Good News and Bad News on the Allowed Annual Rent Increase

City Council recently discussed the maximum allowed annual rent increase. The good news is that councilmembers agreed to keep it indexed to the annual change in consumer prices (CPI). We can call that a win! The bad news is that Council will keep it at 100% of CPI. That generates the allowed increases of 4.1% and 3.8% (for Chapter 6 and for Chapter 5 tenants respectively). That more than is necessary to provide the landlord with a ‘fair return’ under the law.

There are two components to the maximum allowed increase: the percentage allowed however it is calculated; and the range (if any) in which that percentage can fluctuate. The calculation varies for Chapter 5 and Chapter 6 and so does the range.

Chapter 6 rent increases under the old system were limited to a maximum of 10% every year as many of us will remember. That 10% didn’t change with consumer prices. In that long era of low-inflation some of us saw big rent increases that did not reflect the landlord’s cost of operating housing. Those increases went straight to cash flow. The Chapter 6 maximum rent increase was not limited by a range because it was a fixed percentage of course; it did not change year-to-year so there was no need for a floor or ceiling.

Chapter 5 rent increases, in contrast, were always indexed to consumer prices and were recalculated monthly according to an arcane formula. There was a ceiling of 8% put on the allowed percentage (in a high-inflation era Chapter 5 tenants saw their increase capped at 8%) but there was no floor. So the allowed increase as indexed to CPI could float down with consumer prices in periods of low inflation. Both were a benefit to those tenants who saw very low increases over many years.[1]

Read on about the particulars of this complicated topic or scroll right down to the section, Tenant Impact: How the Maximum Allowed Increase Affects You.

City Council Changes the Chapter 6 Allowed Rent Increase

City Council in 2017 agreed to also peg the allowed annual rent increase for Chapter 6 tenants to consumer prices (like Chapter 5). So now the allowed rent increase for all tenants in Beverly Hills is indexed to CPI. But Council added a floor of 3% which keeps the allowed annual rent increase percentage from drifting below 3% even in deflationary times when the change in consumer prices is zero. Score one for the landlords!

At the November 20th study session, Council maintained that Chapter 6 maximum allowed annual rent increase — still 100% of CPI. In fact there was no debate on it.

Council did debate the appropriate range in which the allowed increase could fluctuate. Should the appropriate percentages for the floor and ceiling be 3% to 7%? Or should they be 4% to 8%? Vice-Mayor John Mirisch and Councilmember Lili Bosse both wanted the 3-to–7 percent range. Mayor Julian Gold and Councilmember Bob Wunderlich wanted a higher range of 4-to–8 percent.

Lester FriedmanCouncilmembers spent exactly three minutes discussing this important aspect of the rent increase. The solution was offered by Councilmember Les Friedman: “Like Solomon: 3.5% to 7.5%.” Councilmember Wunderlich agreed: “Split the baby.”

Had councilmembers spent an extra minute to discuss it they would have realized that splitting the baby would doubly disadvantage Chapter 6 tenants. Why? On one hand, agreeing to a floor of 3.5% instead of 3% allows the landlord to demand an extra half-percent even in a zero-inflation environment. That’s a half-percent giveaway! On the other hand, the ceiling of 7.5% (instead of 7%) allows the landlord to demand an extra half-percent should inflation later carry the CPI-indexed allowed rent increase that high. Lose-lose for tenants.

Update:  The Federal Reserve Bank of New York recently forecast [pdf] a 1-in-6 chance of a US recession by next November. The Cleveland Fed calculated that probability at <em>1-in-4</em> by next December. These are uncomfortably short odds for any tenant who is concerned about paying the rent, because an economic downturn will likely be followed by a broader contraction in the economy and increased employment instability too. Of course we could see downward pressure on wages which would allow rent increases to gallop away from those who rent in a tight market. While a tempering of consumer prices may provide some relief, that will not be the case if the rent stabilization ordinance includes a 3.5% to 7.5% range on the allowed annual rent increase. For example, as prices increase at a rate as low a 1% annually  (like a few years ago), renting households could pay three times that annual rate of increase when the next rent hike kicks in. That’s why it’s imperative that there be no floor and the allowed increase instead be allowed to move in concert with the overall change in the price for goods and services. After all, that’s what goes into providing rental housing. An arbitrary floor as high as 3.5% is simply padding the landlord’s operating margin at a time when tenants can least afford it.

A compromise might have been 3-to-8 percent (keeping with the current 3% floor) or 4-to-7 percent which would at least buffer the tenant from the highest inflation. But CPI as never been anywhere close to 7.5% anyway (it topped out at 5.8% in 2009 according to the December 18th staff report) which is why any range at all simply disadvantages the tenant. It’s a false compromise.

