In a major loss for the building industry, the California Supreme Court upheld an inclusionary housing ordinance ("IHO") adopted by the City of San Jose (“City") in California Building Industry Association v. City of San Jose, filed June 15, 2015. In upholding the IHO, the Supreme Court concluded that the adoption of the IHO was a valid exercise of the City's police power and not an exaction subject to the constitutionally-based reasonable relationship standard. As a result of this decision, we could see many cities in California adopting similar IHO's. This will likely result in increased costs for market rate housing to support the added costs associated with building affordable units.

IHO Requires Affordable Units

In 2010, the City enacted an IHO that required residential developments of 20 or more units to set aside 15% of those units as affordable. This obligation could also be met by constructing affordable units off site, or by paying an in-lieu fee estimated to be approximately $122,000 per required affordable unit.

The California Building Industry Association ("CBIA") filed a facial constitutional challenge seeking to set aside the IHO as invalid on its face, arguing that the City violated controlling state and federal law by adopting the IHO without demonstrating a reasonable relationship between the requirements it imposed and an increased need for affordable housing created by the new residential development. In short, CBIA argued that the standard of review for exactions applied so that the City must provide evidence showing that the IHO’s fees and exactions on new development are reasonably related and limited to the City's reasonable cost of addressing the negative impacts caused by the new development. The trial court agreed with CBIA and the City appealed.

The appellate court found that the IHO was not a land use exaction subject to heightened scrutiny, but an exercise of the City’s police power which is entitled to substantial judicial deference. As an exercise of the City’s police power, the IHO is invalid only if arbitrary, discriminatory, and without a reasonable relationship to a legitimate public interest. The California Supreme Court granted review of the Court of Appeal’s decision to decide which standard of judicial review applies to a facial constitutional challenge to IHO's that require set asides or in lieu fees as a condition of approving a development permit.

Set Aside Requirement is Constitutional

The California Supreme Court ("Court"), in a unanimous decision (with separate concurring opinions by Werdegar and Chin), upheld the decision of the appellate court and the City's IHO. The Court first analyzed the two alternative standards of judicial review at issue. First, the review of challenges to the exercise of police power, the standard advocated by the City and supported by the appellate court, which assumes that an exercise of police power by a city is reasonably related to the public welfare. Although there must be a reasonable basis in fact to support a city's exercise of police power, the burden is on a challenging party to demonstrate that the measure lacks such reasonable relationship. Second, the heightened scrutiny review required when a potential unconstitutional taking is at issue, advocated by CBIA and applied by the trial court, which holds that exactions imposed by a city IHO are only valid if the city can establish a reasonable relationship between the amount of a city's need for affordable housing and the portion of that need attributable to a particular development project.

The Court concluded that the first standard applies because the IHO did not impose any exactions and, thus, did not trigger the unconstitutional conditions doctrine recently highlighted in the U.S. Supreme Court's Koontz decision. The Court determined that the condition requiring a set aside of affordable units was not an exaction because it did not constitute the payment of a monetary fee but rather simply placed a limit on the way a developer may use its property. In support of this, the Court states that the set aside obligation does not require the developer to dedicate any portion of its property to the public or pay any money, but rather simply places a restriction on the property by limiting the price for which the developer may offer certain units for sale.

The Court noted that many land use regulations result in a reduction in the market value that a property may command in the absence of regulations and this does not constitute a taking of the diminished value of the property. In this regard, the Court reasoned that the affordable housing requirement was no different than limitations on density, unit size, number of bedrooms, required set-backs, or building heights. With regard to the IHO's in lieu fee component, the Court held that as long as a permitting authority offers a property owner at least one means of satisfying a condition that does not violate the takings clause, the property owner has not been subjected to an unconstitutional condition. Thus, since the set aside is not an unconstitutional requirement, then the other options available to the property owner, such as an in lieu fee, are not subject to challenge even though, standing alone, they could constitute an unconstitutional condition.

Implications of this Decision

This case stands for the proposition that local agencies in California may adopt IHO's as an appropriate exercise of their police power and that such ordinances will only be overturned if it can be established that the decision was arbitrary, capricious, entirely lacking in evidentiary support, bears no reasonable relationship to a legitimate public interest, or is unlawfully or procedurally unfair. Given this deferential standard for legislative actions, it will be very difficult to mount a successful legal challenge to such an ordinance. A proliferation of IHO's patterned along the lines of the one adopted by San Jose will likely result in increased costs for market rate housing to support the added costs associated with building affordable units.

In addition, this decision has different impacts on two important appellate court decisions from 2009. In footnote 6, the Court first recognized that the IHO expressly only related to new for-sale units, and not new rental units, thus the holding Palmer/Sixth Street Properties, L.P. v. City of Los Angeles (2009) 175 Cal.App.4th 1396) was unaffected. Later, the Court held that the decision in Building Industry Assn. of Central California v. City of Patterson (2009) 171 Cal. App. 4th 886, was incorrect to the extent that it held that IHO conditions are valid only if they are reasonably related to the need for affordable housing attributable to the project to which the IHO applies.