Finding Your Path: The Fallacy of Rent Control

August 1, 2019
Authors: Lorne Polger, Senior Managing Director
Publishers: The Pathfinder Report

Affordable housing! Affordable housing crisis! Affordable housing is the biggest threat to our community since the Black Plague struck in the14th century! If we don’t “fix” the affordable housing crisis by tomorrow, everyone will leave town and California will be an empty dust bowl! Think, Oklahoma, circa 1933.

How do we fix it? More governmental control, that’s the answer! Place limits on capital! Restrict improvements to our aging housing stock! Tell business owners how much they can charge! Sure, that’s the trick! History tells us this methodology worked beautifully in various industries that did it, right? Like, the telephone business before deregulation! Like the airlines, before deregulation (you know, when it cost $800 to fly round trip to New York 30 years ago, instead of the $200 you might pay today if you found a good deal on the Internet).

Wrong, wrong, wrong, with a ginormous capital W. While the laws of supply and demand, are not exactly laws of nature; they’re not far from that. Across historic economic cycles, it’s been proven, virtually without exception, that when you increase supply with static demand, prices will drop. When you increase supply with lessening demand, prices will drop more. Conversely, when you decrease supply with static demand, prices will go up. When you decrease supply with increased demand, the price will go up more.

When a community artificially restrains rents by adopting rent control, it sends the market a false message. It tells builders not to make new investments, and it tells current property owners to reduce their investments in existing housing. Under such circumstances, rent control has the perverse consequence of reducing, rather than expanding, the supply of housing in a time of shortage.

What have our local governments and community groups done over the last 20 or so years? They’ve made it harder to build. They’ve made it harder to increase supply. They’ve made it harder to meet our community’s housing needs. What has been the result? A significant increase in the cost of housing! Now, wait. Are you suggesting that the same officials who have implemented policies to increase our cost of housing are now going to further regulate the sector in hopes of increasing affordability? You betcha. History shows what will happen.

Economists are virtually unanimous in their condemnation of rent control. In a survey of economists of the American Economic Association, 93% agreed that “a ceiling on rents reduces the quality and quantity of housing available.

”When I think of rent control, I think of San Francisco, Berkeley, Santa Monica, and New York City. Those four cities have deep experience with the rent control experiment. So, we have actual data to show how it works! Perfect! Then instead of holding our finger to the wind to predict the future or using the Farmer’s Almanac, we can see what actually happened over time. Brilliant! Rent control worked great, right, which is why the State of Oregon implemented it last year, and we are talking about it now for California! Uh, wrong. Couldn't further from the truth.

Those four cities are all on the top ten list of least affordable housing markets in the country. Wait a second. If you put rent control in Slot A, shouldn’t you get cheaper housing out of Slot B? Nope. By forcing rents below the market price, rent control reduces the profitability of rental housing, directing investment capital out of the rental market and into other more profitable areas. New construction declines and existing rental housing is converted to other uses. And owners are disincentivized from investing to improve (and even to maintain) their properties. Remember the rule, if supply stays static or reduced and demand increases, prices will rise. Studies have shown, for example, that the total number of rental units in Cambridge and Brookline; Massachusetts, fell by 8% and 12%, respectively, in the 1980s, following the imposition of stringent rent controls. Rental inventories in most nearby communities rose during that period. Similarly, in California, the total supply of rental units dropped 14% in Berkeley and 8% in Santa Monica between 1978 and 1990. These municipal experiments have shown that rent control has had the exact opposite result than what was intended; shrinking existing supply, dramatically reducing new supply, leading to dilapidated existing housing stock (because owners have zero incentive to make repairs or renovations), and leading to huge increases in price.

Example: San Diego

So, let’s focus on the supply side of the equation. As a long-time client used to tell me, developers develop when it makes sense to develop. From 2000 through 2003, an average of 9,325 homes were permitted in San Diego each year before declining 48% to an average of 4,825 homes permitted a year, from 2004 through 2009. The average from 2007-2018? A mere 2,600 homes per year.

