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Housing Policy • February 1, 2006

Council Considers Condominium Conversion Policy

Council Considers Condominium Conversion Policy Part I

By Michael St. John, Ph.D.

Berkeley's City Council is in the midst of a far-reaching policy debate about condominium conversion. The law has changed recently such that some conversions of rental property are now allowed, but the debate is far from over. The outcome will make major changes in Berkeley's housing landscape over the coming years. As always in the case of government regulation, there will be winners and losers.

The prevailing progressive wisdom, up until 2005, was that condominium conversion should not be allowed because conversions would reduce the stock of rental housing. In the old days, before Costa-Hawkins, all rental housing was firmly rent controlled. By 1990 rents in Berkeley were lower than rents anywhere in the Bay Area. All rental housing in Berkeley could therefore be thought of as “affordable housing”. Reducing the stock of rental housing through condominium conversions, it was believed, would therefore reduce the number of rental units available to lower income households. Allowing reductions in the rental housing stock violated the prevailing wisdom, which assumed that homebuyers could take care of themselves but that renters needed the City's help. Condominium conversion was therefore prohibited.

But with rents and therefore property values artificially depressed by rent control, because restrictive rent control had caused the rental market to become so tight that the vacancy rate was near zero, and because the creation of condominiums was prohibited, adventuresome lower and middle-income people began in the 1980s to buy and occupy rental property under tenants-in-common arrangements. A “TIC”, as these properties soon came to be known, is an arrangement whereby several people pool their resources to convert property to owner-occupant use more informally than through condominium conversion. This movement developed considerable momentum through the 1980s. It seemed clear that, in another decade or so, a significant proportion of well-located rental property in Berkeley might be converted to TICs. So the City, following its progressive wisdom, in 1992 prohibited additional TIC creation for properties with four and more units, at the same time reaffirming that condominium conversions were still prohibited.

The TIC prohibition was accompanied by a program of disinformation. Focusing on the disadvantageous aspects of TICs (joint mortgages, principally), the City said that TICs were unwieldy, even dangerous, and that buyers should be protected from being lured into participation. TIC conversions were to be prohibited, it was said, so as to protect unwary buyers from getting into a mess. Real estate professionals were told that they must warn prospective buyers about the dangers of TIC arrangements. There were forms to distribute and penalties for non-compliance. This program made quite an impact. TICs came under a dark cloud.

But having made it out that TICs were dangerous and contrary to public policy, the City got itself in a jam with the owners who had converted to TICs during the 1980s and before the passage of prohibition in 1992. These owners, a tiny but articulate minority, lobbied for, and eventually received, permission to convert their properties to condominiums, the more appropriate conversion option according to the City. So during the remaining years of the 1990s there were no new TICs and no conversion of rental property to condominiums, but most of the pre-1992 TIC properties were converted to condominiums. Also allowed to convert during that decade were two homes on one lot, golden duplex properties, and family-occupied properties.

Meanwhile, the underlying premise had changed. The State of California in 1995 passed the Costa-Hawkins Act, which meant that, gradually, the old, controlled rents would disappear. No longer could the progressives count on rent control to provide a pool of affordable housing. A decade later, by 2005, rents were at or close to market for roughly 75% of the rental units in Berkeley. This being so, these units could no longer be considered “affordable housing”. In time, none of Berkeley's rental units will be rent controlled in the old sense. The City has therefore redoubled its efforts to create and preserve affordable housing by subsidizing the creation of permanently affordable housing through the efforts of non-profit housing suppliers, principally RCD (Resources for Community Development) and AHA (Affordable Housing Associates).

But the City soon ran out of money for these projects. Federal funds for housing initiatives also have dried up. By mid-2005, the Affordable Housing Trust Fund, the source of funds for these projects, was empty.

Meanwhile, a 2004 San Francisco lawsuit resulted in what is known as “the Tom decision”, a ruling that cities cannot prohibit tenant-in-common ownership. So the City planners were faced with the prospect that rental property would be sold to owner occupants as TICs, since the City's 1992 prohibition ordinance no longer held water.

