How To Eliminate Excessive Residential Rents Without Rent Controls Or Rent Caps

Secure reasonable rents by imposing an Excess Rent Tax that removes the landlord’s financial incentive to charge an excessive rent

Image by Mohamed Hassan from Pixabay

By David Grace (Amazon Page — David Grace Website)

The Free Market No Longer Drives Rents Down

We have long counted on free-market competition to yield competitive rent prices based on the Cost + Overhead + Profit formula.

Historically, a successful, mature business in a competitive market has earned a percentage of profit between 10% and 25% of the total of its costs plus its overhead.

But, as I pointed out in this column

When The Free Market Drives Prices Up Instead Of Down — Virtual Cartels

when the excess inventory and/or production capacity for a product, including housing, is materially less than the market share of the companies acting together to raise prices, that limited supply of the product versus the large market share of those seeking to raise the price will allow those high-market-share companies to make more money by raising prices than they will lose from the decrease in their sales resulting from the higher price.

This results in a price that is much higher than a cost + overhead + profit price and which, instead, approaches the monopoly price.

A Virtual Cartel’s Power To Increase Prices

In the paragraph above I said “companies acting together.” Birds in a swarm do not agree with each other to fly in a certain direction, but by watching each other they act together and fly in a flock without needing any specific agreement to do so.

Today, sellers, including but not limited to landlords, watch what their market leaders do and often raise their prices to mirror their market leaders’ price without ever explicitly meeting and agreeing to do so, in other words, they act as a virtual cartel.

Through the use of market information and software like YieldStar landlords can and often do act as a virtual cartel, like a flock of birds moving in a common direction.

That virtual cartel collectively has a market share materially greater than the vacancy factor, thus allowing those landlords who use YieldStar to make more money by raising their rent than they will lose from the decrease in their occupancy factor arising from the increased rent.

A Low Vacancy Factor & Market Concentration Drive High Rents

Residential rentals is one of those markets where a low level of inventory in proportion to the concentration of the market share results in the free market’s profit motive driving prices up instead of down.

If a landlord has 100,000 rentable square feet and rents it all at $3/sq ft, its monthly gross income is $300,000. But, if a low level of inventory and/or a virtual cartel allows it to raise its rent to $4/sq ft and only lose 20% of its tenants then its gross income at 80,000 rented square feet increases to $320,000/month while at the same time its costs decrease because the vacant apartments do not consume maintenance, utilities, or management overhead.

These landlords make more money by charging a higher rent and having a 20% vacancy factor than they would by charging a lower rent and having a 0% vacancy factor.

In San Francisco many landlords have left some of their commercial units vacant in order to facilitate an increase in the rent on their remaining occupied store fronts.

Consumers Need A New Tool To Replace Weak Market-Price Competition

In these situations where the market drives prices up instead of down consumers need another tool to drive prices, in this case rents, back down to the Cost + Overhead + Profit level.

One such tool is a tax policy that

• 1) makes it more profitable for landlords to charge a lower rent
• 2) more profitable for a landlord to rent vacant units at that lower rent, and
• 3) less profitable for a landlord to charge a rent that is higher than a Cost + Overhead + Profit rent.

How Would That Tax Policy Work?

At the end of the tax year the landlord’s accountant would total

• The number of square feet rented each month to get the total number of square feet rented over the entire year.
• The amount of rent collected for the entire year
• All the property’s costs including the amortized share of capital costs that the IRS rules require to be amortized over several years. These costs would include all direct costs and all overhead costs to get the Costs + Overhead expense for the property for the entire year.
• — — Costs would include actual mortgage payments on loans encumbering the property as of the closing of the purchase of the property.
• — — Costs would exclude any additional mortgage expenses on loans encumbering the property after the closing of the purchase of the property.
• — — Costs would exclude any payments to any owners or related parties at rates in excess of three times the minimum wage.
• The total annual Costs + Overhead would be multiplied by the Profit Percentage to get the total of Costs + Overhead + Profit figure for that property, that is the Target Rent.
• The Target Rent would be subtracted from the Total Rent received.
• If the Total Rent the landlord received was greater than the Cost + Overhead + Profit rent for that property, the Target Rent, then the landlord would owe a tax equal to that excess.
• If the Total Rent Received was less than the Target Rent then the landlord would be entitled to a refund of previously paid Excess Rent taxes or a carry-forward Excess-Rent-Tax credit.
• The accountant would keep a ten year running total with the Excess Rent Tax credits and debits offsetting each and with tax payments and tax refunds based on this running total.

