• Reduced Property Tax Revenues

As property values among rent-controlled buildings drop, so do the taxes that a municipality can assess on those buildings.

• High Administrative Costs

The municipal infrastructure required to create, monitor and manage complaints and appeals within a rent control system can be tremendous, and often outweigh the short-term benefits envisioned for rent regulation.

• Low Income Residents Still Lose Out

Those living in a rent controlled unit often cling to their units, even after their income exceeds the intended limits of affordable housing. Some renters also unofficially sublet their units to family or friends, in order to retain control of a low rent base. This reduces the inventory of available rent control units for the true low-income wage individuals who need them. It also creates new factors that all renters in this category must contend with, such as finders fees and other entry costs.

At its most errant, rent control can also breed a unique form of discrimination. As the NMHC says, “By eliminating rents as the basis of choosing among a pool of potential customers, rent control opens the door to discrimination based on other factors.” Among these are income and credit history, race, sex, family size and “other unlawful factors” that bias the selection process in spite of Fair Housing laws.

The leading urban policy magazine City Journal has highlighted rent control’s very counter-intuitive reality. It points to New York City as a prime example, noting that, “It has finally dawned on many New Yorkers that rent controls, far from solving the city’s housing problem, are a prime cause of it.” Even with 1.1 million rent-controlled apartments, Journal reports that NYC’s middle-class families still struggle with crowded living conditions, a monopoly of rent-controlled units among the wealthy and limited new construction to help expand local housing options.

In fact, according to the magazine, “Harvard’s Joint Center for Housing Studies discovered that Manhattan’s high-income neighborhoods and a few wealthier areas in Queens won the lion’s share of New York’s rent subsidies (“rent subsidy” being the difference between the maximum rent for a regulated apartment and the actual rent for a comparable unregulated unit.)” Why? Because, “The greatest subsidies go to stable households living in desirable apartment buildings and neighborhoods…” As a result, “Poor and minority families, especially large households with children, don’t benefit in the least from rent controls.”

What Can Owners Do Now?

As the NMHC asks: Why should the uniquely public burden of providing subsidized housing to the poor and middle class be borne solely by providers of rental housing?

Even before stricter rent controls are put in place, San Jose values still pale in comparison to nearby, nonrent-controlled communities. In 2015, for example, San Jose’s multifamily average per-unit sales price was $219,554. In the rest of Santa Clara County, the per-unit sales price was $439,425. As these figures show, the average value in non-rentcontrolled communities is considerably higher, offering an investor a far greater opportunity to recoup investment dollars from either buying a property with deferred maintenance or from renovating and improving a currently owned property.

Investors know this scenario well, and because of it, are already buzzing about exchanging their San Jose assets for properties in nearby, nonrent-controlled communities. Others are in the process of buying and are simply saying, “Not in San Jose.” And so their investment dollars — and their tax revenues — are going elsewhere, such as Mountain View, Sunnyvale, Campbell, Santa Clara or Milpitas. In the long run, this takes an entire market — like San Jose — out of a dealmaker’s realistic playing field.

Those who oppose rent control generally agree that our solution to high rents and tight inventories involves a return to the basic fundamentals of economic stimulation. Some examples: Federal and state programs that provide financial assistance to low-income renters and, in turn, increase their ability to stimulate the economy through buying and renting activity. Also, programs and policies that support easier renovation or new construction of affordable housing units — a move that increases and diversifies San Jose’s multifamily inventory rather than narrowing it.

In this new reality, San Jose owners have a few options. Option one: Hold on to their property and live with the lower income, lower returns and increased management obligations. Option two: Exchange out of the San Jose market into a nearby city that does not have rent control. However, those considering option two have a small window of opportunity. They need to move soon, while the market is still strong and values are still high — and before other owners throw their hands up in frustration and join the masses wanting to sell off their San Jose rent controlled assets.

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