RCA’s Costello talks rent controls, apartment cap rates

There’s a growing chorus in support of rent control in some parts of the country and these opinions may have some merit: Rent prices continue to escalate nationwide.

Commercial mortgage brokers and their investor clients who work with apartment properties may ask, does imposing wide-ranging rent-control legislation, as California did last month in limiting annual rent increases to 5% after inflation, have unintended impacts to multifamily-housing finance?

Jim Costello, senior vice president of Real Capital Analytics (RCA), thinks so. The economist recently authored a post on RCA’s blog, which asserts that rent control is placing upward pressure on apartment capitalization rates. Comparing the 12 metro areas that have some rent control in place with 46 others that have no rent control, Costello and RCA found that in 10 out of the 12 regulated markets (83%), apartment cap rates rose over the past year. In the unregulated cities, only 19 of 46 (41%) have seen a cap-rate increase.

The result is that multifamily properties in rent-controlled markets are being repriced in a manner that could result in more loan defaults, less new construction and lower housing availability over the long term.

Scotsman Guide News spoke with Costello about the phenomenon and he discussed, among other things, the impacts on the commercial mortgage industry and the long-term ramifications on supply.

How much should the mortgage industry be aware of this, and how big of an impact can this have in the short and long term?

In the short term, in some of these markets, it’s not going to have much of an impact. You know, it’s an overly broad brush on painting with respect to any type of rent control. You look at a Portland, Oregon. They’ve got, like, only 7% (plus whatever inflation is) as a cap on rent growth. And in that kind of a framework, that’s still healthy income growth for a property. A lender making a loan in Portland at the moment doesn’t have to worry about challenges to the the quality of the income from that asset.

But it’s a start. That’s one piece of regulation and maybe, in the future, they could feel like they want to change it and make it more aggressive. That kind of potential issue is what they need to worry about. It’s sort of, “can I get paid back?” or “is this loan going to turn into an asset where the value is going to fall?” Because with limits on the income potential, nobody is going to pay as much as what you’re lending at.

So, I mean, it’s not the end of the world. But there’s a lot of uncertainty in play and I think people need to look at it more closely to make sure that if you’re lending into a market, that it’s not going to get worse — that the regulatory environment is not going to get tighter than it currently is. If you’re in a market like this, you need to be conservative in your underwriting, so that you’re not expecting strong income growth to help you out there. There’s a level where [rent-control regulation] is really going to limit things.

Clearly, there are other factors also at play here other than just the rent-control regulations. How much of the cap-rate growth is strictly due to rent controls?

Well, we haven’t done the full attribution analysis of that issue for a couple of reasons. One, there’s just not enough data to get into it and it’s just not enough observation points. But if you look at the data, the other thing that stands out is the markets that tend to have rent control introduced are the ones with the lowest cap rates. And so, there’s a bit of a correlation between these issues you have.

It is the case that you’re seeing this political pressure for rent control in the most expensive markets in the country, and those are the markets that have seen rents climb the fastest. You have a faster growth in rent and, all other things equal, you’re going to have a lower cap rate. It’s just that investors are going to be excited about the rent growth and step up and pay more for the assets.

But they’ll hit a limit of what the consumers will go on to pay before they either voted with their feet and started to migrate out to some of these expensive markets or, in this case, push back politically. So, it’s that issue of the relative costs. We’re kind of late in the cycle on asset prices and there’s some extra risk in being in an expensive market at the top of the cycle, more potential downside. The investors just aren’t stepping up for these assets the way they were in the past.

How much do these factors affect the inventory picture?

If you impose rent control — and this is not speculation, this has been shown … you limit the income growth from a property. And, as a developer, you’re going to be less willing to bring new assets into the market because there’s uncertainty of how much income you can get from the asset moving forward. It’s not necessarily going to pay off relative to what the cost of developing will be.

So, if I’m a developer, I’m not going to do that. Instead, I might build condos. We saw this, for example, in San Francisco, which currently has rent control. When it was first introduced, going back a few years, the reaction was to try and take units off the market and take them out of the rental inventory — pick them up and sell them as condominiums. So, thanks to [the] rent-control effort, San Francisco has fewer rental units today than when rent control started before. It’s discriminatory —you’re trying to keep people out of your local economy. It harms the cities with respect to new folks who may want to come in and participate in the vibrancy of that local economy.

The majority of rent controls thus far have been enacted in large, pricey metros with escalating rents. Do you see this issue having similar impacts in third- and fourth-tier cities in which price pressures aren’t as great?

Sure. Look at Fresno and Stockton (California). They’re close to the Bay Area, but they’re not the Bay Area and they haven’t seen rents [rise] to the same extreme. You’re not going to face the same pressure at the get-go, but if you’re limiting rent growth in these dynamic economies and you’re limiting construction so that there are no housing options [in these big metros], for some folks, their only option is going to be to do a longer commute.

I mean, it sounds awful to me, but driving from Stockton to Oakland, or Fresno to San Jose, every day or even occasionally, may be the only option some people have. That puts additional burden on the state transit system, more greenhouse gas in the air — and that’s exactly what the state doesn’t want.


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