Altus Insight September

The Altus Insight

Market news, commentary and relevant topics for today’s alternative asset investor

Date: September 30, 2019 FR: Forrest Jinks

RE: We are All Socialist Now

“This bill will prevent egregious rent gouging and predatory evictions, while striking a balance to allow landlords to make a fair rate of return,” he said during Wednesday’s floor vote. “Until we build the 3.5 million units that will stabilize our state’s housing crisis, we need to help Californians stay in their longtime homes.”

Assemblyman David Chiu

 

“Words matter. This is not rent control. This is an anti-rent-gouging bill,”

Assemblyman Rob Bonta, D-Alameda, a co-author of the bill.

 

Newsom said most of the homeless people on the street when he left office were not from California, but added "we took responsibility" for them. "The vast majority (of San Francisco’s homeless people) also come in from — and we know this — from Texas. Just (an) interesting fact,"

Governor Gavin Newsom

 

Us enlightened Americans look at Venezuela’s Nicolas Maduro and shake our heads and click our tongues. He should know better than to think you can control the price of food (or medicine, or currency, etc.) just by putting price controls in place. Doesn’t he know that it just creates a black market where those that have a supply of food can sell it at a much higher price to those that have the means to buy it? And meanwhile the offsetting result is less food availability at the controlled prices, impacting those that only have the means to purchase food at the controlled prices? With the net impact resulting in increased burden on the very people that the price controls in theory (or at least in word) were trying to protect.

Here in the US, our central bank is the largest price manipulator/controller in the world in how it manipulates short term interest rates. Interest rates are, after all, the cost of money. Other central banks also manipulate the cost of money, but none across such a large swath of currency. But this is a topic for another day. Today we are going to talk about California.

For those of you who haven’t heard, this month California became the third country in the union to have state-wide rent control. And because California was embarrassed that two other states beat it to its normal perch of unquestioned insanity, the rent control imposed is the most restrictive of the three.

In writing the Altus Insight each month I try to enter the realm of politics only as so much it impacts economics and investing; and try to do so without my personal biases getting in the way. Be warned, this month I am not even going to pretend to try. Also be warned that this Insight is longer than most, both due to the length of the text and the inclusion of some visuals.

This Insight started off with some pretty amazing quotes, but unfortunately, I couldn’t find the quote I was really looking for. Right after the Assembly passed the rent control bill, Gavin Newsom had a money quote about the new California rent control law, stating that the just cause eviction component of the law would have kept thousands of homeless from being homeless if these laws would have been in place previously.

Seriously Governor? I know you are not ignorant to the laws of economics, and further you know that all those “thousands” of housing units that lost tenants through non just cause evictions filled right back up with other residents. So, if it hadn’t been for the unjust cause eviction, it would have been the new resident on the streets instead of the last one. This is what is known as rhetoric. Besides, I thought the homelessness problem was imported from Texas, directly into the same cities that already have rent control and just cause eviction.

Even Assemblyman Bonta of Mr. Newsom’s own party acknowledges that words matter. Despite the new measure controlling what landlords can do with their own properties, this isn’t rent control, it is “anti-rent-gouging.” It is just rhetoric, and a great way to get votes.

Rather than rhetoric I prefer the term narrative. Narrative is something that everyone knows that everyone else knows, and is used to sell an idea or position through the implication that even questioning the assertion amounts to heresy. Unfortunately, it’s prevalent throughout our society, and is certainly the case here.

Economists suffer from Physics jealousy. Economics is not a true hard science like physics or chemistry where experiments can be modeled and tested (even if we sometimes ignore the results due to current narratives). Economics, especially the forward-looking forecasting type, resides in a world of theory where models cannot be experiments, but instead can be manipulated for particular outcome, purely by the inputs and assumptions within the model. Yet, even without Economics being able to take a place among the hard sciences, it still does possess mathematical qualities that can’t be judged as “right” or “wrong” as in most economic theory, but are in and of themselves economic identities, otherwise known as mathematical equations. For instance, GDP growth has a mathematical equation. That equation isn’t right or wrong, it’s just an equation.

As it relates to rent control (with apologies to Mr. Bonta), the economics identity at play is the law of supply and demand. Below is a graphical depiction of supply and demand curves. The supply of a good (or service) and the demand for that same good (or service).

The intersection of the curves determines “price”. Increase supply, price goes down. Decrease supply, price goes up. Increase demand, price goes up, decrease demand price goes down. As with any three- variable equation, any two of the variables can be used to solve for the third, and a change to any of the variables requires a change to at least one of the others for the equation to remain in balance.

There is also something called elasticity of demand. Products that can be easily interchanged with other products are said to have elastic demand curves. Products that are not easily interchanged are considered inelastic. Prices on Nike shoes can go up for a while, but as they go up more and more people flee Nike and buy Adidas. Adidas may not make me feel as cool, but it still provides the same functional utility for my feet. This is an example of elastic demand. The more elastic the demand, the more sensitive to price that demand is. Below shows how a flat demand curve has more sensitivity to price than the graph shown previously.

