Opinion ID: 2347494
Heading Depth: 1
Heading Rank: 2

Heading: Substantive Due Process Confiscation

Text: We have discussed claims that municipal rent control ordinances are facially confiscatory in the companion case of Hutton Park, supra . While the Parsippany-Troy Hills ordinance differs in significant details from the ordinances considered in that opinion, none of those points of difference is such as to lead us to the conclusion that the ordinance at issue here is so restrictive as to facially preclude any possibility of a just and reasonable return. 68 N.J. at 571. Unlike the plaintiffs in the companion cases, the present plaintiffs allege that the ordinance is confiscatory as applied and have presented evidence in support of that claim. Jerold Goldberg, a certified public accountant, testified as to the financial condition of Cambridge Village, a garden apartment complex containing 130 units, identified by plaintiffs as a typical small garden apartment complex. In fiscal 1974, the gross income of the complex was $313,162, [4a] an increase of 6.7% over the gross income of $293,460 received during fiscal 1973. Expenses for the fiscal year, excluding management fees and payroll to officers or interested parties, [5] were $178,212, an increase of 19.2% over the 1973 expenses of $149,516. No evidence was presented bearing on the reasonableness of these expenses, on the value of the complex or, most important, on the possibility that the net operating income did not provide a fair return on the owners' investment. Jacob Weiss, a certified public accountant, testified as to the financial condition of Knoll Gardens, a garden apartment containing 1108 units, represented by plaintiffs to be a typical large apartment complex. In fiscal 1974, [6] gross income totaled $2,600,311, a 3.8% increase over the $2,503,707 fiscal 1973 gross income. Expenses for fiscal 1974, excluding officers' salaries, management fees, depreciation expenses, and state franchise and unincorporated business taxes, totaled $857,943, an increase of 24.6% over the 1973 fiscal year figure of $688,645. Once again there was no evidence as to the reasonableness of the expenses, as to the value of the apartment complex or as to whether the net operating income was a fair return on investment. Although the subsidization of housing may be deemed a desirable or necessary response to social or economic ills, landlords cannot be compelled by municipal ordinances to subsidize the housing needs of their tenants. The legislative power to set rates does not give a municipality the power to compel the doing of services without reward ... Budd v. New York, 143 U.S. 517, 547, 12 S.Ct. 468, 477, 36 L.Ed. 247, 257 (1892). As discussed in Hutton Park, supra, 68 N.J. at 565, a rent control regulation, to survive a constitutional challenge, must be nonconfiscatory as applied as well as nonconfiscatory on its face. The test for confiscation is whether the ordinance permits an efficient landlord to obtain a just and reasonable return on his property. Hutton Park, supra, 68 N.J. at 568-569. We do not regard this appeal or the companion cases as the appropriate vehicle for a comprehensive or definitive formulation of the methodology for determining whether a landlord is receiving a fair return under a given rent control ordinance. The law concerning fair return in the context of rent control is still in its nascent stages. Moreover, in none of the cases decided today has the landlord sought to demonstrate the inadequacy of its net return. Consequently, the records before us are not suited to a full treatment of the question of fair return. We further consider that from a procedural point of view it is highly desirable (though not mandatory) that municipalities enact, as part of their rent control ordinances, provisions under which landlords will be assured a just and reasonable return. These provisions should set forth standards and criteria by which the parties, the local rent control agency and reviewing tribunals can be guided in determining the adequacy of returns actually received under the ordinance. See, e.g., L. 1953, c. 216, § 16(h) and L. 1966, c. 168, § 4(e). To say nothing more, for example, than that a landlord may seek relief if he cannot realize a reasonable profit from his investment would be inadequate since it fails to provide useful guidelines by virtue of which landlords can seek such relief. However, the courts are still the final arbiters as to whether a landlord is able to obtain a just and reasonable return under a rent control ordinance. Therefore, in the interest of assisting tribunals in the resolution of future cases, we deem it appropriate to provide some guidance on the question of whether an ordinance is confiscatory as applied. Consequently, we set forth guidelines in more detail than would be necessary to resolve the particular issues raised by this appeal. We also examine some of the factors which should be considered in cases where landlords challenge a rent leveling ordinance as confiscatory. We do not, however, wish to imply that reliance on any one formula or method for determining the figures relevant to this question is mandated by this opinion. Therefore, our comments are intended to be general. We expect that as cases are litigated and records of expert testimony are fully developed, more information will become available to refine and, if need be, alter these guidelines. We perceive that deciding whether a rent regulation permits a just and reasonable return requires consideration of the value of the rental property, the reasonable expense of operating the property, the income, the rate of return on the value of the property actually permitted by the rent regulation, and the minimum rate of return which would be just and reasonable for that property. Basically, this procedure involves two separate stages of calculations. First, the tribunal must make a factual finding as to the rate of return on the value of the property which the landlord will in fact receive under the governing rent leveling ordinance. Second, the tribunal must make a factual determination as to that rate of return below which an actual rate of return would be confiscatory. This second determination can be designated as the just and reasonable rate of return on the value of a given rental unit. If the rate of return which the landlord actually receives falls below the just and reasonable rate, then the ordinance must be invalidated as confiscatory. The general procedure for determining just and reasonable return is familiar to the law of public utilities. Cf. Public Service Coordinated Transport v. State, 5 N.J. 196, 216 (1950); In re Intrastate Industrial Sand Rates, 66 N.J. 12, 21-22 (1974); FPC v. Natural Gas Pipeline Co., 315 U.S. 575, 584, 62 S.Ct. 736, 742, 86 L.Ed. 1037, 1048 (1942). See generally, Garfield & Lovejoy, Public Utility Economics, (1964); Bonright, Principles of Public Utility Rates (1961); Kahn, The Economics of Regulation (1970). To this extent utilities law may provide some guidance for our purposes. However, because of fundamental differences in the nature of the property involved and the purposes of the regulations, public utility precedents are of only limited value to the field of rent control. In particular, it should be noted that constitutional challenges to rent leveling ordinances are not rate-fixing cases. Courts should not be concerned with balancing competing interests and determining what is the best rate level. Rather, their sole task is to determine the lowest constitutionally permissible rate. That which follows is an examination of the various factors which should be considered in making this determination.
