The Complexities of California’s Housing Crisis: Part I
By: Roderick Wright
Housing in California, particularly the lack of affordable housing is a complex issue. Like most complex social problems there are numerous causes and villains. The solutions are usually simple, but the political will is challenging. Why don’t we simply build more apartments and houses, simple enough right? Guess what? There are those who benefit from the current situation.
In many instances, the people complaining on one side are contributing to the problem they are protesting. The challenges of housing are adversely affected by all levels of government, as well as the private sector. As I will describe, in some cases an action intended to solve a problem has made it worse. For example, the elimination of accelerated depreciation made apartment ownership less attractive for private investors, particularly the smaller “mom and pops.” For your non-financial types, “accelerated depreciation” sounds like Greek, but to the investor community, it can be the Holy Grail. Similarly, rent control provides a short-term benefit to some renters but stifles private investment over the long term exacerbating the problem.
In this article, a house or apartment building is defined as the convergence of six things: (1) land, (2) labor, (3) building materials, (4) entitlements (e.g., permits and fees), (5) financing (e.g., investment capital, insurance, etc.) and (6) return on investment (ROI). Obviously, ROI is a variable and assumes some risk. If you add these six things together and divide the sum by the square footage of a structure, you get a relative cost per foot. The cost per foot is a benchmark for measuring housing costs. In order to produce lower cost housing, you must alter one of these, therefore reducing the cost per foot. By increasing the building density on a piece of land, you effectively reduce the cost of the land per square foot. Similarly, if you get lower cost financing or reduce any of the other elements, costs can be reduced. Conversely, reducing ROI makes housing a less attractive investment causing capital to move to other ROI producing opportunities.
The vacancy rate (the number of available rental units in a defined area) within the Los Angeles area is less than two percent and among the lowest vacancy rate in the nation.
This scarcity of available housing units means rental prices are higher, often beyond the ability of many low wage workers to afford, even if they can find an available unit to rent. Communities in South and East and Los Angeles are seeing housing sale prices nearing one million dollars! Many two-bedroom apartments are renting for nearly $2,000 per month. These high prices and the scarcity of rental units are causing gentrification in many communities, as more affluent buyers and renters who would have chosen to live in other areas now find South and East Los Angeles desirable and affordable. In addition, we are seeing more single-family houses being made available as rentals as fewer potential buyers can afford to purchase a home.
In this article, I examine many causes of the housing crisis, both by the government and private sectors. On the Federal level, we know that tax policy often influences how people invest their money. On the State level, the California Environmental Quality Act (CEQA) can and often does play a major role in hindering the development of housing, which we will discuss. Zoning on the local level and the process of securing entitlements is a significant factor in permitting or denying the development of housing.
Finally, the lending patterns of the private sector affect the housing markets. Taken together we have a crisis largely of our own making. This crisis can be resolved in the same way we got here, the recognition that rental property owners (a/k/a, “landlords”) are not the villains, private homeownership is a positive thing, and providing decent housing is an honorable pursuit worthy of private and public collaboration and investment.
Many of the housing programs we see today at the Federal level began during “The New Deal” after the great depression of 1929. This depression was caused largely by unregulated speculation in the stock market, and a banking system lacking in any real oversight or safeguards. To rebuild some confidence in the banking system in 1933, the Federal Deposit Insurance Corporation (FDIC) was established to restore the security that consumers needed to trust banks again. In 1929, over 30% of American mortgages were in foreclosure. The Securities and Exchange Commission (SEC) was established in 1934 to put some regulation on the stock and securities markets to guard against wild speculation, phony margin buys and outright fraud.
