Hardship on Both Sides: COVID-19 Impacts Multifamily Property Owners as Well as Their Tenants
Part 3: A New Regulatory Climate Threatens the Feasibility of Residential Investments and Further Impairs Housing in California
There is an interplay between local efforts such as the new City of Los Angeles residential eviction moratorium ordinance (see Part 1 of this Breaking Ground Blog series, "City of L.A.'s New Ordinance Foretells More Trouble for Multifamily Property Owners," May 15, 2020) and the various statewide exercises being considered in Sacramento, notably the proposed California Assembly Bill (AB) 828, introduced by Assembly Member Philip Ting. Even with the controversy created by an individual jurisdiction such as Los Angeles, lawmakers are considering a statewide law that provides that, if a multifamily property landlord cannot reach a "deal" with a tenant for repayment of unpaid rent that was deferred during the COVID-19 crisis, the tenant can admit the default and the court will have the authority to reduce the rent by 25 percent. A separate proposed bill, introduced in the California State Senate as SB 939 by Sen. Scott Wiener, would have similar impacts on commercial landlords and will be examined in an upcoming Breaking Ground Blog post. Both bills are still pending.
Under the proposed law, a defendant in a residential unlawful detainer case can notify the court that it wishes to stipulate to an order, and the court will hold a hearing to determine whether the rent failure resulted from COVID-19 hardship. AB 828 provides that absent evidence to the contrary, the court shall presume that increased household costs or decreased earnings giving rise to rent defaults were due to COVID-19. If the court finds that it will not have a material economic hardship on the landlord, the court shall then issue an order allowing the tenant to remain but adjusting its rent downward by 25 percent (for the next 12-month period). The tenant would also be required to repay installments of the past due amount from unpaid rent during the crisis over a 10-month period, without interest.
If the landlord owns 10 or more rental units, the court must presume that the issuance of this type of order would not constitute a material economic hardship. "Material economic hardship" for multifamily property owners is defined in the bill with language that many might find curious: "Persons enduring the hardship would have to limit spending on household necessities. Reduction in savings, profit margins, discretionary spending, or nonessential assets shall not constitute material economic hardship."
By the Numbers: A Scenario
According to the University of Southern California's annual Lusk Center Multifamily forecast, average Los Angeles County apartment rents in 2019 (prior to the COVID-19 crisis) were $2,230 per month. Consider the example of a 50-unit apartment building with units that rent for $2,000 per month, just below the County average. Basic cash flow modeling dictates that the $100,000 of gross revenues collected each month would be reduced by a vacancy factor of 2 percent to 5 percent as well as by operating expenses, which run typically about 15 percent to 18 percent. So, net income from the building would be approximately $80,000 monthly. By rough conservative estimate, the nearly $1.2 million of cash flow a year would qualify for a loan of about $15 million. That would require a monthly loan payment of between $55,000 and $75,000 per month. The landlord restrictions discussed in this article would impact that structure in two ways:
- If half of the tenants in the building defer their rent for four months because of COVID-19 hardship, the gross revenues (the $100,000 in the paragraph above) would be reduced to $83,333 per month. The operating expenses for the building have not changed, and the resulting net income is only $63,333 per month. Some landlords would be able to make their mortgage payments with these numbers, but only barely, and others already would be under water from merely the deferred rent. If a landlord in the City of Los Angeles tried to collect the lost rental revenue, they could face a minimum of $10,000 damages per violation under the City's new ordinance, plus attorneys' fees and costs, and the chance of non-recovery.
- The outlook would be even more challenging under proposed AB 828. Remembering that the text of the proposed bill requires a presumption that there is simply no economic hardship for a building of this size (that is, anything larger than 10 units), consider that in addition to rent lost during COVID-19, a court could order a 25 percent rent reduction when landlord and tenant don't come to agreement on a repayment plan for the deferred rent. So while the loss of deferred rent would bring the monthly cash flow from $100,000 to $83,333 under our assumption, a court could further reduce the cash flow to $75,000 per month for up to one year. The expenses still do not change, so the net income would now be $55,000 rather than $63,333. This property likely will not cover its mortgage – and as soon as the crisis is over it could go into foreclosure and possibly receivership. But, according to the proposed state law, it would not be a material economic hardship if the owner of the multifamily property can still afford groceries.
Takeaways and Considerations
As residential landlords ask what are they supposed to do if AB 828 passes, here are a few immediate takeaways on how the new laws might be expected to play out:
- Landlords cannot evict, send notices of default, charge late fees or attempt to enforce non-rent covenants in their residential leases in the City of Los Angeles.
- Landlords should try to work out a plan for repayment with tenants, but once the COVID-19 crisis ends and the orders are rescinded, tenants will go back to paying current rent while landlord efforts to collect the arrearages may be problematic.
- If the landlord attempts to collect the back due rent or proceed against the tenant for any reason, the tenant has the option to sue. If the tenant wins, the landlord could owe them at least $10,000 plus legal fees and expenses.
- If AB 828 becomes the law, the court has the ability to recast the lease to reduce its rent by 25 percent.
- Consider the residential tenant who deferred paying rent for four months during the crisis. That deferred amount can be repaid over 12 months when the crisis ends. If a lease renewal seeks to recapture that repayment during the renewed term, that rental rate will be above the rate asked by competing landlords with equivalent apartments (who also might be offering rental incentives), so many tenants are likely to move. Recovery of the deferred amount against a former tenant would be costly and uncertain.
- Once the crisis is over and rents are at least 25 percent below the previous market rate – local and state rent laws will restrict how quickly landlords can increase rents back up to the pre-COVID levels, although newly constructed units will not be similarly constrained. This would put current properties below market and behind many of their competitors, with limited ability to get back to market.
It's understandable that elected officials have concerns about constituents who have been economically affected by the COVID-19 crisis, but many landlords are being impacted as well.
Also in This Series
DISCLAIMER: Please note that the situation surrounding COVID-19 is evolving and that the subject matter discussed in these publications may change on a daily basis. Please contact your responsible Holland & Knight lawyer or the author of this blog for timely advice.