The Negative Impacts Of Rent Control For Real Estate Investors
Recent rent control laws in California, New York, and another states reflect challenging times for real estate investors. Efforts to protect low-income residents in fast growing cities have led to the passage of a raft of pro-tenant laws. Rent control, restrictions on background checks, and higher thresholds for eviction make it harder than ever to make money in real estate. Here is how new rent control laws impact real estate investing.
Fewer Units Can Be Rented For Market Rates
One of the notable negative impacts of rent control laws is that a significant numbers of units are not rented at market rates. When rent control laws go into effect, tenants often respond by staying in their units for as long as possible. In many cities, rent control laws mandate that existing tenants cannot have their rent increased by more than 2.5% per year. That means that in some buildings a significant number of tenants are not paying market rates. Depending on the city, some landlords may receive only a fraction of the rental income that would normally be expected.
That makes it difficult to earn a profit renting properties or when properties are eventually sold. I’ve found that in certain jurisdictions, there is little a landlord can do to evict tenants that have been abusing rent control laws. For example, one New York City resident has lived in the same rent-controlled apartment for decades and paid $28 a month. That’s decades of lost rental income that could have been used to make improvements and attract new tenants. Rent control laws effectively “lock” units for years.
Greater Difficulty Recouping The Cost Of Maintenance And Repairs
Maintaining residential real estate properties requires periodic maintenance. Some of that maintenance is routine and necessary to provide an appropriate standard of living. The cost of more significant renovations can in part be passed on to residents and used as leverage to raise rents. Renovations can take the form of furnished common areas, a rooftop deck, or other amenities. Recent rent control laws dramatically impact the financial analysis behind such renovations. In many cases, landlords have found that renovations, or anything beyond basic maintenance, no longer make financial sense.
That has recently been the case in New York City. The Stuytown complex in the East Village is a professionally managed property home to 30,000 residents. In July 2019, Stuytown management prepared a series of renovations and improvements to the grounds. Following New York’s new rent control laws, Stuytown announced that it was halting all planned improvements. The fact that Stuytown management may not be able to rent a significant portion of its 11,000 at market rate makes improvements a serious financial risk.
Lower Valuations For Rental Properties
There are a number of ways to value rental properties. One of the simplest to understand is the Gross Rent Multiplier (GRM) approach. The GRM approach values a rental property in terms of the amount of rent an owner can collect each year. If a seller is asking for $750,000 for the property and the combined annual rent of all units is $150,000, the GRM is 5x. It's important to note that the GRM does not take into account taxes, interest, or any required maintenance. This approach allows for easy comparison of gross rent multiples among different properties.
A large number of rent-controlled units in a particular building will mean that there are fewer units that can be rented for market rates. Over time, the Gross Rent for the building will be lower than it would be if the owner could charge market rates. Let’s say that the building that collected $150,000 in Gross Rent now collects $100,000. In order to offer a competitive valuation compared to the previous scenario, the seller would now offer the same building for $500,000, a 33% price cut. Rent control can significantly hurt property sellers over time and buyers will have less flexibility to develop their new property.
Added Regulatory Hurdles
Rent controls have been passed in major cities amid a wave of pro-tenant legislation. Some cities like Portland have mandated that landlords must reserve units for below market rate rentals. Other cities like Los Angeles have passed laws prohibiting no-fault evictions. These laws have made being a landlord in some of the largest American cities far more difficult. In some cases, cities have specifically targeted landlords who have challenged new legislation.
This follows a larger trend of pro-tenant legislation that penalizes landlords. This is especially true in cities such as San Francisco and New York, where landlords have faced targeted activist campaigns. In some cases, attempts to improve properties have been met with significant backlash. Ultimately, being a landlord and making a profit has become increasingly difficult in certain states. Purchasing property in Texas or other states that are more pro-landlord can reducing the risk of activism that hurts my bottom line.
Major cities have become increasingly unfriendly to landlords and that is unlikely to change in the coming years. Landlords and real estate investors need to navigate new laws that prevent them from charging market rate or evicting tenants. Political uncertainty also makes it more difficult to effectively value rental properties. Fortunately, the challenges of operating in the California or New York real estate market don’t apply nationwide. Consider investing in Dallas Fort Worth. Real estate investors like us deserve the chance to focus on our properties instead of the state house.
