‘Enterprise Zones’ Offer Way to Meet Critical Rental Shortage

Los Angeles is the premiere melting-pot city in the nation, with thousands of people coming here every month. Yet only a fraction of the city’s expanding population can afford to buy homes. And because too few single-family homes are being built to satisfy demand, home prices will continue to increase. We have an ever-growing population that can’t afford to buy homes and who, therefore, must rent.

Despite this, the number of apartment units permitted in Los Angeles has steadily declined from more than 20,000 in 1986 to only 8,504 units in 1990. And 1991 has been worse. For example, during September and October of this year a total of only six apartment permits valued over $1 million were issued for the entire city of Los Angeles.

So why aren’t we building apartments?

For starters, Los Angeles doesn’t like apartment buildings. We’re used to growing horizontally, that is, out instead of up. We don’t identify with those dirty, old, high-density cities in the East. We want ranch homes with lawns, pools and two-car garages.

The prevailing mood against growth in general, and high density rental housing in particular, has led to large-scale down-zoning of apartment property. In spite of recent official claims to the contrary, we now have a critical shortage of buildable lots. As a result, the value of apartment land has increased dramatically during the past decade.

In the southeast San Fernando Valley, one of the areas in which my company builds apartments, for example, land costs have doubled in the last five years from about $20,000 a unit to about $40,000 a unit. Because apartments aren’t being built, it should follow that the supply of multifamily lots would increase. Paradoxically, this has not been the case. The absolute number of such lots is still disproportionately low when compared to the demand from developers.

But not all developers who buy multifamily lots do so to build apartments. Much of the demand comes from condominium builders who can afford to pay more for land because the value of a finished condo unit is substantially greater than a comparable rental unit. Competition between condos and apartments will certainly worsen and increase the value of land zoned for multifamily use.

Unfortunately, scarcity of lots and escalating land values are not the only difficulties facing apartment builders. For example, there’s the cost and perils of obtaining a building permit.

Fees for things such as sewer access have more than doubled while the process of obtaining permission to build from the city has become time consuming and precarious. What should be a routine and predictable procedure is now an exceedingly expensive, treacherous one in which the developer can never be certain of what the city will ultimately allow him to build.

And if that were not enough, new building codes instituted over the past several years make building design inefficient and construction difficult. Just a few years ago builders could build an ordinary apartment building with an underground garage for about $45 a square foot. Today a building designed for the same lot but subject to the new building codes will cost about $85 a square foot.

These factors and others make apartment projects unattractive to developers and investors alike.

For example, let’s say that a lot becomes available in a high-rent area of Sherman Oaks. We determine that we can build 10 apartment units. The cost of the lot is $40,000 a unit or $400,000. We decide to build seven two-bedroom units and three one-bedroom units on this lot.

The two-bedroom units will be about 900 square feet while the one bedroom units will run about 750 square feet for a total building area of 8,550 square feet. At $85 a square foot, the building will cost us about $727,000 to build including financing. The land and the cost of construction combined total $1,127,000.

The rents in the area suggest that we can expect to receive $950 a month for the two-bedroom units and $800 a month for the one-bedroom units. The annual gross scheduled income is $108,600.

Say we decide to sell the building. The comparable sales in the area tell us that the building will sell for about 9 1/2 times the annual gross income, which comes to about $1,032,000 or $103,200 per unit.

Based on a total cost of $1,127,000, if we sell the building we will have a net loss of $95,000.

On the other hand, if we were to build only a seven-unit condominium project on our lot, we could sell the completed units for about $220,000 each for a total of $1,540,000. Even if one allows for units of 1,200 square feet each and building costs of $100 per square foot (as opposed to $85 a foot for our apartment), the condo project will still show a profit of about $200,000.

So we have several problems--our population is increasing rapidly, we’re running out of room, there are fewer multifamily lots than ever before and condominiums are squeezing out apartments.

Are there solutions? Yes, but they will be difficult to implement. First, Los Angeles is going to have to grow up. That is, building must become vertical and, brace yourself, much higher in density. It’s not a question of if so-called densification will occur; it’s a question of when.

Second, steps can be taken to revise federal tax law to facilitate apartment construction. For example, we need to eliminate the “passive-loss” rules of the 1986 Tax Reform Act. This prevents owners of apartment buildings that lose money from using the losses to offset ordinary income. Allowing investors to pass through losses will provide much needed incentive for investors faced with losses often associated with the ownership of new apartment buildings.

But perhaps the easiest way to spur regional apartment construction without creating expensive new government programs is the creation of local “enterprise zones.”

Specific target areas or neighborhoods in which rental housing is particularly needed should be defined and property taxes for new apartment buildings, along with fees associated with obtaining building permits, should be reduced for a finite period of time.

Building will be stimulated in exactly the areas where the scarcity is greatest and where the likelihood of new rental housing construction is very low. Generally these neighborhoods are impoverished and are unattractive to apartment developers. Without some intervention, very little development will occur and consequently property tax revenue will remain flat or perhaps even decline. Temporarily suspending or reducing fees and property taxes will lure builders into these target zones.

Ultimately, after a period of time, property taxes can be re-assessed and the local tax base will increase. For the city (and county) this straightforward solution will create local jobs, increase the supply of desperately needed rental housing and eventually increase the local tax base.

Until we embrace the basic imperative of densification, it is unlikely that any significant progress will be made in providing decent housing for all of our residents.

If Los Angeles continues to inhibit developers from building high density rental housing in the hope that the need for housing and its coincident problems will somehow go away, the unfortunate but inevitable consequence will be an ever worsening degradation of our social and economic environment.