Steve Barton, the head of the Housing Department, then put two and two together and devised a new strategy. Since rent control could no longer be relied upon to provide affordable housing, the City would continue to develop permanently affordable housing in partnership with the non-profits. Since TICs could no longer be prohibited, condominium conversions would be allowed, hopefully stemming a flood of TIC conversions. Since condominiums are worth more than TICs, and far more than rental property, the City would place a tax on conversions, with the proceeds going into the Affordable Housing Trust Fund.

It was brilliant, really. A win-win of sorts. Property owners would be allowed to convert their property to condominiums, but the City would receive a cut, with which it would create affordable housing projects. At the initial limit of 100 units per year and at the initial tax rate of 12.5% on sale prices, the plan was projected to generate something like $4,000,000 to $5,000,000 per year for the Affordable Housing Trust Fund — a significant sum by any standard. Leveraged with other funds, this might allow the creation of 50 to 100 affordable units per year. In time, it could be expected that Berkeley would have enough affordable housing for its lower income citizens.

But the devil is in the details. The topic has become highly political. There is no solid consensus among Council members about how these policies should be implemented. Those on the left decry the loss of even 100 units of rental housing per year and think the tax should be higher. Those further to the right think that 12.5% may be too high and would favor conversion of more than 100 units per year. Council members are all over the map when it comes to the hot topics of exemptions from the fee and “inclusionary conversions”.

In May, the Council passed the basic conversion plan. In October, the Council amended the plan in minor ways. A Council workshop is scheduled for January 17, 2006. At this workshop all of these topics will be considered:  exemptions, inclusionary elements, the fee, and so forth. Thereafter, the Council may settle on a policy that will establish conversion guidelines for the coming decade.

Council Considers Condominium Conversion Policy

Part II

Last month I wrote a report on the history and current situation regarding condominium conversions. I said there that the City Council would, on January 17, 2006, hold a workshop on condominium conversion policy. I will set out here some of the specific issues the Council will be considering.

1.  TENANT PROTECTIONS.  There will be debate about the extent to which current tenants should be protected in the event of condominium conversion. The interim Ordinance, passed in November, grants truly extraordinary protections to sitting tenants. While there is general agreement that tenants should receive protection from immediate eviction following condominium conversion, the extent of protection is not settled. The interim ordinance grants a one-year right of first refusal to a tenant in possession. That means that the tenant may take up to one year to decide if he or she wishes to purchase his or her unit. But if the tenant decides not to purchase, the tenant cannot ever be evicted! Someone may buy the condominium, but the buyer would be prevented from occupying the unit, so long as the tenant wishes to stay. And during that stay, which for some tenants will no doubt be for the remainder of their lifetimes, the rent will be restricted even more severely than under the rent control ordinance. The annual adjustment that will apply to converted units with hold-over tenants will be the same as the annual adjustment under the rent law, but none of the other provisions by which rents can be increased (such as additional tenants or capital improvements) will apply to that tenant. In my view, this degree of protection is unnecessary and inappropriate, especially considering that many of the protected tenants are not low income and don't need protection in any case.

2.  THE AFFORDABLE HOUSING FEE.  The formula by which the affordable housing fee is computed is convoluted and inaccessible to the public. The fees computed by this formula range in the six digits, far above what anyone would ever agree to pay in order to secure permission to convert units to condominiums. The formula prevented conversions for 13 years, from 1992 until 2005, when the current cap of 12.5% of sale price was added. The formula-computed fee is many times higher than the 12.5% cap. The formula fee is clearly unworkable and should be changed.

In addition, there are serious questions about the structure of the fee itself. The fee, even at the 12.5% level, is on the total sales price of a condominium. It is therefore a sales tax. But it really should be a value-added tax, or a capital gains tax, not a sales tax. The sales tax formulation penalizes anyone who has made substantial renovations to a property because the renovations will be taxed along with the entire property. Why should the City receive a tax on renovations? It is not good public policy to discourage renovation. The sales tax would also penalize long-term owners because they would be taxed on the gain in value that occurred gradually over time. Why should the City receive a tax on increases in value that had nothing to do with condominium conversion? A value added or capital gains tax, on the other hand, would base the tax on the value added by the conversion only. It would thus be targeted to the conversion, and would not discriminate against owners who had held their property for a long time or who had done extensive renovations prior to conversion.

