Tag Archives: development finance

Housing as a Utility and the Limits of Redevelopment

In some interesting and spirited discussion on Twitter (like a week ago, I know, ancient history), Daniel Kay Hertz brings up the idea of regulating housing like a utility. First, I’d like to explain why I think housing is not a utility and should not be regulated as such. Then, we’ll look at what issues comprise the real barriers to development, and the implications of those barriers.

Development in built-up cities is hard. There’s little vacant land, and construction is more complicated than on empty sites in the suburbs. In fact, development is so difficult and barriers to entry so great, says Daniel Kay Hertz, that development can’t keep up with demand; therefore, we should simply nationalize places like Manhattan. All rents – residential and commercial – would be regulated.

Is Housing a Utility?

In the economic sense, a product or service is considered to be a utility if it is most efficient in the long run for production to be concentrated in a single firm. This is most likely to be the case in an industry where it would be difficult for a new company to enter the market (“high barriers to entry”) due to very large up front capital costs. For example, consider the water supply for Los Angeles. In order to have two or three firms compete to provide water, you’d have to build two or three water systems.

Note that unlike industries that are naturally competitive, to compete with a utility, you have to build a lot of redundant infrastructure. To compete for your smart phone business, Apple and Samsung do not both build you phones, of which you only use one while the others sit idle. However, to compete with LADWP’s water supply, a new provider would have to build another water system and another water pipe to your house. You’d have two water connections, but only use one. That’s a lot of redundant water pipes, and it would cost a lot of money, so it’s much more efficient to have one water company with regulated rates.

Natural utilities almost always end up being heavily regulated private firms or heavily regulated public agencies. When they are not, such as broadband internet services, it creates the potential for monopolies that Wall Street analysts call “comically profitable”, but the rest of us might opt to call criminally profitable instead. Therefore, if a product is a natural utility, it’s important to recognize that and regulate it as such.

However, housing does not meet this definition of a utility. While housing development has considerable capital costs – millions or tens of millions of dollars even for relatively small projects – it’s an order of magnitude less than the billions or tens of billions of capital dollars that would be needed up front to compete with LADWP or Time Warner Cable.

In addition, there is little efficiency to be gained from concentrating housing production in a single firm (or government agency). If developers want to compete for your housing business, they do not build you redundant apartments. Most cities with tight housing markets have low vacancy rates, that is, very little idle housing infrastructure, suggesting there is little inefficiency in having multiple firms compete to provide housing.

Lastly, note that utility-type regulation is not intended or well-suited to address the types of issues we have with housing. The primary problem we have with housing is scarcity, a lack of housing. Utility regulation, in and of itself, address only natural monopoly problems; if there are problems with scarcity and allocation, additional regulations such as tiered utility rates much be introduced.

Therefore, while we can see the need for policies to address the impacts of housing scarcity on low-income households, there’s no compelling reason to regulate the entire residential (or commercial) sector of Manhattan. This is important, because simpler solutions are almost always better. The central administration needed for a nationalized Manhattan would be very complex, and the potential for unintended negative consequences would be large. For the costs of nationalizing Manhattan, we could almost certainly implement a more effective program of improved transportation and housing benefits for low-income households.

Are There Limits to Redevelopment?

Nevertheless, it is undeniable that in a place like Manhattan, redevelopment of land is much more difficult than in the suburbs. Almost any project will entail demolishing an existing building and displacing the revenue-generating uses currently occupying the site. Let’s take a closer look at the implications of increasing difficulty of redevelopment. In this analysis, we’ll ignore regulatory barriers like zoning, which can be changed, and focus on theoretical economic and technological limits.

Empirically, we can guess that once the existing building on a site reaches a certain size, redevelopment is impractical. Demolition of large buildings is rare, even in places with extremely high land values and lack of regulatory barriers like zoning. The tallest building ever intentionally demolished by its owner to make way for a larger structure is the Singer Building in New York City, which was 47 stories tall, though the bulk of the building was only 12 stories. The Morrison Hotel in Chicago was 45 stories, but again, much of the building was considerably shorter. Beyond that, there’s the City Investing Building in NYC (33 stories) and a few high-rise hotels in Las Vegas.

To see why, consider that every property owner has three development options:

  • Do Nothing: continue to operate the property as is. This is the lowest risk option. Future revenues and operating costs are relatively certain.
  • Refurbish: maintain the existing building, but make internal improvements that increase value, such as refinishing apartments. This is the medium risk option. Construction can be staged, but some revenue will still be lost during that time period. Future revenues are expected to be somewhat higher. Operating costs may be higher or lower, depending on relative efficiency of the new units and the impact of taxes.
  • Redevelop: demolish or largely demolish the existing building and replace it with a newer, larger structure. This is the highest risk option. All existing uses will have to be removed during construction, resulting in significant loss of revenue during that time period. Future revenues are expected to be much higher, and operating costs will likely increase due to larger size and higher tax value.