Key to Residential Stability: Keeping the Maximum Allowed Annual Increase Low

We can talk about 3-to–7 percent or 4-to–8 percent ranges and relocation fees and the rest, but all of these are a distraction because the key to residential stability is a sustainable maximum allowed annual rent increase. That is best accomplished by indexing the allowed rent increase to CPI but at less than 100%.

Why not 100%? Indexing the allowed rent increase to 100% of CPI (the same rate of change in consumer prices) seems intuitive. Landlords’ operating expenses increase year-to-year and perhaps the allowed rent increase should change by the same approximate percentage. However there are three reasons that 100% of CPI is too much:

  1. The maximum allowed annual rent increase is only one component of the return to the landlord — and it is arguably the least important component when we take into account asset appreciation and vacancy decontrol; and,
  2. The rent increase compounds like bank interest year-after-year and so the actual return from that allowed percentage is much greater over time than is the increases in operating expenses which do not compound.[2]
  3. Vacancy decontrol which allows the rent on every new tenancy to be established at the market rate.

First, the components. A primary component is the margin on rental operations. City consultant HR&A Advisors estimates that providers of rental housing earn a margin of 66% on average after operating expenses are paid. However tenants looked at the expenses of three actual properties and found that the margin was much higher — about 75%.

Net operating income chart
A 75% margin is pretty good for any business let alone one that confers great tax advantages AND pays down a significant asset that will appreciate at a double-digit rate these days.

Maybe those are efficient operations. Still, the average 66% is whopping margin in any business. (Landlords by the way never provided any numbers to verify their claim to need a 7% increase every year.)

Second, the appreciation. Skyrocketing prices for real estate means the owner’s asset builds equity much, much faster than he can even collect in rent. Perhaps doubling in value over a decade. Those who have held for decades have seen a fivefold increase in value. That represents a tremendous return in addition to the net operating income from rentals.

Finally and perhaps most important is vacancy decontrol. The rent on every new tenancy is established at the market rate. For all the bellyaching about rent control, the fact is that relatively high turnover in Beverly Hills (according to the city’s consultant) means that rental buildings in the aggregate are always chasing market rent because tenants continually vacate. That more than makes up for the few way under-market units.

Each of those factors all contribute to the ‘fair return’ on the landlord’s investment. In fact, court decisions in California have established that a ‘fair return’ can be provided even when the maximum allowed annual rent increase is indexed at 50% of CPI. That’s why half of the rent control cities in California benchmark their allowed annual rent increase at less than 100% of CPI. Beverly Hills is in the other half! [3]

Indexing the maximum allowed annual rent increase to 100% of CPI is simply a giveaway from tenants to landlords. But City Council has not spoken in detail about whether the percentage-of-CPI should at something less than 100%.

Tenant Impact: How the Maximum Allowed Increase Affects You

Rent burden Beverly Hills renting households chart
Fully 51% of Beverly Hills renting households pay more than 30% of household income in rent, according to the American Community Survey 2012-2016.

The key issue for tenants is the magnitude of the allowed increase. Next to earning power it is the most important determinant of stability for most renting households. Today half of renting households pay 30% or more of their household income in rent. The federal government calls that ‘rent burdened.’ Those households cannot comfortably cede ground to an excessive increase.

Indexing the maximum allowed annual increase to the annual change in consumer prices at the appropriate percentage is the best way to keep families housed. That is the key to sustainability. That’s why 6 of 14 rent control cities in California have identified the appropriate percentage as less that 100% of CPI.

Consider how the maximum allowed annual rent increase at 100% of CPI affects the average 2-bedroom tenant in Beverly Hills. For the average 2-bedroom with a starting monthly rent of $2,796 and 10 years of compounding increases, the rent will be $3,480 at 60% of CPI. At 100% of CPI, though, the monthly rent for the same unit after the same 10-year period would be $4,014 — a difference of $535 every month.

To see compounding rent increases in action here is a chart of that same 2-bedroom unit at three CPI percentages: 60% (West Hollywood), 80% (Santa Monica) and 100% (Beverly Hills Chapter 5 and 6). Notice how the curve climbs more quickly at the higher percentages of CPI.

Rent for a 2-bedroom unit after 10-year period
The difference between 60% and 100% of CPI is clearly shown at the end of a 10-year tenancy. Because the allowed rent increase compounds annually, the cost of that additional increment to tenants is much greater at the 100% of CPI rate.

The different percentages make for a whopping increase in the cumulative rent paid too! After 10 years in an average 2-bedroom unit the tenant will have paid $29,495 more at the 100% of CPI than the 60% of CPI.

