HOWARD v. SANTA MONICA RENT CONTROL BOARD

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Court of Appeal, Second District, Division 1, California.

Vera HOWARD et al., Plaintiffs and Respondents, v. SANTA MONICA RENT CONTROL BOARD, Defendant and Appellant.

B013459.

Decided: March 14, 1986

Joel M. Levy, Santa Monica, and Hadassa K. Gilbert, Los Angeles, for defendant and appellant. David M. Shell, Sacramento, for plaintiffs and respondents.

The Santa Monica Rent Control Board (hereafter Board) appeals from a judgment granting Vera and John Howard's (hereafter the Howards) petition for a writ of mandate.   We reverse.

FACTUAL BACKGROUND

The Howards purchased a ten-unit apartment building in February 1980 after the City of Santa Monica adopted its rent control law.1  They made a down payment and financed the remainder of the purchase price by obtaining loans secured by a first trust deed in the amount of $317,000 with a variable interest rate starting at 9.77 percent and a second trust deed in the amount of $230,000, due in April 1982.

By May 1983 the interest rate on the first trust deed had risen to 11.75 percent and the interest rate on a refinanced second trust deed was set at 2 percent above the prime rate.   By this point the Howards were operating the property in a negative cash flow position (i.e., the Howards' operating costs, including debt service, exceeded the property's income).

On April 1, 1983, the Howards filed a petition with the Board for an individual rent adjustment based on increased operating expenses, completed capital improvements, and proposed capital improvements.

A hearing was conducted before a hearing examiner on April 25, 1983.   After receiving documentary evidence and the testimony of Vera Howard and various tenants, the hearing examiner took the matter under submission.   The hearing examiner issued her decision on June 8, 1983, granting the Howards a permanent $5 per month increase in all but one apartment unit and an increase for capital improvements in all but one unit ranging from $3.78 per month to $55.33 per month to be phased out as these capital improvements were amortized.   Pursuant to Santa Monica Rent Control Board Regulations section 4101, subdivision (c)(2)(ii), the hearing examiner did not consider expenses due to debt service.

The Howards appealed the hearing examiner's decision to the Board on June 20, 1983, contending, inter alia, that the hearing examiner should have considered mortgage payments as expenses.   Regarding this issue, a report issued by the Board's staff stated:  “Regulation 4101(c)(2)(ii) directly excludes mortgage principal and interest payments from operating expenses.   The hearing examiner correctly complied with this regulation and has not abused her discretion by disallowing petitioners' claim in the current year.  [¶] The purpose [of] the Net Operating Income approach to maintaining a fair return is to ensure that a fair return is earned on the property after accounting for operating expenses.  [¶] While a landlord who has financed the property may have to pay debt service out of his Net Operating Income, such payments go in part to increasing his equity in the property.  [¶] On the other hand, a landlord may on occasion refinance the property and take equity out of the property for other use.   However, under the Net Operating Approach, the Board will not consider such refinancing proceeds as return.   If the Board were to consider debt service in its fair return analysis, it would consider refinancing proceeds as return to be offset against the need for rent increases.  [¶] The Net Operating Income approach, which doesn't consider either debt service or refinancing for purposes of evaluating entitlement to rent increases has been approved in several court tests.  [Citations.]”

In its decision dated July 21, 1983, the Board adopted a modified version of the hearing examiner's findings of fact and conclusions of law.

On December 5, 1983, the Howards petitioned the trial court for a writ of mandate pursuant to Code of Civil Procedure section 1094.5.2  The trial court granted the Howards' petition in a judgment filed on December 27, 1984.   This judgment and the writ of mandate filed the same day ordered the Board to set aside its decision and to recalculate the Howards' allowable rent increases taking into consideration, inter alia, increased interest payments and to provide the Howards “a fair return by allowing them to break even on their property.”

The Board's motion for reconsideration was denied by the trial court on February 7, 1985.

