Free market image from Shutterstock.

On Wednesday, we discussed what’s wrong with the notion that supply and demand don’t apply to housing. But on the other end of the spectrum, a free-market approach isn’t the whole answer to housing affordability, either.

Some people (on the left) oppose new market-rate housing development. They claim that new development only provides high-end housing, which doesn’t do anything to help the supply of more affordable options.

Others with a more libertarian view (a more right-leaning view in our region) claim that if we get rid of all zoning regulations, the free market will take care of it and build housing for everyone.

Both arguments are wrong.

Yes, adding more housing must absolutely be a part of the strategy to make housing more affordable. And zoning changes to allow people to build taller and more usable space near transit, rent out carriage houses, and avoid expensive and often-unnecessary parking are all steps in the right direction. But some proponents go on to say relaxing zoning will solve the problem all on its own. It won’t.

The free market will only build housing for higher incomes

Even if cities roll back many land use regulations, squeeze down construction costs, and leverage new financing tools, the cost of building new housing won’t fall below a certain point.

Graph from McKinsey.

This report from McKinsey found that even if you take all of these steps together, it will only cut the gap between what housing costs and what people can afford to pay in half (assuming people spend 30% of their income on housing — a generally-recommended level).

A developer finances a new development by offering investors a return. If the return is higher than investing in something else, investors will finance the project. If the return is not high enough, especially given the risk, investors will put their money elsewhere and the housing simply doesn’t get built. Regulations add to development costs. The development review process also adds costs when projects get delayed or shrunk down, and it increases the risk.

The city’s baseline costs for But even without these costs a newly-constructed one-bedroom apartment in DC are over $2,000 a month to meet the level of return the market demands.

A person’s income has to be about $38 per hour, or $80,000, for this kind of rent to only take up 30%. If someone earns $15 an hour, or $32,000 a year, he or she can only afford an $800 apartment— or less than half of this level.

More density does not change the basic math

Even if land is free (which it’s not) and regulations offer unlimited density, buildings still cost money to build. And taller buildings cost more money per unit than short ones.

In the DC Office of Planning’s study on DC building heights, Anita Morrison, a principal with Partners for Economic Solutions, found that while regulations might reduce potential development, unlimited height and density is not the simple solution to affordability.

“Unlimited FAR [density measure Floor Area Ratio] is not the magic cure, because the cost of building with concrete and steel is much more per square foot than low-rise stick-built [wood frame] construction up to five or six stories,” Morrison explained.

To prove this point, Morrison offered an analysis of varying scenarios for a new apartment building. Assume a new building on a half-acre lot where the land price is set at zero (such as a deal to build on public land). Rent would be $1,127 for a one bedroom apartment, which is affordable to households making 60% of AMI ($51,600 per year). Is this building economical to build?

To find out, Morrison tested different heights ranging from 65 feet (six stories) to 250 feet (23 stories). The rent didn’t cover the cost of construction or meet the minimum return on investment in any of these cases.

The 65-foot building costs $168,000 per unit, while the costs for high-rise steel and concrete buildings of 130 to 250 feet are higher. The 200-foot building costs $241,000 per unit. Even if the building’s parking is above-ground (cheaper) rather than below-ground, the return only improves to 4.6 percent, “still nowhere close” the 7 percent required return on investment, according to Morrison.

Of course, most development projects include paying for land. The higher the zoning, the more valuable the land, so some of the gain also turns into higher land costs rather than lower housing costs.

What about “filtering”?

In response, free market advocates claim that “filtering” helps supply housing at rents below new construction. Instead of living in new buildings, poorer people can live in unrenovated older ones.

Like the argument about new market-rate housing, this is true, but only to a degree. It is true that increasing supply eases upward pressure on all prices. But the reservoir of naturally cheaper, older buildings runs out after a while.

When many people moved out of urban areas, a lot of buildings started decaying and so prices went down. Now that urban areas are popular again, in growing cities like DC, older buildings are a dwindling resource. New buildings won’t get old fast enough, and they won’t offer cheap-but-only-adequate places to live, to actually offer housing for the lower end of the income spectrum.

Old buildings need renovation. Even if they’re low-income housing, they still need repairs and rehabilitation—they may not need granite countertops, but the plumbing has to work well. Once a market-rate building in a growing neighborhood needs renovation, there’s enormous incentive just to go further and make the building higher-end to capture the higher rents or sell it as more expensive condos.

Take the 1400 block of W Street NW, just north of the booming epicenter of 14th & U Streets. Six nearly-identical apartment buildings line the southern side of the street. In 2000, all started out as unsubsidized market-rate, affordable rental apartment buildings, except 1424 W Street. The one exception was converted to a limited equity mixed-income cooperative in the early 1990s by the tenants. Today, two of the buildings are high-end market rate, while four are part of two affordable cooperatives.

Image from Bing.

During the early 2000s, all of these buildings changed hands and filtered up to a higher rent market. The three westernmost buildings, totaling 100 units, formed an affordable cooperative with financial help from the District government through the Tenant Opportunity to Purchase Act (TOPA), which lets a tenant group match a buyer’s offer. The buildings were renovated for $11 million, and many of the existing tenants were able to become owners.

Without direct intervention via TOPA the program and funding from the city, all of these old apartment buildings would be high-priced market rate housing today — despite the hundreds of new units being constructed on vacant lots adjacent to this block.

While there were some regulatory limits on construction, there was a lot of vacant land nearby at the time. Supply was not constrained by zoning, but rather by financing and property owners’ readiness to build. It’s hard to speculate that any amount of nearby new construction would have prevented these buildings from being renovated into high-end housing.

On a larger scale, the increased supply of housing in the area helps absorb demand for more housing, but it’s not enough to stem the demand for such a sought-after location. Between 2005 and 2011, the rental housing market’s growth added more than 12,500 units. But at the same time, $800/month apartments fell by half, while $1000/month rentals nearly doubled. Strong market demand will shrink the availability of low-priced units. That’s what has happened over the last decade as DC transformed from a declining city into a rapidly growing one.

Supply matters, but it’s not the whole story

Building more housing is important. But simply relaxing constraints on density and height isn’t enough to build and sustain a housing stock that’s affordable to the working class, which makes up a large share of our overall population and workforce.

We should roll back some of the regulatory delay and restrictions that do a lot more harm than good. We can reduce parking requirements, allow accessory apartments, increase height limits in a few parts of town, and fight for projects that will add housing, especially near existing transit.

At the same time, the District needs to find ways to create new affordable housing for people of making under 50-80% of AMI (a household of two earning up to $70,000) and preserve the affordable housing that already exists. The market will not meet those needs on its own.