On certification to Superior Court, Law Division, Bergen County (A-164/165 Americana Associates v. Borough of Fort Lee and A-166/167 New Jersey Realty Co. v. Borough of Fort Lee).
For modification in Helmsley and reversal in New Jersey Realty Co. and Americana Assoc. -- Chief Justice Hughes and Justices Mountain, Sullivan, Clifford, Schreiber and Handler. Opposed -- None. The opinion of the Court was delivered by Mountain, J.
Rent control ordinances have proliferated in the five years following this Court's decision in Inganamort v. Borough of Fort Lee, 62 N.J. 521 (1973), which upheld a municipality's power to enact such an ordinance. The principles governing attacks on the facial validity of rent control ordinances were discussed at length in Hutton Park Gardens v. West Orange Town Council, 68 N.J. 543 (1975); Brunetti v. Borough of New Milford, 68 N.J. 576 (1975), and Troy Hills Village v. Parsippany-Troy Hills Tp. Council, 68 N.J. 604 (1975) (hereinafter sometimes called the "Trilogy"). In those cases, we held that a rent control ordinance must permit an efficient landlord to realize a "just and reasonable" return. Hutton Park Gardens, supra, 68 N.J. at 568; Brunetti, supra, 68 N.J. at 592; Troy Hills Village, supra, 68 N.J. at 620. On the present appeal, we are required to determine whether the application of the rent control ordinances of Fort Lee has or has not denied landlords this minimum constitutional return.
Fort Lee enacted its first rent control ordinance in 1972. Under Ord. No. 72-1, landlords could increase rents by the percentage rise in the Consumer Price Index (hereinafter "CPI"). After the municipality's power to regulate rents was confirmed in Inganamort v. Borough of Fort Lee, supra, the ordinance was superseded by Ord. No. 74-32, effective November 6, 1974. Section 2 of the new ordinance still purported to limit rent increases to the percentage increase in the CPI. A crucial proviso, however, overrode the CPI limitation:
Notwithstanding any of the foregoing provisions of this section to the contrary, no landlord may request or receive a percentage increase in rent with respect to any housing space which is greater than two and one-half (2 1/2%) per cent of the last prior rent during any calendar year.
In light of recent economic trends, the practical effect of Ord. No. 74-32 was to impose a 2.5% ceiling on rent increases.*fn1 In addition, Section 6 permitted landlords to pass through to tenants increases in property taxes. Landlords could seek hardship relief to supplement the automatic increases. Guidelines governing the granting of such relief were embodied in Ord. No. 75-45.
The validity of Ord. No. 74-32, or the "2.5% ordinance," was immediately challenged in A-163, Helmsley v. Fort Lee, an action in lieu of prerogative writ. The twelve plaintiffs, owners of multiple-family dwellings in the borough, contended that Ord. No. 74-32 was not justified by any housing emergency, and further that it deprived them of a fair and reasonable return on their investment.*fn2 On November 20, 1974 the trial court entered a temporary restraining order against enforcement of the 2.5% limitation on automatic rent increases.
On July 31, 1975 the trial court held the 2.5% limitation to be facially constitutional, but continued its order restraining
enforcement. By order, the court permitted the landlords to raise rents up to the percentage increase in CPI, but increases greater than 2.5% were to be placed in escrow. The restraining order and escrow arrangement have been continued during the appellate process. On March 31, 1977 the Appellate Division affirmed the trial court judgment.
Meanwhile, Fort Lee had enacted a major revision of its rent control system on June 30, 1976. Ordinance No. 76-8 limited automatic rent increases to a "maximum annual percentage," or "MAP," which was derived from increases in real estate taxes and specified components of the CPI. Thus, rent increases were to be related to operating cost increases. The details of the MAP plan will be discussed in Section V, infra. The MAP formula was not to become effective, however, until thirty days after the "final and complete disposition" of the appeal in Helmsley v. Fort Lee. Ordinance No. 76-8 also repealed, effective immediately, the sections of Ord. No. 74-32 which permitted landlords to pass through to tenants real estate tax increases. The impact of the tax passthrough repealer was substantial; the 1976 tax rate had been recently announced, and it represented a 30% increase over the 1975 rate.
