Legal compliance & taxes

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.

Local Ordinances

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 (), 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.
  • Substantial upside when people
  • Buildings with sub-market rents are analogous to value-add opportunities.  At some point in the future, every tenant will move out 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
  • Ability to increase rents after making capital improvements.
  • More reliable income.

What to look for in rent controlled apartments:

  • Stabilization Rate:
  • Existing Tenants:

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 () 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:
  • Current and Future Cap Rates:

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:

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.

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