Feature
by Elizabeth Miller
Every year landlords make investments in their properties: exterior painting, new windows, replacement of water heaters and upgrades to the common areas of their buildings. And every year landlords face the restrictions of rent control, which force the acceptance of below market rents in a city with ever-rising costs. Under the San Francisco Rent Ordinance, building owners may pass through some or all of the capital improvement costs incurred on their property to their tenants. The landlord, or an agent working on behalf of the landlord, must submit and have certified a petition to the San Francisco Residential Rent Stabilization and Arbitration Board following the rules set forth by the ordinance. While the ordinance itself seems long and daunting to many building owners and an appearance in front of the Rent Board is, for others, something to be avoided at all costs, capital improvement passthroughs are a legal way to increase rents in the city of San Francisco beyond the yearly miniscule percentage given out each March. In this way, capital improvement passthroughs can increase the monthly amount of rent above and beyond the base rent paid by tenants.
The Question
In a building with 1-5 residential units under rent control, 100% of the capital improvement cost incurred may be passed through to the tenants. These costs are then amortized over a 10-, 15- or 20-year period, depending upon the type of improvement. The amortization (a payment of a cost using monthly installments) is determined by the Rent Ordinance and based upon the expected life of the capital improvement. For example, an owner who has painted the building exterior would expect the paint to last at least 10 years, while the replacement of the building’s pipe system should last at least 20 years. Therefore, the cost is amortized over the lifetime of the improvement. For those tenants who live in the building for the life of the exterior painting, or ten years, they will pay monthly for the benefit of the completed work.
Buildings with six residential units or more are permitted to pass through 50% of capital improvement costs to the tenants, with the exception of seismic upgrades, which are passed through 100%. The amortization rates for these buildings are 7 and 10 years for capital improvements and 20 years for seismic upgrades.
For all capital improvements, owners are permitted to pass through all or part of the cost with interest. Interest, whether a true cost incurred by taking out a fixed-rate loan to pay for the work or an imputed rate established by the Rent Board, is amortized over the same period as the cost of the job.
As with all rent increases in San Francisco, there are extensive rules for passthroughs: how much of a passthrough is permitted each year; how to submit the data to the Rent Board, such as invoices and/or quotes and proof of payment; the correct forms to use; proper notice served to the tenants; and conforming to deadlines established by the ordinance. All of the rules for submitting data to the Rent Board, as well as the seemingly formidable hearing in front of an administrative law judge, with or without tenants in attendance, can lead an owner to ask: “Is it worth it?”
The Answer
Many owners have tenants who for one reason or another are paying well below market rent. More often than not, even when a tenant has been in the building for years and has received all annually allowed increases, the current rental rate is severely under the amount that could be obtained if the same unit was vacated and put on the market today. When given the rare opportunity to use another vehicle to raise the rents on those tenants, why not use it? (Capital improvements may be passed through to only the tenants with under market rates, if that is what the owner chooses.) If a tenant is paying $375 per month rent in a unit that could earn $1,200 in today’s market, why not try to bring the rent up in any legal way possible? Capital improvement passthroughs will probably be unable to bring the below market rental rate up to market rates or even close, but it is almost always worth doing.
Take, for example, a 3-unit building where Unit 1 rents for $765, Unit 2 rents for the market rate of $1,400 and Unit 3 rents for $800. If the owner spent $10,000 to paint the exterior of the building the calculations would be: $10,000 times the imputed (or actual interest rate up to 10%) for this improvement amortized over 10 years. In this case, using the Rent Board’s imputed 4.3% interest rate, the sum would be $12,324 over the 10-year period, or a $34.23 increase per month, per below market tenant.
The owner could choose which tenants should be noticed for the increase. In this particular building, Units 1 and 3 are below market rate and could be increased $34.23 a month or $410.76 per year, each. For the two units, $821.52 will be paid back to the owner for the cost of painting the building (with interest) each year, money spent by the owner and paid by the tenants. Ten years could seem like a long time to collect monies already spent, and many times the tenants move before the term is over. If they move, the unit comes up to market rent and the passthrough for that unit is no longer collected. However, in many cases the tenants with the lowest rents have been in the building for years, if not decades, and will not move out over $34.23 per month.
The above calculation is one example of the monetary benefits of the passthrough. Other examples may have a higher or lower rate of return. If an owner has a 40-unit building and is trying to pass through work that only cost $5,000, the return will only be 64 cents per month per unit at a 10-year amortization. Even in this case, is it worth it? Well, it is still more money than the owner had before and the tenants are paying for work that directly benefits them. Also keep in mind that most owners have completed many capital improvements over the years. In the same 40-unit building, there were probably many improvements done, some big, some small; over the years, these costs add up. Owners who consistently pass through their capital improvements receive a higher return on their investments, one month at a time.
Improvements have to be made on buildings at some time or another and, since the dawn of rent control, owners have had to face the rising costs in San Francisco with limitations on the rents they may charge. Should owners absorb the cost of capital improvements and call it the cost of doing business or should they pass on the cost to the residents in a legally approved manner? Whether owners use their time to comply with the many rules of submitting a capital improvement petition through the rent board or hire someone to do the paperwork, we think we have proven that it is worth it to utilize the opportunity to raise rents through improvements in San Francisco. The landlord should take advantage of the system; if more dollars are spent on the building, more should be made.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or the San Francisco Apartment Magazine. Elizabeth Miller has been in the rental housing industry for 11 years and is currently the petition specialist with Property Management Systems. She can be reached for a consultation on Rent Board issues at 415-661-3860. Copyright © 2006 by the San Francisco Apartment Magazine. All rights reserved.