Why a Rent Increase Pegged to 100% of CPI Favors Landlords

Starting in 2017 Beverly Hills has continually amended the rent stabilization ordinance to provide additional protections to Chapter 6 tenants. That includes the relocation fees an most recently an end to no-just-cause eviction. The city also reduced the cap on the maximum allowed annual rent increase and, importantly, linked it to the annual change in consumer prices (CPI). Let’s look at the latter change in more detail.

Chapter 6 was added to the rent stabilization ordinance in 1985 to extend modest protections to tenancies that start at more $600 per month. The most notable of them was a 10% cap on the maximum allowed annual rent increase. Of course that was not much protection at all.

City Council heard from many tenants who fear what we have called the “slow-motion eviction” — getting pushed out by successive rent increases of that magnitude. So we applauded City Council’s decision to provisionally reduce the rent increase cap to 3% in January of 2017.

The following month, Council tweaked the ordinance to move from a fixed 3% to an allowed annual rent increase that floats with the change in consumer prices. Municipal Code section 4-6-3(B) says:

Such increases shall not exceed the greater of: 1) three percent (3%) of the rental rate then in effect, or 2) the percentage equal to the percentage increase, if any, of the Consumer Price Index for the Los Angeles/Riverside/Orange County Area.

The 3% cap in effect then had reflected the annual change in consumer prices for the preceding year; it was in interim measure. Subsequently city council amended the ordinance to allow the percentage increase to float with CPI. However the ordinance puts a floor under it too: even during a time of low inflation the landlord can demand 3% even as the landlord’s own costs don’t rise much. A subsidy to the landlord!

Why CPI Matters

The key to residential stability is a sustainable rent increase and that is best controlled by linking the cap on the allowed annual rent increase to CPI. Indeed that is the usual practice for rent control cities and all but two in California tie their allowed rent increase to CPI. Tenants have called for making the CPI-linkage permanent.

The federal measure of consumer prices provides a regional benchmark to approximate the landlord’s cost of operating rental housing. Landlords’ operating expenses do fluctuate and the CPI-linked rent increase allows them to recover an increase in their costs for energy, goods and services. All are included in the CPI’s ‘all items’ basket.

Landlords, however, have claimed that CPI is not the appropriate benchmark for their costs. Rightly they say that CPI doesn’t measure housing inputs specifically. However there is no alternate measure of those costs and CPI does cover nearly all of their costs. Thus it is a good proxy for the change in landlords’ cost of providing housing.

Localities look to CPI largely because no landlord provides actual operating expenses. In Beverly Hills, no landlord provided any operating financials and said they would not. Of course they have not provided any support their claimed need of a 7% annual rent increase to cover their rising costs.

What is 100% of CPI?

Typically rent control cities link their increase to CPI at 100% of the change in consumer costs. When those costs to consumers rise by a given percentage in any year from the last year, the allowed annual rent increase is set at that same percentage. This is known as 100% of CPI: the rent increase is 100% of the percentage identified by the Bureau of Labor Statistics for a particular region. Ours is the Los Angeles-Long Beach-Anaheim region.

Most localities with rent control use 100% of CPI because the point is to allow an increase that reflects the owners changing costs. The principle is to provide the property owner a ‘fair return’ on his investment so he can keep in business. The ‘fair return’ standard is actualy required by state law. Any locality in California with rent control must allow the operator to maintain his net operating income: profit on operations. A city can’t deny him the income necessary to operate profitably of course!

The San Jose RSO study about ‘fair return’ explains:

The type of fair return standard which is used to determine whether allowable rent increases have been adequate to cover operating cost increases and permit growth in net operating income, by comparing current current net operating income with a base year net operating income is known as a “maintenance of net operating income” (MNOI) standard. Under this standard — known as a “maintenance of net operating income” (MNOI standard — apartment owners are entitled to rent increases which are adequate to cover operating cost increases and to permit growth in net operating income. […] Jurisdictions with MNOI standards provide for indexing a base period of net operating income by varying percentages of the percentage increase in the Consumer Price Index, ranging from 40% to 100%.

Localities can establish the fraction of CPI that best suits them. Beverly Hills currently allows 100% of CPI for both Chapter 5 and Chapter 6 rent-stabilized tenants. Our municipal neighbors, West Hollywood and Santa Monica, allow rent increases at only 75% of CPI. Berkeley allows 65% of CPI.

Why Less than 100% of CPI?

It may seem intuitive that a landlord should see a rent increase proportional to the increase in his operating costs. The landlord’s costs are increase most years (often exaggerated as 7% or 8% annually) and so shouldn’t the rent increase by that much at least? That’s why 100% of CPI seems reasonable if the landlord is to get his ‘fair return.’

However the fair return guaranteed by the law is based on more than just income from operations: it also includes asset appreciation and other considerations like vacancy decontrol, which allows the rent for every new tenancy to be established at the market rate.

A significant part of the fair return is generated by asset appreciation – and those ‘paper gains’ do count toward as a return on investment! Indeed the paper gain on property value appreciation generally exceeds the change in costs of operation. So proportionally speaking the needed rent increase can be somewhat smaller. If the value of the property increases at a rate faster than the increase in operations costs (CPI) then to meet the fair return standard something less than 100% of CPI will be necessary.

