Why is New Housing in California So Expensive?

You probably had an answer to that before you even finished reading the question. But I’m willing to bet it’s not the whole answer. There are a lot of things that go into building housing, and California is a big place, so different things might matter more in different places.

If you’re reading this blog, odds are the first thing that came to your mind is zoning. In the already-dense built-up parts of LA and OC, zoning is indeed the most likely culprit, since it is simply illegal to build more housing on most of the land. But go further east, and there’s lots of land zoned for residential development, yet prices are still much higher than comparable locations in other states. Looking at this could help shed light on factors other than zoning.

The Inland Empire Should be as Affordable as Phoenix

Here’s a look at the cheapest offerings in the Inland Empire and in Phoenix from DR Horton, one of the biggest homebuilders in the US, and of the big builders operating in California, probably the most focused on trying to build entry-level homes.

The cheapest offering in Phoenix is $136k; in the IE, $264k, making the cheapest new construction in the IE almost twice as costly as Phoenix. That’s quite a difference. In terms of amenities, the IE does better than Phoenix – driveable to SoCal’s beaches, close to a bigger urban center in LA, closer mountains, better climate – but not enough to justify that margin. And it terms of wages, Phoenix passed the IE after the Great Recession and has seen substantial wage growth in the last two years, while IE wages have been stagnant. So not only are IE residents getting hit with higher housing costs; their wages aren’t keeping up. Small wonder that the Phoenix MSA was the fastest growing region of the country last year, adding 82,000 people.

Taking all of DR Horton’s projects in the IE and in Phoenix, plus projects from Pardee Homes (another entry level builder) in Riverside County to fill things out a little, here’s the cheapest house offered in each subdivision, plotted against distance from the bedroom community to the central city.

As we’d expect, housing gets cheaper the further we get from the central city. You might look at this and think that the IE could hit Phoenix levels of affordability another 20 miles out, but cheap housing that far from the center city wouldn’t really do much to help. People will commute from Buckeye to Phoenix; no one is commuting from Barstow to LA. (Note: the low-cost developments close to Phoenix are all in South Phoenix, a historically black and Latino neighborhood that faced all the systematic discrimination and disinvestment you’d expect.)

Replotting the data looking at the cheapest house offered in each subdivision against the size of the house is very revealing.

The smallest new houses in the IE are in the neighborhood of 1,600 SF (though I know KB Home has a project at 1,430 SF), while in Phoenix many project are around 1,250 SF and one is as low as 1,100 SF. This is counterintuitive to housing prices being higher and wages being lower in the IE; we’d expect to see smaller houses in the IE than in Phoenix. The incremental cost per square foot is not substantially different between the two regions, but IE housing developments appear to face structural issues that add about $100k to the cost of a house. The same issues are probably responsible for making small houses infeasible in the IE.

Now looking at the largest house offered in each subdivision, let’s plot the cost per square foot versus distance from the city center.

While there will always be variability between municipalities, the overall trend is what you’d expect – cost per square foot declines as you move further from the city. This is a proxy for how much people value being able to live closer to the center.

Finally, let’s look at cost per square foot versus house size.

The cheapest new construction in the IE is around $120/SF (though KB Home has a project in Victorville that hits $100/SF) while in Phoenix many projects are under $100/SF. Note that cost per square foot doesn’t seem very impacted by house size; this is because we’re looking across the whole region. Within a given subdivision, house prices per square foot are always lower for larger houses.

Why is IE Housing So Expensive?

I think this should prompt a deeper look at what goes into the cost of building housing in California. Starting from the bottom up, the inputs to housing are:

• Land – the physical place where house is built
• Zoning – rules that specify how many houses you can build on a piece of land
• General Impact Fees – fees paid to a municipality or service district by all development, such as parks fees & school fees
• Special District Fees – fees paid by development within a special district, commonly known as Mello-Roos fees in California
• Materials – the physical products that make up a house, like wood and drywall
• Building Code – the regulatory requirements that specify the details and quality of construction
• Labor – the people who assemble the raw materials into a house
• Soft Costs – the architects, engineers, planners, code consultants, & other professionals whose services are needed to design & permit the project
• Carrying Costs – the interest on loans, the taxes on property, & other similar costs paid in the time between the purchase of the land & sale of the house

Land

The most basic input to housing is having a place to build. Unlike in LA/OC, there’s still a lot of greenfield land in the IE that is zoned for residential development or has approved master plans. High housing costs should bring that land to market to be developed.

