Option 3: Straight Pass-Through of Allowable Costs 1. Pass-through of "uncontrollable" documented costs; 2. Pass-through of "increased" documented costs, or 3. Pass-through of "allowable" documented costs up to a 6 percent ceiling. Option 3 would have adequately protected the owner from bearing the brunt of many of the uncontrolled costs, which were factors in determining rents, while preventing increases in his profit margins. It also would have had the effect of educating the public as to the true nature of the factors primarily causing the rise in rents. It would have seemed flexible allowing for accommodation to an unlimited number of existing situations, and fair. Except for the third variant, however, option 3 would not cushion the tenant against a rise in rent which might be beyond his or her ability to pay. It would require a detailed definition of what were "uncontrollable," "increased," or "allowable" costs. It would have demanded a standardized accounting procedure for all owners resulting in expensive administrative costs if the method specified did not conform to an owner's customary accounting system. It could have resulted in pointless and counterproductive disputes between tenants and owners over such issues as minor cost increases, the necessity for certain costs, the selection of firms supplying services (insurance), etc., the desirability of an escrow fund to meet anticipated costs, as opposed to absorption of increased costs as they occurred (pending after-the-fact rent increases). According to the Rent Advisory Board, the record keeping involved for the cost passthrough option could have conceivably cost an additional three percent per year-which in turn would have been passed on to the tenants as a rent increase. (No derivation for this three percent figure is available.) Monitoring could have imposed an extremely heavy workload for the Internal Revenue Service. It also would have been difficult for tenants to detect hidden profits buried in the intricacies of accounting. Further, while tenants had an interest in knowing the basis of any rent increase, they had no inherent right to know the business of the owner beyond that point. It would have been difficult to inform tenants adequately without an invasion of privacy of the owners' business information. Option 2, Modification 2(b) was accepted. It should be noted that the three percent standard in Option 2, 2(b) was based upon the assumption of a privately owned, normally profitable rental unit already renting at market prices. Such a standard was inappropriate for properties which had been under rent restrictions before the Freeze, and their renting at below market level. The numerical standard was derived by the Rent Board staff, presumably from the overall program goal to reduce inflation-and hence landlord costs to the two or three percent range. After selecting the basic standard, the Board had to decide whether the allowed annual rent adjustment should be in addition to any adjustment necessary to bring below-market rentals to current market levels in the first round of rent increases. The Board determined that there would be an additional increase permitted. Thus the rent adjustment standard had two parts. The landlord was entitled to a three percent maximum increase in rent automatically allowable for any unit in any 12-month period after 30 days notice of increase. Also allowable was a dollar-for-dollar passthrough of cost increases resulting from state or local property taxes and other charges, fees and levies of any kind, which might have been imposed by such government agencies with respect to improved real estate, and charges for municipal services exclusive of gas and electricity. The Board felt that an allowance for increased costs was clearly necessary, and to simplify administration, it was felt that a simple formula, which allowed flexibility, would be most desirable. It seemed sensible to use a straight percentage figure that represented a reasonable estimate of total anticiapted increases in operating costs. The dollar-for-dollar pass-through of increases in property taxes and municipal charges was recommended because municipal charges had been one of the items of cost which had been increasing most rapidly and had been unpredictable in amount. In addition, it was felt that documenting such cost increases would be relatively simple. Since the renters, as voters, exercised some control, either directly or indirectly, over that factor of rent increase, it was theoretically within their province to determine whether this portion of a formula would or would not be used, since only the increase in taxes would be passed through under the formula. Further, it was felt that the approach selected would provide for a more equitable situation between tenants and homeowners. It should be noted that the three percent standard was more stringent than it might seem. Rents had customarily been adjusted upon change of tenants or lease renewal rather than during tenancy. While necessary under long term leases, this practice had customarily also applied to leases with month-to-month or week-to-week tenancies. Consequently, as a rule of thumb, any specified percentage of increase per individual unit would produce only approximately one half that percentage increase in gross receipts over one year's time (if lease expiration dates are randomly distributed). Thus, for buildings which were predominantly rented under annual, fixed-rent leases, a three percent increase per unit translated into approximately a 1.5 percent increase in gross rent receipts for the owner. There was a dissenting recommendation from some members of the Rent Advisory Board that the basic allowance for pass-through of increased operating costs other than taexs be four percent rather than three percent since other sectors of the economy received generally full cost pass-throughs. Because averages were to be used for a base rent instead of the