Let’s Talk Inclusionary Zoning: An Interview With Bill Witte

Below is an interview transcript with Bill Witte. This transcript is part of a series of interviews that are meant to shed light on how experts think about inclusionary zoning. You can see a full listing of all the transcripts here. This transcript was lightly edited for clarity.

Owen Pickford (OP): To get started, can I ask you if you’re at all with Seattle’s inclusionary zoning policy and what we’re doing up here?

Bill Witte (BW): Not specifically. I don’t know the exact policy.

OP: Would it be helpful for me to give you a quick overview of what we’re looking at? We spent about two years looking at the previous incentive zoning policy and it was kind of a weak policy because it wasn’t creating enough units for the city to be happy. They brought together stakeholders, 25 stakeholders from a bunch of different backgrounds to draft a more comprehensive affordability policy. They came up with 65 recommendations. Two of which might be called the centerpiece, inclusionary upzones. They’re going to upzone all the urban villages and implement inclusionary zoning when they do the upzones. The urban villages are the areas in the city that have been designated for growth. They account for the most development capacity and in the past years they’ve accounted for about 85% of total development. The inclusionary requirement will probably be between 3-10% and it will depend on the urban village that is being upzoned.

BW: Would it be 3 to 10% on site with no in-lieu fee or off-site option?

OP: There is going to be an in-lieu option. They have not discussed an off-site option. That’s kind of the background. I’m personally pretty familiar with the debates that go on around this. I wrote a longer piece about it. I generally find myself to be somewhat supportive of the policies. I think if they’re implemented, well, I’m supportive of them. I’m familiar with about five different pieces of research that looked at empirical data and tried to answer the question I’ve heard the most often; does inclusionary zoning affect the supply of housing? I got connected to you through David Rosen because I asked him, “you’re supportive of these policies. You have these opinions. Are there people whose opinions you respect, who know a lot about this, who might disagree with you about some of the specifics?” And he put me in touch with you. What I’m curious about is where your views might differ from David Rosen’s and you’re thinking about Inclusionary Zoning.

BW: Do you mean generally or specific to Seattle’s policy?

OP: Generally, that’s my preference.

BW: I have a middle of the road view about inclusionary, which sometimes pisses off both sides. If you have a master planned community, it could be urban, suburban or exurban, you’re creating entitlements, or density, by discretionary approvals, you absolutely should have inclusionary zoning. There’s no excuse not to, even if you’re quote, “a free market type.” I mean you’re creating value. Why wouldn’t you ask for 15% or something be set aside as affordable on-site? On the other extreme, I’m sometimes leery of policies that are say city-wide for every building over 10 units and it’s building by building. First of all, with the possible exception of a city like San Francisco, there are different neighborhoods in the city, there are different submarkets and it might work in some but not in others. Or if you have an area of disinvestment that’s seeking investment, if you’re trying to encourage development in area that’s largely-low income, why would you make it harder? So I don’t have a single view.

BW: The other point I would tend to make, and again San Francisco seems to be somewhat of an exception to this and maybe parts of Seattle, these work best, or cleanest, if you will, if there’s a quid pro quo, just like I mentioned in the master planned community. We’re going to upzone an area, I think this is somewhat the approach the DeBlasio administration is taking in New York, we’re going to allow you more height or more something and in return you’re going to set aside X percent as affordable units. That way you’re not just taking. The challenge with that in coastal California is that cities can’t always deliver the density politically. So it’s fine to say that but where it works best, and San Francisco has kind of done this, you take an urban village or growth area, maybe it’s not proximate to some established single-family neighborhood or something and you apply it there, you can usually accomplish that. I mean this isn’t China. The government can’t just say ‘that’s it, it’s happening.’ But there’s a better chance of accomplishing that. In general, in growth areas, of which Seattle would be one, where these programs tend to work. It’s not completely linear in the sense that advocates will say, “well if you just require more affordability, sellers of land will just get less for their land.” At some level, I suppose over time that would work but you can’t always count on that. In other words, “Mr. Developer don’t worry because you’ll just pay less for land.”

OP: Can you expand on your logic about that and describe the mechanics or logistics.

BW: I think first of all the main issue on the developer side is timing. San Francisco is about to double its inclusionary requirement and they seemed to have resolved grandfathering. In other words, if you have already submitted all your plans and everything, you already have optioned or bought land, then to simply double that is not fair. It’s a question of when such a requirement would kick in. If you know in advance, you’re a developer and you’re looking for land and that’s the policy it can work. It’s funny, developers like rules. They may complain about them but if there are clear rules you deal with them and you adjust. It’s when there aren’t rules and things change late in the game that it’s more problematic. I think it’s better for all sides, including community groups and advocates and everyone. What are the rules? What’s the deal here? With respect to the land argument, on a prospective basis that can work. Just like you can increase land value by upzoning, you can control it by constraints. Adding a requirement in a residentially zoned area for affordability will reduce residual land value. That said, I know it’s more complicated that.

