
In the years following WWII, national governments directly funded and built social housing that was affordable for people with very low incomes. The policies, programs and funding that enabled the housing construction have been discontinued, even while the need for that housing grew and continues to grow. In the spirit of advancing a discussion about how governments could once again build social housing that is affordable for people with very low incomes, this post looks at how rental housing is financed and how it could be made affordable. It is intended an overview for people who are unfamiliar with the ins and outs of financing rental housing.
Financing rental housing
Any housing, rental or ownership, requires capital investment. This includes social housing. Capital investment is typically financed through loans and mortgages. Rental housing construction has different requirements than ownership housing construction.
The overall cost of rental housing construction can be described in four phases: pre-development, construction, rent up and operations. From a lender’s perspective, each phase also carries its own risks, which affects the interest rate that is charged, quite apart from the amount of money that is required.
Pre-development costs are small compared to the amount that will be required in the later phases. Pre-development, where permission is obtained to build, is also assessed as being high risk as there is no guarantee that anything will get built at all.
The construction phase includes the cost of materials and labour required to take the building from an idea to something that people can live in. Someone pays for the building to be constructed. The cost of borrowing in this phase is affected by the fact that although large sums of money are being spent, the product has little value until it is completed. Part of the cost of borrowing is also down to issues that can’t be controlled while construction is underway. The discovery of buried historic artifacts, adverse weather, and labour disruptions are examples. These issues affect construction borrowing costs regardless of whether it will be ownership or rental housing.
The interest rates for constructing rental housing are also higher than ownership housing. The argument goes that rental housing is being built on a speculative basis, with no confirmation that people will move in, whereas developers borrowing to build ownership housing can demonstrate intent through deposits from secured buyers.
The rent up phase is about the gap between the building’s actual revenue from rents and potential revenue for any units that are vacant. In ownership housing, this gap is transferred to the people purchasing the units.
In the operations phase, long term funding is secured to pay for all of the short term costs that went into the earlier phases. With construction completed, although the total amount to be borrowed is high, the cost of borrowing is less than in the earlier phases.
Bringing down the cost of financing rental housing
There are essentially two ways to reduce the cost of financing rental housing: reducing the amount that will require long term financing, and reducing the cost of borrowing. Any of these can be used for all rental housing, including social housing.
Keeping the costs down
If land costs can be minimized, the long term financing for a building will be significantly lower. One way to do this is to build on land that is provided on a long term lease at a nominal cost ($1 per year is not without precedent). This savings depends on landowners who are willing to accept a discounted rent for the land. Examples of sites that have been used are owned by agencies and charities with social missions. Government land can also be used, provided there is a favourable policy environment. Two examples in British Columbia are discussed on pages 45-48 of this report from the Canadian Housing Policy Roundtable: Promising Practices In Affordable Housing: Evolution And Innovation In BC And Quebec
Construction costs can also be reduced using modular construction, where components of buildings are constructed off site and indoors. Final assembly takes place at the site. Site preparation takes place at the same time as building construction. Each of these strategies shorten the construction time and minimize weather delays, translating to lower capital costs to be financed in the long term.1
A third strategy is to use up-front contributions through granting programs. These can contribute to any phase of the development process. Grants from charitable foundations are one example. Governments also operate grants programs, either by providing direct funding or by waiving costs that they would normally expect to collect. The amount of a grant can be the full capital cost of a housing development, as was done in the early days of public housing in the United States.2
A fourth strategy is sweat equity, which reduces the cost of construction through donated labour. Habitat for Humanity has used this strategy successfully for many years and has to adapted it to complement manufactured home developments. There is also a long history of sweat equity construction in Uruguay, where the completed buildings are operated as co-operatives.3
Lowering the cost of borrowing
Here are three examples of ways to reduce the interest rate charged while the loan or mortgage is repaid. They do not represent the full range of strategies. Any could be used in social housing developments.
One strategy is to reduce the risk associated with the investment, through some form of guarantee. Foundations and governments are common sources of guarantees. The guarantees need to be tailored to minimize unintended consequences. For example, government guarantees of this type have recently been associated with shoddy construction in the help to buy program in England.4
The second is to support long-term financing through government borrowing. Governments can borrow at lower interest rates and for longer terms than a community agency or charity.
A third strategy is to borrow from lenders with modest income expectations. Examples include community foundations, and lending institutions with a social mission.
How much difference will this make?
A specific example demonstrates how financing costs are affected by keeping the cost down and lowering the cost of borrowing. Assume that the starting amount to be financed is $200,000 over 35 years. At an interest rate of 5.5%, the monthly payment is $1,065.92. In the case of keeping the cost down, if the amount to be financed goes down to $175,000, with the interest rate constant, the monthly payment drops to $932.68. In the case of reducing the interest rate, if the interest rate drops one per cent to 4.5%, the monthly payment drops to $941.37. When the amount to be borrowed and the interest rate are both reduced, the monthly payment lowers to $823.69.
This hypothetical example demonstrates how the monthly payment that would need to be charged to pay for long term financing would be affected. It’s still a long way from being affordable for a household earning $30,000/year, where 30% of income translates to $750 per month, and social assistance amounts, which are even lower.
What does this have to do with social housing?
There is plenty of evidence that many people with very low or no incomes are housing cost burdened in the US, the UK, Canada and other countries. This is even before speaking about the people who are homeless.
This post addresses one component of rent: the cost of long term financing, which is a key cost in social housing. It also demonstrates the size of the challenge in achieving affordable rent levels for people with very low or no income. Yet, we need to find the ways to do this (social or otherwise) and we need a lot more of it than we’ve been producing recently.5
All of the strategies discussed above have been used to build social housing and could be used again in the future. It is worthwhile to reconsider them. Some have been recently tested and show promise. This report from Joseph Rowntree Foundation suggests further ideas: Innovative Financing Of Affordable Housing
Footnotes
- Here’s an example in Vancouver that was reported in Daily Hive: This Vancouver Social Housing Took Just 2 Months To Build
- See sections 9 and 11 of the United States National Housing Act of 1937
- See P2P Foundation: Sweat Equity
- Try: How UK Housing Assistance Creates Ugly, Dodgy Investments
- ‘We’ refers to the global ‘we’ — country, state, city, community and residents.