Five Things: Will Prop 33 Destroy California's Housing Market?

Tenant advocates hope third time's the charm for controversial ballot initiative

With the election just weeks away, both sides of California’s fierce housing debate are pleading their case that Proposition 33 will either save or destroy the state's badly broken housing market.

The arguments are hyperbolic, consistent with 2024’s apparently theme of existential questions being decided at the ballot box.

So let's dive in to just what's at stake this year with Prop 33.

1) Background, please

Proposition 33 is the latest in a trio of state ballot initiatives aiming to expand protections for the 44% of California households that rent their homes.

Known by proponents as the "Justice For Renters Act," Prop 33 would repeal Costa Hawkins, a 1995 law passed limiting what rent control restrictions California cities can enact within their borders.

Prop 33 (along two previously failed attempts - Proposition 10 in 2018 and Proposition 21 in 2020), is backed by the Los Angeles-based AIDS Healthcare Foundation, and counts support from labor unions and tenant advocacy groups.

Unsurprisingly, the initiative is opposed by real estate trade groups and landlord associations, and even has the formal opposition of the LA Times, San Francisco Chronicle and California Governor Gavin Newsom.

The primary financial backer of these initiatives, AIDS Healthcare and its leader Michael Weinstein, have spent an estimated $100 million in the past three years in support of these initiatives.

Maybe the third time will be the charm.

2) Wow, this Costa Hawkins thing must be pretty bad then, right? Right??

Well, not really.

Enacted in 1995, Costa Hawkins prevents cities from putting in place some of the more draconian rent control restrictions found in other cities and states.

Specifically, Costa Hawkins states that buildings completed after 1995, condos and single family cannot be subject rent control restrictions. The statute also mandates "vacancy decontrol," which means landlords can charge market rent after an apartment is vacated.

Opponents of Prop 33 fear that wider rent control restrictions will further deter developers from building new housing, which could exacerbate the already high cost of housing in many California cities.

Importantly, repealing Costa Hawkins would not automatically place new construction and single family homes under the jurisdiction of existing rent control laws in cities like San Francisco or Los Angeles. A Yes on Prop 33 means cities would have the freedom to enact new legislation and wrap more housing into existing rent control regimes or create new ones.

3) That doesn’t sound too bad, so what’s everyone afraid of?

Setting aside the the fact that economists nearly unanimously agree that rent control is a net negative for renters, there are two major concerns if Costa Hawkins get wiped off the books.

First, rent control on new construction would limit a developer (or future owner's) ability to raise rents along with the market, making the projects less valuable.

A less valuable finished building means less profit for the developer, which means fewer projects get built. That doesn't bode well if you believe more of a thing makes it cheaper (ie supply and demand).

Minneapolis/St Paul is an interesting case study on this topic, and perhaps the best A-B test for rent control we have in the wild.

Minneapolis enacted rent control in 2021 for the entire metro region, after which neighboring St. Paul include new construction in its new 3% annual cap on rent increases.

Almost overnight, developers delayed or canceled projects, and housing construction dropped dramatically in the wake of the new law.

Witnessing the reaction, Minneapolis took a more measured approach, and even St. Paul reversed course the following year and exempted new projects from rent restrictions.

Second, and perhaps most concerning, is that repealing Costa Hawkins puts the specter of Vacancy Control on the table.

Vacancy Control, which is Prop 33's true bogeyman, is the most significant risk to California housing markets buried within the repeal of Costa Hawkins.

In jurisdictions with Vacancy Control (segments of New York for example), landlords are limited in how much rent they can charge once a unit becomes vacant. The allowable rent increase is usually tied to the rent previously charged plus a small portion of renovation costs needed to get the unit ready to lease.

Tenant advocates argue that this dynamic keeps rents low and affordable for tenants of all income levels.

However, the rent cap limits an owners' ability to recoup renovation expenses, capital improvement costs, and in the long-run makes it nearly impossible to keep up with rising operating costs.

This means in delayed repairs, leaky roofs, pests, capital flight, and the gradual destruction of a city’s housing stock. So say Prop 33 opponents anyway.

Stricter Vacancy Control rules enacted in 2019 have been disastrous for New York City, with property values declining precipitously even though rents have continued to rise, as owners choose to keep units off the market rather than invest in money-losing upgrades.

4) Yeah but let’s talk about San Francisco, where my friend’s daughter just moved into a $4,200 1-bedroom in the Marina that her dad pays for, with a vintage range and leaky clawfoot tub a block away from the Palace of Fine Arts … wait, she won’t benefit from this, right?

Don’t worry, she’s already protected by existing SF rent control (remember, rent control isn’t means tested).

Even though San Francisco rent control is among the strictest in the country, the repeal of Costa Hawkins would have a dramatic impact on the local housing market.

Setting aside the indirect impact of giving capital yet another reason not to invest in building new housing in San Francisco, property values would drop overnight.

For example, for a potential acquisition we’re currently underwriting, we project that the annual rental income of $500,000 will rise to around $700,000 within five years, partly thanks to tenants with recent, but below market leases we expect will move out.

This dynamic is part of what makes investing in San Francisco apartments appealing, there is an embedded market-to-market as tenants move out.

Modifying our pro forma to include Vacancy Control, the property is worth about 20% less overnight, and that doesn’t account for any knock-on effects if investors cross off San Francisco like they have New York.

5) Who cares about those real estate fat cats, rent control protects the little guy, the working man.

Yeah, not really.

The real loser, ironically, would be lower and middle income tenants.

Borrowing an example from San Francisco real estate broker Dimitris Drolapas:

Dimitris is right - there’s no free lunch.

Rent control protects a tiny fraction of the renter population, at the expense of the rest. And expanding these restrictions means a more unequal housing market that works for fewer and fewer Californians.