California Cities Can Require Developers to Build and Sell Affordable Housing in Their Projects

Local governments may enact laws that require all new residential development projects of 20 or more units to sell at least 15 percent of the for-sale units at a price that is affordable to low or moderate income households, the California Supeme Court has held.

The case marks a defeat for the California Building Industry Association (“CBIA”), who sought to invalidate San Jose’s inclusionary housing ordinance on the basis that the law was an unconstitutional condition in the form of a development exaction under the takings clauses of the United States and California constitutions. An “inclusionary housing ordinance” is a law that requires a developer to construct and offer affordable housing as a part of its proposed development project. The case is California Building Industry Ass’n v. City of San Jose, decided June 15, 2015.

The decision is significant for cities and counties as they grapple with the limited amount of affordable housing in the state. Many cities and counties are now expected to follow San Jose’s example and adopt laws imposing affordable housing requirements on for-sale development in their jurisdictions. The imposition of affordable housing requirements on new for-rent housing is limited by the Costa-Hawkins Rental Housing Act, a 1995 state law.

For developers, the decision is another example of the tough legislative requirements imposed on new developments in California.  Developers of large scale projects have often had to deal with cities and counties demanding that in return for long term vested rights to build their projects, the developer is required to provide a percentage of affordable housing in the overal project. Now, not only can cities and counties bargain for a required percentage of affordable housing in development agreements, they can mandate it as law on projects as small as 20 units (and perhaps fewer!). Developers in cities and counties that adopt such laws will now need to include in their pro formas the cost of building, offering and selling affordable units to low income and moderate income families. Those financial impacts not only include lower returns on construction and development costs, but the added expense of implementing an affordable housing program as part of the project (unless the local government provides those services).  The inclusionary requirements will certainly reduce developer profit, but may also affect the financial viability of the project as a whole.

Chief Justice Cantil-Sakauye wrote for the Court that the conditions that the San Jose ordinance imposed upon future developments did not impose “exactions” upon the developer’s property so as to bring into play the unconstitutional conditions doctrine under the takings clauses of the federal or state constitutions. The conditions do not require the developer to pay money but place a limit on the way a developer may use its property, the court said. The ordinance serves legitimate government purposes of increasing the number of affordable housing units in the city and assuring that new affordable units are distributed throughout the city as part of a mixed-income development. Therefore, the court reasoned, the affordable housing ordinance is a zoning restriction, not a taking. The higher standard of court review applied to takings cases did not apply. Instead, the court could apply the much lower judicial review standard for zoning laws: such laws will be upheld so long as they have a reasonable relationship to a legitimate governmental interest.

CBIA’s lawsuit was a “facial” challenge to the City of San Jose’s ordinance, which argues that the ordinance was unlawful for essentially all reasonably conceivable projects. Another path to challenge the City of San Jose’s ordinance is still available. It is still possible for a developer to make the argument that the law, “as applied” to its particular project, is a taking. Under compelling facts, the California Supreme Court could find that “as applied” the law was confiscatory or an “unconstitutional condition” to the development of the project. However, such a lawsuit would be a risky endeavor given the Court’s prior holding.

In addition, CBIA could appeal the decision to the United States Supreme Court to review the California Supreme Court’s interpretation of federal takings law.  Strategically, it would probably be best for the CBIA to wait for a project with compelling facts in an “as-applied” challenge rather than using the facial attack. It could well be the case that the chances of prevailing would be higher in an “as-applied” challenge.  The risks of losing the case in another “facial” challenge and establishing national legal precedent similar the California Supreme Court’s holding would definitely not be welcomed by the development community.

Charter Cities Not Required To Pay Prevailing Wages to Private Construction Workers on Locally Funded Public Works

In July, the California Supreme Court issued an opinion with far-reaching impact on the payment of prevailing wages in public works projects. In State Building Construction Trades Council of California, AFL-CIO v. City of Vista, 54 Cal.4th 547 (July 2, 2012), the court exempted charter cities and their contractors from the obligation to pay workers state-mandated prevailing wages when a public improvement project is a “locally funded public work.”

