The Greatest Threat to Tenants is the Proposed 3.5% Floor on Increases

Rent day is an opportune moment to revisit City Council’s proposal to raise to 3.5% the floor on the range for the maximum allowed annual rent for Chapter 6 tenants. At the last meeting, councilmembers appeared ready to allow landlords a 3.5% increase even inflation is low and landlords’ costs hardly increase. As Councilmember Bob Wunderlich honestly described it, this is a straight-up subsidy. Indeed it is an unearned bonus that every tenant would have to pay should Council agree to keep a floor in place.

In January of 2017 City Council lowered the cap on the allowed maximum rent increase to 3%. That was good news then and long overdue. But the change let the maximum allowed rent increase move with inflation (as measured by the change in consumer prices, or CPI). CPI has climbed to 4.1% now, and tenants are feeling the sting of the maximum increase. But inflation will again decline, and so will CPI to which the maximum allowed rent increase is pegged.

The floor on the maximum allowed increase means that when CPI returns to historic levels – as low as zero or even the 25-year average of 2.3% – the landlords will still be able to raise the rent as much as the floor will allow. Today the floor is 3% (as set in early 2017) and Council now proposed to raise it to 3.5%.

There is no need for a floor at all because anything above the CPI percentage is nothing but an unearned bonus for the landlord.

The floor on the maximum allowed annual rent increase is a subsidy to the landlord which is paid by the tenants and it exists for no good reason. And as the following charts show, it can be a whopper of a subsidy!

Before we dive into the proposed subsidy promised by a 3.5% floor, we need to talk about a few key concepts that Council has not discussed — but should have.

Fundamental Concepts Behind the Annual Rent Increase

Rent control caps the allowed annual rent increase to ensure that rents rise in line with the economy – not substantially faster. The objective is stability. At the same time, the city must allow a sufficient economic return to those who operate rental housing. The cap furthers the social objective while recognizing how costs to the landlord change over time.

The maximum allowed annual rent increase defines that cap. The cap can be a fixed percentage regardless of inflation (in Beverly Hills it was 10% for Chapter 6) or it can be a percentage tied in some way to inflation. Most rent control cities in California link their cap to the annual change in consumer prices (CPI) and today Beverly Hills does too: 100% of CPI (for both the Chapter 5 and Chapter 6 households). Here the allowed annual rent increase can be the same percentage as CPI but no higher.

’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 provided by gross receipts (rents) but also by asset appreciation and other forms of 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.

A maximum allowed annual rent increase at more than about 60% of CPI provides the landlord with more than a ’fair return.’ Some cities allow landlords only that 60% of CPI. Today CPI is running 4.1% year-over-year, so 60% of CPI would allow the landlord a 2.5% annual increase. West Hollywood permits 75% of CPI (an increase of barely 3%). Beverly Hills allows increases at 100% of CPI (4.1%) for both Chapter 5 and Chapter 6 tenants. That is more than is necessary for a ‘fair return.’

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.

All of those concepts are fundamental to any discussion about rent control but Beverly Hills City Council didn’t talk about them.  Councilmembers didn’t talk about why a range is necessary or the impact it will have on tenants. The Council discussion about the maximum allowed increase lasted just ten minutes total over the past two meetings.

This post takes a look at the proposed range of 3.5% to 7% and illustrates the very substantial impact it could have on Chapter 6 tenants.[1]

City Council Creates a ‘Hidden’ Subsidy for Landlords

The 3.5% to 7.5% range agreed by all of our councilmembers in December (read the meeting recap) would put an effective floor of 3.5% on the maximum allowed annual rent increase no matter how low is inflation or how small is the change in consumer prices. Even when inflation is near-zero, the landlord who demands the maximum allowable rent increase will raise the rent by 3.5% each year — and that increase will compound like bank interest year after year.

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.[2]

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 according to the policies set by other rent control cities. Yet City Council wants to give away to landlords a bonus on top of it.

What the 3.5% Floor Means for Landlords

If City Council is going to award landlords a subsidy though that effective 3.5% floor on the maximum allowed annual rent increase, then we should know more about how that works in practice; and we should ask what effect it will have on tenants. City Council asked neither question!

The subsidy kicks in when the change in consumer prices (CPI) year-over-year runs below 3.5%. When inflation is low it is not driving up consumer costs (and that includes the cost of providing rental housing). Yet in low-inflation years the landlord could still demand a 3.5% rent increase under the Council’s proposal. That’s because the bottom of the range (3.5%) puts an effective floor under the increase allowed to the landlord…even when the change in consumer prices is zero.