ISSUES

 The issues presented by this appeal are (1) whether the trial court, in reviewing the Board's decision regarding the Howards' petition for an individual rent adjustment pursuant to section 1094.5, should have utilized the substantial evidence or the independent judgment standard of review and (2) whether the Board must take the interest payments made by a property owner into account when making its decision on such a petition.3

DISCUSSION

I

 The first issue we must resolve is what standard the trial court should have applied when it reviewed the Board's decision regarding the Howards' petition for an individual rent adjustment pursuant to section 1094.5.

Section 1094.5, subdivision (c), provides:  “Where it is claimed that the findings are not supported by the evidence, in cases in which the court is authorized by law to exercise its independent judgment on the evidence, abuse of discretion is established if the court determines that the findings are not supported by the weight of the evidence.   In all other cases, abuse of discretion is established if the court determines that the findings are not supported by substantial evidence in the light of the whole record.”

In Bixby v. Pierno (1971) 4 Cal.3d 130, 144–145, 93 Cal.Rptr. 234, 481 P.2d 242, the court applied section 1094.5, subdivision (c), to a decision by a nonconstitutional state agency of statewide jurisdiction and concluded that the independent judgment test was applicable where the decision substantially affected a fundamental vested right.   This rule was made applicable to the decisions of state agencies of local jurisdiction and local agencies in Strumsky v. San Diego County Employees Retirement Assn. (1974) 11 Cal.3d 28, 44–45, 112 Cal.Rptr. 805, 520 P.2d 29, wherein the court restated the Bixby rule of review as follows:  “[I]f the order or decision of the agency substantially affects a fundamental vested right, the court, in determining under section 1094.5 of the Code of Civil Procedure whether there has been an abuse of discretion because the findings are not supported by the evidence, must exercise its independent judgment on the evidence and find an abuse of discretion if the findings are not supported by the weight of the evidence.   If, on the other hand, the order or decision does not substantially affect a fundamental vested right, the trial court's inquiry will be limited to a determination of whether or not the findings are supported by substantial evidence in light of the whole record.” 4  Therefore, the appropriate standard of review in the case at bench depends on whether the Board's decision substantially affected a fundamental vested right possessed by the Howards.

In explaining how a court is to determine whether a fundamental vested right is substantially affected by an administrative decision, Bixby v. Pierno, supra, 4 Cal.3d at pages 144–146, 93 Cal.Rptr. 234, 481 P.2d 242, states:  “The courts must decide on a case-by-case basis whether an administrative decision or class of decisions substantially affects fundamental vested rights and thus requires independent judgment review.  [Citations.]  As we shall explain, the courts in this case-by-case analysis consider the nature of the right of the individual:  whether it is a fundamental and basic one, which will suffer substantial interference by the action of the administrative agency, and, if it is such a fundamental right, whether it is possessed by, and vested in, the individual or merely sought by him․  [¶] In determining whether the right is fundamental the courts do not alone weigh the economic aspect of it, but the effect of it in human terms and the importance of it to the individual in the life situation․  [¶] ․ in determining whether the right is sufficiently basic and fundamental to justify independent judgment review, the courts have considered the degree to which that right is ‘vested,’ that is, already possessed by the individual.  [Citation.]”

The Howards contend that the Board's decision substantially affects their fundamental rights to own property and to pursue a livelihood.   The Howards improperly rely on several cases discussing these rights.

