SEARLE v. CITY OF BERKELEY RENT STABILIZATION BOARD (1990)

In this case we hold that rent control regulations violate due process when they (1) provide an inflation adjustment of net income by an arbitrary percentage of the increase in the consumer price index, (2) prescribe an inflation adjustment of net income only from the middle of the year after net income was frozen to the month before a landlord applies for the adjustment, (3) require each landlord to file and pursue an individual application in order to obtain the uniform inflation adjustment, and (4) fail to establish guidelines as to what constitutes a fair return on investment so that landlords may make informed decisions whether to petition for an increase in rents on the basis they do not receive a fair return on their investment.

I. BACKGROUND

Dagmar and John Searle and Eleanor Swift (Landlords) appeal from a judgment denying them a peremptory writ of mandate, thus affirming the Berkeley Rent Stabilization Board's decision on their petition for an individual rent ceiling adjustment.

The Rent Stabilization and Eviction for Good Cause Ordinance passed by Berkeley voters in 1980 provides, in section 11, for automatic annual general rent adjustments (AGA's) based on citywide average increases in operating costs.   In section 12 the ordinance provides for individual rent ceiling adjustments (IRA's) available by petition and based upon a particularized showing that a landlord is not receiving a fair return on investment.

Pending the adoption of “regulations setting forth specific guidelines,” former Regulation 1275 limited a fair return on investment to maintenance of base year net operating income as defined in former Regulation 1264.   Net operating income (NOI) is gross income (primarily rents) less “property taxes, reasonable maintenance and operating expenses, and the amortized cost of capital improvements” (Reg. 1263).   The base year for most properties is 1979, the last year before rent control (Reg. 1262).   Effective July 1, 1987, Regulation 1264 was amended to provide for maintenance of base year NOI “adjusted by 40% of the percentage increase in the Consumer Price Index (CPI) since June 1, 1980, if 1979 is the base year, or since the midpoint of any alternative base year” to be obtained only by individual petition by a landlord.   As amended, Regulation 1275 now allows any rent increase necessary to avoid a confiscatory taking under the state and federal Constitutions, and contains a nonexclusive list of factors to be considered.   Increases pursuant to Regulation 1275 are not subject to the limits of Regulation 1274 restricting yearly increases to the lesser of 15 percent of current rents or $50.

In Searle v. City of Berkeley Rent Stabilization Bd. (1988) 197 Cal.App.3d 1251, 1253, 243 Cal.Rptr. 449, we upheld a provision of the ordinance which precluded Landlords from recapturing three years worth of AGA's lost by the previous owner of an unregistered apartment building which Landlords purchased in October 1984, and then registered.   We held, “Such a provision does not violate the Constitution or any statute when the ordinance also provides that any landlord can, upon registration, petition for an individual rent adjustment and obtain a fair return on investment.”  (Ibid.)  In fact, we noted that Landlords already had an IRA petition pending.  (Id. at p. 1254, fn. 1, 243 Cal.Rptr. 449.)   The Board's final decision on that petition is the subject of this appeal.

In their petition filed September 18, 1986, Landlords requested a rent increase based in part on exceptionally low base year net operating income (Reg. 1262(C)), and fair return on investment (Reg. 1275).¹  After a hearing on November 3, 1986, Landlords were granted a 30 percent upward adjustment in base year net operating income.   The hearing examiner stated, “As the NOI method is the means authorized by the Rent Board to provide landlords with a fair return on their investment as required by the Ordinance, Petitioners' request for an increase to provide a fair return will be considered the same as the request for an NOI increase.   In the absence of a Board regulation permitting indexing, an increase for NOI based on inflation index is not allowed.”

On December 26, 1986, Landlords appealed the hearing examiner's decision to the Board, in part on the issue of NOI inflation indexing.   Tenants also appealed challenging any increase in base year NOI.   In its March 30, 1987, decision on appeal the Board stated that it did not automatically index NOI for inflation and that Landlords had not proved that failure to do so in their case caused a gross inequity.   Finding that the hearing officer had used the wrong fair return standard, the Board remanded the petition for a redetermination of the base year NOI adjustment.

