Scott Beyer's Three-part series on how to implement a free-market housing strategy in San Jose

Scott Beyer, Founder of the influential Market Urbanism Report and author of the widely respected book: Market Urbanism: A vision for free-market cities, is a leading proponent of classical liberal reforms to address the national housing crisis. In Part I of an exclusive 3-part series for Opportunity Now, Beyer begins his analysis of San Jose's current policies, and what needs to change.

America is experiencing a housing affordability crisis - particularly these last 2 years. A combo of easy money Fed policy and Covid-induced inventory shortages caused a 31% spike in the Case-Shiller Index, the highest ever over a 2-year span. 

But in San Jose the crisis came well beforehand, and it’s now the 2nd most-expensive U.S. city behind San Francisco. Its $1.44 million median home price is over 3 times the national median. The city’s average rent is $2,741, also well above the national median and ahead of peer cities like Phoenix and Las Vegas. At last count in 2019, nearly 7,000 residents were homeless.  

In this 3-part series, we discuss why San Jose became like this and what it has done to address the problem. In parts 1 and 2, we analyze government-driven supply-side and demand-side policies. “Supply-side policies” are defined as subsidies that various levels of government use to get more housing built, as to increase overall unit count (think low-income housing tax credits or affordable housing bonds). “Demand-side policies” are designed not to increase the supply of housing, but to cool prices and improve affordability for the units that already exist (think rent control or tenant rental assistance). In part 3, we describe market solutions that would be cheaper and more effective than both these supply-side and demand-side measures. 

The main reason San Jose - and the Bay Area - is unaffordable is its inventory shortage. According to Census figures crunched by Market Urbanism Report, San Jose had the 6th-lowest permitting rates of 20 large U.S. metros studied. It permitted housing at well below half the rate of famously affordable metros like Houston. 

Scott Beyer of the Market Urbanism Report continues his exclusive analysis of SJ Housing woes. In Part 1, Beyer examined the negative effects of the supply-side solutions that San Jose has implemented to address its affordable home crisis. “Supply-side” means taxpayer-funded subsidies that let governments increase overall home supply. In Part II, Beyer discusses San Jose’s demand-side policies, which have an even worse effect. “Demand-side” means efforts the city takes not to increase supply, but to manage demand for units that already exist. These include policies to cool prices, such as rent control and inclusionary zoning; and policies to help individuals better afford housing, such as rental assistance.

Rent Control and Inclusionary Zoning

San Jose’s rent stabilization policy has been in effect over 40 years. While there are exceptions to certain units, the policy generally prohibits multifamily housing built before September 7, 1979 from increasing rent by more than 5% annually. The rule applies to 38,421 units. 

But this has simply spiked rents in San Jose’s non-stabilized, market-rate units, causing a broad citywide increase. Year-over-year, rents went up 10.56% between 2021 and 2022; median rent for a 1-bedroom apartment has increased nearly 40% since 2015. 

Critics may argue that this simply means the policy has too many exemptions. But cities with broad ordinances have similar problems. In San Francisco, over 60% of all units are rent-restricted. According to the Brookings Institution, the result of expanded rent caps was a 15% increase in conversion to condominiums, resulting in less rental housing overall and higher rents. The Manhattan Institute had similar findings from Cambridge, MA; when rent control was expanded there in the 1970s, 10% of units subject to the policy were converted to condos.

In theory, rent control seems to attack the problem of high rent, and it might for those already living in the regulated units. But per the examples above, it increases rents for non-regulated units, and more crucially, discourages new home construction. In St. Paul, MN, for instance, new construction collapsed after rent control was authorized in 2021. 

Inclusionary zoning, while slightly different, is also a price control - what I’ve come to call Rent Control 2.0. It takes different forms, but the gist is that it requires certain percentages of newly built units to be set aside as affordable. Sometimes this happens as a voluntary measure, in exchange for upzonings. Other IZ policies, however, are mandatory for most or all new developments.