In Traux v. Raich (1915) 239 U.S. 33, 36 S.Ct. 7, 60 L.Ed. 131 the voters of Arizona amended their Constitution by initiative to prohibit any employer of more than five employees from employing less than 80 percent qualified electors or native-born citizens of the United States.   Raich, a foreign-born resident of Arizona and not a qualified elector, lost his job as a cook.   In sustaining Raich's challenge to this law based upon the equal protection clause of the Fourteenth Amendment to the United States Constitution, the court stated:  “It is sought to justify this act as an exercise of the power of the State to make reasonable classifications in legislating to promote the health, safety, morals and welfare of those within its jurisdiction.   But this admitted authority, with the broad range of legislative discretion that it implies, does not go so far as to make it possible for the State to deny to lawful inhabitants, because of their race or nationality, the ordinary means of earning a livelihood.   It requires no argument to show that the right to work for a living in the common occupations of the community is of the very essence of the personal freedom and opportunity that it was the purpose of the Amendment to secure.  [Citations.]  If this could be refused solely upon the ground of race or nationality, the prohibition of the denial to any person of the equal protection of the laws would be a barren form of words․  The discrimination against aliens in the wide range of employments to which the act relates is made an end in itself and thus the authority to deny to aliens, upon the mere fact of their alienage, the right to obtain support in the ordinary fields of labor is necessarily involved.”  (Id., at pp. 41–42, 36 S.Ct. at pp. 10–11.)

A similar situation existed in Purdy & Fitzpatrick v. State of California (1969) 71 Cal.2d 566, 79 Cal.Rptr. 77, 456 P.2d 645 wherein a statute prohibited the employment of aliens on public works.   In declaring this statute repugnant to the Fourteenth Amendment to the United States Constitution, the court stated:  “Labor Code section 1850 discriminates on the basis of alienage, and such classification invokes a strict standard of review.   Moreover, the state may not arbitrarily foreclose to any person the right to pursue an otherwise lawful occupation.   Any limitation on the opportunity for employment impedes the achievement of economic security, which is essential for the pursuit of life, liberty and happiness;  courts sustain such limitations only after careful scrutiny.”  (Id., at p. 579, 79 Cal.Rptr. 77, 456 P.2d 645, fns. omitted.)

In Anton v. San Antonio Community Hosp., supra, 19 Cal.3d 802, 140 Cal.Rptr. 442, 567 P.2d 1162, a hospital revoked a physician's medical staff membership after 13 years.   The hospital was the only one located in the City of Upland, the physician lived approximately one mile from the hospital and maintained an office in a building located across the street from the hospital.   Additionally, the parties agreed that many hospitals required staff physicians to reside nearby and therefore it was unlikely that this physician would be granted staff membership at other hospitals.   In discussing whether a fundamental right was involved, the court stated:  “We think it manifest—and indeed defendant has not contended otherwise—that the decision before us has a substantial effect on a right which is ‘fundamental.’  ․ As the court said in Edwards v. Fresno Community Hosp. (1974) 38 Cal.App.3d 702, 705 [113 Cal.Rptr. 579], ‘Although the term “hospital privileges” connotes personal activity and personal rights may be incidentally involved in the exercise of these privileges, the essential nature of a qualified physician's right to use the facilities of a hospital is a property interest which directly relates to the pursuit of his livelihood.’   This interest is clearly fundamental within the meaning of Bixby and Strumsky.”  (Id., at p. 823, 140 Cal.Rptr. 442, 567 P.2d 1162, fn. omitted.)

Unlike these cases, it is clear that the case at bench does not involve a suspect classification which unreasonably and arbitrarily obstructs the Howards' opportunity to pursue their livelihood (as in Truax and Purdy & Fitzpatrick ) nor does the decision in question effectively prevent the Howards from operating their business (as in Anton ).

