Missing Middle Executive Summary
One of the major policy shifts in the 2040 draft General Plan is a material up-zoning of low-density residential (LDR) land uses, increasing from 1 unit per acre to 5 per acre.
The 2040 General Plan makes no mention as to whether the “missing middle housing” must be affordable housing or simply market rate housing.
“Missing middle housing” is missing not because of restrictive zoning laws but rather because affordable housing cannot be economically developed on LDR lots
What is the social benefit being gained by the Town up-zoning all LDR land in existing neighborhoods, especially now that SB 9 has been signed into law?
After deducting the projected costs and profit from the development’s expected sale price, we are left with how much the developer can afford to spend on land. This amount is called “residual land value” and it plays an important role in determining what gets redeveloped
At the moderate- income level for a three-person household, the allowable housing sales price would be approximately $500,000. By comparison, in October 2021 the median sales price in Los Gatos was approximately $2,425,000
The proposed changes do not appear to come close to delivering the desired benefit of producing affordable “missing middle housing”
Developers will always develop land to its highest and best use.
The Town should not up-zone all LDR land uses but rather rely upon the newly passed SB 9 to drive the development of affordable housing in LDR land uses.
Will Missing Middle Housing Ever get Built on Redeveloped Low Density Residential Land?
One of the major policy shifts in the 2040 draft General Plan is a material up-zoning of low-density residential (LDR) land uses. The current 2020 General Plan allows for a LDR density range from 1 to 5 dwelling units per acre while the 2040 draft General Plan increases these densities from 1 to 12 dwelling units per acre. This is a 3x increase in density.
On a typical 10,000 square foot lot (.230 acre), this up-zoning would allow for 2 units (.230 x 12) to be developed where currently only 1 unit (.230 x 5) is allowed.
The density increase is being proposed to allow the development of “missing middle housing” through standard zoning or through a planned development agreement with the Town. It should also be pointed out that the 2040 General Plan makes no mention as to whether the “missing middle housing” must be affordable housing or simply market rate housing. Please refer to Figure 3-5 of the 2040 General Plan for an illustration of “missing middle housing” that potentially could be developed on a typical Town block.
The question is, given the very high land costs of existing residential lots in the Town, can “missing middle housing” be developed economically, and would it be “affordable housing”? If, upon analysis the “missing middle housing” is missing not because of restrictive zoning laws but rather because affordable housing cannot be economically developed on LDR lots, then what is the social benefit being gained by the Town up-zoning all LDR land in existing neighborhoods, especially now that SB 9 has been signed into law?
The economics of redevelopment – residual land cost
In a built city such as Los Gatos, where nearly every parcel already has some building of improvement or use on it, new buildings come as redevelopment. A developer’s decision to demolish and replace an existing building involves many considerations, such as how much it would cost to purchase the lot, the cost to demolish and replace the building, and how much revenue a new structure would generate.
In making the determination of what gets developed, a developer has an idea of what to build, how much it will cost to develop, how much it will sell or rent for, and how much profit will be needed to attract investors. After deducting the projected costs and profit from the development’s expected sale price, we are left with how much the developer can afford to spend on land. This amount is called “residual land value” and it plays an important role in determining what gets redeveloped. If the actual cost to purchase the land exceeds the projected “residual land value” of the planned project, the redevelopment will not occur.
Can affordable Missing Middle Housing be developed?
Let’s return to Figure 3-5 and examine the development economics of “C”, which shows the redevelopment of an older single-family lot home on a typical 10,000 sq. ft. parcel into a stacked duplex. Let’s assume that the target buyer of a stacked duplex is a younger family of 3, earning $112,700 which is a moderate level of income (80 to 100 percent of median area income (AMI)). As reported on page 23 of the Land Use Alternative Report, at the moderate- income level for a three-person household, the allowable housing sales price would be approximately $500,000. By comparison, in October 2021 the median sales price in Los Gatos was approximately $2,425,000 or approximately $1,100 per sq. ft.
Let’s assume the existing house and lot can be acquired for $2,00,000 with the older home being demolished and replaced by the duplex (net gain of 1 housing unit). Since by design “missing middle housing” is smaller housing, let’s assume the new duplex will be 2 units, each approximately 1,200 sq ft consisting of 2 bedrooms and 2 bathrooms. The cost to build the duplex will run approximately $300 per sq. ft or $720,000 ($300 x 2,400 sq ft). Additionally, the developer will require a minimum of 20% of the total sales price for fees, interest, and profit. This would total $200,000. Putting this together, we can compute the “residual land cost” for this project as:
Allowable Sales Price of 2 units $1,000,000
Less: Development Costs $720,000
Less: Fees, Interest and Profit $200,000
Residual Land Cost $80,000
Since the cost to acquire the land is $2,00,000, it is uneconomical for a developer to redevelop the lot into affordable “missing middles housing” since the actual cost of the land far exceeds the residual land costs. Even if the land cost was one half the prevailing land costs, “C” still would not be a viable project. Purchase prices for development of land parcels are determined by the “residual value” that remains after all costs of development, construction, fees, interest, and profit are deducted from expected total sales price.
Developers will always develop land to its highest and best use. Given the example above, what would the market rate sales price have to be for a duplex to be developed using the same assumptions? If we back solve for the sales price, this is what we get:
Land cost to acquire $2,000,000
Plus: Development costs $720,000
Plus: Fees, Interest and Profit $680,000
Total Sales Price of 2 units $3,400,000
At a total sales price of $3,400,000 which is $1,700,000 per unit the project would be “viable”, only if a buyer could be found at that sales price. Since there are many choices in housing, a buyer for our duplex would naturally look at alternative housing. At a sale price of $1,700,000, the duplex’s purchase cost would be $1,417 per sq. ft. Are there other housing alternatives that could be acquired at a cost less than $1,417 and be a close substitute for the duplex unit?
The answer is yes, and the alternative housing can be found at the N40. A 2 bedroom, 2 bath town home which is approximately 1,500 sq ft. can be acquired for $1,598,000 or approximately $1,065 per sq. ft. This would suggest that the maximum price the duplex can capture in the market is $2,556,000 (2,400 sq ft x $1,065). At that sales price, the “residual land value” can be computed as follows:
Market rate sales price for 2 units $2,556,000
Less: Development costs $720,000
Less: Fees, Interest and Profit $511,200
Residual Land Cost $1,324,800
Since the purchase price of the land exceeds the residual land cost, even at market rates, a duplex will not be developed. Again, the reason for this is not because of zoning laws but rather because of the high cost of land.
Conclusion
It is a fair question to ask whether the policy of up-zoning all LDR land uses and supporting smaller, less expensive units within existing LDR neighborhoods will deliver the desired result of redeveloping existing lots with affordable “missing middle housing”. Because this is not a zoning issue but rather a land cost issue, it appears that “missing middle housing” is only viable where land costs are considerably less, which cannot be found in LDR existing neighborhoods.
While homeowners in an existing neighborhood may not have a right to keep their entire neighborhood zoned as low density (given the social and economic costs of limiting multifamily housing) they did after all buy into a single-family neighborhood and deserve fair and reasonable consideration for any changes in zoning laws. Given that the proposed changes do not appear to come close to delivering the desired benefit of producing affordable “missing middle housing”, it is hard to understand the reason for proposing such zoning changes.
In conclusion, the Town should not up-zone all LDR land uses but rather rely upon the newly passed SB 9 to drive the development of affordable housing in LDR land uses.
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