RSO Commission to Discuss the Rent Increase Cap and Allowable Pass-Throughs

The Rent Stabilization Commission at its regular July 6th meeting will revisit an issue that will concern every Beverly Hills rent-stabilized household: potential future amendments to the rent stabilization ordinance relating to the maximum allowable annual rent increase and and the charges that may be passed-through to tenants. Each can make a difference in the amount of rent we pay but affect the price of housing in very different ways. Let’s take a look at what’s on the commission’s agenda and how it may affect tenants.

City Council has tasked commissioners with recommending amendments concerning a variety of rent stabilization ordinance provisions. To date the commission has made some recommendations. Beverly Hills should inspect rental units but should not use a habitability standard any higher than the state’s current ‘fit for human habitation’ standard. The commission recommended a change to relocation fees that would disadvantage most tenants. The commission also declined to require landlords to disclose to tenants our rights when the landlord presents a ‘cash-for-keys’ offer. Most notably the commission last fall recommended an immediate end to the moratorium on evictions and rent increases. (City Council sunset the moratorium ten months later.)

It has not been a good run for tenants at the Rent Stabilization Commission. So we are concerned when the commission discusses something important like rent increases and pass-throughs. And that is what is on the Wednesday July 6th Rent Stabilization Commission agenda:

Staff seeks recommendations regarding possible amendments to the Rent Stabilization Ordinance for both Chapter 5 and Chapter 6 of Title 4 of the Beverly Hills Municipal Code regarding surcharges that allow housing providers to pass through costs to tenants relating to water service penalties and/or surcharges, refuse fees, and for Chapter 5 tenants only, capital expenditures, improvement expenses mandated by law, including seismic retrofit, utility expense, and for additional tenants. Staff also seeks recommendations regarding possible amendments to Chapters 5 and 6 regarding the amount of the maximum allowable annual rent increases. — Rent Stabilization Commission agenda item #2

That discussion description buries the lede though. Isn’t the rent increase more important than allowed pass-throughs? We think so, and especially for longer-term tenants for whom a more restrictive rent cap will mean much lower rents down the line. In contrast, a pass-through is a charge that is added to the base rent. Because a rent increase does not act on the pass-through charge, pass-throughs don’t affect the rate of increase that determines the rent over the longer haul. Still, a pass-through adds dollars to the cost of monthly rent so we need to pay attention!

The description of item #2 only suggests the broader problem with the way the discussion is presented. The 292-page staff report is completely inscrutable for most members of the public. It stitches together prior staff reports and attachments, and in some cases staff reports that are attached to those earlier staff reports, in a way where the material folds in on itself. Some of the material appears twice. So it is rough going for the general reader. In order to wrap our mind around this Frankenstein we had to generate our own table of contents.

To make this proverbial gordian knot of a staff report usable for the public we have broken out key documents here (and left the rest of the chaff on the barn floor):

Let’s move on to the two components of the Rent Stabilization Commission’s July 6th meeting: a potential recommendation to City Council concerning the allowed annual rent increase and allowed pass-through charges.

Maximum Allowable Annual Rent Increase: How Much?

Key Concepts

The maximum allowable annual rent increase is the amount that the rent is allowed to rise for existing rent-stabilized tenancies. Rental housing that is exempt from rent stabilization does not have a local cap and may rise according to state law. Under our rent stabilization ordinance, a rent-stabilized rent may be increased only one time in any 12-month period. The allowed increase is indexed to inflation in Beverly Hills and reflects 100% of the percentage change in consumer prices (known as CPI).

Rent stabilization is comprised of Chapter 5 tenancies (initiated at $600 or less) and Chapter 6 tenancies (all others not exempt). The allowed increase is calculated differently.

  • Chapter 5 rents can rise no more than 8% or the CPI (as calculated) on the date of the rent increase. That calculated percentage is established by the city each month according to a complicated formula intended to act like a moving average in order to smooth-out variability in the monthly CPI. There is no ‘floor’ on the Chapter 5 rent increase so the allowed percentage can be as low as zero if there is effectively no inflation.
  • Chapter 6 rents can rise as much as the CPI percentage as established by the city each July according to the May-to-May annual change in consumer prices. If CPI is 8% then the allowed Chapter 6 rent increase is 8%. Unlike Chapter 5 there is no ceiling so rent increases have no upper limit in high-inflation times. However there is a floor of 3% so the landlord can demand 3% even when inflation is zero.

