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Chapter 5: Capital Constraints

After land and entitlements, the most important input into the housing production process is capital—lots of it. Housing capital takes two general forms: investment, or equity capital, and debt capital, or financing. Of the $30 billion to $40 billion dollars spent on new housing in California in 1998, approximately 10 to 20 percent took the form of equity capital. The remaining eighty to ninety percent was debt.

If California is to produce enough housing to meet projected demand, developers, builders, apartment investors, non-profits, local governments—and most importantly, households—must have ready access to multiple forms of debt and equity capital. Homebuyers must have access to mortgage financing, as well as to down-payment capital. Single-family developers and homebuilders must have access to investment and debt capital for land acquisition, site improvements, and construction. Multi-family developers and investors must have access to investment and debt capital for land and property acquisition, for construction, and for permanent financing. Developers of affordable housing must have access to subsidy funds. Local governments must have access to bond financing to provide needed public infrastructure and services. Any breakdown in the supply of capital for housing, or any increase in the cost of capital will have severe ramifications in the housing market.

Debt and equity capital for housing are substitutable and complementary at the same time. The larger the homebuyers' down payment or investor's equity contribution, the less financing they need. Similarly, the greater the amount of financing that is available, the less the amount of cash that is needed. This is the substitutability side of the equation. On the complementary side of the equation, the greater the down payment, the larger the amount of qualifying debt.

Housing capital is available from three general sources. Private capitalùfunds to be used for the purchase and development of private housingùis available in equity form from households and investors, and in debt form from permanent and construction lenders (see Exhibit 32). Public capital, money for the provision of public infrastructure, is principally available in debt, or bond form, although many local governments also pay for capital infrastructure from current tax revenues. Housing subsidy capital is tax revenue or bond debt (or in some cases, tax expenditures) that is earmarked for the construction and/or operation of housing for low-income households.

The cost and availability of capital varies by source, but not dramatically so. Public debt capital, because it is either tax-exempt or backed by a government agency—and is thus less risky—is generally less expensive and easier to raise than private capital. However, as we note below, the availability of public capital is sharply constrained by use, statute, and increasingly, by local politics.

The availability of private investment capital depends foremost on its ability to earn competitive returns: the greater the potential return of a particular project or asset class, the greater the flow of private capital to it. The cost and availability of investment capital are also critically attuned to risk. As the risk of a particular project or asset class increases relative to the risk of comparable investments, the supply of investment capital to that project or asset class declines.

The determinants of private debt capital availability are much more complicated. They include the overall cost of capital (as reflected in the Federal Funds rate, prime rate, or other cost of funds), the ability of lending institutions to attract depositors and/or sell mortgages on the secondary market, the ways in which lending institutions underwrite loans, and the attractiveness of mortgage-backed securities to private and institutional investors.

The availability of housing subsidy capital depends principally on funding authorizations by Congress, the California Legislature, local legislative bodies, or the citizenry. In the later case, citizens may vote to approve the issuance of bonds, the proceeds from which may be available to homebuyers, builders, or non-profit developers.

When the supply of capital to housing declines or when its cost increases, the housing market contracts, regardless of the level of housing demand. Sales of existing properties slow, as does the pace of new construction. This is not the end of the story, however. As the supply of housing contracts relative to housing demand, rents and prices should begin to rise, causing investor returns to increase. Increasing returns, in consequence, cause investment and debt capital to be re-attracted to the housing sector.

Capital markets have become increasingly integrated, especially during the last decade. Traditional divisions between debt and equity capital are breaking down as lenders and investors both access the same capital sources. Divisions between public and private capital forms are also breaking down, as secured mortgage debt increasingly competes with public bond debt. On the positive side, increased capital market integration means more funds are potentially available for housing. On the negative side, capital flows to housing have become potentially more volatile as housing must now compete for capital with other sectors, often on a minute-to-minute, percentage point-to-percentage point basis.

This chapter examines the specific availability and cost of five forms of housing capital: (i) private debt capital for homeownership; (ii) equity and debt capital for the development of rental properties; (iii) equity and debt capital for land acquisition and improvement; (iv) public debt capital; and, (v) funding availability for affordable housing.

We begin with the obvious but all-important caveat that capital markets, like politics, are completely unpredictable. Today's capital market conditions provide little in the way of reliable information about future conditions, be they short-, medium-, or long-term. The fact that some types of capital may be cheap and plentiful in July 1999 does not mean that they will be either cheap or plentiful in December 1999, December 2000, or December 2009.

Private Capital Availability and Cost

The Supply of Mortgage Credit for Homeownership

Home mortgage credit has been readily available at attractive rates throughout the U.S. since the early 1990s. Borrowing costs on fixed rate mortgages during the first quarter of 1999 were at their lowest point in 25 years. The beneficial effects of lower mortgage interest rates on homeownership affordability are difficult to overstate. For example, with mortgage interest rates at 10 percent, and assuming a 15 percent down payment, a family with an annual income of $60,000 can qualify to purchase a $166,000 home. With interest rates at 8 percent, the same household with the same $60,000 income qualifies to purchase a $198,000 home. Were interest rates to fall to 6 percent (about .75% below where they are currently), the same household could qualify for a $242,000 home (see Exhibit 33). The benefits of low mortgage interest rates to households in the $40,000 to $50,000 category are even more profound.

Assuming inflation remains under control, and there are no significant increases in mortgage default rates, mortgage money should remain plentiful and inexpensive for the foreseeable future. Indeed, it may become more plentiful. In recent years, Fannie Mae (The Federal National Mortgage Association) and Freddie Mac (The Federal Home Loan Mortgage Corporation) have each increased their purchases of adjustable rate mortgage pools. Under federal mandate, both agencies, together with the members of the Federal Home Loan Bank System, must find ways to increase lending to moderate-income households, members of ethnic and racial minority groups, and to central city neighborhoods. Low mortgage interest rates make such loans safer as well as more attractive.

Growth also plays a role in increased lending activity. California's continued growth insures that there will be a strong demand for housing, and that residential property values should continue rising. This should make it easier and safer for lenders to underwrite mortgages made on California properties.

