Blog Costs

Sharpening the Pencil: How Smart Policy Can Reduce the High Cost of Homebuilding

January 22, 2024

How much does it cost to build new housing? And are these costs aligned with what the market will bear for rents, or broad goals of housing affordability? 

In the world of housing contractors and developers, the term for a new housing development that can charge rents that are reasonable to the typical renter is known as “penciling:” If a project “doesn’t pencil,” that means the costs of construction are higher than can be recouped in rent – and nothing gets built at all. 

Because of this dependent relationship between market rents and construction costs, understanding housing finance is critical to making good housing policy. This updated Terner Center report, Making It Pencil (2023), illuminates how developers decide whether or not to build new apartment buildings by explaining the basics of housing development and finance, paying particular attention to the ways public policy can affect a housing project’s financial feasibility.

Key Takeaways

  • Understanding housing development finance is key to making good housing policy.
  • Changes in the California housing development market—rising construction costs, stagnant rents, high interest rates, and stricter financial requirements—have made new midrise residential development financially infeasible.
  • Public policymakers control many of the factors that influence developer decision-making around the financial feasibility of new housing construction, and better policy could make more new homes financially feasible.

To examine the financial feasibility of new market rate housing, researchers constructed mock financial analyses of a new 120-unit mid-rise “five over one” housing development in four urban areas: the East Bay, the South Bay, Sacramento, and the westside of Los Angeles.

The models relied on a set of fairly optimistic assumptions: the projects would not be required to complete an environmental impact report or provide affordable housing. The site would not require demolition of an existing structure, environmental remediation of contaminated soil, or infrastructure upgrades. Parking requirements were limited to one space per apartment. Impact fees would be limited to $40,000 for each home.

Even under these relatively favorable conditions, none of the projects made financial sense to build. In every case, investors would be better off buying an already-existing apartment building than building a new one.

The researchers then looked at a few ways policy changes could help make new housing financially feasible. They found that by lowering total impact fees to $10,000 per apartment, reducing parking requirements to 0.25 spaces per home, and allowing 25% additional density, policymakers can get projects much closer to penciling.

Leaving aside the specific California development scenarios, the report is an excellent introduction to real estate finance for policymakers because it explains fairly abstruse concepts in the clear, accessible language we have come to expect from the Terner center.