Why It Matters

Rent control allows a locality to regulate the price of rent. The maximum allowable annual rent increase is the principal means by which the city controls that price. The effect of a cap is twofold: it limits the change in the price of rent from one year to the next; and over time it should moderate the rate that the rent rises relative to the market price. That moderating greatly varies with the annual percentage change due to compounding (much like interest on a savings account). A higher percentage increase will have a greater compounding effect than a lower percentage and — over time for existing tenancies — will push the rent up at a more steep rate of increase. A lower percentage tends to flatten the rate-of-increase curve. Over the long term it can make a difference of hundreds of dollars in rent per month.

What’s Up for Discussion

The Rent Stabilization Commission will discuss several aspects of the maximum allowable annual rent increase:

  1. To what extent should the rent increase reflect inflation as measured by the annual change in consumer prices?
  2. Should there be a ceiling or a floor on the allowed annual rent increase?
  3. Should Chapter 5 and Chapter 6 be harmonized by adopting a citywide formula for calculating the rent increase for rent-stabilized units?

In the background is legal concept called ‘fair return.’ Landlords are entitled by law to earn a “just and reasonable return” on rental operations when a locality like Beverly Hills controls the price of rent. That means the cap imposed on the annual rent increase can’t be overly restrictive if the landlord is to earn enough to maintain the property and profit from rental operations.

For more about the fair return concept read the San Jose study. For more about balancing these interests in practice read the HR&A Advisors Allowable Rent Increase final analysis memo.

The key issue for most tenants is the percentage that the rent is allowed to rise, and that percentage is established by the city to reflect inflation. All rent control cities index their allowed rent increase to inflation as measured annually by the Bureau of Labor Statistics. That measure is called the consumer price index (CPI). There are many published CPI indexes but most cities use the one that tracks prices for ‘all items’ in the urban consumer’s basket of goods and services (called CPI-U).

For example, the maximum allowable annual rent increase percentage that is allowed to Beverly Hills landlords with Chapter 6 tenants is the same percentage as the May-to-May CPI-U for our region. As it is the same exact percentage we can call it 100% of CPI. As the table on p. 5 of the HR&A memo shows, localities use a variety of percentages of CPI to establish their rent increase, from 65% in Berkeley to 100% in Beverly Hills and beyond. Using 100% of CPI is intuitive because in theory it reflects the rate of inflation in our region.

But is 100% of CPI the right percentage? Notably West Hollywood and Santa Monica limit annual rent increases to 75% of CPI which equates to three-quarters of the rate of inflation in our area. At today’s rate of inflation it means the difference between an 8% rent increase in Beverly Hills and a 6% rent increase in West Hollywood. (At the moment West Hollywood still has a rent freeze!)

Again if we go back to the fair return concept, the annual rent increase may determine the rent component of the landlord’s return; but other factors contribute too. Vacancy decontrol allows the landlord to set a market price on a vacant unit. That means at any time some portion of units that have turned over recently rent at or near market and aren’t really price-limited at all. Also, apartment leasing generates ancillary revenue from fees and charges. Unscrupulous landlords tend to unlawfully withhold some or all of the deposit to generate yet more revenue.

In the broader scheme, tax breaks allow landlords to realize more income and even offset gains in other businesses. And of course the appreciation of the underlying asset (the land and improvements) returns a whopping gain over time — wealth that is transferred (often tax-free) to heirs or realized at the time of sale.

If a key issue is what percentage of CPI is appropriate to generate a fair return, then another key issue is whether to establish a floor and/or ceiling on the increase in order to effectively limit the range in which the percentage can fluctuate. That can protect tenants at a time of high inflation or conversely reward landlords with a relatively larger dollar increase when inflation is low or nonexistent.

Today the base rent for Chapter 5 tenants can’t be increased more than 8% regardless of inflation due to a ceiling. The base rent for Chapter 6 tenants can rise by 3% even when inflation is zero because that 3% is an effective floor that protects landlords. So many decisions to make?

Commissioners must balance the city’s interest to maintain stability among renting households with the landlord’s right to earn a fair return but as we look more closely that means really digging into the material and interrogating the concepts. But past commission performance doesn’t suggest a deep-dive into the issue. To be fair City Council didn’t dive too deep either.

Lastly, should the maximum allowable annual rent increase for Chapter 5 and Chapter 6 tenants be harmonized through a citywide formula for calculating the rent increase? Chapter 5 tenants have long enjoyed relatively smaller rent increases and may be disinclined to agree. However their numbers are small and dropping and some may have had to pay sizable pass-through charges. That could argue for consistent policy on both the rent increase and pass-throughs for both chapters 5 and 6.

