Not many good options are available to solve a stubborn problem.
Today’s studio apartment rent is yesterday’s home mortgage payment and there is a new generation of Californians for whom their downscaled American dream is simply to move out of their parent’s house or not have to share a flat with three roommates. What, you may ask, is the solution?
Option 1: Do Nothing and Wait
Ironically, a solution tends to be created automatically in cities like Los Angeles and San Francisco when homelessness, crime, the Work from Home movement and other societal factors are added to the already problematic rents and people are driven to look elsewhere to live and work. Business and building owners will go belly-up and the new fire-sale replacement landlords will have lower operational costs which are guaranteed to translate to lower rents. Most would agree, though, widespread financial collapse has many negative carryover effects, including societal destabilization, lower property values, an increase in vandalism, and a hard-to-reverse inertia to move out of such neighborhoods rather than into them.
Option 2: Enact Rent Stabilization Ordinances
While likely considered with the best of intentions, laws passed to limit rent increases, while protecting current renters, work against addressing housing demand by discouraging new market rate apartment construction.
A quick look at the numbers behind a typical ground-up apartment development project, at current lending rates, reveals a surprising secret: The return on investment is often not sufficiently higher than what are considered zero-risk investments to make them worth the risk to build. This leaves a viable market only for high-rent luxury apartments or income-qualified apartments subsidized with government grants or tax incentives. Apartments serving middle-income renters are stuck in a vicious cycle–too costly to build more of them and potentially too costly to properly repair and renovate in cities where rent controls are voted in. Rent controls, while blocking the occasional incidence of genuine landlord greed, are also a huge disincentive to new construction. New buildings will not compete with rent controlled buildings, they simply will not be built.
Just before the pandemic, the cost to build a new “market-rate” rental apartment building in Mid-City Los Angeles was hovering around, say, $450,000 per apartment unit including all the associated parking and site infrastructure, consultant fees, interim financing, permit fees, and land purchase costs. Financing 70% of that cost at 2020 interest rates on a 30-year loan resulted in a mortgage payment of about $1600 per month not yet adding on the cost of vacancies, property management, landlord-paid utilities, or taxes. When adding these in, an analysis of a recent project showed the expected return on investment to be about on par with a 3.5% 10-year U.S. Treasury Note, but at much higher risk. Current loan interest rates add about $350 per month to the above costs, which are either passed through as higher rents or become a block to building such a project at all.
Option 3: Everyone Takes the Bitter Pill to Lower Overall Inflation
While there are many economic theories on the cause of overall U.S. inflation, arguably the most convincing one is that we Americans can’t resist printing money we don’t actually have as a solution to our ills. As many countries are now resisting the U.S. dollar’s historical role as the default instrument of international trade, our already high U.S. price inflation risks soon becoming hyperinflation. The bitter pill, if we take it, will be to actually live within our means, no longer funding a giant military, a giant government bureaucracy, and many paid social benefits unless we are willing to tax ourselves more for these. This will be an important debate for all Americans which I hope we do take on before it’s too late.
Should we successfully reduce inflation to a low baseline without destroying the economy, the price rise of commodities such as land and building construction materials, the cornerstone of the real estate development costs driving the high rents, will also go down. As rents and other household budget costs become more affordable, so will the cost of local construction labor, creating a virtuous cycle.
Option 4: Prioritize Low Price by Building Cheap, Fast (and Maybe Shoddy)
One way to drive lower rents is to build as cheaply as possible and continue to rent these buildings out long after they are past their prime. Cheap commercial construction, using the lowest quality materials, is only good to last about 20 to 30 years without serious degradation. In California, these buildings usually remain occupied 60 years and counting, leaving no opportune time to demolish and replace without incurring an intolerable gap in rental income. Where such buildings stand, the clock starts ticking on a slow, block-by-block countdown to semi-slumhood. Ultimately renters get to vote with their dollars on how appealing this option is, but neighbors, who might not get a say, are forced to forever tolerate this sort of low-quality and eventually deteriorated building stock to serve as the creaky fabric of their city.
Option 5: Build More Housing Stock as Quickly as Possible to Approach Supply/Demand Parity
This is by far the best option to combat high rents, but concerns about increased traffic, rampant NIMBYism, and a statewide regulatory legacy of being development-restrictive makes this difficult to pull of in practice. In much of California, there is a popular culture of aspiring to low-density and detached one to two-story single family dwellings, which makes it very hard to break the mold.
A second stubborn headwind to this approach are the limited pool of builders who in turn hire a workforce who can only commute so far. Such a limitation has the effect of bidding up baseline costs which, again for market-rate apartments, tends to self-limit the quantity of construction projects at any given time.
The best bet is likely to be the creation of apartments through the conversion of existing sites zoned for commercial uses, such as office buildings, and retail stores, as these legacy uses continue to diminish. An excellent grassroots proposal is the Livable Communities Initiative which seeks to develop walkable and neighborhood-friendly medium density residential uses above existing commercial ones.
Option 6: Create Price Competition by Expanding the Building Construction Supplier Base
The U.S. construction industry has been surprisingly timid about the adoption of new, potentially cheaper, fabrication technologies and I think I know the reason why. Because it can. Being limited in time and space to a particular locale, construction is traditionally done almost fully on-site and thus inherently limited in labor supply. At least when an economy is healthy, this reality limits competition, maximizes profits, and dampens innovation.
As mentioned in a previous post, I founded the building fabrication company Inhabio in 2022 and, with Co-CEO Andre Bueno, we are together attempting to disrupt the local construction cost paradigm. The process works like this: Synchronis conceptualizes, designs and engineers a building locally, in a modularized, systemized manner. If buildings can be likened to a pizza, Inhabio bakes and delivers the “pizza,” slice by slice, from an out-of-market location where currency exchange rates strongly favor the U.S. dollar. By being vertically integrated and arbitraging currency exchange rates, the retail cost, including shipping and installation, is expected to total about 20% less than the lowest current local construction costs, while adding the benefit of using long-life steel and concrete materials instead of wood. The use of factory robotics will further allow economies of scale so that fabrication may also occur in high labor-cost regions such as the U.S. should currency exchange rates change drastically.
Extrapolating back to the above cost model driving high rents, the lower construction costs of Inhabio’s system translates directly to an average of almost $400 per month per unit in rent reduction if all other factors remained the same. Sound good? Root for us if it does. More good news coming soon as we rollout our first installations.