Inclusionary Policies End Up Making Housing More Expensive

A foundational principle in my thinking about and working in housing is that prices for housing units are determined by their supply in relation to demand. More housing with fewer people needing housing, prices will fall. If need for housing rises and supply lags, prices will rise. A corollary of this principle is that adding costs to production of housing necessarily leads to higher prices and rents for housing. But it is also important to add, that any intervention that limits or controls prices or rents has the same result. In the end, rules and regulations that add costs mean those costs have to be recovered with higher prices and rents. Regulations that mandate lowered prices or rents in a percentage of units mean other units have to make up the difference. That’s where we start a look at Cambridge, Massachusetts inclusionary zoning program.

According to the City of Cambridge’s website,

“Under the current inclusionary housing provisions, developments of ten or more units are required to allocate 20% of residential floor area for low and moderate income tenants or moderate and middle income homebuyers. To expand options for families, the ordinance encourages developers to provide three-bedroom units within the 20% of floor area. In developments of 30,000 square feet or larger, the ordinance requires the creation of three-bedroom units in the affordable component. Monthly costs for affordable units are set at 30% of household income.”

The intention with these policies is good, to lower prices for people who don’t earn enough to pay rent every month. The problem, however, is that the only place to recover the costs of buying land, building, and operating housing is from rent. When rent is limited by a mandate and not set by the market, the only way for a project to recover costs is to raise rents in all the other units. A recent Boston Globe article is a good way to walk through how when regulation is stringent and rents are capped, the end result is less housing which limits supplies and then boosts prices.

The article starts with a one project that has finally gotten permits but remains unbuilt.

“Nearly a year since the project’s developers — the local group North Cambridge Partners — finished their trudge through city permitting, this patch of prime real estate is still just a sparse storefront and a lot scattered with vehicles.”

I will often use the example of parking lots remaining parking lots to illustrate why inclusionary zoning makes things worse. When permitting times and costs go up, and then there are limits mandated on rent or fees charged in lieu of including lower rents. When rents can’t recover the costs or fees eat into operating costs, it just makes more sense to keep a property a revenue producing parking lot – or strip mall or small retail building. “Put another way,” the article points out, “a policy aimed at generating affordable housing may actually be preventing it.”

But until 2022, the project was working. Rents in not restricted units could still cover costs because they were higher – not a great outcome, but feasible.

“Then came 2022, when the economy of building homes in the United States began to shift. Materials costs soared, and interest rates more than doubled. Not only did those changes reduce builders’ profit margins, they also made investors more skeptical of the return on investment from housing, so they began demanding higher margins to finance projects.

Altogether, those factors dramatically increased the cost of building homes. And while setting aside 20 percent of a project’s units at below-market rents may have been sustainable three years ago, it is a lot harder now.”

Yes, developers have to borrow money and that is a cost. When the cost to borrow money rises along with regulation, prices go up to cover those costs. Then very intention of the inclusionary rules, lowering prices for consumers, is thwarted by the regulation itself.

“In other words,” the article goes on to say about the project, “the $18 million the developers would lose on the inclusionary units, even with the market rate units set at luxury prices, is quite consequential.”

The article interviews developers who would have to charge a staggering $1,500 per square foot to absorb and offset the relatively miniscule $275 per square foot price for “affordable” units. Those figures tell the whole story; inclusionary zoning only works when the prices for all other units rise to compensate for what is a regulatory subsidy.

Going back to the principle at the top: to create affordability the best and only answer is more housing, not more rules. Doing this requires local governments to understand how the money works. If costs go up, so do prices and rents. When local governments add costs and reduce the ability to collect rent, the consumer costs of housing rise to subsidize the limited set aside units. Then, if other costs outside the control of local government like borrowing go up, then nothing gets built which contributes to scarcity and high prices for everyone. The Cambridge story is instructive. Inclusionary requirements will eventually make housing inflation worse.

There is one exception that is important to note. When local government offers incentives that offset the inclusionary requirements, a balance can be struck. In Seattle, the Multifamily Tax Exemption (MFTE) program has created thousands of units, far more than an adjacent inclusionary policy in the same city. The numbers in both cities show that good numbers matter more than good intentions.