Pass-Throughs and Surcharges: What You Need to Know

City of Beverly Hills allows the landlord to pass-through to tenants certain costs of doing business such as refuse collection and alley maintenance. And if the city hits the landlord with a penalty using too much water then the landlord can pass along 90% of that expense too. Longtime tenants may also pay for the landlord’s new roof, a paint job and even seismic retrofit because those capital expenses can be passed-through. Let us explain!

What is a Pass-Through?

A ‘pass-through’ is a surcharge on top of the rent which allows the landlord to recover certain operating expenses and capital expenditures that are incurred as part of owning and operating residential rental property. The pass-through is separate and apart from the rent which means those expenses can be passed-through to tenants without a process or in some cases even city review. In the case of refuse, for example, the landlord only needs to provide the tenant with a copy of the city’s bill.

Pass-throughs are local; they are enacted through ordinance. In Beverly Hills allowed pass-throughs are codified in chapters 5 and 6 of the rent stabilization ordinance. Because pass-throughs are determined locally, there is considerable variation among localities concerning the expenses that a landlord may pass on to tenants. If a locality has controlled the price of housing by limiting the rent increase, then it is likely that the locality also allows one or more pass-throughs to enable the landlord to recoup certain expenses.

However most most localities have not enacted rent control and so don’t allow any expense to be passed-though. That is because the rent can be raised to cover all costs related to maintenance and improvements (such as a new roof). Even despite rent control, the fact is that landlords can not only cover expenses but take an estimated seventy cents out of every rent dollar as net income. Every dollar in expenses that is passed-through to tenants is another dollar in net operating income for the landlord.

From the tenant’s perspective, pass-throughs are an unwelcome additional housing cost on top of the base rent. And pass-through surcharges can stack! Allowing the landlord to pass-through expenses related to utilities, capital improvements and perhaps even seismic retrofit can add the dollar equivalent of four or five percentage points to the rent owed. That amounts to an annual rent increase on top of the annual rent increase.

By the way, the pass-through surcharge is not rent so it is not subject to the rent increase (which modifies only the base rent). The amount of the pass-through surcharge is determined solely by the expense that is passed-through plus. In the case of capital expenditures, the expense is amortized over some period of years and can include the cost of interest.

Let’s look at few different pass-throughs to highlight the pass-throughs on the books today in Beverly Hills. City Council may expand, restrict or otherwise amend them in the near future so it is helpful to understand the issue. That’s why we have this explainer!

Administrative pass-through

The most common pass-through allowed in rent control cities is a surcharge to cover the cost of administering a rent control program. Many localities share that cost between tenants and landlords: each party pays 50% of the annual expense. For tenants it is passed-through as a monthly surcharge. It is not a big-dollar item — generally less than $10 per month — but it suggests that tenants have a stake in regulating rental housing and we are willing to pay for it.

Beverly Hills today does not have an RSO administration pass-through. The city bills landlords $63 per unit each year for rent stabilization administration. This is called the ‘rent control enforcement and administrative fee.’ At present passed on to tenants. But the name is somewhat misleading: the fee was on the books long before the city got serious about regulating rental housing and it has not been updated to reflect the program’s actual cost. (Instead it is simply increased with inflation.)

If City Council revisits pass-throughs then we can probably expect to see an RSO administration pass-through. The city has already indicated some work in planning for “fee recovery” and that could result in a monthly tenant surcharge that in 2018 was estimated to total $7.42 (representing a 50% share of program cost). Today the rent control enforcement and administrative fee paid by landlords simply disappears into the city’s general fund; it is not dedicated to RSO program expenses.

Another potential recurring pass-through could be a surcharge for a systematic rental housing inspection program. Today Beverly Hills has no such program but we do need one (and the city’s Rent Stabilization Commission has recommended it). How to fund it? Most likely through fee recovery. That’s what City of Los Angeles does: it passes 100% of the cost to tenants via systematic rental housing inspection program fee (presumably because tenants benefit from a regular inspection of rental housing). The program costs each renting household $43.32 per year which is assessed as a monthly surcharge of $3.61.

These are examples of expenses that can be passed-through to tenants without any process at all. They are simply administrative and are allowed by ordinance.

Utilities Pass-Through

An expense like a utility must be documented if it is passed-though to tenants. About half of rent-control localities in the state allow some form of utilities pass-through (most commonly a special assessment or consumption penalty).