Passing-Through the Landlord’s Cost of Doing Business

Key Concepts

A ‘pass-through’ is a charge which is permitted by statute to be passed directly to the tenant. It is not part of the base rent and is not used to calculate a rent increase. For example landlords can pass-through charges to Chapter 6 tenants that include:

  • 90% of the cost of water service penalties and/or surcharges imposed by the city if the landlord installs in the tenant’s unit such water conservation plumbing fixtures as water-saving toilets, low-flow shower heads, and faucet aerators. (B.H.M.C. 4–6–7)
  • 100% of the cost of any ‘refuse fee’ imposed by the city. That includes both the bimonthly residential solid waste collection fee of $48.17 per dwelling unit and the bimonthly alley refuse fee of $32.54. (B.H.M.C. 4–6–8)

Landlords can pass-through charges to Chapter 5 tenants that include the water surcharge and refuse fees and also these additional charges:

  • Capital improvements that benefit the entire building the cost of which is annualized in accord with IRS depreciation schedules and then assessed to each tenant based on the square footage of each tenant’s unit not to exceed 4% of the amount of the base rent. The cost of improvements that benefit of one or more units are borne only by tenants who benefit. (B.H.M.C. 4–5–304(A)).
  • Improvements mandated by law (e.g., seismic retrofit) the cost of which is assessed to tenants based on the proportion of unit size in square feet to the total property and annualized in accordance with IRS depreciation schedule. (B.H.M.C. 4–5–305)
  • Increase in cost of basic utilities like electricity, gas, or water if such a utility is included in the base rent and the utility cost has increased by a percentage which is greater than the percentage annual rent increase allowed by the rent stabilization ordinance. The difference between the percentage rent increase and the percentage utility cost increase is what may be passed-through to tenants. (B.H.M.C. 4–5–306)
  • 10% rent increase for any additional tenant(s) not on the lease (B.H.M.C. 4–5–307). This is the only pass-through which does increase the base rent and thus would be compounded by future rent increases.

Why It Matters

First, pass-throughs can shift some of the cost of rental operations from the landlord to his tenants.

The refuse fee is a good example. The city allows the landlord to pass-through 100% of this charge. On a per-unit basis that amounts to $40 per unit. If the tenant pays for refuse then the landlord is relieved of the cost of providing this essential service. (In fact refuse collection is so essential that the landlord can’t opt out of it.) That’s $40 more net income.

However the landlord cannot pass-through the refuse fee if the rental agreement says that the landlord pays for refuse. But in cases where the rental agreement is not explicit, or where there is no written rental agreement, then the landlord can pass-through the refuse cost with 30 days notice. (By the way, when a tenancy goes to month-to-month the agreement terms don’t change; the landlord can’t then choose to pass-it-through.)

Second, a pass-through can cushion the impact on the landlord of rising rates or utility surcharges.

For example the city allows a landlord to pass-through to a Chapter 5 tenant the difference between the percentage increase in the cost of a utility and the allowed percentage increase in the base rent. If the rent can rise by 2% under the rent stabilization ordinance but gas rises 5%, then the landlord can pass through the dollar value of the difference (but only to Chapter 5 tenants).

Likewise, the city allows the landlord to pass-through to all tenants 90% of any water usage penalty that is assessed by the city for excess water usage. In principle this pass-through recognizes that the landlord can’t be responsible for tenants’ water consumption. And maybe that’s good for discouraging excess consumption. But it does off-load some of the utility cost to tenants.

In each of those cases the pass-through operates outside of the rental agreement.

Third, a pass-through like the capital expenditure provision for Chapter 5 tenants can effectively offload to tenants the landlord’s cost of maintaining or improving the property.

For example say the property needs a a new roof. That is periodic maintenance. Yet the landlord can pass-through that cost to Chapter 5 tenants. Of course basic maintenance is a responsibility of the landlord — not the tenant who pays rent for maintained premises.

Another example: the landlord wants to reposition the property in the rental market. That means an investment to upgrade the property: new fixtures, siding, pavement, whatever. The cost of these improvements can be passed-through to Chapter 5 tenants too.

Arguably all tenants benefit from an improved property. But the real value accrues to the landlord through higher rents and a higher property value.

What’s Up for Discussion

When it comes to pass-throughs it really does feel like zero-sum: every dollar in expenses that a landlord can pass-through to the tenant is a dollar that goes to the landlord’s bottom line. Should landlords be allowed to pass-through everyday costs of doing business — like replacing the roof — much less turn to tenants to fund improvements that make the property more desirable to prospective tenants or buyers?

When tenants pay to maintain or improve the property we become passive investors however without the prospect of earning any return. Moreover, when the value of the property rises there is all the more incentive for the landlord to hasten the departure of long-term tenants to reap the gain from vacancy decontrol.

