Development impact fees do NOT hinder construction of entry-level homes
Development impact fees erode the value of raw land, but the fees are not so high as to present a barrier to new home construction at entry-level prices.
A recent article from a noted real estate industry source cited development impact fees as a hindrance to development of entry-level homes. I want to demonstrate why this is not the case.
Raw land value
Most people view raw land as a cost input similar to concrete, lumber, or labor. While raw land certainly costs builders money, the price of raw land does not behave anything like those other cost inputs.
The “sticks and bricks” and other components of house construction are commodities. As commodities they can be easily transported from one place to another, and builders can find suitable substitutes when they are in short supply. Further, many other end-users of these commodities compete with homebuilders when establishing market pricing, so builders may influence market prices, but they don’t establish them. The same is not true of raw land.
The value of raw land for residential construction is established entirely by homebuilders, particularly in California where planning and zoning limit other potential uses. Land can’t be transported from one location to another, and no substitutes for land exist except for other pieces of land. This may sound like landowners can dictate pricing, but in the real world it doesn’t work that way. Landowners can, and often do, ask too much for their land, but in those cases, builders don’t raise their bids, they merely look at other parcels owned by more reasonable sellers.
The valuation of residentially zoned raw land is determined by the maximum amount a homebuilder is willing to pay for it. But how do homebuilders determine the most they will pay in a competitive bid situation?
Builders set the price
The valuation of land used for residential housing is mysterious and often misunderstood. The valuation of lots and raw land requires a detailed knowledge of construction and marketing costs as well as a good estimate of the sales price of the final product: a residential housing unit. In short, the value of a lot is the total revenue (sales price of the home) minus the costs of production and the necessary profit. Land value is a residual calculation.
The value of a piece of land is whatever is “left over” after all the other costs of production and profits are subtracted from revenue. This is a key point. Land for residential home use has no intrinsic value. It is a commodity useful for the production of houses just like lumber or concrete except that the value of raw land is determined almost exclusively by the bids of homebuilders. Nobody else is willing to pay nearly as much for residentially zoned land as homebuilders are.
For a given price level, if the cost of house construction increases, the value of land decreases; if the cost of house construction decreases, the value of land increases. This last point is often confusing as the inverse relationship between building cost and land value does not seem intuitive, but since land value is a residual calculation, this relationship is the reality of the marketplace. The value of a piece of land used for residential housing is directly tied to the revenues and costs of house construction. This is an important point because it completely negates the arguments put forward about development fees inhibiting entry-level home construction.
A Simple Example
Let’s say a 2,000 square foot house sells for $400,000. That comes to $200/SF. The actual construction cost for the sticks and bricks is about $100/SF for a production builder. That means $100/SF of house price is left over to pay builder overhead, profit, and land costs. If profit and overhead run at about 20%, then 30% of the sales price is the value of the lot that sits on it. In this example, that’s $120,000.
Now let’s say the same 2000 SF home would sell for $600,000. The cost of production of the home hasn’t changed, $100/SF. However, with the higher sales price, builders can pay much more for a lot to build that house on because they can still make a profit. If profit and overhead is 20% of the price ($600,000 x 0.2 = $120,000) and the cost of construction is $100/SF ($100/SF x 2,000 = $200,000), the lot is now worth $280,000 ($600,000 – $120,000 – $200,000 = $280,000). Multiply these per-lot numbers by lots/acre density, and you can see how the Irvine Company gets over $4 million per acre for its land.
A flawed example
The example below is intended to demonstrate how the high cost of development impact fees prevents homebuilders from providing entry-level homes. Based on the discussion above, can you spot the flaw in the analysis?
Notice that the example above shows raw land cost as a fixed price. We know from how builders operate in the real world that raw land value is not a fixed price. In fact, this cost is determined by factoring out everything else. If the raw land cost were reduced by $30,000, the deal works just fine. Builders know this too, so if any builders were to bid on a property to provide entry-level housing, they would all bid $40,000 per unit rather than $70,000 per unit as in this example because that’s all the land is worth.
Who stands to benefit most from reducing impact fees? Land developers, not entry-level buyers.
Since impact fees are a cost input, any increase in impact fees comes straight out of land residual, which is why land developers loathe impact fees. In the real world, impact fees do not inhibit entry-level home construction, it impairs the bottom line of land developers. It’s really that simple.