Looking back over the past twenty-five years it is clear that there are quite a few years where CPI fell below 3.5%.

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. But were a 3.5% floor in place then, landlords could have demanded a 3.5% rent increase even when inflation was near zero and there was little or no change in consumer prices. In those years, landlords would have benefitted from the subsidy if they chose to demand a 3.5% rent increase from their tenants even if the rise in their own costs was much lower.

Indeed it is in low-inflation years that subsidy would be especially large — a subsidy that comes directly out of each affected household’s housing budget. Returning again to the past 25-year period, we can look hypothetically at how frequently the subsidy would have kicked-in (if the 3.5% floor was then a policy) and at how large that subsidy would have been in low-inflation years.

if a floor of 3.5% on the allowed rent increase were in place for the 1993-2018 period.
The extend of the subsidy is evident in this hypothetical illustration of a 3.5% floor in place over the past 25 years. Many years of low inflation makes that 3.5% increase in any or every year quite valuable to the landlord.

The benefit of the 3.5% floor to the landlord is twofold: it pushes up the allowed increase way beyond CPI in low-inflation years; and that greater increase compounds year-after-year. That dual effect is evident if we look at the magnitude of the allowed rent increase on an hypothetical apartment.

The average rent for a 2-bedroom unit in Beverly Hills was $2,796, according to the latest available data (2017) from the rental unit registry. We can looking ahead to ten years’ of hypothetical rent increases using the past ten years of inflation as a rough benchmark.

If we allow the rent to increase at the maximum allowed under the city’s current policy, we see a relatively moderate increase between year one and year ten of an average 2-bedroom tenancy. The allowed 100% of CPI increase is moderate because in some of those years inflation will be low (as it was in the past). Compounding annually that allowed increase results in a 2-bedroom hypothetical rent of $3,331 — the light grey line in the chart. (For comparison purposes we will chart the City of West Hollywood’s allowed 75% of CPI increase. That results in lower increases every year and a final-year rent of $3,290.)

Chart comparing CPI vs CPI plus the proposed floor of 3.5% for the period 2008-2018.
The proposed floor of 3.5% allows landlords to demand a 3.5% rent increase even in low-inflation years. Because many years are low-inflation, and because those increases compound annually, allowing for a floor ramps up the cost of rent dramatically relative to a rent that is ‘straight CPI.’

It is the dark grey line that represents the magnitude of the 3.5% floor subsidy. The final rent for the hypothetical tenant after a 10-year tenancy could be much higher — $3,951 — if the landlord demanded the maximum rent increase. That’s because in every low-inflation year the landlord could ask for a 3.5% rent increase. In some years that subsidy will be multiples of the CPI. The table below shows just how large that subsidy could be on a percentage basis based on the actual economic cycle over the past decade. The steep climb is a product of both the outsized subsidy in some years and the fact that it compounds every year.

CPI 100% CPI with
3.5% floor
% increase
above CPI
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%

Average-Year Example

Let’s take as an example an average year to illustrate how the 3.5% floor subsidy works in practice. Over the past 25 years CPI averaged 2.3%. That figure also represents the average annual change in the costs that the landlord pays to provide the housing (including inputs like energy, labor, durables, insurance and other services but not mortgage interest because that is related to real estate investment and not rental operations).

The subsidy comes in when the change in the landlords costs is less than the rent increase that he can demand as a result of the 3.5% floor in the allowed range for the maximum increase. Under the current Beverly Hills rent stabilization ordinance, the maximum allowed annual rent increase (at 100% of CPI) would be 2.3%. That would cover the landlords rising costs. But the proposed 3.5% floor would allow the landlord to raise his rents by 3.5% even when the landlord’s actual costs increase by much less and therein is the subsidy.

In our average-year example, when the rise in the landlord’s costs (2.3%) is lower than the rent increase he demands (3.5%) then the subsidy will be 1.2%. That subsidy is realized in rent dollars when it is multiplied by the landlord’s prior year’s rents. That’s because it represents an unearned 1.2% increase over the prior year’s rents. That’s additional money in the landlord’s pocket.

In this example, an average-sized 7-unit property when each unit rents at the city’s average of $2,365 would produce a total subsidy for the property of about $2,400 that year. (The figure is found by multiplying the 1.2% in our average-year example by the gross rents produced by the 7-unit property each at $2,365 per unit per month. That amounts to a $198 subsidy each month. Over 12 months it amounts to $2,383.) Again, any increase in the base rent will compound each successive year and this subsidy will too.

