Real estate investors often express trepidation when it comes to buying rental property in San Jose, CA. One of their biggest fears is around the city’s expansive rent control ordinance, known as the Apartment Rent Ordinance (ARO), San Jose Municipal Code Chapter 17.23. Investors often worry that the ARO will prevent them from realizing a fair return on their investment.
These are absolutely valid concerns. As of today, San Jose property managers and landlords can only increase rent-controlled units by a maximum of 5% per year. It is presumed that the 5% annual cap will assure the vast majority of rental property owners receive a fair and reasonable return. But the City Council realized that there are some circumstances where 5% is insufficient. As such, a provision was included in the Interim ARO Ordinance (effective June 17, 2016) that allows for an override of that maximum through what’s known as a “Fair Return” petition.
This article – the latest in a series of Landlord Journal articles aimed at demystifying San Jose’s Apartment Rent Ordinance for San Jose property managers, owners and investors – explores the process for obtaining a “Fair Return” waiver.
Defining a “Fair Return”
The ARO has very explicit language around what it considers to be a “fair return.” The Interim ARO established a new standard in which to evaluate whether an owner is receiving a fair return. Under the new Maintenance of Net Operating Income (MNOI) standard, a landlord is considered to be getting a fair return if his current net income is equal or greater than the net operating income (NOI) adjusted for inflation. The Interim Ordinance set January 2014 as the “base year.”
The adjustment for inflation is calculated using the sum of a percentage of the annual increases to the San Francisco Bay Area Consumer Price Index (CPI) for the petition period, prorated as needed. The petition period is considered the period between January 2014 and the date the San Jose property manager or landlord files a Fair Return petition.
Fair Return petitions will be considered for two reasons: (1) the NOI for the current year is less than the base year NOI with the inflation adjustment; or (2) the owner was not receiving a fair return in the base year because the base year NOI for the property was unusually low.
Eligible operating expenses include, but are not limited to, business license fees, real property taxes, utility costs, insurance, reasonable repair and maintenance expenses, management fees, attorney’s fees, and capital improvements needed to maintain the same level of services as previously provided. Operating expenses do not include expenses incurred as a result of deferring maintenance, debt service, penalties or fees assessed for violating the ARO, depreciation of the rental unit, and any expenses for which the landlord has been reimbursed (e.g., utility rebates, security deposits, insurance settlements).
Gross income includes gross rents; income from laundry facilities, garage or parking fees or other services if not included in rent; utility costs paid directly to the landlord by the tenants if not included in the rent, and interest from security and cleaning deposits.
Making a Case that Base Year NOI Did not Provide Fair Return
Don’t get too excited too quickly! The process of obtaining a Fair Return waiver is cumbersome. San Jose property managers and rental property owners must submit a host of documents if they want to claim that the base year NOI did not provide a fair return.
The housing commission will only adjust the base year NOI if a hearing officer determines that:
- The landlord’s expenses in the base year were unusually high or low in comparison to other years due to unusual circumstances. The hearing officer will consider a number of factors when making this finding, including: (a) the landlord made substantial capital improvements that improved housing services during the base year that were not reflected in the base year rent levels; (b) substantial repairs were made due to damage caused by uninsured disaster or vandalism; and (c) maintenance and repair costs were below accepted standards or resulted from the intentional deferral of repairs and maintenance that resulted in a decline of housing services.
In cases such as these, base year NOI may be re-calculated using an average of the unit’s expenses incurred by the property owner over a number of years.
- The landlord’s gross income during the base year was disproportionate. Reasons for this may include: (a) the gross income in the base year was unusually low as a result of the quality, location, age, amenities and condition of the housing (Note: the City considers rent to be “unusually low” if it is less than 75% of 2014 fair market rents as defined by HUD, and this provision only applies to units without housing violations); and (b) gross income during the base year was significantly lower than normal because all or part of the premises was uninhabitable during construction or repairs.
The Process for Obtaining a Fair Return Waiver
San Jose property managers and landlords interested in filing a Fair Return petition must file a well-defined process.
The first step the owner must take is to notify all tenants in writing that he plans to file a rent increase petition and the grounds for the petition. The owner must give tenants notice before filing a petition with the housing commission.
Next, an owner must submit the actual petition with the city. The Fair Return Petition form requests general information about the owner, site and unit. Petitioners must also outline a “Proposed Individual Rent Increase Schedule” that includes the current rent for any unit included in the petition, as well as the rate the owner would like to increase rents to. The owner must also submit a detailed Income Summary (with copies of rent checks, bank statements, etc.) and Operating Expense Summary (including copies of property tax bills, utility bills, management expenses, etc.). This information is then reconciled in a Summary of Income and Expenses to determine current NOI.
A capital expense worksheet must also be submitted. This includes a description of all capital expenses, costs (including the cost of debt used to finance the improvements) and the amortization period for each item. Financial records for 2014 must also be submitted if the landlord is required when landlords make a Fair Return claim related to the Base Year NOI.
Within 10 days, the housing commission will set a hearing date and notify both the San Jose property management company or landlord and the residents who would be impacted by the ruling. Residents can then file a Tenant Opposition Statement in objection to the Fair Return petition. During the hearing, the city will consider both sides of the case before making its final determination.
Although it isn’t easy (by any stretch of the imagination!) to obtain a Fair Return waiver, the tool is a valuable one provided by the San Jose ARO to ensure that San Jose property managers, landlords and real estate investors can realize a fair return. Otherwise, there would be little reason for anyone to invest in San Jose’s rental housing stock.
To learn more about the Fair Return process, visit the City of San Jose’s housing website.