The number of apartments permitted averaged 7,250 years from 2000 through 2005 as the economy grew and multifamily financing was easy for developers to obtain. From 2006 through 2008, the number of multifamily units permitted declined to 4,825 a year and then further declined to 1,825 a year (75% below the 2000-2005 peak) between 2009 and 2010 as developers found it harder to obtain construction and permanent financing and rental vacancy rates increased. The number of multifamily units permitted rose to 4,400 a year from2011 through 2014 when rental market conditions tightened, and then increased to over 5,000 units in 2015and 2016. Wait, that’s all? But we’re a county with 3. 3million people, with around 50,000 new people arriving every year. How can we possibly meet housing demands with those low numbers? Wouldn’t that mean prices are going up and making things less affordable for our residents (see paragraph above on the laws of supply and demand)? Duh. Over the past decade, annual housing growth in San Diego has averaged approximately 0. 5%, while the average population growth has averaged 1. 2%. No wonder that from 2013 to 2017, monthly rents in San Diego increased by 34%!

So, the solution is simple. Why don’t we just build more? Any idea how much it costs in permit fees to the County for the construction of one single-family home before you strike that first nail with a hammer? Would you believe a range of about $15,000 to over $150,000 per single-family home, depending on the City (the City of Diego being the highest)? Yup, you read that right. Fees have increased, land prices have doubled over the last ten years, construction costs have increased more than 30% over the last three years, labor costs are way up, so where do you think prices have gone? Up! Because they can’t go anywhere else absent a change in one of the four cost drivers above.

Developers build projects when they receive a suitable return on their investment to justify the risk. They know that an apartment unit, a condominium, or a single-family house is going to cost them X to build. They are going to sell it, or rent it (then subsequently sell it) for Y. The difference between X and Y must be enough to justify the risk of development. (After all, they must pay the bank back on the loan they guaranteed for the project; remember the Great Recession when prices dropped, and they couldn’t? It wasn’t good, in case your memory is short.) If the spread is big enough, to quote my old client, developers will develop. If the spread isn't enough, they won’t. And that’s where we sit today.

Over the last ten years in San Diego County, we have significantly undersupplied the marketplace with new housing. As a direct result, prices on both for rent and for sale housing have increased. In fact, they have increased dramatically. While that’s been great for owners, it has negatively impacted affordability, and as a result, has made it harder for folks to (i) save for a down payment for a home; (ii) have discretionary money to spend on things other than their housing; and (iii) afford other basic necessities to enjoy a healthy, productive life. So, the answer is rent control! Let’s just slam the breaks down on price increases! Do you know what happens when you slam the brakes? The car skids. And that is exactly what will happen in California if rent control is legislatively enacted (recall that just nine months ago, a ballot initiative to permit rent control in the State was resoundingly defeated with 62% of voters disapproving the measure). The people have spoken, why aren't the legislators listening?

The solution is far simpler. Make it easier to build and make it easier to build with increased density to reduce the cost per unit. San Diego’s Mayor, Kevin Faulconer, was very much in tune with this concept. In 2018, he backed an update to the Affordable Housing Density Bonus Program to incentivize developers to increase the production of smaller and more affordable units and backed several code changes to streamline the development process, remove unnecessary barriers to development and increase production. This past June, the Mayor proposed to wipe out height limits for apartment and condominium projects built near transit lines. He said the proposal would spur construction of more housing, especially housing for middle-income residents, by allowing taller buildings with smaller sized units and then streamlining the approval process for such projects. Harrumph said the local planning groups! Harrumph said the local NIMBY’s (not in my back yard). Harrumph said the local BANANA’s (build absolutely nothing anywhere near anything). Quoting one of my favorite singers, Alanis Morrissette, isn’t it ironic? Isn’t it ironic that many of the same groups leading the charge on rent control are the ones restricting new supply, which will lead to more affordable housing? It is, Alanis, it is.

Reducing permit fees, entitlement time frames, density restrictions, and arcane rules like overparking buildings will all make a dent in making projects pencil for developers. It won’t reduce land, construction, or labor costs, but it will make a big difference in allowing some projects to pencil that otherwise would not. And that's exactly what we need in San Diego, throughout California and in other high-cost cities in the western U.S.

Remember, developers, develop when it makes sense to develop. Let’s make it easier for them to do that, so we can solve a problem, not create a bigger one.

Lorne Polger is Senior Managing Director of Pathfinder Partners. Prior to co-founding Pathfinder in 2006, Lorne was a partner with a leading San Diego law firm, where he headed the Real Estate, Land Use, and Environmental Law group. Reach him at lpolger@pathfinderfunds.com.