Beverly Hills allows the landlord to recover 90% of any imposed water-use penalties provided that the landlord has installed water-conserving plumbing fixtures. The theory: landlords cannot control tenant water consumption and so tenants should pay for usage in excess of what the city has determined in normal usage. (This is different than the metered cost of water which may be paid by the landlord or paid by the tenant — whether individually metered or prorated by unit — according to the terms of the rental agreement.)

If a water penalty were to be assessed (no penalty is assessed at present) then it would be passed-through to all rent-stabilized tenants as a per-unit surcharge prorated according to the landlord’s formula for dividing that responsibility. The rent stabilization ordinance does not specify a means to prorate the penalty. However it is prorated, though, the landlord must provide tenants with the water bill and the basis for calculating the pass through (see rent stabilization ordinance section 4–6–7(B).

More tenants will be affected by the refuse fee pass-through. Beverly Hills allows landlords to pass-through 100% of the city’s charge for collecting refuse. That cost is comprised of a bimonthly bill for $48.17 for solid waste collection and $32.54 bimonthly for an alley refuse fee. That amounts to a monthly charge of $40.36 on a per-unit basis for properties with alley pickup (curbside pickup is billed slightly differently). Refuse may be passed-through to all rent-stabilized households unless the lease states that the landlord pays for refuse.

Today not many renting households pay for refuse. However with landlords paying greater attention to rent stabilization and specifically the city’s cap on the annual rent increase, it is likely that they will look for pass-through revenue where they can find it. If the lease is silent then the refuse cost can be passed-through with 30 days notice and a change in terms of tenancy. New tenancies are likely to see it formalized in a clause in the rental agreement.

In Beverly Hills there is another utility-related pass-through that applies only to the relative few tenancies that are Chapter 5. This is important because it reflects how expenses may be passed-through to tenants differently depending on how the tenancy is regulated.

By way of background, Beverly Hills is somewhat unique in that our rental housing is regulated by either one of two tiers of rent stabilization. Chapter 5 tenancies started at $600 or less in monthly rent; they were entitled to a lower cap on the annual rent increase and as a result the monthly rent for these approximately 200 tenancies is lower than the great majority (97%) of rent-stabilized tenancies which are Chapter 6. Over time City Council has allowed additional pass-throughs for Chapter 5 tenancies to provide landlords with additional revenue.

Chapter 5 tenants with a shared utility can pay a surcharge to the landlord if the percentage rise in the cost of a utility rises is greater than the allowed rent-increase percentage. Effectively the tenant shares in the rising cost. If the utility cost rises 4% but the rent is allowed to rise only 3%, then the surcharge allows the landlord to recover that additional 1%. Again this only applies to Chapter 5 tenants in Beverly Hills.

No special process or administrative review is necessary. With proper documentation the landlord simply passes it through these expenses with a surcharge.

Capital Expenditures

Beverly Hills, like other jurisdictions, does allow the landlord to pass-through certain capital expenditures that relate to property improvements and expenses that are mandated by law. These pass-throughs are more complicated because costs are amortized, prorated and, in some cases, subject to a cap. These require a review.

Beverly Hills allows landlords with Chapter 5 tenancies to pass-through two categories of capital expenditure: elective property improvements which are made at the behest of the landlord; and improvements which are mandated by law over which the landlord has not control.

An elective capital improvement, according to rent stabilization ordinance section 4–5–304(C), is a “permanent improvement or renovation…other than ordinary repairs or maintenance.” The pass-through calls out painting and resurfacing but in reality it can include a variety of improvements the cost of which may be borne by tenants.

For example, city staff thinks a new roof qualifies for this pass-through. But in our view, replacing the roof every couple of decades is an essential part of maintenance — not an improvement. Indeed the appearance of rooftop tarps atop multifamily apartments in the winter shows how common is it to defer this essential maintenance.) Ultimately the RSO office would determine eligibility for this category of pass-through.

Let’s take an example: installation of central air conditioning in a 4-unit complex of like-sized units. This $30k job can be prorated across four units and amortized over a 10-year period. That results a monthly surcharge of $62.50 for a Chapter 5 tenant over a ten-year period. Because the capital improvement surcharge maxes out at 4% of the tenant’s base rent, a Chapter 5 tenant who pays $1,200 in rent could pay not more than $48 monthly (4% of $1,200) in addition to the base rent…and any other surcharges that are passed through.

