Surreal Estate

A Unit in Time

written by Justin A. Goodman

New and proposed laws enhance
tenant protections and lower rents
by adjusting the length of occupancy and ownership.

Editor’s Note: We are pleased to bring you the debut of “Surreal Estate,” a quarterly column where landlord attorney Justin Goodman will explore the intersection of market innovation and evolving regulation. Goodman is a regular contributor to the magazine’s Legal Q&A and with this column adds his take on our ever-changing and sometimes surreal market. 

Real property is unique. At least, that’s how the law generally regards it. “Contracts” can take many forms and encompass many subject matters. All contracts involve a legally enforceable promise (made enforceable either by another promise or an invited performance), but most are only enforced for a money judgment (the dollar amount that compensates the non-breaching party). However, real estate contracts can often be enforced for recovery of the real property itself—money cannot compensate for something unique.

And yet the rental housing market attempts to commodify “housing” as much as possible. From that perspective, higher density is better than a single-family home; deregulation is better than price-controls; short term leases are better than eviction-controlled, long-term tenancies; and most importantly, market certainty is better than murky regulation (or lack thereof), inviting investment in known quantities. Although, as with any market, this one sees participants pushing the line on where innovation either transgresses regulation or invites more. This column will explore where that line is today and how novel market participation either expands or contracts the market, based on the reaction (or prescience) of regulators (like the Board of Supervisors, the Rent Board, the Planning Commission and even the State Legislature).

San Francisco’s recent regulations express its preferences about length of occupancy and length of ownership for its rental housing stock. Both agendas expand housing opportunities for longer term tenants, but unfortunately, they cost owners a great deal of flexibility.

For as long as modern rent control has existed, courts have prevented rent regulations that are “confiscatory.” This generally means that price controls may limit rents but must allow them to outpace inflation so that the owner maintains a return on investment. (Rent control ordinances, including the new statewide price controls, are keyed to changes in CPI for this reason.)

Returns on investment are also inhibited by the costs of updates and improvements. Where tenants naturally move in and out, landlords are motivated to renovate vacant units to charge the highest rents. But for long-term rent-controlled tenants, the incentive to stay put increases over time. For these same tenants, it is inevitable that carpets wear thin, cabinetry deteriorates, tile chips, etc., while landlords lose opportunities to update. When rent control distorts these incentives, “passthrough” regulations can help restore balance (and maintain minimum income requirements in the process).

Operating and maintenance (O&M) expenses also diminish returns. San Francisco will consider year-over-year increases in water and sewer service charges, janitorial services, garbage removal, elevator service, insurance, routine repairs and maintenance in authorizing O&M passthroughs. Until 2018, it would also consider changes in debt service and real estate taxes to allow newer owners to afford carrying costs when they took on debt to purchase property and faced increases in property taxes following the change in ownership.

However, in April of 2018, the Board of Supervisors prohibited O&M passthroughs for debt service and for increases in property taxes resulting from changes in ownership. The legislative findings stated that that, “more and more landlords have sought O&M increases on the basis that their debt service and property tax costs have suddenly increased. But these costs do not reflect amounts that were reinvested to maintain or improve the buildings. Rather, the landlords claiming these increases are new buyers who are seeking to offset the costs of acquiring property.”

The findings concluded that “property tax and debt service are not true O&M expenses, and treating them as such encourages real estate speculation, fuels tenant displacement, and circumvents the purpose of rent control.” By increasing the effective cost of ownership for new buyers, San Francisco was blunt in expressing its preference for the type of owner it wants—the long-term landlord who won’t (or can’t) sell her apartment building. The long-term tenant breathes a sigh of relief, as everything stays the same forever.

The ordinance doesn’t specify which landlord’s use of O&M passthroughs prompted the change, but it anecdotally refers to a December 11, 2017 article in the SF Chronicle. That article treats Veritas Investments/Greentree Management as the poster child for the practice, which had been on the books for decades. (This is the legislative equivalent of being passive aggressive.)