Ordinance No. 76-8 was immediately challenged in two actions in lieu of prerogative writs, A-164, New Jersey Realty Co. v. Fort Lee and A-166, Americana Associates v. Fort Lee, which were consolidated for trial. The Fort Lee Tenants Association, and later the Department of the Public Advocate, were permitted to intervene as defendants. On March 11, 1977 the trial court held the tax passthrough repealer valid, effective June 30, 1976, but invalidated all other sections of Ord. No. 76-8 because of the contingent effective date.
On July 21, 1977 we granted certification in Helmsley v. Fort Lee and in the appeals and cross-appeals in New Jersey Realty Co. v. Fort Lee and Americana Assoc. v. Fort Lee then pending unheard in the Appellate Division. 75 N.J. 31, 32
(1977). We vacated the Appellate Division judgment in Helmsley, consolidated and remanded all three cases for a plenary hearing on the issue of just and reasonable return, at the same time retaining jurisdiction.
The 17-day hearing on remand concluded on December 14, 1977. It would serve no useful purpose to attempt to summarize, however briefly, all of the evidence adduced at this hearing. Instead, we will here merely outline the nature of the proofs, referring to specific factual showings, where appropriate, in later sections of this opinion.
The keystone of plaintiffs' case was a survey of the operating histories of 35 multiple-family buildings in Fort Lee, prepared by a certified public accountant whose clients include the operators of several Fort Lee apartment buildings. The 35 buildings in the survey contain 7542 apartments, or units; they comprise approximately 85% of all rental units in the borough. Fifteen buildings with 4958 units were classified as highrises, 11 buildings with 2053 units as lowrises, and 9 buildings with 531 units as garden apartments.*fn3 The survey included buildings whose landlords were not plaintiffs in this litigation. For each building, the landlord supplied detailed financial data for the years 1970 through 1976, including financial statements, utility and fuel bills, real estate tax bills, payroll and income tax returns, insurance and mortgage information, monthly rent rolls, and any applications for hardship relief. From these data several tables were prepared for each building showing actual profit and loss and projecting future trends under the 2.5% limitation. The plaintiffs' survey was interpreted by several expert real estate consultants. Other experts and several landlords discussed the theoretical and practical effects of rent control in Fort Lee. Several witnesses addressed the question of determining a just and reasonable return. Fort Lee presented
only one witness, a real estate consultant. He testified in general terms about relevant factors in fixing a just and reasonable return. Finally, the chairman of the Fort Lee Rent Leveling Board testified as the court's witness. He described the Rent Leveling Board's procedures.
On March 1, 1978 the findings and determinations on remand were filed. The court determined that "the entire Fort Lee rent control mechanism" was confiscatory and hence invalid.
As the abbreviated procedural history above suggests, this appeal is the culmination of long and complicated litigation. The complaint in Helmsley v. Fort Lee was filed almost four years ago, in November 1974. The length of the litigation has produced an unusual procedural situation. The focus of the Helmsley case has shifted over time. What started as an attack on the facial constitutionality of Ord. No. 74-32 has become a challenge to the ordinance's validity as applied. This is, moreover, an unusual test of an ordinance "as applied," for we are asked to rule on the ordinance's application to the entire borough of Fort Lee, rather than to an isolated building. Plaintiffs have made no attempt to single out their properties; their proofs have been addressed to the boroughwide impact of the ordinance. In the case of an individual building, the landlord would be required to exhaust his administrative remedies by seeking hardship relief. Brunetti v. Borough of New Milford, supra, 68 N.J. at 588. In Fort Lee, however, no administrative body is empowered to review the general effect of the rent control ordinance, at issue in the present case.
One troublesome consequence of the procedural posture described above is that we must reach general conclusions about all apartments in Fort Lee. Plaintiffs' data illustrate vividly the diversity among the 35 buildings in their survey, ranging from a 1260-unit highrise to an 11-unit garden apartment building. Further, even the financial histories of buildings with similar physical characteristics differ widely. Yet, to succeed, plaintiffs must demonstrate that the rent
control ordinance has a widespread confiscatory impact upon the disparate buildings in Fort Lee.
