Reducing Rents To The Highly- Competitive-Free-Market “Cost + Overhead + Reasonable Profit” Price
Use An Excess Rent Tax To Reduce Rents From The Cartel Price To The Highly-Competitive-Free-Market Price
By David Grace (Amazon Page — David Grace Website)
The Prime Benefit Of Capitalism Is Low Prices Resulting From Robust Price Competition
Traditionally, Americans have advocated capitalism because the profit motive provided consumers with a wide variety of products while robust, free-market, price competition delivered those products at the low, highly-competitive Cost + Overhead + A Reasonable Profit price.
Robust Price Competition Is No Longer Available For Many Products, Including Rental Properties
But many factors — market concentration, limited distribution channels, intellectual property restrictions, reductions in inventory, longer build times, and others — have drastically reduced or eliminated robust free-market, price competition.
Since we can no longer rely on robust free-market price competition to deliver products priced at the low Cost + Overhead + A Reasonable Profit price, we need another tool to deliver products and services priced according to the Cost + Overhead + A Reasonable Profit competitive-market pricing model instead of today’s more common “all the market will bear” cartel-pricing model.
This especially applies to prices for rent.
High Rent Is A Primary Driver Of High Inflation
Inflation is driven by increases in fundamental, foundation costs like food, energy and rent, with rent increases being the most fundamental driver of inflation of them all.
People can cut back on their energy use. Other than restaurants, businesses don’t buy a lot of food. But, one way or another, directly or indirectly, increases in rent doubly increase everyone’s cost of living by increasing both the overhead cost of producing and selling products and also increasing the cost of labor.
When residential rent costs increase, workers pass those costs on to employers with demands for higher pay and employers pass those increased labor costs on to consumers with higher prices.
When commercial rent costs increase, retail space costs, industrial structure costs and office rents all increase and then businesses pass on those higher costs with higher prices.
As real estate prices rise, buyers incur higher mortgage costs and higher property taxes which cause new landlords to increase rents to cover their increased purchase and carrying costs and, in turn, tenants increase their wage demands.
Increases in rent charges for newly-purchased properties also increase the rents on existing properties because old owners with lower mortgage payments see these higher market rents and increase their rents to match, and/or old owners pull out cash by refinancing their properties and then raising their rents to cover their new, higher mortgages.
Eventually, real estate prices and rents rise to an unsustainable level. Tenants move out or default. Landlords can no longer cover their high mortgage payments and they default. Properties are sold at a loss in foreclosures. The lower foreclosure prices allow the foreclosure buyers to charge a lower rent to lure back tenants. And the cycle repeats.
But in the meantime, high real estate costs drive both higher wages and higher business expenses resulting in higher product prices.
How Do We Secure A Highly Competitive Price For Rental Property?
If we want to reduce inflation and increase real income, we need landlords to price the use of their properties according to the formula:
- Rent = Cost + Overhead + Reasonable Profit (the highly competitive free-market price)
and NOT according to the formula:
- Rent = How Badly The Buyer Needs The Property + How Much Money The Buyer Has To Spend On Rent (the cartel price).
We Need A Formula To Calculate What Is A Landlord’s Reasonable Profit
To determine the highly competitive free-market price in a low-competition, semi-cartel rental market, we need an algorithm, a formula, to calculate what would be a landlord’s reasonable amount of profit.
Investors Need The Hope Of A Reasonable Return On Their Investment
To figure out the “Reasonable Profit” portion of the competitive-rent-pricing equation, we start with the fundamental capitalist principle that entrepreneurs and investors are driven by the expectation of a reasonable return on their investment.
The expected return on an investment varies with the rate of inflation at the time of investment together with the risk involved.
Creating a formula that will determine what is a “reasonable profit” on the rental of property is difficult because each piece of property is potentially unique and the amount of capital invested and the investor’s level of risk are also potentially unique for each piece of property.
Different Formulas
In previous columns I explored several methods for calculating a landlord’s reasonable profit:
A Fixed Percentage Of Costs As The Return On Investment
- 1) Profit = a fixed percentage of costs, e.g. a reasonable profit equal to 20% of costs.
