How would you like to be in a business where the law dictates that your biggest expense grows more slowly than your revenue? That’s what happens for owners of rent controlled apartment buildings with under-market tenants in Los Angeles.
Here’s how:
As an apartment building owner, your biggest operating expense every year is the property tax bill. For example: In 2010, for my first apartment building (a 16 unit building near Silverlake in LA – read about it here), out of operating expenses of around $62,000, property tax came to around $14,000 (22% of total expenses). The next largest individual expense lines were utilities, at around $12,000 (this building has one gas meter and I pay it- ouch) and general repairs, at around $7,000. Nothing else was more than $4,000.
Ah, but what about rents? Under Los Angeles’ rent control (called the Rent Stabilization Ordinance), annual rent increases for rent-controlled buildings (anything built before mid 1978) are limited to between 3-8%, with the actual number determined by a committee each year.
Imagine you buy a small building for $350,000. Maybe you have four one bedroom units that could rent for $1,000 on the open market, but you have tenants paying $700 and they have the right to stay forever. Bummer, right?
Not necessarily — check the numbers: In year one, your property taxes are 1.25% x $350,000 = $4,375. Let’s assume your other expenses are around $7,400 (I’ll explain this assumption in a later post). Your total expenses (before mortgage payments) are therefore $11,775.
Your rents are $700 x 4 units x 12 months = $33,600.
So your net profit (again, before mortgage) is $33,600 in rent – $11,775 in expenses = $21,825. Not bad.
Now, let’s zoom ahead 10 years. We’ll make the following assumptions: Property taxes grow by 2% per year (by law!). Rents grow by the minimum legal amount in Los Angeles (3%). Other expenses also grow by 3%.
Here’s what your profit and loss statement looks like now: Rents have risen to $45,155. Property tax is up to $5,333. Other expenses are now $9,945. So your operating profit before paying your mortgage is now $29,877. That’s around $8,000 more per year in your bank account!
And here’s the best part: This building is a piece of cake to own. It’s like a savings bond with upside. Your tenants NEVER move out, because their rents have remained at least 30% below market the entire time.You just collect the rent, make sure the place is in decent shape, pay the bills, and collect your profits every year.
In the unlikely event a tenant moves out, you throw a party and raise the rent by $300 per month, adding an additional $3,600 to your annual profit.
It’s amazing how that 1% difference in growth rate of rents and property taxes makes so much difference to your bottom line. For that, you can thank Prop 13.