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Colony Cove Properties, LLC v. City of Carson

California Court of Appeals, Second District, Fourth Division

October 21, 2013

COLONY COVE PROPERTIES, LLC, Plaintiff and Appellant,
v.
CITY OF CARSON et al., Defendants and Respondents.

APPEAL from judgments of the Superior Court of Los Angeles County Nos. BS124253 & BS124776, David P. Yaffe, Judge.

Gilchrist & Rutter, Richard H. Close, Thomas W. Casparian and Kevin M. Yopp; O’Melveny & Myers, Matthew W. Close and Tamar M. Braz for Plaintiff and Appellant.

Aleshire & Wynder, William W. Wynder, Sunny K. Soltani and Jeff M. Malawy for Defendants and Respondents.

MANELLA, J.

Appellant Colony Cove Properties, LLC, a Delaware limited liability company, is the owner of the Colony Cove Mobile Estates, a mobilehome park (the Park) containing approximately 400 spaces, located in respondent City of Carson (the City). At the time appellant purchased the Park, it was rent controlled.[1] Appellant submitted applications for rent increases in September 2007 and again in September 2008. After hearings in June 2008 and June 2009, respondent Carson Mobilehome Park Rental Review Board (the Board) approved increases in the monthly rent per unit of $36.74 and $25.02. Appellant contended that even after the rent increases approved by the Board, the rental income from Park residents was insufficient to cover its expenses, including interest payments on the $18 million loan it had secured to purchase the Park. Appellant maintained that to avoid becoming confiscatory, rents must be set at a level sufficient to provide a profit after payment of debt service. In two separate proceedings before the trial court (consolidated for appeal), the court denied appellant’s petitions for writ of administrative mandamus seeking to overturn the Board’s determinations. We conclude that substantial evidence supported the determination that the rent levels set by the Board provided appellant a fair return. Accordingly, we affirm the trial court’s decision denying the petitions. We reverse only that portion of the court’s order striking appellants’ reservation of their federal claims.

FACTUAL AND PROCEDURAL BACKGROUND

A. Purchase of Property

Appellant purchased the Park for $23, 050, 000 in April 2006, putting $5, 050, 000 down and financing the $18 million balance at a variable rate, which in 2007 was approximately 7 percent.[2] The Park had 404 spaces, of which 403 were available for rent.[3] At the time of the sale, the Park’s tenants were paying rents averaging $408 per space per month, and the Park’s gross income totaled approximately $2.2 million per year, including miscellaneous income from sources other than rent. The Park’s “net operating income” (a figure calculated by subtracting regular operating expenses, but not debt service, from gross income) was $1.1 million. The prior owner’s debt service was approximately $350, 000 per year, leaving over $700, 000 in cash profit.

B. Rent Control Ordinance

Since 1979, the City of Carson has had a “Mobilehome Space Rent Control Ordinance” (Carson Mun. Code, § 4700 et seq.; (Ordinance)). The Ordinance requires the Board to “grant such rent increases as it determines to be fair, just and reasonable.” (Ord., § 4704(g).) In general, a rent increase is “fair, just and reasonable” if it “protects Homeowners from excessive rent increases and allows a fair return on investment to the Park Owner.” (Ibid.) The Ordinance sets forth certain non-exclusive factors the Board is to consider in determining whether to grant an owner’s request for rent increases, including (1) changes in the consumer price index for consumers in the Los Angeles-Anaheim-Riverside area; (2) the rent charged for comparable mobilehome spaces in the City; (3) the length of time since the last Board determination of a rent increase application; (4) any capital improvements undertaken and completed; (5) changes in property taxes or other taxes; (6) changes in utility charges; (7) changes in reasonable operating and maintenance expenses; (8) unusual repairs; and (9) services provided. (Ibid.)

The City has adopted “Guidelines for Implementation of the Mobilehome Space Rent Control Ordinance” (the Guidelines). The Guidelines provide that the factors in section 4704(g) of the Ordinance are to be used “to focus on changes in a park’s income, expenses and circumstances, including changes in the general economy, to determine whether a rent increase is appropriate to allow the owner to keep earning a fair return..., ” that “[n]o one factor... is determinative, ” and “the factors must be considered together and balanced in light of the purposes of the Ordinance and all the relevant evidence.” (Guidelines, §I(C-D).) The Guidelines further provide that “[t]he Board cannot reconsider its decisions on a rent adjustment application after they have been embodied in a formal written resolution setting forth the findings of the Board. Therefore, each rent increase application after the first application is evaluated only on the basis of changes in income, expenses, profit, the CPI, maintenance, amenities and services that have occurred since the date of the last increase approved by the Board.” (Id., ¶ I.E.)

