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  Los Angeles Lawyer
The Magazine of the Los Angeles County Bar Association
 
 

January 2009     Vol. 31, No. 10


 
 

MCLE Article: Gimme Shelter

SB 1818 may ultimately provide developers with the incentives they need to build affordable housing

By Aamir Raza and Ted M. Handel

Aamir Raza is a solo practitioner in Los Angeles whose practice focuses on all phases of land development, including acquisition, entitlement, CEQA compliance, and construction. Ted M. Handel is of counsel with the Landmark Law Group, Inc. His practice focuses on representing developers in all facets of real estate transactional matters, including the development of affordable housing projects, as well as forming nonprofit organizations and addressing compliance issues.

 
 
By reading this article and answering the accompanying test questions, you can earn one MCLE credit. To apply for credit, please follow the instructions on the test.
 
 

Despite the precipitous decline in home values over the past year, "affordable housing" remains an oxymoron throughout much of California. For many families, senior citizens, and persons with special needs, the cost of decent, safe housing is barely within their budget, if not actually beyond their means. While many Californians try hard to keep a roof over their heads, state and local officials have had an equally difficult time creating an incentive for developers that, on the one hand, encourages them to build housing that renters and homeowners can realistically afford and, on the other, allows developers to earn a fair rate of return on the investments they make in their projects.

The task of policy makers is further complicated because the perception of affordable housing often does not comport with reality. Contrary to some, it is not housing for the poor; rather, it covers shelter for persons of low to moderate income. It is also not limited to apartments; instead, it also includes for-sale housing units. And, finally, this housing may be a standalone project or a specified number of units within a larger residential development restricted to persons at certain income levels.

While state law mandates that affordable housing units be built within multifamily developments located in Coastal Zones,1 few local jurisdictions outside these areas have adopted similar policies. Instead, cities and counties have sought to create development incentives, such as density bonuses, to encourage developers to build affordable units. In an attempt to require all local jurisdictions to provide incentives for affordable housing development and create some uniformity with these incentives, the California Legislature enacted SB 1818.2

Since this law went into effect in 2005, many local jurisdictions have struggled with adopting conforming ordinances. Some have left the issue to case-by-case decisions, while others have established extensive menus from which developers can choose the incentives they want to incorporate in their projects or create their own.

SB 1818 has also achieved mixed results depending on the type of affordable housing being built. For developers constructing rental housing in which some or all of the units are income restricted, the law provides them with the opportunity to build more units and incorporate other concessions that can enhance their multifamily projects. In contrast, before the recent financial and credit crisis effectively put a halt to condominium projects, developers were frequently concluding that the economics of a for-sale project often would not "pencil" when affordable units were included--even with the incentives of SB 1818.

Density Bonuses

A density bonus allows a developer to build a certain number of additional units in its project beyond the maximum number of residential units otherwise permitted by the applicable local zoning restrictions. The bonus is usually calculated by multiplying a statutorily set sliding scale percentage against the number of units that can be built as a matter of right. The drawback of a density bonus is the developer must enter into a long-term covenant--usually from 25 to 40 years--with the local government restricting the rental or sale of those units to persons of very low, low, or moderate income.

Thirty years ago, the first density bonus law was enacted in California. Under the original law, a minimum of units for either 10 percent very low-income households (at 50 percent of area median income, or AMI,3 as adjusted for family size) or 20 percent lower-income households (at 80 percent of AMI as adjusted for family size) had to be set aside in order to qualify for the density bonus, which was fixed at 25 percent.

Four years ago, the legislature's enactment of SB 1818 essentially provided developers with a new density bonus law. SB 1818 requires local governments to grant developers density bonuses in exchange for building affordable housing units. The new law made several significant changes to promote the development of affordable housing. The first was establishing a tiered density bonus system that lowered the minimum threshold to qualify for a 20 percent bonus to housing developments with either 5 percent very low- or 10 percent lower-income units. The percentage then increases to a maximum of 35 percent.4 The bonus for for-sale projects is applicable to those of moderate income (i.e., households at 120 percent of AMI as adjusted for family size); a 5 percent density bonus applies for a 10 percent set-aside, and this increases to a 35 percent density bonus if 40 percent is designated for moderate-income units.

