In this article, we’ll talk about why California will never energize developers to build enough housing to meet demand with its inane policies. As a developer, I have a very good understanding of the road blocks we face in providing housing in this state. As a native to this state and to Los Angeles, I grew up loving this state and city more than anything else. Over the years, our state and local governments continue to test my love in new ways, thus making it exponentially more difficult each year that I continue to live here. Let’s discuss some of the key areas that state and local policies have failed Californians overall but also where the opportunities may emerge.
SB8
This law was passed at the end of 2021 and went into effect January 2022. The thrust of this law was to limit the amount of public hearings that a city can require a developer to participate in to 5. Not a bad idea for a law and it forces the cities to make a decision instead of dragging out a project’s entitlement process for all eternity, which would in effect be a de facto denial of a development project.
However, somewhere in the process of finalizing this bill, a certain state senator added language in the bill requiring developers to go through an additional hurdle towards construction. In short, if a project that is being developed in a city that has some form of rent control, such as Los Angeles, San Francisco, West Hollywood, Oakland, or Berkeley, the developer must determine the entire population of all tenants that occupied the property over the preceding 5 or 10 year period (depending on if it was an Ellis removal) and ascertain each of their income levels. If their income levels fell under a certain guideline, that unit that was demolished, even if it was a single family home, is required to be replaced as an affordable housing unit, deed restricted for 55 years and thereby limited to charge rent at 30% of the prevailing market rate in the area. So a single family home being considered to be demolished and replaced with more apartments in 2023 requires the developer to find out who the tenants were as early as 2018, get their tax returns (which the prior tenant has no obligation to provide) to determine if the house would be replaced as an affordable unit. If the developer cannot prove this tenant’s income level to the local housing authorities during their permitting process, then it is assumed that the tenant fell under that income threshold and thus the unit being demolished should be replaced as an affordable unit.
Mind you, the cost to build an affordable unit and a market rate unit are virtually identical. Yet with a 70% decrease in rents permanently under market, nobody is writing a check to the developer to subsidize this construction.
I can only imagine that when this law was passed, the lawmaker who wrote this was thinking about a 30 or 40 unit project that replaces a duplex on the same site. In this scenario, usually a developer is utilizing some kind of density bonus to be allowed to build more units anyway. In exchange for this increased unit count, they would agree to build some units as affordable.
But what happens when you’re demolishing a duplex and replacing it with 4 units instead, netting only 2 additional apartments? Or worse, what if you demolish a duplex and replace it with a new duplex in case the old one is functionally obsolete? You lose a LOT of value. In these scenarios, the cost of your project would far exceed the fair market value of the finished product, which is the fastest way for a developer to go out of business and stop providing more housing units. Dumb law. Repeal this section of the law and let the market do its thing.
Transfer Taxes – ULA
Specific to the city of Los Angeles, on April 1, 2023, a new transfer tax shall be introduced for all property sales in excess of $5MM and in excess of $10MM. In the case of $5MM, a transfer tax shall be assessed at 4.5% and over $10MM it shall be 5.5%. By comparison, prior to this law being passed, the same tax was 0.5% of value. Dubbed as the “Mansion Tax,” the revenue generated from this will be used to build affordable housing units, which should in theory lower the cost of housing in the Los Angeles and benefit the general public. However, the tax doesn’t apply to just mansions, it applies to ALL properties, including apartments, industrial, retail, hotel, and office. 4% may not seem like a lot, surely anyone who owns high priced properties can afford such a tax, right? Let’s think through this scenario then:
Developer Dave raises capital to build a 10 unit apartment in Los Angeles. Land costs $2MM, construction costs $5MM for a total cost of $7MM. He hopes that it will be worth $10MM. Like a typical developer, Dave isn’t flush with cash and goes out to his investor contacts to raise money. Investor is willing to write a $3MM check but needs to make at least 15% on an annualized basis to meet their own investment requirements. A 10 unit apartment in LA might take 3 years to complete if everything is executed to perfection, which means the Investor simply would like to clear $1,350,000 in profit for the use of his money during this period. Sounds greedy but considering the risk and timing of a development, the investor needs to earn a premium for taking risk. If Dave can get this Investor his $1,350,000 in profit, Dave gets to participate in any profit over and above that amount.
The property sells for $10,000,000, minus broker commissions of 5% ($500,000), minus transfer tax of 5.5% ($550,000), minus title and escrow and other transaction costs ($50,000), leaves net sales proceeds of $8,900,000. Building and costed $7,000,000 which means $1,900,000 remains to be split. Investor takes $1,450,000, leaving Dave with $450,000 for his time. Not a bad outcome, but Dave spent 3 full years of his time to earn that fee at a rate of $150,000/year, and the amount was far from certain. He might be better off working for another company where his pay would be guaranteed. If I was Dave, I’d decline that project because the margins are just too thin to be worth the time, heart ache, and hassle. Also, this is executed to perfection. What construction costs increased by 10% between acquisition and construction? That could never happen, right? Just look at what’s been going on over the past 3 years in the construction industry and I think you’d decline this project too.
Prop 13
I’d argue that the core issue that plagues and severely hinders the construction of new housing in California is this law. Passed in 1979 and voted in by the public, property taxes (usually around a little more than 1% of assessed value) are no longer assessed annually at the property’s fair market value. Instead, you take the lesser of a 2% increase to prior year’s assessment or the fair market value of the property and that’s your tax basis for that tax year. Only when the property is ultimately sold will the property tax basis be reassessed at the fair market value.
Commonly, you will see two homes, Home A and Home B, next door to each other, both equal in a hypothetical current fair market value of $2,000,000. Home A was acquired by the current owners in 1985 have a property tax basis of $150,000. Assuming a rate of 1.2% on basis, they would pay $1,800 in taxes annually. Home B was just sold this year, and they have a property tax basis of $2,000,000, thus resulting an annual property tax bill of $24,000. What a difference! You can see that the owners of Home A will probably never leave their home as long as they can help it.
The fundamental problem with the outcome above is what those taxes are ultimately used for! Property taxes go towards paying for schools, police, fire, infrastructure, and an assortment of other services that we as residents come to rely on. However, in the absence of sales activity, which fluctuates according to market conditions, the property tax base to pay for all of these services only can escalate 2%, annually. Last I checked, the teacher’s union, police union, and fire union aren’t requesting a mere 2% raise per year. They will need more to cover the cost of living in this state. I would argue that this math fundamentally makes cities in California massively averse to adding more housing units because the economic impact on their budgets of providing services to new residents would turn upside down over the long run. It is for this reason that permit fees for residential construction are sky high, since the permit fees are the last ditch effort by the City to collect on something to pay for these new future costs.
The Opportunity
All seems like doom and gloom above. However, the above also represents an opportunity for investors to profit. Holding long term in California will reward investors with patience, since little no competition is coming in the way of new residential properties. Demand will always outpace supply while government thinks of new ways to break the laws of economics with price controls and regulations and act surprised when that never works.
Thoughts? Reach out to me and let me know what you think about our state and solutions we could implement to improve our supply of housing.
-Stephen Morris, CPA, MBT, CCIM
As a CPA, my background has been almost entirely focused on the real estate industry since my start in public accounting back in 2005. Over the past 10 years, I’ve also been a real estate developer, where I completed numerous projects in the city of LA, primarily ground up apartment buildings. I am also a licensed real estate broker in the state of California.
I love to help people out with their tax and operational problems and coach clients and colleagues on best practices to increase their wealth through real estate investment strategies.