Rental Owners: California's Rent Control Push Is Cause for Concern

It’s not just the weather that travels from west to east across the continental United States. Everything from Tony Hawk’s skateboarding to the humble Cobb salad got its start in California, eventually drifting eastward.

For better or worse, the West Coast has a long history of setting trends and then spinning them out across the country. More recently, California has been pushing its historically low cap rates into neighboring states like Arizona and Nevada, much to the delight of incumbent local investors.

The burning question for rental property owners today is: will statewide rent control regimes be the next West Coast export?

Oregon Leads the Way in Rent Control

In unlikely fashion, it’s actually Oregon that’s leading the charge with a first-in-the-nation statewide rent control bill passed earlier this year. Senate Bill 608 was signed into law in February and immediately capped annual rent increases at the consumer price index (CPI) plus 7 percent. The only exemptions are for buildings less than 15 years old and subsidized below market rentals.

In practical terms, that means most Oregon landlords will be limited to raising rents, on average, a maximum of 8 to 10 percent per year. Notably, the new legislation does not include vacancy control, so Oregon rental property owners will retain the right to set rents as they wish once an existing tenant vacates.

What’s perhaps most notable about the recent action in Oregon is that while the legislation potentially sets a dangerous precedent for property owners, it’s also relatively mild in its actual restrictions. Even 8 percent annual rent increases can add up fairly quickly, and with compounding, can result in a 26 percent bump in just three years.

All things considered, the result could have been worse for Oregon property owners. Time will tell if the new regulation delivers enough stability to the rental market to short-circuit support for more drastic rent controls.

California Starts Down Two Paths to Rent Control

Not to be outdone by its slightly damp neighbor to the north, California legislators are now proposing a slew of new regulations aimed at protecting existing tenants and increasing the housing supply across the nation’s most populous state.

AB 1482 advanced out of assembly committee on April 25 and promises to cap annual rent increases at CPI plus 5 percent statewide, except where more restrictive local rent control laws remain in place. In areas with existing rent control, including Los Angeles, San Francisco, Oakland, and other cities, the more restrictive local regulations would continue to prevail.

If AB 1482 becomes law, rental property owners from San Diego to Yreka will see their ability to increase rents for existing tenants capped at roughly 6 to 8 percent per year, with no exceptions for single family homes or newer construction. Of all the rent-control or “anti-rent gouging” bills currently being considered by California lawmakers, AB 1482 is probably the one with the best prospect of becoming law.

Taking a slightly different tack, the California Senate is currently considering SB 50, which would wrest control of certain residential zoning regulations from local cities and counties. It’s a complicated package of legislation that’s designed to force higher density housing construction near rail and bus transit corridors.

While there are notable carve-outs for smaller cities and beach towns, many of California’s urban centers would see a significant uptick in higher density new construction near transit. Under a separate provision, communities throughout the state would also be unable to prevent the further subdivision of many existing duplexes and single family homes into three- and four-unit properties.

What’s Behind the New Legislation?

Taken together, AB 1482 and SB 50 can be seen as roughly representing two camps of thought regarding solutions to the continuing housing affordability crisis that grips not only California, but also an increasing number of urban areas across the country.

On the one side, organized and well-financed tenant advocates are beginning to gain some modest ground in their efforts to bring rent controls to increasingly large swaths of the country. It’s likely they will succeed in California, in one form or another before the end of the 2020 election cycle.

Early results from the legislative push for more rent control in California will certainly influence what happens in other parts of the country, where rents are rising and tenant rights groups are gaining political influence.

On the other hand, housing advocates (and developers) are also gaining traction, advancing the argument that restrictive land use policies are a significant source of upward pressure on housing costs, especially on the West Coast. Many California communities are so united in their distaste for residential growth and its negative perceived impacts on schools and traffic that it has become nearly impossible to get approval for even fully conforming new housing developments.

This is likely to change significantly over the next few years, as a direct result of SB 50 or from whatever similar bill rises to take its place should SB 50 falter this year.

Taken together, there is a decent chance that this two-pronged approach may yet move the California housing market back toward a more sustainable balance in time to avoid more draconian restrictions on rental property owners. Six years of steadily rising rents and a continued shortage of new home deliveries has resulted in a pressure cooker environment around all things housing related up and down the West Coast. Letting some steam out now may be the best hope for avoiding a major blow up.