The courts have upheld rent increases that are capped at less than 100% of CPI because 100% of CPI would provide more return than necessary in order to cover the increase in operating costs under the ‘maintenance of operating income’ concept.

One look at multifamily asset appreciation in Beverly Hills suggests how that particular aspect of the fair return really does materially benefit landlords!

Leveraged Debt

Moreover, the paper investment gain can be realized by leveraging debt. For example, the owner who holds a small equity stake in a property can still realize 100% of the asset appreciation when he sells even though he’s financed most of the purchase. The San Jose study explains:

The rationale for less than 100% indexing has been that the rate of increase in equity may exceed 100% of the rate of increase in the CPI even if the rate of increase in the overall value of a property is lower. For example, the value of an apartment building may increase by 20% from $1,000,000 to $1,200,000. but the increase in the equity of an owner who purchased with a 70% loan may increase from $300,000 to $500,000.

Where the property overall realized a 20% gain in appreciation, the owner’s leverage of financing returns to him not merely a 20% increase in his stake upon sale, but instead he sees a 66.6% gain ($500k-$300k/$300k) because he’s used the bank’s money to make money.  That is leverage at work! That’s why asset value can provide a significant boost to the landlord’s return on investment especially when it’s leveraged.

While the increase in appreciation of the property is considered as a component of fair return, and that figures in to the calculation of net operating income, the cost of the debt does not add to operating costs. Fair return under the law views the cost of debt service to be a function of investment and not operations.

Cities like Santa Monica, West Hollywood, Berkeley and San Francisco recognize how fair return includes many factors beyond the rent and so set their percentages of CPI between 65% and 75%. In Beverly Hills the current rent stabilization ordinance allows increases at 100% of CPI for both Chapter 5 and Chapter 6 tenants.

The Key to Residential Stability in Beverly Hills: Less Than 100% of CPI

City Council at the November RSO study session tentatively agreed that the range within which the CPI-indexed maximum allowed rent increase should fluctuate is 3.5% to 7.5%. But councilmembers didn’t address whether the underlying linkage to CPI should be 100% or less. Tenants have advocated for a smaller percentage in line with our neighbors but we have not been able to get the arcane question onto the agenda.

The city’s own consultant, HR&A Advisors, estimated that providers of rental housing earn a margin of 66% on average (after operating expenses). That is a nice margin! But it is necessarily an estimate based on industry figures; no Beverly Hills landlord has agreed to provide actual operations figures.

Renters Alliance did take a peek at the books on a few actual properties and found that the margin on average was higher — above 70% — on the properties we looked at.

If rental operations are returning a 66% margin on average, there is certainly reason to examine whether landlords require a 100% of CPI rent increase to achieve their fair return.

Also, strong appreciation for rental real estate means a substantial component of the landlord’s fair return is achieved with capital gains. We see multifamily properties double in value over a decade, and those who held on for longer see even greater rises in value. That is a tremendous return on investment in addition to the margin on operations.

Each contributes to fair return. In fact, California courts have established that fair return can be met with rent increases at only 50% of CPI because other gains make up for the capped rents. We argue that 100% of CPI in Beverly Hills is simply a giveaway to landlords.

How the Maximum Allowed Increase Affects Us

The key issue for tenants is the allowed rent 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 any 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. It is the key to sustainability. That’s why 7 of 12 rent control cities in California that use CPI have identified the appropriate percentage as less that 100%.

Consider how 100% of CPI affects the tenant with an average 2-bedroom tenant in Beverly Hills. With a starting monthly rent of $2,796, and after 10 years of compounding increases, and using the past 10 years of CPI as a hypothetical, the rent on that apartment would be $3,480 if 60% of CPI is the formula.

But at 100% of CPI, that same tenant will pay $4,014 in the tenth year — a difference of $535 every month. The chart above shows how it literally adds up over time. This chart shows the 10th year rent.

Such outcomes are not hypothetical however; tenants in cities like San Francisco (60% of CPI), West Hollywood and Santa Monica (80%) and Beverly Hills (100%) see those outcomes. The higher the percentage the more money is transferred from the tenant’s housing budget to the landlord’s pocket.

And boy does it make a difference over the long term. Here’s how much a long-term tenant would pay in cumulative rent after ten years at various percentages of CPI.

At 100% the Rent Outpaces Fixed Incomes

The prospect of a high and compounding maximum allowed annual rent increases is a big concern for seniors on fixed incomes. Today Beverly Hills allows the landlord to demand a 3.8% rent increase on Chapter 5 tenants, many of whom are senior. But the federal government gave those tenants a Social Security cost of living adjustment (COLA) in 2018 of only 2% — half of the rate of the current allowed rent increase!

While the maximum allowed annual rent increase is indexed to consumer prices for our Southern California region, COLA is calculated nationally and uses a different CPI index. By design it lags high-growth regions like ours.

Households that rely primarily on social security will see the affordability gap between income and rent widen. Their rent burden will increase. What could be done? Make 80% of CPI the formula for the rent increase!