In City of Vista,  the court held that the wage levels of contract workers building locally funded public works are a “municipal affair” and not a matter of “statewide concern.” As a result, the California Constitution protected Vista’s adoption of an ordinance prohibiting the payment of prevailing wages, because the ordinances of charter cities supersede state law with respect to “municipal affairs.”

Facts

In 2006, while Vista was a general law city rather than a charter city, city voters approved a sales tax to fund renovation of several public buildings. In February 2007, following a special election, Vista changed from a general law city to a charter city. One of the purposes of the change was to give the council the power to decide whether to impose prevailing wages on the construction of its planned public works projects.

Shortly after that, the Vista City Council enacted a city ordinance to prohibit city contracts from requiring payment of prevailing wages, except in three limited circumstances: “(a) such payment is compelled by the terms of a state or a federal grant, (b) the contract does not involve a municipal affair, or (c) payment of the prevailing wage is separately authorized by the city council.”  The city council then enacted a resolution approving contracts for the public buildings to be financed by the sales tax, but did not require compliance with the state’s prevailing wage laws. The State Building and Construction Trades Council of California (“the union”) then filed suit.

The Court’s Decision

The court started its analysis with what is commonly known as California’s “home rule doctrine.”  This doctrine is set forth in Article XI, section 5, subdivision (a) of the California Constitution, which provides, “It shall be competent in any city charter to provide that the city governed thereunder may make and enforce all ordinances and regulations in respect to municipal affairs, subject only to restrictions and limitations provided in their several charters and in respect to other matters they shall be subject to general laws. City charters adopted pursuant to this Constitution shall supersede any existing charter, and with respect to municipal affairs shall supersede all laws inconsistent therewith.”

In view of the language of the California Constitution, the court said, “[T]he controlling inquiry is how the state Constitution allocates governmental authority between charter cities and the state.”

The court then applied the framework for determining whether an ordinance of a charter city concerns “municipal affairs” or whether the ordinance would be superseded by state law as dealing with matters of “statewide concern.” California Fed. Savings & Loan Assn. v. City of Los Angeles, 54 Cal. 3d 1, 17 (1991) (“California Fed. Savings”).

The court concluded “that the wage levels of contract workers constructing locally funded public works are a municipal affair (that is, exempt from state regulation), and that these wage levels are not a statewide concern (that is, subject to state legislative control),” reaffirming City of Pasadena v. Charleville, 215 Cal. 384, 389 (1932). 

In support of its holding, the court reasoned as follows: 

  • First, “the construction of a city-operated facility for the benefit of a city’s inhabitants is quintessentially a municipal affair, as is the control over the expenditure of a city’s own funds. Here, the two fire stations in the City of Vista, like the municipal water system in Charleville, … are facilities operated by the city for the benefit of the city’s inhabitants, and they are financed from the city’s own funds. We conclude therefore that the matter at issue here involves a ‘municipal affair.’” Second, noting that the prevailing wage laws expressly cover public works of a city, whether a charter city or not, the court found that “an actual conflict exists between state law and Vista’s ordinance.”
  • The court rejected the union’s arguments that what may have once been a “municipal affair” was now a state concern because (i) the prevailing wage is now set by the Director of the California Department of Industrial Relations, rather than the local contracting body, as when Charleville was decided, (ii) the state’s economy is interconnected at the state level and regional levels, and (iii) that prevailing wages support state-wide apprenticeship programs in skilled crafts. The court considered these arguments and instead stated: “[T]he question presented is whether the state can require a charter city to exercise its purchasing power in the construction market in a way that supports regional wages and subsidizes vocational training, while increasing the charter city’s costs. No one would doubt that the state could use its own resources to support wages and vocational training in the state’s construction industry, but can the state achieve these ends by interfering in the fiscal policies of charter cities?” The court answered “no.” The same principle that applies in the court’s prior decisions with respect to public employees held true for private employees as well.

Factors Cities and Developers Should Consider

City of Vista significantly changes the trend in California on the issue of the payment of prevailing wages. Over the past 10 years, the legislature has expanded the types of projects that qualified as “public works” and were subject to the payment of prevailing wages. This ruling allows charter cities to separate themselves from the legislature’s prevailing wage requirements. Today, charter cities can exert much greater control over their capital improvement expenditures. 