With respect to debt service as an allowable expense, the Guidelines provide that allowable expenses include “[d]ebt service incurred prior to adoption of the Ordinance to purchase or operate the park” and “[d]ebt [s]ervice necessarily incurred to operate the park after adoption of the Ordinance... if the financing arrangements were prudent and consistent with customary business practice.” (Guidelines, § II(A)(2), subds. (d) & (e).) However, debt service incurred to purchase a park after adoption of the Ordinance is an allowable expense only if “the purchase price paid was reasonable in light of the customary financing practices, ” and the applicant has “the burden of establishing the reasonableness of the purchase price and financing procedures.” (Id., §II(A)(2), subd. (f).) The Guidelines explain: “The reason for these general rules is that passing on increased debt service due to purchase at prices above those that can be justified by the income earned by the park under rent control or incurred by unusual financing methods, such as 100% financing, would defeat the purpose of rent control.” (Ibid.)

The Guidelines go on to state that “in evaluating a rent increase application, the Board may consider, in addition to the factors specified in § 4704(g) of the Ordinance, a ‘gross profits maintenance [GPM] analysis, ’ which compares the gross profit level expected from the last rent increase granted to the park prior to the current application (‘target profit’) to the gross profit shown by the current application.” (Guidelines, §II(B).) According to the Guidelines, the GPM analysis is “intended to provide an estimate of whether a park is earning the profit estimated to provide a fair return, as established by the immediately prior rent increase, with some adjustment to reflect any increase in the CPI”; it is “an aid to assist the Board in applying the factors in the Ordinance, ” and is “to be considered together with the factors in § 4704(g), other relevant evidence presented and the purposes of the Ordinance.” (Ibid.) The Guidelines expressly state that the GPM analysis is “not intended to create any entitlement to any particular rent increase.” (Ibid.)

In October 2006, the Guidelines were amended to provide that the Board “may also consider, a ‘maintenance of net operating income [MNOI] analysis, ’ which compares the net operating income (NOI) level expected from the last rent increase granted to a park owner and prior to any pending rent increase application (the so called ‘target NOI’) to the NOI demonstrated in any pending rent increase application.” [4] (Guidelines, §II(C).) Such MNOI analysis “is intended to provide another method to estimate whether any applicant for a rent increase is earning a constitutional fair return, as established by the immediately prior rent increase, with appropriate adjustment(s) to reflect changes in the CPI, and is a methodology approved by the courts in which changes in debt service expenses are not to be considered in the analysis (unlike a gross profits maintenance analysis, where such changes may be considered).” (Guidelines, §II(C)(2).)

The Guidelines state that “[t]he Ordinance assumes that the profit earned by park owners when the Ordinance was adopted provided a fair return because it was based on rents chosen by the owners prior to the regulation” (Guidelines, §I(C)) and further assumes that “park owners attempted to rebut that presumption when they first applied for an increase.” (Guidelines, §IV(A).) The Guidelines further explain: “Most applications submitted to the Board have been based on the factors in the Ordinance and Park Owners rarely offer evidence concerning their investment in a park, the return being earned on the park or the return being earned by comparable mobilehome parks.” (Ibid.) However, if an applicant believes “the park cannot earn a fair return without an increase greater than that permitted by application of the factors in the Ordinance, ” he, she or it may attempt to rebut the presumption by presenting additional evidence not specifically related to the Ordinance factors, including (1) the date the park was purchased; (2) the purchase price; (3) the rents charged and the net operating income of the park prior to the purchase; (4) an appraisal of the park at the time of purchase; (5) the amount of the down payment and/or current amount of equity; (6) any capital improvements made; and (7) the “Overall Rate of Return [defined as “ratio of net operating income to purchase price” of comparable] mobilehome parks in jurisdictions with and without rent control at the time of the application.” (Guidelines, § IV(A)

(1-4).)

