The Economic Challenge for the Rent Guidelines Board: Balancing Long-Term Affordability in Rent Stabilized Housing
UPDATE: April 20, 2022 - This post is a summary of a White Paper on the same topic. Read the Economic Challenge for the Rent Guidelines Board.
Rent stabilized apartments account for nearly half of all rental units in New York City and are a vital source of relatively low-cost rental housing. New Yorkers who live in rent stabilized apartments pay a lower median rent and have a lower median income than households in unregulated apartments, but are also more likely to experience maintenance deficiencies. The responsibility for overseeing the economic viability and affordability of this important housing stock rests with the nine-member Rent Guidelines Board (RGB), which sets annual rent adjustments for rent stabilized apartments. Given the importance of the rent stabilized apartment stock, it is essential to think hard about how to preserve both its quality and quantity.
In June 2019 the State Legislature passed the Housing Stability and Tenant Protection Act (HSTPA). While HSTPA did not formally change the RGB’s role, it did make its annual increases far more determinative of the long-term economic health of buildings with rent regulated apartments. Before HSTPA’s passage, rent stabilized rents could and did rise at higher rates than the RGB’s annual vote. Other rent increases were permitted upon tenant vacancy and at lease renewals (in the case of preferential rents), or to recover the cost of investing in capital improvements. With HSTPA having eliminated or diminished these methods, the RGB is now the primary, if not sole, driver of income an owner is allowed to realize from rent stabilized apartments. This heightened responsibility requires that the RGB carefully assess the consequences of these changes, and modify its decision-making criteria accordingly.
One segment of the rent stabilized stock is at particular risk in the HSTPA era: those buildings without any significant source of income other than from rent stabilized apartments. While many buildings with rent stabilized apartments also derive income from deregulated market rate residential apartments, we estimate that 60 percent of all rent stabilized apartments are in buildings that were both built before 1974 (the year rent stabilization was instituted), and essentially composed of only rent stabilized apartments. To understand how to protect this stock of affordable rental housing in both the short and long run, the RGB needs to focus in particular on the economics of these buildings and to collect data that can help it do so.
In this post we lay out the long-term relationship between net operating income (NOI) and the sustainability and quality of rent stabilized apartments. We then examine how best to use the tools and data available to the RGB to make its determination. Finally, we suggest two ways that the RGB could adapt to the HSTPA era when setting guidelines for annual rent increases (or possibly even decreases in a deflationary world). One is to have increases in Consumer Price Index (CPI) be a starting point in the board’s deliberations over setting guideline rental increases, the other is to make automatic guideline increases based on CPI, leaving the Rent Guidelines Board to simply monitor for any needed adjustments.
The Impact of Revenue Shortfalls on Housing Quality and Economic Viability
The long-term economic viability of rent stabilized apartments depends on having sufficient rent increases that are large enough to preserve a building’s NOI to the degree necessary for not impairing the maintenance standards of the building.
Building owners need sufficient income not just to cover operating costs that are subject to market dynamics (such as the cost of labor, fuel, utilities, maintenance, insurance, and administration costs), but also those subject to government levies, such as property taxes and water and sewer fees. The amount of money left over after operating costs—NOI—pays for debt service on any mortgage and provides a return to the building owners. NOI also serves as a primary determinant of the market value of a building, as market values tend to rise and fall with changes in NOI. To guard against devaluing buildings in inflation-adjusted (so-called “real”) dollars requires that NOI remain constant in real dollars. A change in the level of NOI is an important indicator to lenders and investors that building revenue is sufficient to cover operating costs, debt service, and a reasonable return on investment.
If rent increases are insufficient to cover increased operating costs and to compensate for the impact of inflation, then negative consequences are almost certain to follow over time. To protect NOI and prevent a building from losing value, owners might look to reduce operating costs, and in turn, reduce maintenance standards to minimal code standards. Other consequences potentially include a spillover effect on the quality of neighboring properties, as well as a decline in the City’s property tax base as property values fall in inflation-adjusted dollars.
It is important to note that funds from NOI do pay debt service. Even in the case of a simple refinancing (generally required every 5-7 years), any declines in NOI that cause a decline in a building’s market value could limit the ability of owners to refinance a mortgage without needing to contribute additional investment equity. In the extreme, lower cash flow and higher equity requirements could result in forced sales or foreclosures.
These harmful scenarios may be growing more likely, as evidenced by the most recently available RGB data, which always lags current market conditions by nearly two years. On March 31, 2022, the RGB released data showing a decline from 2019 (the year HSTPA was enacted) to 2020 of both 7.8 percent in average NOI per unit and 2.8 percent in average per unit operating expenditures.
Also important, but not the subject of this blog post, is the funding needed to replace building systems when they wear out or become obsolete, such as plumbing, mechanical systems, electrical wiring, and roofs. Investments in these capital improvements are particularly critical to these buildings which, by definition are nearing or exceeding 50 years of age. Funding for these investments is considered separately in the law through rent increases tied to Major Capital Improvements and Individual Apartment Improvements, both of which HSTPA significantly curtailed. It is worth noting here that these rent increases could be replaced by a reformed J-51 property tax abatement and exemption program.
Getting Commensurates Right
State law entrusts the RGB to establish guidelines that cap rent increases for rent stabilized apartments. To carry out this responsibility, the RGB examines data compiled by its staff (including building-level income and expense data from the Department of Finance—DOF) as well as testimony from tenants, owners, the City, and other interested parties. As part of this process, the staff generates a set of five “commensurates” which each lay out an estimate of what rent adjustment would hold NOI constant in either nominal or inflation-adjusted terms for rent regulated units. As described by the RGB:
Throughout its history, the Rent Guidelines Board has used a formula, known as the commensurate rent adjustment, to help determine annual rent guidelines for rent stabilized apartments. In essence, the ‘commensurate’ combines various data concerning operating costs, revenues and inflation into a single measure to determine how much rents would have to change for net operating income (NOI) in rent stabilized apartments to remain constant.
