Developers always cry poverty on the need for the inclusionary units. But the reality is that 20% of the units in any project are sub-par locations, layouts, views, and command reduced pricing. So those units end up being the Inclusionary Housing Units. It is not like the developer is giving up the penthouse.
The entire reason for the policy is that the market cannot supply newly constructed affordable units without subsidy. Either the government subsidizes the construction of affordable units directly, or it requires private businesses, developers, to provide them as a cost of doing business. Unless developers are directly subsidized, through LIHTCs for example, they do not make money on affordable units. Inclusionary housing policy therefore increases marginal costs without increasing revenue to offset those costs, diluting returns on investment. The developer’s primary option is then to increase prices on market rate units to achieve the returns required by investors and lenders.
When marginal costs exceed the developer’s ability to recoup revenue from market rate units, and returns are sufficiently diluted that developers can’t raise the required capital, that is when a development “doesn’t pencil.” If developers can’t reasonably underwrite a return sufficient to attract investors and adequately cover debt payments, development stops.
This is where an understanding of policy and its externalities comes in. Inclusionary housing requirements increase marginal costs. Energy regulations increase marginal costs. Lengthy community and environmental reviews, impact fees, outdated zoning, etc., all increase marginal cost and risk. Each regulation increases the cost to entitle, to design, to build, or to operate housing, and therefore increases the revenue that must be generated to achieve the required return on investment.
Building housing is a public good, but it is not charity and carries significant risk. Investment 101 is understanding risk adjusted returns. Investors allocate capital based on the return they expect relative to the risk they are taking. A very simple example would generally place bonds as low risk low return and the stock market at high risk high return, with real estate somewhere in the middle. If development cannot offer a sufficient risk adjusted return, then capital goes elsewhere.
None of this is to say that we shouldn’t have inclusionary housing policies, energy codes, community processes, etc. Rather, Boston and Massachusetts may have regulated themselves out of a well functioning housing market, where the marginal costs created by each regulation have accumulated to the point that market rents and condo sales can no longer support returns sufficient for new construction. This is compounded by broader economic conditions such as inflation and interest rates. But capital looking to build buildings will go to places with a lower marginal cost of doing business or use construction methods which are more cost effective, which is what we are currently seeing.
My take is that we have some soul searching to do to determine which policies are most important to protecting the public interest, and how we can thoughtfully reduce the marginal cost of housing development.