The Guidelines expressly state: “[The Board] will not consider return based on the current fair market value of a park or the value of park property for purposes other than use as a mobilehome park.” (Guidelines, §IV(A)(4).) Further, “[s]ince mobilehome parks are unique investments, it is unlikely that the return on other types of investments would be found relevant by the Board [T]he return on investments which do not have the potential for appreciation in value are not relevant.” (Ibid.) The Guidelines recognize that even comparison with other types of rental housing is of limited relevance because owners of mobilehome parks do not have the responsibility or expense of maintaining the actual housing units, mobilehome parks experience much lower vacancy rates than other types of rentals, and mobilehome park residents invest in improvements which enhance the owner’s investment. (Ibid.)

C. Appellant’s September 2007 (“Year 1”) Rent Increase Applications

1. General Rent Increase Application

a. Initial Calculation

In September 2007, appellant submitted to the Board an application for a rent increase of $618.05 per space per month.[5] The figure was derived from calculations performed by appellant’s expert, John P. Neet.[6] Neet assumed that appellant was entitled to a 9 percent per year return on the $23, 050, 000 purchase price of the Park, or $2, 074, 500 per year.[7] If appellant’s debt service on the $18 million loan used to purchase the Park was taken into account, the Park’s current income was approximately $900, 000 less than appellant’s expenses.[8] The requested rent increase would have resulted in almost $3 million in additional revenues every year. Neet called this calculation a “Net Operating Income (Including Debt Service)” analysis.

This analysis was subsequently criticized by the Board’s experts as “meaningless” and “mak[ing no] sense” because appellant did not have $23 million invested in the Park and if it had, there would have been zero debt service. Neet agreed the criticism was well-taken and made no further reference to this analysis -- or to the $618 rent increase it allegedly supported -- in his supplemental reports. Prior to the hearing on its application, appellant withdrew the contention that a monthly rent increase of $618 was required under any proper analysis.

b. Subsequent Calculations

In connection with appellant’s initial application, Neet conducted two additional analyses, which purported to justify lesser rent increases and which, with some adjustments, form the basis of appellant’s current contentions concerning fair rent. Neet calculated, based on the same expected 9 percent return on the property’s $23, 050, 000 million purchase price, that even excluding appellant’s debt service, there would be a shortfall of $1.769 million, requiring an increase in rents of $365 per space per month.[9] Neet also calculated that in order for appellant to receive a return of 11.5 percent ($580, 750) per year on its actual equity (the $5.05 million down payment), rents would need to be raised $327 per space per month when debt service was taken into account.[10] Neet called the former calculation a “Net Operating Income” analysis and the latter calculation a “Net Income to Equity” analysis.[11]

After receiving the Board staff’s initial analysis (discussed further below), which concluded that a significant portion of appellant’s alleged operating expenses should be disallowed, Neet recalculated the rent increase required under his “Net Operating Income” analysis and concluded a lesser increase of $210 was warranted. Neet also recalculated the rent increase under his “Net Income to Equity” analysis and concluded an increase of $161.84 was warranted.[12]

In May 2008, while the application was pending, appellant submitted an MNOI analysis by Michael St. John, Ph.D. For the base year, Dr. St. John used 1978 -- the year prior to imposition of rent control -- and concluded a $208.22 per space per month rent increase was necessary to maintain that year’s net operating income based on indexing the 1978 net operating income at 100 percent of the reported increase in the CPI since 1978.[13]

2. Supplemental Rent Increase Application

In September 2007, appellant also submitted a supplemental rent increase application, referred to as a “fair return” application.[14] The supplemental application contained a Gross Profit Maintenance (GPM) analysis.[15] The application stated that in order for appellant to maintain the 2005 (pre-purchase) gross profit, an increase of $388.85 per space per month was warranted. Essentially, it concluded appellant was entitled to approximately $800, 000 in gross profits to match the prior owner’s 2005 gross profits of $718, 240, adjusted for inflation by 100 percent of the CPI. To reach that figure, an additional $1.88 million in revenue was needed in view of appellant’s much larger debt service. That figure, divided by 403 spaces and 12 months, equaled the requested $388.85 increase.

