Regulatory Market Dynamics: When Real Estate Rules Break Markets

What Are You Doing?

San Francisco, along with many of its neighboring cities, experienced a surge in population during the infamous Gold Rush of the 19th century. People from all parts of the country flocked to the area in search of striking it rich, with the city's population growing from about 1,000 in 1848 to 25,000 by the following year. Subsequently, a housing crisis unfolded, with many would-be miners unable to find a place to lay their heads.

Fast-forward nearly 200 years, and housing remains an issue in San Francisco, with the city having more than 7,500 homeless residents in 2023. In addition to having a large unhoused population, researchers from Chapman University and the Frontier Centre for Public Policy in Canada analyzed 94 major cities across eight countries and listed San Francisco as the eighth least affordable city. One of the primary factors contributing to this issue is the city's zoning regulations. In the fall of 2018, Harrison Hohman shared his thoughts on San Francisco's zoning issues in The Stanford Daily:

"The existence of this suburbia, transplanted into the core of one of the nation's most important cities, is permitted by a rigid collection of ultra-restrictive zoning laws. These regulations limit the height of all buildings (generally 40 feet maximum), the types of developments that can be built (almost exclusively duplex and single-family) and even the locations where buildings can cast their shadows (not over parks or public squares). … The opposition to de-zoning efforts has been spearheaded by existing homeowners and the city council members and neighborhood associations that represent them. Their case has traditionally hinged upon a few loosely-related arguments, some reasonable, if outdated, and others downright immoral. … The trouble arises however, when these ordinances are used as blunt weapons wielded toward any and all development projects that the neighbors don't like, regardless of their potential to improve a city. In the case of San Francisco, preservation laws seek not to adapt but to suffocate any change long before it can threaten the status quo."

Hohman's op-ed expressed a sentiment that aligned with many San Franciscans, however, in 2022, 38 percent of the city's land was zoned for single-family homes, which represented nearly two-thirds of all the land that was zoned for residential purposes. Experts who spoke with the San Francisco Examiner in 2023 noted that eliminating single-family zoning would be ideal but challenging to implement. In addition to zoning issues, San Francisco set high inclusionary zoning restrictions which prevented some developers from building. An excerpt from an article written by Lyanne Melendez was too comical to not include:

"For years, San Francisco forced developers to set aside about 22% or more for on-site affordable units. That high number kept some builders on the sidelines. But in 2023, the state basically asked San Francisco 'What are you doing?' and told the city to lower that requirement to between 12% and 15%."

In addition to zoning regulations and affordability requirements hampering development, both San Francisco and the state of California have rent control regulations that limit how much landlords can raise rents. However, instead of focusing on San Francisco's rent control measures, we will turn our attention to another city that has recently implemented what is arguably the strictest rent control policy of any major U.S. city: St. Paul, Minnesota.

The St. Paul Experiment

In November 2021, St. Paul enacted a rent control ordinance that stood out from those in other cities. Unlike most rent control laws that include vacancy decontrol provisions—allowing landlords to reset rents to market rates once a tenant vacates—the ordinance initially limited rent increases to 3 percent annually, regardless of inflation and without exceptions for vacant units. This meant there was no mechanism for adjusting rents to market levels, potentially capping rent growth below inflation for an indefinite period. Additionally, unlike typical rent control measures that exempt new construction to encourage housing supply, St. Paul's policy did not offer such an exemption, applying the 3 percent cap to all residential rental properties.

Since its implementation, the city government has introduced changes to soften the terms of the law. Specifically, the new adjustments allow landlords to raise rents to maintain a constant net operating income adjusted for inflation, using the property's 2019 operating income as a baseline. Landlords can also self-certify rent increases of up to 8 percent per year, subject to potential audit. Rent increases between 8 percent and 15 percent require city approval. The maximum allowable rent increase in a single year is capped at 15 percent, though any amount exceeding 15 percent can be deferred and applied in future years. Finally, the amended law exempts new construction for 20 years.

Despite these adjustments that made St. Paul's rent control regulation more comparable to those in other cities, the city experienced a sharp decline in building permits in 2022 compared to its neighboring city, Minneapolis (see Graph 2.5). While this decrease cannot be solely attributed to the regulatory changes, it is likely that these adjustments contributed to a portion of the decline observed.

Economic Impact and Investment Implications

Kenneth R. Ahern and Marco Giacoletti authored a paper analyzing the wealth redistribution effects caused by rent control. They provided an estimate of the property value losses incurred as a result of these new regulations:

"According to the Ramsey County Assessor's Office, there are 73,103 private residential parcels in St. Paul, with an aggregated estimated market value of $24.2 billion. Using the most conservative estimate of a value loss of 4.4%, our estimates imply that rent control caused an aggregate loss of $1.06 billion dollars to property owners in St. Paul over the nine months since its passage. Using the upper-range of 8.1% from the triple-difference tests, the aggregate loss is $1.96 billion dollars. Because property taxes are based on estimated market values, this decline could have significant implications for tax revenue, the dominant form of revenue for the city of St. Paul."

Given these two examples—San Francisco and St. Paul—it is evident that accounting for regulatory market dynamics when evaluating a real estate investment is crucial. A shifting regulatory environment can significantly impact investment returns and project viability, which are arguably the most critical factors for any type of investment.