This memo outlines the reasons municipalities should complete a feasibility study, the key components of a typical feasibility study, and Grounded Solutions’ best practices for designing and preparing inclusionary housing feasibility studies. View Memo
Every inclusionary housing program should consider how much of a city’s affordable housing needs developers should be expected to meet. Typically, cities establish this basic requirement as a percentage of units or square footage area of each development that must be set aside to be rented or sold at affordable prices on site.
According to a 2007 study by the Non-Profit Housing Association of Northern California, the most common requirement in California was 15 percent.
Some cities allow developers to build fewer units if they serve a higher-need population. In any case, the baseline performance option sets the economic bar against the other evaluated alternatives, so it must be appropriate for local market conditions.
Set Aside Requirements
Source: Hickey, Sturtevant, and Thaden (2014)
Set Aside Requirements in Different Cities
Source: Hickey, Sturtevant, and Thaden (2014)
Increasingly, cities commission economic feasibility studies to determine how large of a set-aside to require while avoiding financial hardship to developers.
Traditional inclusionary housing programs—which are designed around the assumption that units will be provided on site even if they allow payment of fees as an alternative—generally evaluate the economic feasibility of their performance requirements and then set in-lieu fees so they are economically comparable to (or slightly more expensive than) the performance requirement.
Santa Cruz, California
In Santa Cruz a process of closely analyzing project economics led the city to reduce their inclusionary requirements. By listening to what the data was telling them, the city was able to build broader support for a more effective policy. A staff member explained:
“We kept hearing from developers that they couldn’t build rental units in the City of Santa Cruz because of the cost, which was exacerbated by the 15 percent inclusionary unit requirement. Ultimately the statistics supported their claim…Our financial analysis showed that rental developments did not ‘pencil’ at all with inclusionary requirements in place. In response, the City suspended the ordinance and initiated a working group of developers and architects to revise the inclusionary ordinance and encourage the development of rental housing. The goal was to create an ordinance that would not be a barrier to rental housing…As a result of this effort, the developers have some ownership of the ordinance and [are] willing to provide feedback to staff. [We] continue to maintain an open dialogue with developers and watch the trends.”*
An economic feasibility study conducted by a qualified real estate economist can provide local policymakers with a clearer sense of how inclusionary housing requirements will impact the profitability of local development projects and the price that developers can pay for developable land. The economist will research local prices and rents as well as the key factors driving the cost of building. The economist will use this information to assess whether or not proposed affordable housing requirements would make typical projects infeasible. Any kind of feasibility study is necessarily somewhat imperfect, but the goal is to give policymakers a general sense of the likely impact of proposed housing requirements and incentives on land prices and development profits. Ultimately, a detailed feasibility study is the only way to address legitimate concerns about whether affordable housing requirements could do more harm than good.
Read more about conducting an economic feasibility analysis here.
It is important for cities to be aware of market conditions when they set their inclusionary housing requirements, both for the entire city and for various neighborhoods.
Most cities do not adjust their inclusionary requirements at a neighborhood level. For cities without wide variations in neighborhood market conditions, this may be appropriate because incentives and inclusionary requirements automatically compensate for differences in market conditions. For example, it may be more expensive to build in high-cost neighborhood, but a density bonus is worth more in neighborhoods where home prices or rents are higher.
Some cities, however, have responded to concern about the impact of inclusionary requirements in certain sensitive neighborhoods by varying their requirements or incentives by neighborhood. This is called geographic tiering.
Rather than vary the requirements by neighborhood, some cities vary their requirements based on construction type. These are generally places where local market conditions make higher-density construction economically marginal enough that affordable housing requirements can become a barrier to development.
The decision to vary affordable housing requirements by neighborhood or construction type should typically be made based on the findings of an economic feasibility study. In general, a city may want to pursue these varying requirements if the feasibility study showed that citywide supportable requirements would have an adverse impact on the feasibility of otherwise desirable development in certain areas.