Via @FactChecker23, we have this set of price data for 46 metro areas, including home (total), structure, and land costs. Here are plots of total home cost and land cost for the IE and Phoenix.

Here is a plot of the difference between IE and Phoenix home prices, with a breakdown of the delta into structure costs and land costs.

With the exception of a strange jump in 2011 (that almost suggests a change in methodology of the underlying component data), the structure delta is remarkably stable throughout the housing bubble, Great Recession, and recovery. $20k to $30k of the price difference between the IE and Phoenix is in the physical structure itself. The large swings are driven entirely by land, with IE land prices rising higher than Phoenix during the bubble and recovery, and crashing to par during the recession.

This pattern suggests a structural issue with land availability. This could be due to second-order factors like CEQA, though as noted above there are many greenfield sites where master plans are already approved. However, another possibility is that in California, the inefficient property tax structure resulting from Prop 13 decreases the penalty for land speculation, because taxes do not keep pace with land values. In Arizona, property assessments increase with the value of the property and the increases are not capped like they are through Prop 13. Another possibility is that ownership of developable land in the IE is more concentrated, making collusion to drive up prices easier.

Zoning

Zoning drives up the cost of housing by limiting the number of houses that the cost of land can be spread across. A detailed analysis of density and zoned capacity in the IE and Phoenix is well beyond the scope of this blog. However, as an example, consider the general plan of Buckeye, a growing suburb west of Phoenix with very affordable housing. Much of the city is zoned for 3-6 dwelling units per acre (du/ac), which is typical of “medium density” zoning found in many IE master plans.

General Impact Fees

General development impact fees are fees imposed by cities on new development that are intended to pay for the costs of providing public services to the new development. Again, a comprehensive review of general impact fees is beyond the scope of this blog.

However, like with land costs, the long shadow of Prop 13 means that basic structure of taxation and municipal finance in California lends itself to high development impact fees. Unable to reassess properties to true market value or increase the tax rate, and limited in their ability to assess fees by subsequent propositions, California cities increasingly rely on development fees to plug holes in municipal budgets. Young cities in the Inland Empire, such as Jurupa Valley and Menifee, as well as other inland cities that have annexed land in recent years, face additional budget shortfalls as a result of faulty city finance legislation passed by the state during the financial crisis. The convoluted system of state funding to municipalities is itself a legacy of Prop 13.

To take some example, the city I live in, Glendale, charges a fee of $18,751 per multi-family unit (page 115 of 146) and $21,828 per single-family unit for parks alone. That fee could easily be expected to add $100-$150/month to baseline rents. In the Inland Empire, cash strapped cities have driven total impact fees up as high as $65,000 per unit in Riverside County and $75,000 per unit in San Bernardino County – around 25% of the cost of some of the cheapest development.

Meanwhile, the city of Buckeye charges literally no parks fee on most new residential development. The sum of parks, library, streets, public safety, water, and wastewater fees ranges from about $10k in the lowest cost districts to $20k in the highest cost districts. Across Maricopa County in Surprise, the sum of fire, police, library, parks, general government, public works, water, and wastewater fees is similar, ranging from about $10k to $18k. Surprise charges a parks fee of $785 – less than 5% of what Glendale charges, despite Glendale being a major secondary central business district with a large commercial tax base and large sales tax generators.

Lastly, it should be noted that impact fees can be used outright as a way for NIMBYs to stop development, since higher fees will decrease construction.

Special District Fees

Special district fees, or community facilities districts, more commonly known as Mello-Roos fees in California, are additional property taxes assessed in special districts to fund improvements such as streets, water, drainage, schools, parks, and so on. Mello-Roos fees are assessed as parcel taxes, not based on real value, so the actual burden is much higher for lower value parcels. This encourages the development of larger, more expensive houses, because there is “more house” to spread the cost across. As far as I know, there’s no equivalent in Arizona.

Materials

The cost of materials fluctuates with both the supply of materials available and the demand for construction materials. While this could have national impacts, there is little reason to suspect the market for materials is so different between SoCal and Arizona that it would drive a regional difference in the cost of construction.

Building Code

Without doing much in the way of detailed investigation, we can say with some certainty that California’s building code has more stringent requirements. First, the seismic detailing required for safe construction in California should result in some increase in costs. Second, California has famously high standards for energy efficiency for new construction. It’s hard to say off-hand what the cost impact is, but these aren’t things we’d want to compromise on anyway.