Elective capital improvements can also apply to individual units occupied by Chapter 5 tenants. For example, interior remodeling, such as painting or renewing kitchen appliances, would qualify, as would flooring and many other improvements beyond maintenance. The amount of the surcharge would depend on the cost, the amortization period (which varies in accord with IRS guidelines) and the cap if it applies.

What happens when the property as a whole is improved? That cost can be passed-through only to Chapter 5 tenants. The landlord would presumably recoup the bulk of the expense from incoming tenants who in theory pay a market rent that reflects the improvements.

Seismic Retrofit

The second example of a capital expenditure eligible for a pass-through is an improvement which is mandated by law. A good example is seismic retrofit. Beverly Hills requires owners to structurally reinforce rental property if there is one or more dwellings situated above pull-in parking (an arrangement called ‘soft story’). Retrofit costs an estimated $10k to $15k per unit, on average, and pursuant to the rent stabilization ordinance the expense may be only passed-through to Chapter 5 tenants.

Section 4–5–305 codifies this capital expenditure pass-through for mandated improvements:

In addition to any capital expenditure surcharge permitted by section 4–5–304 of this article, the landlord may pass through to the tenant of an apartment unit the cost of any improvement mandated by any government statute, rule, or regulation enacted after March 24, 1981, including interest or the value of capital up to eighteen percent (18%) per annum, allocated among all the dwelling units of the building in proportion to their size, determined in square feet, and annualized in accordance with the straight line depreciation schedules allowed under the federal income tax laws.

Seismic retrofit is a relevant example because about 3-in–10 rental properties must be retrofit and many tenants may be on the hook for the bill. Between the high cost of the work and the cost of the money (even if the landlord self-finances!) this could make for a ’seismic’ surcharge indeed!

For example say the retrofit for a 10-unit property costs the landlord $100k financed at 8% interest over the 10-year amortization period. The cost of principal and capital is $145,593.11. When prorated across the ten units it comes to about $145k per unit over 10 years. The monthly surcharge for each household would be about $100. That’s a significant additional cost of about 4% on top of the average city rent. Because there is no 4% cap on this surcharge (unlike elective improvements) it would disproportionately burden tenants with lower rents: the surcharge would represent a larger percentage increase on top of the base rent.

Like all capital expenditure pass-throughs, the seismic retrofit surcharge will require city review to ensure that the expense is proper and the annual percentage rate is below the allowed 18% (eighteen percent!).

Adjustment for Property Tax Increase

Chapter 5 rent stabilization also allows the landlord to pass through a surcharge for a property tax increase. This pass-through is merely academic because the property tax burden actually declines for owners of rental property. Rents are allowed to climb at a rate much higher than than the rate of increase for property taxes (2% annually). So we use this example to show how certain pass-throughs may be subject to a hearing.

From section 4–5–402 of the rent stabilization ordinance:

If a landlord seeks a special hardship rent increase because of an increase in the amount of property taxes assessed against an apartment building, a hearing officer designated by the city manager may grant such an increase….

This pass-through is allowed only in cases of documented hardship. A city-contracted hearing officer conducts a hearing which would balance the public’s interest to prevent unreasonable rent increases against the landlord’s right to operate profitably. The example is academic because no landlord will be harmed by property taxes and landlords almost never document their hardship (if it exists at all).

Rent Adjustments Upon Application

Speaking of hardship hearings, we round out this explainer with a provision in the rent stabilization ordinance that illustrates the financial safety net for landlords if they fail to make money. Chapters 5 and 6 both include a hardship clause that requires the city to allow a rent increase greater than otherwise allowed if the landlord can document harm due to the price control on rent.

Rent stabilization for Chapter 6 calls the process a ‘rent adjustment.’ Ordinance section 4–6–11 says, “A landlord may file a rent adjustment application with the City for all rental units in the landlord’s rental complex to achieve a just and reasonable return.” Subsection (1) continues:

An application for a rent adjustment…shall produce at the request of the hearing officer any records, receipts, reports or other documents in the applicant’s possession, custody or control that the hearing officer may deem appropriate to make a determination whether a rent adjustment should be approved. The application shall be made under penalty of perjury and supporting documents shall be certified or verified as requested.

The subsection continues, “A rent adjustment shall be approved in order to provide a just and reasonable return and maintain net operating income.” What follows is an amortization schedule for a wide variety of operating expenses enumerated in the ordinance for the purposes of determining net operating income. Just as the cost of elective capital improvements can be passed-through to Chapter 5 tenants, this Chapter 6 provision allows landlords to recover expenses if his net operating income falls short of the just and reasonable return to which the landlord is entitled under state law.