3. Board Experts’ Reports

The Board hired its own expert, Kenneth Baar, Ph.D, who performed both a GPM analysis and an MNOI analysis. Under Dr. Baar’s GPM analysis, which used 2005 as the base year, increase in rents would have been in the $200 range (the precise number dependent on the rate used for the increase in the CPI between 2005 and 2007), and all but approximately $15 of it would be due to appellant’s increased debt service. However, Dr. Baar expressed the opinion that use of a GPM approach to calculate fair rent would not be appropriate because the amount appellant paid for the Park “was not ‘reasonable in light of existing rents.’” He also noted that “[i]n recent decades, ” some real estate investors “have accepted a very low rate of return at the outset in return for the prospects of appreciation and some tax shelter benefits.” Dr. Baar expressed the opinion that appellant had paid an excessive price for the property and incurred negative cash flow based on its belief that it would automatically “obtain a substantial rent increase.”[16] Dr. Baar stated that rate of return formulas which include debt service “suffer from the shortcoming that they are circular in the context of rent regulations. In the marketplace, investment is determined by the allowable returns. Therefore, it is circular to let the investment determine the allowable return. In effect, this approach allows the investor to set the allowable return by setting the investment.” Dr. Baar expressed the additional concern that if debt service were generally to be considered in determining rent increases, “debt service arrangements may be manipulated for the purpose of obtaining larger rent increases, ” for example, by “refinanc[ing] at a lower interest rate or pay[ing] off [a] loan after the rent increase is granted.” Dr. Baar reviewed the Board’s past actions in resolving rent adjustment applications and concluded: “[I]t has not been the standard practice of the Board to grant substantial rent increases based on increases in debt service.”

Dr. Baar ultimately concluded that in determining the amount to increase rent for a new owner with higher debt service, an MNOI analysis was more appropriate than a GPM analysis: “The rationale for an MNOI approach is that regulated owners are permitted an equal rate of growth in [net operating income] regardless of their particular purchase and financing arrangements. Therefore, rents are regulated depending on increases in expenses and the inflation rate ([CPI]).” It becomes the investor’s task to determine what investment and financing arrangements make sense in light of the growth in net operating income permitted under the fair return standard.” Although specific financing and purchase arrangements were not considered, the growth in net operating income allowed some level of increasing debt service and finance costs over time. Furthermore, “because value is a function... of net operating income, indexing [net operating income] leads to appreciation in the value of a property, which may be converted into a capital gain. This approach meets the twin objectives of ‘protecting’ the mobilehome owners from ‘excessive increases’ and providing park owners with a ‘fair return on investment.’”

Dr. Baar conducted an MNOI analysis, using 2005 as the base year.[17] Using the Park’s 2005 net operating income of approximately $1.1 million, he calculated that to maintain that NOI after allowable adjustments, rents would need to be increased $8.61 if indexed at 50 percent of CPI, $12.12 if indexed at 75 percent of CPI and $15.65 if indexed at 100 percent of CPI.

The City also retained James Brabant as an expert, primarily to analyze Neet’s reports and calculations.[18] Brabant pointed out discrepancies in Neet’s calculations, including that Neet essentially used one figure for net operating income ($304, 838) to justify his claim that a rent increase was needed, and another, much higher, figure ($1.1 million) to justify the purchase price paid by appellant. Brabant further criticized Neet’s report for contending that 9 percent represented a reasonable rate of return, when the capitalization rate used to justify the sales price was 4.75 percent, and capitalization rates from six comparable sales ranged from 3.9 to 6.3 percent.[19] In this regard, Brabant stated: “If you perform an analysis that uses one rate to justify a purchase price and then use a higher rate for the fair return analysis, a rent increase will always be indicated.” With respect to the 11.5 percent return used in Neet’s “Net Income to Equity” analysis, Brabant stated that Neet failed to supply “any equity dividend rates extracted from sales of mobile home parks to support his use of an 11.5% rate, ” and concluded that the Board could “give little weight to or choose not to have confidence in this aspect of the Neet analysis.”[20] Finally, to the extent Neet attempted to justify the high returns he deemed appropriate based on the riskiness of the investment, Brabant concurred with an opinion expressed by Dr. Baar that “‘after a park has been constructed and occupied with mobilehomes, there is virtually no rental risk, ’” stating that “[t]his conclusion has ...


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