If your gut reaction is to run for the fences when someone suggests you buy a rent-controlled property, you’re not alone. Many real estate investors shy away from rent-controlled units—and often for good reason. Rent-controlled units are subject to a host of regulations that affect how much rent can be raised, how often, and under what circumstances. Some ordinances also prohibit evicting tenants from rent-controlled units unless for a very narrowly-defined set of circumstances.
Rent control is made all the more complicated by the fact that ordinances vary from city to city and state to state. Staying up to date on the latest rent control policy is no easy task, particularly for investors who have holdings in multiple communities.
Yet despite their drawbacks, I still believe rent-controlled properties can be a valuable addition to an investor’s portfolio.
Let’s start by clearing up a few rent control myths.
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4 Myths About Rent-Controlled Properties, Debunked
Myth #1: Rent-controlled units are always cheaper than market-rate apartments.
A lot of people assume that rent-controlled units always rent for drastically below-market rents. To be clear, this certainly does happen. However, there are also circumstances in which the rents being charged are at or above market rents. Most rent control ordinances allow landlords to bring units up to market rents after a tenant has vacated the unit. Rent increases will be capped from thereon out, but the landlord will be able to charge market rents in the meantime.
Related: The Pros and Cons of Accepting Section 8 Housing
Myth #2: You can only charge rents based upon what a tenant can afford to pay.
This is where a lot of people get rent-controlled confused with affordable housing programs like Section 8. Those programs limit how much a landlord can charge for rent and outline what percentage of that rent the tenant is required to pay (versus an amount subsidized by an affordable housing program). That’s not the case with rent-controlled units. A tenant’s income or ability to pay has no bearing on whether he/she is able to secure a rent-controlled unit or how much the landlord can charge for that rent-controlled unit. Rent is not pegged to income or other needs-based factors.
Myth #3: You can never raise the rent on a tenant in a rent-controlled unit.
Again—simply not true. Although landlords are limited by how much they can raise rents in rent-controlled units, they can always raise rents (even if only by a marginal amount). Some cities tie the maximum allowable increase to the change in the area’s Consumer Price Index, which usually ranges from 2 to 5 percent each year. Other cities have a prescribed cap, such as 5% each year, regardless of the local rate of inflation.
What’s more, most cities allow landlords to increase rents for other reasons, such as in the event capital improvements have been made. More on that below.
Myth #4: All rent-controlled properties are old and dilapidated.
Newer rental units tend to be exempt from rent control laws. In California, for example, any unit built and occupied prior to February 1995 is exempt from the state’s rent control law that all cities and towns are required to follow. But just because rent-controlled properties tend to be in older buildings does not mean that the units are always in poor condition.
You’ve probably heard stories about landlords allowing their rent-controlled buildings to fall into a state of disrepair because, absent charging market rents, they cannot afford the cost of repairs and maintenance. Some landlords have even been known to sabotage their own buildings to force rent-controlled tenants out. In my experience, though, most property owners maintain their rent-controlled properties to the same extent they maintain their market rate buildings. Many cities and towns even allow landlords to increase rents above the maximum amount that would typically be allowed each year if the owner has engaged in significant capital improvements.
Advantages of Rent-Controlled Properties
Many of the real estate investors I’ve spoken to shy away from investing in markets with rent control without ever taking the time to understand the nuances of that city’s rent control policy. If you know the ins and outs of the local laws, rent-controlled properties can actually be a highly valuable addition to any investor’s portfolio. Here are five reasons why:
1. Lower Acquisition Costs
The purchase price for rent-controlled buildings tend to be lower than market-rate properties, making them more attractive to savvy investors who have a long-term, buy and hold investment strategy. Related, there’s usually less competition for rent-controlled buildings, so investors can avoid the bidding wars that drive up acquisition costs.
Related: How to Raise the Rent on Your Tenants as Painlessly as Possible
2. Lower Turnover
Every time a unit turns over, a landlord risks the unit sitting vacant for some time. Even in a hot rental market, landlords must absorb the costs of finding and screening for qualified tenants. Rent-controlled units tend to turn over less frequently, saving landlords the costs (and headaches!) associated with releasing units.
3. Potential for Substantial Upside
Properties 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 reset to fair market value. When that happens, the effective cap rate will increase.
Matthew M. Baron, president of Simon Baron Development, elaborates: “Rent-regulated buildings offer built-in upside in the long term because as those units turn, you’re able to increase those rents. It’s like buying a low-yield safe bond that over time has the upside of equity real estate.”
4. Ability to Increase Rents After Making Capital Improvements
As noted earlier, many cities and towns allow landlords to increase rents beyond the annual maximum in order to recover the costs associated with capital improvements. For instance, in Oakland, up to 70% of actual capital improvement costs, plus imputed financing, may be passed through to tenants. These improvements enhance the value of the property, thereby sparking higher rents when released on the open market.
5. Consistent Stream of Revenue
Owning rent-controlled property provides a cushion against a decline in rents. Suppose there is a market downturn and rents decline by 15%. In a rent-controlled building, any unit rented for more than 15% below market value prior to the market downturn will be unlikely to turn over or warrant a rent decrease.
“Some people avoid rent-stabilized buildings like the plague,” says Eric Margules, president of Margules Properties. “I don’t. I’ve always bought rent-stabilized because of the almost guarantee that [rents]can’t go down.”
Tenants might still be paying submarket rents, but at least these rents are stable over time, providing landlords with a predictable, consistent stream of revenue despite market cycles.
Consider This When Evaluating Rent-Controlled Investments
Buying rent-controlled property can be a valuable addition to any real estate investor’s’ portfolio. However, landlords should be cautious not to jump the gun without considering a number of factors that could influence their return on investment, including:
Someone who buys a fully stabilized (leased) property will have to wait until existing tenants move out to bring those units up to market rate. If I’m going to invest in a rent-controlled building, I tend to look for properties that are vacant or partially vacant so I can make any needed building improvements and then rent at fair market rates when first leasing up the property.
As a general rule of thumb, I steer clear of rent-controlled properties where existing tenants have been there a really long time (say, 5+ years) and rents are more than 50% submarket. This is usually an indication that tenants aren’t going to vacate the unit any time soon, making it difficult to increase rents to market rate.
In my 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 markets with rent control. The more space tenants have, the more likely they are to stay.
Current and Future Cap Rates
Rent-controlled properties should be evaluated based on their existing cap rates as well as their potential cap rates if and when rents are raised to market rate. If you suspect tenants will move out six months from now, buying a rent-controlled property at a 4% cap rate could actually 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 of revenue in the process. The trick is predicting when people will move out—no easy task, even for the most skilled investor.
Rent-controlled properties can be a great investment for those with a long-term, buy and hold strategy. When the market invariably 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 investment horizon may benefit from the cash flow predictability that rent-controlled units offer.
Ability to Navigate Local Laws
Rent control laws change frequently. Just last year, ballot measures changed the rent control policies in four Bay Area cities. Buying and managing rent-controlled units often proves to be too much for novice, small-scale or foreign investors.
If you fall into one of these categories, consider hiring an experienced property manager to navigate the complex web of local laws on your behalf. “You don’t want to be anywhere near an asset like this unless you know how to manage it,” says Joel Moser, founder and chief executive officer of Aquamarine Investment Partners.
The Bottom Line
Rent-controlled properties are not without their complexities, and I certainly do not blame investors who avoid them at all costs. Yet when managed properly, rent-controlled buildings can be a highly lucrative addition to any investor’s portfolio.
Would you consider putting your money into rent-controlled properties (or do you already)? Why or why not?
Let’s discuss below.