Thanks to Edward Pinto for sharing his interview by Fortune journalist Shawn Tully appearing in today's Fortune publication at https://fortune.com/2022/08/26/california-housing-market-supply-scarcity/ Pinto embarks on a six city tour of live events in California starting September 19 in San Francisco and concluding in San Diego on September 23.
Register for the free event at https://www.aei.org/california-housing-conference/
California rolls out a daring new housing policy to combat high home prices and increase supply
By Shawn Tully
California is the last place you’d think that would lead the way in adopting daring new policies designed to dramatically increase the supply of housing. For decades, the Golden State’s been in the forefront of doing just the opposite by imposing the nation’s toughest restrictions on new building by far. In housing circles, the joke is that the state’s municipalities have gone beyond the “Not in my backyard” or NIMBY restrictions so common in coastal markets to another dimension of stonewalling dubbed BANANA, for “Build absolutely nothing anywhere near anyone.”
Amazingly, California recently enacted a new law that, if it works as planned, could break the logjam and over time, swell the stream of new homes entering the market each year. [For Fortune’s latest look at where home prices are heading in 2022 see this story.] Under California’s plan, these new abodes would also be much lower-priced than the newly-built houses that now trickle forth, and the programs would achieve “natural,” market-based affordability without relying on subsidies or income limits. The approach, titled “Light Touch Density,” was developed by the American Enterprise Institute’s Housing Center in 2019. The idea is simplicity itself: If homeowners can put two units on their lots instead of just one, the same land is now supporting two abodes. The land costs per dwelling are cut in half, sharply reducing the biggest input into the total cost of a unit. In place of the old policy that freezes the volume of buildable lots, the Golden State would generate abundant new supply by allowing the ground under homeowner’s existing residences to sprout freshly-built units.
“This is all about individual homeowners making decisions,” says Ed Pinto, director of the AEI Housing Center. “So it will evolve gradually but surely, the way compound interest raises returns. Keep in mind, we’re talking about a base of millions and millions of lots.”
Spearheading the new law was one of California’s most powerful politicians, President Pro Tem or effective majority leader of the state senate, Toni Atkins (D-San Diego). The legislature passed the Light Touch bill, or SB9 (for senate bill 9), late last summer, and Governor Gavin Newsom signed it into law in September. It took effect on January 1, 2022. SB9 makes 80% of all of the state’s land zoned single family residential eligible for Light Touch density. “Now, the challenge is seeing whether the different municipalities embrace the new rules, or try to undermine them by continuing to limit construction, something they’ve been very good at,” says Pinto. Backed by a grant from the Hilton Foundation, Pinto and his Housing Center colleagues are holding conferences all across the state in September attended by developers, local politicians, academics, and homeowners. For how, he’s cautiously optimistic. “Many towns, including San Diego, are already encouraging residents to join Light Touch, though others including in Silicon Valley are resisting,” he says.
According to Pinto and his staff, Light Touch is attracting strong interest from policymakers in such cities as Grand Rapids, Austin and Spokane. It will be fascinating to see if the same folks who so routinely opposed new building in their towns get more tolerant of homes rising around them––as they view the dollars available by unlocking hidden value in their own homes.
California’s dire housing shortage gave birth to Light Touch
California is notorious as America’s most unaffordable state for housing. The median home sells for over ten times the average resident’s annual income, twice the national norm. Average prices now exceed $900,000. And at those numbers, Californians are getting homes that are for the most part extremely small, and decades old. “By vintage, the median home probably dates from around 1975,” says Pinto. “People jest that you can get a ‘starter home’ that started as a starter home in 1957, and covers 1200 square feet. Only it costs $1 million.” In Santa Clara County, home to San Jose, the typical existing home is just 1,700 square feet, and fetches $1.3 million. The “nothing in my income range ” problem is so crushing that four in ten residents aged 18 through 34 are bunking with their parents.
At the heart of the crisis is a self-imposed shortage of land. “California has made buildable land artificially scarce by putting so much of that resource off limits,” notes Pinto. “The state and towns have imposed the nation’s thickest web of rules to block new construction.” It takes roughly ten years for developers to win approval from towns and environmental authorities for new subdivisions within 50 miles of the coast. For the inland areas, the timeline is more like five years. “In the process, the towns bargain the developers down from building 400 units, to say 300 units,” says Pinto. “Those delays and the pressure to shrink density even if you get approvals are forces that have sent the prices Californians pay for shelter soaring.”
The roadblocks to getting land approved for building has choked the flow of new homes. Five students graduate from high school for every housing unit erected in the state. Florida, Texas, South Carolina, and Arizona all deliver between nine and ten new construction permits each year per 1000 population, three times the output in California. At the same time, the state’s proved a surprisingly robust jobs machine in recent years, beating the national pace from 2012 to 2019, and even staging a sturdy comeback from the pandemic’s pounding. It’s the combination of employment expansion that swells demand, and gridlocked supply that’s sent prices for the rare newly-built and aging existing homes alike to heights beyond the reach of more and more Californians, especially the young getting their first jobs or starting families.