The problem here is that costs include mortgage payments which can vary widely between identical properties, depending upon how long ago each owner acquired the property (old low-payment purchase mortgages and new high-payment purchase mortgages) and the amount of cash the owner invested.
A Varying Percentage On Capital As The Return On Investment
- 2) As a varying percentage return on the cash invested based on a reference to financial-industry benchmark rates at the time of investment.
This formula quickly became complicated and led to materially varying levels of profit for similar properties depending on the interest rates that were in effect at the various times that the properties were acquired.
A Fixed Dollar Amount Per Sq. Ft. As The Return On Investment
- 3) A fixed dollar per square foot amount of profit based on the median income level at the time of calculation.
This method resulted in the same amount of profit per square foot for diverse types of properties without reference to the quality, cost or nature of the properties.
A Fixed Percentage Of The Original Investment As The Return On Investment, Adjusted For Inflation
After re-considering these previous approaches to determining how to calculate the reasonable profit portion of the competitive-pricing formula, I decided that a more practical way to determine the level of the landlord’s reasonable profit — the best way to determine a rental price that mimics the rent that would be charged in a highly-competitive free-market environment in a world where there is no such highly competitive free market — would be to recognize that as a reasonably low-risk investment, the simplest choice would be to pick some fixed-percentage rate of return on the amount of risk capital actually invested, and then adjust that dollar amount of profit according to the amount of inflation between the date of the original investment and the present time.
Picking The Percentage Rate Of Return
Thinking about a reasonable percentage rate of return on the relatively low-risk capital invested in real property, a ten-percent-per-year rate seemed to me to be realistic, though a case could be made for a different rate of return somewhere between 5% and 15%.
The Profit Formula Using A Fixed-Percentage Return On Capital
So, assuming that a landlord’s reasonable profit on the purchase of income-generating real estate would be 10%/year of the amount of capital invested and adjusting that amount of profit each year for
— (1) inflation between the date of investment and the present date and
— (2) the vacancy factor during the current tax year (have more vacancies, expect a lower profit)
let’s run some sample numbers.
Some Sample Numbers Using This 10% Return Value
Property & Investment Details
Lets assume that ten years ago a group of investors purchased a 100 unit apartment house consisting of 25 studio units, 25 two-bedroom units and 50 one-bedroom units containing a total of 105,000 rentable square feet at a purchase price of $25,000,000 with $5,000,000 down and $20,000,000 financed with a 30-year mortgage with an amortized monthly payment of $107,500 and monthly costs and overhead, other than the mortgage, of $40,000.
Annual Profit If Fully Occupied
A 10%/year return on the $5M risk capital would be $500,000/year/12 months = $41,667/month profit if the building was fully occupied.
Next, we have to convert that total monthly profit amount into a return per rented square foot.
Why per rented square foot?
Monthly Profit Per Rented Square Foot
If the property were only 10% occupied the owners would not expect to receive the same dollar amount of profit that they would earn if the property were 90% occupied.
The amount of profit earned has to be in proportion to the level of success the owners have in operating their investment, with profit declining as the rate of occupancy declines.
So, we begin by dividing target monthly profit of $41,667 by the total monthly rentable square footage.
$41,667 monthly profit/105,000 square feet = $.397 profit/month/rented sq ft. assuming the building is fully occupied.
We multiply that full occupancy profit-per-square-foot times the number of actually rented square feet during that month.
If the property was 90% occupied that month, then 90% X 105,000 sq ft = 94,500 rented sq ft X $.397 profit per rented sq ft = $37,516 reasonable landlord’s profit that month.
If the average monthly occupancy rate over the course of the entire year remained at 90%, then 90% X 105,000 sq ft = 94,500 X 12 months = 1,134,000 occupied square feet that first year X $.397 reasonable profit per square foot = $450,198 reasonable profit for the landlord during that first year of ownership.
If the property had had an annual occupancy rate of 50% then the landlord’s reasonable profit on its capital investment for that year would have been $250,110.
As a business’ success declines, so does the owners’ entitlement to earn a profit from the operation of that business.
