Kosmont on the Fiscal Disincentives Undermining Local Approval of Housing Development

We’ve connected many times over the last two decades—2002, 2014, and now—to talk about post-Prop 13 in California, how cities respond to the pressure for more housing, and about the incentives for housing that exist in the current state-local process. Give us the background for why cities have the fees and regulations they have on housing today.

Larry Kosmont: You can bring a horse to water, but you can’t make him drink, and I think that applies to local government and housing. The reason that adage is so punctuated in California is because every city manager and city council is dealt a set of cards that makes it hard for them to play the housing card.

The reason for that is the financial revenue structure of local government is heavily reliant on property tax, which under Prop 13 is somewhat levelized and minimized to 1 percent of value with a 2 percent annual bump. What happens in the eyes of the city manager or city council is that housing—at almost any density—just doesn’t provide the revenue to support the services that housing requires.

When it comes to the zoning choices cities have, if they match those choices to revenue—which perhaps they shouldn’t but do—housing is one of the least favorite answers, just intrinsically. It was somewhat different when cities had redevelopment, which mandated cities to set aside 20 percent of the tax increment in their project areas for housing. That mandate essentially manufactured housing opportunities.  Today, city councils and managers face bleak prospects of never-ending increases in local government costs led by nearly insurmountable pension fund obligations. Each city’s annual budget cycle is laden with tough choices and increasing unfunded pension obligations. Collaterally they are being asked, pressured or even told to induce more housing; it’s just a tough choice for them.

Based on the models we used to evaluate the economics of a project, housing doesn’t carry its weight in terms of revenues versus expenditures for the services that it requires, which inevitably drives a solution to build anything but housing. So, housing flunks the fiscal benefits test, and collectively, California flunks its housing delivery needs. Everyone loses out.

Let’s break down some of those expenses in addition to pension costs: roads, sewers, traffic lights, sidewalks, parks. Talk a little bit about how those expenses have risen over the last 40 years since Prop 13 and the constraint on cities to go for housing.

Infrastructure overall is an underfunded piggy bank in local government, because local revenues haven’t been enough to support the escalating construction costs that we face in California. As a result, without other forms of government funds—whether it be an additional sales tax levy or state gas tax funds—infrastructure is getting paid for primarily from one-time revenue sources. There are very few cities that consistently make ongoing infrastructure investment because most cities are spending between 50 to 70 percent of their day-to-day budget on salaries, pension obligations, and benefits with the rest going to the cost of day-to-day operations.

Millennials in California—who in their youth played SimCity and realized that the neglect of police, fire safety, traffic mitigation causes havoc in the game for your city—don’t seem to reflect that understanding in their push for more housing.

Yes, and no. At the end of the day, if you ask constituents what the purpose is for local government, I think the primary choice is that it’s to provide a safe environment. When people think about safety, I think part of that includes a user-friendly living environment where they can live and thrive from an educational, social, and cultural perspective. So, to interpret millennial and even Gen Z perspectives on housing based on what local governments seem to provide them is probably a little bit of a misguided notion.

Those generations would like a level of quality housing in a safe neighborhood that has authenticity to it—perhaps a little less suburban than what the Baby Boomer generation grew up with—but they still want that quality of life. Frankly, just about all the cities I work with —and we represent over 60 of them—are really in business to provide an elevated quality of life, it’s just the challenge of making housing part of that equation.

Everyone believes housing is a place for jobs to sleep at night, but when local leaders look at their pocket books, they must decide what comes first. Do they go after jobs and sales tax and leave housing to someone else? Well, yes, but that doesn’t do well for many in the community who actually desire housing. So, we’re always in a structured imbalance between consumer demand for a quality place to live and limited governmental capability or desire to deliver housing based on the constraints they operate under. 

I wonder if you could comment on the changing nature of residential property ownership in the metropolitan areas of California. The latest report suggests that investment firms like Blackstone are the largest owners of residential real estate in Sacramento, San Francisco, Silicon Valley, Los Angeles, and San Diego—a particularly significant change in the last decade. What’s the significance, if any, of that change? 