Ironically, too much housing demand—especially if it is not accompanied by adequate housing production—might actually decrease mortgage availability. Should home prices (and thus mortgage loans) rise to levels above Fannie Mae and Freddie Mac maximum mortgage loan limits (currently set at $240,000), the ability of lenders to sell loans on California properties in the secondary market would be diminished. Since somewhere between fifty and sixty percent of new home mortgages are purchased by Fannie Mae and Freddie Mac, this would substantially diminish the amount of mortgage capital available to California homebuyers.

Investment Capital for Rental Housing

Investment capital for the construction and purchase of ownership housing commonly takes the form of a down payment. Investment capital for the development and purchase of rental housing usually takes the form of investor's equity. Apartment investors, like all investors, require some minimum risk-adjusted return-on-equity if they are to be persuaded to invest. When apartment rents fall below the levels necessary to support such returns, investors reduce the capital they provide to the apartment sector, and new construction slows or ceases. If investors begin withdrawing capital from the apartment sector, apartment values must ultimately decline.

Rents in many California apartment markets are currently well below the level required to attract investment capital. To find out where and why this is the case, we constructed a simple financial simulation model of apartment investment in six California counties: Santa Clara, Contra Costa, Los Angeles, San Bernardino, Sacramento, and Fresno. The inputs to this model include local development costs and particular assumptions regarding financing and operating costs (see Exhibit 34). The model outputs are the difference between current market-wide median rent levels and the rents required to provide investors with a 12 percent cash-on-cash return.¹ (Cash-on-cash return is measured as the ratio of annual {before-tax} cash flows to invested equity.) We call this difference the current rent gap.

None of the simulated projects are real. Instead, they are archetypes of the broad apartment market in each county. Some of the input assumptions are common across all six markets. For simplicity's sake, it was assumed that all six projects consist exclusively of two-bedroom units, and that every project would be financed with a 7.5 percent, 30-year mortgage, underwritten on .75 loan-to-value ratio. The number of parking spaces required per unit, two, is also the same in all six markets. Operating expense ratios (the annual share of rental income required to pay taxes, utilities, insurance, management expenses, maintenance, reserves, and contingencies) range between 30 percent and 35 percent, depending on the market. At two acres, each project occupies the same sized site.

Other project parameters vary by market. As indicated in the top half of Exhibit 34, land costs range from a high of $40 per square foot in Santa Clara County, to a low of $10 per square foot in Fresno County. Reflecting the variation in land costs, project densities also vary: from a high of 40 units per acre in Santa Clara County to a low of 15 units per acre in Fresno. At 850 square feet, average unit sizes are slightly higher in Santa Clara and Los Angeles counties than in San Bernardino, Sacramento, and Fresno counties.

Construction "hard costs" range from a high of $95 per square foot in Santa Clara and Los Angeles counties to a low of $60 per square foot in Fresno County. Reflecting different difficulties of development, "soft costs" range from a low of 20 percent in Fresno and Sacramento counties to a high of 30 percent in Santa Clara County. Parking requirements also vary depending on local zoning codes and market conditions. Because of its higher density, the Santa Clara County project is assumed to be constructed using a podium-parking design; projects in the other markets are assumed to be developed with on-grade parking.

To estimate required rent levels, we first determined the total development costs associated with each project. These vary from a high of $14.2 million (for 80 units) in Santa Clara County to a low of $2.9 million (for 30 units) in Fresno County. Subtracting out the maximum supportable mortgage (based on a loan-to-cost ratio of .75) yields the investor's required cash. This varies from a high of $3.5 million in Santa Clara County to a low of $728,000 in Fresno County. Assuming investors in all six markets would require a 12 percent cash-on-cash return, the Santa Clara County project would have to generate an annual (before-tax) cash flow of $424,000 in order to attract investment capital. At the opposite extreme, the Fresno County project would have to generate an annual cash flow of $87,400.

Adding back in debt service, operating expenses, and projected vacancy losses yields total scheduled gross income, or revenue (these calculations are shown in the bottom half of Exhibit 34). This number is then divided by the number of units and months per year to yield an estimate of minimum required monthly rent. The required minimum monthly rent varies from a high of $2,186 in Santa Clara County—reflecting that county's higher land and development costs, larger units, and more expensive parking facilities—to a low of $1,138 in Fresno County. Compared to total development costs, required rents are actually higher in Fresno County than in Santa Clara. This is because Fresno County densities are so much lower than Santa Clara County densities, resulting in the construction of fewer income-producing rental units.

The bottom section of Exhibit 34 compares investor-required rent levels with 1997 median rent levels, as published by RealFacts, a private market research firm. The difference between the two, or the rent gap, varies from a high of $986 in Santa Clara County to a low of $568 in Contra Costa County. Expressed in percentage terms, the rent gap is highest in Fresno County, and lowest in Contra Costa. In Fresno and Sacramento counties, for example, the apartment rent levels required to attract investors are more than double current median rents. In southern California, required rent levels are 80-90 percent higher than current median rents. In the Bay Area, the percentage rent gap varies between 60 and 85 percent.

These variations reflect the fact that compared to development costs, current rents are somewhat higher in the Bay Area than in southern California, and much, much higher than in parts of the Central Valley. Yet even in the Bay Area, current median rents are not adequate to provide investors with a 12 percent cash-on-cash return. (1999 Contra Costa County median rents would provide investors with the equivalent of a 3 percent cash-on-cash return.)

The rental housing market is actually much more varied and complicated than this simple analysis indicates. Small-scale apartment owners, for example, have traditionally been far more interested in having secure cash flows than in maximizing their cash-on-cash return. Depending on the stock market, future investment-hungry real estate investment trusts may be willing to settle for reduced returns. Operating expenses may be reduced through careful management. Parking requirements may be negotiated downward, and common-area construction costs may be reduced.

These caveats notwithstanding, this analysis demonstrates why the only unsubsidized apartments now being built in California are at the upper end of the market, where achievable rents are higher. Until land and construction costs fall, and/or until suburban densities rise, and/or until market rents increase, potential apartment investors will remain on the sidelines. The resulting lack of construction in the face of rising apartment demand will ultimately cause rents to rise above required levels. This is exactly what happened in 1997 and 1998 in San Francisco and in parts of San Mateo and Santa Clara counties.

