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Don Poland, PHD, AICP featured in CT Planning magazine

Affordable Housing and Financial Feasibility

by Dr. Donald J. Poland, AICP

Original article appears on pages 20-23 in https://ct.planning.org/documents/4192/CT_Planning_F20.pdf

I have been fortunate to have worked on housing and affordable housing issues for developers, municipalities, and non-profit neighborhood investment programs. I believe this broad experience has afforded me the ability to understand the complexity of affordable housing from different perspectives. Therefore, this article’s aim is to focus on the perspective and challenge that receives the least attention in our planning efforts to address housing availability. That issue is the economics of housing, affordable housing, and the financial feasibility of 8-30g developments.

It has been over 30 years since 8-30g, the Affordable Housing Land Use Appeals Act, was adopted into law. Three decades on, and the need for affordable housing is still as great. Unfortunately, while most agree on the need, there is often disagreement on the policies needed to increase the supply of affordable housing. In addition, there remains much debate over the effectiveness of 8-30g.

Housing markets function in accordance with the laws of supply and demand. Scarcity of housing overall — and at specific price points — results in higher housing costs. Demand drives scarcity when demand outpaces supply. Therefore, if we are to understand the challenge of affordable housing, it is critical that we understand the economics and financial feasibility of developing affordable housing. While 8-30g is a well-intended policy, it has fallen short of performing as it was intended — producing an adequate supply of affordable housing in Housing markets function in accordance with the laws of supply and demand.

Scarcity of housing overall — and at specific price points — results in higher housing costs underserved higher-income communities. Unfortunately, growth in two of the three demand drivers (jobs and population) has been anemic since 8-30g was adopted — household formations being the third demand driver with moderate growth. Affordable housing aside, the economics of speculative real estate development has been sluggish at best across all asset classes since 8-30g was adopted. The result: soft-to-weak market demand with high costs and low returns that challenge the financial feasibility of most real estate developments.

While some communities resist development — change, growth, and affordable housing — others have embraced development. However, even those communities that embrace development are often confronted with the challenges of weak-market conditions and marginally feasible developments that often require public participation in the form of subsidies, the most common being (property) tax abatements. Developers would develop more real estate, including housing and affordable housing, if there were ample demand and stronger returns — i.e., if more developments were financially feasible. However, anemic demand, modest returns, and unpredictable land use approvals undermine market confidence and increase risk.

The development of affordable housing poses even greater risks (e.g., community-opposed and denied applications) than market rate housing, and lower returns (e.g., below-market rents). As designed, 8-30g is intended to mitigate this increased risk and the low returns.
However, 8-30g cannot overcome the anemic demand and modest returns that can undermine financial feasibility. Understanding this is important to the broader discussion of affordable housing and public policy.

Simply put, 8-30g is a market-based approach to a social need for affordable housing. 8-30g provides regulatory incentives (e.g., increased density, greater chance of approval, etc.) to entice private developers to build, own, and manage for info on advertising rates and availability, affordable housing, provided 30% of the units are restricted as affordable.

In other words, 8-30g assumes that incentives will overcome the risk and cost of developing and operating the affordable units. In theory, this is a novel and innovative policy approach. In practice, when confronted with the realities of weak-market conditions, it is challenging at best to design and develop a financially feasible 8-30g project.

The reason for this is many variables that determine financial feasibility — the unique financial dynamics of all real estate developments. These many variables include market strength, land cost, labor cost, site development cost, utility connection fees, utility user fees, permitting fees, financing interest rates, tax rates, and achievable market rents. Most important, each of these variables influences both the upfront development costs and long-term operation costs. Cost vs. Returns = financial feasibility.

To understand how financial feasibility works, let us explore some basic economics of developing a 2-bedroom housing unit in the Hartford region. To accomplish this, I will compare the costs and returns of a market rate unit, and of affordable units at 60% and 80% AMI. In addition, I will extrapolate the per unit calculations to a 100-unit market rate and
affordable developments. In doing so, I use generalized market values and development
costs based on recent market research to provide reasonable representation of an actual development in the Hartford region.