Graphically, the cash flows for these options look like this:

redevelopment

In deciding what to do, owners must consider the present value (PV) of each option. The second and third options offer higher revenues, but further into the future. Due to the time value of money, these future revenues are worth less to today’s PV. These options require the owner to forgo revenue during construction, which takes away from their PV. In addition, the owner must consider the risk of a real estate market downturn between today and the completion of the new project, which further devalues the future revenues in today’s PV.

With this framework, we can see why redevelopment is harder in built-up areas. For vacant land, the existing revenue is probably zero, and the site can be developed quickly, so risk is lower. If a tall building already occupies the site, the existing revenue will be large, and the construction period longer. Building technology might limit the additional density that could be developed on the site. At some density of existing development, it will no longer be profitable to redevelop the site.

This implies that once a city reaches a certain density of development, the only development option possible is geographic expansion of the city, and improved transportation to reduce the time cost of distance. For example, in 1890, the Lower East Side was probably close to this limit. Skyscraper technology was new, so buildings were limited to the height allowed by masonry construction, and tenements were carried up to such height accordingly. The inability to traverse longer distances in a short time at reasonable cost resulted in those buildings being occupied at very high population density.

This also implies that, quite logically, rents per unit floor area will always be higher in places where potential development sites are already occupied by existing buildings. Some price premium will be required to induce redevelopment of an occupied site versus vacant land.

With today’s building technology, it’s probably impractical to redevelop most sites that are occupied by buildings taller than 25 stories. (Note that some grad students with some time and funding could do the research to find real results. And if it’s already been done, someone please point out where!) That means that if an entire district is already developed to that height, further redevelopment will be difficult and it is unlikely that the market will be able to provide significant new supply locally. The proper solution to this problem would be to improve transportation to reduce price pressures by making it easier to travel from districts with more redevelopment potential.

Where Are We Today?

However, for the US, the nature of this theoretical limit is just that – theoretical. With the possible exception of a few small parts of Manhattan, nowhere in the country is developed to that intensity. Everywhere in Los Angeles County has land with low intensity existing development that, at least theoretically, has low barriers to redevelopment.

Regulating housing like a utility would be trying to resolve regulatory failures – zoning and permitting – with further regulation. If regulations are not producing the desired results, it’s a much better approach to reform the failing regulations than to try to resolve the negative outcomes of the first set of regulations with a second set of regulations. It is not hard to see that nationalizing Manhattan, or any other city, to resolve the failures of existing land use regulation might result in even worse negative outcomes. For the cost of any such program, we could devise less complicated housing subsidies and transportation improvements that would have a better chance of achieving the desired results and less chance of negative consequences.

Barriers to Fine-Grained Urban Development

Ok, so here’s the long-delayed compliment to these posts on LA density and mid-rise development, regarding the problem of enabling smaller footprint projects and different development models. The size of a development’s footprint was raised by Neal Lamontagne in criticism of mid-rise developments that take up the whole block, but really, it is just as applicable to high-rise development.

I agree that this is an important issue, for many of the same reasons I outlined for supporting mid-rise development in general: it opens the door for a wider variety of people to try their hand at land development. That means more new ideas, more development models, more sensitivity to local market conditions. If you ask me, communities are much more empowered to control their own future when many people in the community are potential developers than when a handful of the most active community members try to control a handful of developers through a handful of city planners.

So why don’t we see more fine-grained development? Let’s explore a few causes. They are somewhat varied, but they mostly come down to the fact that impediments to building have fixed components and variable components, so the larger the project, the greater the number of units upon which to distribute the fixed costs.

High Up-Front Costs

These costs are related to up-front project activities like doing traffic studies. Obviously, there’s an incremental cost too, since larger projects will have more impacts, but all activities have some mobilization cost – an amount that will be incurred no matter how small the actual task.

Here’s a simple analogy. Suppose it costs you $100 to rent a delivery truck for a day, plus $10 in gas for every delivery trip you make, and that you make $20 per delivery. Obviously, you need to make at least 10 trips to break even, and many more trips than that to turn a decent profit. If the fixed costs of $100 were to go down, a delivery business making fewer trips would be feasible. Likewise, high fixed costs for development make smaller projects more difficult, because there are fewer units amongst which to distribute the costs.

Cities have direct control over some fixed costs, through things like permitting requirements and fees. Many cities charge a fee for plan review, often on a basis of how many units or square feet there are in the development. The per unit fee may decline as the number of units increases, because the city also faces fixed costs in doing the reviews. The result is that larger projects are saddled with smaller costs per unit, so they take less of a hit to the bottom line.

Permitting requirements also favor larger projects. Once you are required to do an EIR, for example, you incur some pretty large costs, which encourages you to go for the biggest project possible. In addition, due to the high fixed costs of doing an EIR, it is much more logical to try to permit one large block-sized project than four quarter-block-sized projects. The requirements to do things like EIRs create a market incentive to consolidate properties into the largest possible projects, so that the hassle and cost of going through the permitting process will only be incurred once.

