Why It’s Time to Consider Adding Rent-Controlled Properties to Your Portfolio

by | BiggerPockets.com

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.

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.

buy-and-hold

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:

Stabilization Rate

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.

Existing Tenancy

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.

Unit Size

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.

Investment Horizon

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.

About Author

Colin Wiel

Colin Wiel holds multiple patents in artificial intelligence, has redefined Boeing’s control systems, and has launched his own programming consulting firm. He is clearly no stranger to innovation. Prior to being Co-Founder, Chairman & CTO of Mynd, Colin was Co-Founder and CIO of Waypoint Homes, now Starwood Waypoint (NYSE: SWAY), and grew the company to be the second largest SFR real estate investment trust (REIT), managing 17,000+ homes across the country. He was named Ernst & Young Entrepreneur of the Year in 2014, and Goldman Sachs Top 100 Most Innovative Entrepreneurs in 2012. When Colin’s not devising new ways to immerse technology into the fabric of real estate and property management, he’s spending time with his two boys, engaging in wildlife and nature conservation efforts, and actively participating in various expressions of humanity, community, and philanthropy.

11 Comments

  1. John C. Carlson

    Colin,

    I’m a commercial appraiser & would like to ask how you arrive at a reasonable value for a rent-controlled building you want to make an offer on? How you adjust prices for other rent-controlled buildings that have sold with below market rents against the building you want to buy?

    Somewhere, I have an Excel spreadsheet which adjusts on a ratio basis, a rent-controlled building I am appraising against comparable rent-controlled sale comps. This spreadsheet accounts for ratio differences in rents from one building to the other. Would like to find out your methodology, especially since you are a tech person.

    The worst below market rent example I have is a Beverly Hills 4-plex that I appraised a year or so ago. Today’s rents for the units in the building I was appraising were $3500/mo. One of the units was occupied by an very elderly couple who had lived there since 1961 & were only paying $350/mo.

    I guess the best thing you could say is that they may be passing soon & the unit would roll-over to market rents. (Perhaps this seems ghoulish, but its true) In the meantime there was a tremendous loss in rent from this one unit.

    John C. Carlson

    • Colin Wiel

      Hi John,

      I look at two going in cap rates: one based on current rents, and one based on market rents. Most people are very focused on the cap rate based on current rents, so the valuation is primarily based on that. For example, in Oakland, pretty nice buildings trade around a 4% cap rate based on current rents, which is pretty similar to cap rates on buildings in non-rent controlled cities in the Bay Area.

      This creates a bit opportunity, IMO, when the rents are dramatically sub-market. I get very interested when I see buildings like the one you referenced with the elderly couple where the rents are way below market. I believe the market generally undervalues the increase that will inevitably occur when those rents return to market rate.

      – Colin

  2. John Barnette

    Other downsides of rent control and associated eviction protections in the Bay Area. A landlord is perpetually stuck with a paying but otherwise problem tenant. Noisy, hoarding, disrespectful to landlord, neighbors, etc. Smoking, drugs, you name it. They are protected. Even if their behavior impacts quiet enjoyment of other tenants or makes the property less attractive to live in. Landlords hands are tied often with rent control…at least in San Francisco.

    • Jerome Kaidor

      SF is pretty extreme. I grew up there, but wouldn’t touch it with a 10 foot pole. With rent increases limited to a fraction of the CPI, you are effectively getting less rent every year. And the Board of Supes seems to find new stuff to hang on landlords every election cycle.
      I believe that the supervisors view their positions as a jumping-off place into state and national politics. To make a name for themselves, they must legislate.

  3. Marc Gerstein

    If you invest here, make sure you have a love, a passion, for details and a generous budget for legal services. Every locale is completely different, so you cannot simply assume you can step up to a market rent after a vacancy or even if or how you can get compensated for capital improvements.

  4. Scott Radetich

    I’ll throw my example out there, elderly tenant and his son living in NYC paying $700 a month. Pops has been there 30+ years. The condo is now worth 2.25mm, fair market rent is $6000. The tenant has been offered a $400,000 cash for keys, won’t take it. Yes that is a Four hundred thousand dollar cash for key offer… Since the tenant is over 65 you can’t evict in NYC.

    I’ll skip the rent control, thank you.

    • Marc Gerstein

      Yes, horror stories like that in NYC are probably more commonplce than roaches and subway delays.

      As a formet Chief Hearing Officer and later head of the FairMarket Rent Appeals unit for NYC rent stabilization, it is my opinion that one should not dare consider investing in ny rent regulated unitd based on advice received from a web site like this, that is oriented toward real estate investing. This is a very legally intense endeavor that should not be contemplated except on the basis of very close consultation and analysis with local attorenys who specialize in represnting landlords in regulated buildings. Comps, cap rates, etc. take a distant back seat to an understanding of all the nuances of the local regulatory and political scene, and don’t underestimate the latter — what’s legal today may not be a year from now.

    • Michael Williams

      Scott sometimes what we think is important may not be as important to elderly people. Have you tried to ask him what can you offer him that would be valuable enough for him to move? It may be something that is less than $400k. What have you or the person making the offer have to loss?

      • Scott Radetich

        This case is an example of when rent control goes way past “fair”. This tenant is very well educated, fairly well off, and living in a luxury apartment in the heart of NYC all for $700 a month. If you were him would you leave?

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