Rising rents, however, generate increased rent burdens and hardship, particularly for low- and moderate-income households. Invariably, they result in displacement and increased crowding. This then, is the "Catch-22" scenario confronting hundreds of thousands of current and future California renters. Rents and project cash flows must rise if there is to be sufficient production to meet demand. At the same time, rising rents make it ever more difficult for low- and moderate-income renters to find the housing they need, want, and can afford. This, in turn, increases the need for rental housing subsidies.

Capital for Land Development

Land developers purchase raw land (sometimes from long-time land owners, but also from land speculators), entitle and subdivide it, and, sometimes, depending on the developer and market, install on-site services (e.g., streets, sewers, drainage) and pay for off-site improvements. These activities are generally carried out two to five years ahead of unit construction. The long lead times and high costs associated with these activities make them incredibly risky. The metropolitan area may not expand in the direction or at the rate expected. Rising interest rates or a recession may dampen demand. Competition from other land developers and builders may dampen prices. The development approvals process will almost certainly prove lengthier and more expensive than originally anticipated.

The high levels of risk associated with land development make it difficult for land developers to find investors and financing. As a result, potential land investors typically require large premiums over and above other types of real estate investments. Lenders who make land development loans impose lower loan-to-value-ratios, charge higher rates, and/or require the loan to be a recourse loan. If other, lower-risk lending opportunities are available, lenders may eschew land development loans altogether. When that happens, the capital available for land acquisition and development may fall below the level required to provide a steady and secure pipeline of entitled and finished lots. Ultimately, of course, a shortage of lots causes lot prices and returns to rise, thereby re-attracting capital.

However, unlike the multi-family case documented above, this adjustment process may take years, not months. Because the new home market is so segmented by location and quality, equilibrium may be restored in one part of the market but not another. This adjustment process mostly occurs in the background of the real estate and housing market. Lenders are not required to report their land loan activities or their financing terms. Investors in land never disclose the terms of their investments. Homebuilders regard their land and improvement costs as proprietary. County recorders may require that land transactions be listed, but this can be done so as to mask true transaction prices. About the only housing market actors who regularly report their land purchases are public homebuilders.

Because the land market is so obscure, no one knows whether the total amount of capital currently flowing into land acquisition and site development is adequate, whether and why it might be adequate in some locations but not others, or how lending terms on land and development loans are affecting the development process. Anecdotally, some land developers report that they are having difficulties finding sufficient loan capital. Likewise, some lenders report that they are currently out of the land loan business. Other developers and lenders report that it's business as usual.

How much investment and loan capital will be required to support future land development? Assuming that California homebuilders build an average of 175,000—225,000 units per year at an average cost of $200,000 per unit—and further assuming that land and subdivision improvements account for between 15 and 25 percent of total development costs, then between $5 billion and $11 billion dollars of total capital will be required each year for land acquisition and site development. Assuming fifty to sixty percent of this amount is borrowed, California builders and developers will need annual access to between $3 billion and $7 billion dollars of loan capital.

This is a large, but by no means excessive amount of financing. The question facing policy-makers and developers is whether, because of local risk factors, it will be available in the amounts and at the rates required to accommodate projected household growth in specific regions and counties.

Public Debt Capital

Population and household growth cannot occur in the absence of supporting capital infrastructure—highways, streets, bridges, sidewalks, mass transit, schools, parks, government buildings, sewer, water, and electrical service. Growth is the most important, but by no means only factor affecting the demand for public facilities and services. Because public facilities and services are what are known in economics as "normal" goods—that is, demand increases with income—as California grows wealthier, it will likely require additional infrastructure investments over and above those needed to accommodate population growth. Because of rising health and environmental standards, additional investments will be required to insure that California's public infrastructure stock is safer and more environmentally benign. Last, because even the most well-designed and built systems wear out, additional investments will be needed to replace deteriorated and obsolete infrastructure. Not replacing aging and deteriorated infrastructure when required, so-called "deferred maintenance," adds even more to the total infrastructure bill.

Public Debt Forms

The traditional vehicle used by local governments to fund infrastructure is long-term borrowing; that is, the issuance and sale of bonds. State law allows all California local governments and public agencies to issue four general bond types: general obligation bonds, revenue bonds, special assessment district bonds, and lease-obligation bonds. A fifth bond type, revenue anticipation bonds, may be issued by local redevelopment agencies. A sixth bond type, Mello-Roos Community Facilities bonds, may be issued by designated community facilities districts to finance growth-related infrastructure and public services.²

Public bond types are differentiated along two dimensions: use and backing. Funds obtained from the sale of general obligation bonds may be used to pay for any type of capital infrastructure, which serves a public purpose. This includes the construction and upgrading of roads, schools, recreation facilities, public buildings, and in-ground utilities, as well as land acquisition. General obligation bonds are backed by the issuing municipality's property tax base. (In the unlikely event of a default, bondholders could conceivably lay claim to city property tax revenues.)

Issuing general obligation bonds has always been more difficult in California than in many other states. California State law requires that two-thirds of local voters approve the issuance of all general obligation bonds, regardless of purpose. Proposition 13 (enacted in 1978), which limited annual increases in property assessments to 2 percent, and Proposition 4 (enacted in 1980), which limited property tax revenue increases to the rate of population growth, further curtailed the ability of California local governments to issue general obligation bonds.

Deterred from issuing general obligation bonds to pay for needed infrastructure, almost all California municipalities have turned instead to revenue bonds, lease obligation bonds, and/or special assessment bonds. Revenue bonds may be issued to fund revenue-generating public improvements such as parking garages, recreation facilities, and publicly owned utilities. Revenue and lease-obligation bonds are both underwritten on the basis of earmarked revenue sources. Should the bond issuer default, bondholders may only make claims against the financed asset, not the treasury or general tax revenues of the issuing municipality. Local issuance of revenue and lease-obligation bonds does not require voter approval.³ Indeed, city councils and boards of supervisors may charter municipal corporations, which may then issue revenue or lease-obligation bonds without a legislative vote. Special assessment bonds, which are to be repaid out of special assessment district fees, may also be issued without voter approval. If, however, a majority of property owners in a special assessment district protest their assessments or the establishment of the district, a vote must be scheduled. To avoid coming under the aegis of Proposition 13, local special assessment districts must be smaller in size and different in function than the municipality in which they are located.