In a letter to the hearing examiner dated May 7, 1987, Landlords indicated they “assume[d]” that on remand he would consider the issue of indexing de novo “in light of the Rent Board's new rules.”   On July 18, 1987, after a hearing on remand, the hearing examiner raised Landlords' increase in base year NOI from 30 to 35 percent, but did not mention indexing.   Again both parties appealed.   In particular, Landlords urged the Board to allow NOI inflation indexing under amended Regulation 1264, although by its terms it applied only to petitions filed after July 1, 1987.

In its final decision on appeal dated March 4, 1988, the Board lowered Landlords' increase in base year NOI from 35 to 4 percent, but agreed to retroactive inflation indexing which resulted in an additional 15.7 percent upward adjustment (40 percent of the 39.3 percent CPI increase between June 1980 and August 1986).   As a result of these NOI adjustments Landlords were permitted to increase rents by 22.5 percent.   They then filed a petition for peremptory writ of administrative mandamus (Code Civ.Proc., §§ 1094.5, 1094.6) challenging the constitutionality of the NOI inflation-indexing regulation (amended Reg. 1264).   After a hearing, the trial court denied Landlords' writ petition.

II. ISSUES ON APPEAL

 Landlords assert that Regulation 1264 violates due process by (1) limiting NOI inflation indexing to 40 percent of CPI increase, (2) indexing only from June 1980, and (3) requiring individual petitions for indexing.   Although not raised before the Board, the constitutional challenge was properly before the trial court, for “a litigant who must exhaust [administrative remedies] need not present his constitutional claim before the administrative agency whose existence or regulations he seeks to challenge.   After pursuing the available administrative procedure, he may present the constitutional claim for the first time in the courts.”  (Laird v. Workers' Comp. Appeals Bd. (1983) 147 Cal.App.3d 198, 204, 195 Cal.Rptr. 44, citation omitted;  see also Floystrup v. City of Berkeley Rent Stabilization Bd. (1990) 219 Cal.App.3d 1309, 1317, 268 Cal.Rptr. 898.)

 The Board contends Landlords' attack on the delay inherent in the individual petition process is not cognizable on appeal because they did not raise it below.   This is incorrect.   Although not treated as a separate issue, this factor was raised in Landlords' trial briefs.   In any event, “parties may advance new theories on appeal when the issue posed is purely a question of law based on undisputed facts, and involves important questions of public policy.”  (Fisher v. City of Berkeley (1984) 37 Cal.3d 644, 654, fn. 3, 209 Cal.Rptr. 682, 693 P.2d 261, citations omitted.)   It is undisputed that Regulation 1264 comes under the rubric “Standards for Individual Rent Ceiling Adjustments.”

III. INTRODUCTION

“In determining the validity of [rent control] provisions, our sole concern is whether they reasonably relate to a legitimate governmental purpose and we must avoid confusing reasonableness in this context with wisdom.”  (Oceanside Mobilehome Park Owners' Assn. v. City of Oceanside (1984) 157 Cal.App.3d 887, 909, 204 Cal.Rptr. 239, citation omitted.)  “The purpose of rent control is to permit an efficient landlord to pay all actual and reasonable expenses and receive a fair profit while, at the same time, protecting the public interest in having affordable and properly maintained rental housing available to the citizens of the community.”  (Cotati Alliance for Better Housing v. City of Cotati (1983) 148 Cal.App.3d 280, 296, 195 Cal.Rptr. 825.)

A. Adjustment for Inflation

 In Fisher v. City of Berkeley, supra, 37 Cal.3d at page 683, 209 Cal.Rptr. 682, 693 P.2d 261, the Supreme Court, while upholding the facial validity of Berkeley's rent control ordinance, observed that continued failure to adjust base year NOI for inflation would eventually produce confiscatory results.   According to the Board, Regulation 1264 was amended “in order to avoid any such legal pitfalls.”   Landlords claim, however, that there is no rational basis for limiting indexing to 40 percent of the CPI, and suggest that anything less than 100 percent indexing is irrational and confiscatory.

