Inclusionary Zoning: More Problems, Less Solutions, and Making Markets More Inefficient All at One Time

March 26, 2007

If there is one market that is over-regulated it must be the market in real estate. In Madison, Wisconsin, regular zoning is not enough to assure that elected officials are able to keep a tight squeeze on the quantity and type of developments taking place. Rather, many leftists in the area want to re-enact their inclusionary zoning (IZ) laws even after they were thwarted by the Wisconsin Court of Appeals in August 2006.

Inclusionary Zoning places a price ceiling on rents and sale prices of “affordable housing” required to be constructed on new developments. These laws basically require developers to bribe the zoning regulators with low-income units in order to receive more flexibility in property zoning or increased density on their development. However, developers can sometimes choose to pay a fee estimated to be the cost of including these IZ units rather than to build the affordable housing units in this property. This “buy out” does nothing more than defeat the original purpose of the law in the first place—to create affordable housing. In all, IZ is yet another example of local governments coming up with new creative ways to enact rental controls into law and enacting more control over real estate markets without understanding some basic economic principles pointed out below.

First of all, proponents of IZ seem to think that developers will only build large properties that target higher income citizens thus allowing for more profits. While this may in part be true, it is far from the whole story. Just like all markets where producers follow demand, developers will follow demand for property. If there is demand for half-million dollar condos in downtown Madison, then they will build in such a way to profit from this demand. On the other hand, if there is demand for “affordable housing” for Madisonians who make less than the median income, then developers will meet this demand by building houses that can be sold profitably to these potential customers. Real estate development is simple supply and demand.

A second issue with IZ is that it can (and often does) require developers to build and sell units at a loss. Again, developers are not irrational and will try to recover these losses by attempting to increase the prices of the most exclusive units of their development which were the original intent of the construction. But the regular units are priced in a competitive market and this increase may not happen because of the lack of demand at higher prices. Developers could take another route to cut costs on the required affordable housing by providing low quality units with nothing but the bare necessities. For example, the IZ law of Madison only required a refrigerator and a stove unit. In the end, this may cost the new IZ home owner thousands of more dollars to finish their home.

This demand issue can go beyond pricing because IZ can require the building of residential units that may not be demanded at all. If there is no demand, developers will lose additional money on these units. Now not only are these development companies backed into a corner because the IZ units may cost more than the developer receives in benefits, but now the sale or rental of this affordable housing may not occur at all resulting in negative cash flows.

In the previously enacted IZ laws in Madison, if the developer could not sell the IZ unit within 180 days, then the unit could be sold at the market prices. This should not be an epiphany, but if the unit will not sell to someone at a lower cost, then how is raising the price going to help sell the unit? The real reason for this discrepancy is that there is no demand from those “qualified” purchasers to buy an “affordable housing” unit who have to deal with the cumbersome process to become qualified to purchase an IZ unit. When there is no qualified demand, it can take over 180 days for a developer to get a cash flow on their investment by finally being able to raise the price of their IZ units to market price and sell to anyone willing to make the purchase. This uncertainty raises the risk of doing the development and lessens the incentive to build in the first place.

Problems with IZ permeate beyond pure economic factors, and intrude into business ethics as well. This 180 day selling time frame may lead to unethical behavior on the part of the developer. With a qualification process for IZ buyers that takes longer than it should, developers may be enticed to slow down the process even more to get the 180 day holding period to end in order to raise the price of their unit to sell at market to a buyer thus making much higher margins. This, of course, assumes there is any demand for these units to begin with.

A final thought about IZ is the weakening of property rights of the owners of IZ units and other units built with these affordable units. The reason people make purchases is to receive some benefits. It is no different for housing. Americans purchase homes to receive benefits such as protection, the right to have their children attend a certain school, the right to live in a community, the right to reap the investment rewards of an increasing home price and many more. IZ lessens some of these rights. For the IZ unit purchaser, Madison maintains an equity share of the value of the home that was marked down in order to make it affordable. Consequently, Madison Government authorities own a portion of your home and therefore reap some of the benefits while at the same restricting the IZ unit owner’s rights. These include your rental rights to lease your property for an extended period of time and the right to reap the overall benefits of the increasing value of the property. This ownership of private property by the government is nothing more than a mild form of Marxism and should alarm any property owner who enjoys the full bundle of rights they receive from their property.

Inclusionary zoning laws also indirectly affect the property owners of the non-IZ units in a community where IZ is required. Markets come down to choice, and IZ restricts this choice. For example, if someone wishes to live in a property with upper class condominiums only then they could go out and buy a condominium unit in such a complex. If IZ laws are continually enforced for the foreseeable future, this choice will no longer exist especially for new properties. This means IZ can force people to live in communities that they wish not to live and thus restricts the property rights of these owners.

These are all serious issues that arise from IZ that only complicate the real estate market often times making it more inefficient by doing a poorer job of meeting buyers with sellers. However, IZ is just one local zoning issue that has serious flaws. However, maybe it is zoning in general that is the problem in real estate markets. Free market real estate may seem like a sinful myth in Madison, Wisconsin, however a perfect case study for this economic idea can be found in Houston, Texas. Houston is the largest city in the United States without a zoning ordinance. Any land restrictions are put in place by the land owners through deed restrictions in order to prevent negative externalities which are the basis of the arguments in favor of zoning. According to Barton Smith, a University of Houston economist, Houston ranks consistently as the leader among major American cities for housing affordability because it does not have zoning. If Madison law makers are really trying to make housing affordable to Madisonians in need, then maybe they should take a hint from the Houston method of zoning.

Believe it or not, the market is smarter than any one person, or even group of people, including left-wing zealots in favor of inclusionary zoning in Madison. They simply do not want to give up their power over the land-use in their city. It may be back to the drawing board for writers of the IZ laws after the recent court losses, but maybe this time the next zoning plan should start with the gradual removal of zoning laws rather than a new idea to make markets more ineffective in doing what they do best.

Inclusionary Zoning: More Problems, Less Solutions, And Making Markets More Inefficient All At One Time was written by UW Economics Intern © PAI 2007.

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