Demystifying Rent Control for Prospective Investors
California is one of the few states to adopt widespread rent control policies. The mere notion of rent control is a foreign concept to many. Some investors shy away from investing in Bay Area real estate as a result. Their fears over rent control, even if real, can lead to missed opportunities.
We’re here to help demystify California’s rent control regulations and explain why buying rent controlled properties can actually make a lot of sense. It’s not a foolproof strategy, and certainly isn’t for everyone. Here are a few things investors should be aware of as they weigh the decision to buy rent controlled versus non-rent controlled properties.
The state’s Costa-Hawkins Rental Housing Act created a set of baseline limit to rent control regulations that all municipalities are expected to abide by. Most importantly, the law exempts units built after 1995 from rent control. Beyond what’s laid out in the state law, cities are free to establish their own rent control policies if they so choose. A number of cities have set even earlier cut off dates: properties built after October 1978 are exempt in Los Angeles; properties built after June 1979 are exempt in San Francisco; and properties built after January 1983 are exempt in Oakland.
Other cities have chosen not to adopt rent control policies at all.
Among those with rent control ordinances, most establish eviction restrictions, and limit rent increases (typically indexed indexed to inflation), but allow landlords to charge fair market rents when a unit turns and a new lease is signed. In the Bay Area and Los Angeles, the rate of inflation is historically much lower than increases in market rents, so tenants with a long tenure pay substantially below-market rents.
Advantages of Rent Controlled Properties
This all seems awfully complex, no? Given the variation from city to city, and limits on rental increases, why would any investor consider buying rent controlled property? Despite these challenges, we believe California’s rent controlled real estate can still be a great investment. In fact, rent controlled properties have four distinct advantages:
- Lower turnover. The longer tenants live in a rent controlled unit the less likely they are to leave. For instance, someone who has lived in the same apartment for 20 or 25 years may only be paying $800 a month for a unit that would otherwise rent for $3,400 a month on the open market. Residents paying sub-market rents have a financial incentive to stay put. Lower turnover can be a good thing for landlords. There are many costs associated with turnover (marketing, cleaning and repairs, lost rent, etc.) – not to mention the headaches and stress turnover can cause.
- Substantial upside when people do move out. Most investors evaluate real estate deals using cap rates. Typically the higher the cap rate, the better the investment. In non-rent controlled markets, investors may be willing to buy properties with a low cap rate if there’s a value-add opportunity that will result in higher rents, and therefore, a higher cap rate in the near future.
Buildings with sub-market rents are analogous to value-add opportunities. At some point in the future, every tenant will move out (or die) and rents will re-set to fair market value. When that happens, the effective cap rate will increase.
It makes sense to look at two cap rates when buying a rent controlled unit, the actual cap rate based on current rents, and the hypothetical cap rate based on market rents. If the current rents are substantially below market, one might be justified buying a building at a very low cap rate, e.g. 3.5%, knowing that the hypothetical cap rate based on market rents is much higher, e.g. 8.5%. Eventually, the units will turn and the rents will reset to market.
- Ability to increase rents after making capital improvements. There’s a common misconception around a landlord’s willingness to make capital improvements to rent controlled buildings. Most assume there’s no financial incentive for owners to make those capital improvements if they cannot raise rents to offset the costs of those investments.
In reality, most cities allow landlords to increase rents in excess of the annual limit after making capital improvements. In Oakland, for instance, up to 70% of actual capital improvement costs, plus imputed financing, may be passed through to tenants. Capital improvement costs must be amortized over the useful life of the improvement, and passing these costs onto tenants requires approval by the Rent Stabilization Board, but it is possible to do so nonetheless. This mechanism allows owners to continue investing in their property despite the standard limitations on annual rent hikes. These improvements enhance the value of the property, which allows landlords to reap even higher rents when later releasing on the open market.
- More reliable income. Owning rent controlled property provides a cushion against a decline in rents. Suppose there is a market downturn and rents decline by 20%. In a rent-controlled building, any units where the rent is more than 20% below market value prior to the downturn will still be unlikely to turn over or warrant a rent decrease. Tenants might still be paying submarket rents, but at least these rents are stable. Landlords have built-in padding in the event of a market downturn because cash flow is more predictable.
What to look for in rent controlled apartments:
- Stabilization Rate: A property is generally considered to be “stabilized” when at least 90% of the units are rented. One investment strategy is to buy a fully-stabilized asset that’s generating positive cash flow from Day 1. Other investors are willing to buy a vacant or partially-vacant property and then take on the risks associated with lease-up. In a rent controlled market, the latter approach makes a lot of sense. Buying a partially-stabilized building allows landlords to charge fair market rents when first leasing vacant units. Someone who buys a fully-stabilized property will have to wait until existing tenants move out to bring those units up to market rent.
- Existing Tenants: In any market, rent controlled or not, investors should spend some time understanding who currently occupies the building. Who are the tenants? What’s the demographic profile? How long have they lived there? Any problem tenants? These are all common questions. The answers to these questions become critically important when buying rent controlled apartments.
In a non-rent controlled market, owners want as little turnover as possible. Turnover equates to higher expenses. The opposite is true in a rent-controlled market, where regular turnover is considered a good thing because it allows the landlord to bring rents back to fair market value.
We caution investors from buying rent controlled properties if tenants have been there for a really long time (say, 5+ years) and rents are more than 50% submarket. Now, if units are rented at 30% submarket rates today but the property has a history of high turnover, this could be a great long-term investment.
- Unit Size: In our experience, 2+ bedroom units tend to attract tenants that stay longer than those who lease a studio or 1-bedroom apartment. Again, this matters because turnover is a good thing in rent controlled markets. The more space tenants have, the more likely they are to stay. A young couple might decide to stay and raise their family in the unit; or an empty nester might decide to permanently downsize in your apartment. Turnover tends to be higher among smaller units.
- Current and Future Cap Rates: Instead of evaluating the property based upon its current cap rate, investors might consider buying a property based upon its potential cap rate if and when rents are raised to market rate.
The trick is predicting when people will move out. If you suspect tenants will move out six months from now, buying a rent controlled property at a 4% cap rate could be a great deal. If you suspect tenants will stay for another 20 years it doesn’t matter that the property has the potential to turn a 7.5% cap rate because you’ll have lost two decades in the process. The question becomes: how much risk are you willing to take?
- Time Horizon: Buying rent controlled properties can be a great investment strategy for investors with a long term, buy and hold strategy. The real estate market ebbs and flows, with most cycles lasting about ten years (give or take). When the market dips, rents can quickly decline – crippling investors who rely too heavily on the rents they were getting at the market peak. Investors with a long-term time horizon may benefit from the cash flow predictability that rent-controlled units offer.
Many landlords feel skeptical about California’s rent control regulations. We totally get it. There are certainly risks to consider before pulling the trigger. But rent control doesn’t have to be a big, scary black box to avoid altogether. A little due diligence can go a long way, and as many of our property owners have found, can lead to tremendous upside in the long-run.