California governor Gavin Newsom recently signed into law a sweeping measure that limits rent increases to 5% plus inflation per year and also restricts landlords’ ability to terminate lease agreements. Leaving aside the ethic of property right curtailment, the new law represents a doubling-down on demonstrably failed policy. More than ever, the answer to California’s housing shortage is freer markets, not government controls.
California’s real estate is among the most expensive in the nation. The California Association of Realtors reports that median home prices currently hover around $617,000, and are as high as $1,600,000 for San Fransisco. No one is shocked by how such an expense could price average citizens out of the housing market. Further, the link between the state’s top-decile rate of homelessness (currently 329 people per 100,000) and top decile housing costs is a correlation difficult to ignore.
According to PPIC, housing construction in California has fallen to multi-decade lows. In 2005, a little over 200,000 permits for new housing units were issued. Since 2008, that figure has fallen to below 50,000 per year. With growth of 3.1 million people over the same period, even a rough, back-of-the-envelope comparison reveals the problem: 3.1 million new people are chasing less than 500,000 new homes built. Put simply, the state’s population has grown faster than its supply of housing and prices have increased accordingly. Fundamentally, this is a supply problem.
Of course, high prices are a strong incentive for producers to increase supply. What’s more, real estate developers absolutely love developing in areas with an increasing population—especially when that population skews young and educated, as does California’s. By all objective measures, the state should support a strong and steady supply of housing. So where is it?
A 2015 Legislative Analyst’s Office report may offer some clues. According to the report, the tangle of local and state environmental, zoning, and development review requirements has significantly hampered development. In some cases, communities have adopted explicit growth controls, with upper limits on new development. According to the report, “…a project may require independent review by a building department, health department, fire department, planning commission, and city council.” Later in the report, the role of environmental regulation is addressed: “Our review of [California Environmental Quality Act] documents submitted to the state by California’s ten largest cities…indicates that local agencies took, on average, around two and a half years to approve housing projects that required an [environmental impact report].” In real estate development, two and a half years is more than enough to kill a project. Not to mention, two and a half years was the average, implying that half took longer. Bottlenecks to supply yield less supply. Increasing demand without a commensurate increase in supply leads to higher prices. Economics 101 predicts all of this, so we should not be surprised by any of these outcomes.
We should be surprised by the solution on offer from policy-makers. Rather than loosen the barriers which restrict the supply of housing, California’s lawmakers have increased them. Gov. Newsom himself admits the problem of supply in his speech at the bill-signing event saying, “We have to address the issue of production in the state of California. We need to build more damn housing.” This is a demonstration of irony worthy only of Hollywood. At an event where the governor signs a law curtailing supply, he talks about the priority of increasing supply.
It should be obvious that rent controls reduce incentives for developers to build. This is because real estate prices—especially for properties designed to be rented—are priced with “cap rates.” The cap rate of a property is the income received from the property divided by the price paid. When the income received is fixed and not allowed to grow but the property itself continues to gain in value, the cap rate goes down. Obviously, this reduces returns to investors (and makes them invest elsewhere). Compounding the problem is that real estate is almost always financed, so this effect of lowered cap rates is magnified. Projects that may have been viable will be scrapped because they cannot be financed appropriately.
Another effect of rent control is the slowing of continued investment. In the absence of rent control, there is incentive to renovate and restore old buildings—a staple strategy for urban rejuvenation. But when rent increases are limited, investors receive no reward for investing their money to update properties. This worsens urban blight and pushes would-be renters into more competitive markets, exacerbating the shortage of desirable properties.
People will still want to live somewhere, and those who cannot find a place to rent will be forced to buy. In a textbook cascade effect, rent controls will further increase the price of residential real estate, pushing still more people out of the housing market. This cascade effect disproportionately affects the poor and underprivileged as they are out-competed by better-qualified tenants in existing rental properties, sadly leading to increased rates of homelessness. Counterintuitively, rent control is a net negative for the poor.
If it is indeed our objective to generally improve the lives of people, especially the least fortunate, rent control is anathema. Rent control worsens the housing shortage (especially for the underprivileged), exacerbates urban decay, threatens home ownership, and pushes investment out of the state. When faced with the simultaneous treatment of high blood pressure, heart disease, and type II diabetes, the sensible course is to reduce obesity. So it is with the myriad housing troubles of California—the reduction of obese governmental burdens also reduces shortages and price inflation.
To be fair, the future is difficult to see. There is always more than one factor at work in the equations of the real world. In many ways, this is the wisdom of Federalism. Through a decentralized system of problem solving, we have many laboratories within which to run policy experiments. At the conclusion of these experiments, we can take stock, copy good policy and cancel bad policy. Perhaps California’s experiment will defy economic models and yield a new mechanism for mitigating home price inflation.
For such a system to work, however, there must be some point at which the experiment concludes. It should be clear that California’s affordable housing crisis is an engineered one, and rent control is a doubling-down on failed policy. For the sake of the average and underprivileged citizens of California, I genuinely hope my assessment is wrong. I hope this experiment will conclude with greater access to housing and a reduction in homelessness.
As an investor, however, I won’t bet on it.
Franklin J. Parker, Analyst – Free Enterprise
Photo by Anthony Gideon