When the American dream of owning a house simply became another asset class for Wall Street, I think we lost something in the vision of what we are.  Wall Street reacts to supply and demand in a very efficient manner. There’s such an incredible demand for housing and an inability to afford to buy it, large funds convert that imbalance by buying bulk, improving, and commoditizing the single-family home, making what is challenging to buy, affordable to rent.

People still want single-family homes and most still prefer to own. Institutional money has simply acted on the notion that if housing is unaffordable, buy the housing and make it available to rent. Voila, now you have a new asset class that is almost unparalleled; there’s nothing better than building or owning a product on the real estate portfolio side that is a necessity to the users.

People still want to be in a house, so we’ve just commoditized single-family housing. We’re accelerating an investment asset class because we’re not making home ownership available and affordable to a consumer class demanding it.

Give us a little bit of the history of local fees on housing and development in the 60-some cities you represent.

The Turner Construction Cost Index report just came out last week, and you can see that most local governments had ramped up development fees on housing and other products. Development fees in California are expensive, but they’re particularly felt in housing because housing prices are so high. The combination of the high costs of land, construction, and fees makes it easy to conclude that fees are very high here, and that’s the culprit. The fees are too high, but it’s not only the fees that are the deterrent to building housing here, it’s all the other aspects as well.

Cities will typically follow the path of least fee resistance. In the last three elections, we’ve literally had nearly a thousand new initiatives on taxes. Around 70% of the measures have passed. Those new fees are hotel taxes, business license taxes, and with increasing frequency, local sales tax increases. Still, the leader in local government pricing hikes, has been building fee increases. Cities prefer to charge fees and taxes on audiences that aren’t as present in the electoral equation. For example, labor unions are typically very present in local government, so many local government leaders are disposed to approving labor cost increases— because they’re being watched and politically leveraged, in many cases, by labor.  Considering overall community service priorities, while this preference does not necessarily deliver a harmful result, it wreaks havoc on the commercial tax payer. The hotel patron doesn’t live in the community. The business goes home at night. Those kinds of taxes and fees —hotel taxes, business license fees, development fees—are easier to impose. So, that’s where communities have basically put their marbles in terms of tax and fee increases.

What needs to change for California’s cities and communities to have the resources and incentive necessary to allow for greater housing production and density? 

It’s going to be very hard to change the tax structure in California. It’s really hard to change Prop 13, if not impossible. And it’s very hard to fix the high-cost venue that California has become. I think two things need to happen, and they are both about money.  First, the State needs to figure out how to be in a collaborative partnership with local government and help create special financing districts, such as enhanced infrastructure financing districts (EIFDs), CRIAs and others, that can truly help cities use tax increment to support housing production.

In general, Tax Increment Financing (TIF) is the one tool that the state has given cities to use for housing and infrastructure, but they haven’t given cities and counties a robust playground for those tools; because they haven’t mandated local cooperation. As currently structured, state TIF legislation leaves it up to the local agency that is promoting housing or sustainable infrastructure—whether it’s a city or county—to convince other entities to provide a voluntary commitment of tax increment to a newly formed TIF district. It’s not so easy to do, so state startup money must become part of that equation. In other words, local agencies need see some state funding as part of these local districts.

The other thing is that cities need some start-up money to form these special tax districts. You’re starting to see this occur with Prop 2 funds, which provides some initial planning money for more dense housing or blended-use housing projects, particularly near transit. SCAG has funded an EIFD “pilot project” to help locals evaluate the potential for a tax increment district to procure housing and other sustainable improvements. 

Cities need start-up funds and expertise to focus on housing as much as they can. These resources could help balance the political clout of local constituents who just don’t want to see the density or additional housing, which typically happens in coastal cities.

I think if cities were given the motivation to increase density moderately from one dwelling unit per lot to three of four —rather than 50 per acre—and the state provided some funding, you could probably see more a more politically positive mindset on the part of local communities. 

There is a proposed amendment to the California constitution that would require the state to pay for things such as roads, parks, schools, and sewer lines that are currently financed largely through local development fees. Can you talk about the viability and contribution such an amendment would have on housing production? 

The state needs to find a way to help local government pay for infrastructure and housing. I think an initiative that requires some level of state funding for cities on infrastructure, while concurrently pushing local cities to a position where they can’t easily say no to housing, does make some sense. It’s just that the reality of affording such a solution is daunting to me. While I don’t think the state can afford to buy cities’ support for housing, we do need some faster fixes.