Per Capita Public Debt Trends

The long-term effect of Propositions 13 and 4 has been to shift public financing away from general obligation bonds and toward revenue, lease-obligation, and other bond sources. It has not been to reduce total local indebtedness. Quite the opposite: As Exhibits 35 and 36 indicate, total local bonded indebtedness, adjusted for population growth and inflation, increased steadily from $400 per capita in 1984 to $1,400 per capita in 1995. These estimates were obtained by combining the outstanding bonded indebtedness of California cities and counties, including local special districts, but excluding redevelopment districts and special county sales tax bond measures (such as those used to fund countrywide transportation improvements).⁴

Even as overall bonded indebtedness increased at a regular rate, the composition of that indebtedness changed markedly. In 1984, revenue bonds accounted for 48 percent of local (per capita) indebtedness, the single largest source. Largely because of the recession, that share fell to 29 percent in 1990, before increasing again to 38 percent in 1995. Lease obligation bonds helped make up some of the slack: their share of local indebtedness rose from 42 percent in 1984 to 59 percent in 1988, and then fell back down to 38 percent in 1995. In fact, as Exhibit 35shows, revenue bond indebtedness began rising in 1991, just as lease-obligation bond indebtedness leveled off.

The other significant trend involves the increasing use of other non-traditional bond sources. Between 1989 and 1995, indebtedness from non-traditional bond sources rose from essentially nothing to a real per capita level of $264. Throughout this period, general obligation bond indebtedness would fluctuate between six and three percent of total indebtedness, while special assessment district bond indebtedness would fall from four to two percent. Overall, these trends reflect a long-term (and national) shift toward new development and user-based assessments, and away from jurisdiction-wide assessments.

The indebtedness picture varies much more widely for individual municipalities. Indeed, there are often substantial differences between neighboring cities regarding infrastructure-financing practices. These variations reflect differences in city size, age, wealth, and public service preferences. Differences in municipal fiscal structure aside, Exhibits 34 and 35 suggest that overall, California municipalities have had relatively little trouble raising debt capital for new infrastructure. That's the good news. The bad news is local governments have less and less discretion regarding the use of local bond funds, and fewer funds are now available for broad, public-purpose infrastructure investmentsùexactly the sort of investments which most benefit housing.

Substituting Development Fees for Public Debt

Under California law, cities and counties have the authority to require developers to pay for infrastructure improvement through fees,⁵ the dedication of land to public use, or the construction of public improvements. Throughout California, the use of development fees in place of public debt accelerated rapidly in the aftermath of Proposition 13.

Government code section 66000 sets some constraints on the levying of impact fees. Before a fee can be established, increased, or imposed, a municipality must: (i) identify the purpose of the fee; (ii) identify the use of the fee; and, (iii) determine that there is a reasonable relationship (or nexus) between the use and amount of the fee, and the impact posed by development projects. In 1986, the legislature authorized school districts to impose their own fees on new construction. Ten years later, the Legislature capped those fees at $1.94 per residential square foot. Periodic surveys of local development fees by business groups, homebuilders, and public policy researchers reveal tremendous inter-municipal variations in fee amounts and assessment practices, often within a single county.

The fact that different municipalities assess different fees on different types of properties makes simple comparisons difficult. In a recent study published by the Public Policy Institute of California, Dresch and Sheffrin (1998) analyzed the incidence and substitutability of fees and improvement district bond assessments in seven suburban Contra Costa County municipalities. Depending on the municipality, average residential development fees, as of 1994, were found to vary from a low of $11,993 per unit, in the unincorporated Bay Point area of the county, to nearly $30,000 per unit in San Ramon.⁶ When Mello-Roos and local bond assessments were added to reflect the partial substitutability of fees and bond assessments, the range of total assessments increased from $11,993 (in Bay Point) to $34,638 in nearby Antioch.

This latter amount, Dresch and Sheffrin noted, was nearly 20 percent of the average 1994 sales price of new homes in Antioch. In Bay Point, as well as in Clayton, Danville, and San Ramon, the combination of development fees and assessments accounted for seven to eight percent of the average new home purchase price. The extent to which these fees were actually paid by homeowners in the form of higher housing prices, or landowners and developers in the form of lower land prices, was found to vary with local market conditions.

Two major conclusions regarding development fees stand out from Dresch and Sheffrin's work. The first is that fees imposed on new residential development are substantial, and can account for as much as twenty percent of average new home prices. The second is that development fees can and do vary quite substantially between neighboring jurisdictions, sometimes for no apparent reason. To the extent that California cities continue to raise development fees to recover the infrastructure costs associated with growthùa practice that remains extremely popular with residentsùwithout developing a more precise understanding of the financial nexus between development and public service costs, they risk unfairly driving up housing prices, and driving down housing affordability. As usual, the fee burden is greatest for households at the lower end of the homeownership ladder. Moreover, at some point, price-sensitive homebuilders will go elsewhere, leaving fee-dependent cities the unenviable task of trying to recover the long-term costs of growth from their existing residents.

Once upon a time (e.g., before 1978) California's system of local public finance was both fair and efficient. It was neutral with respect to different land uses, and assessed new residents the same costs for providing services as existing residents. Over the last 20 years, this once-neutral system has metamorphosed into a patchwork of assessment districts and development fees, which are neither fair nor efficient. The current system provides a uniformly high level of infrastructure quality to upper-income developments, a moderate and uneven level of infrastructure quality to middle-income developments, and no net improvement in infrastructure quality to infill and entry-level developments. It provides for vast disparities between and within municipalities in both the quality and cost of public services. In the name of making growthùespecially housingùpay its "fair share", it seeks to extract the maximum revenue from new development. How much further this patchwork system of infrastructure finance can be extended without finally collapsing under its own weight is uncertain.

