If your gut reaction is to run for the fences when you hear the words rent control, you’re not alone. Many real estate investors shy away from rent-controlled units—and often for good reason. Rent-controlled units are subject to a host of regulations that affect how much rent can be raised, how often, and under what circumstances. Some ordinances also prohibit evicting tenants unless under a narrow set of circumstances.
Rent control is made all the more complicated by the fact that ordinances vary from city to city and state to state. Staying up to date on the latest rent control policy is no easy task, particularly for investors who have holdings in multiple communities.
Despite their drawbacks, rent-controlled properties can be a great addition to an investor’s portfolio.
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How does rent control work?
Rent control is a form of tenant protection that institutes a legal limit on a property’s maximum rent. Usually, it’s enacted and enforced by your local municipality in a bid to encourage affordable housing. New York City’s Rent Guidelines Board has one of the United States’ most famous rent control laws—most famously allowing Monica Geller to afford her lavish West Village apartment.
It’s easy to see why real estate investors would shy away from rent-controlled apartment buildings. However, modern rent control laws don’t simply cap the maximum amount. Many, like Oregon’s 2019 statewide bill, focus on rent regulation or rent stabilization. These laws prevent landlords from increasing rent dramatically year-over-year.
Some cities tie the allowable increase to the change in the area’s consumer price index, which usually ranges from two to five percent each year. Other cities have a prescribed cap, regardless of the local inflation rate. In the Beaver State, yearly rent increases are limited to seven percent.
A lot of people assume that these units always rent at drastically below-market rates. To be clear, this certainly does happen—but not always. Most rent control ordinances allow landlords to bring units up to market after a renter has vacated the unit. What’s more, most cities allow landlords to increase rents for other reasons, such as after capital improvements.
Rent control: pros and cons
Many real estate investors shy away from investing in markets with rent control without ever taking the time to understand the nuances of the policy. Before buying these properties—or passing up an otherwise-perfect listing—know the advantages and disadvantages.
Pros of rent control
If you know the ins and outs of the local laws, rent-controlled properties can actually be a highly valuable addition to any investor’s portfolio. Here’s why:
- Lower acquisition cost. The purchase price tends to be lower than market-rate properties, making them more attractive to savvy investors with a long-term, buy-and-hold investment strategy. Plus, there’s usually less competition for rent-controlled buildings, so investors can avoid bidding wars.
- Lower turnover. Every time a unit turns over, a landlord risks a vacancy. Even in a hot market, finding and screening qualified renters can be pricey. Rent-controlled units turn over less frequently, saving landlords the costs associated with high turnover.
- Potential for substantial upside. A sub-market rent is a value-add opportunity. At some point in the future, every tenant will leave—and rents will reset to fair market value. When that happens, the effective cap rate increases.
- Rents increase after capital improvements. Many cities and towns allow landlords to increase rents beyond the annual maximum in order to recover the costs associated with capital improvements.
- Consistent revenue stream. Owning rent-controlled property provides a cushion against rent declines. Tenants might still be paying submarket rents, but at least these rents are stable over time, providing landlords with a predictable, consistent stream of revenue despite market cycles.
Cons of rent control
Still, there are good reasons why some investors are wary. The effects of rent control can be negative if you don’t carefully manage your investment strategy. Consider these cons before buying:
- Regulations can be difficult to navigate. Rent control regulations can be regulated at either the city or state level—or both. And it’s not uncommon for two next-door communities to have different policies. The landscape is continuously evolving, and investors need to track these regulations closely.
- Your ability to increase rents is limited. The allowed yearly rent increases can be completely out of line with market averages—particularly in hot-market cities, where rents can experience double-digit increases. This ceiling might make deals less attractive to investors in search of strong cash flow.
- Rent-controlled properties experience lower turnover. As mentioned earlier, low turnover can be a good thing. However, it also can lead to years of below-market rent, especially since tenants in rent-controlled units tend to stay longer than average (sometimes 30-plus years!), and eviction is rarely an option.