Labor

California does appear to have higher construction labor costs than Arizona. Ideally, this would be a comparison between residential construction workers in the IE in Phoenix; however, data doesn’t seem to be available for residential construction, and I could only find California at the state level.

According to the NAHB, a single-family home generates 3 full-time jobs for a year. If IE labor costs were about $300/week higher than Phoenix, that would be almost $50,000 per house. However, builders should respond to higher labor costs by trying to use less labor, and higher-wage labor tends to be more efficient than low-wage labor. In addition, labor costs will scale with house size, so the impact of labor costs should be less on smaller houses.

This is a squishier thing to measure than land and impact fees, since there is no way to spread the cost of land out over more units than the zoning allows and no way to evade impact fees. Note that the NAHB’s estimate of average wages and salaries in building a single-family home is literally greater than the purchase price of the cheapest single-family construction in Phoenix. Finally, it should go without saying that driving down wages results in negative social outcomes in a way that decreasing the profits of land-owning rentiers  or reducing exorbitant impact fees does not.

Soft Costs

Soft costs – such as engineering, permitting consultants, architects, and so on – should vary more or less according to regulatory complexity, so if it is more difficult to permit new housing, higher soft costs would result.

Carrying Costs

Longer times between purchase of the land and sale of the home will result in higher carrying costs, both because of the additional interest that accrues over that time and the fact that longer lag times make projects riskier. An analysis of the impacts of this factor is well beyond the scope of this blog, but cities should do all they can to reduce the time frame and provide certainty in the permitting process.

Conclusion

There are many factors that drive the cost of building new housing. If California is serious about reducing the housing shortage in the state, it must look to and study regions that build new housing at lower costs, understand which factors are the largest cost drivers, and work to alleviate those factors that can be improved in a socially and environmentally responsible manner.

The Money’s in the Infrastructure

This is just a short thought on the economics of transit capital costs and operations, which has been bouncing around in my head in the wake of service reductions at many agencies.

As any transit planner would tell you, reducing service can lead to a vicious cycle, where less frequent and therefore less convenient service causes ridership to drop, which becomes justification for further cuts. This is bad enough in a generic bus system, but at least in that case there’s little capital infrastructure that goes to waste, since most city buses just run on regular streets that are already there.

However, for something like rail transit, it’s truly crazy to cut service (unless you’re forced to by maintenance needs) due to the relative magnitude of capital investment. A brief example shows why.

Consider a 10-mile rail line built at a cost of $150m/mile, a total of $1.5b. Spread out over 30 years at 3%, the cost of construction is about $76m/year. If we run the line for 20 hours a day (4am – midnight) with 6 minutes headways, with reasonable cost per revenue-mile, it costs about $24m/year to run the line. This assumes 320 weekday equivalents, representing slightly reduced service on the weekends. The total cost is about $100m/year, of which capital costs are 75% and operating costs 25%.

Now, let’s impose an austerity plan on the line, reducing service to 16 hours a day (6am – 10pm), cutting frequency in half to 12 minutes, and further reducing weekend service to get weekday equivalents down to 300. The operating cost is reduced by over 60%, but the capital costs cannot be changed. The total cost is about $85m/year, only a 15% reduction from the base plan. As a result, passengers will get much less useful service and some will quit riding the line altogether, further worsening the financial position. And the austerity plan will likely reduce the efficiency of labor and equipment usage, again cutting into the savings.

We can see how illogical this is by considering some simple analogies to driving. Once you have bought a car and committed yourself to monthly auto loan and insurance payments, you can’t cut your costs very much by not driving. In fact, not driving may worsen your position by depriving you of employment. The capital costs are large relative to operating costs.

Likewise, if Caltrans is short on money for maintenance, it would be silly to try to rectify that problem by simply closing one or two lanes on the freeway. No one would ever suggest this because it would be considered intuitively obvious that closing freeway lanes constructed at great capital expense to save a few dollars on maintenance is not in the public interest.

The wrinkle here is that transit agencies often don’t pay for the full cost of capital projects, or don’t account for it out of the same pot of money. In that case, there really should be some mechanism to ensure that adequate operating funds are secured so that the public’s capital investment isn’t wasted. I believe the FTA requires recipients of New Starts funding to demonstrate this in a finance plan, but the enforcement may not be there. The FTA has sometimes demanded that funds be returned when not used for the capital improvements promised – see ARC and Cleveland for examples – so maybe service spans and frequencies should be spelled out in funding agreements as well.