What Is A Realistic Percentage Of Overhead And Profit?

The construction industry aims for a profit of 20% of Costs + Overhead — C+O. The construction industry generally anticipates that overhead will equal 25% of hard costs.

In its best years Apple achieved a profit of between 20% and 25% of Costs + Overhead. These days IBM earns a profit of about 5% of costs plus overhead.

A profit equal to 25% of costs + overhead is more than a reasonable level of profit for a residential landlord.

A reasonable rent is the cost + overhead + 25% Profit rent.

A Safety Net For Very Low Overhead Properties

What if the property was very old and had almost no costs and overhead?

The gross income of an American in the 25th percentile in 2021 was $34,430. Historically, rent was supposed to comprise 30% of gross pay. 30% X $34,430 = $10,329/12 = $861/month.

A one-bedroom apartment is approximately 750 sq ft. $861/750 = $1.15/sq ft.

A studio apartment is approximately 500 sq ft. $861/500 = $1.72/sq ft.

$1.15 + $1.72 = $2.87/2 = $1.435/sq ft

As a safety net for such old properties, the Target Rent should be the greater of (1) the Cost + Overhead + Profit rent and (2) rent at $1.44/sq ft.

As the income of people in the 25th percentile changed the Safety Net Rent would also change.

Costs For A 75,000 Square Foot Apartment House

I ran some numbers for a ten-year-old apartment house with 75,000 rentable square feet and I came up with hard costs (mortgage, taxes, utilities) of about $120,000/month. Since I don’t have access to a real world accounting of actual costs and overhead I multiplied the hard costs which I could roughly calculate times 25% to get a ball park estimate of the total of costs plus overhead.

Multiply $120,000 by 25% and you get an overhead figure of about $30,000/month and a total Cost and Overhead figure of $150,000/mo/75,0000 sq ft = a cost plus overhead figure of about $2/sq ft/month.

At that cost + overhead figure and at a profit level of 25%, the Cost + Overhead + Profit rent, the Target Rent, would be $2 X 125% = a Target Rent of about $2.50/sq ft.

What I Learned

I ran various numbers using total cost + overhead amounts of $2/sq ft (C+O), $2.50/sq ft (C+O) and $3/sq ft (C+O) and a profit level of 25% times the C+O with the assumption that all 75,000 sq ft were rented for the entire year for a total of 900,000 rented sq ft for the year (12 X 75,000).

Using these various C+O numbers and rent of $3, $4 and $5/sq ft and applying the Excess Rent tax, I found that

• At $2/sq ft C+O, the Landlord did not make any additional profit by raising the rent from $3/sq ft to $4/sq ft and made only $25,000/yr additional profit by raising the rent from $3/sq ft to $5/sq ft.
• At $2.50/sq ft C+O, the Landlord did not make any additional profit by raising the rent from $4/sq ft to $5/sq ft.
• At $3.00/sq ft C+O, the Landlord did not make any additional profit by raising the rent from $4/sq ft to $5/sq ft.
• At $3.00/sq ft rent, increasing the costs from $2/sq ft to $2.50/sq increased ft the landlord’s profits by $25,000.
• At $4/sq ft rent, increasing the costs from $2/sq ft to $2.50/sq ft increased the landlord’s profits by $132,500.
• At $5/sq ft rent, increasing the costs from $2.50/sq ft to $3.00/sq ft increased the landlord’s profits by $87,500.

This Plan Motivates Landlords To Improve Their Properties

Since profits are calculated as a percentage of costs, as costs increase untaxed profits also increase.

Put differently, the more money the landlord spends on maintaining and improving the rental property, the more untaxed profits the landlord earns.

Advantages Of This Plan

Under this plan:

• Unlike what sometimes happens with caps on rent increases, this policy would not prevent landlords from recovering all actual increased costs.
• The landlord would earn an industry-standard level of profit before any tax was imposed
• The tax would make it uneconomical for a landlord to raise its rent as high as possible because the excess rent would only be taken away by the tax
• This policy would encourage landlords to spend more money on maintenance and improvements thus encouraging better units for the tenants.
• The policy would be easy to administer because it would be based on numbers landlords already have.
• There would be no complicated applications, forms or filings with some separate government agency.
• There would be no rent boards, rent controls, rent caps or inflation adjustments.