highest 10 percent of transactions, those dissenting suggested that the industry's starting position lagged behind other industries which were subject to the general price regulations. The industry members accepted a three percent compromise only as an alternative to an even lower percentage. The rental industry's three percent had to absorb both pay and price increases allowed by the Commission and the Pay Board, as well as increases mandated by new state and local laws, such as use of low sulphur fuels for environmental reasons. The Price Commision reduced the Rent Board's automatic three percent annual increase to 211⁄2 percnt at its December 20, 1971 meeting. Its reasoning apparently was to align rents with the 21⁄2 percent goal for the overall program. BASE RENT DETERMINATION The Rent Advisory Board next considered policy for base rent determination. The Price Commission defined base rent at the outset of Phase II as follows: "The base price for a lease of an interest in real property is the highest price charged by the person with respect to the same or substantially identical rental units in a substantial number of transactions during the freeze base period. A provision in a lease of an interest in real property executed prior to August 15, 1971, which provides for an increased rental to take effect after August 14, 1971, may take effect after November 13, 1971, to the extent such increased rental does not exceed the base price for the rental of such real property." 12 The Rent Board realized that the terms "market level prices" and "the same or substantially identical units" have always been controversial because they imply the need to determine comparability. To avoid such controversy and simplify administration, it was determined to allow the free market price being charged on an individual unit as of August 15, 1971, to be the best indication of the owner's own evaluation of the relative worth of that particular rental unit. Where, for various reasons, there was no free market price, as of August 15, 1971, a procedure for adjustment had to be provided. To avoid the arbitrary determination of comparability, the owner's own building and judgment of relative values within that building as of August 15, 1971, were used. Apartments let without leases or with only short-term leases rent at the market level. Longer term leases, however, restrain some rents below market levels when prices are rising. The Rent Advisory Board realized the need to provide a means to bring those rents to a fair market value upon termination of a lease, and provided for an adjusted base rent, or base price for a new lease during Phase II. The Board recommended that the landlord have two options to determine base rent in such situations. The Board reasoned that where there had been no opportunity for adjustment during the 90 days prior to August 15, 1971, the base rent should be adjusted at the first opportunity to reflect approximate market level rents in that building as of August 15, 1971. The Board recommended two methods for such adjustment. Method 1 The base rental could be adjusted to the average rental Method 2 If there were no such transactions, the owner could elect to The Board reasoned that the above procedures allowed all of the same or substantially identical rental units to reflect as nearly as possible market level prices as of August 15, 1971. Where, for any reason, no free market transactions occurred within that building, involving the same or substantially identical rental units, during the 90 days preceeding August 15, 1971 the rental level, as of May 25, 1970, for that particular unit, plus a five percent increase, was used as base. The Consumer Price Index for rents advanced 4.8 percent from August, 1970 to August 1971. Therefore, it was felt that the five percent figure would be relatively non-controversial. The Board also recommended supplemental definitions of “substantially identical unit" and "transaction" as a part of the regulations to help tenants and landlords evaluate the base rent determination for themselves. PROVISION FOR CAPITAL IMPROVEMENTS Having provided a method for determining base rent, the Rent Advisory Board had to consider the appropriate rent adjustment for an improvement in a rental unit. Two questions arose: How much improvement was necessary to make an apartment eligible for a rent increase? How much of a rent increase should be permitted? The Cost of Living Council had already confronted this issue during the Freeze. It had permitted rent adjustments to reflect capital improvements costing three months rent (minimum of $250) or more per unit. "Capital improvements" were limited to those so defined in the Internal Revenue Code, and by the IRS for tax administration purposes. This definition was well known and eliminated cosmetic improvements, such as a paint job. The Council had decided that the improved unit should be treated as a new apartment and permitted to have a rent no higher than the rent for a comparable apartment in the same market area. However, the monthly rent could not be increased by more than 12 percent of the amount spent for the capital improvement. The Rent Advisory Board modified the regulation only slightly for Phase II. It determined that the regulation failed to distinguish between discretionary and other reasons for performing capital improvements; i.e., whether the improvement was required by law, or whether it was with the tenants' consent, etc. The regulation, as modified, provided where capital improvements not required by law would result in rent increases of more than ten percent such increases could be implemented only after the IRS had determined that the capital improvement was required for the health or safety of the tenants or to preserve the present value of the residence. AN EIGHT PERCENT CAP The Rent Advisory Board sent a complete regulatory package to the Price Commission for approval. The regulations were designed |