RCA Insights

California’s Prop 10: Battle Is Over, War Is Not

By on November 13th, 2018

Housing is increasingly unaffordable for many residents of California. Proposition 10, which would have allowed local governments in California to reintroduce elements of rent control, was voted down on November 6th. Defeating this ballot initiative does not address the fundamental issues of affordability, however, and opponents of the free market may come back at this topic in the future.

I am writing this note in a West LA coffee shop and glaring disparities of income are on display. The workers here do not have the same disposable wealth as the clientele pulling up in supercars and showing off their designer gear. Seeing these disparities, one can understand why some people develop a righteous indignation to try to soak property owners.

The challenge, though, is that property owners themselves are not driving up rents, they are simply reacting to what the market allows. California is not building enough housing. From 1975 to 2016, the state of California added 18 million new residents. Over the same time frame, permits were issued for only 6 million new housing units. Rents are growing simply because of the laws of supply and demand.

Still, the notion that one can build more units to generate affordability falls on deaf ears for most proponents of rent control. For instance, as I write, I see a new tower in the distance by Century City – it was delivered as a luxury rental building with units on offer for more than $10,000 per month. A barista paycheck does not cover that kind of rent.

When developers are bringing assets to market in places like West LA, yes, in the current market they will try to deliver units aimed at higher incomes. If there is money to be made though, developers would build more affordable units. Part of the issue is regulatory barriers.

If a developer has a piece of land and wants to build something, every regulatory hoop they have to clear represents an additional cost to construction. A joint study by the NAHB and the NMHC has shown that these regulatory demands can account for 32% of the cost of building an apartment building in the U.S. Add more hoops and costs, and developers will need to build units only for high-income earners who can pay high rents.

The degree of regulatory barriers varies across the U.S., however. In cities such as Houston and Chicago, where development rules are more permissive, developers can bring a wider mix of units to the market and rents are more affordable relative to average incomes. As rents climb higher so too do property prices and one can see the impact of development restrictions not only in rents but in property prices.

1811 Rent control Costello MAIN_72-01

The chart above compares the degree of development restrictiveness across markets relative to trends in property prices. It plots the Wharton Residential Land Use Regulation Index, which tracks challenges of construction across markets, against the compound annual growth rate of apartment property prices as tracked by the RCA CPPI. Markets in the Golden State are highlighted in gold text. Over nearly the last two decades, apartment prices as measured by the RCA CPPI have generally grown faster in markets where developers face more challenges in bringing assets to market.

The mechanism here is simple: as localities limit construction, ongoing growth in apartment demand with limited supply will push up apartment rents. Higher apartment rents will drive up property prices. Owners of existing apartment buildings might look at that chart and think that maybe more development restrictions would be beneficial for them. Limits could be beneficial to a point, but when price and rent growth grow too far, it can generate a backlash as it did here in California with Proposition 10.

The Proposition 10 episode in California is only one battle in the ongoing war for affordable housing. The commercial real estate industry should not rest on this one victory and think that the pitchforks have been put away for good. As rents continue to climb, citizens will get angrier. Among many policies that should be pursued to deliver affordable housing, regulatory barriers can be changed to allow developers to deliver affordable units profitably.

Jim Costello

Jim Costello

Senior Vice President
jcostello@rcanalytics.com

Jim Costello has worked in the CRE space on issues of urban economics since 1990, including a 20-year stint at Torto Wheaton Research. Jim expanded the reach of the Torto Wheaton Research team developing forecasts of global market fundamentals. He also developed approaches to pair the forecast results with frameworks to answer investor questions on asset values and relative investment opportunities.

In the aftermath of the Global Financial Crisis, Jim provided advice to the Treasury Department and helped educate these professionals on commercial real estate performance. Jim is a member of the Commercial Board of Governors of the Mortgage Bankers Administration, where he helps policy makers understand the commercial real estate industry.

Jim is expanding the capabilities of the Real Capital Analytics team on issues of real estate market dynamics. Jim has a master’s degree in economics and is a member of the Counselors of Real Estate.