3.  EXEMPTIONS FROM THE AFFORDABLE HOUSING FEE.  The Council will consider exemptions or partial exemptions from the affordable housing fee to certain categories of residents. Currently, a reduced fee will be charged where the owners of duplexes and 3 and 4-unit properties have lived there for seven years or more. But it is unclear that there should be any fees for any of these units or for other units that are already exempt from rent control and therefore don't qualify as affordable housing. Why should an affordable housing fee be charged for converting units that are not affordable rental housing to units that will be affordable to middle-income residents as for-sale housing? There should be no fee on newly constructed units and all other units that are exempt from rent control. Those units are already outside the stock that might be considered "affordable housing". No fee should be charged for their conversion to condominiums.

It has also been suggested that "unaffordable" units (those with rents above $2,000 per month, for example) be exempt from the conversion fee. Why should an "affordable housing fee" be required when a middle- or upper-income rental unit is converted to condominiums? Such a unit, affordable only to middle- and upper-income tenants, will, following conversion, be affordable to middle- and upper-income homeowners. Where is the loss? There should be no fee on conversion of such units.

4.  THE 100 UNIT LIMIT.  The interim ordinance allows only 100 units to convert per year. Tentative permission for the first 50 will be granted before the end of 2005. But 100 units per year is a drop in the bucket. The City has allowed the construction of hundreds of units in the past decade, mostly in high-rise buildings, mostly in the downtown area. During the same time period the University has added hundreds of student beds in dormitory buildings near campus. So the number of available rental units has been going up by more than 100 per year. Meanwhile, rents are down, the market is soft, and there are thousands of vacant units in the City. At the same time, for sale housing is unavailable, home prices are at record highs, and many middle-income residents are priced out of the market. Condominium conversions would increase the supply of homes for middle-income residents. It is unclear why more than 100 units per year should not be allowed to convert under these circumstances. Conversion would help middle-income residents by increasing the supply of condominiums while decreasing the stock of vacant rental units. It would be a win-win.


Council Considers Condominium Conversion Policy

Part III

On February 21, 2006, the Berkeley City Council will hold a workshop on its policy concerning the conversion of rental units into condominiums. The council has for many years prohibited most conversions, but has recently opened the door to a minor extent because a San Francisco lawsuit cut the legs from under the council's parallel prohibition of tenants-in-common sales. As a result, a lot of interest has been awakened in a topic long considered closed.

For several decades City of Berkeley housing policy has been based on the proposition that rental housing is in short supply and should be preserved in order to protect the City's ethnic and cultural diversity. For a quarter century, therefore, we have had rent and eviction controls, prohibitions on tenants-in-common ownership and condominium conversion, funding for the construction of “affordable rental housing”, and inclusionary zoning requirements on new construction, all designed to achieve the underlying diversity objective.

But times have changed. First, the Costa-Hawkins Act changed Berkeley's rent control rules from the restrictive form that began in 1979 to the “vacancy decontrol” form that now prevails throughout the state. Beginning in 1999, rents have gone go to prevailing market levels on turnover. As of 2005, roughly a quarter of Berkeley's rental units were still occupied by pre-1996 tenants paying below market rents. The majority of Berkeley's rental units are rented at market rates now and can no longer be considered “affordable housing” in any meaningful sense.

Second, the appellate court's decision in Tom v. City and County of San Francisco spelled the end of Berkeley's prohibition on tenants-in-common (TIC) ownership. It is now recognized that Berkeley rental property may  be freely converted to tenants-in-common ownership, as it could be before the TIC prohibition was enacted in 1992.

Third, the dot com crash in 2001 led to the exodus of thousands of young professionals from the Bay Area, reducing the demand for rental housing. Rental housing is no longer in short supply. Indeed, the vacancy rate is higher than it has been since the 1960s or early 1970s. There are thousands of vacant rental units in Berkeley today. And rents have been falling, not rising, for the last three or four years. The rental market is soft, not tight, as it had been, prior to these developments, since the late 1970s.

