Reduce Rents By Levying A 100% Tax On Rents Exceeding A Market-Rate Return On Gross Property Value
Move from monopoly rent pricing to competitive-market pricing with a 100% tax on rents exceeding a market-rate investment return
David Grace (Amazon Page — David Grace Website)
This column is about residential rent, but we need to start with a review of rent in general.
What Is Rent?
Let’s say I have a hammer that I’m not using. My neighbor needs a hammer for some work he’s doing around his house. Since I’m not using my hammer I agree to let him use mine for a week for $2.
Now, let’s say I have a bundle of paper in a drawer that I’m not using. My neighbor needs my paper for a project he’s doing. I agree to let him use my paper for a week for $10.
In the first instance, my neighbor is paying me $2 rent for the use of my hammer.
In the second instance, my neighbor is paying me $10 interest for the use of 100 of my one-dollar bills.
Rent, interest, same thing.
I have something I’m not using that someone else would like to temporarily use so they’re paying me a fee for allowing them to use my stuff during a period when I don’t need to use it myself.
That’s all fine until the fee goes from the reasonable to the insane.
The Difference Between Competitive-Market Rent & Monopoly Rent
Suppose that we’re neighbors living out in the middle of nowhere. Your son was working under his car and the jack broke, pinning him under the car. You rush over to my place and ask to borrow my jack so that you can free him and save his life.
I offer to rent my jack to you for two hours for $500.
It’s still rent, but it’s extreme, extortionate rent; a fee that is many times greater than the cost of a brand-new jack.
Whether you call something rent or interest, reasonable or extortionate, it’s all fundamentally the same thing: one person allowing another to use something he owns for some period of time for a fee.
The problem with rent isn’t the concept of rent. That’s fundamental.
The problem is when the thing being rented is vital and the lessor elects to use your desperate need for the item to charge a monopoly-price fee based on your wealth coupled with the level of your desperation.
Having A Place To Live Is Not Optional
With this in mind, let’s talk about housing.
To have a job you must have a place to live. Housing is a vital commodity. Having a place to live isn’t optional.
Landlords Have Three Major Bargaining-Power Advantages Over Tenants
ONE: Housing is a vital commodity. The landlord can walk away from being a lessor for months, sometimes years. The tenant cannot walk away from being a lessee for even a few days.
TWO: It takes years to bring new housing units to market, so that while a tenant needs a place to live today, an increase in the supply of housing units may take years, if ever, before it increases enough to cause price competition that is sufficient to lower the market rate for housing below the monopoly price.
THREE: Market concentration. The overwhelming majority of housing units may be owned by a small minority of landlords. When 20% of landlords own 80% of all the housing units and the vacancy factor is low, the market drives prices up, not down.
For details on how and why this happens, see my column:
How Should We React To Monopoly Residential-Rent Prices?
How should we deal with residential rent prices far higher than the competitive-market price — the near-monopoly cost for a vital product that is controlled by a few businesses in a market with little or no price competition?
When the thing being sold is vital and there is little available additional supply at a lower price, the market drives the price for that thing UP to the highest price being charged in the market.
Economic Anarchists Say: Do Nothing
Economic anarchists say that the market should always set the price, but that theory is based on several false beliefs:
- (1) the assumption that the market for every product is always competitive,
- (2) that the market always drives prices down, and
- (3) that the market always self-corrects shortages in supply.
- Markets are not always competitive.
- Markets only drive prices down under certain conditions. When the market for a vital product is concentrated and the amount of readily available additional supply at a lower price is less than a material percentage of the market share of the largest seller, then the market drives prices up.
- For vital products whose prices are elastic and which require a large amount of time and capital to bring to market, the profit motive encourages a reduction in supply, not an increase.
So, if the market does not lower prices away from the monopoly price/maximum-revenue price and toward the cost + overhead + reasonable profit/competitive-market price, what other tool might we employ to do that?
Rent Control Or Rent-Increase Limitations?
Rent control? A nightmare in too many ways to detail here.
A cap on rent increases? This also has many weaknesses together with a material bureaucratic overhead.
Something Else
We want a tool that will drive rents closer to the competitive-market price and away from the monopoly price; one that operates quickly, clearly, efficiently and with a minimum of additional government bureaucracy.
How Do We Calculate The Competitive-Market Rent Without A Competitive Market?
We begin by looking at rental housing from an investor’s point of view.
We need to understand that the investor spectrum runs from
- Landlords who bought their income property long ago, have paid off the mortgage and have recovered their cash investment. Their costs are low and they can profitably rent their property substantially below the market rate
- Landlords who bought their income property recently and have high mortgage and property tax payments an who need a high level of rent in order to cover their costs
Rent Seen As An Interest Return On An Investment
Let’s say that you have $500,000 that you want to invest. A CD is safe, but you want more than the 1% or so interest that the bank will give you.
