San Francisco Has A Black Market for Housing. That’s as Bad as It Sounds.

The owners of three single-room occupancy (SRO) hotels in San Francisco’s Chinatown recently settled a lawsuit with the city, agreeing to pay a hefty fine of more than $800,000. Among their alleged crimes was that they “illegally converted, combined or added unauthorized housing units” to their properties.

The allegations expose something that should be humiliating for San Francisco: the development of a black market for housing.

The lawsuit was not San Francisco’s only effort to combat the underground housing market. In recent years, to name a few examples, the city sued a man for cramming 15 tenants into a three-bedroom home and fined a developer $1.2 million for constructing an apartment complex with triple the residential units that city planners had approved.

Even Jack “Ziz” LaSota—leader of the Zizians, a cult-like group of transgender vegan programmers linked to several murders—recruited followers as part of a shady rental scheme. LaSota had purchased a used tugboat for $600 and sailed it to San Francisco with plans to evade housing regulations by anchoring it offshore and renting its rooms to like-minded tenants.

“Unauthorized dwelling units” have proliferated in San Francisco for decades. Unpermitted “in-law suites” attached to single-family homes are so commonplace that locals sometimes call them “outlaw suites.” As far back as 1993, the city faced a scandal after the head of the Bureau of Building Inspection was caught operating two of these outlaw suites for 10 years. A similar story involving a senior building inspector came to light in 2021.

In 2014, the city created a pathway to legalize units built before 2013, but it has had lackluster results. According to a 2019 memo from the Planning Commission, the average cost of bringing an unauthorized unit up to code was $60,000, and only 140 of them had been legalized in the previous two years. The memo estimated that as many as 50,000 unauthorized units still existed in the city.

How is it possible to create such an extensive black market for housing?

Contrary to common misconception, black markets are not free markets. Free markets are characterized by secure private property rights and are primarily regulated by competition. By contrast, black markets emerge where the state no longer recognizes property rights and impose laws that restrict legal trade and suppress market competition.

This is why the producers of illicit drugs operate as cartels. Economist Bruce Yandle, as executive director for the Federal Trade Commission, came up with the “bootleggers and Baptists” theory of regulation after noticing that bootleggers had joined evangelicals to support alcohol prohibition because they wanted to stifle legal competition.

Excessive taxes and overbearing regulations can produce outcomes similar to prohibition. Limitations on foreign trade have led to particularly Orwellian examples of black-market activity, such as the Russian fruit smugglers who were caught illegally repairing roads after Russia banned food imports from Europe (a warning, perhaps, for those cheering on President Trump’s trade war).

Black markets expose a regulatory paradox. Sensible governmental regulations are not designed to undermine the regulatory mechanism of the market, but to complement it with quality controls, usually to ensure that the competition to lower prices does not come at the expense of safety. Regulatory excess, though, ironically upends the price-quality tradeoff even more than too little regulation. The drug market illustrates this well—fentanyl and other dangerous contaminants have made the black market drug supply cheaper and far more lethal than the heroin people used to buy from the Sears catalogue.

Black market housing works similarly, with desperate residents choosing dangerous homes because legal rents are unaffordable. The city evicted a man from his $400 “apartment” after discovering it was just a tiny wooden box in somebody else’s living room, violating the fire code. The fire code provides sensible safety precautions that were put in place after the great conflagration of 1906, and it did not impede rebuilding efforts. But when an oppressive regulatory environment creates black markets, all regulations go out the window—even the most sensible ones.

San Francisco’s black market for housing is the direct outcome of the city’s abandonment of private property rights. San Franciscans can still own property, to be clear, but the rights traditionally attached to it are wholly subject to the whims of the populace. In addition to oppressive zoning regulations, San Francisco subjects every building permit to discretionary review. Discretionary review hearings invite every city resident to weigh in on what a person should be allowed to do with his or her property.

These policies have made housing in San Francisco artificially scarce. The existing housing stock is consequently divided between a licit housing market strangled by governmental regulations on the one hand and an illicit housing market protected from competition on the other.

If San Francisco truly wants to stamp out its black market in housing, it must return housing to the free-market principles of secure property rights and market competition.