Opinion ID: 2347494
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Heading: Determination of the Rate of Return Which a Landlord Receives under the Ordinance

Text: In order to establish the rate of return actually being received under a given ordinance, one must deduct reasonable expenses from the gross rental income, and then calculate the percentage relationship between the resulting net income and the value of the landlord's property. Value. Valuation of the landlord's property is, of course, a critical step in determining whether a rent regulation is confiscatory in effect. Cf. In re Intrastate Industrial Sand Rates, supra, 66 N.J. at 21; Public Service Coordinated Transport v. State, supra, 5 N.J. at 217. We must take care, however, to define with precision what we mean by the term value, because, as Justice Brandeis observed 50 years ago, Value is a word of many meanings. Missouri ex rel. Southwestern Bell Telephone Co. v. Missouri Public Service Comm'n, 262 U.S. 276, 310, 43 S.Ct. 544, 554, 67 L.Ed. 981, 995 (1923) (Brandeis, J. concurring). See generally, 2 Bonbright, Valuation of Property, 1166-81 (1937). The meaning of the term must be derived from the purpose for which the valuation is being made. FPC v. Hope Natural Gas Co., 320 U.S. 591, 601 n. 9, 64 S.Ct. 281, 287 n. 9, 88 L.Ed. 333, 344 n. 9 (1944). Rent control begins with the premise that rents are being unfairly inflated as a result of failure in the free operation of the rental housing market  e.g., housing shortages, monopoly power, etc. A standard of valuation which itself incorporates this failure will quickly defeat the purpose of rent control. Thus, valuation based on inflated rents would inevitably and erroneously lead the courts to a conclusion that a regulation which fails to permit such inflated rents is confiscatory. Hall Realty Co. v. Moos, 115 Misc. 506, 188 N.Y.S. 858 (Sup. Ct. 1921), aff'd 200 App. Div. 66, 192 N.Y.S. 530 (App. Div. 1923); 2 Bonbright, Valuation of Property, supra at 1104; cf. I.L.F.Y. Co. v. Temporary State Housing Rent Comm'n, 10 N.Y. 2d 263, 219 N.Y.S. 2d 249, 176 N.E. 2d 822 (Ct. App. 1961). Hence we employ the term value in the present context to refer to the value of the property in a rental housing market free of the aberrant forces which led to the imposition of controls. Where inflated rents are the result of a housing shortage, value refers to the worth of the property in the context of 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. This technique of hypothesizing a rental market with comparable levels of supply and demand has been utilized in English rent control legislation for several years. [7] The Fair Rent, 115 Solicitors' Journal 496 (July 1971). We do not pretend that such a valuation would fairly compensate an owner of residential rental property for permanent and total deprivation of the free use of his property. That, however, is not its purpose. Value in the present context is no more than a meterstick which the courts employ in measuring what rents a landlord is fairly entitled to receive. Justice Brandeis' position that rate-making value and exchange value serve different functions and need not coincide, Missouri ex rel. Southwestern Bell Telephone Co. v. Missouri Public Service Comm'n, supra, 262 U.S. at 289-311, 43 S.Ct. at 547-554, 67 L.Ed. at 985-995 (Brandeis, J. concurring), has long since become the law of the land. FPC v. Hope Natural Gas Co., supra ; FPC v. Natural Gas Pipeline Co., supra . Because value in the sense used here is to some degree hypothetical, it admittedly poses difficult problems of proof. Three methods are conventionally used for valuing real property: depreciated replacement cost, market value based on sales of comparable properties, [8] and capitalized income. See generally, Encyclopedia of Real Estate Appraising 10-16 (Freeman ed. 1968). The method of capitalized income is the one most commonly used in connection with apartment buildings. Id. at 197. Except under the most extraordinary market conditions, these three methods will not ordinarily lead to the same value. Wendt, Real Estate Appraisal 50-54 (1956). In the terminology of real estate appraisal, they must be correlated, i.e., adjusted for discrepancies which arise out of their differing theoretical bases and practical shortcomings as applied to the particular property in question. Encyclopedia of Real Estate Appraising, supra at 120-28. None of these