Neither Fisher, nor Cotati Alliance for Better Housing v. City of Cotati, supra, 148 Cal.App.3d at page 293, 195 Cal.Rptr. 825, on which it relies in this regard, specifies any constitutionally required level of indexing.   On the other hand, contrary to the Board's assertion, the Fisher court's citation to Oceanside Mobilehome Park Owners' Assn. v. City of Oceanside, supra, 157 Cal.App.3d at pp. 897–900, 204 Cal.Rptr. 239 (Fisher v. City of Berkeley, supra, 37 Cal.3d at p. 686, 209 Cal.Rptr. 682, 693 P.2d 261) sheds no light whatever on the validity of 40 percent indexing in the context of Berkeley's very different ordinance.

The Board offers two bases for the 40 percent figure.   One is that it represents a compromise between competing interests revealed at a public hearing and during extensive debate prior to the adoption of Regulation 1264.   Although the Board tells us that “Landlord groups pressed to adjust NOI at a higher percentage of the CPI ․ while tenant representatives argued for less than 40%,” this is not set forth in the record before us, nor is there any other evidence from which to ascertain the reasonableness of the 40 percent figure.   The trial court suggested, “This was a compromise between the rent people, the tenants, who didn't want any inflation factor and the landlords who wanted a hundred percent.”

The Board also relies on a study which it says “states that since 1913 NOI has historically increased at approximately 32% of the rate of inflation under free market conditions, and since 1970 at about 50% of the rate of inflation.” ²  These data arguably justify a figure of 50 percent or more, but do not constitute a rational basis for the choice of 40 percent indexing.

B. Time for Indexing

 Landlords next contend it is irrational to index for inflation from June 1980 in order to maintain the net operating income produced by property in 1979, especially since as to any other base year inflation is measured from the midpoint of that year.   Contrary to Landlords' assertion, the Board did not concede this point below.   Rather it consolidated into one issue its defense of the decision to index at 40 percent of CPI increase since 1980.

The Board's explanation that June 1980 represents a compromise between landlords' wish to index “from an earlier date” and tenants' desire for a date “later than 1980” suffers from the same defects as the compromise rationale for 40 percent indexing for inflation.   There is no evidence in the record to support such a contention.   Moreover, as amicus curiae points out, compromise is not always either rational or constitutional:  “If, for example, a city found free speech discomfiting, it could not limit the circulation of a newspaper to three days a week on the ground that some wanted an outright ban and others wanted no ban at all.”

Still less successful is the Board's attempt to justify the June 1980 date because of the “unusually large increase in the CPI between June 1979 and June 1980.”   It is, after all, the purpose of Regulation 1264 to allow landlords to recoup the purchasing power of their NOI lost because of inflation.   The higher the inflation rate, the greater the loss, absent indexing.

Finally, the Board states, “there was virtually no limit on rent increases which could be imposed prior to December 30, 1979.”   Not true.   Berkeley's Renter Property Tax Relief Ordinance of 1978 (Measure I) froze June 6, 1978, rents until December 31, 1978, after which and throughout 1979, that base rent was reduced to the extent necessary for landlords to share 80 percent of their Proposition 13 property tax savings with tenants.   Thus, the high 1979–1980 inflation rate could not have been “compensated for by rent increases imposed prior to December 1979,” as the Board suggests.   Moreover, how the base year net operating income was produced—whether it included inflated rents or not—is irrelevant to the calculation of losses due to inflation since then.

C. Requirement for Individual Petitions

 Landlords also maintain there is no rational reason to index NOI by a fixed percentage of CPI (which creates an irrebuttable presumption that the same portion of every landlord's NOI is unaffected by inflation) where the adjustment is not automatic and across the board.   As they put it, “There is no reason for estimates in an individual petition system.”   But the larger issue is:  What reason is there for an individual petition system to adjust for the universal impact of inflation?

