2021-09-20

Why the 3% Rent Cap Stops New Housing Construction


[See also my short column in Minnpost about the Saint Paul ordinance and my long-read with all the research about how this rent control proposal affects housing in Saint Paul, an explainer of why a 3% rent cap blocks new housing construction, short posts on how the policy would affect rents and taxesinterviews with housing policy experts on new construction and rent controlguesses about Mayor Carter's plan, and what I recommend we do about the housing crisis instead of the rent control proposal.]



[New unsubsidized housing under construction in Saint Paul, from the Uni-Raymond Cam Bot.]

Ever since I wrote about the problems in the Housing Equity Now Saint Paul (HENS) rent control proposal, the most common question I’ve received has been the question of new housing: Why does a 3% rent cap stop new housing from being built? 

For example, a friend messaged me this the other day:

Why would newer buildings have to increase rent at a higher percentage than older buildings? Why can't they just set the price properly when they open the doors?

This is admittedly confusing. It took a bunch of reading and conversation to get a handle on it. Even broaching the subject is to delve into the logic of real estate development, which I don’t enjoy doing. The vagaries of housing markets and construction financing are just so very pecuniary! It’s not a pleasant form of abstract thinking, but if you want to understand why new housing is halted by this attempt to restrict landlords, it's important to look through examples. 

One reason for confusion is that people often conflate landlords and developers when they talk about the housing industry. This is easy to do, because we’re dealing with the same class of people: rich white guys. 

But when it comes how they make money, there are important differences between developers and landlords. Daniel Herriges at Strong Towns had a great post on this just the other day. Read the whole thing, but here’s the key point for my purposes:

Developers, as a rule, acquire land with an eye to developing it. They're rarely sitting on huge real-estate portfolios, for the simple reason that they couldn't afford to do that and also, well, be developers. 

Making buildings is extremely expensive and puts you in a lot of debt, and selling a completed building is generally the least risky way to pay off that debt and walk away with your profit margin, versus getting into the property management business and having to ride years of market swings. Usually it's necessary to sell off completed projects in order to afford to begin the next project.

When a developer buys land, who is profiting? Any windfall goes to the previous owner, the one who sold to the developer, because they're going to sell it for the highest price they can get. Again, the key point here is that making money on the passive appreciation of property value, or the rent it brings in, is a totally different game from making money by building stuff.

To point this out is not necessarily to defend real estate developers, about whom, as a group, I have mixed feelings. As with any category of people, there are good and bad developers. There are some kind developers who seem very sincere about alleviating people’s concerns, and others who are unabashedly slimy.

When I was on the Planning Commission’s Zoning Committee, we’d hear testimony from developers all the time. I’d often silently groan when we heard a re-zoning proposal and had to listen to some thirty-year-old dude named Chad, who checked every box you could imagine re: stereotypes of a University of St. Thomas business bro. Listening to him give a speech about “the community" while proposing a new 50-unit apartment building was not easy.

I’d hold my nose, but I would almost always vote for Chad’s proposal because 50 new homes next to a bus stop in a walkable neighborhood desperate for housing options is 50 new homes next to a bus stop in a walkable neighborhood desperate for housing options. I’d vote for Chad's project anyway, but I didn’t particularly enjoy it.

It was far easier to hear a developer pitch an affordable housing proposal. Then, they’d talk about inequality and you could vote to approve that without having mixed feelings. But in either case, I voted for the new housing because we continue to have a large housing shortage in Saint Paul. The pace of building subsidized housing, most often though the low-income housing tax credit (LIHTC), is very slow. Without for-profit developers building homes and leasing them at market rates, the housing crisis will become far worse and the city will fall farther behind on climate action and its ability to fund programs.

And, if it's passed, the proposed rent control ordinance will stop thousands of homes from being built in Saint Paul over next few years. Here's why...

Running the numbers on leasing a building

So how does this work? Well, at first glance, the 3% cap seems reasonable (or, it might have before inflation went up). 

As the HENS website states:

According to local research, 3% is actually more than the annual median rent increase over the past 20 years. Three percent annual growth is more than enough to adjust to growing needs, and parallels or sits well below historic consumer price indexes.

This view fails to understand the difference between developers and landlords. 3% is usually fine for a landlord but a huge limit for someone leasing out a new building.

Let’s say you’re a developer. You’ve borrowed millions of dollars from a Wall Street bank to build housing on a site that's been a surface parking lot for a half century on the edge of downtown. It takes a couple of years to do land acquisition, planning, approval, and construction. Now, you’re finally done with your building and ready to fill it and sell it off. 

[A long vacant site in the North Loop, at 2nd Ave. and 2nd Street, in 2017 and 2019.]

If everything is going smoothly in the economy, maybe a 3% cap works out just fine. But what if something happens? There’s a significant chance that there will be a recession or a COVID pandemic or some other unexpected thing (e.g. a big downtown company merges and moves its offices). Let's say that demand goes down.