While the ownership of property often involves a fundamental right (Transcentury Properties, Inc. v. State of California (1974) 41 Cal.App.3d 835, 844, 116 Cal.Rptr. 487), and the opportunity to engage in a lawful pursuit of one's livelihood involves a fundamental right (Truax v. Raich, supra, 239 U.S. 33, 36 S.Ct. 7, 60 L.Ed. 131;  Purdy & Fitzpatrick v. State of California, supra, 71 Cal.2d 566, 79 Cal.Rptr. 77, 456 P.2d 645;  Anton v. San Antonio Community Hosp., supra, 19 Cal.3d 802, 140 Cal.Rptr. 442, 567 P.2d 1162), there is no fundamental right to pursue your livelihood through the ownership of property and earn a profit.   Furthermore, “there is no vested right to conduct a business free of reasonable governmental rules and regulations [citations]” (Northern Inyo Hosp. v. Fair Emp. Practice Com. (1974) 38 Cal.App.3d 14, 23, 112 Cal.Rptr. 872) and an ordinance does not become unconstitutional merely because it prevents property from achieving its maximum economic potential.  (Goldblatt v. Hempstead (1962) 369 U.S. 590, 592, 82 S.Ct. 987, 988–89, 8 L.Ed.2d 130.)   Finally, we note that rent control legislation, when properly implemented, is a valid exercise of the police power.  (Birkenfeld v. City of Berkeley, supra, 17 Cal.3d 129, 130 Cal.Rptr. 465, 550 P.2d 1001;  Fisher v. City of Berkeley (1984) 37 Cal.3d 644, 209 Cal.Rptr. 682, 693 P.2d 261, affd. (Feb. 26, 1986) * 475 U.S. 260, 106 S.Ct. 1045, 88 L.Ed.2d –––.)

 We therefore conclude that the trial court erred in applying the independent judgment standard of review.   The Board's decision did not substantially affect a fundamental vested right possessed by the Howards and the trial court, in reviewing the Board's decision pursuant to section 1094.5, should have utilized the substantial evidence standard of review.  (Accord Campbell v. Residential Rent Stabilization & Arbitration Bd. (1983) 142 Cal.App.3d 123, 126, 190 Cal.Rptr. 829.)

II

 The second issue in need of resolution is whether the Board must consider debt service as an operating expense when ruling on a property owner's petition for an individual rent adjustment.   We conclude that debt service must be taken into account.

The 1984 rent control law provides, in pertinent part:  “Section 1805.   Individual and General Adjustment of Ceilings on Allowable Rents.

“․

“(e) In making individual and general adjustments of the rent ceiling, the Board shall consider the purposes of this Article and the requirements of law.   The Board may adopt as its fair return standard any lawful formula, including but not limited to one based on investment or net operating income.   The Board shall consider all factors relevant to the formula it employs;  such factors may include:  increases or decreases in operating and maintenance expenses, the extent of utilities paid by the landlord, necessary and reasonable capital improvements of the controlled rental unit as distinguished from normal repair, replacement and maintenance, increases or decreases in living space, furniture, furnishings, equipment, or services, substantial deterioration of the controlled rental unit other than as a result of ordinary wear and tear, failure on the part of the landlord to provide adequate housing services or to comply substantially with applicable housing, health and safety codes, federal and state income tax benefits, the speculative nature of the investment, whether or not the property was acquired or is held as a long term or short term investment, the landlord's rate of return on investment, the landlord's current and base date Net Operating Income, and any other factor deemed relevant by the Board in providing the landlord a fair return.

“(f) No rent increase shall be authorized by this Article because a landlord has a negative cash flow as the result of refinancing the controlled rental unit if at the time the landlord refinanced the landlord could reasonably have foreseen a negative cash flow based on the rent schedule then in existence within the one year period following refinancing.   This paragraph shall only apply to that portion of the negative cash flow reasonably foreseeable within the one year period following refinancing of the controlled rental unit and shall only apply to controlled rental units refinanced after the date of adoption of this Article.

“(g) No rent increase shall be authorized by this Article because a landlord has a negative cash flow if at the time the landlord acquired the controlled rental unit, the landlord could reasonably have foreseen a negative cash flow based on the rent schedule then in existence within the one year period following acquisition.   This paragraph shall only apply to that portion of the negative cash flow reasonably foreseeable within the one year period following acquisition of a controlled rental unit and shall only apply to controlled rental units acquired after the date of adoption of this Article.”

Despite the fact that section 1805 does not preclude consideration of debt service in all cases, Santa Monica Rent Control Board Regulations section 4101, subdivision (c)(2)(ii), dictates that mortgage principal and interest payments can never be considered a part of a property's operating expenses.