In Birkenfeld v. City of Berkeley (1976) 17 Cal.3d 129, 171, 130 Cal.Rptr. 465, 550 P.2d 1001, the Supreme Court invalidated a prior rent control scheme which did not provide for general rent adjustments based on generally applicable factors.   The court found the individual petition process “inherently and unnecessarily precludes reasonably prompt action except perhaps for a lucky few.”  (Id. at p. 172, 130 Cal.Rptr. 465, 550 P.2d 1001.)   The court held the combination of rent rollbacks and “the inexcusably cumbersome rent adjustment procedure is not reasonably related to the ․ stated purpose of preventing excessive rents and so would deprive ․ landlords of due process of law if permitted to take effect.”  (Id. at p. 173, 130 Cal.Rptr. 465, 550 P.2d 1001.)   Landlords claim the current procedure for obtaining NOI inflation indexing is subject to the same constitutional defect.   The Board responds that as long as there is any automatic rent increase at all, Birkenfeld is satisfied.   This is an unduly narrow view of the Birkenfeld rationale.

The Berkeley rent control ordinance has been in effect for almost a decade, during which time there has been continuous inflation, albeit at varying rates.   Thus every landlord in Berkeley has experienced the effect of inflation on the dollar amount of base year NOI.   It follows that every landlord is now eligible for NOI inflation indexing.   Yet, under Regulation 1264, each and every Berkeley landlord must go through the individual petition process to receive an upward adjustment set in advance at 40 percent of the CPI increase since 1980.   And that is only the beginning, for while inflation continues, Regulation 1264 says nothing about how landlords are to proceed after an initial indexing.   Presumably, every landlord—including Landlords herein—will have to repeat the procedure periodically, but how often?   And when?   And why?

The Board avers “there is no evidence in the record that current Ordinance procedures preclude the Board from taking reasonably prompt action on petitions requesting adjustment of base year NOI.”   Landlords point to the extensive administrative record generated by their IRA petition and the 18 months from filing to final decision as evidence that the process is unduly burdensome.   Amicus curiae has attached to its brief a declaration and a selective IRA petition processing record purporting to show that “no individual adjustment petition which has included an appeal to the Board, has been concluded within the 120 days required by the Ordinance.”  (See § 12b(12).)  The latter evidence is not properly before us.  (See ante, fn. 2.)   Amicus curiae's request for judicial notice of still more similar data was denied.

The question is not, however, precisely how long it takes to process a given IRA petition, or even IRA petitions in general.   The question is whether there is any rational basis for inflation-indexing NOI case by case rather than as part of the automatic across-the-board general annual rent adjustments.   The Board claims only a limited number of landlords will need to petition for inflation indexing because “many” landlords are currently receiving an equivalent NOI via AGA's.   The record contains no evidence on this point, and the Board's argument is unpersuasive since the AGA's merely account for increased costs in order to maintain NOI at its base year dollar amount.   The claim that, “Additionally, many landlords are currently receiving a fair return on investment even though their base year NOI has yet to be adjusted for inflation,” is likewise totally unsupported by the record, and is vague, unexplained and illogical.

There is no rational basis for relegating NOI inflation indexing to the individual petition process, especially when the applicable regulation specifies that everyone's base year NOI will be raised by 40 percent of the CPI increase regardless of individual circumstances.

D. Fair Return on Investment

 Nevertheless, the Board contends Landlords' claims are not ripe for adjudication because they have not applied for additional relief under Regulation 1275, which expressly guarantees a fair return under the Constitution.   As a matter of fact, Landlords specified that very regulation in their original petition.   They were informed that maintenance of net operating income is fair return.  (See ante, p. 441.)   If that were true, then by definition Regulation 1275 could provide no relief additional to that obtainable under Regulation 1264.

