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How California Rent Control Impacts Asset Management

January 26, 2020

Passed in September 2019 and taking effect this month, California Assembly Bill 1482 puts a cap on rental increases for apartments. For tenants’ rights and affordable housing advocates, this is seen as a major win. For apartment owners and property management professionals, the law’s passage is treated more like the apocalypse.

At VERTEX, we don’t take a position either way in terms of the politics of the issue. However, now that the law is on the books, we can offer some insight into the opportunities that AB 1482 creates for our built environment.

That’s right: AB 1482 is not the end of the world as we know it. In fact, it actually gives the apartment rental industry an opportunity to improve our housing stock, extending its useful lifespan for the next generation.

Apartment Housing Situation in California

With California’s moderate climate, we do not typically experience the foul weather or freeze-thaw cycles that accelerate the deterioration of building components. As a result, the majority of the apartment owners and operators in the market have been able to delay investing in major building renovations, often for decades. With the exception of seismic retrofits and the occasional asbestos scare, our maintenance costs are generally pretty low.

For that reason, owners and property managers do not tend to focus much attention on the building’s overall structure and core systems, focusing instead on simple fixes like paint, flooring, lighting, and bath fixtures. For those that do have an asset management plan, it is usually the traditional method of scheduling upgrades of individual measures over a period of years. For example, they may have their maintenance service replace the water heaters, carpets, etc., one apartment or building at a time, over the course of 10 years, then start the process again with the first apartment.

Plenty of owners have been content to collect their monthly “mailbox money” without planning for the inevitable renovation work needed to keep the property current and competitive in the long term.

Consider this: According to federal tax law, the depreciation rate of a residential rental property is 27.5 years. When our real estate economist, Alan Nevin, performed in-depth research on the apartment market in San Diego, he found that nearly 90% of rental properties were built prior to 2000, with 58% built prior to 1980. That put the median age for the city’s apartment stock at 41 years old, with few having been recently renovated. In other words, the overwhelming majority of apartment buildings in the local market have exceeded their useful lifespans and are therefore overdue for replacement, repair, or refurbishment of major building systems and components for safe operations.

But, the age of our apartment stock isn’t the only issue. In many cases, it’s also mismatched with market demand, leaving renters to choose between luxurious A quality properties they can’t afford or outdated C quality properties without the features and updates they desire.

“In San Diego, the profile of renters includes a substantial number of professionals who can well afford the rent for a B or B+ apartment,” Alan Nevin said. “But they are forced to live in C quality apartments due to the dearth of renovated apartments. With San Diego’s extremely high development costs, it is virtually impossible to build new apartments that are priced for the B or “B+ rental market.”

What we are seeing in San Diego also applies to other markets across California. Therefore, from an economic and demographic standpoint, there is a strong case to be made for improving our existing building stock, particularly in the rental market, to bring the properties up to modern standards.

How Does AB 1482 Change the Housing Situation?

The “Rent Control” part in AB 1482 that everybody has focused on is California Civil Code section 1947.12. It caps how much an owner can increase rent on existing leases or rental agreements.

Apartment associations and other opponents of the new legislation claim that with rent caps, apartment owners will not be able to recover the growing cost of maintenance through rental increases. It is a valid point. If the costs to repair a system are high enough, it may take years to recoup those costs through rental increases at the maximum amounts.

However, the new law does provide one avenue where the owner may establish a higher rental rate. Per 1947.12 (b), in the case of new tenancies, the owner may establish a new initial rental rate not subject to the cap (the increases are capped afterward). However, owners cannot simply terminate and make new leases because lawmakers added another code section to limit how an owner can terminate an existing lease (1946.2).

Civil Code Section 1946.2 (b) lists “just causes” for which an owner is allowed to terminate a tenancy. The important point here is the last no-fault just cause included in the law: Intent to demolish or to substantially remodel the residential real property.

The Silver Lining

Some forward-thinking multifamily property owners have already connected the dots and recognize the opportunity to increase their asset and lease values without being substantially restricted by this law.

Back in mid-2015, well before this law was drafted, Xpera (now part of VERTEX) launched an initiative to educate apartment owners about the incredible opportunities that existed in the marketplace for improving existing multifamily properties through a process called “repositioning.” It focused on a holistic approach to upgrading rental properties, including market research, sustainable design, and professional management practices. Now, this strategy is more relevant than ever.

For apartment owners and operators that are faced with decades of deferred maintenance, the good news is that the rent control law is not a fatal blow to the asset. A well-planned renovation can extend the building’s useful life, reduce operating expenses, improve occupant comfort and allow them to “reset” the asset’s income potential.

VERTEX’s Scott Riffenburgh has first-hand experience in this process. As both a multifamily rental asset owner, as well as a construction manager, he enjoys a big-picture view of asset management and the building upgrade process. He is currently project-managing a substantial rehab of one of his own properties.

“Our trustees were very worried about this new law,” said Riffenburgh. “If we were just upgrading one measure at a time over a period of years (for instance, windows, water heaters, fixtures, etc.), we would be beholden to the new rent control law. But, because we are performing a ‘substantial rehab,’ as outlined in AB 1482, our property is not stuck with current rent caps.”

According to Riffenburgh, the buildings needed a lot of work, and consequently, the rents were quite low. When the work is done, the building will be upgraded from a C property to a B+ property.

“Doing that much work, and being able to finance it, would have been impossible without the AB 1482 exemption for substantial rehab. We would have had to raise the rents beyond the AB 1482 limits just to pay off the loan.”

Riffenburgh’s strategy offers a much better result: After the construction upgrades have been completed, the trustees will be able to increase their rents beyond the limits of the new law, maintaining the same cash flow while paying off their construction loan. Should they decide to “trade up,” they will be able to take advantage of their increased asset value.

Recommendations for Apartment Owners & Managers

Between the new restrictions imposed on the market by AB1482 and the inspection and maintenance requirements of Balcony Bill SB 721, many California property owners may be bracing for a financial apocalypse. However, a substantial rehabilitation approach may be the right solution to bring new life to an asset without being restricted by rent caps.

Should owners opt to pursue this strategy, it is extremely important to manage financial uncertainty when doing an upgrade. There are many potential pitfalls, including unforeseen contractor change orders and delays that can imperil the financial benefits of an upgrade.

To help manage that uncertainty, the process to renovate and reposition should involve professionals in both financial and construction planning.

Critical steps include:

  • An in-depth property condition assessment to create a detailed scope of work
  • A market study to determine which elements would improve the building for a higher tier of rent
  • A specialized proforma financial model that looks at both ROI and cashflow over a period of several years

The bottom line for owners: Rent control is here. The only way around the low annual caps that have been placed on rental increases is to reinvest back into the market’s aging apartment stock — and to take advantage of market opportunities that are almost too good to ignore.

This article was originally published by Xpera Group which is now part of The Vertex Companies, LLC.

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