In 1932, the Federal Home Loan Bank Act was created to assist working-class families with home purchases. This act created the institutions we came to know as savings and loans. Most of the home mortgages in the United States were financed through savings and loans through the 1980s. Then we saw two acts of deregulation, in 1980 the Depository Institutions Deregulation and Monetary Control Act along with the Garn-St. Germain Depository Institutions Act of 1982 allowed savings and loans to take on greater risks beyond home mortgages and into junk bonds. Savings and loans had no FDIC oversight and little regulation after these two laws changed the game. In the end, over one trillion dollars was squandered in the so-called “S&L Crisis” and the mortgage business has never been the same.
Another important program established during this period was the Federal Housing Administration (FHA) The FHA insured mortgages held by banks creating a kind of secondary market. Then would come another important part of the New Deal, the Federal National Mortgage Association, (Fannie Mae) in 1938. Taken together these two agencies provided a new product for housing affordability, mortgage-backed securities. Mortgage-backed securities created a secondary market for mortgage loans, allowing local banks to reinvest their capital, and not be totally reliant on local deposits for mortgage loans. Later, a third agency, the Federal Home Loan Mortgage Corporation (“Freddie Mac”) was introduced. I could go on, but it is important to note here that it was the Federal Government, through Government Sponsored Enterprises (GSE’s) that moved the nation out of the depression and brought about the levels of homeownership we see today. The private markets alone could not have made the necessary investments. Through GSE’s, we also got another product we are all familiar with today, the 30 year-fixed mortgage product which allowed the average American to purchase a home. This would not have been possible without the GSE’s. It is important to note that the federal government did not simply spend tax dollars, but instead created incentives for the investment of private capital through GSE’s.
Over time the Federal Government made other important contributions to the housing industry. The ability to deduct property taxes and mortgage interest costs in computing Federal taxes was a huge incentive for people to purchase homes. For investors in multifamily rental properties, allowable deductions for local taxes, mortgage interest and expenses from taxable income was a major investment incentive. The Internal Revenue Service (IRS) also offered depreciation and accelerated depreciation on rental properties. Depreciation is when you divide the cost of a property by 30 and deduct that amount from taxable, which is referred to as “straight-line” depreciation. Accelerated depreciation allows a much shorter “recovery” period and increases the amount of allowable depreciation deduction. Another important tax advantage was the ability to deduct as opposed to depreciate front-end costs such as land acquisition, permits, and fees, architect fees among others against active taxable income.
The deductibility of front-end investment costs meant a developer could put together a limited partnership (24 persons or less) and distribute actual tax deductions. In addition to tax deductions, investors obtained an equity position in the project. These tax advantages go directly to our housing definition, and to ROI. The investor in these cases had very little risk, if the project went under, he or she had already deducted the investment and could then take an additional deduction on their principal investment loss. If the project went forward, investors had the equity position in the property.
Through the GSE’s and the tax system, we saw over fifty years of prosperity and stable housing costs. Later the Veterans Administration began issuing loan products to veterans making homeownership within reach for more Americans than at any time in history. This period also saw a great deal of urbanization as industrialization changed the living patterns throughout the nation. In 1960, 86.4% of California citizens lived in cities, and by 2010 that number had grown to 95.2% and is still growing. Even with the large agricultural industry in California, most of its people live in cities.
In 1965 the Department of Housing and Urban Development (H.U.D.) was created as a cabinet-level department to address the changing housing patterns of the nation. With H.U.D. came the introduction of many housing programs and direct spending of tax dollars on housing, including housing projects which would later be determined to be poor policy for numerous reasons, not the least of which was the concentration of poverty into a small area. The Section 8 program was the successor to impoverished housing projects.
So, what went wrong? By the early 1970s, we began to see the emergence of Wall Street in the housing capital marketplace. In addition to the beneficial housing inducements I discussed, the New Deal also created the Social Security Act which aided many older Americans during retirement. Coupled with Social Security, getting a house paid off, allowed many Americans to live well in retirement. Wall Street like any other business entity was looking for growth. Social Security and other pension programs were targeted. In 1978, the Revenue Act of 1978 created what we know as the 401(k) plan. It seemed innocuous at the time.
