The YIMBY claim goes like this: "SB827 will concentrate new development in already-rich, single family home neighborhoods, because that's where rents will be highest. This will reduce displacement." What would Marx say?

High rents or high profits?

The YIMBY argument begins with a fallacy that says "developers will flock to wherever rents are highest -- i.e. rich neighborhoods".

The presumed rents are in effect the price for which use of the new housing will be sold. The first YIMBY mistake is to say that capitalists will be motivated simply by higher rents, i.e. higher prices.

As Marx might point out, the motive force of capitalism is not higher prices -- it is the production of surplus value. The main "goal" of capitalism is to increase the total capital, both absolutely and relatively.

Capitalists do not seek the highest prices, in other words, they seek to maximize their accumulation. Abstracted from all else, a capitalist is concerned first and foremost with the rate at which his accumulated capital grows, particularly relative to wages, and to the accumulation of competing capitalists.

A capitalist will find a lower price preferable, in other words, if it allows him to maximize his rate of return.

Profits in rental real estate

In rental real estate, the rate of capital accumulation is approximated by something called the cap rate (and similar measurements). Here is a formula for cap rate:

cap rate = (rent - operating cost) ÷ property sales price

The unit of cap rate is % per unit time. For example, an apartment might have a cap rate -- a rate of return on investment - of 5% per year. That means that the net income each year is expected to be 5% of the property's market price.

The equalization of profit rates

Here is a remarkable empirical fact about rental real estate in a growth market like the Bay Area: the cap rate of existing buildings for sale, and the cap rates for new development, are all about the same, in every part of each city, within a very small margin of variation.

An investor who buys up old rent controlled stock and continues to run it that might get a cap rate of, say, 4% - 6% per year. An investor buying up and renting out single family housing in an exclusive neighborhood might get, say, 4% - 6% per year. An investor in a new 8 story apartment building will get, say, 4% - 6% per year.

That convergence of "returns on capital" has lots of technical detail behind it but it is an example of what Marx (following earlier writers) called the tendency of the rate of profit to equalize.

How, though, does the rate of profit equalize this way in rental real estate? There are many factors but some key ones are:

  1. Construction costs are about the same no matter who is building.

  2. So are comparable building management costs.

But one more reason is very important:

  1. Rates of return on capital for real estate tend to equalize because that's where the sales prices of rent real estate come from.

The price of a posh single family house and its lot, and the price of an apartment building in a moderate or lower income neighborhood are chosen so that the cap rates on the two properties will be close.

If you were to try to sell a property at a price implying a cap rate of 2%, you'll struggle to find a buyer. If you price the same property so that the cap rate is 10%, you'll sell easily and people will think you are a sucker for leaving money on the table.

The possible levels of rent, minus the operating costs, determine the net income. The land prices tend to be roughly a constant multiple of that potential net income.

Beating the standard rate of return

The equalization of returns on rental properties suggest that a developer won't move towards the "highest rents," necessarily -- since that doesn't automatically mean a higher rate of accumulation.

We must ask: How can a developer try to get around this almost-law by which the rate of return is the same no matter where he builds? How can he "break" the law and get a higher rate of return?

In a built-out area, a developer is almost always going to be demolishing improvements to a property in order to build new structures. A developer's role -- financially speaking, even though the work may involve many contractors -- is to keep the demolition and new construction "in house".

A big real estate equity firm attracts investors who do nothing but put in cash, and later take out cash. Inside the equity firm, the firm does the demolitions, development, and building management using its own, proprietary networks of suppliers.

Such a real estate equity firm makes some of it money, perhaps, just on "fees" for handling the cash. But much of the firm's return comes from "in-sourcing" the actual development process, and sometimes building management as well.

(Again, I say "in-housing" even though the equity firm likely uses contractors.)

So there is really a second potential profit on the investment. The arms-length investors who put in and take out cash get the cap rate. Meanwhile, the developer firm gets transaction fees and some of the profits from the development process itself.

What are those profits? Suppose that the developer's rate of profit is R. Then his profits on the development process are:

R × (demolition and rebuild cost - price of demolished bldg)

The price of the demolished structure is subtracted here since it is fully consumed during development.

Even though the cost to build is the same in the rich single family house neighborhood as it is in the moderate or lower income neighborhood, the prices of demolished structures are likely to differ. The rich neighborhood houses are likely very well maintained, on average. In the less rich areas, not so much.

The developer makes a higher profit, in other words, if the project involves demolishing a more depreciated structure (like an old rent controlled building) than if it involves demolishing a well maintained structure.

There is also a third source of profit -- and one that is riskier but not by much. When private equity swoops into some "dis-invested" area -- but that in spite of that neglect is near enough to a rich area to be potentially "up and coming" -- the new investment can be a self-fulfilling prophecy.

Billion dollar funds work with developers to buy up large amounts of land in poor areas of rich regions. Then, having got that land at current prices, they announce plans to aggressively redevelop and upscale those places. On that news alone, the price of their newly bought land goes up.

Thus there is that third source of profit. In total there is the net income on rentals, developer profits, and lastly the speculative profits that are the reward for buying large swaths of land in distressed neighborhoods.


SB827, if passed, will create a significant low point in the regulatory costs of pulling the trigger on redevelopment in already speculatively attacked neighborhoods. Thus, SB827 will accelerate land appreciation there, and consequently, accelerate displacement.

In short, SB827 is a way to revive old racist, classist "urban renewal" policies -- without admitting openly that that is what the law will do.

P.S.: On Segregation and SB827

One view of what is going on in the Bay Area and similar regions is a geographic segregation by income. Poorer people are being displaced. Richer people are moving in. Bourgeois economists call this phenomenon "skill sorting". There is no empirical question as to the reality of this phenomenon -- only questions of "what is to be done".

The theory outlined above shows, in part, that cap rates tend to equalize -- while growth tends to concentrate development on vulnerable neighborhoods that can be, by force of investment, shifted to an "up and coming" category.

That lays bare the basic mechanism of the whole-region "skill sorting". The regionally local growth of high income households in a built out area with an open market for redevelopment will reliably push out poor people.

SB827's authors have proposed "protections" for poorer tenants -- some relocation assistance and a shot -- probably often a long shot -- at return to a "subsidized" unit. The theory above helps us see why such "protections" will be wildly insufficient.

The realization of the expected returns on newly inflated land values require either the replacement of existing tenants with tenants paying much higher rent -- or the production of much costlier housing units which, also, will require tenants to be paying much higher rent.

Thus, SB827-style protections fail twice. On the one hand, the most directly impacted tenants who are eligible for the benefits will often be unable to take full advantage of them. On the other hand, all the other tenants who are indirectly screwed by just the land price increases are simply out of luck.

As it turns out, in other words, public policies to fight economic displacement can not work through market liberalization, even with SB827-style protections. Such "protections" are based on a false understanding of segregation.

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Copyright (C) 2018 Thomas Lord