Land Use Update - Short-Term Rentals and Takings

Short-Term Rentals and Takings

Land Use Update Editor: Daniel R. Mandelker, Stamper Professor of Law Emeritus, Washington University School of Law, St. Louis, Missouri.

Short-term rentals are a challenge to municipalities. A short-term rental is the temporary rental of all or part of a residence for a brief period. Municipalities have prohibited, regulated, and licensed short-term rentals to prevent changes in the character of the neighborhood where they are allowed and to prevent health and safety problems. Regulations can include a permit requirement, a limit on the number of days a unit can be rented or on how many units can be rented in each residence, a requirement that hosts must be permanent residents, different rules for residential and commercial areas, compliance with noise, trash, and parking regulations, and safety measures such as requiring fire safety equipment and carbon monoxide detectors.

Restrictions like these limit an owner’s freedom to use her property and create losses in economic value by reducing rental income, provoking lawsuits that these restrictions are an unconstitutional taking of property. This column discusses judicial decisions that have reached different outcomes in applying US Supreme Court regulatory takings rules to short-term rental ordinances.

The US Supreme Court’s Troubled Penn Central Doctrine

Takings litigation is problematic, and US Supreme Court takings rules are conflicting and incomplete. In Penn Central Transportation Co. v. City of New York, 438 U.S. 104 (1978), which upheld New York City’s historic landmarks law and which the Supreme Court calls its “default” takings decision, the Court adopted three factors for regulatory takings cases. They are: (1) the economic impact of the regulation on the claimant; (2) the extent to which the regulation has interfered with distinct investment-backed expectations; and (3) the character of the governmental action.

In a recent Third Circuit case, Nekrilov v. City of Jersey City, 45 F.4th 662 (3d Cir. 2022), which held that a shortterm rental ordinance was not a taking, Judge Bibas concurred and provided a rare judicial critique of the Penn Central takings factors. Beginning with a comment that “regulatory-takings doctrine is a mess,” he argued that “[a]pplying the Penn Central factors is challenging. For one, they are hard to define and thus hard to meet.” He could have added that the success rate for claimants is very low.

Defining economic impact is one of the difficulties. The plaintiffs relied on lost profits, which is a partial takings claim. Judge Bibas did not discuss partial takings but explained that “precedent is muddy on whether lost profits count as an economic burden,” quoting conflicting Supreme Court decisions. He added that “we do not know how severe an economic loss must be to satisfy that factor” and that the Supreme Court had not spelled out a “mathematically precise” formula. He quoted the US Supreme Court cases that acknowledge that a 95 percent reduction in value might be enough but added Penn Central’s suggestion that reductions in value of 75 percent and 87.5 percent that had occurred in other cases were not enough. These examples imply that a partial taking is not a taking under the takings clause.

The investment-backed expectations factor lacks clarity. Judge Bibas quoted a court of appeals case holding that “investment-backed expectations are reasonable only if they take into account the power of the state to regulate in the public interest.” This rule, which the US Supreme Court has never adopted, creates a circularity problem. It allows the purpose of the law that is attacked as a taking to define investment-backed expectations. This rule means that investment-backed expectations do not exist if a law’s regulation is in the public interest, such as a law regulating shortterm rentals.

Judge Bibas then explained that “[a]pplying Penn Central can be hard for a second reason: we do not know how much weight to give each factor.” Courts reject takings claims by applying only one Penn Central factor, a “one-strikeyou’re-out” rule. This practice, he said, is “especially troubling because Penn Central overlaps with per se regulatory takings claims.” He is referring to the third Penn Central factor, which requires courts to consider the character of the governmental action that is attacked as a taking. Penn Central explained that this factor was meant to distinguish between physical and non-physical takings and that a court will find a taking more readily “when the interference with property can be characterized as a physical invasion by government.”

The problem with this distinction is that the Supreme Court has now decided that physical takings are per se takings, making the character of the governmental action factor redundant. Judge Bibas speculated that “[s]mart lawyers” will try to frame their takings cases as per se takings, but “where does that leave Penn Central?”

The Nekrilov Decision

In Nekrilov, a city had legalized shortterm rentals but later adopted an ordinance that imposed new restrictions. Short-term rentals were limited to 60 nights a year and allowed only for property owners. Plaintiffs invested in properties for leasing as short-term rentals after the adoption of the first ordinance and before the adoption of the second ordinance. They sued, unsuccessfully claiming that the second ordinance was a taking.