OP: This might be a point of disagreement you might have with David Rosen. My impression from talking with him was that land values adjust dramatically and quickly to when things happen. You’re taking a more measured view.

BW: I don’t think that’s always the case and here’s why. If you’re in a city like San Francisco and you don’t have to sell, there’s evidence that land sellers will just wait. Just like in 2009, you own a condo and values are down. Why would you sell? You don’t have to. You’d wait. Since these requirements change over time, there is evidence that at least some sellers won’t sell or they’ll hold out for their price. The other issue that comes up is it’s not always the case that land is zoned for one use. So if you have enough of an inclusionary requirement, maybe a commercial use has a greater value. Unless a city precludes that, and in some cases they might, it could have a higher value for a different use. I think what he’s saying sometimes works but like a lot of these things, it’s very hard to apply these principles across the board. So it depends. Over time, assuming a consistent policy, values will adjust. But it is naïve to think that land sellers will adjust their expectations overnight.

OP: There’s question that I’ve thought about which I haven’t heard from a lot of people. One of the assumptions about developers offering less for land because they can’t make as much or whatever, is that they would still be able to get financing if they offered less for land. I’m wondering if you’re in a market where the normal price for land is X and this policy passes. You know you have to offer less for land. You go to a bank and you show them you’re plan, do you have an experience or knowledge about whether or not that would make it difficult to get financing because the bank would look at that and say, “that’s not a reasonable offer for land.”

BW: No. The bank won’t care. If it seems like it’s a below market offer, the bank will be happy. The bank will think there’s a “land lift” here because it appraises at a higher value. The bank certainly won’t care, just the seller. It’s when you pay too much that the bank cares.

OP: That’s the inverse of this. I’ve talked to a number of people and they’ve said, “When you are in a market that has slack for rents, maybe a really hot market where people are moving in with high incomes that didn’t used to live there, developers might still be figuring out what the rents are that people may pay. Rather than passing costs on to landowners they’ll increase their rents on people moving into the neighborhood.”

BW: It’s strictly a market dynamic. When a developer plans an apartment building, they’ll underwrite a certain rent. Today’s rent is X, and depending on where you believe you are in the cycle, you might trend rents a percent or something until you open. But the way it works in practice is that it’s not linear. For example, rents dropped 15 or 20% down here between 2008 and 2010. Then in 2011 they started coming up. Then in 2013 they went up something like 25%. In other words, it’s not gradual. They go all the way up really quickly and then they flatten out. You really have to gauge where you are in the cycle. It may be that the average over a five or ten year period is 3% increases a year but it doesn’t happen 3% per year. It might go up 5% then down 7%. It’s uneven.

OP: So if you’re a developer, this is related to the last question I had, you’re kind of guessing what rents might be but you might use that trend line. How does a typical bank look at that? Would they accept a 3% trend line?

BW: They’ll do their own underwriting. They’ll do their own analysis. They’ll have an appraisal and do their own analysis based on comparables in the market. I mean everybody has access to the same data so the projections are always a bit of a finger in the air, even if it’s so-called “experts” making them. And rental housing is all about job growth. Job growth and supply. What appears to have happened, I say from afar, in Seattle, which I think is a good thing, is despite all the job growth in Seattle, rent growth is flattening because the city has been pretty good about allowing supply. With new construction, construction costs go way up in a hot market because contractors and sub-contractors are busy, and all the competition tends to be at the high end because that’s what you have to charge to justify these costs. Land costs go up and construction costs go up.

BW: In San Francisco, I think rents are flattening even though there’s good job growth. And there’s still huge unmet demand, but 90% of the unment demand is a little below the highest rent levels and nobody can afford to charge that on new construction. I think that’s already happened from what I can tell in Seattle and is beginning to happen in San Francisco. Back to the inclusionary thing. It’s fairly easy to monetize this. It’s all about projections of net operating income and you can calculate the affect of 3% or 10% at various income restrictions. What’s the reduction in net operating income? That part is easy to do.