Cumulative rent for a 2-bedroom unit 10-year period
The difference between an increase indexed at 60% of CPI and 100% of CPI is most stark when cumulative rent dollars are counted after a 10-year tenancy. Notice the steeper rate-of-increase when the allowed rent increase is indexed to 100% of CPI.

For seniors on a fixed-income, the prospect of a high and compounding maximum allowed annual increase rent increase is a big concern. For example, Beverly Hills allows landlords to levy a 3.8% rent increase on Chapter 5 tenants. But the federal government gave Social Security recipients only a 2% annual cost of living adjustment (COLA) in 2018. That’s about half of the rate of the current allowed rent increase.

Both Chapter 5 and 6 allowed annual rent increases are indexed to consumer prices for our Southern California region but COLA is calculated nationally using a different CPI index and so it lags way behind the allowed rent increase.

CPI vs COLA chart
Social Security COLA has fluctuated quite a bit but in recent years has settled at about 50% of CPI. Seniors may ask, why peg our allowed annual rent increase at 100% of CPI then?

Households that rely primarily on social security will see their affordability gap between income and rent widen. Their rent burden will increase.

What could be done to make the maximum allowed annual increase more sustainable long-term? City Council should agree that 80% of CPI would allow the owners a sufficient return (and in fact it is enough to upgrade their properties).

My Take-Away

The maximum allowed annual increase has been central in the concerns of landlords and tenants throughout the rent stabilization policy process. It garners the most attention. But the maximum allowed increase isn’t the most important factor when it comes to return on investment.

Instead, asset appreciation is the name of the game. That’s why investors buy property. Now, net income carries the property and generates the cash flow. That helps at retirement for individual owners, and allows them to hand the asset off to heirs. But even with these owners rent control is not the primary consideration. Rather it is vacancy decontrol which allows rents to reset to market upon tenant turnover. That keeps aggregate gross rent high.

For tenants, however, the maximum allowed annual increase is among the most important factors. That is because it is the key to sustainability. Seniors know it because they see their fixed-income lagging behind when the allowed increase is 3.8%. Families with children know it because they pay among the highest rents, on average, for larger apartments. The percentage increase on a high rent amounts to a significant jump. Indeed all tenants should be concerned with the maximum allowed annual increase precisely because it compounds year-over-year.

When we look a few years down the road and ask ourselves if we will be able to stay in our apartment we should remember how even when the maximum rent increase stands at parity with the change in consumer prices we will see the rent gallop away from our ability to pay over time (unless incomes keep pace).

The best way to address the rent burden or affordability gap is to follow the lead of our municipal neighbors and set that allowed increase at 80% or less of CPI. City Council has a chance to do that on December 18th. Contact City Council and let them know.

[This post has been updated to reflect the December 18th staff report.]

  1. About that Chapter 5 maximum allowed increase…. Throughout 2017 the maximum allowed annual rent increase averaged 1.1%. That’s about what it was the year before and the years before that. Rock-bottom increases like our neighbors next door in West Hollywood enjoyed. That kept Chapter 5 rents low. As it turns out, too low. The arcane formula uses to calculate the Chapter 5 increase from CPI data was misapplied. For many, many years. Here compounding can have the reverse effect: a permitted increase that is much lower than the change in consumer prices over time will allow rents to lag the broader economy. (That’s what happened: the average Chapter 5 rent in Beverly Hills is $1,094 according to the rental unit registry.) But when inflation started to tick upward, and a new RSO office was created this summer, someone started to calculate the allowed increase accurately. As a result we it double in August from 1.7% to 3.3%. It gets worse: because that Chapter 5 formula is in effect a *lagging* reflection of consumer prices, those tenants are seeing their allowed rent increase (calculated monthly) rapidly catch up to Chapter 6 tenants. (See the chart.) Why will it catch up? Because both Chapter 5 and Chapter 6 use the same 100% of CPI!
  2. Compounding of the increase simply means that when a rent increase percentage is levied, it is multiplying both the base rent and the prior increases. For example: year one of the tenancy is the base rent. Year two the increase percentage is applied to the base rent to get year two’s rent (base + increase increment). In year three the year-two rent (comprised of base rent + prior year increase) is multiplied by the percentage increase. And in each successive year the percentage is applied to the prior year’s total rent — the original base rent plus all successive percentage increases.  ↩
  3. Santa Monica uses 80% of CPI to calculate their maximum allowed annual rent increase. West Hollywood uses 60% of CPI. That means that this year Beverly Hills renters could see a 4.1% rent increase while our neighbors in West Hollywood will see an annual increase limited to less than 3%. And landlords there have to shoulder the entire cost of seismic retrofit too.  ↩

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