 
  

On the other hand, emergency room services are an example of a good or service that is highly inelastic. If you are in the middle of a heart attack you don’t really care if the emergency room is going to bill you

$50,000 or $100,000. For one, you have an extremely high need. For two, when in that situation there are few replacement options (and I am pretty sure you won’t care if you are wearing your Nikes or Adidas’s). Number three, most likely you aren’t going to pay for most of the services provided, so the impact of a higher price provides less financial impact to reduce demand.

Said another way, and as is visually apparent, the more inelastic a demand curve, the greater supply impacts the price of that product or service.

It is all pretty simple really, and most any college sophomore can recall back to their freshman year and recite how supply and demand curves work. But in our infinite human wisdom we believe that because we wish it to be so we can change the laws of supply and demand. There are two ways we do so:

#1. Restricting Supply.

Over the course of time additional supply will not be created if the cost of the next unit of supply is higher than the price that can be obtained for that unit.

For many years the same parties that are now huge housing advocates created the large impediment to supply. NIMBYs (“not in my backyard”) abound in California, and within California’s history of political activism the high rate of objection to housing projects is astounding. I experienced this over and over prior to 2008 when we were more of a redevelopment company than an investment company. Everyone complained about housing, but then would show up in droves to oppose the six-lot subdivision going in on the overgrown parcel of land 15 blocks from their house (unfortunately, I am not making this up).

Politicians understand votes and financial backing comes in large part from those that already have theirs and don’t want anyone else to get theirs. Politicians kowtow to such community pressure, even when the pressure is from those not immediately impacted by the project.

Throughout much of the state, entitlement processes are fraught with uncertainty and can drag on year after year. I had a 23-unit apartment project in what is considered an undeserved part of a town that took 5 years to get approval. Five of the 23 units were to be designated low income with the remaining 13 units being relatively low income just by the nature of their location. Approval was finally granted in 2008. In 2009, because there weren’t enough new projects coming in to pay for the community development department’s overhead, they raised their fees. That project still isn’t built, eleven years later.

Anyone will tell you that Time = Money. In building housing (or any other sort of real estate development) the equation looks more like this: Time = Money2. This is because the longer the project takes, the more out of pocket costs are associated with the project. Time erodes investment returns.

$10 on $100 of investment may be the same $10 in absolute returns whether it is earned in one year or five years, but if earned in one year the returns are 10% per year, and if earned in 5 years the return is only 1.9% per year.

Further, ask any contractor about Cal OSHA or the California Contractors Licensing Board (or most building departments, or workman’s comp, or, or, or) and their eyes will roll back in their heads in dread because those bureaucracies go out of their way to make things difficult on those doing the work. This isn’t necessarily because those in the bureaucracies are doing anything wrong themselves (although their impermeability to being laid off often provides power complexes far outstripping their official authority). They are doing what they have been tasked to do – protect society, but this far down the curve of diminishing returns, the benefits for each additional step of projection creates a cost to society far outweighing the noble benefit.

California has taken it steps farther and instituted Cal Green, and Net Zero, and SUSMP and All Electric, and, and… all things that may not be bad ideas taken in a vacuum, but all additional burdens that add costs.

We institute these things for the betterment of society and require all the bureaucratic oversight for the protection of the buyer, resident, etc.. But are we really doing anything to help? Many parts of the country don’t require permits at all. Building costs in large swaths of the country are a fraction of what they are here in California. I know, I know…it is because labor is so much more expensive here. But why is labor so much more expensive? Much of it is because the increased employer burden and the additional man hours required to build to righteous California requirements. But when is the last time you heard of an apartment building falling in on the residents in Kansas City? Or Minneapolis? Or Nashville?

Most of the rest of the higher cost of labor is because the higher cost of living, which is basically a death spiral, all started by the imposition of the government to protect the people. Housing prices go up, which requires builders to pay more for labor to get them to drive in from areas of cheaper housing (or afford local housing) which in turn drives prices higher.

If the housing shortage could be summed up in a sentence or two it would be this: To reduce the price of housing, the supply must be increased, but to increase the supply of housing, the cost (in time, dollars, etc.) in producing the supply must be decreased.

Most of the country can provide housing at a fraction of the cost of what it takes to provide that same housing here in California. And what do you know, there isn’t a housing crisis in those areas.

#2. Pretending we can outsmart supply and demand.

Why is it we look outward (as towards Venezuela as referenced above) and can see that price controls don’t work, but then think we can make them work for us?

Taken in the absolute micro sense, one tenant may benefit from rent controls. But because price is determined by supply and demand in totality, the next tenant will end up paying higher rents than they would have otherwise paid to bring price back to its natural level. This higher price is acerbated by the reduction in supply (which we will touch on later). Let’s do the math as if in a vacuum for a four-unit property, assuming 100% rent control for ease of math.

