Rent Control White Paper

The Reality of Rent Control in San Jose

By: Michael Shields, CCIM –Silicon Valley Multifamily Group

In April of 2016, the San Jose City Council updated their Apartment Rent Ordinance, approving a new rent control plan for multifamily properties built before 1979. The new directive says that, as of June 17, 2016, owners within this category of multifamily properties may only increase rents by up to 5 percent, instead of the 8 percent previously allowed – a reduction of 3 percent. Moreover, 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 owners of these pre-1979-built assets, a group representing approximately 44,000 apartments that house 11 percent of San Jose’s residents.

In markets that struggle with a high cost of living, rent control is often lauded by citizens. It provides renters with financial relief and positions municipalities as the heroes who delivered that relief. Unfortunately, there are long-term realities of rent control that are not as sunny and can be easily overlooked when quick solutions and grateful constituents abound.

Are these long-term consequences worth quick-fix policies? Most multifamily owners and investors – not to mention economists – would reply with a resounding “no.”

A Quick Lesson in Rent Control

Investopedia defines rent control as, “A price control that limits the amount a property owner can charge for renting out a home, apartment or other real estate.” It goes on to say, “Rent control acts as a price ceiling by preventing rents either from being charged above a certain level or from increasing at a rate higher than a predetermined percentage.”

San Jose adopted its rent-stabilization ordinance in 1979 and applied it to all properties built before this time. This decree prohibited owners in this asset class from raising rents more than 8 percent per year, per unit. However, there were exceptions to this rule. During a unit turnover (when an old renter moved out and a new renter moved in), an owner could raise rents on that specific unit to reflect market value. Additionally, owners who did not raise rents for two years could implement a 21 percent rental increase in the third year. If an owner increased their debt by completing substantial capital improvements, they could also apply to the rent control board for a variance to recoup that outlay through higher rents.

In contrast, owners under San Jose’s new ordinance are limited to a rental increase of 5 percent per year, with only one minor exception: If an owner improves their building, they are permitted to raise rents up to 8 percent in the first year post renovation. After that, increases move back to the more conservative 5 percent annual increase limit. Should an owner miss the 8 percent post-renovation rent increase opportunity, they cannot recoup with a deferred increase and there is no opportunity to apply for variance.

Two rules do remain unchanged: An owner can still increase a unit to market-rate rents during a transition, provided the tenant vacates the unit under his or her own volition. A developer or investor can also purchase a rent controlled property, tear it down and build new units that are not subject to pre-1979-build rent restrictions (assuming said developer or investor can secure all of the appropriate design, review and related approvals from the city.)

Proponents of rent control say that rent caps ensure that a portion of the local multifamily inventory is protected as affordable housing for low- and middle-income residents. That it allows individuals and families with lower incomes to remain in the city, near jobs and other resources – versus being displaced due to high cost of living – and that it allows long-term residents (some say: those who helped build the San Jose community) to remain in units that they have been renting for many years.

When Rent Control Works

Some communities within Silicon Valley have implemented rent control regulations, and the formula is working, but the reasons differ from those noted above. Rent control in Los Gatos, for example, follows a formula whereby rent can be raised 5 percent annually, with debt and capital improvement expenses (among others) allowed to be passed through to the tenants in the form of higher rents according to a specific formula. However, Los Gatos benefits from a host of factors not found in San Jose.

First, it is considered a more upscale and desirable location than San Jose, which appeals to a more professional work force. And although rents in Los Gatos are high compared to other areas of Santa Clara County, demand determines the rental rates. Second, residents in Los Gatos tend to earn more money (Los Gatos boasts one of the highest per capita income rates in the county), which enables renters to afford the submarket’s high rents while also saving to purchase a single family house or condo of their own. Los Gatos renters also tend to be a younger, more transitory demographic, which creates a comparatively high turnover rate. With each turnover, an owner can raise rents to market rate, allowing area projects to maintain solid cash flow. Third, Los Gatos schools are ranked among the best in not just Santa Clara County but in all of California. The correlation between a highly ranked school district and higher rents and property values has been well established for many decades.

San Francisco is also an exception to the rule. It operates under one of the strictest rent control programs in the area and yet values continue to skyrocket. Like New York City, we can attribute this to San Francisco’s extremely unique value foundation, based on world-class economic and lifestyle amenities. However, when it comes to cash flow, even many San Francisco owners are struggling. One example involves a six-unit, rent controlled property in the Inner Sunset that was purchased by its owner approximately 20 years ago. While value has swelled to an estimated $1,500,000, the asset still nets its owner less than $20,000 per year (and that’s without any debt). This equates to a 1.3 percent cap rate, which is ridiculously low for any commercial investment. Moreover, if the property had any debt, it would not generate a positive cash flow at all. In cases like this, we have to ask ourselves: Why would that owner continue to own, when even a conservative stock investment with a 5 percent yield would offer greater profit than his property investment – and without any of the challenges that are synonymous with multifamily ownership and management.