Cities often set affordability levels higher for ownership units than for rental units. A 2007 study of inclusionary housing programs in California conducted by the Non-Profit Housing Association of Northern California found that most affordable rental units were affordable to low-or very low-income households, and most ownership units were affordable to moderate-income households
This policy is often dictated by market prices. For example, a household earning 80 percent of AMI may be able to afford the rental price for a median priced one-bedroom apartment, but cannot comfortably afford to buy a home. Pricing ownership units at 80 or even 120 percent of AMI meets this need. However, inclusionary rental apartments with their price set to be affordable for a household earning 100% of median income would often be the same price, or even more expensive, than regular apartments for rent in the area, so they aren’t necessarily serving a critical housing need
On the other hand, ownership units typically cost developers relatively more to produce. While it would be possible to require that developers price ownership units so that they serve the same income group that is being served in rental housing, this would have a greater impact on financial feasibility for ownership projects. Many cities have determined that allowing developers of ownership units to serve a higher-income group can reduce the burden of the program on ownership projects while still serving a real affordable-housing need.
When considering whether to adopt or revise an inclusionary housing policy, local government agencies often retain an economic consultant to prepare a feasibility study. This study evaluates the economic tradeoffs of requiring a certain percentage of affordable units in new residential or mixed-use projects.
Feasibility studies help policymakers assure that new policies and programs are economically sound and will not deter development, while still delivering the types of new affordable units needed by the local community.
Feasibility studies are different than nexus studies, which are a similar type of analysis often used by local jurisdictions to establish residential or commercial linkage fees to fund housing programs. A feasibility study determines how a new inclusionary policy would affect market-rate housing development costs and profits. A nexus study quantifies the new demand for affordable housing that is generated by new commercial or market-rate housing development.
While every study differs based on the needs and market conditions of the specific area, in general they follow a similar outline:
- Introduction and Policy Context – A description of the purpose and scope of the study.
- Background Economic Trends and Market Conditions – An in-depth analysis of the local economy and the market conditions affecting residential development.
- Economic Analysis of Hypothetical Development Project – Based on prevailing economic conditions and using assumptions from the market analysis, an economic feasibility analysis uses development pro formas to test the economic impact of varying inclusionary requirement on hypothetical development projects or prototypes. This process of modeling how inclusionary requirements might affect the bottom line profitability of market rate residential development should include a sensitivity analysis. In the sensitivity analysis, assumptions from the market analysis loan interest rates, for example, are dialed to their highest and lowest reasonable levels to examine how sensitive the final estimates of profitability are to variations in cost and revenue assumptions.
- Findings and Recommendations – This section builds on findings from the financial feasibility analysis. It includes conclusions about the likely effect of requiring various percentages of affordable units at varying affordability levels in combination with certain types of developer incentives.
Real estate markets are constantly changing. While inclusionary housing programs are often flexible and adaptable, they can’t respond to each and every change in the market. Some communities have increased their inclusionary requirements during housing booms and reduced them or waived them entirely when their markets crashed. However, it is in general difficult for cities to time the market and adjust their inclusionary requirements every time their housing markets change.
A few cities temporarily repealed their inclusionary requirements during the most recent downturn in order to avoid over-burdening projects during a fragile period. But most programs did not feel that this was necessary.* While it is far more difficult for projects to support housing requirements during a downturn, most projects wouldn’t move forward in these times even without affordable housing requirements. Waiving requirements temporarily does little to promote development, but it risks missing the opportunity to produce affordable units when the market unpredictably returns.
It is possible that these temporary waivers helped speed up the market recovery in these cities, but it did so by permanently exempting certain projects that would have been built slightly later without the waiver.
When the market is soft, cities don’t waive fire codes or other zoning requirements, even though they too could help some projects pencil out sooner. Instead, they wait for the market to recover because these are appropriate minimum standards. If housing requirements are modest enough that they are not economic barriers to development most of the time, there should be no need to adjust them for market cycles. On the other hand, if a community experienced a permanent change, like the loss of a major employer that changed the likelihood that rising housing prices will ever again be a challenge, then certainly adjustments to affordable housing requirements would be appropriate. Some communities plan on comprehensive reviews of their policies every 5 years including an analysis of whether inclusionary requirements remain appropriate given longer term economic trends.
For programs with in-lieu fees or housing development impact fees, frequent review and adjustment is important. Many cities have written specific dollar amounts into their ordinances for these fees. Over time, a fixed fee will drop relative to inflation and relative to the cost of providing affordable housing. Some communities have managed to keep their fees up to date by having their council annually approve a change to the fee calculation. However, because this is a controversial issue, these annual approvals can be challenging. In response, a number of communities have indexed their fees to allow for regular increases (and potentially decreases) in response to changing market conditions. For example, San Francisco increases its in-lieu fee schedule annually based on the change in the Engineering News Record Construction Cost Index for San Francisco. Other cities tie fee increases to changes in the Consumer Price Index or a local housing price index.