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When an investor allocates capital to a real estate investment, they implicitly accept some level of risk with the expectation of achieving a positive return. The best of them have an uncanny ability to maximize return while managing or mitigating risk.
When evaluating a potential deal, it is common to analyze several types of risk: the market risk that rents move in an unexpected direction, the interest rate risk that may make it challenging to refinance a loan and the risk associated with the deterioration of a property’s physical structure. All are important components of analyzing a potential investment, but I would argue that there’s a fourth type of risk that’s equally important, but often overlooked in the due diligence phase: regulatory risk.
Regulatory Risk, Defined
We define regulatory risk as the possibility that real estate will become less profitable to own or more challenging to manage as a result of changes in the laws and regulations that govern multifamily residential properties. To complicate the picture, these laws can vary from one city and/or state to another. Thus, it is incumbent upon the investor to understand their responsibility — or potential responsibility — to comply with the regulations that govern their ownership. But, those laws can change, and that is the risky part.
Recent months have brought four great examples of ways that regulatory risk can impact the ability of an investor/operator to make a return on their investment:
1. California Assembly Bill 1482 was passed in 2019 but became effective on January 1, 2020. It mandates two major changes that will impact multifamily owners:
• It limits rental increases, statewide, to “5% plus the percentage change in the cost of living, as defined, or 10%, whichever is lower,” and prohibits “an owner of a unit of residential real property from increasing the gross rental rate for the unit in more than 2 increments over a 12-month period, after the tenant remains in occupancy of the unit over a 12-month period.”
• It also prohibits “an owner, as defined, of residential real property from terminating a tenancy without just cause.”
2. In February 2020, the Seattle city council voted to enact a moratorium on evictions during the wintertime months of December 1 to March 1. The rule applies to low- and moderate-income units and exempts landlords who own four or fewer units, but Seattle is the first city in the nation to enact such a lengthy eviction ban.
3. In January 2020, Jersey City’s special committee on new rent control legislation produced a draft ordinance that would significantly boost tenant protections and require landlords to include details of rent control in lease agreements. It would also create new oversight capabilities for Jersey City’s office of landlord/tenant relations.
4. In November 2019, the city of Berkley, California, proposed an ordinance that would prohibit landlords from performing criminal background checks on potential tenants, with certain exceptions.
These examples are part of a larger wave of tenants’ rights legislation appearing before cities and states across the United States. They also underscore the need to carefully examine existing or planned state and local rental ordinances to determine if and how they’ll impact investment returns.
Regulatory Risk Mitigation Strategies
While I enthusiastically support a tenant’s right to have a clean, safe and fairly priced place to live, I’m also in the multifamily investment business. My firm is accountable to our shareholders, who expect a return on their capital. To that end, we employ and recommend a variety of strategies that seek to mitigate regulatory risk.
To start, portfolio diversification is a bedrock principle of any comprehensive risk management program. In addition to size, class and price, also seek to diversify your portfolio by location. Stay away from cities and states that place an onerous burden on multifamily owners/operators, and focus on high-growth, landlord-friendly locations. Combined, these efforts can minimize your exposure to any one regulatory body and the risk that new legislation will render a property unprofitable.
Next, get involved. Being a good partner and asset to the local community is not just a good business practice; it’s a way to stay abreast of regulatory developments and allows you to get ahead of proposed changes by taking appropriate action.
Lastly, and perhaps most importantly, take your responsibility as an owner/operator seriously. Seek to treat every tenant with dignity and respect. Understand that situations are unique and that financial emergencies happen. Strive to be proactive by making every effort to keep tenants happy, comfortable and in units they can afford.
The next time you are analyzing a potential multifamily investment, I recommend taking the extra step of investigating the prevailing regulatory climate to determine if it poses a risk to the deal’s profitability. I encourage you to speak with local government representatives, city council members and other multifamily owners to perform your assessment and use their feedback as a vital input to your risk-management program.