The court’s decision helps financially strapped charter cities and struggling real estate developers.   Construction spending can go farther with potentially greater public benefit. Public works that had been put on hold because construction was too expensive may be possible. A private development dependent on significant public improvements may not have been financially feasible if prevailing wages (and benefits) had to be paid, but now the project may be possible, simulating the local economy. On the other hand, union employees may find that the wages they will be paid on public works projects will drop in the aftermath of this decision, affecting their wallets.

What’s more, developers and charter cities may need to more closely evaluate Project Labor Agreements (“PLAs”) on multi-craft construction contracts, balancing their costs against the labor relations benefits they offer.

The important question is whether a charter city’s proposed improvement is a “locally funded public work” — something the court does not specifically define. However, the expenditure of “a City’s own funds” was identified as a municipal concern exempt from prevailing wages. But what constitutes “a City’s own funds”? A voter-approved sales tax measure for public construction purposes qualified in City of Vista. If a charter city received money under a development agreement from a developer for constructing a public park, would the use of those proceeds be an expenditure of “a City’s own funds”? If a charter city received mitigation fees or impact fees for a new public library, would the spending of those dollars be “an expenditure of a City’s own funds”? A good argument can be made for each of these, if properly structured.

An interesting strategy worth considering is whether a charter city can create a Mello-Roos communities facilities district, or another special taxing district, and cloak the funds expended by those entities with the constitutional “home rule” protection granted to charter cities. A particularly plausible alternative is using charter city-created public finance tools, such as facilities benefit assessments used by the City of San Diego and the City of Sacramento, to shield a charter city from the payment of prevailing wages.  

The case also raises the issue that unions may take actions to press their agenda on charter cities which refuse to opt into the state’s prevailing wage mandate.  Those strategies could include direct political pressure of city council, the ballot box or use of other legal tools (such as environmental laws and regulations) that prevent or delay the commencement of construction.

— Kenneth Kecskes

Option to Buy Real Estate Does Not Confer “Interest” in Real Property

A California appeals court has held that an option to purchase real property is only a contract right and is not an interest in real estate.  The decision has ramifications for real estate developers that seek to use option agreements to create a “legal or equitable interest in real property” for purposes of California’s development agreement statute. 

An “option to purchase” is a contract in which the owner of land agrees not to revoke an offer to sell real property for a defined period of time.  The option is granted to a potential buyer, called an optionee, who pays a fixed amount for the option.  While option agreement terms vary, an option agreement must describe the subject property and the purchase price, among other things.

An option can be beneficial to both the potential buyer and the landowner.  For example, an option is used to give a potential buyer time to secure development approvals for the land.  If the development approvals cannot be obtained, the potential buyer lets the option lapse, because he is not bound to purchase the property.  Real estate investors also sometimes use an option to tie up property before equity and debt financing is secured.  

Usually, a memorandum of option is recorded in the real estate records of the county where the property is located.  By recording the memorandum of option, anyone searching the real estate records has notice of the potential buyer’s right to purchase the property under the option.  However, sometimes a memorandum of option is not recorded against title to the property, occasionally because the seller will not allow it, or other times because the parties simply elect not to do so for another reason.

People who record a memorandum of option sometimes mistakenly believe they have real property “interest” upon recordation of the memorandum.  It’s easy to make that assumption.  A recorded memorandum of option is a cloud on title even if it is not exercised.  Once recorded, all subsequent purchasers or encumbrancers are on notice of the optionee’s rights to buy the property.  Upon the completion of a sale pursuant to a recorded option, the title received by the purchaser “relates back” to the date the option was given and extinguishes the interests of the intervening party — including intervening easements, leases, deeds of trust, and other transfers.  

Cyr v. McGovran is one of a growing number of cases that find that an option does not vest or grant an “interest” or “estate” in real property.  Dwayne and April McGovran owned a ranch consisting of eight parcels of land in San Luis Obispo County.  The McGovrans listed the property for sale.  The McGovrans and Cyr agreed that Cyr would buy two parcels outright from the McGovrans and, apparently for tax reasons, could have options to buy the remaining six parcels over a period of two years.  If Cyr timely exercised his option to purchase the lots in an agreed-upon sequence, he would then have an option to purchase the next lot in sequence.

