Sunday, March 9, 2014

17million Reasons Rent Control is Efficient


The case of Herbert Sukenik being paid $17million in 2005 to leave his rent-controlled NYC apartment has been receiving a great deal of attention online recently. 

At the risk of perpetuating the brilliant viral marketing campaign for Michael Gross’ new book, which is in fact the source of the story, I want to make a brief comment about it to counter some of the bizarre, emotional, and inconsistent reactions I have seen.

A short version of the story is that billionaire developers Arthur and William Zeckendorf paid $401million for the Mayflower Hotel adjacent Central Park, planning to turn the site into 202 super-luxury apartments.

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, which in turn led to the new owners offering attractive lump sum payments to tenants for them to leave the building. While most tenants accepted offers ranging from $650,000 to $1million, the final tenant held out for an astonishing $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.

To me the most astounding part of the story has been the reaction by the press and social media, which has been of outrage over the injustices of rent control - that for some reason poor old Sukendik didn’t deserve the money.

There have also been cries of rent-control hindering development - that somehow rent-control is ‘inefficient’.

This absolutely wrong. Wrong, wrong wrong.

First, almost everyone has ignored the key fact that a developer buying the building knowing that rent-controlled tenants are occupying it should have expected these expenses and subtracted them from the purchase price. Thus, the tenants win at the expense of the previous building owner. The developer does not lose unless some unexpected legal loophole was exploited (which doesn't appear to be the case) - it is merely that the economic rent was shared between the previous owner and the previous tenant.

It is therefore not any less efficient than in the absence of rent control. No one sees the previous building owner holding out for $401million as inefficient, yet it is exactly the same dynamic at play. 

The second point routinely ignored is that rent-control describes a general set of rules about renting. That the NY set of rules allows this to happen doesn't mean that another set of rent-control rules could be implemented that had mechanisms for relocation and prescribed methods for calculating compensation payments to tenants. After all, in the freehold world there are generally accepted methods for compensation for land owners upon compulsory acquisition by a government authority.

Third, if Sukenik owned his apartment in freehold he would have had the same power to hold out and extract this price from the developer. This happens routinely in Australia and elsewhere when strata-titles buildings are redeveloped. The last hold out seller extracts a massive payout. Yet we see nothing at all wrong with that because they have ‘the right’ to do it. Yet under a different set of laws, tenants could also have such rights, which they did in this case. 

What really surprises me is that almost everyone who has written a reaction to the incident seems to fall on the side of the developer. If the developer had kicked out the tenant for $10,000 it wouldn't be news, but it would have been equivalent to 'Developer screws tenant of their rightful $17million compensation’.

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10 comments:

  1. But none of this is the reason economists are opposed to rent control, as you will well know, so I'm not sure of your point. The problem here isn't about the payment to Sukenik, it's having rent control in the first place.

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    1. So far I haven't actually seen a coherent argument against rent control. Typically all I get is a diagram with supply and demand with a horizontal line drawn on it. But those who make arguments this way don't seem to have a clue about property markets, and typically don't understand the real options issues involved with property development. It's as if that simple model can just be applied to any allocation problem and viola!

      The best reason I've heard so far is that for a given site the existence of residential rent-control on a building means that redevelopment of sites may directed towards non-residential uses instead. But this outcome is easily eliminated with zoning rules that stipulate that only residential uses are acceptable.

      I've heard different views on the decreased incentives for maintenance by owners, but these can be avoided by allocating minor maintenance responsibilities to tenants, as is the case in Germany.

      I'd be happy to hear your reasons.

      If it's not about efficiency of development, which in this case was unhindered despite the payment to the tenant, exactly what argument is left?

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    2. Sure, that's exactly the type of fairly incoherent argument I was talking about. I also read this before responding to your point, which shows the empirical evidence is much more ambiguous than the theoretical arguments.

      All these issues noted in your link are very specific to particular sets of rules in particular cities.

      Further, like almost every analysis of rent control is ignores the real options involved in property development.

      Consider or a moment another housing regulation, zoning. Imagine that a particular area is zoned for residential uses up to 7 storeys high, yet only about 30% of lots are developed to this limit. The remainder are single free-standing homes.

      The local government then announces that in 5 years time the zoning limit will be set to 5 storeys.

      What happens to housing investment?

      Standard reasoning - the same reasoning being applied to rent controls - is that housing supply will fall. After all, this is an implementation of a supply constraint.

      Yet common sense, and analysis of real options (see this paper by Titman, suggests that land owners would rush in to develop their lots to 7 storeys before this window of opportunity closed.

      Thus, in 5 years time there would be more homes in this area than would be the case if the zoning limit was not tightened.

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  2. This is a bloody awful article. Look at the decline in quality of housing in so many rent control areas. Look at the lost investment , the waste.. http://economics.mit.edu/files/7786 To quote someone who actually understand rent control

    "Rent Control: It’s Worse Than Bombing

    new delhi—A “romantic conception of socialism” ... destroyed Vietnam’s economy in the years after the Vietnam war, Foreign Minister Nguyen Co Thach said Friday.

    Addressing a crowded news conference in the Indian capital, Mr. Thach admitted that controls ... had artificially encouraged demand and discouraged supply.... House rents had ... been kept low ... so all the houses in Hanoi had fallen into disrepair, said Mr. Thach.

    “The Americans couldn’t destroy Hanoi, but we have destroyed our city by very low rents. We realized it was stupid and that we must change policy,” he said."

    —From a news report in Journal of Commerce, quoted in Dan Seligman, “Keeping Up,” Fortune, February 27, 1989.

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    1. D, thanks for the comment.

      I read your first link. Nice study.

      But I think you need to be cautious about your views if that is the type of empirical evidence you are relying upon. First, the major impact of decontrol is on prices - it transfers economic rent from controlled renters to building owners (and indeed the neighbours of rent-controlled buildings who arguable suffer a negative externality from rent-control, which again benefits the tenants of those buildings).

      Second, the investment effects are very small, even after ignoring the fact that relocating poorer rent-controlled tenants out of the area provided less incentives for investment in their new areas. An equally sound assessment could be made of the loss of investment of surrounding areas from the decontrol in Cambridge.

      The complete counter-factual scenario is important.

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    2. Hayek suggested a gradual removal of rent control as a means of avoiding sudden disruption of people's lives. This is reasonable. As for investment, decontrol would lead to investment in renovation and construction, which would be more likely to be a boon to surrounding areas, rather than a loss. The evidence is against you, not just this one study I posted above, much much more.

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  4. Reminds me of the guy holding out on selling his house during the development of the Mater in Brisbane. Great analysis BTW

    :-)

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  5. Damn, if someone offered me $1 rent for the rest of my life I'd move in a heartbeat - add $17 million on top of that and... geez. This guy either really liked where he lived or knew exactly what he was doing!

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