The second change was providing developers with the right to request one to three development "incentives and concessions" depending on the percentage of very low- or low- or moderate-income units allocated within a given project.5 However, the statute does not list any specific incentives or concessions that a developer may propose. The local government must grant the applicable incentives or concessions except under certain very limited circumstances in which the incentives do not promote the affordability of the project or there will be a "significant adverse impact" on the environment that cannot be mitigated without rendering the project unaffordable.

A third change requires developers to enter into a covenant to protect the affordability of units for 30 years or longer if mandated by any applicable financing or rental subsidy program. With for-sale projects, a local government must also enforce an equity-sharing agreement when a condominium is eventually sold.6 Under the agreement, the seller is allowed to retain the value of any improvements, recover any down payment, and share in any appreciation. In return, the local government may recapture any subsidy that it provided to the homeowner. SB 1818 also includes provisions promoting the establishment of child care facilities and reducing maximum parking requirements.7

Local Government Compliance with SB 1818

While all local jurisdictions, including charter cities and counties, must comply with the SB 1818 mandates, many councilmembers and supervisors have struggled to support ordinances implementing the law. On the one hand, they recognized the need for affordable housing but, at the same time, were wary of community opposition to these projects. One reason was the perceived stigma of this housing and the persons who would reside within the units. Another relates to the incentives and concessions that a developer may request for a project. Invariably, these incentives involve changes in height limits, floor area maximums, lot coverage, and design standards--the very issues that often foster public opposition to a project. SB 1818 gives no direction on resolving these conflicts beyond providing that incentives may be rejected if they do not contribute to the affordability of a project or they will have a significant adverse impact on the environment that cannot be mitigated without rendering the project unaffordable.

Certain jurisdictions, such as Pasadena, have chosen to make a case-by-case determination on the issue of incentives.8 The Pasadena Zoning Code simply restates the text of SB 1818 without providing any specific guidance on possible concessions. Rather, Pasadena's Planning and Housing Divisions will work with an applicant to determine which incentives are appropriate for the specific site location. Others, like the City of Los Angeles, went through an exhaustive administrative and legislative process to put meat on the bones of SB 1818. The result was that Los Angeles did not adopt a conforming ordinance until April 15, 2008.9

The Los Angeles ordinance tracks SB 1818 as it relates to the density bonus granted for allocating a certain percentage of low- and very low-income units within a development. However, the city went beyond SB 1818 by increasing the for-sale housing density bonus for units set aside for persons of moderate incomes. The city's ordinance provides that if 10 percent of the units are designated for these households, the bonus is 15 percent (as opposed to 5 percent under SB 1818), and if 30 percent of the units are set aside, then the maximum density bonus of 35 percent may be obtained (in contrast to SB 1818, which gives this bonus when there is a 40 percent set-aside).

The ordinance also lists a "menu of incentives" for developers of both rental and for-sale housing. These incentives include:

  • An increase in the height limit equal to the percentage of density bonus for which the project is eligible, subject to certain limitations related to whether the project abuts an area zoned for single family homes or the zoning limits the height or number of stories.
  • A similar enhancement in a project's floor area ratio.
  • Up to a 20 percent decrease in the required width or depth of any individual yard or setback.
  • Up to a 20 percent increase in lot coverage limits.
  • Up to a 20 percent decrease in lot width and open space requirements.

Developers may also request incentives "off the menu." Consistent with SB 1818, the actual number of incentives that may be received is a function of the affordability restrictions the developer agrees to adopt for its project.

If an incentive is on the menu, the Los Angeles planning director must approve the requisite density bonus and the requested incentives unless one of the two SB 1818 limitations applies. Any initiative that is off the menu is subject to notice and a public hearing and approval by the Los Angeles Planning Commission.

In theory, the density bonuses and other concessions mandated by SB 1818 should encourage developers to build housing that low- and moderate-income persons can actually afford. From the vantage point of a developer of a rental housing project, SB 1818 and the Los Angeles ordinance can be quite beneficial. Certain developers build projects that are intended to be completely affordable; that is, every unit is income restricted. Qualifying for the density bonus is no issue because these projects by definition are structured to be affordable to families, seniors, or persons with special needs whose incomes are at or below the very low-income standard. In addition, the projects are subject to regulatory restrictions that exceed the 30-year minimum of SB 1818.

The practical issue for an affordable rental housing developer is identifying which incentives should be requested. Developers will seek those that optimize their projects by leveraging certain debt financing and tax credit equity, achieving their objective of providing housing to certain income groups, and offering amenities to project residents. Consistent with these goals, the incentives most likely to be sought are changes in height limit, floor area ratios, and setbacks. On the other hand, developers will not be inclined to seek a reduction in open space to avoid creating an overly dense project. The Los Angeles ordinance, like SB 1818, also provides a critical concession with regard to reducing the number of parking spaces that must be provided within a development.