In that case, there’s a lot of wiggling around with rents when you lease it up. Sometimes you discount units quite a bit to fill up the building. For example, the rents in a new apartment might swing from $2,200 down $1,700 and back up again over the course of a few years, depending on the demand. Maybe you knock off two months of the rent when someone moves in, aka. the “move-in special.” 

This kind of thing happens all the time the time. There are plenty of examples like this in the Twin Cities right now, and it happens during any major or minor economic downturn.

[The now-completed North Loop building, offering a 10% discount on first-year's rent. It's available now.] 

From the developer's perspective, they need to be able to raise the rents back to their original level when the economy recovers -- say, if workers return to downtown, or if COVID gets better -- especially if when one of their tenants moves out and they have a vacant apartment.

This is how the finances work with new buildings. These rent swings are much larger than 3%, often in the range of 15% or more. For developers leasing out new buildings, not having flexibility to move rents around is a huge problem, and a deal killer when it comes to getting funding for a theoretical project.


The Inflation Clause Makes it Much Worse

The weird inflation problem makes all this much worse. If inflation is close to or higher than 3%, you're just plain screwed. Not only can’t you move rents around to fill a building, you're actually forced to lower rents in real dollars. 

These are not just theoretical concerns. Under the proposed rules, with large economic fluctuations and inflation over 5%, the developers of every new building that opened in 2020 would have gone bankrupt.

[From the latest Bureau of Labor Statistics report.]

It’s worth pointing out that, for the lenders looking at giving loans for new homes in Saint Paul, the variance process doesn't really help. Nobody wants to have to jump through an unknown and unpredictable city committee process in order to set rents. And if inflation goes up, taxes are high that year, or the economy goes down, are we talking about tens of thousands of variances?


De Facto Ban on New Housing 

Whether or not it's possible to make money with a 3% rent cap in place is irrelevant. It’s about the financing, not about the development proposal.

It’s also not really about whether developers make money. You might be thinking, “boo, who cares about banks, developers, or big property owners? They’re all rich and can go suck eggs.” 

That's fine, and sure, but that's also not the point. The HENS proposal greatly increases the risk of loans for new housing construction. Ask anyone who does economic development, and they’ll tell you that developers have trouble getting financing for new housing in Saint Paul as it is. It will become impossible to get loans to build when the city has become three times as risky as anywhere else in the country. 

The people who finance construction have plenty of choices about where to build. When it comes to building new housing, Saint Paul will basically be redlining itself.

[New unsubsidized housing on Snelling Avenue, the kind that won't be built any longer.]

Who Benefits? Practically Nobody

There’s another big reason why nobody applies rent control to new housing: it doesn’t even really help anyone. 

The people who move into brand new apartment buildings are, sort of by definition, wealthier and more mobile than all the other renters in the city. They typically have a lot of choice about where to live. This group of people is not why cities implement rent stabilization policies, and not the people you see on the HENS website.

For example, in which scenario is someone moving into a brand new building better off?

  • A: There are 200 new apartments constructed in Saint Paul every year; the landlord can set any starting rent they want, but cannot move the rent up more than 3% a year.
  • B: There are 1,000 new apartments constructed in Saint Paul every year; the landlord can set any rent they want, moving it up and down depending on competition and the market.    

I would say that Scenario B is better for people who can afford to live in a brand new apartment building. With many more new apartments, they can shop around. They are more likely to get a better deal than one where the people leasing new buildings have quasi-monopoly power. If there’s lots of new housing being built in the city, if a landlord ever does raise the rent too quickly, the people who move into new buildings can always move to another one somewhere else. (I’ve known people that have done this.)

For rent stabilization in general, and according to the HENS literature in particular, the goal seems to be helping BIPOC and working-class renters keep affordable rental housing, especially people that are being squeezed by the housing shortage. Applying strict rent control to new construction doesn’t help this group of people. On the contrary, worsening the housing shortage is very bad for these folks. And applying rent control to new buildings doesn’t even really help the the renters of brand new apartments.  

Put simply, it’s a mind-bogglingly bad approach to the housing problem, with almost negligent benefits and a long list of negative consequences. There’s no good justification for this clause, and it’s the main reason why the HENS rent control ordinance would be a disaster for Saint Paul. If you care about building abundant housing in the city, someone has to build 10,000 new homes in the next few years. Like it or not, if developers don’t do it, nobody will. 

2 comments:

Anonymous said...

The whiplash I kept getting from this article gave me a headache. Developers are bad. Wait we need developers. Wait, they're still bad. But we need the bad developers.

Bill Lindeke said...

I didn't say developers are bad. I think developers try to make money, a lot like realtors do, or most everyone who sells a house. If you think that's bad, then yes.

Mostly, I end with the fact that we need developers, and thus they are probably good all in all, simply because there are no realistic alternatives.

So, yes, it's confusing.