BW: For example you could say that most of us look at return on costs, which is net operating income divided by total development costs. In a very low capitalization rate environment, people or investors will do deals for 5 or 5.5% returns on costs because properties will sell for under a 4% cap rate. In Seattle, it’s probably a little bit higher. Let’s say you were underwriting a 6% return on costs, you now impose an inclusionary requirement and maybe it costs you 20 basis points so the 6% becomes 5.8%. That’s probably ok. So you mentioned a 3% inclusionary requirement, and I say this as a developer, that’s not going to make much difference. Only in a depressed market or a struggling area, a blue collar place, perhaps Federal Way, would somebody be able to say, “gee, I don’t know if I’ll be able to get financing now.” If you’re around Amazon or something, it’s really not going to make much difference. 10% depending on the income level you’re targeting, that’s going to make a difference.

OP: But potentially not enough to make a difference?

BW: Let me put it this way, San Francisco since 2010 has had a 12% inclusionary requirement and there are off-site and in-lieu fee options. And for developers of condominiums where the hit is much greater because there’s such a spread between an affordable condo and the market condo, they almost all take the in-lieu fee option. For rental, they mostly do it on-site. And today, because rents have gotten so high, 12% is fine. They’re proposing to double it to 25% for new projects. That won’t work. I can tell you right now. Not at anything close to today’s land prices. I hate to put it this way but I’ve seen it in San Francisco for years. The progressive community rises up and proposes very constraining development measures after the horse is already out of the barn. What’s happening in San Francisco is there’s a lot product. We’re nearing the end of this cycle for a variety of reasons. So development would probably slow in any event because of natural market reasons and now this will make sure that it ends. The other thing you have to look at, and I don’t know about Seattle, is that San Francisco has all sorts of fees, like a child care fee and and transit impact fee and they keep increasing them. It’s not just the inclusionary reduction in income, it’s the cumulative effect of other mitigations. You have to look at everything that constrains income or increases costs.

OP: The vibe I’m getting from this conversation is that you think a well-crafted inclusionary zoning policy is good policy.

BW: Yes.

OP: But it’s easy to not do that.

BW: Most places have been fairly modest in their requirements because it’s politically hard to get. For developers, the biggest issue is not the scope of the requirement but when it’s imposed, “I’m already in the pipeline. How can you do this?” If you do it with enough notice, then I think things tend to adjust and people can make informed business decisions.

OP: That reminds me. One of the other questions I wanted to ask you about is, people have said in previous conversations about developers that own land but don’t have permits in, Seattle always grandfathers in permits. At the time you put your permit in, the laws on the books are what apply to that permit. If you’re a landowner and you haven’t put in the permit, you’re a developer sitting on land, you might very well be affected negatively. In my mind, there’s two sides to that. One, yes you might end up not getting the return you expected but my guess is that before the policy is implemented you’ll see a rush of permits.

BW: Yes, that is true. Developers are like lemmings. Yes, that would absolutely happen.

OP: I also find myself being a little unsympathetic to developers that are sitting on land and might not get the return they expect. My intuition is that they’re being a little speculative with the land. I’m curious what your take is?

BW: Yes, I think that’s true. I think if you have clear rules and enough warning, I’m not very sympathetic to just free market criticisms. Seattle I think is almost a better example than San Francisco. Where I am sympathetic is where cities make it very difficult and lengthy to build and then impose these requirements. Then you might have cycle risks. You have to take so long to get approved, no wonder there’s a shortage of supply and then you add all this other stuff. Seattle from what I can gather appears to have been fairly good at spurring supply, almost to the point that the market is working and rents are flattening. In other words, if the city is being responsible in its land use policy, then I think these are completely fair. If the city on the one hand is saying, “You’ve got to do this, you’ve got to do that and it’s going to take you four years to get approved.” That’s bad. That’s not good for anybody and that’s the California experience.

OP: So developers here definitely complain about the timeframe but I think the department has released numbers that I think say it’s 3-6 months.

BW: Well let me just make one more comment and then I have to run. California has something called the California Environmental Quality Act, CEQA. What it does is it, unfortunately, can drag out approvals. It allows almost anyone to sue over a permit at no risk or cost to them which is a delaying tactic. Therein lies a lot of the problem in California. Washington I’m sure has it’s own controls but nothing like that. I would just leave you with the thought, if cities are concerned about supply and affordability, then you have to address both within your land use policies. Encourage supply either through upzoning or fast tracking or whatever. In San Francisco, for example, they at least claim that if you agree to 20% affordability they’ll move you faster. I’m not sure if that’s true but that’s what they’ll tell you. In other words, don’t punish people, encourage them, if that’s what you want. If it’s both a supply problem and an affordability problem, then encourage both. Then I have no problem with the impositions.

Bill Witte has an extensive background in housing. He currently works as the Chairman and Chief Executive Officer of Related California. You can read more about him here.