Why Inclusionary Zoning Fails

Randal O’Toole has a piece up about the failure of Denver’s Inclusionary Housing Ordinance (IHO) to generate appreciable amounts of affordable housing and stop the tide of rising unaffordability. It’s spot on in its conclusion that inclusionary zoning is a hopeless project, but a little unclear in its explanation of how these policies actually make housing more unaffordable.

Developers have the option of making payments to the city instead of building the affordable units, and the city uses those revenues to provide a small incentive ($5,500 per unit) to developers that include affordable units. The payment is equivalent to 50% of the price of the affordable unit. It’s not hard to see that in high cost housing areas, it makes much more economic sense to buy out of the IHO, forgo the paltry subsidy, and sell all units at the market price. For a simplified example, consider a 30-unit building, which would be required to provide three affordable units. If the market price is $300k, and the affordable price is $150k, the developer stands to make $300k – $75k = $225k per unit by selling them at market price and $150k + $5.5k = $155.5k per unit by selling them at the affordable price.

However, the statement that the millions of dollars for the city’s affordable housing subsidies were “paid by new homebuyers, which means the inclusionary zoning ordinance actually increased the cost of new housing” implies that developers simply pass through the costs of buying out of the IHO. This suggests that in the above example, the developer would increase the price of the other 27 units by $8,333 to make up the difference. That’s not quite the case: if developers could unilaterally raise prices, they would do it anyway. The price for the market rate units is set by the market, not by any taxes and fees paid by the developer.

The money for the payments comes out of developer profits. That’s not a problem if the developer is putting up a luxury building and making a killing on every market rate unit. But if the developer is trying to build units on which the profit per unit is small, that payment can turn a profitable project into an unprofitable one. And of course, the projects where the per unit profit is small tend to be projects that are cheaper to begin with. In other words, inclusionary zoning policies choke off the very types of development that can best contribute to affordability.

Consider the example above. Without the IHO, the sale of the 30 units would bring in $9m. With the IHO and an in-lieu payment, the project brings in $8.775m – a 2.5% hit. That may not seem like a lot, but for projects on the margin, it makes a difference, and by definition, the most affordable projects are the most marginal ones. For a project that was selling market rate units at $250k, it would reduce revenues from $7.5m to $7.275m – a 3.0% hit. Note that the more affordable the market rate units, the more severe the relative impact on profits. For luxury development, these are nuisance payments. For low- and mid-income developments, they’re deal breakers.

By making lower end projects economically unfeasable, inclusionary zoning policies reduce the amount of new housing supply being brought to market, and that’s what drives up prices. Essentially, they are an increase in the cost of inputs, which shifts the supply curve to the left, resulting in fewer units sold at higher prices. That translates into less affordable housing and fewer people able to access the opportunity of the city.

Note: while I’m in complete agreement with O’Toole that inclusionary zoning is doomed to fail, I do not agree with his solutions to unaffordability. But that’s a topic for another time.

1 thought on “Why Inclusionary Zoning Fails

  1. Pingback: Development Fees are an Inefficient Way to Fund City Improvements | Let's Go LA

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