Funding Affordable Housing For Affordable Housing

No one knows exactly how much money is currently being spent in California on affordable housing or the exact number of households being assisted. ⁷ Estimates of total 1998 housing assistance, from all levels of government and not including the federal mortgage interest deduction, range between $1.5 to 2 billion.⁸

Whatever these totals, they fall far short of the levels required to meet California's existing affordable housing needs. And the future looks bleaker still: In the face of anticipated household growth, and without substantial increases in federal and State funding for affordable housing, California's already-severe affordable housing crisis will get much, much worse. This section explores the basic dimensions of the gap between affordable housing need and available assistance (a more comprehensive analysis is beyond the scope of this report). It begins with current and projected estimates of affordable housing need. Next, recent trends in federal, State, and local housing assistance are considered. Lastly, it looks at current and prospective constraints to increasing assistance levels.

Current and Projected Affordable Housing Needs

Housing need is traditionally measured three ways: (i) as the number and percent of households who pay more than 30 percent of their incomes for housing; (ii) as the number and percent of households who live in physically "substandard" or " dilapidated" housing units; and, (iii) as the number and percent of households who live in crowded and extremely crowded dwelling units.⁹ According to survey data from the American Housing Survey (State Housing Plan Update, 1999) and 1990 Census:

• After accounting for federal, State, and local housing assistance, 3.1 million California households still paid more than 30 percent of their incomes for housing in 1995. More than 80 percent of those overpaying were low-income households, and about two-thirds of those over-paying were renters. Altogether, 2.4 million low-income California households overpaid for housing in 1995.
• According to Census estimates, 1.2 million households lived in overcrowded conditions in 1990. Rates of overcrowding for very-low-income households range from six to fourteen times higher than for other households, depending on the metropolitan area.
• Approximately twelve percent of the State's housing stock is in need of rehabilitation.
  There is significant overlap across these categories. Most households who live in poor-quality and over-crowded conditions also over-pay for housing. Two other categories of housing need also merit mention: homelessness, and the potential loss of currently subsidized housing:
• Although inherently difficult to quantify, California's homeless population in 1997 was estimated at 360,000 persons, about 1.1 percent of the State's 1997 population.
• Because of expiring federal housing contracts, some portion of the current stock of assisted housing is likely to be converted to market rate housing. As of 1998, more than 3,200 rental housing projects, encompassing 185,000 units were at risk of conversion throughout California. Since neither the President nor Congress have announced concrete plans to address this issue, many thousands of low-income California households who currently benefit from federal housing subsidies will likely lose them.

If, as projected, the number of California households grows to 14.1 million by 2010 and 16.2 million by 2020 (see Chapter 2), and if the current percentage of households who are both low-income and are over-paying for housing stays constant at 22 percent, then the number of low-income households needing some form of housing assistance would increase by 675,000 (over 1995 levels) by 2010, and by 1.3 million by 2020. If the number of California households grows as projected, and if the current percentage of households who are both low-income and are overpaying for housing stays constant, then total unmet affordable housing needs in California will rise to the equivalent of 3.1 million units in 2010, and 3.7 million units in 2020.

If these admittedly simple calculations are correct, and if there is no increase in affordable housing funding levels, total unmet affordable housing needs in California will rise to about 3.1 million units in 2010, and 3.7 million units in 2020. In fact, these estimates may very well be too low. Because affordable housing needs track with rents, a slowdown in rental housing production (for whatever reason) will cause rents and therefore affordable housing needs to climb. Should a significant number of at-risk, low-rent housing projects be converted to market rents—as now appears likely—the increase in unmet affordable housing needs would be even greater.

Might current federal efforts to expand moderate-income homeownership help offset these potential increases? Probably not very much, since most of the increase in need will occur at the bottom end of the low-income scale, while most of those who benefit from expanded homeownership programs are of moderate income (i.e., have an income between 80 and 120 percent of the area median).

Federal Housing Assistance Trends and Constraints

Most funding for affordable housing in California, as in every state, is provided by the federal government. Federal housing assistance takes many forms. The single largest housing assistance program, the mortgage interest tax deduction, was estimated at $54 billion in 1996. By contrast, federal housing assistance to low-income households—most of whom neither qualify for nor take the mortgage interest deduction—was estimated at $17.2 billion in 1996. This amount falls far short of the level of need. According to a recent study by the Harvard Joint Center (1995), roughly 9.3 million of the 13.4 million American renters who are income-eligible for federal housing assistance do not receive any.

Adjusted for inflation, federal housing outlays increased 326 percent between 1976 and 1996. Yet as Dolbeare (1999) notes, almost all of this increase was used to maintain and operate the existing supply of subsidized housing. During the same 20-year period, inflation-adjusted federal outlays for new subsidized housing declined by 66 percent. Indeed, in 1996, federal outlays for the production of new low-income housing were zero.¹⁰ Worse yet, when the potential loss of hundreds of thousands of long-time affordable units as a result of expiring federal contracts are added to the equation, it's not difficult to see why The New York Times labeled 1996 as the "year that housing died."

How are these trends playing out in California? The U.S. Department of Housing and Urban Development (HUD) has recently begun publishing estimates of federal rental housing assistance by program area, state and major jurisdiction (A Picture of Subsidized Housing, HUD User website). Exhibits 37 and 38 present these distributions for the U.S. and California for 1996, 1997, and 1998. Note that these estimates do not include homeownership-related tax expenditures, HOME and HOPWA expenditures, or housing expenditures made using CDBG funds.

In terms of subsidy dollars, the largest federal housing-related program in the State (and the country) is the Community Development Block Grant Program (CDBG). CDBG is a "pass-through" program: funds flow directly from the federal government to local jurisdictions for use in alleviating poverty and blight. ¹¹Allocations are made on a formula-basis incorporating measures of population, poverty, and housing distress. According to HUD, California jurisdictions received a total CDBG allotment of $519 million in FY 1999. Although actual CDBG housing expenditures are not available, most jurisdictions spend a significant share of their CDBG allotments on housing and housing-related programs and projects. CDBG is a very popular program at all levels of government. Even so, future CDBG authorizations levels are unknown.

California localities also receive direct federal housing funds through the HOME program. Like CDBG, HOME is a formula-based block grant program. Unlike CDBG, HOME funds must be spent on housing. HOME also requires local governments to provide matching funds.¹² According to HUD, California jurisdictions received a total HOME allotment of $208 million in FY 1999.

