One Tuesday morning, my teenage son sent me a text containing a photo of a broken violin tailpiece. The tailpiece holds the strings on one end (the pegs hold the strings on the other), which is not a common experience. It was the second day of my son’s music festival, and his violin was unplayable.
My son did the only thing in his control – he found a luthier and had a new tailpiece installed. However, he unavoidably missed his first private lesson with his new teacher and his second quartet rehearsal.
The broken tailpiece was only one in a series of circumstances my son could not control in the previous 48 hours. He already had missed the orientation and his first quartet rehearsal. Two days earlier, we had dropped off an excited teenager at Washington National Airport for a month away from home. After successfully checking two huge bags, navigating security with a violin, and making his way to the gate in record time, our son learned his flight was delayed due to circumstances outside his control.
After patiently waiting for three hours, he texted again -- the plane was at the gate, but there was another delay. All DC airports were under a complete ground stop because the computers that run air traffic control for the region were offline. The ground stop affected airports from Baltimore to Richmond, Virginia and disrupted thousands of flights nationwide. The situation was out of our son’s – or the airline’s – control.
Several hours later, the flight was canceled. There wasn’t an available flight out of Washington National for 25 hours, but our son found a seat on a morning flight out of Dulles International Airport. He would need to retrieve his checked luggage and go home only to start the entire process over the next day.
With so many stranded travelers, Ubers were in short supply. Even if he could have secured an Uber, due to congestion pricing, the 20-mile ride to our house would have been prohibitively expensive. So, we trudged back to National Airport to pick our son up.
When we arrived, Washington National Airport was in utter chaos. Everyone seemed to understand that neither they nor the airline could control the delay, so they were accepting the situation and adjusting rather than trying to force an outcome. Hundreds of passengers were frantically texting and calling friends and family, arranging for alternative travel and overnight housing, rescheduling meetings, and calling pet sitters to ensure their pets would be cared for during the delay.
My son’s experiences with air travel and the broken tailpiece during those 48 hours provided a vital life lesson. We can’t control everything in our lives. It takes time to adjust to unexpected circumstances, and often, the outcome isn't what we would prefer. If we try to control the outcome, we will spend unnecessary energy – and could make things worse.
Our country continues to experience economic conditions triggered by a worldwide pandemic and subsequent inflation. These conditions have mostly been outside of anyone’s control. Yet, when government officials see their constituents struggling under crushing inflation and increasing housing costs, they often are driven to try to control the situation.
Many governments have considered rent control to control those economic changes. Recently, the Biden administration proposed a plan that would prohibit landlords who increase rents by over five percent per year from using accelerated depreciation under tax laws.
This article discusses why rent control usually is not the best response to rent increases due to economic conditions. A subsequent article will discuss President Biden’s proposal.
How Commercial Real Estate Owners Make Money
Think of commercial real estate as an investment like a savings account, certificate of deposit, corporate bond, or government bond. Investments that present more risk produce a higher return. Commercial real estate presents more risk than bank accounts government securities and therefore, must pay a higher return than those lower-risk investments.
When interest rates on government bonds, bank accounts, and other low-risk investments increase, real estate and other high-risk investments also must pay higher returns. To pay higher returns, investments must produce a higher net income for each dollar invested. Usually, to produce higher net income, an investment must increase gross income, reduce expenses, or do both.
Most real estate investments cannot achieve higher net income by reducing expenses. Most of the expenses, such as mortgage payments, taxes, insurance, and utilities, are outside the owner's control. The owner must pay those expenses regardless of the cost to avoid foreclosure or having utilities shut off.
Other real estate expenses, such as employee salaries and benefits and property maintenance expenses, aren’t easy to reduce significantly. Most employees won't accept a pay cut, so layoffs are the only way to cut employee costs. With fewer employees, a real estate owner likely will need to reduce services and amenities for tenants. Cutbacks on property maintenance will cause the property condition to decline.
Cutbacks on tenant services and reduced property condition will make the property less attractive to tenants. The eventual result will be lower rents and less rental income for the owner, which might offset any benefit from the reduced expenses.
Further, most real estate investments receive all or nearly all of their income from rents. The only way many real estate investments can increase gross income is to increase rents. Landlords have little incentive to increase rents above the market rates indicated by economic conditions. If they increase rents too much, tenants will move to properties that offer market-rate rents.
Why Rent Control?
Tenants don't like rent increases, especially when their rent goes up faster than their income. And if the rent increases to an amount the tenants can’t afford to pay, they will be forced to move.
Some tenants will move to a less expensive residence. Others may consolidate households with extended family instead of renting, and some may become unhoused.
To avoid these undesirable outcomes, governments pass rent control laws, most of which limit how much a landlord can increase a tenant's rent each year. Rent control can help tenants stay in their residences, but it doesn’t address the root problem—economic conditions that led to increased interest rates and lagging increases in personal income.
Since state and local governments can do little to address economic conditions beyond increasing local minimum wages, rent control becomes an inadequate surrogate. The federal government has more control over economic conditions, but those options are beyond the scope of this article.