Developers of "market rate" rental housing can also benefit in a similar fashion from these laws. The key difference between these projects and one that is completely affordable is that if the developer agrees to designate a certain percentage of units as affordable, the additional units "earned" by the density bonus do not have to be income restricted.

For-Sale Housing Projects

While SB 1818 may benefit rental housing, the opposite seems to hold true for those building for-sale condominiums. The opportunity to add units should equate to more profits, but the economics of a typical condominium project suggest otherwise. This is particularly important given that most development projects over the past decade have been for-sale projects.

The size and scope of a for-sale project is customarily determined during the site acquisition phase because the expected return is essential in calculating the proposed purchase price. In addition to analyzing applicable zoning restrictions, developers will also evaluate the merits of pursuing a density bonus. Because this decision is made at the onset, developers must project the future costs of construction, interest rates, and sales prices.

The following example illustrates the issues that must be considered and is based on a composite of recent actual developments. The unit types and sizes in the example have been standardized. The baseline project has entitlements allowing 100 two-bedroom units of 1,000 square feet each before applying any density bonus. The market rate sales price per square foot for each unit is $500 for projects without low-income units and $450 per square foot for the same project with low-income units on site.10 The cost to construct the project--including land acquisition, soft costs, and carry costs--is $325,000 per unit. As an added incentive to create on-site affordable housing, the project is located in an area with an above average in lieu fee of $15 per square foot. Many jurisdictions offer developers the option of paying an in lieu fee when the revenues are designated to help finance the development of affordable housing rather than have the developer actually build the required affordable units within its project. While many project sites are not located in areas with an affordable housing requirement, this is commonly found in redevelopment areas where state law requires that cities create affordable housing with a portion of the increased revenue from the redevelopment zone.

To compare projects with and without on-site affordable housing, the maximum amount that can be charged per affordable unit must be calculated. The first step is to determine the maximum number of persons allowed in a household. For a two-bedroom unit, state regulations cap the household size at three.11 The calculation applies the applicable county's specific 2008 income levels12 to the for-sale Affordable Housing Cost caps set forth in the Health and Safety Code.13 For a three-person, moderate-income family in Los Angeles, the maximum monthly Affordable Housing Cost is $1,726. For a three-person, very low-income family in Los Angeles, the maximum Affordable Housing Cost is $672. The total monthly Affordable Housing Cost is then reduced by homeowner's fees, utility costs, property taxes, insurance costs, and the like to arrive at a maximum mortgage payment amount.

The example involves a series of assumptions: monthly HOA dues of $100, $10 per month mortgage insurance, $100 per month utilities, $50 per month homeowner's insurance, and property taxes of 1 percent of the purchase price. For moderate-income families, this leaves a maximum mortgage payment of approximately $1,295 per month. For very low-income families, this leaves a maximum mortgage payment of approximately $364 per month. Applying a standard FHA loan--with terms of 3 percent down, 30-year fixed loan with an average interest rate of 6.5 percent--a moderate-income unit can cost a maximum of approximately $211,340, and a very low-income unit can cost a maximum of approximately $59,432. This example shows that projects with the minimum number of either moderate-income or very low-income units to qualify for a density bonus return a smaller profit than smaller market rate projects. (See "Minimum Density Bonus," page 32.)

However, adding more affordable units to make greater use of the density bonus only serves to increase the lost profits when such a bonus is sought. For moderate-income units, a 1 percent increase in the number of units that can be built is allowed for a corresponding percentage increase in the number of moderate-income units up to a maximum of 40 percent. As a practical matter, this one-to-one ratio means that building more moderate-income units does not result in an increase in the number of market rate units in the project. In this example, there will always be 95 market rate units. If a developer builds the minimum number of moderate units, the result is 95 market rate units (5 percent density bonus yields 105 total units less the required 10 moderate units). If a developer builds the maximum number of moderate units, the result is still only 95 market rate units (35 percent density bonus yields 135 total units less the required 40 moderate units). This means that when moderate-rate units are required to be sold for less than the cost of construction, there is no way to offset the loss on the moderate-income units. In fact, in order for a developer to consider building moderate-income units, those units have to be profitable in their own right. (See "Lost Profits," page 32.)