- There’s less incentive to improve properties. One unintended consequence is that there’s less incentive to invest in rental housing beyond routine repairs and maintenance. Over time, this can lead to a deterioration (and therefore, value) of the property.
- Smaller pool of future buyers. Given these challenges, some investors will never even look at these rental properties. This inherently shrinks the pool of potential buyers.
What to consider when evaluating rent-controlled investments
Buying rent-controlled property can be a valuable addition to any real estate investor’s portfolio. However, property owners should be cautious not to jump the gun without considering a number of factors that could influence their return on investment, including:
Someone who buys a fully stabilized (leased) property will have to wait until existing tenants move out to bring those units up to market rate. Look for vacant or partially vacant rent-controlled properties so you can make any needed building improvements and then rent at fair market rates.
As a general rule of thumb, steer clear of rental units where:
- Existing tenants have been there a really long time (say, five-plus years)
- Rents are more than 50 percent submarket.
This usually indicates that tenants won’t vacate the unit anytime soon, making it difficult to increase rents to market rate.
Generally, units with two or more bedrooms attract longer-term tenants than studios or one-bedroom apartments. Remember, turnover is a good thing in markets with rent control. The more space new tenants have, the more likely they are to stay.
Current and future cap rates
Evaluate rent-controlled properties based on their existing cap rates and their potential cap rates if and when rents are raised to market rate. If you suspect tenants will move out six months from now, buying a rent-controlled property at a four percent cap rate could be a great deal.
If you suspect tenants will stay for another 20 years, it doesn’t matter that the property has the potential to turn a 7.5 percent cap rate. You’ll lose two decades of revenue in the process. The trick is predicting when people will move out—no easy task, even for the most skilled investor.
(Learn how to calculate cap rates here.)
Rent-controlled properties can be a great investment for those with a long-term, buy-and-hold strategy. When the market invariably dips, rents can quickly decline, crippling investors who rely too heavily on market peak rents. Investors with a long investment horizon may benefit from the cash flow predictability that rent-controlled units offer.
Laws change frequently, so buying and managing rent-controlled units can prove too complicated for novice, small-scale or foreign investors. If you fall into one of these categories, consider hiring a property manager to navigate local laws.
How investors can profit with rent-controlled properties
The enterprising income investor can find discounted income properties in rent control cities—but how can you be a better owner than the previous seller? Here are a few methods that you can utilize to create a profit.
If you are buying properties with below-market rents, consider applying for hardship increases with the help of your landlord-tenant attorney. Rent control regulations typically permit raises for special hardship cases because they still want landlords to earn a “fair return” on their investments. Regulations define fair return differently, so check your local laws before applying for a hardship increase.
Reduce turnover expense
In municipalities without rent control, the landlord has the negotiating power when it comes to turnover-related repairs. Normal painting and cosmetic rehab that you would have to complete elsewhere can be partially eliminated as long as the unit is rentable by regulatory standards.
Yes, tenants may ask for new painting or certain cosmetic repairs but remember: You will likely have a long list of prospective renters familiar with—and excited about—the rent control rules. Hence, they will often accept units with cosmetic flaws. Reducing turnover expenses increases your bottom line.
Cities with rent control typically allow landlords to raise rent after completing significant capital improvements to the tenant’s units or the building itself. Capital improvements include:
- Add-ons: Adding and charging for laundry, parking space, or self-storage space can increase your net cash flow and your asset value. For instance, let’s say you installed self-storage bins and provided access for an additional $25 per month. This add-on increases your annual rent by $300 per year. In a 10 percent cap rate neighborhood, that increases your asset value by $3,000.
- Conversion: Convert a spacious vacated studio apartment into a one-bedroom unit by adding a wall, closet, and other bedroom-oriented features. Conversion can increase the rental value, and thus the asset value.
(Make sure to estimate the cost of capital expenditures before purchasing the property.)
Rent-controlled properties are not without their difficulties. But when managed properly, rent-controlled buildings can be a lucrative addition to any investor’s portfolio.