The stock market might get you a higher return, but playing the market takes skill and it’s risky. You want a safe investment that will generate at least several times the rate of return that you could get from a CD, let’s say a 5.5% return.
You decide to buy residential property because that is a generally safe investment and you will get the bonus of the increase in market value when you sell the property maybe ten years down the road.
How Do We Pick A Reasonable Investment Rate Of Return?
Since the economy is fluid and market rates vary widely over time, the rate of return on a residential real property investment should be tied to some external index.
The B of A rate on 30-year fixed home loans is roughly 2.2 times the Federal Reserve Discount Rate so maybe 2.2 times the federal discount rate would be a reasonable base rate of return.
The landlord’s target rate of return would be set as of the later of (1) the date the property was acquired or (2) the date the excess-rent tax law went into effect.
The rate of return would be the greater of (1) 2.2 X the Fed Rate (5.5% with a Fed rate of 2.5%) or (2) the weighted average of the interest rate or rates on mortgages encumbering the property, if any, immediately prior to the date the excess-rent tax law became effective.
If this was new property bought after the law went into effect then the rate of return would be 2.2 X the Fed rate at the time of purchase.
If there was no mortgage on the property that was owned before the law went into effect and the Fed rate was 2.5%, the rate of return would be 2.2 X the Fed rate.
If there was a 6% first mortgage on the property owned before the law went into effect then the investment rate of return would be 6% so long as that loan was a lien.
When the loan was paid off the rate would be 2.2 X the Fed rate at the end of that year.
A Floor & A Ceiling
We would want to build in guardrails to avoid unforeseen extreme situations harming either the landlord or the tenant, so the rate of return might have a floor of maybe 3% and a ceiling of perhaps 7%.
Investing In Rental Property To Get A 5.5% Return On Your Investment
An Investor Buying A Property At Today’s Market Price
Investors generally finance their purchases with a bank loan. Let’s say that four years ago the investor purchased a $500,000 house as a rental property at a time when the Fed rate was 2.5% X 2.2 = a 5.5% investor return rate.
At the end of the four years there has been a Consumer Price Index increase of 10%.
$30,250 investment return + $9,000 costs = $39,250/12 mo = $3,271/mo rent.
Because these are merely example numbers, it doesn’t matter what the actual operating costs would be. They could be $18,000 and it wouldn’t matter because the actual operating costs, whatever they might be, would be used to calculate the maximum rent the investor could charge without incurring an excess-rent tax.
In this example, if the actual operating costs were $18,000 instead of $9,000 then the maximum monthly rent would increase by $750/month from $3,271 to $4,021 before the excess-rent tax would kick in.
Rent On An Old Property Bought Many Years Ago
Mr. & Mrs. Smith bought a house for $125,000 many years ago. They have paid off the mortgage and over the years the CPI has doubled. Expenses are $9,000/year.
The Fed rate at the time the excess-rent law went into effect was 2.5% yielding an investor return rate of 5.5%.
5.5% X $250,000 = $13,750 + $9,000 = $22,750/12 mo = about $1,896/month plus utilities.
The house’s market value is $500,000. The Smiths complain, “Hey, we have to rent our property for only $1,900/month while the house next door is renting for $3,271. How unfair!”
But is it? The owner of the house next door put down $100,000 in cash and he’s only netting $250/month after all expenses.
The Smiths put down $25,000 many years ago which they’ve long since recovered, and today they’re making almost $14,000/year profit on this house. $13,750/$25,000 (original cash investment) = a 55% annual return on their original cash risk capital.
And, when they sell the house they’ll collect another $250,000 in profit only subject to capital gains taxes instead of ordinary income taxes. If they sold the house and paid the maximum $50,000 capital gains tax what kind of a return could they get on their $200,000 after-tax cash? 1%? 2%?
By comparison, if they keep the house, their annual return on that $200,000 is $13,750/$200,000 = 6.875% plus annual appreciation on of at least twice the inflation rate.
Given those numbers it’s very difficult to feel that Smiths have gotten a bad deal.
Refinanced Old Property
For mortgages effective PRIOR to the effective date of the excess-rent-tax law, the maximum rent would be the greater of (1) the return on capital based on the inflation-adjusted purchase price plus operating costs exclusive of mortgage payments or (2) operating costs plus the payments on mortgages that were in effect prior to the date the law went into effect.
What if AFTER the excess-rent tax law went into effect, the Smiths took out a big re-financed mortgage based on the property’s current market value with a monthly principal and interest payment that would put the property underwater at the rent rate calculated on their inflation-appreciated purchase price?
If they were allowed to increase the maximum rent to cover the shortfall, then every owner would be able to nullify the rent cap by refinancing their property, pulling out huge amounts of tax-free money and then raising their rent to close to the high rents charged by the new property owners.