San Jose has a particularly stringent IZ law. According to the city’s website, the Inclusionary Housing Ordinance “requires all residential developers who create new, additional, or modified For-Sale or Rental units to provide 15% of housing on-site” that is affordable to households at or below area median income (specifications vary). Notably, the law faced a constitutional challenge in 2016. A building trade group claimed that the impact amounted to a burdensome government taking, but the state court ruled in favor of the city.

The literature on IZ’s impacts varies but doesn’t point to a meaningful increase in housing supply. Some studies find a negative impact on supply, including in California; the authors of that study cited a 20% increase in housing costs and 7% decrease in new construction, in markets which instituted “below-market housing mandates.” Research into local IZ policies throughout Baltimore-Washington did not find that it cooled construction but suggested that IZ drove prices up somewhat. A program in New York City, where some 17% of households are “cost-burdened,” produced only 2,888 affordable units from 2005 to 2013.

What’s more, set-aside mandates can and have been used by NIMBYs to delay or sabotage projects. San Jose residents need not look far for an example. Last year in San Francisco, a project that would add apartments on vacant lots near Market Street, and that had a large set-aside, was rejected because some officials claimed it still wasn’t affordable enough.  One supervisor argued all units should have been set aside. As a result, the land remains undeveloped.

Rental assistance

Rental assistance programs are another feature of San Jose’s demand-side approach. The city and county both have emergency rental assistance programs, and there’s a network of local non-profits offering similar help. The State of California as a whole provided rental assistance during the pandemic, hitting $1 billion in relief as of last September. This of course compliments Section 8 vouchers from the federal government.

Unlike rent control or IZ, rental assistance doesn’t discourage new development, and as affordable housing programs go, is better than many of the alternatives. But if it is not coupled with strong housing growth, it can inflate costs. That is because these subsidies get more cash circulating through the local economy; if all that cash is, however, chasing a relatively inelastic number of units, it will drive up their price.

Which gets to the heart of the problem: San Jose, and the larger Bay Area, simply doesn’t have enough housing, and it undermines the efficacy of the city, county, and state’s supply-side and demand-side policies. In part 3 we’ll discuss the free-market-based land-use reforms - many of them radical departures from the status quo - that are needed to fix this inventory shortage and make San Jose affordable. 

In the final installment of his exclusive three-part series about the local housing crisis, national housing expert Scott Beyer of the Market Urbanism Report explores the advantages of a strategy based on market forces. Previously, Beyer has examined how San Jose’s approach to fixing its affordable home crisis has included a mix of supply-side and demand-side subsidies, including tax credits, bond initiatives, rent control and more. Yet these policies have not prevented housing in the city and metro from being some of the nation’s least affordable. According to Beyer, the answer to increasing supply in San Jose is simple and largely cost-free to taxpayers: restore property rights and let the free market work. This means overturning certain laws that have now distorted land markets there.

Reform zoning, allow denser housing

The city’s zoning code, like many others in the U.S., mostly just allows single-family housing, which on average is less affordable than multifamily. In San Jose, according to the Mercury-News, 94% of the city is zoned exclusively for this. 

Upzoning, meaning allowing for denser construction and more units, creates affordable housing principally through a process called “downward filtering”. Simply put, as new housing comes onto the market, the competition causes older properties to depreciate in value, making them more affordable. This dynamic isn’t unique to housing; we see it with used vs. new cars. Conversely, if new car production were limited, the value of older cars would increase despite their age - “upward filtering”. The Bay Area is a case study in upward filtering; lack of home production is why even old buildings in poor condition have 7-figure sales prices.

Another thing multi-family construction accomplishes is to divide real estate project costs across more heads. For example if a single-family home is subdivided into a duplex, that means two households split the costs of the land, materials, insurance, taxes, et al. Subdivide the parcel into 4 or 6 or 8 units, and each unit becomes even more affordable due to this same economic dynamic. 

There have been recent pushes to remove San Jose’s single family zoning rules, as happened in Minneapolis, but they attract opposition. One alternative proposal calls for upzoning strictly along the city’s transit system. While better than nothing, this will not produce enough units to meet the city’s affordability goals. 

