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Rent Control: A Nightmare to Avoid

With the prospect of higher price inflation coming, I'd like to bring up a potential risk of what might happen more often in some cities in the US and across the world, particularly in places with a more socialist view such as San Francisco.

To many investors in real estate, I've just stated the obvious in my title. All cities or countries that have implemented a rent control have ultimately destroyed the availability of good housing. Rent control has always been implemented only on residential housing, since the government doesn't feel it needs to be involved in commercial real estate where the lease contract is between two businesses. But when it comes to housing, what better way to get more votes than to promote a new law that will freeze rent increases or limit their growth?

One example is in San Francisco where a tenant's rent can be adjusted by only a small percentage yearly. Only when tenants move out can the unit be rented at market rate. The San Francisco Chronicle reports:

Tommi Avicolli Mecca, who works for the Housing Rights Committee of San Francisco, said he and his roommate split the $1,100 rent on their Castro district two-bedroom apartment. He has lived there for 17 years and said the apartment would probably rent for $3,000 now. And without rent control, the landlord could keep raising the rent, meaning few people who make the city unique could afford living there, he said. (See sfgate.com )

So there you have it. This owner is forced to charge about one third of the rent he would normally charge. It is important to note, however, that existing market rates are higher than they would otherwise be if it weren't for rent control. This is because rent control reduces the amount of capital available for investment in multifamily properties. In San Francisco the supply of multifamily properties has declined drastically over the many years that rent control has been in place.

In addition to the rent control, such cities usually also have lots of regulations that prevent new housing development by making it a much more expensive undertaking than it otherwise would be. Removal of all government restrictions would attract tremendous investment and after a few years San Francisco would have plenty of high quality housing. I strongly suggest you read the above-referenced article. You will find the story of a heart surgeon making $500,000-a-year who wants a pad in SF and gets to enjoy the benefit of rent control. He is subsidized by property owners with an income substantially lower than his.

Rent Protest

Usually, these laws are discussed and/or enacted during periods of higher price inflation. In other words, the government's printing press destroys the currency, forcing all prices to go up, hence forcing market rental rates to rise. When this happens, some politicians will yell at these "awful" owners who are raising their rental rates at a time when people are struggling with the burden of rising food prices. So the politicians are trying to fix a problem they themselves created and in the process are creating more problems.

Forcing a lower return on real estate investment will result in investors losing interest in investing in this city or country. They will look elsewhere. Rent control reduces the quantity and quality of housing. Rental income is the revenue a property brings. Even a hardcore socialist would prefer to buy a higher paying dividend stock when all other relevant factors are the same. So this underinvestment will prevent the properties from being improved and maintained properly. They will therefore degrade with time. Sure, the renters will have a fixed rent or very low increases year after year, but then a new problem has been created. And -- you guessed it -- the same politicians who created this problem will likely be yelling again at the owners for not maintaining their properties. Of course they are not purposefully neglecting their properties, they are doing what they can with the artificially low rental income that has been imposed on their assets. Nevertheless, you might see those politicians considering creating a new law that will penalize with a fee any owners who are not maintaining their properties to some arbitrary standard.

Imagine what such a Keynesian-inspired politician might think:

Wow, the city will be able to make new revenue with the fees we will be charging those mean owners and with those fees, and we will be able to hire new city employees to inspect those properties. This will increase employment!

Could they really think so? You think I'm making this up? Recently, New York Governor Andrew Cuomo proposed "Slumlord Prevention Guidelines for bank lending to help protect tenants". But, this is a lot less likely to happen in a state like Texas and more likely to happen in a state like New York or Vermont or the People's Republic of California. In case you are not yet convinced about the damaging effect of rent control, I invite you to read this article from the Library of Economics & Liberty.

Now that we have established how terrible rent control is for real estate investment and therefore quality of housing that is available in a given area, I'll be talking about another type of rent: interest charged on debt. Interest rates effect the amount of rent you must pay on money you are borrowing. A central banking system such as we have can, and has, artificially lowered the interest rates across the board and this rate has become distributed across most assets and therefore investments. Imagine if city A is implementing rent control, forcing returns on investment properties to drop from say 8% to 5%, investors will start investing in city B that does not have rent control. This flood of investors in city B will push down returns from 8% to 7% or 6%, even if this city enjoys no rent control, just because there are more competing buyers pushing the prices up, and returns down.

Well, the same applies in some ways to corporate and municipal bonds an dividend-paying stocks as welll when the Federal Reserve lowers the interest rate. With lower Treasury bonds, people invest in other investment instruments paying higher yield. But just as rent control in a city eventually leads to terrible things after a few years, the same goes for central banks fixing interest rates. The way the problems manifest themselves are quite different though, but we have malinvestment that develops from this practice and will only grow with time.

With this 30-year treasury bond bull market that is about to end within the next few years, I'm afraid we have a lot of malinvestment to unwind and this is why we are "paying" close attention on where we buy and what we buy.


TDV's paid subscriptionweekly dispatch will be providing readers advice on the best investment movesto make to profit as these malinvestments come apart. Click here tofind out more.


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