Meanwhile, the Bay Area has experienced a sharp rise in prices of for-sale housing. Whereas middle-income individuals and families could afford to buy a home in Berkeley in the 1970's, 1980's, and early 1990's, middle-income individuals and families are hard-pressed to find a home in Berkeley that they can afford today. Condominiums are a logical second choice for middle-income residents who want to live in Berkeley but can't afford Berkeley's home prices. Yet condominiums are in short supply. Current rules cap the conversion of rental units at 100 units per year, a number that falls far short of the demand for affordable for-sale housing.

It is time for a paradigm shift. We need a new vision to match new circumstances. What is needed today is workforce housing for university employees, policemen, teachers, city government employees, and other middle-income residents. These individuals and families typically want to own their own homes. Wisely, these families don't plan to remain in rental housing for more than a brief transition period. Understanding well the financial advantages of homeownership, they know that remaining in rental housing prevents the accumulation of equity that, for most Americans, is a crucial component of financial security in retirement.

What makes sense in this market is to allow condominium conversions so that the underutilized stock of rental housing can be turned into for-sale housing needed by middle-income residents. There would be no loss to renters — they are already housed, and already protected by rent and eviction controls. There would be significant benefits to middle-income residents, on the other hand, because a greater supply of condominiums will tend to reduce the over-high prices for condominiums and other for-sale housing, allowing these residents to stay in Berkeley. Otherwise, Berkeley's middle-income working folks will be forced by the high price of homes to seek housing elsewhere and to commute to their jobs in Berkeley, further increasing traffic congestion and parking difficulties.

The 100-unit limit to conversions is overly restrictive. A higher limit will not lead to net loss of rental housing because hundreds of rental units — many of them “affordable” - have been constructed in high-rise buildings in the downtown area in recent years. It would be wise to allow 200 to 500 units to convert to condominiums per year, so that the current imbalance (oversupply of rental units / undersupply of for-sale housing) can be corrected. The best policy would be to remove all restrictions and let citizens determine the number of rental and for-sale units in Berkeley. An alternative would be to set a vacancy rate floor. If the vacancy rate is above 5%, conversions would be unrestricted. If the vacancy rate is below 5% they would be limited.

As to diversity, there is no evidence that the City's housing policies have achieved their goals. A study using census data from 1970, 1980, and 1990 (St. John & Associates, 1993), showed that, even with restrictive rent control and condominium conversion prohibitions, Berkeley was gentrifying faster than any surrounding community. The study showed that lower income residents, single-parent families, working-class persons, households receiving public assistance, and even university students were systematically barred from living in Berkeley during the time of restrictive rent controls, whereas these categories of households were welcomed into all surrounding communities.

A more recent study by San Jose State University economists Benjamin Powell and Edward Stringham showed that “inclusionary zoning” programs don't work either ("The Economics of Inclusionary Zoning: How effective Are Price Controls?", 2004). Communities with inclusionary housing programs added fewer affordable housing units than communities without such programs. The study also showed that these programs make market-rate housing more expensive, and that the decrease in market rate housing construction caused by the programs exceeds by many times the construction of affordable units under the programs.

Taken as a whole, the programs are counterproductive. Space prevents an explanation here of the reasons for the failure of these programs. Suffice it to say that like King Canute, who failed to stop the incoming tide, the City cannot stop steps people take to further their personal financial security.

Meanwhile, the benefits that flow from allowing conversions are significant:

  • 1.5% transfer tax on the sales price of condominium units sold
  • a substantial increase in the assessed value of the property, of which a part goes to the City through increased property taxes
  • the affordable housing fee that would help fund truly affordable housing for low income residents.

These new revenues — which could sum to several million dollars a year - could be used to fund the many important services in the City, which are currently underfunded.

Michael St. John is an economist specializing in rental housing and condominiums and a member of Berkeley's Housing Advisory Commission. His comments reflect his personal views, not the views of the HAC or of BPOA.


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