Financing the development of housing is complex, and financing affordable housing development is even more complicated. It requires significant subsidy to ensure that rents can be maintained at affordable levels.
The major components of cost are shown in the chart below, which is illustrative of a conceptual composite of development in San Jose and is not meant to represent a specific project. As you can see, the most significant of the cost components is materials and labor (hard construction).
A developer of ownership housing determines feasibility based on whether anticipated sales prices will cover all of these costs. A rental housing developer looks at whether rents are sufficient to meet mortgage payments plus pay for ongoing property management and maintenance. In both cases developers will build in a profit, typically 10-15% of the total cost of development.
A developer assumes significant risks when moving forward with a development project. An economic downturn after construction starts could render the projected sales prices or rents obsolete as demand for housing shrinks. With a for-sale project, a higher than expected increase in mortgage interest rates could mean that sales prices need to be lowered. The highest risk projects are high-rise condominiums.
The following are the primary components of the cost of development:
Land Costs – Land costs vary by location within Santa Clara County, and are generally higher in North and West County than in San Jose and South County. Even within San Jose, there is considerable difference in land prices, from $3.8 million per acre in the south and east parts of town and $12.8 million per acre in Downtown.
Hard Construction Costs – “Hard Construction Costs” include both materials and labor. The cost varies by the type of building being constructed, with steel or reinforced concrete framing required for higher-density buildings being more expensive per square foot than wood-frame construction allowed in lower-rise buildings. Buildings that have podium-style parking are more expensive than buildings with surface parking. High rises are the most expensive building type.
Labor costs are a significant cost factor. The boom in the employment sector, starting in mid-2009 following the Great Recession, has created shortages of construction labor. This amounts to about 60% of hard construction costs, making this component the most rapidly rising cost as of 2018.
Soft Costs – Developers must budget for “soft costs” in their development pro forma. In the predevelopment phase, such costs include: preparation of plans and environmental documents needed to apply for zoning permits and other discretionary land use entitlements; preparation of plans for obtaining building permits; and legal costs. During construction, such costs include: insurance; additional legal costs; marketing; and general management oversight.
Fees – Jurisdictions charge fees for reviewing entitlement and building permit processing. Typically fees or taxes are assessed to finance parks, streets, sewers, and other infrastructure needed to accommodate the new development. Some jurisdictions charge a Housing Impact Fee, though most have abandoned this practice in favor of inclusionary housing requirements.
Financing Costs – Developers typically do not take ownership of a project site until after land use entitlements are approved; in the meantime, they make “option” payments to the property owner to keep the land under contract. If the purchase is made using borrowed funds, that loan requires interest payments. All soft and hard costs are included in the construction loan, which also accrues interest. After construction and the development has mostly been rented, a permanent loan (or mortgage) pays off all previously incurred debt plus accumulated interest.
Housing development takes a considerable amount of time, with typical time between idea and move in of three to six years depending on the project’s complexity and other variables such as weather and environmental issues. Once the developer has secured an option to purchase the property, it takes six months or longer to draw up plans and prepare environmental studies before filing for zoning permits or other discretionary approvals. The entitlement process, where the developer receives zoning permits and other needed approvals, consumes another six to nine months. After approval, it takes another 12 months to prepare construction drawings, then another four to five months for building code compliance and review. Once construction starts, it will typically take 12 months for a low-rise building with surface parking, 18 months for a mid-rise wood-framed building on a concrete podium over parking, or 24 months for a steel- or concrete-framed high-rise building.
- Urban Institute: The cost of affordable housing: Does it pencil out?
- Terner Center: Construction Costs
- Terner Center: Development Fees and Taxes – General
- San José City Council Study Session: Local Development Fees and Taxes
- San José City Council Study Session: Project Feasibility
- San José City Council Staff Memo: Project Feasibility by Location