Higher fees for construction permits could be to blame for a shortage of starter homes
The housing market has recovered, but sluggish entry-level construction is putting a squeeze on families that would like to buy their first home. A new report pins the blame on City Hall.
The culprit: Impact fees that builders have to pay municipalities when they get permits for new construction, says the report from Zelman & Associates, a housing research firm. These fees fund the local infrastructure needed to support a growing population—schools, transportation, environmental mitigation and utilities.
Cities boosted these impact fees after the downturn—even though builders were cutting prices—to make up for lost revenue. During and before the housing boom, these fees had supported municipal budgets, together with rising property taxes, which also stopped rising when prices fell.
This all sounds superficially plausible, but upon closer examination, it turns out to be complete nonsense.
The upshot is that housing supply—and not demand—could be more to blame for sluggish sales gains, particularly in the face of prices that continue to rise.
Builders have faced other cost constraints besides permitting fees in recent years, including rising costs of labor, land and supplies. But for entry-level construction, “this is the No. 1 impediment right now,” says Ivy Zelman, the research firm’s chief executive.
I worked closely with several land developers over my career. None of them like impact fees because they are keenly aware of how these fees erode their bottom line. One developer told me that cities are like silent business partners that take half the profit up front without assuming any risk. When you think about it, that’s exactly how it works. The city will get their fees whether the developer succeeds or not, and cities push these fees higher and higher to take advantage of higher home prices.
It’s a bigger issue at the entry level because builders face tighter margins to begin with. It is easier for them to pass along these fees on luxury homes that have fatter margins because the fees represent a smaller share of the sales price, and builders have focused heavily on the luxury market in recent years. “The higher you go in home price, the more you can pass those fees off to buyers,” says Ms. Zelman.
I can’t believe she is saying this. Developers and homebuilders can’t pass on fees of any kind. The market sets the final sales price of the home. The buyer will pay whatever price is needed to out-compete other buyers, and that buyer is completely isolated from any costs borne by the builder and developer. If the builder or the developer pays high fees, they may decide not to build anything, but if they do build, they can’t pass a penny of this cost onto their buyers. They certainly won’t pass along any savings.
Zelman surveyed hundreds of builders across 37 metro areas and found that the average impact fee is up 45% since 2005, to around $21,000. They range from as low as $2,600 in Houston to $72,000 in San Francisco. Six of the top seven most expensive average fees are in California metros. The other is the Washington, D.C., metro area. …
Cities all over the nation realized they were leaving money on the table, and they learned from California cities how to force developers to pay more.
Ms. Zelman says impact fees in the Inland Empire now average around $50,000 per home, up from $11,000 in 2005. If this home is going to sell at the FHA limit, the profit—that is, the incentive to build this home—has essentially been washed out by the impact fee.
“Builders won’t build it, and they won’t build it for a good reason,” says Ms. Zelman.
Ivy Zelman is a very bright woman, so she knows none of this is true, so why did she write it?
Industry insiders often pen articles designed to influence public opinion. They use their status as experts to peddle lies and half-truths that serve their industry. The most extreme example of this in real estate is the constant stream of spin and bullshit spewed forth by the National Association of realtors, but even credible sources of information shill for their industry from time to time.
So why don’t builders design higher-density projects that can blunt some of the bite of these impact fees? Again, blame City Hall. Municipalities have also been unwilling to budge on density, Ms. Zelman says.
What’s to be done about this? There’s no silver bullet. Convincing cities to lower the impact fees seems unlikely. Another possibility, she says, is for the FHA to boost loan limits, though this would require Washington to accept more risk for financing entry-level housing.
So that’s what this article is really about. In early March I stated that the Conforming loan limits inhibit higher home prices. In that post, I made the following observation:
Since raising the conforming limit would allow lenders to make riskless profits, and since it would increase the income and profits for realtor and homebuilders, it’s safe to assume lenders, realtors, and homebuiders will lobby fiercely and persistently to raise the conforming limit.
Ivy Zellman is laying the groundwork for lobbyists in Washington. This nonsense about inhibiting first-time homebuying will play well with politicians who will want political cover for raising the conforming loan limit and exposing the US taxpayer to greater risk. That’s the endgame here.