Emerging Risks for Rental Investors

Changing populations and emerging legislation nearly always bring new risks (and rewards) to forward-thinking real estate investors. Let’s take a closer look at a few key implications of the forces at work in California, on the assumption that they will eventually impact other markets around the country.

First, let’s acknowledge that California has not been the most lucrative place to own rental property if you’re primarily focused on current income. Cap rates are notoriously low in core urban areas along the coast and are only slightly better inland.

If you bought rental property in California from 2009 to 2015 and you’ve been able to raise rents to market, your yield is probably a bit more respectable now and you’ve undoubtedly also seen significant appreciation. If you bought more recently or have not raised your rents, it’s a different story.

If your current rents are close to market, then the annual increase caps contemplated under AB 1482 probably won’t hurt you much in the near future, given that market rents have now leveled off in nearly all parts of the state.

Ironically, it’s the investors who had the option but chose not to raise rents in recent years that will bear much of the burden of the new legislation in the short run. This may be perhaps the most prescient lesson to landlords in other states, where rent control initiatives are just beginning to gain visibility. (Read: get your rents closer to market while you still can.)

What lies ahead is somewhat uncertain. It may take years before we know how the emerging rent control regime will impact investor demand, cap rates, and associated valuations.

Some questions you may want to ponder include:

Will the trend of California residents chasing yield beyond the state’s borders accelerate?
Will Chinese and other international investors find other more promising U.S. markets with uncapped upside?
How will California (and Oregon) landlords react to the next economic downturn?
Will they resist aggressively lowering rents, knowing they’ll be restricted on increases once the economy starts growing again?

I don’t have the answers, but these are all questions worth asking. Savvy investors know that you buy based on where you think the market (and regulation) is going—not where it is today.

Change Brings New Opportunities to Rental Investors, Too

While AB 1482 is full of risks for rental investors, SB 50 is mostly opportunity. The express intent of the legislation is to jumpstart residential development and increase the supply of new market rate and affordable housing units as quickly as possible. For investors with an appetite for development, it may be worth taking a hard look at some of California’s transit corridors for new projects.

Picking up an existing single family home or duplex at a 4 percent cap rate today might be worthwhile, especially if you’re soon able to re-entitle the property for a much larger apartment building.

There may also be incidental opportunities to make other real estate plays based on the long-term assumption of increased density in certain areas. For example, neglected or under-utilized commercial properties or even local operating businesses in these areas might see significant upticks in appreciation once higher-density construction breaks ground.

For investors outside of California, you could apply a similar long-term buy and hold strategy to areas near public transit in other parts of the country. If California’s legislative approach successfully eases the housing affordability crisis, then other states may eventually follow suit. Promising investing opportunities may present themselves all along the most notoriously congested commuter corridors.

Underneath the groundswell in support for measures like SB 50 is the dawning realization that adding new housing units far from where the jobs are is ultimately counterproductive. California is showing an intention to blaze a new path by simply bypassing local control to allow the market to deliver even more housing units on top of existing density.

A similar dynamic may already be shaping up in other urban cores in the United States, and state legislators around the country are surely paying attention to what’s happening in California.

2020 May Be the Inflection Point

If AB 1482 and SB 50 fail to become law this year, the underlying market forces driving the legislation aren’t likely to go away. SB 50 itself is the reincarnation of a similar statewide initiative that died on the vine in 2018.

If these bills don’t make it over the finish line in 2019, we can expect a new push for similar regulations on both fronts to reappear during the 2020 election cycle. Political engagement is likely to be high among all camps in 2020, which may help provide rental property owners across the country an early glimpse of what’s in store for other markets where housing affordability is nearing a tipping point.

Resources:

https://leginfo.legislature.ca.gov/faces/billTextClient.xhtml?bill_id=201920200AB1482

https://leginfo.legislature.ca.gov/faces/billTextClient.xhtml?bill_id=201920200SB50

How do you think rental regulations will pan out in California and elsewhere?

I’d love to hear from you in a comment below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.