 So, let’s shift the emphasis a bit. I think that most communities would thrive if they, in addition to being induced to provide housing, are also induced to provide high-quality jobs. We have a huge housing shortage, but our average housing price is somewhere between $500,000 to $600,000 in most suburban and urban counties, if not more. The reality is that if we could magically produce the million and a half housing units that we’re short—that the governor wants us to produce in the next seven years—you wouldn’t necessarily have the buyers, because most average households can’t really afford a house at that price.

I looked at a SCAG study that shows that in their six-county region, between 2001 to 2016, we’ve created hundreds of thousands of jobs that pay on the higher end, $30/hour or more, and hundreds of thousands of jobs that pay $18/hour and under, but almost no jobs in the middle. We just are not creating middle-class jobs. Inducing and supporting infrastructure as a threshold for providing housing is an important tool, but also motivating local cities and counties to put their tax increment dollars into middle class job creation is equally important. You can’t do one without the other.

What explains the change in point of view of legislators who earlier served in local government, but then champion state preemption and unfunded mandates?

It’s a magical question, and deserves a magical answer that I don’t have. I don’t know if it’s the water or the plane ride, but it seems to me that most responsible local legislators get up to Sacramento with a city perspective in mind, but are quickly introduced to a much broader range of statewide issues and competing interests. The local preferences that once governed their thoughts tend to be diluted after a period of time. It’s consistent; we see it happening. It’s palpable, and I don’t know that there’s a way to fix it.

I’ll tell you something else that happens.  Lobbying in Sacramento is a full-contact sport, and there are powerful lobbies that have different initiatives and motivations from those of local government: the legal lobby, construction lobby, medical lobby, insurance lobby, utility lobby, labor lobby—these are prominent, articulate, and well-funded interests. I think it’s easy to get up there, get lost in the shuffle of dialogue that gets placed on your desk, and lose the perspective that you had in local government.

At one level, local government is just a more direct and clearer perspective to maintain. It doesn’t wear well when you get into the very confusing and convoluted circumstance that is Sacramento.

I wanted to note again before closing, that there have been hundreds of bills introduced this last session related to housing. Some of which would take land use, zoning, and planning decisions away from local government and give them to the state, which would set the outside boundaries for what could be built. Talk a little bit about that change and its impact on the built environment as you and I know it in our cities today. 

Change is coming. The reality is that California isn’t as competitive if it doesn’t have middle class housing. At one level, the state is absolutely right to be concerned about that. At another level, people are fundamentally invested in their local communities and inherently want local control. There’s going to be huge resistance to anything that relegates zoning decisions to within a bracketed higher density level (like SB 50 tried to impose). It’s going to result in a statewide initiative or ballot measure, and who knows where that goes. It’ll be fundamental to the future trajectory of California when the voters are asked to decide about local government control versus Sacramento. Arguments can be made on both sides.

In the revenue-starved environment cities are in—with huge obligations on the infrastructure and labor cost front—the state can be very strategic. It can provide incentives for reasonable increases in density coupled with access to TIF and startup funding sufficient to support that conclusion on the local level. If the state can figure out strategic ways to get that done, then they’ll get local cooperation. 

If you can show a city manager that by creating a special financing district, they could get state-matching funds for a project, they would throw in housing as well as job-generating uses. If the fiscal impact models we use can be adjusted to better reflect updated consumer spending and mobility patterns, then perhaps in a sharing technology-based consumer economy, housing projects can be fiscally demonstrated as bringing more economic vitality, not just as a drain to cities in their role as service providers.

Bottom line, to succeed at housing, the state will have to do better at directing that behavior. If they mandate it, over induce it, or over constrain approvals, it’s going to result in resistance rather than cooperation. And if the state wants to deliver on achieving its own drastic clean air standards, it has another reason to help cities reach an acceptable density equation, which is to induce a reduced statewide carbon footprint. The irony is that a more strategic and balanced “economics-based” push with locals could actually advance the state’s goal of growing a green economy that keeps our middle class from leaving town.