This is the landlord’s financial safety net: in the event the landlord can’t operate profitably under rent control, the ordinance allows the landlord to effectively specific pass-through expenses in the form of a higher-than-allowed rent increase. It operates differently from a conventional pass-through however it achieves the same end: providing additional operating income to the landlord. We highlight this provision because it is a means for the landlord to share his cost of business with his tenants regardless of the pass-throughs on the books.

The preceding section showed some differences between pass-throughs: some require city review, some don’t, and a couple must go though a hearing to ensure that they are accurate. Localities can also enact caps that act as a guardrail to protect tenants from the cumulative impact of pass-through surcharges.

Guardrails on Pass-Throughs

Pass-throughs force tenants to shoulder some part of the landlord’s cost of doing business. That cost can be significant (for example seismic retrofit) but even smaller surcharges can add up. To limit the impact of pass-throughs localities have enacted various guardrails.

A locality may limit a pass-throughs to 50% of the landlord’s expense. That is most common with the RSO administration fee but cost-sharing is also extended to mandated improvements like seismic retrofit. City of Los Angeles and Culver City each limit the tenant’s retrofit cost-share to 50%. Moreover, these cities have placed additional limits on the retrofit pass-through. City of Los Angeles limits the seismic retrofit surcharge to a maximum of $38 monthly while Culver City limits the monthly surcharge to 3% of base rent.

In Beverly Hills seismic retrofit is a mandated improvement and pursuant to rent stabilization ordinance section 4-5-305 a Chapter 5 tenant can pay 100% of the cost over a 10-year period because s. That seems like a bank-breaker. Of course the surcharge will be a larger percentage of the base rent for households that pay a smaller rent!

Some localities limit the total aggregate surcharge to some percentage of base rent so that multiple pass-throughs don’t add up to an excessive burden for tenants. Beverly Hills does not have this provision. A chart in a recent staff report shows how Chapter 5 pass-throughs if maxed-out can add an additional 25% to housing cost.

Why is this Important?

The Beverly Hills Rent Stabilization Commission is currently discussing whether or not to recommend that the city expand, restrict, or otherwise modify pass-throughs that are allowed today. (Watch the August 3, 2022 meeting video.) Chapters 5 and 6 have two pass-throughs in common — refuse fees and water penalties — but otherwise there are many more pass-throughs available to landlords of Chapter 5 tenancies. We have reviewed them here.

The commission was presented with two options at the August 3, 2022 meeting: Allow more pass-throughs to landlords of Chapter 6 tenancies or limit pass-throughs either by precluding them or requiring a formal rent increase process. The commission made no decision but a straw poll of commissioners showed agreement to pass on at least 50% of the cost of seismic retrofit to all rent-stabilized households. (Watch the meeting video.)

The discussion will continue at the next commission monthly meeting. Commissioners could recommend that tenants pay 100% of seismic retrofit (an estimated $125 monthly) or some smaller share. It is worth noting that West Hollywood and Santa Monica both found that landlords should shoulder the full cost of seismic retrofit and that they could afford to do so.

Commissioners could also extend all Chapter 5 pass-throughs be Chapter 6 tenants or, alternately, limit pass-throughs only to the shared RSO administration fee and water penalty. Or commissioners could recommend guardrails on any enacted pass-through. Some guiding questions for the commission and for tenants pondering a future with additional pass-throughs:

• Which expenses could or should be passed-through to tenants and which expenses legitimately represent the cost of doing business for an owner of residential rental property?
• Is passing-through an expense intended to accomplish any objective other than simply allowing the landlord to pad the bottom line with greater net operating income?
• Will a substantial surcharge for seismic retrofit disproportionately burden longtime tenants who would pay it for a decade while more transitory households escape it?
• Is it prudent to impose a dollar or percentage cap on pass-throughs in order to mitigate the cumulative impact of surcharges on low-income households or households headed by a senior on a fixed-income?

Our Take

Not all pass-throughs are unfair, in our view. Tenants have expressed a willingness to share the rent stabilization administration fee and to support a systematic unit inspection program fee if the cost is shared with the landlord.

However there is a difference between sharing an administrative burden and assuming operating expenses for which we also pay rent. At some point pass-throughs make tenants passive investors in our landlord’s property without the equity. As it is, landlords take advantage of tax benefits that reduce the cost of owing and operating rental property. Tenants get no deduction for rent or pass-throughs.