Local housing: A little reality

Much of the "expert commentary" is wrong. Here's what's really happened, and what's in store, for the local housing market

Reading the superficial year-end wrap-ups and “expert commentary” about the city’s housing situation in the local press this week is making my head hurt. So here is a basic primer about what is really going on, what is coming in 2017-18, and some initial thoughts on what to do about it.

Displacement has been the predictable impact of the housing crisis
Displacement has been the predictable impact of the housing crisis


a.    National economic recovery, especially enriching the Investment Class

As has been well documented by many, national (and global) economic growth since 2010 primarily has benefitted the professional class and those of great wealth. While employment numbers have improved steadily too, many are underemployed or in low-wage jobs, and the growth in real wages has been very modest. This has prevented strong growth in consumer spending, the foundation of the national economy, and so this economic recovery has been modest at best.

b.    Historically low interest and investment capital rates

As a direct result of this enrichment of the Investment Class, unprecedented enormous wealth has inevitably been funneled into institutions and investment funds of all kinds seeking to earn a return. But with only modest national economic growth, the opportunities to put those funds to productive domestic use are limited, and so investors must accept very low rates of return. This has resulted in historically low lending rates from banks and financial institutions, and historically low capital investment rates (the “cap rate”) from private equity sources of all kinds. For technical reasons (tax code, risk management, available but fixed supply, mature industry) buying/developing real estate is a leading field for such investment.

c.    Economic boom employment and population growth in San Francisco and the Bay Area

The Technology Sector has lead national (and global) economic growth since 2010. As the world’s premier technology epicenter, the Bay Area is experiencing an unprecedented economic boom as a result. The South Bay has seen the greatest growth, but a significant amount has spilled over to San Francisco and the Central Bay Area, especially the ‘soft’ tech of social media, creative media, web services, and bio-technology. This sudden large-scale job growth has directly lead to sudden large-scale population growth too, with the resulting sudden burst of high demand in the region’s housing markets.

d.    As always, prices go to “What the Market Will Bear”: (1) Housing
As a basic rule of Market Capitalism, whenever demand significantly outstrips supply, prices for a commodity will inevitably rise to the limit that buyers are able to pay. This is exactly what has happened to rents and home sales prices in the Bay Area due to the sudden burst of new Bay Area residents who are also generally very well paid, well over regional median incomes. Their higher-than-average buying power is setting prices and rents today, above what the rest of the middle class can afford. The unavoidable result is all the negative impacts now occurring: doubling up, evictions/displacement, under-the-table transactions, etc. The fact that rents and home prices have leveled off in the last year means this relentless market-adjustment process has been completed – for the time being.

e.    There are other new sources of housing “demand” that have a major impact too

Second homes, global investment buyers, corporate housing, suburban empty-nesters returning to the city, and home sharing (Airbnb) all impact the Central Bay housing market by removing cumulatively significant amounts of new and existing housing stock from the general market that is available for primary residences. This growing trend has made the overall housing market situation significantly worse since 2010.

f.    As a result of all these pro-development factors, the region’s housing development industry has increased its production work significantly – but its capacity has limits

In theory these all-time high rents/home prices combined with these historically low interest/equity rates make development of new housing exceptionally feasible financially for Bay Area residential developers, and so there should be, after some lag time, a commensurate boom in housing development. But there are internal constraints that limit what this Industry can produce unrelated to local zoning etc. First is the overall size and capacity of the industry itself. The number of regional developers still in business at the end of the Great Recession able to undertake larger projects was limited, and it has grown only gradually with the addition of new firms only gradually since 2010.

Second, the scale of their own internal business capitalization constrains the rapid project growth of many without unacceptable risk of over-leveraging. They do not have “deep pockets.” The new REIT capitalized developers who do have “deep pockets” can undertake large projects, but they generally seek to diversify projects geographically statewide/nationally to manage risk. And third, because of the importance of local experience and the uncertainty of how long the current local economic boom will last, it is very difficult for major developers from other metro areas/states to enter the Bay Area housing industry.

g.    As always, prices go to “What the Market Will Bear”: (2) Construction Costs

In addition to these internal industry constraints, one very negative external constraint is the dramatic increase in all construction costs since 2010. Thanks to a simultaneous boom in commercial development and government/institutional projects as well as residential development during these years, the capacity of the Bay Area’s construction industry is completely exhausted. The Great Recession forced a sharp contraction in this industry too. General contractors and trade subcontractors have gradually expanded their capacity since 2010, but only to the extent that their financial capacity permits, and that there are experienced construction workers available in the greater Bay Area to do the work. As a result of the limited Construction Industry supply of trade subcontractors in particular, the construction costs of building new housing have more than doubled since 2010.

h.    As always, prices go to “What the Market Will Bear”: (3) Land Prices

The final “bottom line” constraint on new housing development is that property owners have proved the ultimate beneficiaries of the Bay Area’s housing market boom. After taking into account the key factors of rents/prices, interest/cap rates, and construction costs, the “residual land value” – what a developer is able to pay for a site and still make its desired profit – has on average almost tripled per buildable housing unit since 2010. Unless they own the land already or partner with the owner, developers must find a willing seller and have the cash needed just buy a site. Few have the cash sufficient to tie up more than a few sites at one time for the several years needed to start construction.

i.    Master-planned mega-projects have a huge extra problem: Infrastructure Costs

More than half of the already-approved housing units in the Central Bay Area, especially San Francisco, are part of master-planned mega-projects on public property – Hunter’s Point Shipyard/Candlestick, Treasure Island, and others. And more are planned – Pier 70, Mission Rock, and others. But before their housing can be built, these former industrial/military sites need hundreds of millions of dollars in all-new utility/transportation infrastructure, seismic stabilization, and hazmat remediation work, and will need extensive new parks and public amenities before they are finished. Since, unlike former redevelopment projects, all these projects will be internally self-financed from their own tax revenues, special property assessments, and land sales proceeds, they must be slowly developed in multiple phases over several decades as their internal financing sources gradually grow with completion of their initial phases to become available in sufficient amounts.

