Why isn’t everything affordable? The limits of inclusionary zoning

When you build 10 or more units in Cambridge, 20% are so-called “inclusionary” units (technically, 20% of floor area). These are subsidized affordable units, limited to rental or sale to people with low incomes. This requirement faces two opposing criticisms:

1. Shouldn’t this requirement also apply to construction of smaller buildings, e.g. 2 unit or 3 unit buildings?
2. Doesn’t this raise the cost of new construction by interfering with the “free market”?

To understand the impact, we need to look at some numbers. This is a very simplified model, so I wouldn’t take it literally; the goal is more to get a mental model of the impacts under different scenarios, rather than to figure out exact numbers.

Market price vs subsidized price

Housing units in Cambridge on average sell for about $1 million at the moment.

The requirement for inclusionary units for sale is “households making 90% of the area median income paying 30% of their income for the monthly housing payment”. If we look at the area median income from 2024 and assume the baseline is a 4-person family, that’s around $140,000 income. I then played around with a mortgage calculator and that means these affordable units have to sell for about $500,000.

Developer profit margins

The National Association of Home Builders suggests a 11% profit margin in their recent survey. The Boston Globe says it’s 6% locally as of late 2023, presumably net profit margin.

So let’s say $100,000 profit per housing unit sold… on average. It will vary based on different dimensions (building height, number of units, plus other things I don’t understand.) Like I said, this is a simplified model.

Let’s do some arithmetic!

When you subsidize one or more units in a building, that cost has to be allocated to the other units. For example, if you have 10 identically-sized units of which 2 are subsidized, that’s 2 * $500,000 that needs to be allocated to 8 other units.

Let’s see how that works in different scenarios:

# units	% subsidized	# subsidized	extra cost for each market-rate unit
2	50%	1	$500,000
3	33%	1	$250,000
5	20%	1	$125,000
10	20%	2	$125,000
10	10%	1	$55,556

50% inclusionary: 2-unit building with 1 subsidized unit

The market price for a unit is $1,000,000, so without inclusionary zoning a developer could have revenue of $2,000,000. But one unit is selling for just $500,000!

To get the same profit as before, the remaining market-rate unit would have to sell at $1,5000,000. No one will pay that.

The other option is that the developer reduces their profit. We estimated the average profit at $200,000 ($100,000 per unit), so if that’s their profit in this case they’re going to lose $300,000. In practice profit may vary by project, but it would have more than twice as high as average, which seems unlikely.

The result is that no one will ever build 2-unit buildings, and no inclusionary units will be created this way. The same problem applies to 33% inclusionary.

20% inclusionary: 5-unit building with 1 subsidized unit, or 10-unit building with 2 subsidized units

Here each market rate unit gets a $125,000 cost allocated to it. Average market rate unit profit is on average across projects $100,000, so we’re starting to the hit break even point where the developer (given average profits) won’t lose money at least. And maybe they will be able to raise prices a bit to get to a profit.

One way to cut costs, as I discussed elsewhere, is building more units by spreading the cost of land across more units. So if you build 10 units instead of 5, your cost per unit is lower on the assumption construction costs are linear, and they’re more likely to be making a profit.

In short, a 10 unit building is more likely to be profitable than a 5 unit building with the same percentage of inclusionary units. But the profit margin is still likely to be too small, so this might still result in the building not getting built.

What we’ve learned

Affordable housing units need to be paid for, one way or another. In this case:

• Inclusionary units fund affordable housing by, as a first pass, eating into real estate developer profits.
• If you set the % of inclusionary units too high, the building won’t get built since developers won’t find it profitable. Since we’re currently stuck with relying on commercial developers to build more housing, that’s a problem.
• The more units in the building, the more likely it is that building will still be profitable given inclusionary units, and therefore the more likely it is to get built.
• Developers might also be able to raise prices on units, up to a point, raising the cost of new units and pushing the financial cost on to purchasers of new units.

What should we do to maximize building as many inclusionary units as possible?

1. Make sure it’s possible to build taller buildings. If you’re limited to duplexes, as in my neighborhood, no for-profit developer will ever build inclusionary units. You could change the law to require 1 out of 2 units to be inclusionary, and the result would be that buildings would only ever just be renovated. Not much different than the status quo, really. If you can built lots of units, though, costs per unit go down (up to a point where you have switch building technologies), making it easier to afford inclusionary units.
2. Possibly reduce the % of required inclusionary units. The goal is to maximize the absolute number of inclusionary units, not the percentage. It’s possible we’d end up with more affordable units in total if the requirement was only 10% instead of 20%, because more projects would be profitable so more buildings would get built.
3. Try to reduce housing construction costs. Lower costs means higher profit margin, means more ability and willingness for developers to eat the cost of inclusionary units. There are a bunch of ways the legislature and city might be able to do this.

Another approach is to fund affordable housing in other ways:

• Portland (Oregon) funds the inclusionary units developers build, instead of asking developers to eat the cost. Ideally you negotiate it so that you only pay for costs, not profits, and it doesn’t have to be 100% funded. Portland’s model involves waiving property taxes for some number of years, so it doesn’t involve up-front financial costs for the city.
• Social housing has the city building its own housing aimed at all income levels, with higher-income renters subsidizing lower-income renters.
• Cambridge already puts some money into fully-funded affordable housing, where all purchase and constructions costs are paid upfront by grants, so that rent can be permanently cheaper on the whole building. This funding could be increased.

Inclusionary units get built if developers are making a profit, and their profit comes both from cutting costs (hopefully in good ways) and raising prices for purchasers (effectively a tax on homebuyers). But if the city were to raise property taxes on all the city’s property owners, instead of just implicitly taxing new purchasers, the city could fund a lot more affordable housing.

A bit more

Song of the day: Rasa Sayang by Gerhana Skacinta.