Fundamental Concept: Maximum Allowed Annual Rent Increase

Rent control is intended to moderate the increasing cost of rental housing and to enhance the stability of households that rent. Local ordinaces typically include price controls, limited reasons for tenancy termination and regulation of rental housing conditions. Here we look specifically at price control: What does the ‘maximum allowable rent increase’ really mean?

The cap on the maximum allowed annual rent rent increase is the primary means of controlling the price of rental housing. Broadly, rent control is intended to regulate the rent so that it rises in tandem with the change in consumer prices. How closely the allowed rent increase is tied to the change in prices determines how sustainable is the cost of rental housing on average. Keeping the rate of the allowed increase less than other costs change makes rental housing relatively more affordable; allowing the rent to rise faster than prices over time will make it relatively less affordable.

The objective behind controlling the price of rental housing is household stability. We want households to feel secure in their housing and to invest in the community. By extension, the broader community is more stable when household turnover is low. Demand for rent control is higher in high-inflation times when the cost of housing outpaces earnings, rents rise, and households feel more precarious. Regulating what the landlord can demand for rent reduces the pressure and enhances stability.

The maximum allowed annual rent increase is a cap on the increase that can be demanded by the landlord. A cap on the annual rent increase will moderate the rise in housing cost but must also recognize that the cost of providing housing changes over time. A cap can be a fixed percentage regardless of the change in consumer prices; it can be a percentage that varies but is tied to the change in consumer prices; or it can be a fixed percentage over and above the change in consumer prices.

Some rent control cities also specify a range within which the maximum allowed annual rent increase can fluctuate with CPI. A range establishes both a floor for the allowed increase (which protects landlords in low-inflation times) and a ceiling (which protects tenants when inflation runs high). No landlord is obligated to raise the rent, of course. The range becomes important to any landlord who would raise the rent to the maximum allowed. That’s because the maximum increase would bump-up against the ceiling when inflation runs very high. However when inflation runs low the rent can still be raised at a rate much greater than CPI.

How can various rent cap formulae affect how much the rent rises? In Beverly Hills the allowed increase for many years was 10% annually (for Chapter 6). Now the maximum allowable rent increase is pegged to 100% of CPI (or the change in consumer prices). Today it is about 4%. But West Hollywood uses a smaller percentage — only 75% — which means the maximum annual rent increase in that city today is about 3%. (4% CPI x .75 = 3%.) In addition the state is discussing a statewide price control that would be calculated differently: taking the CPI figure and giving the landlords fully 5 percentage points more. If CPI is 4% then the discussed state cap on annual rent increases would be 9%.

The percentage of CPI (a measure of consumer prices) is the key to sustainable rent. Most rent control cities in California link their cap to the annual change in consumer prices (CPI) and today Beverly Hills does too: we use 100% of CPI for both the Chapter 5 and Chapter 6 households (although the method of calculating it is a little different). So in Beverly Hills the rent can increase annually at about 4% today (the same percentage as CPI) In West Hollywood the increase today is about 3% (75% of CPI). In other areas of the state, the increase could be 9% (CPI + 5%). That means that these various formulae can put the allowed increase somewhere between 3% and 9% depending on where one lives — a three fold difference! How a locality’s formula leverages CPI is the key to a sustainable increase.

The maximum allowed annual rent increase is more important than we think because the maximum increases compound year-on-year. Aside from the additional absolute dollars paid in rent year-to-year pursuant to a rent increase, it is compounding that is the most important concept (especially to a long-term tenant). What do we mean by ‘compounds’? It’s like compound interest paid by a bank: when the interest is reinvested the following period’s interest is calculated not only on the principal deposit but also on the accumulated interest. It builds over time. For example, a 4% annual rent increase applied year-over-year will show not a straight line rent cost but an accelerating rent cost. (See this example chart.)

Landlords like to talk about the percentage increase but don’t like to talk about the gift that keeps on giving: the compounding rent increase!

How Do Price Controls Affect the Landlord?

Price controls must balance the right of the landlord to earn a ‘fair return’ on operations. It is in the public interest that housing providers continue to provide housing. And we want owners to continue to reinvest in the property because rental housing is a renewable resource. In fact in California, price controls must allow for profitable operation plus a return on the investment. How that is defined is largely up to the regulating locality, though the state courts have established a minimum parameter. The extent to which the regulations allow a greater or lesser return varies by locality.

Fair return’ is a legal concept that identifies the economic return necessary to sustain the rental business. That includes covering the cost of operation and maintenance but does not include significant capital improvements (which is rewarded by higher rents) nor does it account for mortgage interest (which is related to the underlying investment). Rent control cities generally benchmark their maximum allowed annual rent increase to the ‘fair return’ standard.

In the eye of the law, the landlord’s ‘fair return’ is not only the rent receipts but also asset appreciation and other revenue. These include tax benefits (lower capital gains, tax-free ‘like-kind’ exchanges, and accelerated depreciation) and corporations and limited liability companies fare best under the new tax law. Also, because every vacant apartment fetches market rent, only some proportion of households in a property benefit from the controlled rent. All of it goes into providing the landlord with the ‘fair return’ needed to operate the business profitably.

Courts say an allowed annual rent increase at 60% of CPI provides the landlord with more than a ’fair return.’  Why would Beverly Hills allow 100% of CPI then? Because political will and circumstances vary from one place to the next. One city allows landlords only 60% of CPI — or about a 2.5% annual increase today. The 100% of CPI that Beverly Hills allows is more than sufficient for a ‘fair return’!

Each of these concepts is fundamental to any discussion about rent control. But Beverly Hills City Council didn’t talk much about them over the past two years of rent stabilization policy discussion. Councilmembers didn’t talk about whether a range is necessary or the impact it could have on tenants. City Council discussion about the maximum allowed increase lasted just ten minutes total over the past two meetings!