But most of their core infrastructure has to be financed and built first. The first such master-planned project, the Mission Bay Project that was approved in 1996 and began construction in 1998, is now nearing completion by 2020 – after 22 years – but it had the unique advantages of the newly-built city- funded master sewer system it needed, the city-built/funded Third Street Light Rail line it needed, and initial private ownership of most of the site. Plus it gained an extraordinary “anchor tenant” – the globally important new UCSF research campus, that significantly enhanced its land values. So it is going to take 20 to 30 years to complete these mega-projects and actually bring their tens of thousands of new market and affordable housing units on-line.

2.    NOW WHAT??

a.    No one knows how long current national economic growth will last

We are about to witness a full-scale experiment in radical Republican “Voodoo” economic theory. If one believes that tax cuts for the wealthy somehow trickle down to increased consumer spending, that de-regulation will avoid a repeat of past financial markets meltdowns, that cutting general government spending/employment by billions/millions somehow still puts more people to work by expanding the defense industry, that eliminating minimum wages, benefits, and health care for workers somehow boosts their spending power and the economy, and that raising interest rates by fiat will somehow spur investment spending, than one can be optimistic the current modest economic growth in the US will continue indefinitely. Just like it did in the 1920’s, until … Oh.

Otherwise though, after one last flurry of stock market-style hype, a definite cooling off of the national economy by 2018 once these new realities begin to take hold would be most likely, and worse is possible. If the Federal Reserve Bank continues to increase interest rates by fiat in 2017, that would by an additional negative factor, but presumably the Fed would reverse course quickly if a downturn looms.

b.    No one knows how long this Bay Area Boom will last

We are about to learn if history repeats itself. If one believes the Bay Area’s “unicorn” tech start-ups can go on indefinitely losing money, like Uber, or just not making any money, like Twitter, without eventual massive downsizing, or can be bought up by industry giants, like Linkedin, without eventually relocating elsewhere, or that a Trump Administration international trade war might not backfire on export-oriented Silicon Valley, or the tech industry is somehow immune to negative national economic conditions, than one can be optimistic the current economic boom in the Bay Area will continue indefinitely. Just like it did in 2001 … Oh.

Otherwise though, 2017 looks likely to be a year of local wait-and-see with Tech Industry expansion in a holding pattern, until the national economy’s prognosis clarifies by 2018. But worse is possible.

c.    The impact of Republican tax cuts on housing development

The combined impacts of radical Republican cuts to the capital gains tax, the corporate tax rate, and income tax rates would have some foreseeable consequences, besides Making the Rich Richer. Long-time land owners would have an incentive to sell development sites in 2017 while prices are still high thanks to a big cut in the capital gains tax they would pay. At the same time cuts in corporate taxes will boost stock prices in the near term (this is already happening in anticipation), attracting fluid equity investment away from real estate. Lower income tax rates also will reduce the tax-driven attractiveness of real estate investment. (In particular, anticipation of lower corporate tax rates have already impacted the Low Income Housing Tax Credit market, suddenly cutting offered equity investment rates by almost half.) Overall, the impacts would be disadvantageous for residential property ownership and new housing development. Property values/prices should adjust downward eventually to offset these multiple impacts, but that typically requires a full business cycle – a recession – to complete. And if the Fed continues to increase interest rates by fiat in 2017 that would by an additional very negative factor for new housing development, forcing both financing/mortgage interest rates and equity investment cap rates to move up significantly.

d.    What Local Policy can’t do about housing development

•    The city and region cannot avoid the consequences of a national economic downturn or higher Fed-set interest rates.

•    The city cannot reverse the negative impacts of radical Republican tax cuts on housing development. In theory the State of California might to a partial extent, but that is highly unlikely.

•    The city cannot expand the internal capacity of the local housing development and construction industries.

•    The city cannot stop Market Capitalism from charging “what the market will bear” for anything and everything it can.

•    The city cannot stop people from wanting to live here. In fact, a wave of new “domestic refugees” may come to the Bay Area to escape a coming national wave of social repression and economic desperation.

e.    What Local Policy can do about non-government-subsidized housing development and the City’s general housing market, especially its affordable housing
•    The city can continue to apply existing policies that achieve the Prop K 33% affordable housing goal through community-approved up-zonings, public-private partnerships for development of city-owned property, and negotiated development agreements for large private sites. (The upcoming Central Soma Plan will be the next such opportunity).

•     The city can use its regulatory/taxing powers to prevent or financially disincentive diversion of new and existing housing to uses other than primary residencies (restrictions/fees on home sharing, second homes, corporate housing, investment buying).

•    The city can recapture a significant proportion of the much increased land values since 2010 by requiring more inclusionary affordable housing in future new development (as Prop C in fact has done on an interim basis), including “equalizing” the increased land values resulting from the State “density bonus” law.

•    The city can use its regulatory powers to financially dis-incentivize “upmarket” conversions of its de facto affordable residential hotels by mandating full code upgrades, including ADA, for such changes.

•    The city can close loopholes in the Rent Stabilization Ordinance that might allow existing rent-controlled units to be replaced by non-rent-controlled units in new projects.

•    The city can establish a $1+ billion Infrastructure Finance Bank to fund the extraordinary infrastructure costs of the several master-planned mega projects, and cut their 30-year development of tens of thousands of housing units – at least 33% affordable – in half, to just 15 years.