Table 1: Market Rate Rent

For the market rate unit, we shall assume that the occupants are a 3-person household with the median household income of $88,100. At 30% of their income, the family’s housing budget is $26,430/year (or $2,202/month), enough to pay the market rate rent for a 2-bedroom of $2,070 (or $1.97/sq. ft.). Typically, as the starting point for determining feasibility, a return of $2.00/sq. ft. is required to cover costs. Therefore, the $1.97/sq. ft. is deemed reasonably feasible.

The feasible return of $1.97/sq. ft. is assumed to cover all development and operation costs spread over an 8-year development proforma, including a 12% return on investment (ROI). The reason the $2.00/sq. ft. is a starting point for feasibility is that costs and returns are not fixed values for all developments. The values will vary, often between $1.85 and $2.40/sq. ft. depending on the actual costs and the attainable rents.

Let us explore one variable cost, property taxes. In our first example, the $1.97/sq. ft. includes taxes on an assessed value of $105,000 (70% of appraised value) at a mill rate of 27 mills. An identical unit in a neighboring community with a mill rate of 33 mills would raise the per-square-foot rent by four cents to $2.01.

While such a small increase sounds insignificant, the difference, extrapolated over 100 units or 105,000 square feet, results in an additional $4,200 per year in tax and operating expenses (or $33,600 increase over the 8-year proforma). The same would be true of marginal increases in other costs (e.g. land cost, site improvements, utility connections, user fees, etc.). If each of these costs increased by 4 cents per square foot, the identical unit in the neighboring community would require a rent of $2.16 per square foot to be feasible. However, if the maximum achievable remains $1.97/sq. ft. the development would not be feasible. Hopefully, you are starting to see not only the effects of marginal variations costs, but that excessive municipal fees (e.g. sewer connections, land use application, building and zoning permits, etc.) can and do impact feasibility and the cost of affordable housing.

Table 2. Taxes Per Square Foot

Now let us consider the same 2-bedroom unit and 3-person household adjusted for affordable rents. Table 3 shows that the maximum affordable rent at 80% AMI is $308 less per month than the market rate rent ($3,696 less per year). The maximum affordable rent at 60% AMI is $762 less per month ($9,144 less per year). However, qualified affordable rents must also adjust for utility costs since total housing costs cannot exceed 30% of household. Conservatively adjusting for utility costs further reduce the maximum affordable rents by $200 per month, as shown in the table. As a result, the yearly decrease in unit rental income increases to $6,096 at 80% AMI and $11,544 at 60% AMI.

Table 3. Affordable Rents

The loss in rental income for the affordable units is substantial and the cumulative effect extrapolated over 100-units significantly impacts financial feasibility. Table 4 shows the gross income of a fully market rate development versus a mixed-income development. The 100 market rate units (assuming 100% occupancy) gross $2,484,000/year. The mixed-income development, with 70 market rate units, 15 affordable units at 60% AMI, and 15 affordable units at 80% AMI, has a gross income of just $2,219,840/year. That is $264,160 (or 11%) less in yearly income than the market rate development.

While an 11% decrease may not sound significant, it is important to understand that most costs are fixed (e.g. debt, utilities, taxes, insurance, management, etc.) and remain the same for both the market rate and affordable development — the debt service alone likely accounts for 50% of yearly gross revenue. The result, the 11% decrease in revenue, directly impacts profitability and return on investment, substantially decreasing the financial feasibility
of the project.

Table 4. Gross Incomes of Hypothetical Market-Rate and Mixed-Income Developments

Developing a financially feasible market rate housing development is challenging enough with anemic demand and marginal return. Add to the development a requirement for 30% affordable units and it becomes next to impossible. While increases in density reduce the cost of land per unit, most of the other costs remain constant. Therefore, the benefits of density are minimal in the context of total cost. The many variables and variation in their costs have meaningful impacts on financial feasibility. In addition, since such costs vary across different geographies, understanding these costs helps to better understand locational variation in the production of affordable housing. By reducing or waving fees and abating taxes on affordable units, municipalities could meaningfully and positively impact the financial feasibility of affordable housing development.

Don Poland is Managing Director of Urban Planning at Goman+York and Visiting Associate Professor of Urban Studies at Trinity College.