Photo by afagen on Flickr.

Is inclusionary zoning just another inefficient government subsidy? Not at all. It’s actually a clever program that creates some permanent affordable housing and also builds political support for more density.

Last week, Matt Yglesias expressed reservations about DC’s inclusionary zoning law. IZ lets develo­pers of apartment and condo buildings over a certain size build more density than they otherwise could. In exchange, they have to set aside some of the units as affordable.

People must earn less than a certain income level to be eligible for these affordable units. In DC, that level is 80% of area median income (AMI)—not that low of an income. People eligible for the units can enter a lottery for them. Someone who rents such an apartment will pay lower-than-market rent in perpetuity. Someone who buys such a condo can resell it later, but at a rate that keeps the unit at a below-market level, while still letting the seller enjoy some gains.

Is this economically inefficient? Yglesias wrote:

But the fundamental issue here is that IZ is an extremely cumbersome way to try to help people. Instead of giving one family a $120,000 discount on a condo and giving another family a $130,000 discount on a condo the city could just hold a lottery. Look at the list of DCPS students eligible for free school lunches, select two of them randomly, and cut each family a check for $125,000.

There’d be little need for paperwork, no need for loans, and the families could decide for themselves how they want to use their bounty. If the city wants to obscure the cost of the lottery, they could simply say that developers of market rate housing projects need to stage the lotteries.

It’s true that unlike IZ, my “give lots of money to people in need” initiative would not ensure the existence of economically diverse neighborhoods. But a question people have to ask themselves is what’s the purpose of these policies. Are they supposed to help low-income families or are they supposed to make upscale yuppies feel better about their neighborhood?

I think the giveaway is that the lucky inhabitants of these “affordable” units aren’t allowed to sell the units at market prices. Imagine a low-income family faced with high medical bills. Luckily for the family, it actually owns an apartment that’s pretty expensive. But perversely, no matter how badly they need the money they’re not allowed to sell the apartment to raise it.

The encumbered sale is perfectly reasonable

Yglesias’ last argument is the simplest to address. Certainly a family owning an IZ unit could sell the apartment. They simply have to sell it at a discount to the current market price, just as they bought it at a discount. That’s not really that strange.

We can draw an analogy to a small company. Say you have a business idea but you need to buy some equipment. You could borrow money from the bank, or you could get investors and sell them part of the company. Let’s say someone agrees to invest $250,000 in your company for 50% of the equity. Your company is now worth $500,000 and you own half.

You and your employees do a good job and the market opportunity turns out to be a good one, and your company grows in value to $1 million. Your share is worth $500,000. Say you need money for the medical costs in Yglesias’ example. You can sell some or all of your share. But you couldn’t say that it’s not fair you can’t sell the whole company for a million; you only own half.

An IZ unit is like a little company where the city owns a share. You get to control the unit itself—the city has no voting stock—but if you sell, you can only sell your share, to someone else who can come in and assume the same business arrangement you had.

There’s nothing intrinsically wrong with this, other than that it’s not the way housing has traditionally worked. But the condominium (and before that, the co-op) was unheard-of for a long time, as well, and then it existed, because it met a particular need.

Anyone who doesn’t like this kind of arrangement doesn’t have to buy such a unit, just as the company owner could borrow money, or put in his or her own money, or try to make the business work with less capital, if they don’t want to give an investor such a big share.

Why not give people cash instead of housing?

Yglesias’ first point basically asks, instead of subsidizing housing, why not just give some poorer people some cash, and then they can buy housing on the open market?

This is a fairly common economist response to a government program giving something away. If having a free market is generally better than not, then rather than giving people some good, why not give them money and let them make the choice? Maybe they can actually consume less of the good, and this creates an incentive to do that.

This is the argument for a parking cash-out. Rather than giving a bunch of office workers free parking, why not give them money equal to the cost of renting that parking in a garage? Given the money, the office workers have an incentive to take transit or carpool instead, and keep some of the money. The cash option doesn’t cost the employer any more, and transportation gets more efficient.

On the other hand, we don’t do this with, say, food stamps. The government has a certain interest in making sure people buy food instead of buying booze or drugs and going hungry. Moreover, food is a basic necessity and the food stamp money doesn’t go so far that people will end up overconsuming food (unless it’s overconsuming junk food, which is excessively cheap thanks to corn subsidies).

The main difference between IZ and the “give them cash” principle is that “give them cash” requires the government to come up with some money, which it might not make back in taxes. IZ takes the cost of some affordable housing out of the producer surplus for the developer. The developer is making some profit on each unit. The bonus density adds additional units and thus additional profit, but IZ restricts those so that much of the profit goes to the homeowner rather than the developer.

As long as the amount the buyer pays for the affordable unit exceeds the incremental construction cost and taxes, the developer will still make money on these additional units, all of which they wouldn’t have been able to otherwise build.

