California’s Budget Solution: An Affordable Housing Problem?

It has been said that as California goes, so goes the nation. Unfortunately, this seems to be holding true for the fiscal affairs of many states throughout the country. Like California, many states are facing unprecedented budget deficits. The numbers are staggering and, not unexpectedly, so too are the solutions being proposed to overcome the crises. With radical proposals come devastating unintended consequences.

Gray Davis, Governor of California, recently made a proposal to solve part of the state's budget crisis which could potentially impact the low-income housing market in California to the tune of $100 million. Naturally, the reaction by California's development community has been charged. And, if California is truly a trend-setting state, then the development communities in other states should pay close attention to the California example so that they are prepared if — or, perhaps more accurately, when — a similar proposal is suggested in their state.

California's Budget Crisis

Faced with a $35 billion budget deficit, California's Governor Davis has announced that the California Legislature will have to make sharp cuts in spending, but the Governor is also considering several alternative revenue sources. One proposed measure is to shift $500 million in unencumbered tax increment from 400 redevelopment agencies ("RDAs") to California's General Fund. The effect of this reallocation on the availability of affordable housing could be dramatic.

Redevelopment, including the provision of safe, sanitary housing, is funded in part by so-called tax increment financing. In general, the amount of tax increment allocated to an agency is equal to the difference between property taxes generated from a specific geographic area in a given year and property taxes that were generated in the same geographic area in the "base year" during which the redevelopment plan was adopted.

In addition to the overall goal of eliminating social and economic blight, the California Legislature has declared that RDAs are to use their tax increment revenue to expand the supply of low- and moderate-income housing. Consequently, the Community and Redevelopment Law, as amended, constituting California Health and Safety Code Section 33000 et seq. (the "Redevelopment Act") requires that RDAs spend at least 20% of their property tax increment revenue on affordable housing for seniors, people with disabilities and low- or moderate-income families within the territorial jurisdiction of the RDA. These funds help developers and RDAs to provide housing, finance repairs, subsidize rents, improve infrastructure and assist with home ownership for low- and moderate-income individuals.

By seeking a reallocation of $500 million in tax increment, Governor Davis' proposal would reduce the available funds for low- and moderate-income housing by $100 million. Affordable housing constituents estimate that reallocating $500 million from the RDAs to the General Fund could cause the loss of up to 15,000 affordable housing units statewide. The City of Los Angeles alone could lose one-third of its affordable housing budget.

Responding to the Threat

Despite the apparent threat to the availability of funding for affordable housing, strategies on both the local and the state level can be implemented to mitigate the potential damage.

On the local level, developers need to be proactive, signing contracts with the applicable RDAs earlier in the development process because the State of California may only reallocate "unencumbered funds." Once moneys are earmarked for a specific purpose, they may not be reallocated for another purpose.

Moneys are deemed encumbered if they are committed for appropriate expenditures pursuant to a legally enforceable contract. Appropriate expenditures under the Redevelopment Act include, but are not limited to, the acquisition of real property or building sites, and the acquisition, construction and rehabilitation of buildings or structures.

Although each RDA may possess its own policies and procedures, the redevelopment process generally begins with a developer supplying the applicable RDA with a letter of interest, wherein the housing assistance is proposed. Thereafter, the RDA and the developer negotiate the details of the assistance in a legally binding contract. If the RDA owns property upon which the developer proposes to build the to-be-assisted project, the RDA and the developer enter into a Disposition and Development Agreement ("DDA"). If the developer owns the property, then the form of agreement is called an Owner Participation Agreement ("OPA"). Once the RDA has committed tax increment funds to the developer through either the OPA or the DDA, the funds become encumbered for the designated purpose.

On the state level, redevelopment leaders are lobbying to see the definition of "encumbered" relaxed to include mere allocations to redevelopment projects that are in early planning phases. The hope is that the state will recognize housing funds as earmarked by an RDA for a project even though no formal agreement has been executed with a developer. One variation of this effort is AB 1058, which was referred to the Committee on Housing and Community Development on March 13, 2003. AB 1058 proposes that an RDA that incorporates certain community benefit standards into a redevelopment project is exempt from any transfer of tax increment funds to the General Fund. Even though the terms of a project are not formally agreed to through a DDA or OPA, a project that includes identifiable benefits to the community, such as providing a sufficient number of affordable housing units, generating additional tax revenue and increasing economic activity within the project area, is saved from a possible gubernatorial reallocation of redevelopment funds.

Additionally, developers may find themselves looking for alternatives to tax increment such as those found in Proposition 46. Passed in November 2002, Propo-sition 46 will bolster the number of affordable housing units in the State of California through the issuance of $2.1 billion of general obligation bonds, with more than half of the proceeds funding a variety of housing programs aimed at the construction of rental housing. These programs generally provide low-interest loans to developers in order to fund part of the construction costs. In exchange, the developer must commit a portion of the units in the project to low-income households for a period of 55 years.

More Work To Do

Opportunities exist to minimize the harsh effects of any proposal to reallocate moneys for redevelopment to California's General Fund. Developers must work earnestly to execute agreements with the RDAs for existing projects to encumber RDA funds early in the redevelopment process. Developers should also track AB 1058, and similar legislation, which if passed will protect millions of dollars of unencumbered redevelopment funds from reallocation. Developers should never stop looking for alternatives to tax increment financing of low-income housing, such as the public-private partnership embodied in Propo-sition 46. Unfortunately, whatever the fate of the Governor's proposal, the development community has much more work to do to ensure the availability of low-income housing — both in California and across the nation.

Lewis G. Feldman is the Managing Partner of the Century City office and may be contacted via e-mail at lfeldman@pillsburywinthrop.com or by phone at (310) 203-1188.

Douglas A. Praw is an associate in the Century City office and may be contacted via e-mail at dpraw@pillsburywinthrop.com or by phone at (310) 203-1131.

Pillsbury Winthrop LLP is a global law firm with power and presence on both U.S. coasts and abroad, with core practice areas in: real estate, litigation, technology and intellectual property, energy, capital markets and finance. The firm has 17 offices and approximately 800 attorneys worldwide. For further information on the firm's real estate practice, please contact Jim Rishwain at jrishwain@pillsburywinthrop.com or (310) 203-1111.