The big problem is the cost of land, and that’s what Light Touch aims to solve
The chronic shortage of buildable lots causes two aftershocks. First, it inflates the land values in the few fresh subdivisions that navigate the gauntlet. Second, because so little competing supply emerges, the land under those often small and venerable existing homes gets pricier and pricier. As Pinto points out, the cost of actual construction, comprising building materials, labor and financing, is higher in California than other states. But the biggest difference by far is the gulf in land prices. He cites the case of Santa Clara County. “The average price of a newly-built home there is $2.1 million, and the average size is 3,200 square feet. The construction cost is probably $1 million, so the land value is over half the total at $1.1 million.” How about existing homes? They average a meagre 1,700 square feet, and go for a norm of $1.3 million. “The fully depreciated value of the house itself might be $200,000,” says Pinto. “As in the case of the new house, the land’s worth $1.1 million.” But for the old-time residence, the land value is multiple that of four walls of aluminum siding and sheetrock.
If a homeowner were to tear down the abode and build a new one, that would only make sense if the replacement is big and expensive. “You’d build a 3,500 square foot house that sells for $2.1 million like all the new houses,” says Pinto. “And it would cost $1 million to build. When you have a $1 million piece of land, you can’t put a small investment on an expensive lot, it makes no sense. You need to get the ratio of the cost of the new house to the land back in line.”
But Light Touch transforms those economics. Say a homeowner in Santa Clara has a typically small, old house on one-quarter acre. Under SB9, he or she can build a second dwelling without subdividing the lot and creating a new one. That home can be detached and sit alongside the owner’s existing place. Or, the owner could tear down the house there now, and put up two detached units with their own backyards, or two attached townhouses. “In either case, the owner is taking land worth $1 million, and dividing into two parcels each worth $500,000. On a $500,000 piece, it makes sense building not a unit that costs $1 million, but one that costs $500,000,” says Pinto. “So the total cost of the new unit, or the new two units, is $1 million each. That’s still expensive.” But it's a bargain for Santa Clara. The add-on homes would be selling 30% below the median price of $1.45 million for all homes in the county.
It gets better. Under SB9, homeowners also get the option of dividing their existing lot into two lots. That would allow them to then build first, an extra unit on the piece under their own house, and two additional units on the newly-created lot. Suddenly, one lot under one dwelling has spawned three more. This solution could appeal strongly to developers, who could buy an existing home, tear it down, and erect four new ones. Getting approval, however, is more complicated than the process of putting a second unit on your lot. That’s because it requires filing a new subdivision plot plan with the municipality. That course could give towns an opening to block homeowners from securing the four-for-one option.
Some municipalities are bound to resist
In these early days, it’s not clear how many towns will resist the new rules, or how effective their pushback will be. “For example, the state has set a minimum size on new units at 800 square feet. A town could also set that minimum as the maximum, so that building a new unit isn’t economical because it’s too small,” says Pinto. Towns could also impose restrictions in building heights, and put caps on the rent an owner could charge for a second house on their lot. A deterrent from chopping one lot into two: Charging inflated fees for a new subdivision.
We’re already seeing a backlash, especially from wealthy enclaves. In the Silicon Valley’s Woodside, the town council recently froze all S9 applications, citing an exemption for mountain lion habitats. But in a good omen for Light Touch, Woodside backed down when the California attorney general stated that the town was violating state law. Temple City, a suburb of LA, has indeed imposed a maximum size of 800 square feet, along with sundry requirements including a mandate that an owner must remove the existing driveway prior to getting a permit. By contrast, San Diego has embraced the new rules. “They’re putting out pamphlets and doing lots of counseling to make it easier for homeowners to put the second residence on their lots,” says Pinto. “San Diego is taking the position that it will add minimal additional requirements, and simply follow the state law, which is extremely liberal in allowing the additional units.”
That the first “expanded density” law passed in California still amazes Pinto. “But it shows how disastrous the housing shortage became there,” he says. As background, Pinto talks about his own first encounter with the forerunner that helped inspire his brainchild. “I grew up in Palisades Park, New Jersey,” he told me. “In 1939, it passed a law allowing homeowners to put a second unit on their lot. That ensured adequate supply in the years that followed, and allowed the population to double from the time I left in the late 1960s.” Pinto says that what caused Palisades Park to stick with that unusual policy for eight decades was the groundswell of support from generations of its homeowners. That’s a preview, he says, of the grass roots appeal Light Touch could achieve. What benefited the Garden State is moving to the Golden State and if Pinto has his way, will spread affordable using the raw materials few thought of before, the ground under the ranches, bungalows, cottages, and tudors already standing.
Best, Ed Pinto, Senior Fellow
Director, AEI Housing Center