Laws like this generally cannot apply retroactively, but Veritas voluntarily waived its valid increases as tenant unrest culminated in rallies and protests by September of 2019. While not necessarily because of the conflict, Veritas took steps to sell a large number of apartment buildings mere months later. The offering is noteworthy, not only because it represents roughly a third of the portfolio of one of San Francisco’s largest landlords, but also because it features an early example of the “Community Opportunity to Purchase Act” (COPA) in practice.

COPA requires that sellers of multi-unit residential property give qualified nonprofit purchasers a “right of first offer” and “right of first refusal.” Sellers comply by emailing information about the number of units and rental rates to each of the qualified nonprofits designated by The Mayor’s Office of Housing and Community Development. If a nonprofit responds within five days, they have 25 more days to make a purchase offer. (This also preserves their right of first refusal, if the seller accepts an offer from a private buyer.)

COPA is one of the bigger changes in San Francisco housing law this decade (arguable the condemnation of property for public use, but without the bother of a lawsuit). But it became effective without challenge—perhaps because of the ease of compliance. COPA’s mechanisms allow owners to easily notify the nonprofits, who can efficiently preserve their right to acquire affordable housing for the market-clearing price (set by a ready, willing and able buyer), all with a simple email.

Although, efficient is not always effective: the city initially accused Veritas of timing the notification over the holidays to hinder a timely response, demanding even more time to present offers. It was later reported that a nonprofit’s timely response got caught in a spam filter.

Veritas is starting its COPA compliance from scratch, and nonprofits are getting another chance to bid. The city’s affordable housing budget may spare long-term tenants from shouldering some of the contemporary carrying costs for a newer owner. Although this outcome will be a little ironic.

COPA compliment’s San Francisco’s Small Sites Program, which for years has allowed nonprofits to purchase lower-rent buildings and maintain them as permanent affordable housing. However, Veritas’ tenants might be surprised to learn that the Small Sites Program plays by its own rules. It can afford market prices, in part, because the units are no longer protected by rent control.

Instead, rents are expected to average 80% of area median income. Some tenants will benefit more than others, but the means-tested program requires that tenants pay at least 20% of their income in rent. It also requires that they move into smaller units if their existing rental is “too much housing” for their household size. Annual rents must increase as much as 3.5%, and the nonprofit can petition for further increases to maintain “financial feasibility.” And this sounds similar to what Veritas was trying to do, but the city ultimately fulfills its goal of ensuring long-term ownership and long-term occupancy.

Proposed legislation also hopes to limit tenant turnover by toggling the allowable length of new tenancies. Supervisor Peskin’s amendment to the Planning Code would create a new use type, called “intermediate length occupancy”—defined as offering a unit for occupancy “for a duration of greater than 30 consecutive days but less than one year.”

The amendment appears to be motivated by a specific project on Market and Church, which offers units for corporate rentals, but would apply city-wide. While occupants of corporate rentals actually live in their units, they may not be staying in the city long-term or will at least be looking for long-term housing before they do. The amendment wouldn’t ban the use outright but would strictly limit development.

The change would follow a pair of amendments to the Residential Hotel Unit Conversion and Demolition Ordinance (HCO), also sponsored by Supervisor Peskin. The first amendment prevented private hotel operators of SRO units from leasing for a term less than 32 days. Residential hotel operators challenged the law and sought an injunction. They argued that the change in timing eliminated their formerly lawful ability to offer units for shorter, traditional hotel stays. They were forced to be landlords rather than hotel operators.

The Court of Appeal reversed the trial court’s initial denial of the preliminary injunction, but while the hotel operators were making progress on their case, the city amended the HCO again—changing minimum rentals from “32” to “30.” What happens over those two days? By day 31, the occupant becomes a tenant at state law. By day 32, she acquires all the protections of the Rent Ordinance (see sidebar page 14).

Taken together, these regulations advance the city’s affordable housing agenda by focusing on timing of occupancy, rather than expanding substantive rights themselves. If occupants are in possession longer, their rents will tend to be lower. Unfortunately, it comes at the cost of owners’ flexibility in exercising their property rights.

Justin A. Goodman is with Zacks, Freedman & Patterson, P.C. and can be reached at 415-956-8100.