A Two-Tier Apartment Market in the US

So far this year, three states, California, Oregon and New York have enacted sweeping rent control laws in their states. These new laws cap annual rent increases to inflation (measured by the Consumer Price Index) plus 7% in Oregon, inflation plus 5% in California and in a convoluted system in New York, the rent increase is based on the five-year average rent base per the Rent Guidelines Board. The new rent control measures in California don’t apply to any newly constructed apartments for 15 years and in Oregon, new properties are also exempted for 15 years.

We expect many more liberally run states like Illinois, New Jersey, Maryland, Connecticut and Massachusetts to also enact rent control measures similar to the above three states by the end of 2020. As an apartment owner or developer in California and Oregon, you may be fine with annual rent increases of inflation plus 5% or 7%.

However, this whole rent control discussion is more about politics than it is in helping low-income tenants with rising rents and affordable housing. Politicians will use these laws every election period to get votes by tweaking the laws to make them more tenant-friendly and owner negative. For example, the California law will likely be tweaked in the next few years from inflation plus 5% to 3.5% or 4% and for the new construction exemption period to be reduced from 15 to 12 or 10 years and so on.

This situation creates tremendous political risk, which is one of our 15 CRE risks as discussed in many prior articles and my two books on CRE, “The 50 Commandments of CRE Investment” and “CRE Investment for Pros (and Dummies Too)”. These state rent control programs will also create a two-tier apartment market in the US during the next few years.

The top or A tier will be states with no rent control and market-oriented rent and business policies. The bottom or B tier will be all the states with draconian rent control policies. During the next five to seven years, institutional debt and equity capital for apartment acquisitions and developments from banks, REITs, insurance companies, pension funds and private equity firms will begin to flow primarily to the Tier A states.

While the Tier B states will see a lack of capital and investment demand for new and existing apartments. Apartments less than 15 years old, that are currently exempt from the above rent control laws, will fall in value as the end of the exemption period approaches. Apartment values rent levels and new construction in the Tier A states will rise and be vibrant and the opposite will occur in the rent control states. The Tier B rent control states will see higher cap rates and less demand for investment and development. Look for many of the large public REITs and other institutional investors to begin shifting their portfolios to these market rent states during the next few years.

When the large REITs like Essex Property Trust, Equity Residential and AvalonBay, which have big portfolios of apartments in CA, begin shifting their investments out of CA, this will be the first indication of the reality of this new two-tier apartment market. Since Oregon enacted its rent control laws in May of 2019, cap rates for apartments have risen about .50% and apartment investment has declined 38%, according to local real estate brokers.

Joseph J. Ori is executive managing director of Paramount Capital Corp.