Plaintiffs assert at the outset that there is no rational basis for enacting any rent control measure in Fort Lee. The preamble to Ord. No. 74-32 pointed to unwarranted, exorbitant rent increases to justify imposition of the 2.5% limitation. Plaintiffs claim that they have shown that rents in 1974 were at reasonable levels, and that no other factual basis for the ordinance existed.
Municipal authority to enact rent control ordinances under the police power delegated by N.J.S.A. 40:48-2 was recognized in Inganamort v. Borough of Fort Lee, supra, 62 N.J. 521 (1973). A rent control ordinance is a valid exercise of municipal power if there is any rational basis for the enactment. Brunetti v. Borough of New Milford, supra, 68 N.J. at 594; Troy Hills Village, supra, 68 N.J. at 616; Hutton Park Gardens, supra, 68 N.J. at 564-65.
Contrary to plaintiffs' contentions, their own proofs demonstrate an adequate factual basis for adoption of rent control in Fort Lee. In Troy Hills Village, supra, the municipality's expert testified that a vacancy rate of less than 3% indicated a serious housing shortage. Other testimony then showed that the local vacancy rate was less than 2%. We found that, on this basis, the governing body could rationally conclude that rent control was necessary. Similarly, in the present case, several of plaintiffs' experts stated that a 5% vacancy rate was typical of a housing market in equilibrium; one fixed a 3% vacancy rate as indicative of a housing shortage. Plaintiffs' financial data indicate a 1973 vacancy rate of less than 1.5% in 28 buildings with 4648 units. One 1260-unit complex, Horizon House, had a 7% vacancy rate which appears to be aberrational. Even including Horizon House, the borough-wide vacancy rate was 2.6%. As in
Troy Hills Village, supra, these data constitute a rational basis for adoption of rent control. We note parenthetically that vacancy rates dropped under Ord. No. 74-32. The 1976 vacancy rate in 35 buildings with 7542 units was 1.9%. Thus it is apparent that there continues to be a rational basis for rent control in Fort Lee.
The vacancy rate data render irrelevant plaintiffs' contention that no exorbitant rent increases preceded enactment of the 2.5% ordinance. We note in passing, however, that the testimony plaintiffs cite on reasonableness of rents was almost wholly conclusory, without adequate foundation. Further, plaintiffs' financial data are equivocal at best. Between 1970 and 1973, plaintiffs' data reveal percentage increases in net operating income, see Note 5 post, greater than the increase in the CPI in one highrise, 6 of 7 lowrise buildings, and 4 of 7 garden complexes. That is, for these buildings, landlords' profits were keeping ahead of inflation. While these data do not necessarily establish a pattern of rent gouging, neither do they refute the assertion in the preamble to Ord. No. 74-32 that speculative and unwarranted rent increases were being demanded.
We turn now to the constitutionality of Ord. No. 74-32, which limited annual rent increases to 2.5% and permitted landlords to pass through to tenants increases in real estate taxes. It is axiomatic that a rent control ordinance must permit an efficient landlord to realize a "just and reasonable return" on his property. Hutton Park Gardens, supra, 68 N.J. at 568. Satisfactory formulations of just and reasonable return, however, have proven to be elusive. Before reaching the question as to what level of return is confiscatory, consideration must first be given to what constitutes the proper formula for computing a landlord's return.
There are at least three basic approaches to defining fair return. In an early regulatory case, the United States Supreme
Court decreed that return on fair value must be the criterion for confiscation.*fn4 Smyth v. Ames, 169 U.S. 466, 545, 18 S. Ct. 418, 433, 42 L. Ed. 819, 849 (1898), decree modified, 171 U.S. 361, 18 S. Ct. 888, 43 L. Ed. 197 (1898). The Court later modified this position, approving (but not mandating) the use of return on investment. Federal Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591, 64 S. Ct. 281, 88 L. Ed. 333 (1944). A third standard, the fraction of gross income comprised by operating profits, was employed in the now-expired New Jersey Rent Control Law, L. 1953 c. 216. We upheld its constitutionality in Jamouneau v. Harner, 16 N.J. 500, 526-28 (1954), cert. denied, 349 U.S. 904, 75 S. Ct. 580, 99 L. Ed. 1241 (1955).
