San Francisco has strong rent-control laws. Once you put a tenant in a rent-controlled apartment, you can't raise his rent by more than about 2% per year, and you can't evict him except under special circumstances. Meanwhile, there is never a shortage of people who are looking for a place to live in San Francisco. That combination of laws and circumstances is guaranteed to depress the value of residential property, at least as far as property owners are concerned. But what is the financial impact? Here’s a way to think about it, based on recent sale prices.
The first clue that rent control depresses property values is that vacant apartments are usually worth more than occupied apartments. A vacancy represents an opportunity to replace an outgoing tenant (who typically would have been paying less than market rent) with someone who is willing to pay full price for a home. Take a look at the chart, below, which shows median prices for three-unit buildings sold in San Francisco since 2005.
The median price difference between an empty three-unit building and a full one is $265,000, or approximately $90,000 per unit. Roughly speaking, that’s the value of a one-time opportunity to increase the rent to current market value. (How much of an increase are we talking about? Apartment buildings typically sell for about 14 times gross rent, so $90,000 of extra value equates to about $535 per month of extra rent.)
Unfortunately for property owners, the impact of rent control is much greater than $90,000. Installing a new tenant usually will result in higher rent, but the new tenant will benefit from the same 2% annual limitation on rent increases as the old tenant. For comparison purposes, market rents in San Francisco historically have increased at around 4% per year. At those rates, the new rent will be 10% below market in only five years.
It’s straightforward to calculate the cost (in present value terms) of a 2% annual limitation on rent increases. However, it’s easier (and probably more reliable) to work with current market values. Specifically, since condos are exempt from the most onerous aspects of rent control, we can estimate the impact of rent control by comparing condo prices to apartment prices. Take a look at the chart, below, which shows the median price per unit for occupied apartments, vacant apartments, tenancy-in-common (TIC) units, and condos.
The price difference between a vacant apartment and a condo is $355,000. To be fair, some of the difference in price is attributable to differences in quality. As indicated in the chart, TIC’s typically sell for around $120,000 more than vacant apartments. Since there is very little difference (from a legal point of view) between a TIC and a vacant apartment, we should attribute most of the $120,000 price difference to quality improvements that generally are made when apartments are ‘converted’ to TIC’s.
That still leaves a difference of $235,000 to be accounted for. That’s the typical price difference between a condo and a TIC. The most obvious reason for the price difference is that interest rates on TIC loans are higher (by around two percentage points) than interest rates on condo loans. Ultimately, however, the price difference is attributable to rent control. Why? A TIC owner could reduce his interest rate simply by converting his TIC to a condo. However, the City makes condo conversion difficult, precisely because condos are largely exempt from rent control.
Adding it all up, the impact of rent control comes to roughly $325,000 per unit. That’s for the special case of three-unit buildings, but the impact is likely to be similar for other buildings. I wonder if the creators of rent control had any idea that they would be imposing such a large burden on property owners.
The delinquency rate for August of 2009 (i.e., the latest available) was 4.45%. That's almost three times higher than the 1.57% delinquency rate that was recorded in August of 2008, when the financial crisis was already well underway. While it's certainly not scientific, I think it's reasonable to look at the chart and conclude that delinquencies are likely to continue rising for some time.
Recorded default notices appear to be stabilizing. There's an important distinction, however, between a default notice and a delinquency. A borrower is said to be delinquent when he falls behind on his loan payments. When he falls far enough behind, the lender may record a Notice of Default, which is the first step in the foreclosure process. Recent changes in California law make the foreclosure process more difficult, so the number of recorded default notices probably understates current delinquency rates.