In terms of both subsidy dollars and recipients, the largest single rental housing subsidy program in both the U.S. and California is the Section 8 voucher program. Section 8 vouchers totaling $193.7 million were distributed to 204,000 California households in 1998—up from 197,000 households in 1996. According to HUD, the average monthly Section 8 voucher in California in 1998 (including administration costs) was $538.

By increasing the dollar demand for subsidized housing, Section 8 vouchers should also, in tight housing markets, encourage some level of new construction. At least this is the theory. In practice—and especially in California—Section 8 rents are well below market rents for new housing, making it difficult for assisted households to compete with market rate tenants. More to the point, many property owners are reluctant to rent to Section 8 tenants.

The Clinton Administration, in its FY 2000 budget, proposed increasing California's Section 8 allotment by approximately $84 million. Whether Congress will authorize this increase is currently unknown. The long-term stability of project-based Section 8 assistance to individual tenants is also unclear. Many expiring five-year Section 8 contracts are now being renewed on a one-year basis.

The next largest federal housing subsidy program in California in 1998, measured in dollar terms, is the Low Income Housing Tax Credit (LIHTC). In 1998, the California Tax Credit Allocation Committee (the State agency charged with administering the LIHTC), allocated $43.1 million in 9% federal tax credits and $33.4 million in complementary State tax credits. ¹³ Altogether, these allocations resulted in the construction and/or rehabilitation of approximately 6,000 affordable housing units. As a matter of State policy, most of these units were affordable to households with very-low and extremely-low-incomes.¹⁴

Per federal law, annual allocations under the 9% program are capped at $1.25 per State resident per year. This significantly limits the number of projects and units, which are awarded credits. In recent years, fewer than 20-25% of eligible projects have been awarded 9% credits. Projects that do not receive an allocation are almost never built.

Looking forward, bipartisan bills have been introduced in both the U.S. Senate and House of Representatives which would increase the per capita LIHTC allocation from $1.25 to $1.75 per year, as well as index it to inflation. Nationwide, by some estimates, this would result in the construction of an additional 27,000û30,000 affordable units per year. While certainly welcome—and absolutely crucial if California's affordable housing developers are to continue their success—the effect of such an increase on affordable housing production in California would be proportionately smaller, primarily because of the State's very high development costs. The prospects for passage of these bills are currently unknown.

California has proportionately fewer public housing units than the rest of the country. In 1998 federal public housing assistance averaging $383 per month was directed toward 45,700 California households. The number of public housing tenants in California in 1998 was down about one percent compared to 1996.

In 1993, the President announced an ambitious 20-year plan to replace many of the nation's oldest, and most dilapidated high-rise public housing projects with newer, more contemporary, and lower-density projects. This program has come to be known as HOPE VI. Significantly, the HOPE VI replacement formula was not set at one-to-one. This means that more older units are being demolished than new units constructed. Moreover, because HOPE VI allows for subsequent rather than concurrent replacement, older projects may be demolished before newer ones are complete. This has resulted in a significant amount of short-term, if not long-term displacement. Not only are HOPE VI projects smaller than the public housing projects they replace, their income-eligibility standards are much higher. Many HOPE VI projects are designed as mixed-income communities, rather than as housing for the very poor. Whatever the social policy merits of mixed-income projects, if fully implemented, HOPE VI will result in a substantial decline in the number of available public housing units and an even steeper decline in the number of assisted very-low income assisted households.

The balance of federal rental housing assistance to California in 1998 ($114 million) occurred under the Indian Housing Program, U.S.D.A.'s Rural Development Programs, the 202 (elderly housing) program, the 811 (housing for the disabled) program, several homeless assistance programs, and a variety of FHA-administered rental programs. As with Section 8, these programs are projected to neither increase nor decrease in size or scope. Should California housing prices and rents continue rising, the net effect of not increasing assistance levels is for either the number of assisted households to decline, or the per household subsidy-need gap to grow.

Excluding the LIHTC program, CDBG, and HOME, just under 400,000 California households received some form of direct federal rental housing assistance in 1998. This was about two percent more than the number of households who received federal assistance in 1996, but one percent less than the number who received it in 1997. Earlier totals are not available.

Regardless of the current level of federal housing assistance to California, it reaches far fewer households than need it. This is because federal housing subsidies are tied to congressional authorizations and not to need. Looking forward, this situation is likely to get much worse. As California's population grows, so too will the number of low-income households requiring assistance. If apartment rents and housing prices continue increasing at even a fraction of recent levels, then the amount of required subsidy per assisted household will also grow. Lastly, if even a few thousand of the hundred-thousand-plus units that are at-risk of conversion from affordable to market-rate rents are actually converted, the resources required to maintain current housing assistance levels will increase significantly. This "triple-whammy" of population growth, escalating rents, and a declining affordable housing stock will put further strain on an already over-stressed system, and turn what is currently a large housing needs gap into a vast canyon.

State and Local Housing Assistance Trends and Constraints

California has three principal state agencies involved in allocating federal housing funds, and/or making affordable housing loans. The Treasurer's Office allocates private activity bonds (chiefly mortgage revenue bonds) and mortgage credit certificates; and administers the previously discussed federal and State Low-Income Housing Tax Credit programs. The California Housing Finance Agency (CHFA) operates single- and multi-family below-market interest rate (BMIR) loan programs using proceeds from the sale of both tax-exempt and taxable bonds. The California Department of Housing and Community Development (HCD) administers federal block grants statewide for non-entitlement jurisdictions, as well as gap financing programs, predominantly for rental housing and special needs groups (e.g., farmworkers) from State bond funds and general funds. The funds administered by HCD address not only housing, but also community and economic development.