On a percentage basis alone, an average-inflation year shows that a 3.5% rent increase when costs rise only 2.3% represents a 50% bonus on top of the costs covered by the CPI component of the allowed rent increase. (That is, the 1.2% extra increase is 50% greater than the 2.3% rise in costs.) That’s a very significant unearned bonus!

What the 3.5% Floor Means for Tenants

When Council agreed in December to provide landlords with a subsidy in this fashion, no councilmember discussed the magnitude of that subsidy. No city staff report projects the possible impact on tenants. Let’s take a look!

So far we have pointed to an average-year example which, by definition, is a moderate example. In many of the past 25 years inflation was much lower than the average and in year 2009 consumer prices actually declined (a less-than zero percent change). Yet even in that ultra-low-inflation year the landlord could have demanded a 3.5% rent increase were the 3.5% floor in effect then. That period of low inflation will return.

Say we return to the first chart which shows CPI over 25 years. We can clearly see two post-recession economic cycles: inflation runs high as the economy overheats then it turns downward and bottoms out before recovering. Most recently we saw that cycle begin after the economic crisis. Ten years ago the economy was coming off a period of irrational exuberance and CPI was running high (3.7% in 2008). That was close to where we are now (4.1% CPI) but quickly it turned downward and the following years were a trough for both the cost of housing inputs and household earnings.

The subsidy becomes a problem when household earnings stall but the rent continues to increase. That’s what could happen in low-inflation years. If we take that 2008–2017 10-year cycle and project it forward hypothetically, then we can start to quantify the potential impact of the subsidy on a tenant’s housing budget.

The average 2-bedroom apartment in Beverly Hills rented for $2,796 in 2017 (the only year for which we have city data on rents). Under the current policy, the landlord could raise his rents by the same percentage as CPI. That is a relatively moderate cost to tenants over time: it is much less than tenants could have seen under the old 10% max increase, yet more than our neighbors in West Hollywood and Santa Monica will see under those cities lower rent caps. But that is not the difference that counts.

The impact of the floor on the housing budget is revealed by comparing how rents could increase under the current CPI formula and how much more quickly hypothetical rents could rise were a 3.5% floor allowed. That is illustrated in the second chart by the divergence of the grey lines for an average 2-bedroom apartment.

When we drill down to the effect of that divergence after some time the magnitude of the subsidy becomes much more clear. In the 10th year of a tenancy, for example, the gap between the current ordinance and the proposed 3.5% floor yawns wide and the premium paid by the hypothetical tenant becomes quite significant. That holds across unit sizes but is magnified at higher rents (which is characteristic of larger units).

Base year Year 10
Size category Average rent
by CPI only
Increased by CPI
with 3.5% floor
Effective monthly
subsidy to the landlord
Studio $1,389 $1,655 $1,963 $308
1-BR $1,934 $2,304 $2,733 $429
2-BR $2,796 $3,331 $3,951 $620
3-BR $3,867 $4,607 $5,465 $858
4-BR $4,936 $5,880 $6,975 $1,095

Looked at another way, this is the monthly premium the hypothetical tenant would pay after ten years of tenancy during which the landlord raised the rent by the maximum allowed taking into account the floor of 3.5% in low-inflation years.

Maximum potential monthly subsidy per unit
The proposed 3.5% floor would add significantly to the hypothetical tenant’s rent payment after, say, 10 years of tenancy. And because it is applied to the rent it would scale up with higher rents.

Again, the subsidy is the difference between the current allowed rent increase (100% of CPI) and the allowed increase when the 3.5% to 7.5% range is added to the ordinance. The magnitude of the subsidy for each unit size category is the premium the average tenant could pay if landlords take advantage of the maximum increase allowed with the floor.

Those subsidies to landlords really add up. We can do a rough back-of-the-envelope calculation if we take the average rent for 7700 rent-stabilized units in Beverly Hills ($2,365) and calculate the 10th year rent under both the a ‘stright CPI’ increase (no floor) today and the proposed CPI plus the floor of 3.5%.