The 401(k) plan not only competes with Social Security and pensions, but it would soon have negative impacts on the housing market. Wall Street at one time sold stocks and securities to investors, primarily to wealthy individuals. With the availability of 401(k) plans and other products, Wall Street could now approach a far wider market. Quietly, the war for investment capital had begun. Wall Street needed someplace to invest all that new money. Then, the Tax Reform Act 0f 1986 limited tax deductions to a first and second home only. The Wall Street lobby tried to eliminate homeowner deductions altogether, the first and second home was a compromise! This law also eliminated the deductibility of frontend costs of construction, and instead it was replaced by the Low-income housing tax credit, which limits the deduction to projects that go through a Tax Credit Allocation Committee in California. As you might guess, the rules of the Tax Credit Allocation Committee, almost limit the benefits to Wall Street investors and larger projects.
Another program that came out of the “New Deal” was legislation known as “Davis-Bacon.” Simply put, this law says that if any Federal dollars are used in a project, the project must pay prevailing wages. In other words, developers of these projects must hire only union equivalent labor. For many smaller developers, the cost of the prevailing wage exceeds the amount of Federal dollars the project might receive, so they don’t bother even applying for federal funds. This is particularly troubling for smaller developers with their own construction crews. We might consider adjusting Davis-Bacon to larger contracts or projects. But guess what, there will be push back from the building trade unions, whose members are the beneficiaries of Davis-Bacon.
Later would come the elimination of accelerated depreciation and the recent Trump Administration deduction limit or “cap” for state and local taxes of $10,000. Taken together, these changes in federal policy have crippled the housing market. Moreover, in 1992 and 1999 Congress passed laws requiring the GSE’s to expand their services to lower income borrowers resulting in the expansion of this secondary market to Wall Street. These changes that were intended to loosen qualifications for loans had the impact of raising prices and inducing more foreclosures. In fact, these changes would form the foundation of the mortgage meltdown in 2008. Allowing Wall Street into the secondary market brought about products such as “Stated Income” on loan documents also known as liar loans, “Negative Amortization,” meaning the monthly payment didn’t cover the interest, so the principle grew, “Interest Only” meaning you never reduced principle and the now popular “Reverse Mortgage” allowing the homeowner to consume equity today, jeopardizing retirement and inheritances tomorrow. But that’s for another article.
Also created during this period was the growth of mortgage companies which bypassed the GSE’s and involved Wall Street deeper into the mortgage industry. Most famous of these was Countrywide Financial which by 2008 held 20% of all the mortgages in the United States! Countrywide usually packaged their loans to large investors such as GSE’s. But their growth came from the sub-prime market, loans that were non-conforming, meaning the loans either didn’t meet the standards required for GSE’s like Fannie Mae. Sub-prime loans had higher fees and interest rates, Countrywide was convicted in New York State of forcing qualified African American buyers into the sub-prime category. Countrywide went bankrupt and was acquired by Bank of America in 2008.
Clearly Wall Street was looking for more revenue, they didn’t care about consequences to the housing market or anything else. They could be a villain here, but who would have thought the 401(k) plans would siphon off housing dollars? The government, Democrats and Republicans, thought they were helping us, but as we can see now, they were wrong. Even though we are spending record amounts of tax dollars on housing, private dollars are not being invested at the same rates as in prior years. Because the Federal tax incentives are gone, the risk is increased for investors, particularly small investors.
This article will be continued next month with a discussion of the complexities of California’s affordable housing crisis and the role that California’s legislature and local jurisdictions have played in creating California’s affordable housing shortages. We will also offer many proposed solutions to alleviating California’s present affordability situation.
Roderick D. Wright is a former member of the California State Assembly, and the State Senate. He has been an apartment owner for over 40 years. He is a member of the Apartment Association of Greater Los Angeles. He was a founding member of the Minority Apartment Owners Association. He is also a former real estate developer. firstname.lastname@example.org