Tuesday, 11 March 2014

Rent controls are efficient

Or so says Cameron Murray at the Fresh Economic Thinking blog. And whats more he claims to have 17 million reasons for it being so! Well I have only one reason for him being wrong, a below equilibrium price. Given that at such a price you have an excess demand, its hard to see how this can be called efficient.

Murray points to a situation in the US where one Herbert Sukenik was paid US$17million in 2005 to leave his rent-controlled NYC apartment by a developer who wanted to redevelop the Mayflower Hotel, in which Sukenik lived, adjacent to Central Park. The building was occupied by many long-term tenants under New York’s rent-control laws. This meant that tenants could only be evicted upon mutual agreement. Most tenants accepted offers ranging from $650,000 to $1million to leave but Sukenik held out for a US$17million lump sum payment, in addition to the developers offering him another apartment to live in for the rest of his life for a peppercorn rent of $1 per month.

What I don't get this how this shows rent control is efficient. Or says anything much about rent control at all. To me what this shows is that in low transaction situations where bargaining is between just a few people the Coase theorem holds. If one party, the developer, values an asset more highly than the current holder of the asset, the tenant, then the higher valuing party can buy the property rights to the asset from the lower valuing party. The price paid is just a transfer between the parties with no implications for efficiency.

The question that economists  would ask is, Should there be rent control in the first place? No this question most, more than 90% of economists according to surveys, would have grave doubts. Economist Assar Lindbeck went so far as to say, “In many cases rent control appears to be the most efficient technique presently known to destroy a city—except for bombing.” In fact those apossed to rent control range from Milton Friedman and Friedrich Hayek to Gunnar Myrdal. Myrdal stated, “Rent control has in certain Western countries constituted, maybe, the worst example of poor planning by governments lacking courage and vision.” And its not often you get Friedman, Hayek and Myrdal agreeing!!

Walter Bock outlines some of the issues economists have with rent control,
Economists have shown that rent control diverts new investment, which would otherwise have gone to rental housing, toward greener pastures—greener in terms of consumer need. They have demonstrated that it leads to housing deterioration, fewer repairs, and less maintenance. For example, Paul Niebanck found that 29 percent of rent-controlled housing in the United States was deteriorated, but only 8 percent of the uncontrolled units were in such a state of disrepair. Joel Brenner and Herbert Franklin cited similar statistics for England and France.

The economic reasons are straightforward. One effect of government oversight is to retard investment in residential rental units. Imagine that you have five million dollars to invest and can place the funds in any industry you wish. In most businesses, governments will place only limited controls and taxes on your enterprise. But if you entrust your money to rental housing, you must pass one additional hurdle: the rent-control authority, with its hearings, red tape, and rent ceilings. Under these conditions is it any wonder that you are less likely to build or purchase rental housing?

This line of reasoning holds not just for you, but for everyone else as well. As a result, the quantity of apartments for rent will be far smaller than otherwise. And not so amazingly, the preceding analysis holds true not only for the case where rent controls are in place, but even where they are only threatened. The mere anticipation of controls is enough to have a chilling effect on such investment. Instead, everything else under the sun in the real estate market has been built: condominiums, office towers, hotels, warehouses, commercial space. Why? Because such investments have never been subject to rent controls, and no one fears that they ever will be. It is no accident that these facilities boast healthy vacancy rates and relatively slowly increasing rental rates, while residential space suffers from a virtual zero vacancy rate in the controlled sector and skyrocketing prices in the uncontrolled sector.

Although many rent-control ordinances specifically exempt new rental units from coverage, investors are too cautious (perhaps too smart) to put their faith in rental housing. In numerous cases housing units supposedly exempt forever from controls were nevertheless brought under the provisions of this law due to some “emergency” or other. New York City’s government, for example, has three times broken its promise to exempt new or vacant units from control. So prevalent is this practice of rent-control authorities that a new term has been invented to describe it: “recapture.”