Few people in today's economy can purchase property without financial assistance.   The variable interest loan is a common form of loan which has a fluctuating interest rate that changes in accordance with a settled measuring guide.   This guide is usually reflective of the strength of our economy.   While the formula for the calculation of interest (e.g., the second trust deed in the case at bench is calculated at 2 percent above the prime interest rate) may be the subject of negotiation depending on the bargaining strength of the parties (especially if it is a loan from a private lender), the measuring guide itself is not within the parties' control.   Since it is difficult to predict what the interest rate on a variable rate loan will be at any given point in the future, it is unrealistic for the Board to treat increased costs in debt service as a foreseeable business risk in all cases.

The 1984 rent control law's statement of purpose (section 1800) provides, in pertinent part:  “The purpose of this Article, therefore, is to alleviate the hardship caused by this serious housing shortage by establishing a Rent Control Board empowered to regulate rentals in the City of Santa Monica so that rents will not be increased unreasonably and so that landlords will receive no more than a fair return.”   Rather than ensuring that landlords receive no more than a fair return, the Board's Regulation section 4101, subdivision (c)(2)(ii), is geared toward ensuring that landlords cannot receive a fair return.

Since allowing no more than a fair return is the underlying basis of the 1984 rent control law and since debt service bears directly on the issue of what contitutes a fair return, we conclude that increases in debt service must be considered by the Board when making a decision regarding a petition for an individual rent adjustment.

 While we agree with the trial court that increased debt service must be considered as an operating expense by the Board, we do not believe that this requires the Board to guarantee a break-even point to each property owner.   There can be instances where a person is receiving a fair return but is not operating the property at a positive cash flow.  (See Oceanside Mobilehome Park Owners' Assn. v. City of Oceanside (1984) 157 Cal.App.3d 887, 907, 204 Cal.Rptr. 239, quoting Brunetti v. Borough of New Milford (N.J.1975) 350 A.2d 19, 30, 350 A.2d 19.)   To guarantee a break-even point without any inquiry into the use to which the borrowed funds were put or other relevant criteria would allow property owners to subvert the purpose of the rent control law merely by encumbering their properties with high interest loans and then seeking rent adjustments to cover the debt service.

III

 We have already decided that the trial court erred in applying the independent judgment standard of review to the Board's decision regarding the Howards' petition.   However, it is unnecessary to have the trial court review the Board's decision under the substantial evidence test since the Board's action of completely ignoring the extremely material evidence of debt service necessarily rendered its findings unsupported by substantial evidence as it effectively precluded the Howards from proving their case.  (See generally Seneris v. Haas (1955) 45 Cal.2d 811, 241 P.2d 915;  Bates v. Stoehr (1964) 229 Cal.App.2d 628, 633, 40 Cal.Rptr. 432;  9 Witkin, Cal.Procedure (3d ed. 1985) Appeal, § 354, pp. 357–358.) 5

IV

In summation, we have held that the trial court should have applied the substantial evidence test when reviewing the Board's decision pursuant to section 1094.5.   However, the trial court need not reconsider the Board's decision under the substantial evidence test since that decision cannot be supported by substantial evidence where extremely material evidence regarding debt service is excluded.   Finally, we have held that while debt service must be considered as an operating expense, the Board is not obligated to guarantee each property owner a break-even point in order to meet the requirements of a fair return.

DISPOSITION

The judgment is reversed and the matter is remanded to the trial court which is directed to vacate its judgment on peremptory writ of mandate, recall the writ, and remand the matter to the Board for further action giving appropriate consideration to debt service as expressed in this opinion.   Each party is to bear their own costs on appeal.

I concur in the majority decision, but in addition am compelled to add the following conclusions.

The Santa Monica 1984 rent control law, on its face, is unlike that previously approved in Fisher v. City of Berkeley (1984) 37 Cal.3d 644, 112 Cal.Rptr. 418.   In the Berkeley law, the ordinance provided that the Rent Control Board could grant individual rent adjustment to the landlord “[T]o provide for a fair return on investment.”  (Id., at p. 692, 112 Cal.Rptr. 418;  emphasis added.)

