Development Under Statewide Rent Control

California and New York reignite their battle against housing shortages with the enaction of statewide rent control laws. These initiatives, among other things, cap the amount that landowners can increase rent each year. Rent control laws, like these, have the long-term effect of holding rental prices below market value. Historically, when the government caps the price of a good irrespective of its market value, the short-term consumer benefit is often negated by resultant supply shortages. (The Political Economy of Wage and Price Controls: Evidence from the Nixon Tapes, Public Choice, October 13, 2016.)

During the late 1970s, for example, facing increasing housing rents, the mayor of Santa Monica, California, signed into effect a rent control bill that restricted how much landowners could increase rent. The rent control measure covered a particular beach-front apartment whose penthouse was being rented at $600 per month. The mortgage, property taxes, and other expenses attributable to that unit soon increased to an amount double, and then triple, the amount of the monthly rent. Operating at a loss, the property owner defaulted on his mortgage and the bank began foreclosure.

Like Santa Monica’s housing problems of the 70s, California’s and New York’s rent control policies make use of the same method (imposition of price controls) to address the same problem (high cost, low stock). Admittedly, New York’s and California’s newest laws may not be as draconian as those implemented in Santa Monica (a so called “second generation” rent control law). California, for example, expressly exempts homes built within the last 15 years, and expires in 2030. The “new building” exemption and 2030 sunset are intended to mitigate what opponents and economists predict will be a chilling effect on new development, associated reduction of the property stock, and consequent rent increases. (Why Rent Control Doesn’t Work, Freakonomics Radio, April 3, 2019.)

But will California’s new-building exemption be enough to save its statewide rent-control program from the pitfalls plaguing the government’s price-caps of the past? This article will consider this question and, more specifically, what impact statewide rent-control policies might have on property development.

The Law: California Assembly Bill 1482

California Assembly Bill 1482 (or “AB 1482”) was signed by Governor Gavin Newson on October 8, 2019. The bill, which will be in effect from January 1, 2020 to 2030 (unless extended), generally restricts owners from annually increasing rent more than 5%, plus inflation, or 10%, whichever is less, statewide. Under AB 1482, all residential rental properties in California will be subject to rent control unless the property was issued its certificate of occupancy within the last 15 years. Hence, unless otherwise exempted under AB 1482, starting January 1, 2020, all residential real properties with certificates of occupancy dated on or before December 31, 2005 will be subject to rent control. Prior to AB 1482’s enaction, except as to mobilehome spaces, California law prohibited cities from regulating rents on residential properties constructed after 1995.

The Economics: Rent-Controlled Property Development

As noted by Tom Bannon, the CEO of the California Apartment Association, “Apartment builders have to look long-term to make sure their costs pencil out.” (Are Your Housing Costs Sky High? A New Fight Over California Rent Control is Coming, The Sacramento Bee, April 3, 2017.) Under AB 1482, an apartment building’s returns on rent will plateau exactly 15 years after its certificate of occupancy—when rent control takes effect. As with the aforementioned case of the Santa Monica penthouse, property taxes, mortgage rates, and other expenses will continue to increase beyond a property’s first exempted 15-years—and steadily so until, inevitably, the owner’s operating cost-per-unit exceeds each unit’s rent. Before AB 1482, California owners could mitigate these losses “with the rent increases from units that had new tenants or were otherwise deregulated.” (New York Rent Control: From Bad to Worse, GlobeSt.com, July 18, 2019.) However, under regulation that makes it substantially harder to evict tenants and applies to every rental property in the state, that’s no longer an option.

Instead of developing California multifamily rental property, then, a developer might be more inclined to develop high-end condo housing or other types of homes-for-sale. Former Berkeley Housing Director, Dr. Stephen Barton, claims that this is exactly what happened in San Francisco after it initiated its rent control regulations. According to Dr. Barton, when tenants stay in their homes longer, newer, wealthier tenants drive demand for the construction of luxury housing. (Rent Matters, University of Southern California, October 2018.)

His sentiments align with the findings of a 2017 study from Stanford University on the effects of rent control in San Francisco, which found that rent controls “lead to a housing stock which caters to higher income individuals.” (The Effects of Rent Control Expansion on Tenants, Landlords, and Inequality, Stanford University, Nov. 29, 2017.) The study concluded that, taken together, rent control led to “increased property investment, demolition and reconstruction of new buildings.”

The Impact: Less Multifamily, More Luxury

Unfortunately, the study showing rent control’s positive influence on construction in San Francisco may not hold water when applied statewide. Luxury or not, a developer isn’t going to build a home it doesn’t think it can sell. While San Francisco might not have issues selling luxury homes in its discrete and insular market replete with Silicon Valley millionaires and other wealthy denizens, California’s $550,000 average-price-per-home is already driving would-be home buyers out of the state.

According to recently released data from the US Census, about 38,000 more people left California than entered in 2018. (State Population Totals and Components of Change, United States Census Bureau, May 23, 2019.) This marks the second straight year that California saw a net decrease in populous migration. The cited cause: housing affordability

If developers choose to build luxury homes over affordable housing, then the decreased affordable housing stock would increase California’s average-price-per-home. And an increase in California’s average-price-per-home might then exacerbate California’s migration. However, with rent control, potential home-buyers are between 10 and 20 percent more likely to remain in their newly-regulated rental properties than leave. (The Effects of Rent Control Expansion on Tenants, Landlords, and Inequality, Stanford University, Nov. 29, 2017.) The removal of those individuals from the housing market, in addition to those leaving the state, might very well curb California’s housing-demand such that the average-price-per home sees a net decrease. Regardless, less demand for average-priced homes means less construction of the same.

Conversely, demand for California’s luxury real estate is not as likely to take the same hits given that the state’s migration is less pronounced at higher-income levels. To wit, the number of incoming residents with college degrees almost matched those that left. For those with graduate degrees, the number of incoming residents actually exceeded the outgoing by about 10,000. While this might not make up for this year’s 36% decline in incoming foreign real estate investment, it certainly won’t hurt California luxury real estate under AB 1482.