Increasing The Profit To Keep Pace With Inflation
The property was purchased ten years ago, so let’s say that in that ten-year period inflation has increased by 25%. 1.25 X $.397 = $.496 profit/month/sq ft. today if the property were fully occupied.
If we add together the total number of square feet actually rented each month over the course of the current tax year, let’s assume that we get total rented square feet this tax year of 1,134,000 rented square feet (105,000 sq. ft X 12 months X 90%).
If the profit/sq ft this year is going to be $.496/rented sq ft then the reasonable profit this year would be $.496 X 1,134,000 actually rented sq. ft. = $562,464 reasonable profit this year as a reasonable return on the owners’ original risk capital of $500,000 invested ten years ago and adjusted for 25% inflation over the ten year period since the investment was made.
If the costs and overhead this year have increased to $50,000/month or $600,000 for the year then the total of costs & overhead ($600,000) + mortgage payments ($1,290,000) + reasonable profit ($562,464) would yield a competitive-market rental income of $2,452,464.
This is the highly-competitive free-market target rent based on the formula of: Rent = Costs + Overhead + Reasonable Profit.
Calculating The Excess Rent Tax
If we divide this target rent of $2,452,464 by the 1,134,000 rented square feet, we get an average highly-competitive market-rental price of $2.16/sq ft./month.
But, suppose the landlord charged $2.50/sq foot/month X 1,134,000 rented square feet over the 12 months and thus collected rent of $2,835,000.
In that case the landlord would incur an excess rent tax of $2,835,000 (actual rent collected) MINUS $2,452,464 (Costs + Overhead + Reasonable Profit) = $382,536 excess rent tax.
The point of this tax would be to deprive the landlord of the profit it made by charging rent over and above a reasonable profit, highly competitive market rent. This assessment of an excess rent tax would motivate the landlord to lower the rent from $2.50/sq ft down to $2.16/sq ft in order to avoid incurring a tax since after paying the tax the landlord would still only net a rent of $2.16/sq ft anyway.
Rent That Is Less Than This Reasonable Profit Amount — Rolling Over Losses Today Against Profits Tomorrow
If gross rent receipts that were less than $2,452,464 (costs plus reasonable profit) then the difference between the actual rent received and the cost+overhead+reasonable profit figure would be rolled-over as a loss-credit against any future excess-rent taxes.
This year-by-year roll-over process would cover the most recent ten years of excess rent taxes versus excess rent credits so as to smooth out the profits and losses over “lean” years and “fat” years.
In short, on a square footage basis the landlord would be expected to earn an average 10% profit on his/her original risk capital, adjusted for inflation, times the number of square feet actually rented during the current tax year.
If the landlord charged a rent that was higher than what was required to cover actual costs plus the reasonable profit, then that additional rent actually received would be deemed to be in excess of the cost + overhead + reasonable profit price and that excess rent and would be subject to a 100% excess rent tax to discourage the landlord from charging a rent that was higher than the highly-competitive free-market rent.
If the rent collected was less than a cost + reasonable-profit rent, then the shortfall would be a credit against excess rent taxes accruing in subsequent years.
How This Tax Would Benefit Tenants While Still Providing Landlords With A Reasonable Profit
Since the excess rent tax would take away any profit from charging a higher than a “reasonable profit” rent, landlords would be motivated to
— (1) reduce the rent to the highly competitive free-market price and
— (2) increase the amounts spent on property maintenance and upkeep because increasing those costs would increase the amount that would be deducted from rental income before calculating any potential excess rent tax.
Lower Rents Mean Higher Net Wages & Lower Inflation
If you keep rents at the highly-competitive free-market level then you increase the net wages of residential tenants, reduce the costs of commercial tenants and reduce inflation, all while giving landlords a financial incentive to spend more money on the maintenance and upkeep on their properties.
It’s a win-win for every individual renter and every business renter while still providing landlords with an income stream that both recovers their legitimate costs and provides a financially reasonable level of return on their investment, all without any bureaucratic price setting, rent increase formulas or rent controls.
— David Grace (Amazon Page — David Grace Website)