Rent control has destroyed entire sections of sound housing in New York’s South Bronx and has led to decay and abandonment throughout the entire five boroughs of the city. Although hard statistics on abandonments are not available, William Tucker estimates that about 30,000 New York apartments were abandoned annually from 1972 to 1982, a loss of almost a third of a million units in this eleven-year period. Thanks to rent control, and to potential investors’ all-too-rational fear that rent control will become even more stringent, no sensible investor will build rental housing unsubsidized by government.
So the landlord may have a tough time of it but what about the effects on the tenants, it has to be good for them, right?
Existing rental units fare poorly under rent control. Even with the best will in the world, the landlord sometimes cannot afford to pay his escalating fuel, labor, and materials bills, to say nothing of refinancing his mortgage, out of the rent increase he can legally charge. And under rent controls he lacks the best will; the incentive he had under free-market conditions to supply tenant services is severely reduced.

The sitting tenant is “protected” by rent control but, in many cases, receives no real rental bargain because of improper maintenance, poor repairs and painting, and grudging provision of services. The enjoyment he can derive out of his dwelling space ultimately tends to be reduced to a level commensurate with his controlled rent. This may take decades, though, and meanwhile he benefits from rent control.
And then there is the "old lady effect".
Consider the case of a two-parent, four-child family that has occupied a ten-room rental dwelling. One by one the children grow up, marry, and move elsewhere. The husband dies. Now the lady is left with a gigantic apartment. She uses only two or three of the rooms and, to save on heating and cleaning, closes off the remainder. Without rent control she would move to a smaller accommodation. But rent control makes that option unattractive. Needless to say, these practices further exacerbate the housing crisis. Repeal of rent control would free up thousands of such rooms very quickly, dampening the impetus toward vastly higher rents.
So some tenants gain from rent controls  while others lose, what determines who wins and who doesn't?
If the building in which he lives is in a good neighborhood where rents would rise appreciably if rent control were repealed, then the landlord has an incentive to maintain the building against the prospect of that happy day. This incentive is enhanced if there are many decontrolled units in the building (due to “vacancy decontrol” when tenants move out) or privately owned condominiums for which the landlord must provide adequate services. Then the tenant who pays the scandalously low rent may “free ride” on his neighbors. But in the more typical case the quality of housing services tends to reflect rental payments.
If local or central government thinks that some high social end is served by allowing tenants to sit on someone else's property in perpetuity at below market rents, then it should use public funds, after proper democratic deliberation, to buy or lease the premises for market value which it can then lease out to people they believe are in need. Or they could use public funds to supplement these people's income. Tax increase would at least get across to voters the idea that low cost housing does indeed cost rather than hiding that cost by forcing it upon a subset of society, landlords.


Cameron Murray said...

Paul, you can't say "The price paid is just a transfer between the parties with no implications for efficiency" and then quote a bunch of reasons it is inefficient. It's either just a transfer or it's not.

I think you miss the bigger picture point that freehold rights are also a form of 'rent control' in that the freehold owner is given the rights to extract all the rent.

Your last paragraph simply reiterates the belief that freehold title is somehow a 'natural right' and that any other form of right, say to tenants, is somehow unnatural and inefficient.

In many places all property is held in leasehold title from the government on long term leases for peppercorn rents (for example, the whole of the ACT). Is this also inefficient? Because it is an identical situation with two different parties.

Would you think the efficiency impact would be different if the tenant could trade their lease?

Paul Walker said...

Given there is an allocation of property rights, and there is, the transfer is not the problem, thats just someone gets X and someone pays X, net zero. The issue is here is the allocation of property rights in the first place. Under rent controls the allocation could be inefficient for the reasons stated. It is hard to see a permanent excess demand as an equilibrium,

The right for an owner to let a tenant use his property is fine as long as the terms of the contract are freely agreed to. Under rent control they are not. The price (rent) is not the market price, its below the equilibrium rate in a situation where the landlord would clearly prefer, and could get, the market rate, if it was not for the rent control.

As an NZer its hard for me to see anyone wanting any part of the West Island at any price!! But a peppercorn rent could be the market price for ACT!