The court applied the rule that economic impact under the first factor usually is measured by the effect a regulation has on the value of a property. Plaintiffs lost an estimated 50 percent to 66 percent of their potential revenue from short-term rentals because of the second ordinance, but the court held that this loss was not a “drastic” reduction in value that amounted to a taking, especially because the properties retained multiple beneficial uses. It quoted a US Supreme Court case holding that loss of profits is a “slender reed” for a takings claim but did not acknowledge the “muddled precedent” on this issue.

The plaintiffs also claimed the first ordinance that allowed short-term rentals, coupled with encouraging statements made by city officials, created an investment-backed expectation. The court disagreed. The first ordinance and official statements were only qualified endorsements. For example, restrictions in the first ordinance provided that short-term rentals could not “materially disrupt the residential character of the neighborhood.” The plaintiffs may have relied on the first ordinance when deciding to invest in short-term rentals, the court held, “but they failed to take into account the restrictions in place in that ordinance and the City’s strong interest in regulating residential housing.” This is the circularity problem.

The court then considered the character of the second short-rental ordinance, rejected claims of bad faith in its adoption, and upheld it as a general zoning regulation that restricted the use of residential housing to protect the residential housing market. This is a novel interpretation. The Supreme Court did not include good faith and legislative purpose as factors bearing on the character of the governmental action.

The Texas Case

Most state cases have rejected taking claims against short-term rental ordinances, but a Texas court, applying a “two-strike rule,” considered two of the Penn Central takings factors and refused to dismiss a takings claim against an ordinance that prohibited short-term rentals. City of Grapevine v. Muns, 651 S.W.3d 317 (Tex. Ct. App. 2021) (petition for review filed). The plaintiffs pleaded that the first zoning ordinance and city employee encouragement created reasonable investment-backed expectations for short-term renting. The court held that fact issues existed on the economic impact and investment-backed expectations claims that the trial court had to consider.

The plaintiffs rented their residential property for several years on a shortterm basis without interference from the city under the zoning ordinance that applied at that time. It allowed a “singlefamily detached dwelling” in the zoning districts in which the short-term rentals were located, defined as “an enclosed building having accommodations for and occupied by only one family.” The court held that this definition did not prohibit short-term rentals because the word “family” did not require a “single housekeeping unit” related by blood or marriage. Neither did the ordinance include occupancy-duration restrictions “when none are there.” Not all courts agree with the Texas court on these issues. See the extensive discussion in Slice of Life, LLC v. Hamilton Township Zoning Hearing Bd., 207 A.3d 886 (Pa. 2019).

The city prohibited short-term rentals in a short-term rental ordinance after receiving complaints such as noise disturbances, increased vehicle traffic, and street-parking problems, and an increase in complaints from residents about short-term rental guests. Applying the Penn Central takings factors as applied under Texas takings law, the court held that the plaintiffs suffered an economic impact under the first factor. It applied the rule that lost profits are a relevant takings factor that affects the value of a property and the severity of the economic impact on a property owner. An inability to continue renting property on a short-term basis because of an ordinance “can constitute evidence of economic impact.”

The city argued that a taking did not occur because the plaintiffs could lease their properties on a long-term basis as an alternative and because they admitted that their properties were worth more than when they were purchased. The court rejected these arguments, holding that short-term rentals generate a higher average rent than long-term leases and that the ordinance prevented the plaintiffs from participating in this “active, lucrative market.” Penn Central does not support this rule. The Penn Central Court approved cases holding that a taking does not occur “when the challenged governmental actions prohibited a beneficial use to which individual parcels had previously been devoted and thus caused substantial individualized harm.”

Applying the second Penn Central investment-backed expectations takings factor and quoting and discussing Texas cases, the court held that existing and permitted uses are a “primary expectation,” that historical uses of the property are critically important, and that regulations at the time of purchase and knowledge of existing regulations should be considered. This rule is consistent with Penn Central, which implies that a taking occurs when a regulation interferes with a “primary expectation concerning the use of the parcel.” The US Supreme Court has also adopted a rule that notice of existing regulations should be considered, and courts have applied this rule in takings cases.

The result in the Texas case may be explained by the decision to completely prohibit short-term rentals, which eliminated any opportunity to earn income from this activity. Less drastic regulations might survive a takings claim under the Texas rules, particularly noise, trash, and safety measures that are necessary to protect public health.

Confusion and ambiguity exist in takings law. It does not provide a principled doctrine that courts can use to decide takings cases, which makes takings litigation difficult and unpredictable. Recent Supreme Court cases have resolved some issues at the edges, but a rewrite of Penn Central is unlikely.

Published in Probate & Property, Volume 37, No 1 © 2023 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.