A similar, but far less dramatic, increase in lost profits occurs when the density bonus is maximized for very low-income units. For every 1 percent additional very low-income unit, a developer receives a 2.5 percent increase in the project density, up to a maximum bonus of 35 percent.

The data in the example appears to suggest that building the minimum number of on-site moderate-income units is comparable to a market rate project. However, the data ignores two critical items that argue against seeking a density bonus. First, the additional units extend the construction schedule, thereby increasing the project's carry and interest costs. This will result in a per unit cost that can be significantly higher than the $325,000 per unit calculated in the example. Second, most projects, especially those with Mello-Roos/community facility district14 charges, may have nonmortgage housing costs that exceed the maximum Affordable Housing Cost before any mortgage payment is taken into consideration. For example, projects in Orange County or Santa Clarita often have HOA dues and Mello-Roos/community facility district charges that alone can exceed $900. In this situation, very low-income units would effectively have to be sold for free and then the developer would have to provide some ongoing financial support. As for moderate-income units, the selling price would have to be reduced considerably.

Apart from the economics of a density bonus, developers must also be concerned with whether the requested concessions will be granted, especially since the project will be constrained within the same parameters as a nondensity bonus project. Because the decision to pursue the density bonus has to be made very early in the design process, any denial of concessions would likely require a substantial redesign of the building and inevitably put the project behind schedule, if not over budget. In a significant number of cases this would cause the developer to lose the project by failing to meet processing deadlines in the project financing or by exhausting the funds needed to complete the redesign.

Despite this, the landscape in which SB 1818 will continue to evolve is changing with the recent downturn in the residential and financial markets. Land prices and construction costs have been substantially reduced. Sales prices are slipping and the spread between moderate-income units and market rate units is shrinking. The effect of a 40 percent drop in the sales price,15 and an equivalent decrease in the cost per unit, would have a substantial effect on the figures in the example.16 (See "Impact of Market Downturn," page 32.)

Will SB 1818 ultimately provide developers with the incentives they need to build affordable housing? The past four years certainly provide no guidance because it has taken that long just for many local jurisdictions to adopt conforming ordinances. For affordable rental housing in the near future, the answer is yes. SB 1818 will most likely lead to the creation of more units and better quality projects for tenants. Regarding for-sale projects, however, the answer is far less certain. The silver lining in today's worsening economic times and declining property values is that lower land costs could make the inclusion of affordable for-sale units more feasible.

The bigger question will be whether these projects can be entitled, financed, and constructed before the housing market eventually turns around. When that occurs, developers may once again decide that taking advantage of density bonuses and allocating a portion of their for-sale units to persons of low and moderate income may ultimately not be in their best financial interests.

 
 

Endnotes

1 Gov't Code §65590.
2 Gov't Code §§65915 et seq.
3 The California Department of Housing and Community Development calculates median income annually.
4 Gov't Code §65915(b); see also the entire density bonus table at Gov't Code §65915(g)(1), (2).
5 Gov't Code §65915(d).
6 Gov't Code §65915(c).
7 Gov't Code §65915(I); Gov't Code §65915(p).
8 See Pasadena Zoning Code §17.43.050.
9 City of Los Angeles Ordinance No. 179681.
10 The projected sales price of the market rate units in projects with on-site very low-income units is reduced by 10 percent due to the stigma factor; that is, the perceived reluctance of a buyer of a market rate unit to pay many times the price for the same unit as an affordable buyer. The reduction also results from the knowledge that market rate buyers fear that affordable buyers will not maintain their property in the same way as market rate buyers. In actuality, this reduction may not occur after the project is completed, but developers incorporate this factor in their pro forma projections.
11 Health & Safety Code §50052.5(h).
12 25 Cal. Code Regs. §6932.
13 Health & Safety Code §50052.5.
14 Gov't Code §§53311 et seq.
15 According to a California Association of Realtors September 2008 report, median home prices dropped by 40.9% when compared to September 2007. This decline is largely attributable to the deals that are available to acquire failing or foreclosed projects and the declining cost of construction labor, as contractors are forced to compete for the fewer construction jobs that are now available.
16 The 40% drop in cost per unit is based upon lower land costs for new site acquisitions and the lower construction labor costs caused by the number of out-of-work contractors bidding for each job.

 
 


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Copyright 2009, Los Angeles Lawyer magazine. All Rights Reserved.

 
   
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