Rent Seeking for Rent Control

February 4th, 2011

This article in the NY Times article about Rent Control is a veritable case study in law and economics, public choice theory, the coase theorem, and any other economic theory a GMU alum knows in his sleep.

Let’s break this down.

THERE are nearly a million rent-stabilized apartments in New York City. Which means that there are at least a million lucky people who know they have relatively low rent that isn’t going to rise too far, too fast. These fortunate souls also know that their leases, especially for apartments in Manhattan and parts of Brooklyn, are worth far more than the paper they are written on, should the landlord or a developer decide to buy tenants out.

Rent control artificially keeps the price of rents below the market rent. These apartments, limited in supply, are in high demand. Even though the rental value is fixed, these apartments can be sold on a black market of sorts. As usual, a market distortion caused by the state results in a black market whereby supply and demand can help resolve this distortion–albeit with significant transaction costs, as this article will show.

How does this black market work?

A whole industry is built around paying tenants to move, and it is cloaked in mystery. Developers, seeking to spend as little as possible, make offers quietly and individually. Neighbors, wary of spoiling a deal, don’t talk to one another about those offers. There are no guidelines to help people figure out what an apartment is worth, and no easy ways to calculate the emotional toll that comes with moving from a home, sometimes after decades.

Unsurprisingly, this black market is in the dark. Information costs are quite high, and transaction costs skyrocket. Because this is not a public market, people cannot know what a market price is for their apartment. Some people get ripped off. Some people make out like bandits.

Often, in the end, it comes down to whether one has the stomach for a fight: the longer one of these battles plays out in a building that the owner is determined to empty, the worse conditions tend to get.

The people who wait till the end–known as hold outs in economics–raise the costs for everyone involved, and generate numerous sunk costs. While I am not usually opposed to hold outs–to wait for a higher price is rational–here it is disturbing because the state gave the owner a monopoly rent of sorts, and they can cool their heels while paying a sub-market rent, and need not be tempted by what would usually be a reasonable offer. What are some of the offers on the high and low ends?

For instance, at one building on 23rd Street, many tenants took the $17,000 initially offered by the developer, said Steven R. Wagner, a real estate lawyer at the firm Wagner Davis who represented a tenant there.

Mr. Wagner said his client, after months of refusing to budge, skedaddled when the developer agreed to pay more than $400,000.

There are even more extreme cases.

At 220 Central Park South — a trophy address by any estimation — a development team from Vornado Realty Trust and the Clarett Group, after years of court battles, has reportedly paid more than a dozen tenants $1.3 million to $1.6 million apiece to vacate their rent-controlled homes so the building can be torn down and a luxury condominium tower put up in its place.

Make no mistake that New York taxpayers are subsidizing that exorbitant buy-out fee. First, in providing someone with a sub-market rent, they are subsidizing the full cost of the apartment building. Second, when a new person wants to buy that Apartment at Central Park South, they will be forced to pay a higher rent because of this insane buy-out amount.

While this may seem to benefit the owner of a rent-subsidized apartment, it actually creates perverse incentives, and even disincentives to earn more money. Why bother improving your station in life if you can live in such a cheap apartment? This creates massive dead weight losses for society. For example:

Maggie Kim, 34, had heard about people bought out of rent-stabilized apartments, and when a developer bought her building, she knew it might be worth her while to hang tight.

When she moved to New York more than a decade ago, she went through all the frustration that usually comes with looking for a place in Manhattan. Then she went to see an apartment in a building owned by “the friend of a friend” of her mother. Located in the 40s, near Bryant Park in Midtown, it was a spacious one-bedroom that was clean and, most important, rent-stabilized. At $700 a month, it was about as cheap as one could hope to find in Manhattan.

As an artist, Ms. Kim doubts she could have afforded to live in the neighborhood if she had had to pay market rate.

For the next decade, with the rent increasing only $75, she happily called the apartment home, even after she started making more money and might have been able to afford a bigger place.

“It’s Manhattan,” she said, “and if you’ve got a big, cheap apartment to yourself, it is kind of stupid to give it up.”

If forced to pay market rent, perhaps she would no longer be an “artist,” and you know, get a real job 😉 OK, that was mean, but you get my point.

Also, owners of buildings with rent-stabilized apartments have little incentives to provide good services:

“It did get a little spooky living there,” she said. “There were a lot of problems with rodents, and one night I discovered a homeless man sleeping in the entryway.”

Economics in one blog post? For more on rent control see here and here.