While the information available paints at best, only a partial picture of the level of State housing assistance, the major sources are:

• The California Debt Limit Allocation Committee (CDLAC), the agency that oversees private activity bond issuances, reported that a total of $874 million of State and local (private activity) housing bonds were issued in California in FY 1998-99, including $105 million in single-family mortgage revenue bonds, $111 million in mortgage credit certificates, and $656 million in multi-family bonds. These issuances benefited 2,500 homebuyers (38% of whom were low-income), and 13,000 renters (12,000 of whom were low income). According to CDLAC, total housing bond issuances in FY 1998-99 were just 53 percent of the State's allowable debt issuance ceiling.
• During the 1998/99 fiscal year, the California Housing Finance Agency (CHFA) originated approximately $960 million in single-family loans, $133 million in multi-family loan commitments, and $215 million in mortgage loan insurance. Over the next five years, CHFA anticipates annual single-family mortgage lending of one billion dollars, $190 million in annual multi-family lending, and mortgage loan insurance activity of $1.19 billion over a five-year period.¹⁵
• In 1998, the California Tax Credit Allocation Committee (TCAC) allocated $44.8 million of tax credits under the federal Low Income Housing Tax Credit program, and $44.6 million of State low-income housing tax credits. An additional $37 million of tax credits were allocated to cover tax-exempt affordable housing bond issuances.
• During the late 1980s and into the mid-1990s, the California Department of Housing and Community Development (HCD) administered $550 million in State housing bonds (from Propositions 77, 84, and 107), and approximately $50 million in annual federal funds. There were no new housing bonds during the 1990s. HCD currently administers approximately $174 million in federal and State funds for housing and community development assistance. This is predominantly local assistance in the form of loans and grants.

As large as it is, California's housing assistance effort clearly falls short when compared to the State's enormous affordable housing needs. Given the high cost of producing new housing in California, the State's tremendous growth, the failure of housing production to keep pace with that growth, and the size of California's low-income population, additional State housing assistance is clearly warranted.

At the same time, there are significant constraints which limit the State's ability to meet its housing needs. Some of these are external. The federal Low Income Housing Tax Credit program is, for all intents and purposes, capped at the federal level, as are CDBG, HOME, ESG, and HOPWA programs. Other constraints are structural. Any major increase in State funding for low- and very-low income housing would require either passage of a statewide bond issue, or a significant change in State budget priorities. And as important as mortgage revenue bond funds and mortgage credit certificates are to stimulating total production, both programs provide only shallow subsidies, not the deep subsidies required by very low-income renters. In summary, until there are significant and concurrent changes in federal housing programs and State law, California, like many states, will continue to face an ever-deepening mismatch between those for whom housing assistance resources are available, and those who have the greatest housing assistance needs.

Leverage vs. Competition: The Affordable Housing Developer's Dilemma

Except in a few rural locations, for-profit builders in California cannot economically supply significant amounts of affordable housing.¹⁶ As a result, most new affordable housing units in California are built by non-profit sponsors. And because no one subsidy source is large enough to cover all development costs, most non-profits are forced to obtain funding from a half dozen or more different sources. Known as leverage, this idea of forcing non-profits to "beat the bushes" for complementary funding sources makes sense, at least in theory. In practice, because the supply of complementary funding sources consists mostly of government money and is therefore also constrained, "leverage" has become competition. A little competition is a good thing. Too much competition, especially when it does not attract additional resources or result in a net increase in production, promotes frustration and burnout. Moreover, many affordable housing non-profits are finding they have to work harder just to keep pace. Competition for LIHTC funds remains keen both from other non-profits, and more recently, from for-profit developers. Like all developers, non-profits need a steady supply of affordable sites, and recent increases in land prices are making it more and more difficult for even experienced and well-capitalized non-profits to compete for sites against cash-rich REITs and private partnerships.

Chapter Summary

• Mortgage Money Should Remain Plentiful: Assuming inflation remains under control, and no dramatic increase in mortgage default rates, mortgage money should remain plentiful and inexpensive for the foreseeable future. Indeed, given efforts by Fannie Mae, Freddie Mac, and the federal Home Loan Banking System to systematically increase the flow of mortgage capital to central city neighborhoods and moderate-income households, it is likely to become more plentiful.
• Apartment Rents Too Low: Current apartment rents are far too low, on average, to attract needed investment and debt capital to the multi-family sector. Based on the results of a simple financial model, we estimate the market rent gap (the difference between current median apartment rents and the rent required to attract investors) to range between $550 and $1,000 per unit, depending on the market. These estimates indicate why the only un-subsidized apartments now being constructed in California are at the upper end of the market (where rents cover development costs). They also suggest that until land and construction costs fall, and/or average development densities rise, and/or median rents rise, California will continue to suffer a huge shortfall of apartment construction.
• Obstacles for Developers: Compared to the rest of the country, California's high land costs and uncertain entitlements process are making it difficult for land developers to obtain needed land and subdivision improvement loans. While this difficulty serves to restrain speculative oversupply, it also constricts the land delivery and improvement pipeline, widening the timing gap between demand and production.
• Effect of Tax Initiatives: The long-term effect of voter-enacted tax-limitations initiatives—especially Propositions 13 and 4—has been to shift public infrastructure financing away from general obligation bonds and toward revenue, lease-obligation, and other bond sources. It has not been to reduce total local indebtedness. Adjusted for inflation, total local bonded indebtedness in California increased steadily from $400 per capita in 1984 to $1,400 per capita in 1995.
• Local Governments: Good News, Bad News: Local differences in municipal fiscal structure aside, California municipalities have had relatively little trouble raising capital to finance new infrastructure. That's the good news. The bad news is local governments have less and less discretion regarding the use of local bond funds, and that fewer funds are now available for broad, public-purpose infrastructure investments—exactly the sort of investments which most benefit housing.
• Development Fees: Many California communities assess development fees to complement or substitute for the issuance of debt. A recent survey of seven growing Contra Costa County communities found residential development fees to vary from a low of just under $12,000 per unit in one community to more than $30,000 per unit in another. In some locations, development fees alone accounted for nearly 20 percent of the average new home sales price. To the extent that California cities continue to raise development fees to recover the infrastructure costs associated with housing without developing a more precise understanding of the financial nexus between development and public service costs, they risk needlessly and unfairly driving up housing prices and driving down housing affordability.
• Number of Low-Income Households Needing Help is Expected to Rise: If, as projected, the number of California households grows to 16.2 million by 2020, and if the current percentage of households who are both low-income and are over-paying for housing stays constant at 22 percent, then the number of low-income households needing some form of housing assistance would increase by 1.3 million by 2020. If there is no comparable increase in housing assistance levels, total unmet affordable housing needs in California will rise to about 3.7 million units in 2020. In fact, these estimates may very well be too low. Because affordable housing needs track with rents, a slowdown in rental housing production (for whatever reason) will cause rents and therefore affordable housing needs to climb.
• Federal Housing Assistance: Most funding for affordable housing in California, as in every state, is provided by the federal government. In 1998, we estimate, federal housing assistance to California totaled approximately $1.2 billion, not including tax expenditures associated with the mortgage interest deduction. Future funding levels for some federal housing programs, including Community Development Block Grants, the Low Income Housing Tax Credit program, and Section 8, generally look secure, and may actually increase. The future of other programs is less clear, and will likely depend in part on whether and how federal caps on discretionary spending are implemented. Regardless of which way the political winds blow in Washington, federal housing assistance levels to California in the future—as in the past—will be substantially inadequate when measured against the level of need.