The McGovrans’ lender filed a notice of default as to some of the parcels subject to Cyr’s options.  As a condition to obtaining a new loan, the McGovrans gave the new lender an option to purchase the same six parcels that Cyr had options to purchase.  The lender’s option was exerciseable only if Cyr failed to timely close escrow on two of the lots.  The lender’s option conflicted with Cyr’s options in that the escrow closing dates shown in Cyr’s options were later than those shown in the lender’s option.  Pursuant to Cyr’s options, he had until December 30, 2003 to close escrow on two of the lots.  Pursuant to the lender’s option, Cyr had until September 15, 2003 to close escrow.

In August 2003, Cyr became aware of the potential problem with the lender’s option which could cloud title to the properties.  Cyr did not close escrow on the two lots by the September 15th date shown on the lender’s option.  On September 16, the lender recorded a Memorandum of Option Agreement clouding title to the two lots.  On November 4, 2003, Cyr’s attorney took issue with and denied the claim by the lender that it had some right in the properties which was superior to Cyr’s rights.

Cyr assigned his option rights on one of the lots to Mesa Vista, Ltd.  He assigned his option rights on the other lot to Mid-Coast Capital.  Both companies timely closed escrow pursuant to their options.  On November 26, the lender filed a complaint for specific performance of its option.  On the same date, the lender recorded a lis pendens.  The lawsuit was eventually dismissed and the lis pendens was expunged.

On December 23, 2005, Cyr filed an action against the McGovrans and their real estate agents.  One of the causes of action was for negligence, alleging that the McGovrans negligently failed to assure that the McGovrans did not grant to their lender an option inconsistent with Cyr’s options.  The McGovrans filed a motion for summary judgment.  The trial court agreed with the McGovrans on the basis that the complaint was not filed within the two year statute of limitations for an action based upon professional negligence.

On appeal, Cyr argued that the three-year statute of limitations for an injury to real property applied, not the two-year statute of limitations for a professional negligence action.  The court rejected Cyr’s argument.  The court reasoned that Cyr did not have title to the real property and it was the lender, not Cyr, who recorded the Memorandum of Option Agreement and the lis pendens that clouded title to the properties.  The basis of the negligence action was not injury to the real property, but injury to the option rights to purchase the properties.  The latter injury was allegedly caused by respondents’ negligent performance of professional services.  Quoting Wachovia Bank v. Lifetime Industries, (2006) 145 Cal.App.4th 1039, 1050, the court reasoned:  “Although an option gives the optionee contractual rights to purchase the property, it is ‘merely an offer to sell and vests no estate in the property to be sold.'” The option holder does not have an “interest” in the land, the court found.

The court went on to say:  “An option is transformed into a contract of purchase and sale when there is an unconditional, unqualified acceptance by the optionee of the offer in harmony with the terms of the option and within the time span of the option contract,” quoting Steiner v. Thexton (2010) 48 Cal.4th 411, 420.

Real estate developers and investors that purchase option rights should pursue recordation of a memorandum of option when feasible.  A recorded option offers more protection to a potential buyer because it offers constructive notice of the option and  “relation back” benefits. On the other hand, some sellers of real estate may prefer that the option not be recorded, because it acts as a cloud on title.  This is a matter of negotiation between the parties.

The Cyr case also calls into question a strategy used by cities, counties and developers in redevelopment transactions where the city or county owns the land.  When this strategy is followed, a city or county grants an option to a prospective developer/purchaser to create an interest in the property.  A “legal” or “equitable” interest is necessary to support the vested rights secured by a development agreement.  The Cyr case stands for the proposition that an “interest” in real property is not created by an option agreement, but the court’s decision does not expressly distinguish between “legal” and “equitable” interests.  There may be an argument that an “equitable” interest is created upon the signing of the option, but that argument looks less compelling in light of the Cyr court’s holding.  Depending on the facts, it may be more prudent for a city and developer to enter into a real estate purchase agreement, instead of an option, at the time the development agreement is entered.  The purchase agreement could be structured with pre-closing conditions that relieve the developer from the obligation to purchase the property in the event entitlements are not secured.  Legal counsel should be consulted to negotiate and draft such an agreement.