Section 1800 of the Santa Monica law provides “that landlords will receive no more than a fair return.”   This language intimates that the maximum possible be a “fair return” on investment and by definition implies that something less than a fair return is acceptable.   Regulation 4101(c)(2)(ii) then goes on to establish this interpretation by insuring that landlords cannot receive a fair return by not taking into account higher variable interest rates.

“A fair return on investment” obviously contemplates that a landlord would receive procedural due process at a hearing which could consider all aspects of the investment.   A negative cash flow in and of itself is not a reason to automatically raise rents because there may be numerous reasons for the investment.   But a regulation that precludes consideration of increased costs including rising variable interest rates per se deprives a landlord of procedural due process.

If landlords cannot receive a fair return on investment so that they are in the position to consistently lose money, then ordinarily it is only a matter of time before the landlord must sell the property to recover the loss of income from appreciation or, worse yet, lose the property through foreclosure because the income is insufficient to make the payments.   If plaintiffs respondents could show such a pattern of foreclosure, then the law would clearly be confiscatory and Birkenfeld v. City of Berkeley (1976) 17 Cal.3d 129, 169, 130 Cal.Rptr. 465, 550 P.2d 1001 would apply to invalidate the legislation.   However, plaintiffs respondents have not made such a showing by the record in this case.

By invalidating Regulation 4101(c)(2)(ii), as it was applied to the Howards, my learned colleagues have validated the Santa Monica rent control law so that it will now pass constitutional muster.

FOOTNOTES

1.   The original rent control law was adopted by the voters of the City of Santa Monica at the April 10, 1979 municipal election.   This rent control law was amended by the voters of the City of Santa Monica at the November 6, 1984 municipal election.

2.   Unless otherwise stated, all statutory references are to the Code of Civil Procedure.

3.   In their brief the Howards contend that the current rent control law, which declares in its statement of purpose, in pertinent part:  “A growing shortage of housing units resulting in a low vacancy rate and rapidly rising rents exploiting this shortage constitute a serious housing problem affecting the lives of a substantial portion of those Santa Monica residents who reside in residential housing” (Rent Control Charter Amendment, art. XVIII, § 1800) is invalid.   Despite the fact that the Howards do not dispute that a housing shortage may still exist, they argue that since increases in rental fees have been strictly confined since 1979, rapidly rising rents no longer exist in the City of Santa Monica and therefore the “constitutional facts” supporting the police power regulation (see Birkenfeld v. City of Berkeley (1976) 17 Cal.3d 129, 160, 130 Cal.Rptr. 465, 550 P.2d 1001) has vanished.   The Howards therefore request this court to declare the current rent control law unconstitutional.   The identical argument was unsuccessfully made to this court in 301 Ocean Avenue Corp. v. Santa Monica Rent Control Board (1985) 175 Cal.App.3d 149, 159, 221 Cal.Rptr. 610.   For the reasons stated therein, we reject the argument in this case as well.

4.   The Bixby rule of review was subsequently applied to the decisions of nongovernmental agencies subject to section 1094.5 in Anton v. San Antonio Community Hosp. (1977) 19 Cal.3d 802, 140 Cal.Rptr. 442, 567 P.2d 1162.

FOOTNOTE.   Advance Report Citation:  54 U.S.L.Week 4222.

5.   In its brief, the Board contends that it has been enjoined from calculating allowable rental fees on the basis of individual financing arrangements in James W. Baker et al. v. City of Santa Monica et al. (Super.Ct.L.A.Co., No. WEC 058763).   We note that enforcement of the judgment and injunction in that case has been stayed pending resolution of the appeal by writ of supersedeas filed October 18, 1983.

DEVICH, Associate Justice.

L. (THAXTON) HANSON, Acting P.J., concurs.