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.
The determination of the minimum rate of return which is constitutionally permissible is largely one of fact. There are a number of approaches which may be taken in determining the existence of such fair return. Examples may be found in statutes and regulations in this and other states and in the federal government over the years. See, e.g., L. 1953, c. 216, § 16 and L. 1966, c. 168, § 4(e), which fixed criteria for fair net operating income in terms of given ratios of net operating income to gross income of buildings of that class, and other factors. See also British Rent Act of 1968, Sec. 46, supra. We leave to subsequent cases a fuller examination of the advantages and disadvantages of these methods. However, to assist the lower courts in resolution of future cases, we do set forth general guidelines to be followed when evaluating figures which various parties proffer as representative of the just and reasonable or constitutionally minimal rate of return. In determining what is a just and reasonable return, the court must evaluate the interests of the consumer and general public as well as the interests of the landlord. Hutton Park, supra, 68 N.J. at 570 and cases cited therein. It is no objection that rental levels under the ordinance incidentally cause the value of the property to decline. Hutton Park, supra, 68 N.J. at 569; Permian Basin Area Rate Cases, supra, 390 U.S. at 769, 88 S.Ct. at 1361, 20 L.Ed. 2d at 337; FPC v. Hope Natural Gas Co., supra, 320 U.S. at 601, 64 S.Ct. at 287, 88 L.Ed. at 344. Furthermore, rent levels may permissibly work hardships on landlords in atypical cases, may drive inefficient operators out of the market and may preclude persons who have paid inflated purchase prices for buildings from recovering a fair return. Hutton Park, supra, 68 N.J. at 570; Permian Basin Area Rate Cases, supra, 390 U.S. at 769, 88 S.Ct. at 1361, 20 L.Ed. 2d at 337; Hegeman Farms Corp. v. Baldwin, supra, 293 U.S. at 170-71, 55 S.Ct. at 9-10, 79 L.Ed. at 262-63; Covington & Lexington Turnpike Rd. Co. v. Sandford, supra, 164 U.S. at 596-97, 17 S.Ct. at 205-06, 41 L.Ed. at 566-67; N.J. Central Traction Co. v. Bd. of Public Utility Comm'rs, 96 N.J.L. 90 (Sup. Ct. 1921). However, to be just and reasonable a rate of return must be high enough to encourage good management including adequate maintenance of services, to furnish a reward for efficiency, to discourage the flight of capital from the rental housing market, and to enable operators to maintain and support their credit. A just and reasonable return is one which is generally commensurate with returns on investments in other enterprises having corresponding risks. On the other hand it is also one which is not so high as to defeat the purposes of rent control nor permit landlords to demand of tenants more than the fair value of the property and services which are provided. Cf. Permian Basin Area Rate Cases, supra, 390 U.S. at 792, 88 S.Ct. at 1373, 20 L.Ed. 2d at 350; FPC v. Hope Natural Gas Co., supra, 320 U.S. at 603, 64 S.Ct. at 288, 88 L.Ed. at 345; Missouri ex rel. Southwestern Bell Telephone Co. v. Missouri Public Service Comm'n, supra, 262 U.S. at 291, 43 S.Ct. at 547, 67 L.Ed. at 986; Public Service Coordinated Transport v. State, supra, 5 N.J. at 225. The rate need not be as high as existed prior to regulation nor as high as an investor might obtain by placing his capital elsewhere. Hutton Park, supra, 68 N.J. at 569-570; Covington & Lexington Turnpike Rd. Co. v. Sandford, supra, 164 U.S. at 596-98, 17 S.Ct. at 205-06, 41 L.Ed. at 566-67. As noted above, the task of the tribunal is to determine the lowest constitutionally permissible rate. There is no constitutional obstacle to a rent control ordinance which permits a higher rate of return. [10] The duty of the courts is limited to assuring that the ordinance does not oblige the efficient landlord to accept less. Plaintiffs' proofs are almost exclusively concerned with periods prior to the adoption of the rent increase formula at issue in this appeal. This in itself does not render the attack premature. Where expenses and income can be projected forward with reasonable accuracy and the effects upon the rate of return of the regulation computed, property owners need not wait until they have already begun to suffer unjustly depressed returns before seeking judicial relief. The proofs themselves, however, are manifestly insufficient to sustain plaintiffs' heavy burden of proof. Plaintiffs have tendered no evidence with respect to the value of the properties in question. Their evidence of expenses was fragmentary and inadequately documented, and they have made no effort to prove what rate of return would be constitutionally required in the present context. On the record before the Court, plaintiffs' attack on the ordinance as confiscatory as applied must fail.