An argument can be made for passing-through utility surcharges and penalties when they are consumption-driven. For example, should a landlord be penalized because his tenants fail to conserve water despite city penalties intended to discourage consumption? Arguably that cost should fall on the actual consumers. (To identify water scofflaws the city requires a ‘master’ water meter for every new multifamily property to track water used for landscaping.)

Less of an argument can be made for improvements that are mandated by law. For example, seismic retrofit was mandated by city hall as part of a broader safety program but landlords didn’t want to make that investment. Yet the retrofitted property is more valuable on the market and insurance costs are likely lower. Should the tenant pay for that improvement?

Landlords say tenants should pay for seismic retrofit because tenants who live above a garage, for example, are safer in the event of an earthquake. City Council seemed prepared to agree and allow 100% of the cost to be passed-through. Council didn’t ultimately decide, but seemed ready to assess that cost to all tenants at a rental property (not only those who directly benefitted from the safety improvement) over an amortization period of about seven.

At present only Chapter 5 tenants can see a seismic retrofit pass-through. Practically speaking that’s not much of a benefit for the landlord: only 3% of rent-stabilized households are Chapter 5. Doing the math that means on average only 1-in–2 rental properties are home to such a tenant.

Should seismic retrofit costs be passed-on to all tenants? Again, as passive investors we wouldn’t benefit from the insurance price break much less get a cut of the added-value in a sale. As for the refuse charge billed by the city for trash collection and alley maintenance, this seems like a straight-up cost of doing business. Should tenants have to shoulder the $40 per unit? If so we will wish we paid more attention when the city raised multifamily refuse rates much more steeply than for single-family households.

Our Take on the Max Increase and Pass-Throughs

The Rent Stabilization Commission on July 6, 2022 will discuss two of the most important issues that will come to it: how much to allow rent-stabilized rents to rise, and whether the landlord can pass-through some of the costs of doing business. The commission’s track record suggests this will not be a meticulous examination of the relevant issues. Notwithstanding the 292-page Frankenstein staff report, it is likely commissioners will speak not from the data or studies but their own experience. And that suggests another divided vote on a recommendation.

What probably won’t get any airtime is outgoing Councilmember Bob Wunderlich’s question which he raised several times in recent months: Does our city need to allow annual rent increases at 100% of CPI when other rent control cities allow a substantially smaller percentage? High-inflation has sharpened the focus on how the maximum allowable annual rent increase is calculated.

We believe that 100% of CPI is an unnecessarily generous return to landlords in this era of skyrocketing real estate values and apparent investor hunger for multifamily properties. If this commission undertook a sober examination of fair return in the context of vacancy decontrol and asset appreciation, we believe the commission would agree with rent boards in Santa Monica, West Hollywood and Berkeley that landlords can get by with substantially less.

In fact we view the percentage rent increase as a relatively minor factor in the landlord’s fair return. It is marginally more important than the spare change collected by the coin laundry but not nearly as important to the bottom line as higher market rents and property appreciation.

We can recommend allowing 75% of CPI and limiting pass-throughs to only those related to tenant consumption.

Tenants should concede support for the current water surcharges and penalties pass-through. Why? Because landlords that install water-efficient fixtures shouldn’t have to pay the city’s consumption penalty if the tenants cannot moderate their use of water. Rental properties have small front and side yards. Compared to residential water usage, the water for landscaping seems a drop in the bucket.

Moreover, if we don’t like the city’s water policy we can make that an election day issue. Rent-stabilized households are more than half of all city households!

We cannot support a seismic retrofit pass-through. Tenants should not be passive investors in an asset from which we will derive no return on investment. It is in the landlord’s interest to retrofit his property: it increases the value, reduces insurance cost, and vulnerable so-called soft-story units may be more attractive to potential tenants. Why should all tenants pay for that mandated improvement?

For too long some landlords in Beverly Hills pocketed 30 or more cents of each rent dollar while allowing their property to deteriorate. Those landlords shouldn’t be able to pass the cost of maintenance and improvements to tenants now. And many landlords depended on allowed rent increases of as much as 10% per year (until it was outlawed) to cover them for every sin of inefficient management and even mismanagement. Those days are gone.

Professional landlords recognize that maintenance and improvements are rewarded by much higher rents and they are prepared to make that investment. They don’t need passive investors. Heck, there’s no shortage of would-be investors making outrageous offers simply to get in the rental housing business. Need we shoulder any cost of doing business on to tenants? We don’t think so.

Further Reading

HR&A Rent Stabilization Analysis Data Brief (2018)

Rent stabilization ordinance Chapter 6

Rent stabilization ordinance Chapter 5