Shadow-Market Housing

In large metropolises, a housing shortage can severely damage the city’s economy.  Experience shows that when such cities adopt rent control, they usually try to avoid outright housing shortages by leaving segments of the market unregulated.  Unsatisfied demand is diverted into this unregulated sector.  Because of the shadow-market effect people in this sector pay higher-than-market prices.  Still, they are rarely conscious of the causation.  Instead, they simply regard the city as “an expensive place to live” and often become a constituency for extending rent control to their own apartments.

It should be recognized that not all cities enforce rent control with the same enthusiasm.  Both the city and county of Los Angeles adopted rent control in 1979, but the county dropped it shortly thereafter.  The city government exempted new construction and allowed sizable rent increases.  It also adopted a form of vacancy decontrol that allows rent to rise to market value each time a new tenant moves in.  A 1990 study by the Rand Corporation found rent control saving tenants only $8 a month.  Since then, the city has depopulated and vacancies rose close to 10 percent.  “We can’t even get the rent the rent board allows us,” said Dan Faller, director of the Apartment Owners Association of Southern California, Inc. [Remember, this was way back in 1987.]  As a result, there is little shadow-market effect. Washington, D.C. is also depopulating and its rent control ordinance has little impact. Toronto has regulated all rental housing down to single-family homes since 1979, but allows generous eight percent annual rent increases.  The regulation seems to have only small impact.

New York and San Francisco, on the other hand, enforce two of the strictest sets of rent ordinances in North American.  (In many European countries, regulation has destroyed private rentals to the point that there is little left but public housing.)  Both cities allow only small rent increases and neither has vacancy control, although San Francisco will soon be adopting it according to a new state law.  Neither city is depopulating and both experience a high demand for housing.  As a result, both have developed strong shadow markets.

New York City split its housing market at the outset in 1947 by exempting all future construction. Torontoexempted all new construction when controls were adopted in 1979. San Francisco did the same.  Thus, while Santa MonicaandNew Jersey communities used rent control intentionally to prevent new housing construction, these other cities worried that no new housing would ever be built.

Unfortunately, the strategy of exempting new units often backfires.  Sooner or later, tenants in the new buildings will realize their position relative to rent-controlled neighbors and seek controls on the rents of their own dwellings.  This happened inNew Yorkin 1969, when Mayor John Lindsay was forced to adopt “rent stabilization” to cope with the excessive rent in “post-war” housing – that is, housing built after 1947 that was originally exempt from regulation.  Lindsay promised that all post-1969 housing would remain outside rent stabilization.

But inflationary pressures forced the New York State Legislature to break this pledge within five years with the Emergency Tenant Protection Act of 1974.  Since then, builders have learned that sooner or later, any new housing inNew York risks being “recaptured,” the term used by city officials, that is brought under regulations.  Consequently, little new rental housing is ever built. Toronto also repealed a new construction exemption in 1989 and now “recaptures” all new housing after five years.  Thus, little is built.  And San Francisco continues to exempt new housing, but does so much to discourage construction through zoning and no-growth ordinances that, with a one percent vacancy rate, the city still adds only 500 residential units a year.

1997

New housing thus makes up a stable – if somewhat uncertain – segment of the shadow market.  Another common sector is smaller buildings, particularly those that are owner-occupied. Cambridgeexempted two and three unit owner-occupied buildings. San Joseexempts duplexes and single-family homes, but regulates the 10,000 mobile homes in its jurisdiction. Berkeley does not regulate duplex apartments when the owner occupies one unit. San Francisco originally exempted buildings with four units or fewer, but this was overturned in a popular referendum in 1994.  Now, the city even regulates rented single-family homes. New York’s rent stabilization does not apply to buildings with fewer than six units, although the old rent control regulations from 1947 can still govern small units.

Finally, rented condominiums and cooperative apartments are commonly exempted – although this is an extremely controversial policy in most rent-controlled cities.   The problem is that once apartment houses fall under rent control, many owners will attempt to escape the regulation by selling of the apartments to individual owners.  This frustrates rent control officials because it diminishes the supply of rental housing.  InNew York, condominiums and cooperatives are treated as single units and thus exempted under the small owner rule.   In Washington, however, an apartment building under cooperative or condominium ownership is regulated as multi-family housing, even though it has multiple owners.

Most cities with rent control usually end up adopting strong laws to discourage conversion to condominium and cooperative ownership, in order to close an escape hatch from the regulated market.  In 1989, Cambridge adopted a law actually making it illegal for owners of converted condominiums to live in their own apartments.  Instead, owners were to be forced to rent out their apartments as rent-controlled units, in order not to “diminish the supply of rental housing.”  Active enforcement of this law would evict individuals from their own property was begun in earnest in 1992.  The prosecution of these “condo criminals” swelled the ranks of rent control opponents and played a large role in passage of the statewide referendum that in 1994 ended this regulation.

In major cities, then, these three exempted sectors – new construction, smaller buildings, and rented condominiums generally form the shadow market.  Even in the strictest rent-controlled environment, this shadow market may grow to considerable size.  InNew York, the unregulated sector now makes up 36 percent of the 1.7 million-unit rental market.  InSan FranciscoandSan Jose, it makes up about half.  Only in Berkeley and Santa Monica does the shadow market make up less than 20 percent of all rental housing.

William Tucker is the author of The Excluded Americans: Homelessness and Housing Policies –

(Regnery), and Zoning, Rent Control, and Affordable Housing – (Cato). Reprinted with permission of The Cato Institute, a public policy research organization — a think tank – dedicated to the principles of individual liberty, limited government, free markets and peace. Its scholars and analysts conduct independent, nonpartisan research on a wide range of policy issues. For more information, visit www.cato.org.