The main opposition is from homeowners. A common critique of multifamily upzonings is that they’ll lower property values, but research has found an inconclusive effect on property values. What instead happens is that land values increase, but because those values are being divided across more heads (in the process described above) per-unit costs go down.  

Other upzoning opponents include some affordable housing advocates, who argue that leaving development to the market does not produce affordability. Those claims are specious. We’ll remind readers of a chart shared in pt. 1 showing the obvious correlation between permit numbers and home price stabilization. San Jose and the larger Bay Area are now on the wrong end of that chart. 

We see examples overseas, too: Tokyo, a high-demand, dense city (population there has been growing, despite nationwide decline), has kept housing affordable throughout the last two decades by eliminating local zoning in favor of liberalized land use. 

Fortunately, California has taken one recent step to increase housing availability, by passing a bill legalizing accessory dwelling units (ADUs) by-right in most cases. San Jose itself introduced an amnesty program to legalize illegally-built ADUs that meet certain conditions. But broad citywide upzoning is ultimately necessary for the city’s new home supply to scale. And there’s a larger regime of restrictive rural zoning in Santa Clara County and other parts of the Bay Area that also prevent housing and need to be loosened. 

Curtail impact fees 

San Jose also imposes development impact fees. One such fee, discussed in part 1, is the city’s affordable housing impact fee, assessed on market-rate projects with greater than 2 but fewer than 20 units. This is used to finance affordable housing construction, costs developers $19.61 per square foot, and increases 2.4% annually. Developers also must, depending on the project, pay fees for park expenses, rent mediation, and multi-family construction. 

Impact fees reduce home supply and create barriers for young aspiring homeowners, who must (especially throughout California) pay impact fees in the 5- or 6-figures. San Jose’s affordable housing fee is on the higher side, adding nearly $40,000 to a 2,000sqft home. The Sightline Institute notes that the fees have a particularly negative effect on ADUs: “as with any fee, an impact fee creates a stronger disincentive the smaller the budget, because it piles on a larger percentage cost increase.”

We propose that San Jose scrap its fees and instead raise revenue through standard taxation. That way the city is getting all households to fund services, rather than sticking the bill disproportionately on new homebuyers. 

Reduce bureaucracy 

Along with zoning, rent control, impact fees, and other regulations, new housing in San Jose is stifled by a larger “process” that emanates through city, county and state government.

Getting a permit is challenging in the city, as reported by San Jose Spotlight, because there are lots of rules and not enough planning department staffers, creating a long lead time between applications and a decision. Other bureaucratic inertia, such as parking minimums, historic preservation rules and design review, add to the time and costs of approval.

One notorious rule impacting the whole state is the Environmental Quality Act, or CEQA. The law provides broad latitude for individuals to litigate against development projects for alleged environmental harm. CEQA has been shown to slow housing construction statewide, particularly urban infill units (which is ironic given CEQA’s stated environmental goals). As Christopher Elmendorf writes, while there are exemptions to the rule, they are hard to attain. “[A] developer hoping to qualify for the ‘Infill Housing in Urbanized Areas near Transit’ exemption must satisfy no fewer than 27 distinct conditions.”

This played out in nearby Santa Clara when a 162-unit senior housing complex ran up against litigious NIMBYs who brought a CEQA case against it. They lost that case, but because of the decade-long delay, the entire project’s financing was compromised.

The true shame of San Jose’s housing policy - which is echoed (generally to a lesser degree) across the U.S. - is just how self-conflicting it is. City, county and state regulations make it expensive or impossible to build housing in most areas. When this causes a supply shortage and affordability crunch, taxpayers are forced to fund subsidy programs that further inflate the market without adding much housing (due to the regulations in place). 

It doesn’t need to be this way. A good first step would be for San Jose to authorize a broad upzoning - say, by allowing fourplexes by-right citywide, as some staffers have proposed. Then it can cut other regulations like parking minimums and inclusionary housing set-asides. This should spur fairly immediate new production that has the long-term effect of cooling prices. If it can work in other U.S. cities like Houston and Phoenix, it should work in San Jose. 

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