Although amended Regulation 1275 indicates that—in principle at least—the Board no longer equates fair return with maintenance of net operating income, it still does not compensate for Regulation 1264's major defects:  the requirement that landlords seek NOI inflation indexing by individual petition, and the not-unrelated failure to provide regular relief from ongoing inflation.   The Board seems to be suggesting that if, at the end of the 18–month individual rent adjustment process, Landlords feel the relief provided by Regulation 1264 is insufficient, they should then file another petition requesting additional relief under Regulation 1275.   Then, at some unspecified time in the future, when continued inflation has reduced the purchasing power of their NOI by an additional unspecified amount or percentage, they should do the whole thing over again ․ and again ․ and again․   And so should every other landlord in Berkeley.   This boggles the mind.

Furthermore, the current version of Regulation 1275 itself, although an improvement, remains constitutionally inadequate.   It still does not furnish specific guidelines enabling a landlord to understand the burden he or she must meet to obtain relief and the benefits to be expected if that burden is satisfied.   It does not say what fair return on a landlord's investment is, nor provide a formula for determining it.   It does not say precisely how the relevant factors ³ will be used to determine a fair return.

E. Summary

To summarize, six years after Fisher, the Board has yet to adopt a regulation under which landlords can effectively petition for a fair return on their investment.   Four years after Cotati, the Board adopted a regulation permitting NOI inflation indexing, but that regulation also is fatally defective.   The Board has proffered no rational basis, nor can one easily be imagined, for indexing from June 1980 in order to maintain the net operating income of base year 1979.   While the decision to index by only 40 percent of the increase in the consumer price index appears almost as arbitrary, an even more serious defect of Regulation 1264 is that it provides constitutionally-mandated inflation relief only to those, such as Landlords herein, willing and able to go through the costly and time-consuming individual petition process.   And even for those “lucky few” it does not provide for ongoing maintenance of net operating income in the face of continuing inflation.   If the erosion of NOI by inflation were taken into account in the annual general rent adjustments, indexing by less than 100 percent could conceivably be justified, since additional relief would remain available through individual petition for a fair return on investment under revised Regulation 1275.

IV. CONCLUSION

In the ten years since Berkeley passed its rent control ordinance, it has engendered more than its share of litigation.   In many cases, including this one, it is difficult to disentangle the actual legal issues—if any—from the morass of political invective, ad hominem attack, and policy argument in which they are buried.   It seems as if individual landlords challenge every regulation every time it is applied, while the Berkeley Property Owners' Association commandeers every individual challenge and turns it into an attack on the “true character” of the entire rent control scheme and its adherents.   The Board's intransigence in the face of these challenges and attacks more than fulfills the landlords' expectations and sets the stage for a new round of litigation.

This really ought to stop.   It is perhaps time for landlords to resign themselves to rent control;  it appears to be here to stay.   No one in the foreseeable future is going to make a killing in residential rentals in Berkeley.   Repeated piece-meal attack on the ordinance will not bring back the good old days, but only waste time and money and continue to polarize the community.   Likewise, it is probably time for the rent board to recognize that what one journalistic wag has facetiously called the People's Republic of Berkeley is in fact a city in a state in a nation with a functioning market economy, governed by a Constitution which guarantees landlords a fair return on their investment.

Nor, facetiousness aside, is Berkeley's problem unique.   We are witnessing a state-wide proliferation of rent control ordinances and a concomitant increase in acrimonious and divisive litigation over their various provisions.   Since communities usually adopt rent control in order to retain affordable rental housing in areas experiencing housing shortages, the trend is bound to continue so long as the state's urban population continues to grow and the urban space available for new housing remains finite.   In addition, the entirely local nature of rent control legislation thus far has added to the volume—and thus to the expense in both time and money—of rent control litigation.

Although state-wide rent control may be unnecessary, it is clear that local communities which choose to adopt rent control would benefit from statutory guidance.   We call upon the Legislature to address this issue and assist landlords, tenants, local communities and the courts by articulating California's public policy on rent control and its operation so that future disputes can be resolved without repeated litigation.   We are confident that strong legislative leadership can develop a regulatory scheme which achieves equity for landlords and tenants alike.   As we said seven years ago, “The purpose of rent control is to permit an efficient landlord to pay all actual and reasonable expenses and receive a fair profit while, at the same time, protecting the public interest in having affordable and properly maintained rental housing available to the citizens of the community.”  (Cotati Alliance for Better Housing v. City of Cotati, supra, 148 Cal.App.3d 280, 296, 195 Cal.Rptr. 825.)