So, the max rent needs to be calculated on the inflation-appreciated purchase price and it will be up to the owners to avoid incurring additional mortgages after the effective date of the law that would result in the maximum rent being insufficient to service the operating costs plus the new mortgage payments.
Otherwise we’re just converting old owners whose rents can be kept low into new owners whose rents are very high so that they can pull out tax-free cash and invest it elsewhere.
An Excess-Rent Tax On Rents Above That “Reasonable” Rate Of Return
In our first example above, let’s say that when the investor filed his/her tax return at the end of the year, s/he submitted receipts showing that s/he spent $9,000 on taxes, insurance, and maintenance, a copy of the sale documents showing that s/he bought the property for $500,000 four years ago; the notation that the published CPI has gone up by 10%, and report that s/he received $3,271/mo in rent. Great.
But suppose that instead of $3,271/month rent, s/he charged rent of $5,000/month — $60,000/year.
What if the government reviewed his/her tax return and said, “Given your expenses and at a 5.5% return on your inflation-adjusted investment your rental income should have been $39,252. You collected $60,000. You owe us $20,748 as an excess-rent tax”?
The Effects Of An Excess-Rent Tax
How would the existence of such a tax affect a landlord’s conduct?
ONE: It would discourage the investor from charging much more than the $3,271/month.
Sure, the investor might want to charge a little more to cover unforeseen expenses like replacing the water heater ($1,800) or the like. And if s/he knew that the house was soon going to need a new roof that would cost $10,000 and knew that the government had set a fixed amortization period of 5 years for major repairs, s/he would have collected an extra $3,800 or so this year.
The interest on any money s/he borrowed to finance the roof repairs would also be a deductible cost or, if s/he paid it out of savings, the lost interest would be a deductible cost.
TWO: Because all the expenses are deducted from the tax calculations, the tax would encourage the investor to spend money to keep the property in good repair or at least not deter him/her from making repairs.
THREE: Because the tax calculation is based on the original purchase price adjusted for inflation, not just what the investor originally paid for the house, as inflation increased the property’s value each year, the amount of rent the investor could charge without incurring an excess-rent tax would also increase.
For example, if four years after the investor purchased it the total inflation factor was 10% then the rent could increase to 5.5% X $550,000 = $30,250 or a $2,750 rent increase, so as inflation increased the original value of the property, the return on investment would increase.
Remember, s/he invested $500,000 with a target of a 5.5% return, $27,500/year. If the net capital return increased from $27,500 to $30,250/year then the new rate of return would be $30,250/$500,000 = a 6.05% return on the investment.
FOUR: The tenant’s rent would also increase over time, but at a rate less than the inflation-adjusted percentage increase in value of the real estate. The first year’s rent would have been $27,500 + $9,000/12 = $3,042. In this example, while the property’s inflation-adjusted acquisition value increased by 11% ($550,000/$500,000) the rent increased by only 7.5% ($3,271/$3,042).
FIVE: Because any rent above the set rate-of-return would be taken away in excess-rent taxes, the investor would effectively be prevented from materially increasing the rent without the need for any rent stabilization boards, complaints, hearings, enforcement process and all the other complexities and bureaucracy of some kind of a rent-control system.
- Under such a system the landlord would recover all his/her costs plus an initial market rate of return that increased over time with inflation plus the big rewards of income-property ownership — depreciation tax deductions and capital gains on the appreciation when the property was eventually sold.
- The tenant would get a rental rate based on adjusted purchase price, costs of operation and a reasonable level of profit to the landlord (initially 5.5%) with rent increases limited to increases in operating costs and an inflation-adjusted appreciation in the property’s value.
Roll Over Excess-Rent Tax Credits In Subsequent Years
For the most recent ten years of ownership, the amount by which rents received were less than the maximum rent would be rolled over as a credit against excess-rent taxes accruing in future years or excess-rent taxes paid in previous years.
This rollover feature would even out expenses that one year were higher or lower than expected and income that was higher or lower than expected.
Summary
Landlords with low or no mortgages would have an economic disincentive (the 100% excess-rent tax) to charge the same, high market-rate rent that landlords with substantial mortgage-payment obligations must charge in order to break even.
Every landlord could charge rent up to but not exceeding break even plus a reasonable rate of return on their inflation-adjusted investment but not rents that would pay a rate of return higher than the reasonable rate of return on that inflation-adjusted investment.
Tenants would avoid large rent increases and pay rent based on their landlord’s costs and inflation-adjusted acquisition value instead of rent driven up to the highest price in the market irrespective of high or low risk capital invested and operating costs incurred.
All of that would happen without the bureaucracy of rent control or a government agency setting a fixed price for vastly differing properties with differing expense structures.
— David Grace (Amazon Page — David Grace Website)