Make The Conduct You Want More Profitable

Businesses pursue more money.

If you want landlords to keep their property in good condition, make it more profitable for them to spend money on maintaining the property.

If you want to deter landlords from raising rents, make it more profitable for them to charge a lower rent and unprofitable for them to charge a higher rent.

Sample Numbers That I Used

Here are some sample numbers showing what the Excess Rent Tax and the landlord’s profit would be using those numbers. Feel free to run your own calculations using your own numbers.

The total rent received for the entire year:

• $2,700,000 @$3/sq ft
• $3,600,000 @$4/sq ft
• $4,500,000 @$5/sq ft

If because of vacancies only 750,000 sq ft of the 900,000 sq ft were rented over the course of the year then the average rent per rented sq ft would be $2,700,000/750,000 = $3.60/sq ft rent and if the costs & overhead were $1,800,000 then the C+O per rented sq ft would be $1,800,000/750,000 = $2.40/C+O rented sq ft.

You can recalculate the scenario using any numbers you like.

Compute The Year’s Total Cost+Overhead

MULTIPLY the rented square feet TIMES the Cost+Overhead/rented sq ft = Annual Cost + Overhead

• 900,000 X $2.00/sq ft = $1,800,000 Annual Cost + Overhead (C + O)
• 900,000 X $2.50/sq ft = $2,225,000 Annual Cost + Overhead (C + O)
• 900,000 X $3.00/sq ft = $2,700,000 Annual Cost + Overhead (C + O)

Compute the Cost + Overhead + Profit “Target Rent

MULTIPLY C+O TIMES Profit %age = Profit ………. Annual Target Rent

• $1,800,000 C+O @2.00 (C+O) X 25% = $450,000 … $2,250,000 Annual Target Rent
• $2,250,000 C+O @2.50 (C+O) X 25% = $562,500 … $2,812,500 Annual Target Rent
• $2,700,000 C+O @3.00 (C+O) X 25% = $675,000 … $3,375,000 Annual Target Rent

Compute The Excess Rent Tax

Total Rent Received MINUS Annual Target Rent = Excess Rent Tax

• $2,700,000@$3 rent — $2,250,000 @$2.00 C + O = $450,000
• $3,600,000@$4 rent — $2,250,000 @$2.00 C + O = $1,350,000
• $4,500,000@$5 rent — $2,250,000 @$2.00 C + O = $2,225,000
• — — — — — — — — —
• $2,700,000@$3 rent — $2,812,500 @$2.50 C + O = $0
• $3,600,000@$4 rent — $2,812,500 @$2.50 C + O = $787,500
• $4,500,000@$5 rent — $2,812,500 @$2.50 C + O = $1,687,500
• — — — — — — — — —
• $2,700,000@$3 rent — $3,375,000 @$3.00 C + O = $0
• $3,600,000@$4 rent — $3,375,000 @$3.00 C + O = $225,000
• $4,500,000@$5 rent — $3,375,000 @$3.00 C + O = $1,125,000

Compute After Tax Profit

Rent Received MINUS C + O MINUS Tax. . . . . . . . . = After Tax Profit

• $2,700,000@ $3 — $1,800,000 @ $2.00 — $450,000 = $450,000
• $3,600,000@ $4 — $1,800,000 @ $2.00 — $1,350,000 = $450,000
• $4,500,000 @ $5 — $1,800,000 @ $2.00 — $2,225,000 = $475,000
• — — — — — — — —
• $2,700,000 @ $3 — $2,225,000 @ $2.50 — $0 = $475,000
• $3,600,000 @ $4 — $2,225,000 @ $2.50 — $787,500 = $587,500
• $4,500,000 @ $5 — $2,225,000 @ $2.50 — $1,687,500 = $587,500
• — — — — — — — —
• $2,700,000 @ $3 — $2,700,000 @ $3.00 — $0 = $0
• $3,600,000 @ $4 — $2,700,000 @ $3.00 — $225,000 = $675,000
• $4,500,000 @ $5 — $2,700,000 @ $3.00 — $1,125,000 = $675,000

— David Grace (Amazon Page — David Grace Website)

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