For the reasons stated, we call upon the Legislature to develop a statutory scheme to accomplish this purpose.

V. DISPOSITION

The judgment is reversed and the cause remanded to the trial court with directions to issue a writ of mandate ordering the Berkeley Rent Stabilization Board, within one year, to (1) conform Regulation 1264 (inflation indexing of net operating income) and Regulation 1275 (fair return on investment) to the principles set forth herein, and (2) setting aside the challenged decision, adjust Landlords' rents accordingly.

I concur in the result and in the legal reasoning of the majority opinion.   I write separately only to express a difference with the majority's concluding remarks.   Rent control in Berkeley, as in other communities, deeply affects some of the citizens' most important economic and personal interests.   Berkeley voters have shown their determination to maintain relatively low rents, security of tenure and an economically integrated community.   Rental property owners, understandably, desire more than to scrape by without going out of business;  they wish to share in the wealth which California's growing economy has traditionally brought to those who own rental property.   Meanwhile, the intense debate continues on whether rent control is good, bad, effective or too costly to society.   I do not believe we should reproach either the City of Berkeley, renters or property owners for instigating or defending litigation intended to further their rights and interests.

The fractiousness decried by the majority is by no means restricted to the courts;  the local and state political scenes have been the sites of frequent efforts to strengthen, weaken, abolish or preempt Berkeley's ordinance, and elections for seats on the rent board are accorded almost the same importance as city council elections.   The issue's repeated appearance on the ballot and in the appellate courts represents, therefore, not an outbreak of litigation, but merely one segment of a broad struggle to adjust deep social conflicts.

I anticipate scant prospects for statewide regulation.   California's economy and society are notably diverse, and the needs and desire of one local community may be dramatically different from those of another.   I doubt that our state Legislature can provide “statutory guidance” equally suited to each.   A possible result is a statewide political compromise satisfactory to none—and the debate or litigation will still not end.

FOOTNOTES

1.   Landlords also requested and received increases based on capital improvements both planned and completed.   Their request that increased debt service be considered was denied.   They raised the issue again in the trial court, but not on appeal.   Thus we do not address it, although the Board still apparently does not consider debt service in fixing NOI or in determining a landlord's fair return on investment.

2.   In its brief amicus curiae the Berkeley Property Owners Association launches a broadside attack on the study's “flawed assumptions” and “outdated data”—not to mention its conclusions—based primarily on a different study which it has appended to its brief.   Since neither the evidence nor the argument was before the trial court, neither is properly before us.  (DeYoung v. Del Mar Thoroughbred Club (1984) 159 Cal.App.3d 858, 862–863, 206 Cal.Rptr. 28;  CNA Casualty of California v. Seaboard Surety Co. (1986) 176 Cal.App.3d 598, 618, 222 Cal.Rptr. 276.)   Nevertheless, it must be recognized that the quoted data may be irrelevant to the influence of inflation in the 1970's and 1980's on NOI in the Bay Area.

3.   One factor currently listed in Regulation 1275 is the landlord's return on the property, including income generated, tax benefits derived, and appreciation in value.   The Board alleges that Landlords refused to furnish the hearing examiner with the requisite tax information.   Landlords contend their tax returns are privileged under King v. Mobile Home Rent Review Bd. (1990) 216 Cal.App.3d 1532, 265 Cal.Rptr. 624.   Nothing in that case precludes the Board from considering a landlord's tax benefits (see Cotati Alliance for Better Housing v. City of Cotati, supra, 148 Cal.App.3d at p. 295, 195 Cal.Rptr. 825) or requesting relevant tax data for that purpose.

KING, Justice.

HANING, J., concurs.