As the following table shows, adding a floor of 3.5% to CPI effectively doubles the additional rent collected every month in the tenth year of tenancy compared with the base year’s rent. That is, the average hypothetical tenancy starts at $2,365 and sees the rent rise to $2,817 with a CPI-only allowed increase. In the last year the rent payment is $452 higher than the first year. That same tenant could find the tenth-year rent payment to rise to $977 if the floor of 3.5% is added to CPI.[3]

Average rent
Year 1 Year 10
CPI 100% $2,365 $2,452 $2,817
CPI 100% plus 3.5% floor $2,365 $2,452 $3,342

Now multiply that hypothetical average subsidy by the 7,700 rent-stabilized units and it becomes a whopping bonus to landlords of as much as fifty million dollars citywide in just that last year of the hypothetical tenancy. That is on top of the higher rents generated by CPI-only increases. This is what that aggregate subsidy looks like. The grey wedge is the premium from the 3.5% floor.

Maximum aggregate potential subsidy as a proportion of allowed CPI increases for all units.
Comparing an allowed increase at 100% of CPI with one that provides the landlords with a 3.5% floor makes a huge difference in aggregate rent collections citywide. Almost 50 million bucks difference!

City Council discussed none of this. Instead councilmembers pointed out the value of the 7.5% ceiling on the range as protecting tenants. But it will not protect tenants: while landlords would get a big subsidy from the floor, tenants will get ZERO protection from the 7.5% ceiling because CPI has not reached 7.5% in more than two decades. Instead keeping any floor in place, much less increasing it from 3% to 3.5%, means a potentially much higher rent over time for tenants simply to provide a subsidy to landlords that they don’t need.

Why aren’t landlords entitled to that subsidy? Because landlords on average garner about 66% of gross rents as net operating income, according to city consultant HR&A Advisors, which crunched the numbers. Moreover, landlords and their industry association have provided absolutely no support for any claim otherwise..

Who will the the proposed 3.5% floor on the maximum allowed annual rent increase affect most? Tenants who pay lower rents today, and those who will stay in their apartment for a longer period. A below-market tenant will see the landlord bring their rent up to market much more quickly with a floor because in low-inflation years the floor allows an increase that is a multiple of the landlord’s rise in costs. That is a subsidy that goes right to the bottom line.

And second, the longer the tenant resides in her apartment, the greater will be is the magnitude of the subsidy. Because it compounds annually, in subsequent years it pays an increasingly large dividend to the landlord. This subsidy is the gift that keeps on giving…and then gives more and more!

The best reason to eliminate any floor on the maximum allowed annual rent increase is because it is simply not necessary. That is why we tie the allowed increase to consumer prices in the first place! When the landlords’ costs rise steeply, the allowed increase rises steeply too. And when the increase in those costs declines, the allowed increase should follow it back down. Any floor on the allowed increase contravenes the whole purpose of letting the allowed increase fluctuate with consumer prices. And the key to sustainable rental housing in Beverly Hills is a sustainable annual rent increase.

Councilmember Bob Wunderlich pitched the 3.5% floor in connection with his idea for a low-income tenant subsidy, but the tenant subsidy may never come. Yet tenants could be stuck with the landlord subsidy for a generation.

  1. Note to Chapter 5 tenants: none of this applies to you. City Council in 2017 linked the allowed increases for both Chapter 5 and Chapter 6 tenants to CPI, but only Chapter 6 currently has a floor of 3%. (The proposed range would raise it to 3.5%.) Chapter 5 tenants have no floor on the maximum increase. As inflation declines and consumer cost increases slow, the Chapter 5 allowed percentage follows CPI as low as zero. That’s why we need to remove the Chapter 6 floor of 3% and resist any effort to raise it to 3.5%.  ↩
  2. Councilmember Wunderlich supported his concept for the high 3.5% floor and the subsidy it provides by echoing this unsupported claim from some landlords: they are unable to maintain their properties under the current 100% CPI allowed annual rent increase (currently 4.1%). However the ‘fair return’ concept suggests otherwise, and explicitly notes that the cost of maintenance and indeed all other costs are sufficiently covered at 60% of CPI. Nevertheless, Councilmember Wunderlich justified this unnecessary and gratuitous giveaway by tying it to his ‘qualified tenant’ subsidy proposal. But it is unclear that City Council will agree. Yet we tenants will foot the bill for the landlord subsidy.  ↩
  3. This analysis comes with two caveats: all future rents are not adjusted for inflation; they are expressed in today’s dollars. And a key assumption in the analysis is that the hypothetical landlord (or all hypothetical landlords) will take advantage of the maximum allowed increase whether it is 100% of CPI or CPI with the 3.5% floor subsidy. Not all landlords may demand the maximum increase, of course; but we have certainly heard landlords say they will establish their rent increases at whatever is the allowed increase set by the rent stabilization ordinance. Presumably that would hold in years of low inflation too.  ↩

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