California Misses The Target On Commercial Property

I won’t ever claim to be an expert in real estate; such a designation requires years of experience dealing with the challenges and opportunities (and many nuances) of the real estate market. But I do know that often, commercial real estate sits vacant for a long time. Empty store fronts and lots that are zoned for commercial use can frustrate neighbors and people who would like to see a housing use instead. Commercial use creates higher returns but carries complexities with that opportunity like difficulty landing a tenant. This problem was exacerbated by Covid-19’s impact on businesses of all sizes. The California legislature has made two new laws in an effort to make it easier to build housing on empty commercial lots, but as with other legislation, one hand of government gives while the other takes.

Before digging into the new California laws, Senate Bill 6 (SB 6)and Assembly Bill 2011 (AB11), it’s worth looking at why commercial properties can be problematic. There is a great tutorial online at Fortune Builders that points out the advantages and challenges of commercial and residential real estate. The same reasons that make commercial real estate more lucrative also make it more difficult to lease: a solid business tenant can generate long term cash flow, but businesses can take longer to make the commitment. Larger chain stores, for example, need corporate approval. Many businesses have unique demands of space and location, including things like kitchens. And the longer-term commitment means more consideration is often needed before signing a deal. Add in a global pandemic and changes in work practices and customer expectations, and it’s easy to see why some commercial properties have sat vacant, maybe even adding to visual blight.

It makes a lot of sense, then, to consider activating these sorts of properties for housing use, especially if some properties may not ever return to commercial use. This is ever truer when housing demand is pressing limited supply boosting prices. Without too much thought, my first idea would be to allow these properties to be fast tracked through the process – maybe skipping zoning process altogether – and just turned into housing use. That’s exactly what SB 6 and AB 11 aim to do, allow commercial properties to be turned into housing without a lot of local hassles from zoning codes or city councils. But do the bills deliver?

There is a very succinct and useful summary of each bill by law firm Holland Knight which advises real estate clients. Here’s their summary of HB 6:

“California Senate Bill (SB) 6 of 2022 does not provide a ministerial approval pathway, but does allow residential use on commercially zoned property without requiring a rezoning. To invoke the law, however, applicants must commit both to prevailing wages for workers and to ‘skilled and trained workforce’ requirements.”

Sorry. That sound you heard is my hand slapping my forehead followed by a sigh. You might remember my criticism of prevailing wage requirements in Low Income Housing Tax Credit (LIHTC) projects. There is nothing wrong, in my view, as a matter of policy, to subsidize almost anything. Paying more wages and training more workers is obviously a benefit. But it is also a cost, and often a big cost. I had real life experience back in 2010 when the federal government went green in a big way funding lots of energy efficiency rehabs. The problem was that they included wage requirements that ate away the long-term energy savings that would have paid for the improvements in the first place. Similarly, removing zoning barriers saves time and money, but if high labor costs and other labor requirements erase those savings, then housing becomes less feasible or more expensive.

Let’s look at Holland Knight’s summary of AB 11.

“California Assembly Bill (AB) 2011 of 2022 provides a streamlined ministerial approval pathway, comparable to SB 35 of 2017, for qualifying multifamily projects on commercial zoned land that prevailing wages and meet specified affordable housing targets. The legislation provides two distinct options for eligibility: one where construction is paid for by for 100 percent Below Market Rate (BMR) projects located on commercial zoned land, and a second for mixed-income (typically 15 percent BMR) projects located on ‘commercial corridors.’ Eligibility is further limited by numerous site and project criteria requiring careful review.”

There’s that sound again. Sorry. All those requirements sound complicated, don’t they? Go back and take a quick look at my posts on entitlement and permitting. Anyone who has built housing in the United States will likely roll their eyes at the phrase “further limited by numerous site and project criteria requiring careful review.” Those include environmental review, a treacherous process in California. Again, the California legislature couldn’t resist imposing requirements with one hand that likely offset the benefits they granted with their other hand. It’s impossible to know whether any new housing will happen with these additional requirements but keep in mind “affordable” housing means limits on income and more reviews means more costs. Making a project work with one or both on a commercial property is a difficult puzzle to put together.

The lesson here is the same one for California’s efforts to reduce local regulation on residential zoning requirements (see my closer look at residential legislation): reducing requirements while adding more isn’t really reducing requirements. Politicians and interest groups like labor, find it next to impossible to let go of the process even while acknowledging that rules add costs that reduce returns to the point that projects won’t work. This split personality in California isn’t unique but is endemic across the country. We have a long way to go conceptually to build enough public support for simply getting out of the way and letting housing happen.