However, these commensurates are not fulfilling their intended purpose to provide guidance to the RGB about how to maintain constant NOI. In fact, prior to HSTPA, data showed that NOI in buildings with at least one rent stabilized unit was increasing, despite RGB rent increases at lower amounts than what the commensurate guidelines intended to keep NOI level. There could be two reasons. First, the RGB was unable to quantify the impact of rent increases outside of annual lease renewals, making it impossible to determine what annual rent increase would truly hold NOI constant. Notably, HSTPA has effectively resolved this issue, as these mechanisms have been greatly curtailed or eliminated.
The second and remaining problem is that information from the DOF relied upon to analyze trends in income and expense include data not just on rent stabilized apartments, but also from market-based income and expenses attributed to unregulated residential and commercial units in the same building. To be in the database the RGB requests from DOF, a building needs only to have a single rent stabilized unit; the rest of the residential units would have been deregulated by exceeding the high-rent/vacancy decontrol or income thresholds allowed pre-HSTPA. Adding to the disconnect between commensurates and reported changes in NOI in the DOF data is the inclusion of buildings that were built after 1974, the year New York State instituted rent stabilization. These post-1974 rent stabilized apartments were added to the rent stabilized stock as part of state or local government programs (e.g., 421-a) and their income and expense trends and levels can be very different from those of rent stabilized apartments in pre-1974 buildings.
A Commensurate for Long-Term Economic Viability
Given HSTPA’s limits on rent increases outside of the RGB’s annual guidelines, the RGB needs only a single commensurate to preserve affordability without triggering the range of negative consequences outlined above. The calculation of that new commensurate simply requires a realistic estimate of increases in operating costs, using the regional Consumer Price Index (New York-Newark-Jersey City, NY-NJ-PA, all urban consumers) (CPI) to estimate the rate of inflation. With data currently available to DOF on buildings of almost exclusively rent stabilized apartments, it would be possible to monitor how well this new commensurate performs at holding constant inflation-adjusted NOI.
To help simplify the task of calculating the commensurate, our research has found that increases in operating costs closely track increases in CPI. With the exception of property taxes and water and sewer fees, increases in operating costs for fully rent stabilized buildings (that is, where 95 percent or more of the units are rent stabilized) have risen between 2006 to 2019 at essentially the same rate of inflation. Property taxes have risen at a higher rate than inflation, reflecting real increases in NOI, the result of the inclusion of market-rate units as well as the ability of owners to increase rents over and above the guidelines. With this commensurate property taxes should also only rise at the rate of inflation, as long as tax rates themselves do not increase. As such, no additional adjustment to the setting of guidelines would be necessary in order to specifically account for property tax increases. Additional adjustment might be needed for water and sewer fees if they continue to rise faster than inflation. With the more targeted DOF data, any deviation in the correlation between CPI and operating costs will be easy to identify and correct.
Two options that the RGB could employ to implement the use of this proposed new commensurate are:
- Make the new commensurate the starting point for the RGB’s deliberations to set the annual rent guidelines.
This approach would continue the RGB’s annual deliberations to balance affordability and the long-term economic viability of rent stabilized apartments. In this case the RGB would start with a strong presumption that the new commensurate be the basis for setting the guidelines. Deviations from the commensurate would be limited. For example, setting a higher guideline would only be allowed if the data were to show NOI falling in real terms. Setting a lower guideline would be allowed only if data showed NOI rising in real terms, or in unusual circumstances where, for example, it seems prudent to protect tenants in the very short-term from a sudden and unexpected increase in rents. Even in this latter case, the RGB will have to weigh the impact of a sharp increase in rents on tenants whose incomes might be slower to adjust to inflation against the impact on landlords immediately confronted with higher and a potentially permanent increase in operating costs. A good example of this type of event might be the sudden and steep jump in inflation during this pandemic period. The most recent (March) 12-month trailing CPI amounted to 6.1 percent, up from 1.6 percent in March 2019.
- The new commensurate becomes the one-year guideline with the RGB monitoring how well CPI has tracked actual increases in operating costs and periodically evaluating whether adjustments are needed.
This second approach would be simply to rely in most years on the CPI for determining the annual increases. While the relationship between increases in CPI and increases in operating costs may exhibit some year-to-year variability, our analysis suggests a stable relationship over time. As a check against changes in this relationship (and the relationship to property taxes), the RGB would periodically convene to review trends and see if additional adjustments are needed. Such reviews could be done every so often—perhaps every five years—to prevent any systemic misalignment between CPI growth and expense increases from growing into long-term problems. This type of “automatic” system might be more credible to tenants and owners. It may also produce guidelines that, over the long-run, minimize rent increases without triggering a decline in housing quality, as well as any other negative consequences to New York City’s renters, building owners, and more broadly to New York City’s neighborhoods and tax base.
As the RGB begins its deliberations for setting the 2022 guidelines, it needs to consider both the affordability and the long-term sustainability of the rent stabilized stock as the HSPTA era begins to be reflected in its reports. It can create the tools to do so by tracking data on fully rent stabilized buildings and adopting a new commensurate that accounts for increases in operating costs as well as overall inflation. This post lays out a way for the RGB to develop and rely on that new commensurate. The urgency to adapt its decision-making to this new reality has been made even more evident by data recently released by the RGB showing a 7.8 percent decline in NOI between 2019 and 2020, even before taking inflation into account. Given the importance of the rent stabilized stock not just to current, but also future generations, the RGB needs to keep the long-term economic viability of this housing clearly in focus.