References

Nancy O. Andrews. 1998. Trends in the Supply of Affordable Housing: Meeting America's Housing Needs. Washington, D.C.: National Low Income Housing Coalition.

California Controller's Office. Various years. Financial Transactions of California Cities. Sacramento.

California Controller's Office. Various years. Financial Transactions of California Counties. Sacramento.

California Department of Housing and Community Development. 1997. State of California Consolidated Annual Performance Evaluation Report. Sacramento.

California Department of Housing and Community Development. 1999. State Housing Plan Update. Sacramento.

California Debt Limit Advisory Committee. 1999. Summary of Private Activity Bonds. Sacramento. (unpublished data).

California Housing Finance Agency. 1999. Portfolio Summary (CHFA website).

DeParle, Jason. 1996. Slamming the door. New York Times Magazine. (October 20): 52-57.

Marla Dresch and Steven M. Scheffrin. 1997. Who Pays for Development Fees and Exactions? San Francisco: The Public Policy Institute of California

Harvard University Joint Center. 1995. The State of the Nation's Housing: 1994. Cambridge: Harvard University.

Martin Kiley. 1998. Craftsman 1998 National Building Cost Manual. Carlsbad: Craftsman Book Company.

National Association of Homebuilders. 1996. The Future of Homebuilding. Washington, D.C.

RealFacts Corporation. 1997 Rent Estimates.

U.S. Department of Housing and Urban Development. 1996, 1997, 1998. A Picture of Subsidized Housing (HUD User website).

Endnotes

1. Although some investors will invest in properties that generate a 10% or even lower cash-on-cash return, the current benchmark for most for-profit real estate investors is 12%.
2. Community facilities districts may be established by a two-thirds vote of registered voters living within the district. If there are fewer than 12 registered voters, a two-thirds vote of the landowners in the district is sufficient.
3. At least one taxpayer association has suggested extending the 2/3 voter-approval requirement to cover local revenue bonds, lease obligation and special assessment bonds. Should such a law be enacted, probably by initiative, it would substantially constrain the ability of local governments to raise needed infrastructure capital.
4. Estimates of bonded indebtedness for California jurisdictions are published annually by the California Controller's Office.
5. California law does not distinguish between impact fees, development fees, and exactions.
6. A 1995 survey undertaken by the Building Industry Association of San Diego County put average development fees for that region in the $18,000 to $23,000 per unit range.
7. Affordable housing is generally defined as housing which is affordable to households earning 80 percent or less of area median income (AMI), assuming the households spend no more than 30 percent of their income on housing-related expenses. The State definitions of low and very-low income households are those with incomes at 80 percent and 50 percent, respectively, of the area median income, as adjusted for household size, high cost areas, and minimum thresholds. Individual programs may have variations on these levels.
8. This estimate includes all federal housing capital and operating assistance, Community Development Block Grants, the Low Income Housing Tax Credit, State private activity bonds, and California Housing Finance Agency (CHFA) bonds.
9. Crowded housing units are defined as those in which there is more than one person per room, not including kitchens and bathrooms. Severely crowded units are defined as those in which there are more than 1.5 persons per room.
10. This excludes federal tax expenditures through the low-income housing tax credit program, and expenditures under the HOPE IV public housing replacement program.
11. The California Department of Housing and Community Development administers the CDBG and HOME programs for non-entitlement communities. These are mostly rural cities and counties.
12. The specific matching ratio depends on the specific uses to which HOME funds are to be put. The federal-to-local matching ratio for tenant assistance, for example, is 4-to-1. For new rental construction, the match is 2-to-1.
13. The California Tax Credit Allocation Commission (TCAC) administers two LIHTC programs: the nine- percent (9%) credit program and the four-percent (4%) credit program. Under the 9% program, sponsors can sell annual credits equal to nine percent of eligible basis for up to ten years. Per federal law, annual allocations under the 9% program are capped at $1.25 per State resident per year. Proceeds from the sale of 9% tax credits typically cover 40 to 50 percent of development costs. Assuming an average per-unit development cost of $150,000, this means that the 9% LIHTC will typically fund between 500 and 700 new affordable housing units each year. TCAC annually awards the 9% tax credits based on a combination of formula and competition. Nine percent credits may not be used in concert with some federal housing grant programs. This limits their ability to leverage other financial resources. The 4% credits are applied the same way as the 9% percent credits, but are not limited by the $1.25 per capita ceiling and may be used in combination with other federal housing dollars. Sponsors are therefore not required to compete for them. Funds raised from the sale of 4% credits typically cover 20-30 percent of project costs. California has its own 3 percent (3%) LIHTC program, which may only be used in concert with the federal 9% program. Use of the 3% State tax credits typically increases the amount of equity non-profits are able to raise from private sources by 10 to 20 percent.
14. Very low-income households are those with incomes less than 50% of the area-wide median, with adjustments. Extremely low-income households are those with incomes less than 35% of the area median income. Area median incomes (AMIs) are typically delineated by metropolitan statistical area or by county.
15. CHFA Five-Year Business Plan, Fiscal Years 1999/2000 û 2003/2004, May 1999.
16. Many California cities have adopted inclusionary zoning ordinances, which require developers to set aside some proportion of their production for low- and moderate-income households. These units are rarely affordable to households with incomes less than 80 percent of the area median without additional subsidies.

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