Mini-Case Study on Mega-Project Management

When people think about mega-projects in Boston, the Big Dig, along with its enormous cost overruns and construction quality issues, is what comes to mind. But there’s another Boston mega-project that started at about the same time, and didn’t become an archetype for infrastructure incompetence: the Boston Harbor clean up.

In the 1980s, due to decades of pollution from poorly-treated sewage and combined sewer overflows, Boston Harbor was a stinking embarrassment. A lawsuit under the Clean Water Act resulted in the state being forced to improve stormwater and sewage treatment systems so that water quality in the harbor would recover. It’s a little surprising that there doesn’t seem to be a detailed study comparing the two projects; because both projects were constructed at about the same time in the same city, there should be less issue correcting for exogenous factors like legal precedents, quality of local contractors and engineering consultants, and political institutions.

However, a trio of articles from the fall of 2006 offers some insight. A short article in Governing cites three major factors: continuity of oversight leadership, local funding, and in-house talent at the Massachusetts Water Resources Authority (MWRA), the agency created in 1985 to oversee construction and operations of the sewer treatment system. Continuity of leadership came in the form of oversight from the same federal judge and several long-serving MWRA board members, while the use of local funds for construction created an external incentive to control costs. Inside the MWRA, a small team of talented engineers oversaw the contractors and consultants, providing strong owner representation.

In a Commonwealth Magazine expert panel on the Big Dig, Douglas McDonald, who served as Executive Director of the MWRA for nine years, cites the MWRA board of directors as the critical difference between the two projects. According to McDonald, the Executive Director had to report to the board of directors and a community advisory board every month, answering questions in real time. In contrast, leadership at the Massachusetts Turnpike Authority, which managed the Big Dig, saw more frequent turnover and political interference. McDonald says that “it’s not totally clear to whom the Bechtel corporation [which oversaw the Big Dig] ever reported.”

Lastly, in a long-form article looking at the mismanagement of the Big Dig, Boston Magazine cites the high level of in-house talent at the MWRA as the critical factor. The article quotes David Luberoff of Harvard’s JFK School of Government saying “it’s clear the state needed to have someone with Bechtel’s expertise, but the state could have done a better job of managing the managers. You have to have a small, highly skilled, highly respected group of people who could look over Bechtel’s shoulders.” In other words, a project as unique as the Big Dig is always going to be beyond the capabilities of the managing public agency, and there’s nothing inherently wrong about using outside consultants. However, strong advocacy on the owner’s part is still required.

The article goes on to quote Paul Levy, another former MWRA director, saying that “we had a 50-person project management team within the MWRA of highly paid, very experienced people… right after I hired Dick Fox, I remember [Big Dig architect and former Secretary of Transportation] Fred Salvucci calling to congratulate me, saying he wished he could do that but it was not possible under the state personnel system.” Thus, it appears that a political decision – subjecting the DOT to the state’s personnel system but exempting the MWRA – made it more difficult for the Big Dig to hire people with the skills required to oversee the project. The inability to pay wages that are competitive with the private sector is a pervasive problem for public agencies.

Readers with experience in private land development will not be surprised by any of this. As a land developer, you need to hire a team of consultants to successfully complete a large project, including legal professionals, civil engineers, architects, mechanical-electrical-plumbing consultants, structural engineers, construction contractors, and construction managers. While they are all on your payroll, they all have other interests as well, which may conflict with your priorities. Architects will select more elaborate designs and finishes, both out of professional pride and the desire to have future clients see a portfolio of high-quality work. Civil engineers don’t want to aggravate the public agencies they interact with for other projects. Construction managers don’t want the contractor community to see them as too adversarial. Contractors might be losing money on another project and looking to make up that loss on other jobs. As an owner, you must strongly advocate for your interests and priorities. If you’re asleep at the switch, you’ll end up paying too much for the job, even if the entire project team is working ethically and there are no serious issues.

The harbor cleanup project was not without issue. For example, in 1999, two workers died near the end of the project’s nine-mile long tunnel due to a failure of the improvised breathing systems that they were using. However, the project was successful in its water quality goals; today you can swim at Spectacle Island, something that would have been unthinkable in the 1980s. The MWRA seems to be one of the more respected state agencies.

Meanwhile, the problems with the Big Dig have poisoned the public debate on transportation mega-projects. People now expect that the projects will be poorly built and have massive cost overruns, which makes it much more difficult to build political support. Progressives that think cost effectiveness and public trust don’t matter, take note.