Plaintiffs attempted to show that the operation of the 2.5% ordinance had denied them a just and reasonable return on the value of their buildings. They presented several expert witnesses who attempted to calculate the rate of return upon the value of the property in "a hypothetical market in which the supply of available rental housing is just adequate to meet the needs of the various categories of persons actively desiring to rent apartments in the municipality." Troy Hills Village, supra, 68 N.J. at 624. Plaintiffs' proofs were insufficient to show confiscation on this theory.
First, plaintiffs failed to meet the standards articulated by their own witnesses. Stephen Lewinstein, John Bailey and R. A. Stuart Miller testified as experts in evaluating real estate investment opportunities. They stated that investors desired a rate of return on value, defined as the ratio [78 NJ Page 212] between net operating income ("NOI") and value,*fn5 of 10.5% to 12%. In addition, Bailey presented data showing apartment building sales in which the expected net operating income ranged from 8% to 12% of the sales price. Plaintiffs contended in their brief that the expert testimony established that investors desired a rate of return "in the range of 10%." Assuming arguendo that this is the minimum
constitutional "just and reasonable" return, see Hutton Park Gardens, supra, 68 N.J. at 568, we consider plaintiffs' value data.
As we will discuss below, estimation of value presents difficult problems of proof. For the moment, we will accept plaintiffs' proffered expert opinions on value. R. A. Stuart Miller estimated the value of 22 buildings in 1976 in a hypothetical equilibrium market. (Bailey presented similar estimates for three buildings, but no conclusions as to the general impact of a rent control ordinance can be drawn from a sample so small.) Using Miller's valuation material and the 1976 net operating income derived from plaintiffs' survey, we can calculate rates of return on value. These data reveal rates of return "in the range of 10%,"*fn6 plaintiffs' postulated desired return. Thus, by plaintiffs' own criteria they have failed to prove that return on value was confiscatory.
This case was the first serious attempt to prove a rent control ordinance confiscatory as applied under Troy Hills Village, supra. Consequently, we feel constrained to comment on some of the problems which were revealed by this litigation. As predicted in Troy Hills Village, supra, valuation presented "difficult problems of proof." 68 N.J. at 624. The preferred valuation method for apartment buildings is capitalization of income, since investors purchase apartment [78 NJ Page 214] buildings as income-producing properties. See North, "Appraisal of Apartment Buildings," in Encyclopedia of Real Estate Appraising 196 (Friedman ed. 1968). Not surprisingly, all the valuation data at the remand hearing were based on capitalization of income. Once income is controlled, however, using capitalization of income to determine value to regulate future income is a circular process.*fn7 In theory, one could rely upon comparable sales data to avoid the circuity problem. In practice, unfortunately, arms'-length sales of rent controlled apartment buildings are rare. None has been reported in Fort Lee since rent control was imposed in 1972. Sales prices of "comparable" buildings not subject to rent control offer little guidance. The source of an apartment building's value is its income stream; therefore, income will be a crucial factor in determining comparability. Rent control, however, limits the potential growth of that income stream (and also therefore the potential capital appreciation on resale). Thus, the expected future income of a building subject to rent control will be less than that of a "comparable" uncontrolled building. The difference in future income will, of course, be reflected in present value. Construction or replacement cost, a third valuation method, is used primarily
for insurance appraisals of apartment buildings. At best, it determines an upper limit on present market value. See North, supra, at 197; Wendt, Real Estate Appraisal 212 (1956). Finally, assessed valuation will be based on one or more of the above methods, and will therefore be vulnerable to corresponding criticism.