When Rent Control Fails

Unfortunately, San Jose does not offer the draw of San Francisco and it is not the young professional’s darling like Los Gatos. Here, when rent control fails to do what leaders intended, the ripples are significant. An owner’s return on investment erodes, which discourages property improvements on existing rent control assets and the construction of new product in the market. Renters who do have a rent control unit remain in place, clinging to their low rents even when their income would allow them to move on to a higher rent base. This limits the availability of rent controlled units for those it is meant to serve: Low-income residents. While this is happening, administrative costs soar, added barriers like “finders fees” for rent control units emerge and bottom-line tax revenues fall.

The result is a broken system, with a rundown inventory of units, low investor interest, low profit margin for owners and high operational costs for municipalities – all wrapped up in a still-ineffective social change machine. Even the U.S. Department of Housing and Urban Development (HUD) has concluded that “The benefits of rent control, from the tenant’s standpoint, are likely to decline steadily over time, as the quality of units deteriorate.”

With these thoughts in mind, it is not surprising that a poll by the American Economic Association reports a 93 percent of members surveyed agree that a “ceiling on rents reduces the quality and quantity of housing available.”

The National Multifamily Housing Council sums up the key drawbacks of rent control 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. The NHMC also points out that this can lead to the abandonment of an unprofitable property or condominium and cooperative conversions, which in turn serves to reduce – not increase – the stock of affordable housing.

  • Inhibition of new construction

Low return rates in rent-controlled multifamily markets is not an attractive draw to investors. On the contrary, it serves to direct investment capital 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. In the late 1980s, the NMHC reported this causing New York City an approximate $4 billion loss in taxable assessed property values, equating to an estimated $370 million in lost annual property tax revenues. While not as significant, Berkeley has experienced a similar scenario.

  • 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 want to stay there, even once their income exceeds the intended limits of said 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.

HUD itself notes that, “Even moderate rent-control ordinances reduce mobility noticeably, thereby leading tenants to occupy units whose characteristics are not well-suited to their current circumstances, such as family size and job location.”

The Owner’s Challenge

From the owner’s perspective, here’s how a failed rent control scenario plays out in San Jose… First, the city adjusts the rent increase ceiling from 8 down to 5 percent, based on an artificial threshold that the Housing Department thinks is “fair.” Almost immediately, owners see a drop in future cash flows. Soon, building maintenance issues arise and landlords are stuck between a rock and a hard place. They want to improve their buildings, create nice places for tenants to live and earn market rents that build a sound investment. However, under strict rent codes, these results simply aren’t achievable.

Consider this: Investor A buys an older, rent-controlled property in San Jose for $1 million. The property needs modernization and it is lacking curb appeal, so she invests $200,000 into upgrades such as plumbing, interiors, a new roof and similar improvements. The building emerges as a valuable, improved member of the local inventory. Unfortunately, based on the new 5 percent rent cap, it will take Investor A more than 30 years to make her money back.

And so Investor A opts to not make property improvements and her asset sinks into layers of deferred maintenance issues. The property value drops in parallel, putting Investor A in an unfortunate capitalization scenario. She could sell, but new buyers face the same challenge: They can’t get the buy-and-improve (or even maintain) scenario to pencil. And so they pass on the opportunity to invest, taking their money to a non-rent-controlled market.

The Renter’s Reality

Though rent control is most often championed by social and political advocates, time and again the reality is far from positive. Instead of contributing to an anti-poverty solution, rent control tends to do just the opposite by accelerating the deterioration of housing quality and availability, and creating a disproportionate occupancy of rent controlled units by higher income individuals – all while doing nothing to restrict owners of post-1979 properties from continuing to significantly raise rents on their apartment units.

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.”

This creates a dark outlook for San Jose renters expecting true relief from the city’s new ordinance, and an even darker outlook for well-intentioned owners wanting to provide quality living units for the market.

Where Do We Go from Here?

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?

Most economists will tell you that rent control ultimately reduces and deteriorates existing supply, and deters new investment in the community. Renters lucky enough to live in a quality rent-controlled unit often hold on to that unit tightly. Thus, low- and middle-income families are still pushed to the less desirable units in the rent control inventory.

Investors also lose out. Even before stricter rent controls are put in place, San Jose values still pale in comparison to nearby, non-rent-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-rent-controlled 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, non-rent-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.

Like the idea of rent control itself, more buying and selling seems like good news for real estate brokers. And it’s true that, in the early stages, brokers will be flush with deals. But the dark side is that there is a dark side. In the long run, rent control takes an entire market – like San Jose – out of a dealmaker’s realistic playing field, which greatly reduces the number of investors willing to purchase properties. And that doesn’t bode well for anyone.

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.

Even the Economist notes that, “In places where demand to live in the city is rising (as in London, New York and Seattle) a more effective policy would be to build more housing.”

What Can Owners Do Now?

For San Jose owners, rent control will usher in reduced income, increased expenses and more red tape in complying with the city’s new apartment rental registry – all factors leading to a net lower cash flow. Decreased investor demand will also breed lower property values.

If you fall in this category of owner, you have a few options. Option one: Hold on to your 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.