We’re going to be spending a lot of time this week looking at whether the upzones proposed as part of the so called Grand Bargain on housing actually add value to projects. Intuitively, I think the Grand Bargain isn’t feasible financially. New square footage comes at a cost and so do rent restrictions. My guess is that the additonal revenue or value created by the new square footage doesn’t offset those costs. The Grand Bargain ignores a basic principle of economics, that when you add cost to the production of something that will be sold in a market it will go up in price since the sale price is the only way to recover the additional costs. Our early look at the numbers shows that the costs of Grand Bargain’s mandatory upzones and inclusion of rent controlled units aren’t offset by the value they create.

There will be lots of numbers we’ll be kicking around. I suggest the feature video above as a way to prepare for our discussion. The video elegantly describes how money works in rental projects. New square footage creates an additional construction cost and rent restrictions limit revenue in the new square footage. Here are some of the questions we’ll be asking as we look at how the Grand Bargain plays out in neighborhood zones.

• What impact do added construction costs have on the bottom line, NOI and cash flow?
• How much additional revenue is generated by new units and what effect does additional revenue have?
• What happens to NOI and cash flow if new revenue is less than additional costs?
• Since the NOI and cash flow is the basis upon which money can be borrowed for a project, what impact would lower NOI and cash flow have on loans?
• Can rents be dialed up to offset costs?
• What if increased rents also increase vacancies because they’re higher than comparable housing? What effect would those higher vacancies impact NOI and cash when seeking a loan?
• How will changes in NOI and cash flow impact the Debt Coverage Ratio (DCR) for financing.

The video doesn’t account for construction costs, but it does show the delicate balance between the various elements of an operating budget for rental properties and how they impact NOI.

Gross Rent [Scheduled]
(Vacancy Reserve)
__________________
= Gross Rent [Adjusted]
(Maintenance)
(Management)
(Property Taxes)
(Landlord Insurance)
(Other — Utilities, HOA, etc)
___________________

=Net Operating Income [NOI]
(Capital Expense Reserve)
___________________

Cash Flow from Operations [CFO]

The real problem for the Grand Bargain is what it ends up doing to that NOI and CFO line in a pro forma. If the added costs end lowering NOI and rents can’t be raised enough to offset that impact then it will impact whether the project can get financing. Most lenders expect a ration of NOI to borrowed money to be $1.20 of NOI to every dollar of debt service. When NOI drops the DCR does too from the minimum required by most lenders and investors. That lowered ratio can kill a project.

Here’s a tutorial on how a DCR is calculated.

If the upzones raise costs and additional rents or raised rents can’t offset those costs, then the project can’t get necessary financing, whether from a borrower or investor. That means the project doesn’t happen. 

This creates a the need for a legal challenge because forcing projects to lose money is fundamentally against State law, specifically Chapter 82.02 of the Revised Code of Washington (RCW). There is a paper from a few years ago that highlights the legal hazards of mandatory and voluntary programs that aren’t fair.

We’re going to analyze the proposal looking at the economic impact and how it affects the basic math that determines whether a project can get needed loans or investment. If the Grand Bargain kills projects it is not only counter to its stated intent of creating more affordable housing, but would likely be illegal. We may need to go back to the drawing board and use the principles of good housing policy we’ve already mapped out.