How the Real Estate Cycle Responds to Rent Increases
Although rent control may sound like a good idea, rent control laws interfere with a real estate economic cycle, which (if allowed to proceed uninterrupted by government regulation) organically addresses rent increases through increased supply. The real estate cycle has four main stages: Recovery, Expansion (or Growth), Hyper Supply (or Over Supply), and Recession, which have the following characteristics:
Recovery: Low vacancy rates, new construction hasn’t yet increased, moderate absorption rate, gradual rent increases, seller’s market due to low supply
Expansion: There are low vacancy rates, new construction is increasing to create more supply, the absorption rate is still moderate to high, rent increases are moderate to high, and it's still a seller's market.
Hyper Supply: Vacancy rates are increasing due to increased supply, new construction remains moderate to high (so additional supply is on the way), the absorption rate has slowed due to the increased supply, rent increases also have slowed, and it's become a buyer's market
Recession: Vacancy rates are high as supply outstrips demand, new construction is declining in response to excess supply, high supply also leads to low absorption, rental rates are static or even decreasing, and it's a strong buyer's market
So, since rent increases are usually the greatest during the Expansion stage, by the time government concerns lead to rent control initiatives, help is already on the way in the form of new construction.
Typical Rent Control Provisions
Although rent control laws vary, rent control laws may include these provisions:
· All rent control laws limit annual rent increases, usually based either on the Consumer Price Index (CPI) or a fixed annual percentage per year
· Many laws don’t apply to newer properties (so as not to discourage new development that will increase supply)
· Some laws do not apply to landlords who own very few rental units
· Most laws include exceptions where the landlord has made significant improvements to the property
· Some laws only apply to properties typically housing low- to middle-income tenants
· Most laws include provisions to disincentivize landlords from non-renewing tenant leases so the landlord can replace them with tenants paying higher rents.
How Rent Control Negatively Affects Landlords and Tenants
Rent control laws limit landlords’ potential for revenue growth without regard to market factors of supply and demand or landlord expenses. However, like tenants, landlords are affected by inflation. They must pay increased salaries for property management and maintenance staff, maintenance supplies, and other operating expenses.
If landlords can’t increase rents to cover those costs, they may need to lay off employees, pay employees below-market rates, or cut amenity or maintenance expenses. So, while tenants might not experience rent increases commensurate with the economic conditions, they will likely receive fewer services and amenities for their money.
For the same reason, rent control laws also can disincentivize property improvements, which reduces the quality of the community’s housing stock. Landlords unable to recoup the costs of major upgrades (or facing significant regulatory burdens to recover costs under rent control laws) have little incentive to advance the cash to make those upgrades. Although tenants might not experience substantial rent growth, they may live in antiquated units needing significant repair.
Further, rent control may increase scarcity and make it more difficult for people to find housing. Although rent control laws might not apply to new construction, by keeping market rents low, rent control still limits financial prospects for new rental properties. With less opportunity for profit, developers may be disincentivized from adding new rental units to an already tight market.
Rent control laws also can "trap" tenants in ill-suited housing. Since most rent control laws focus on limiting increases for existing tenants, tenants may be hesitant to move.
For example, the two-bedroom, one-bath apartment that was perfect for a couple with one child may be inadequate for a family that has grown to include two adults and three children. If due to rent control, they are paying below-market rent on their two-bedroom apartment and know their rent cannot be increased significantly, the couple may decide they cannot afford a market-priced three-bedroom home that is better suited for their larger family.
Rent control may result in less landlord flexibility for tenants facing financial challenges. Most rent control laws do not prohibit landlords from evicting tenants who don't pay their rent. Since it’s expensive to evict a tenant and prepare an apartment for a new tenant, landlords often will work out payment plans for tenants who get behind in rent payments.
However, if, due to rent control, the tenant is paying below-market rent, the landlord's incentives may change. Rent control laws rarely prohibit the eviction of tenants whose rent is delinquent. So, rather than working to retain the current tenant, the landlord may be inclined to evict the tenant and find a new tenant who will pay more rent.
How Rent Control May Affect Tax Revenue
Eventually, rent control can reduce the government’s real estate tax and income tax revenue. If landlords have lower revenues, their income from their investments will decrease, and their income tax obligation will be lower.
Real estate taxes aren’t based on income. Instead, they are based on the market value of the real estate. And real estate market values are tied to the property’s income.
If rent control results in property income below what the market otherwise would provide, property value and assessed tax values (and therefore, tax revenue) also will not increase at the pace indicated by economic conditions. So, rent control may cause property values to decrease, which could result in lower real estate tax revenues than the market otherwise would produce.
Since real estate taxes are determined by local and state law, those lower tax revenues might not immediately affect federal tax revenue. However, lower property values might affect federal capital gains tax revenues since sellers won't realize as much gain when they sell their properties.
Conclusion
As my son learned from his flight cancellation and broken tailpiece, there are things we can’t control. As the Serenity Prayer so eloquently states, we should “accept the things we cannot change.”
The country has been experiencing inflation, and rent is only one expense that has increased rapidly. One government institution—the Federal Reserve—is already involved in addressing inflation on a macro level through interest rates.
Rather than attempting to control inflation in single industries – like residential real estate – the government should accept what it cannot change, at least not without risking making things worse. Instead, the government should let supply and demand “regulate rent prices and expand programs to ensure people do not become unhoused because they cannot afford rent.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.
