Thursday, April 30, 2009

Green Building Economics 102: Affordable Green Housing

The key takeaways from my last post on green economics is that green building is more valuable and many people are willing to pay more for green buildings. This is great for the high-end of the market, but what does this mean for affordable housing? Obviously if green housing is more valuable, i.e. more expensive, this means green housing might be less affordable for potential buyers. How can we balance the need to keep green housing affordable with the green economics I presented last time? That is the focus of my post today.

(In this post, I will make the assumption that affordable housing is owned by the occupant. Of course, this is not always the case, but this simplifying assumption doesn’t actually change the underlying economics and makes it easier to write this post. If you are interested in how this would apply to renters, please email me and I would be happy to talk with you.)

Affordable housing in China
In China, as elsewhere, “affordable housing” usually means keeping upfront cost as low as possible. A pillar of China’s affordable housing program has been government subsidized development of affordable housing under the 经济适用房 or “Economical and Comfortable Housing” program. This program consists of a combination of subsidies in the form of land grants and reduced taxes and caps on developer profits to keep upfront prices low. For more info on this policy, see this Harvard Joint Center on Housing Study report (PDF). Although I am not an affordable housing expert, this program seems to have been pretty effective in creating affordable housing: in 2003, for example, Economical and Comfortable Housing accounted for nearly a quarter of all housing units sold in Beijing. Despite these successes, China still does not have enough affordable housing to satisfy its lower- and middle-class populations and the government is trying hard to fix this situation. The government is embarking on the construction of 7.5 million affordable urban homes between now and 2011, and an additional 2.4 million affordable rural homes.

On the surface, this approach of minimizing upfront costs makes sense. Certainly, those less well-off will have less ability to save and purchase homes. So subsidization means that more families are able to afford the down payments needed for these home. However, this narrow focus on upfront cost ignores any element of lifecycle costs. In many cases, the cheaper upfront option is actually much more expensive over its lifecycle, and in some cases, significantly more expensive.

In the case of this affordable housing program, I suspect that something like this happens: the developer designs the building one way and convinces the authorities to allocate his pre-determined profit margin based on those estimated costs. When it comes time for construction, the developer then has an incentive to cut as many corners as possible in order to reduce costs and max out profit. This is certainly a skeptical view, but given the compliance rates I showed in a recent post, this is unfortunately a likely reality.

The result? In most cases, the developer uses cheaper insulation and poorer insulating materials. The developer then sells off the property and washes his hands of any responsibility for the long-term operating costs of the building. The new owners, who were ostensibly buying this home because it was affordable, are now saddled with an energy inefficient home. Every year for the life of the building, the new owners will have to pay more in utility costs. Moreover, when it comes time to sell, what do you think will happen to the value of this home? That’s right, it will have depreciated greatly thanks to poor quality and high energy bills. So as we can see, even though this home was cheaper upfront, it carries a much larger lifetime cost. Who could call this affordable?

What does affordable really mean?

In order to properly define affordable, we must move beyond this narrow definition of affordability and consider total cost of ownership (TCO). TCO measures how much it costs to occupy a house or apartment annually, and includes everything from rent (or mortgage) to utilities, maintenance and taxes and can even include transit fees related to daily commute. Using this definition, homes with lower TCO are affordable, while homes with high TCO are not. After all, an avoided expense is just as good as money in the bank, in the sense that both increase a citizens ability to save and spend.

Total cost of ownership for green homes is lower

As I said in my post on green economics last week, it’s obvious that operating costs for green buildings are lower than comparable buildings. Therefore, it also makes sense that TCO for green homes should be lower than their energy-guzzling brown counterparts.

A recent study by Michelle Kuafmann, a green home guru in Northern California, confirms that TCO is lower for green homes. Even with a 3% cost premium for green features and the larger resulting mortgage, green homes still cost less, thanks to lower utility bills. Unfortunately, the increase in mortgage costs due to the green premium drowns out a lot of the utility bill savings, resulting in a pretty meager $2 in gross savings over the conventional building. (Note: Unlike the US, China does not have tax deductibility of mortgage interest, so ignore the net calculation here.)

But in fact, Kaufmann’s analysis understates the case for green building, at least in the US. As I mentioned before, insurance companies are offering lower insurance rates for green homes and some banks are offering lower interest rates. Most green homes focus on proximity to public transit, which means shorter commute times and less commuting expense compared to their sprawling brown counterparts. Furthermore, as energy and water prices rise in the future, this TCO case for green buildings will get even better.

How to get from here to there?

It’s clear that green homes have much lower TCO than their brown counterparts. But unfortunately, this doesn’t change the fact that green homes often cost more upfront. And although we should focus on TCO when analyzing affordability, this doesn’t mean we can totally ignore upfront cost. So how can we minimize TCO while keeping upfront cost low?

We can use two primary policy tools: incentive alignment and green financing.

First, government could and should require developers of affordable housing to have a long-term stake in the operating cost of the buildings. Government could set up a scheme whereby developers guaranteed some sort of typical level of energy costs for the residents. Any costs above this amount would be borne by the developer, and any savings below this amount would be split between the developer and the tenant. This would give the developer a big incentive not to cut corners and save energy over time. If government is interested in lowering TCO as they should be, this policy would be a useful lever to align the incentives of both developer and tenant.

Second, government should encourage banks to step up their green financing programs for customers to purchase green homes. Banks should offer a mix of lower interest rate “green loans” that will lower TCO further and also larger loans that will help reduce the upfront cost to purchasers. The mortgage is almost always the largest expense on a home and lower interest rates would further lower TCO. For example, let’s take another look at Michelle Kaufmann’s numbers. In the analysis below, I used the same figures but assumed the bank offered a 0.25% interest rate reduction for green homes. As you can see, this frees up significant savings, bringing the cost advantage for green from around $2 to nearly $87.

This type of green financing program is not unprecedented in China. The Chinese government has been using green loans to encourage other sectors to go green, but hasn’t done much for green financing of buildings, and nothing for green financing of affordable housing. Hopefully Chinese banks will expand this to individual customers, particular those in the lower- and middle-income brackets.

The future

Eventually, I think building a green home will actually cost less than building a conventional home. Zeta Communities, for example, is working on making pre-fabricated net-zero housing that costs less than standard brown housing. But until these cost breakthroughs occur and green buildings are superior on both total cost of ownership and upfront costs, government policy will have to help drive adoption.

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