  • January 1st, 2019, all units at market rent of $1000/mo
  • Rent Control imposed December 31, 2019
  • With 5% annual increases, 2022 rents would have been $1158. $1158 *4 units = $4632
  • Two residents leave, two remain. The math works like this $4632 – ($1000*2) = $2632. $2632 divided by 2 means the two new residents have to pay $1316 each, $158/mo more than they would have otherwise had to pay, which is a subsidy to the remaining two original residents.

If this is extrapolated across an entire market, it is no wonder why real estate developers aren’t opposed to this bill. At least in the short term, the lid on the existing housing stock will result in upward pressure on rents for any vacant housing stock, of which new apartments certainly qualify. (Longer term this benefit diminishes, as new housing analysis is almost always dependent on future rent growth).

Unfortunately though, just like with buying new housing, there is a qualification process required to be accepted as a lessee. The higher the price of the vacant unit, the fewer the people that can qualify. And because rent control is designed to keep tenants in their existing housing, they are economically dissuaded to move out and up, even when they have the means to do so. New tenants entering the rental housing pool (new adults, people moving to new areas, people that fell on hard times, etc.) are then penalized because they can’t afford the higher rents. People that were in place when the rent control went into effect don’t want to move, therefore restricting available entry level housing.

And let’s be clear here. The politicians aren’t claiming to help those that can afford the expensive new apartments in the fancy new communities. They claim they are trying to help those at the opposite end of the income spectrum. The very ones that need entry level housing.

With government intervention, housing becomes like government spending:

  1. It is a reallocation of income, from those that can (or have to) afford the more expensive resulting rents to those that were lucky enough to have low rents at the time the rent control went into place.
  2. Like deficit spending, a benefit is given to current residents at the expense of future residents (our kids) who have to deal with the lack of entry level housing or pay a higher price for it, as described above.

But what about the black market mentioned in reference to Venezuela? Just read here: https://www.theguardian.com/us-news/2016/mar/31/san-francisco-housing-market-craigslist-airbnb- box-tent (the fact that this all happens in San Francisco with its highly oppressive rent control measures and heavy restrictions on new supply is not a coincidence folks).

 

It might be easy for skeptics to say that I am taking such a voracious position of opposition because of my experience in the multifamily rental business. In actuality, the opposite is true. As an investment company we are professional operators. Our existing residents have great service but are all at or close to market rents. Because we are starting at market rents, we can then increase rents at 5% a year plus inflation, each and every year. Dependability is hugely valuable to investors. And now we have it.

To some (and substantially less) degree the new rent control is causing me financial damage. I have a rental property that has been leased to the same residents since I purchased it in 2010. During that time market rents have exploded, but these residents have been great residents and so we have raised their rent very little. In exchange for providing a better value to my tenants, I am penalized because I now can not raise the rents to market, at least until some point in the future when they move out. But why would they? They have below market rent and are assured of having below market rent for years and years into the future.

Up until now, if I were to sell that property I wouldn’t be penalized badly for the low rents because a buyer would know they could raise rents at their bidding and get returns up to where the market expects them to be. Now? With the rents being permanently impacted, a buyer has to base their purchase off the lower rents, thus impacting my sales valuation.

This is why the large special interest groups acquiesced and dropped their opposition to this rent control bill. They aren’t the loser. The smaller landlords who have provided discounts to their residents are the losers. The little old gentleman or lady that owned 12 units for the last thirty years but now needs to sell to pay for their care are the losers.

And there is still another way the tenant universe suffers injury. Prior to rent control, landlords could/would buy dilapidated properties and renovate the buildings, providing nicer housing and nicer neighborhoods. They were able to do this because the rents would increase (people willing to pay the higher rents). With just cause eviction in place the landlord’s hands are tied for improving the property, or at minimum the cost of doing so goes up greatly. Higher cost of supply requires higher price…

This article grew too long to discuss the just cause portion of the new rent control, so just know this: the just cause clause hurts the neighbors of unruly tenants and puts a huge burden of proof on landlords. It is a big deal. However, rent control is impossible without just cause, so there really isn’t a way that I see that it could ever be avoided so long as rent control is a reality.

I won’t pretend there aren’t winners from rent control. The largest winners are the politicians that pander to their constituency by giving them what they want “today”. Just because it harms others, oh well. The other winners are those that already live in housing at below market rents. They just won the lottery, if their idea of winning the lottery is to live in the same apartments for years and years into the future. Large owners of rental properties also probably won. They now have built in rent increases every year into the future. All the rest of us…we share the burden of those that are the winners.

 

Happy Investing.

 
  

Forrest Jinks

Altus Equity Group, Inc. off: 707/932-5887

fax: 707/544-2972

www.altusequity.com

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.