Perhaps the most underappreciated fixed cost that cities have control over is time. Time is money. If you are trying to build a project, all of the time you spend in the permitting phase is time that you are paying architects, paying engineers, paying lawyers, paying planners, paying property taxes, and bringing in no revenue. For large developers, this is a nuisance – the cash flow from other completed projects will keep you going. If you are a small-time developer, who has a harder time getting financing anyway, delays in permitting and legal processes can be a death sentence. Indeed, there is a long tradition in urban planning of simply waiting until recalcitrant actors exhaust their resources and fold.

If cities want to encourage more small-footprint development, they need to do all they can to eliminate these barriers. That means increasing the size and variety of projects that can be built by entitlement. It means processing applications quickly. And it means eliminating many of the pointless studies required of developers.

Zoning

Zoning requirements act in two primary ways: one, they specify how much of the property can be developed through setbacks, height maximums, and floor-to-area (FAR) ratios; two, they may also specify the minimum size of development for a particular use, e.g. a minimum square footage for a one-bedroom apartment. Setbacks and height maximums may be fixed (e.g. setback always 20 feet) or they may have fixed and variable components (e.g. 5% of lot width but no less than 5 feet).

These rules make it more difficult to configure buildings on small sites. Setbacks take up a larger percentage of the site on a smaller property. Minimum square footages might make a site more difficult to use. For example, if the minimum apartment size is 500 SF, and the maximum FAR on the lot is 1350 SF, you couldn’t build three apartments. Maybe the market for three 450 SF apartments is there, but you won’t get to find out.

Now of course, you could ask the zoning board for a variance. The ability to grant variances means that municipalities can have almost limitless power over development – set very restrictive zoning, and arbitrarily grant variances to whoever you feel like giving them to. Variances take time and money, and there’s no guarantee you’ll get one.

Parking Requirements

If you’re laying out a parking lot, you need space for the aisles and the entrance/exit. If you have a multilevel structure, you need space for the ramps. Now, a huge garage might need more than one entrance/exit, and rarely you will see more than one set of ramps up and down between levels. But up to a certain size, one entrance/exit and one set of ramps will do. The larger the size of the parking lot, the smaller the percentage of total space lost to entrances/exits, ramps, and aisle ends.

This means you can accommodate the required parking (and developers rarely build more than the minimum) more efficiently on a larger lot. A block-size development with two entrances/exits and sets of ramps loses less space than six small developments on the same block. For small parcels, it might be geometrically impossible to meet parking requirements, or might require resorting to expensive treatments like robotic car lifts.

The doubtful wisdom of parking minimums has gotten a lot of attention from people with a much bigger platform than me, like Matt Yglesias, so there’s no need to go into detail here. At the very least, cities could eliminate the requirement that parking be provided on site, which would open up the market for efficient use of existing parking capacity and allow for developers of small properties to meet requirements by providing leased spaces elsewhere.

Elevators

Current regulations provide an exemption from elevators for very small buildings: anything two stories or less, and anything with less than 3000 SF per story. Once you hit the threshold of needing an elevator, though, it makes sense to go as big as possible. Again, it makes financial sense to build the whole block so you can distribute the costs of the elevators on more units.

Banks and Insurers

Banks and insurers drive residential construction towards full-block apartment buildings constructed by big-name developers the same way that they drive commercial development towards suburban office parks and malls. It’s a model they have great familiarity with and a ton of data on. Numbers to plug into their spreadsheets; lots of similar deals in the past to make investors feel warm and fuzzy. You want to build a plaza with a Target and a Ralph’s? Done. You want to build a few hundred SFRs? Done. Wanna build a four-story building with half the first floor as retail, no pre-lease, and limited parking? Slow down.

Note that this is one of the reasons that immigrant communities are often forced to self-finance; banks are uncomfortable with development models that those communities want to bring with them, and that prevents good ideas from spreading. For example, many supermarkets in Asia have a food court inside, and you’ll find this model in K-town and other Asian immigrant neighborhoods. It’s a very successful model, yet for the most part, it hasn’t been adopted by the major supermarket chains.

Promoting Fine-Grained Development

Now, some of these things can’t be changed. Cities have limited power to coerce banks into changing lending practices, and city financing schemes like tax subsidies tend to have undesirable side effects. It would be pretty heartless to argue for going back to a time when people with disabilities couldn’t access housing or shopping. But a lot of what worked 100 years ago would work today:

  • Reduced requirements for up-front studies
  • Fast processing of permit applications
  • Liberalization of zoning schemes
  • Elimination of parking minimums
  • Investment through local or regional financial institutions that are more responsive to local conditions

In other words, like many urban development issues, making progress on this issue is simply a matter of getting out of our own way.