methods is wholly suitable to the problem of determining value in the present context. The capitalized income method begins with a prediction of future income and thus tends to become circular in the rate-making context. FPC v. Hope Natural Gas Co., supra, 320 U.S. at 601, 64 S.Ct. at 287, 88 L.Ed. at 344. To establish current value under this method, the appraiser supplies a desired rate of return as one element in his initial calculations. Because, in the context of rate regulations, the court will use the resulting determination of value to calculate the actual rate of return, the process exhibits circuitous reasoning. Market value based upon sales of comparable properties is sound only insofar as the comparable sales involve properties situated in a rental market that approximates the hypothetical rental market described above. [9] In addition, it may be misleading because the current market value of rental housing depends in large measure upon the earning which can be derived from it. Wilson v. Brown, 137 F. 2d 348, 353 (Emer. Ct. App. 1943). The depreciated replacement cost method also may tend to be misleading when, as appears to be true at the present time, the high cost of construction is a major cause of housing shortages. Cf. Southern Burlington Cty. NAACP v. Mt. Laurel Tp., 67 N.J. 151, 204-05 (1975) (Pashman, J. concurring). All of these methods, though, may shed light on the value of the property as the term is used here, once their deficiencies are recognized. In determining value, the court should take full advantage of the enlightenment which these methods of valuation may provide, as well as that provided by any other soundly conceived method which the parties and their expert witnesses may suggest such as assessed valuation or original cost depreciated. Cf. Public Service Coordinated Transport v. State, supra, 5 N.J. at 217. Expenses. The landlord is entitled to reasonable expenses including taxes and depreciation. These expenses may include, but are not limited to, expenditures for utilities, insurance, maintenance, reasonable repairs, depreciation for capital improvements, taxes, allowances for vacancies and uncollectibles, and depreciation on property. Frequently, a municipal rent leveling ordinance, as in the instant case, will permit landlords to impose direct surcharges on their tenants to cover the cost of realty tax increases or increased services. To the extent that income from these surcharges reimburses the landlord for the cost of certain items, the surcharges should either be included in gross income and included as an operating expense or be totally disregarded, so that they are excluded from gross income and excluded from operating expenses. Naturally, during the examination of ordinances which do not contain such provisions, there will be no additional income from surcharges; however, the costs incurred by the landlord will be reported by the landlord as operating expenses. Finally, it should be noted that the constitution does not require that inefficient operators be permitted the same return as efficient managers. Hutton Park, supra, 68 N.J. at 570; Permian Basin Area Rate Cases, 390 U.S. 747, 769, 88 S.Ct. 1344, 1361, 20 L.Ed. 2d 312, 337 (1968); Hegeman Farms Corp. v. Baldwin, 293 U.S. 163, 55 S.Ct. 7, 79 L.Ed. 259 (1934); Covington & Lexington Turnpike Rd. Co. v. Sandford, 164 U.S. 578, 596-98, 17 S.Ct. 198, 205-06, 41 L.Ed. 560, 566-67 (1896). When an unreasonable expense has been incurred, the court should reject it and substitute a more reasonable alternative in its place. Plaintiff's books are, at best, merely prima facie evidence of expenses. They are always open to question for lack of reasonableness. Cf. Public Service Coordinated Transport Co. v. State, supra, 5 N.J. at 218. Gross rental income. In evaluating the income permitted by a rent leveling regulation, each individually administered apartment complex should be treated separately. A property owner will not be permitted to subsidize projects which yield an inadequate return out of his profits derived from other projects. Nor may the fact that one project is receiving more than an adequate return be concealed by averaging it together with projects bringing in lesser returns. Insofar as income is projected into the future, the landlord is entitled to reasonable deductions for vacancy rates due to ordinary turnover, if they are not already accounted for as an operating cost.