Greatest Threat to Tenants? The Proposed 3.5% Floor

Today is rent day, and that makes it an opportune moment to revisit City Council’s tentative consensus on a 3.5% floor for the maximum allowed annual rent for Chapter 6 tenants. As Councilmember Bob Wunderlich honestly described, this is a straight-up subsidy to landlords. We see it as an unearned bonus. Let’s take a look at what the floor is and what it means for tenants that could pay it.

What Role Does the Floor Play?

In January of 2017 City Council reduced the ceiling on the allowed maximum rent increase for Chapter 6 tenants to the annual percentage change in consumer prices for our region. That was good news: it meant the rent increase would more or less move with consumer prices as measured by the consumer price index, or CPI. Consumer prices are on the rise, up by 4.1% over last year. Some tenants — especially those on fixed-incomes — will feel the sting at their next increase.

However the year-over-year change in consumer prices will probably soon moderate and inevitably the rate will decline with lower inflation. Pegging the maximum allowed annual rent increase to CPI means that the allowed rent increase should follow it back down to 1% or 1.5% or whatever.

But currently there is a 3% floor on the maximum allowed annual rent increase for most tenants. It was added in February of 2017 and is reflected in this bit of the rent stabilization ordinance:

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. -- BHMC 4-6-3(B)

The 3% floor would keep the maximum allowed annual rent increase at that percentage even when CPI declines again. We know it will: over the past 25 years it has averaged about 2.3%. Even in low-inflation times, that 3% floor in the rent stabilization ordinance will keep the annual increase at 3% even if the change in consumer costs (and the landlord’s own costs) is much more moderate. The floor provides a subsidy in low-inflation times.

There is no need for a floor. A rent increase above the rate of change in consumer prices is an unearned subsidy for the landlord payable by the tenant. And that subsidy in the form of higher monthly rents will compound each year. That extra half-percent really does add up!

What the 3.5% Floor Means for Landlords

The 3.5% floor is a subsidy that kicks in when the annual change in consumer prices (CPI) is below 3.5%. Consider that low inflation means prices are not increasing rapidly year-to-year. That includes the cost of providing rental housing, such as utilities, goods, labor, etc. In those years, allowing the landlord to demand a 3.5% increase awards the landlord with income that far exceeds his change in costs. The magnitude of that subsidy reflects the magnitude of his profit after costs are covered.

Why should a landlord be able to demand a 3.5% annual increase even when consumer prices (CPI) increase by only a percent or two in any year? When his costs of operating rental housing rise at a much lower rate of increase? Councilmember Bob Wunderlich explained it at the last December 18th rent stabilization meeting:

The concept is that even if CPI was below 3.5%, they could still raise the rent by 3.5%…it gives the landlords, who say that their expenses rise more rapidly than CPI, the ability to have a modestly higher rent increase in a low-CPI [inflation] environment.

Landlords like to say their costs increase at a rate greater than CPI but they have provided no support for that claim. They also say that with a CPI rent increase (at 4.1% now) they can’t even maintain their properties. Nonsense! The 100% of CPI that Beverly Hills allows landlords get is more than enough. Yet City Council is poised to give away more to landlords.

If City Council is going to award landlords a subsidy though the 3.5% floor, then we should allo know how that floor will work in practice. But it was not sufficiently explained to Council nor discussed by Council.

How Often Might a Subsidy Kick-In?

We can’t predict the future but we can look to the past. Over the last twenty-five years it is clear that there are quite a few years where CPI fell below 3.5% and thus the floor of 3.5% would have provided the landlord with some subsidy.

Change in CPI between 1993-2018 relative to the proposed range on the maximum allowed annual rent increase.
CPI for our Los Angeles region seldom breaks though the 3.5% floor proposed by City Council. Overall the average change in consumer costs runs only 2.3% — far below the proposed floor.

As the chart shows, CPI rarely exceeded 3.5% over the past quarter-century. When inflation was near zero the landlord would have benefited most becaues he could demand a 3.5% rent increase from his tenants even if the rise in his costs was zero. And that subsidy that comes directly out of each affected household’s housing budget.

Returning again to the past 25-year period, we can take a hypothetical guess at how frequently the subsidy may kick-in going forward if the next 25 years look like the last. The orange indicates the magnitude of the subsidy were a 3.5% floor in place. That’s a lot of subsidy in low-inflation years!

Hypotheical 3% floor subsidy 1993-2018 chart
If the Chapter 6 rent increase had been indexed to CPI and a 3% floor was in place during our era of low inflation, it would have provided a significant subsidy to the landlord (represented in orange) in years when the floor was higher than CPI.

The benefit of the 3.5% floor to the landlord is twofold: it pushes up the allowed increase as a percentage much higher than CPI in low-inflation years. The greater increase compounds year-after-year of course.

The table below shows just how large that subsidy could be when inflation is low. The right hand column calculates the magnitude of the subsidy as a percentage component of the maximum allowed annual rent increase had it been in place over the past ten years.

