Lately, zoning constraints have begun to ease in many communities, and state and local leaders support, grassroots organizing, and business sector engagement have helped to open opportunities for new development. Yet as these zoning barriers recede, developers are experiencing new challenges related to financial feasibility, which is blocked by escalating construction costs, higher operating expenses and insurance, and the rate of return expected by equity investors.
There are many different ingredients that go into a residential development. Developers put in labor and seed capital, generally all at-risk if a development doesn’t pan out. The funding for site acquisition and construction typically comes from two sources: loans and equity investments. Short-term construction loans give way to long-term mortgages (held by EOHLC, quasi -public agencies, and private banks) with predictable payment schedules. But loans can’t cover the entire cost; some major equity investment is needed. Some of that may come from the developer, but most of it will come from outside equity investors who get some portion of the net rent or sale proceeds. How much they get depends on the income and operating expenses of the development and sale price once it is sold. Since these values are not certain (costs could be higher, rents could be lower), there is some risk associated with being a capital investor in a development.
EOHLC focus groups with industry representatives revealed that major equity investors are seeking a risk-adjusted return that is a certain amount above the ten-year treasury bond rate. For example, if the ten-year treasury bond is 6.25%, then investors might be looking for a return of 6.75% to cover the risk associated with a certain type of development. If forecasts show the development can’t meet that rate of return given current assumptions about construction costs, operating costs, or rental income, then equity investors may choose to invest elsewhere. That means the development can’t get built unless the financial picture improves, or the developer can find another source of equity with lower return expectations.
Production is particularly difficult in weaker markets where even market rents and sale prices are insufficient to achieve an acceptable rate of return for lenders and equity investors. For affordable housing developers in regions with a lower median income, a low rent standard means cash flow is hard to sustain. Inclusionary zoning is a tool to produce deed restricted units without public subsidy. The creation of inclusionary units has little to no direct impact on the construction cost of the development, since deed restricted units must be effectively identical to the market rate units. The financial difference emerges during operation, since inclusionary units don’t produce as much income. Industry representatives report that in some cases the net present value of the lost income approaches or exceeds the entire profit margin for the developer.