The building industry negotiated on the original IZ law to reach levels that didn’t wipe out all their producer surplus and turn affordable units into a net cost. They probably pushed for more than necessary, so that some producer surplus remains, giving them some buffer and giving us confidence that the law isn’t excessive.

Unlike cash, IZ protects affordable units in perpetuity

Yglesias suggests alternatively having the developer run a lottery to give out the difference between the market-rate and affordable unit. This would take the money out of the producer surplus, and have the same effect as IZ… at first. But unlike cash, this unit has restrictions on sale—that “investor” who owns some of your “company.”

If I give you $25, it’s yours. If I invest $25 in your company, such as by buying some stock in a public offering, you still get the $25 to spend today and can use it toward equipment or hiring or office rent, but I got something of value back in return.

The net result of this policy is that someone gets to live in some housing while shelling out fewer dollars, but the city also keeps some of the value of the transaction for itself in the form of this equity. That serves the social goal of maintaining a stock of affordable housing over time as well. In the end, IZ creates affordable housing but at lower cost to society than by other means.

Some affordable housing organizations don’t like this system. They prefer to have a juris­dic­tion create affordable housing, lottery it off to needy families, and then let those families resell in the future at market rates. When the family sells, they have to pay back the subsidy, but they keep most of the appreciation.

The problem with this system is that it doesn’t preserve the affordable housing in the long run. People who receive units can flip them after a number of years and pocket at least a large percentage of the difference. Meanwhile, the unit stops being affordable for the next person. In this way, it actually is more like the lottery in Yglesias’ hypothetical, or to extend our analogy, it’s like financing the company with a loan instead.

Under that kind of system, you create affordable units, but they quickly evaporate out of the city’s stock of affordable units. IZ creates a pool of these units that stick around, keeping at least some inventory of less expensive housing for the future.

IZ is a way to get extra density

Inclusionary Zoning is a program that Yglesias and other economically-minded urbanists should actually be very excited about. Yglesias wrote a whole book on how restrictions on supply are holding our cities back. These restrictions stem mainly from resident opposition to added density.

IZ builds political support to do what might otherwise be impossible: allow more density under zoning. The political calculus might not favor such a change on its own. Just upzoning a property gives extra value to the property owner, creating a producer surplus, but little benefit to residents beyond the vague promise of more “eyes on the street” and more shops and restaurants.

But there is some political power behind doing more to create more affordable housing, and a group of people who stand to benefit from such a policy. Add that to the equation, and it becomes possible.

In other words, even if IZ is imperfect, it might be the most politically feasible way to achieve higher density.

Yes, IZ is somewhat imperfect

There are indeed some challenges with IZ. Like any program, has some transaction costs, which the “give them cash” hypothetical alternative largely avoids. There have been some obstacles to getting mortgages for IZ condo units, though this problem is actually easily solved: other jurisdictions simply agree to let the affordability policy expire if the property goes into foreclosure. The city agrees to give up its “call option” in this case to get lenders to buy in.

Some IZ units may be going to people who are just temporarily low income, like recent college graduates who have every ability to soon earn much more than the area median income. Appropriately tuning the law could probably address most of these abuses, and while it does increase administration costs, it shouldn’t be a deal-breaker.

IZ also has only limited impact. DC is only creating a small number of IZ units so far, largely because Mayor Fenty delayed the program for years while many new buildings gained permits without IZ. Those buildings are just now being built.

Also, the federal height limit constrains the amount of bonus density that DC can grant. IZ can only let developers build more when local zoning is more restrictive than the height limit, which is the case for most of the District but not in the densest areas with the most growth. Other jurisdictions can grant far more in incentives, as in the White Flint plan.

Is there a free market solution to housing affordability?

It would be much more satisfying to devise an economic system that creates housing choices at all points on the income spectrum inherently, by market forces, rather than through government mandate. I simply don’t believe that removing all zoning caps would do this, however.

Buildings cost a lot to construct, and taller buildings cost more per unit than smaller ones because they require more expensive materials. Lenders only want to fund the projects with the highest return, and capital is scarce, especially now. There is enough demand near the top of the income spectrum to consume all of the units that could get financing.

As it is, developers tell me that there is considerable development, already approved, that is just not happening yet because of financing constraints. If things aren’t getting built which have no zoning barriers, then removing zoning barriers won’t solve all problems.

It’s still worthwhile to push to reduce barriers for the long term, and there are plenty of examples where zonng rules or historic preservation limits do indeed take away needed housing opportunities.

But in the meantime, there is indeed value in creating mixed-income communities. It’s far more than just a way to “make upscale yuppies feel better about their neighborhood.” In a future part, I’ll discuss the many advantages to mixed-income neighborhoods, for both wealthier and poorer residents.

David Alpert is Founder and President of Greater Greater Washington and Executive Director of DC Surface Transit. He worked as a Product Manager for Google for six years and has lived in the Boston, San Francisco, and New York metro areas in addition to Washington, DC. He lives with his wife and two children in Dupont Circle. Unless otherwise noted, opinions here are his and not the official views of GGWash or DCST.