The theoretical problems of valuation were here compounded by the practical difficulties of estimating value in a hypothetical housing market where supply and demand are in equilibrium. None of the witnesses had performed such an analysis before; none knew of any recognized appraisal method for making hypothetical equilibrium valuations. Indeed, plaintiffs' expert testimony concerning the existence of equilibria in Fort Lee was contradictory. Further, no satisfactory foundation was laid for much of this testimony. Hypothetical equilibrium valuations in rent controlled markets must depend upon comparisons with other municipalities or other time periods, since rent control would not be necessary if the housing market were in equilibrium. In Parkview Village Assoc. v. Borough of Collingswood, 62 N.J. 21, 30-33 (1972), this Court discussed the use of "comparable" buildings in valuation. We stressed that comparisons with several buildings with similar physical characteristics from the same geographic area should be used. Parkview Village Associates, supra, dealt with tax assessments, where local comparisons are readily available. Under rent control, however, contemporaneous local comparisons are unavailable by hypothesis. Furthermore, the requisite foundation for comparability of geographically remote buildings is difficult and expensive to establish.
In Troy Hills Village, supra, we outlined tentative guidelines for determining whether a rent control ordinance was confiscatory. At the same time, we cautioned that further litigation would be needed to illuminate this complex subject. After considering the massive record compiled by plaintiffs, we are satisfied that a value-based criterion for confiscation under rent control is practically unworkable.
Plaintiffs did not restrict their arguments to return on value. Although they presented no data on the amount of their investment,*fn8 they did introduce detailed histories of operating expenses and income for 85% of all apartment units in Fort Lee. This information permits us to evaluate the borough-wide impact of the challenged ordinance upon landlords' net operating income.
Several income-based standards for confiscation under rent control have been employed in other legislation. One such approach places a ceiling upon the fraction of total income a landlord can be expected to spend for operating expenses. For example, the New Jersey Rent Control Law, L. 1953, c. 216 § 16(h), permitted landlords to seek a rent increase when operating expenses rose above 75% of total income. The rent control bill introduced last session in our Legislature contained a similar provision, but relaxed the confiscation threshold to 60% of total income. New Jersey Assembly Bill No. 504 (1978). New York City's maximum base rent ("MBR") formula allots 57.6% of total income to operating expenses for buildings under rent control.*fn9 Note, The ABC's of MBR: How to Spell Trouble in Landlord/Tenant Relations,
10 Colum. J. Law & Soc. Prob. 113, 123 (1974). A second approach, used in Cambridge, Massachusetts, guarantees a landlord a "fair net operating income," based upon the actual NOI in a base year adjusted to compensate for inflation. In other words, the Cambridge plan assumes that a landlord's profits at a specified date in a free housing market were fair. The inflation adjustment thus attempts to keep the landlord in the same economic position under rent control.
Turning to Fort Lee, rent control has had a perceptible impact upon the magnitude of NOI and upon the fraction of gross income that NOI represents.*fn10 NOI in 1976 current dollars remained at or slightly below 1973 levels in most buildings. The highrises as a class fared distinctly worse than lowrise and garden complexes. The median change in highrise NOI was approximately a 5% decrease between 1973 and 1976; the median change for lowrise and garden complexes was less than 1%. While isolated buildings showed declines in NOI of up to 25%, no building experienced a substantial increase. Over the same time period, the Consumer Price Index increased approximately 30%. Thus, in terms of purchasing power, all landlords' NOI decreased by roughly one-quarter.
The operating ratios show that landlords were spending approximately 10% more of their income for operating expenses in 1976 than in 1973. The median operating ratio for highrises,
.566, was approaching the .600 level deemed confiscatory by Assembly Bill No. 504; four highrises with 1900 units had operating ratios greater than .600. "New" buildings (defined by plaintiffs as those fully rented after 1970) appeared to be in financial distress in 1976. In seven new buildings, with 1744 units, income was not adequate to cover operating expenses and debt service. Only five new buildings, with 439 units, had positive cash flows in 1976.
These data must be measured against plaintiffs' goal: to invalidate the 2.5% limitation as applied to all apartments in the borough, not simply to a single building. To succeed, plaintiffs must show by clear and convincing evidence that the ordinance had a wide-spread confiscatory impact upon efficient landlords. See Hudson Circle Service, Inc. v. Kearny, 70 N.J. 289, 298-99 (1976); Hutton Park Gardens, supra, 68 N.J. at ...