CPI 100% CPI with
3.5% floor
% subsidy
2008 3.7% 3.7% 0.0%
2009 -1.8% 3.5% 3.5%
2010 1.8% 3.5% 1.7%
2011 3.1% 3.5% 0.4%
2012 1.6% 3.5% 1.9%
2013 1.0% 3.5% 2.5%
2014 1.7% 3.5% 1.8%
2015 1.1% 3.5% 2.4%
2016 1.4% 3.5% 2.1%
2017 2.5% 3.5% 1.0%
2018 4.1% 4.1% 0.0%

What the 3.5% Floor Means to Tenants

Rent increase rates comparedThe real measure of the potential subsidy is not in percentage points but in rent dollars. Here we can see how the 3.5% floor’s subsidy, with the compounding of that subsidy over time, pushes up rent for an average 2-bedroom apartment (which was $2,796 according to the registry). If we again project forward ten years of of hypothetical rent increases using the past ten years of inflation as a rough benchmark, we see a steady increase in the rent when it is increased by the maximum of 100% of CPI (the blue line).

For comparison purposes, the maximum allowed annual rent increase in City of West Hollywood’s is less than 100% of CPI. Over ten years that proportionally-lower allowed percentage keeps rents more reasonable (as indicated by the green line). The difference is relatively modest.

Including the 3.5% floor to the mix pushes the rent too damned high! The red line shows the difference between rents increased by 100% of CPI and rents increased with the 3.5% floor in place.

Here is what it looks like for the average apartment rent in Beverly Hills. Starting with the average rent of $2,365, ten years of maximum increases using the past decade’s change in consumer prices as a hypothetical, the final year’s rent gets quite a boost from the 3.5% floor! After ten years of tenancy the difference in the rent is $520 per month.

Average rent
Year 10
CPI 100% $2,365 $2,823
CPI 100% plus 3.5% floor $2,365 $3,343

The Subsidy is Proportional to the Rent

How will average tenants fare with the 3.5% floor subsidy depending on unit size? In this table we compare average rents across different unit sizes. Again this is the hypothetical rent after ten years with and without the 3.5% floor. We can see the difference. The right hand-column puts a dollar figure to the value of the subsidy from the floor alone. For the 2-bedroom tenant it is $615 per month in that 10th year. Just to emphasize the point: this is not income provided to the landlord to cover his rising costs; it is over and above those costs. It is the subsidy!

Year 10
Size category Average rent (2017) Increased
by CPI only
Increased by CPI
with 3.5% floor
Studio $1,389 $1,658 $1,963 $305
1-BR $1,934 $2,308 $2,733 $425
2-BR $2,796 $3,337 $3,952 $615
3-BR $3,867 $4,615 $5,465 $850
4-BR $4,936 $5,891 $6,976 $1,085

Visually we can highlight in orange the relative value of the subsidy across unit sizes.

Potential subsidy by unit size 3.5% floor

Again, the subsidy (in orange) is the difference between the maximum allowed rent increase under our current policy (100% of CPI) and the allowed increase when the 3.5% is included.

How it Adds Up for Landlords

Consider the magnitude of the wealth transfer in the aggregate! Were landlords inclined to levy the maximum allowed annual rent increase every year — as we see happening these days — we can estimate how much additional rent goes to landlords from the 3.5% floor subsidy alone. We can take the average apartment rent and project forward over ten years of rent increases comparing a straight CPI allowance versus including the 3.5% floor with the allowed annual increase. The difference in monthly rent in that 10th year, multiplied by 12 months, then multiplied by the number of units, will produce the extra the subsidy returned to landlords throughout that tenth year.Subsidy from the fllor after 10 years chart

First we find the average rent for an apartment in Beverly Hills: $2,635. (That’s the average across all apartments big and small from registry data.)

Then we calculate that the subsidy returns $520 per month more in that tenth year than does the straight CPI allowed increase. We find that by subtracting the CPI monthly rent from the increase with the floor included. That gives us the difference in monthly rent in year 10 when the floor is added.

Then we multiply that $520 monthly difference in rent by 12 months to get the annual difference in rent with the subsidy included.

Finally we multiply that annual difference between no floor (CPI) and the 3.5% floor by the 7,700 RSO units and we get $48 million extra in rent paid to landlords for year 10 of a ten-year tenancy for the average apartment that today rents for $2,635.

Again, that’s a WHOPPING bonus of nearly fifty million dollars paid to landlords in year ten of our hypothetical tenancy only because the CPI-linked rent increase puts a 3.5% floor under the maximum allowed rent increase. The grey wedge is the subsidy over an above the $260 million that landlords would collect in rent in that tenth year. It is an 18% subsidy under our rough analysis.

Takeaway: There is No Need for a Floor

In City Coucil’s preliminary consensus to include the 3.5% floor, nothing at all was said about the magnitude of the impact on tenants. And when Councilmember Bob Wunderlich supported the 3.5% floor as part of the 3.5% to 7.5% range for the allowed rent increase, he explicitly connected it to his proposal to provide a low-income tenant subsidy to cushion the blow. But the tenant subsidy seems to have disappeared in the debate, leaving only the range with the 3.5% floor teed-up for inclusion in the rent stabilization ordinance.

In fact there is no reason to provide a floor on the maximum allowed annual rent increase in the first place. That’s why we link the increase to CPI: we want the increase to reflect the change in the cost of providing the housing. Anything else is an unearned bonus to the landlord.