Sustainable Financing for Slum Upgrading

Dr. Bruce Ferguson MIT Upgrading Course

June, 2002

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Outline of Presentation

  1. The big picture and its financial implications   2. Strategies for sustainable finance of slum

upgrading: range of improvements, cost per unit, drivers of cost at project level

  3. Recovering costs: service charges, property taxes, and housing microfinance

  4. Financial lessons

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  I. THE BIG PICTURE AND ITS FINANCIAL IMPLICATIONS

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Slum formation arises from a chain of economic/financial factors   The low/moderate-income majority cannot afford to make

the debt service payment for purchase of the least expensive commercially built unit

  Hence, commercially financed, developer-built housing production usually covers only a small part of new household formation: less than 30% in most developing countries

  The alternative available to the remaining large majority is to build their housing progressively over 5 to 20 years

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Illustrative Home Affordability Calculations for a Contractor-Bill Core Unit Financed by a mortgage

Bolivia Colombia Venezuela Suriname

Cost 40 m2 house on 100m2 lot

$6,000 $16,000 $ 5,000 $13,000

Typical amount borrowed 1/ $4,800 $12,800 $4,000 $10,400

Annual interest rate 14.5% 31% 33% 39%

Average term 9 years 20 years 10 years 15 years

Monthly payment 2/ $78 $142(UPAC)

$111 $328

Typical monthly earnings oflow-income households

$75 $350 $225 $200

Typical monthly earnings ofmoderate-incomehouseholds

$200 $1,200 $350 $400

Maximum payment-to-income ratio of Lenders

25% 30% 30% 35%

Payment-to-income ratio oflow-income households

104% 40% 49% 164%

Payment-to-income ratio ofmiddle-income households

39% 12% 32% 82%

Estimated share of low-income households in pop.

Above 60% 78% 80% Above 70%

1/ 80 percent loan to value ration in the four countries.2/ Venezuela, Suriname, and Bolivia use mortgage instruments that amortize conventionally. Stable macro-financial management has allowed Colombia has to adopt successfullly a price level adjusted mortgage. Thisinstrument fixes mortgage principal amounts and repayments to a unit that remains in constant in real terms(the "UPAC"). This system greatly lowers monthly payments in the first years (helping to resolve the "tilt"problem withe conventional amortiziation, which front loans the real value of payment), and - thus - assists inhouseholds qualifying for loans.

From: Bruce Ferguson, 1999

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Slums solve the individual’s immediate need for shelter but at tremendous private and public cost

  The resulting informal settlements are candidates for becoming slums. Although slums satisfy individual’s immediate need for affordable shelter, they generate immense private and public costs

  The private costs borne by slum families include the tremendous effort necessary to build an adequate house over a long period, environmental degradation, disease, isolation from the mainstream, and urban violence (which also spill over into the rest of the city)

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The main public cost of slum upgrading...

  Consists of ordering these settlements and providing road-related infrastructure

  This reordering and basic infrastructure costs 2x to 3x that of formal-sector development. Guatemalan example: a subsidy for a new unit is $2,000, while that for slum upgrading costs $4,000

  Thus, slum formation creates a huge fiscal time bomb for Government

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Financial implications of the high cost of slum upgrading   Governments can only afford to fix the urban slum

problem for a small share of the population, e.g.: the favela bairro program of Rio de J. covers 500,000 of a total metro population of more than 10 million

  The best way to deal with slum upgrading financially is to decrease or stop slum formation, and then upgrade the existing slums starting with the least costly

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The key to stopping slum formation...   Is to raise formal-sector production to close to the rate of

new household formation. Countries (Chile, Costa Rica, El Salvador) that do this greatly decrease or stop new slums

  The best methods are to: (a) reduce subdivision standards to stimulate a low-income land development industry (El Salvador); (b) create a public mechanism for large-scale land development (Bogota); and (c) expand home finance/microfinance to reach low-income people

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  II. SUSTAINBLE FINANCE OF SLUM UPGRADING

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ProgramComponents Chile Colombia Argentina Brasil Brasil Brasil Bolivia Brasil PMB MVE PROMESA PROAP PBV HBB SMB PROAP (1990-95) (1995) (1996) (1996) (1996) (1998) (1998) (2000)

Infrastructure

Potable waterSanitation solutionDrainageRoad systemPublic lightingElectricity

Urban ServicesGarbage collection

Housing SolutionsSanitary coreHome improvementResettlement

Equipment and SocialServices

Community servicesPublic squares & sports fieldsChild care facilitiesServices for vulnerable groupsHealth clinicsIncome and job generation

Environment

Arborization and reforestationEnvironmental recuperationand mitigationProperty Regulations

Reordering based on land useProperty titling

Community Development

Sanitation and environmentaleducationCommunity organizing

Components of Sum Upgrading Projects

From: J. Brakarz, 2002

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“Slum upgrading” covers a wide range of improvements & services..   Core investments: water, sanitation solution,

drainage, roads   Frequent additions to the core: electricity, public

lighting, land title regularization, childcare facilities

  Others: health clinics, public squares, job and income related investments

  Thus, cost can escalate dramatically to unsustainable amounts

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First step: fix cost per unit through:

  Cost benefit analysis

  Cost efficiency analysis

  Spreading the available resources over need

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Cost benefit analysis

  Compares discounted present value of costs with that of benefits

  Pilot project designs lead to engineering studies that determine the upfront construction costs. Other costs - such as O & M - must be discounted to their present value value, and added to arrive at a cost/subsidy per unit

  Benefits….

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…(benefits) are calculated by one or more of three methods:   Property appreciation

  Willingness to pay

  Hedonic price studies

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Cost Efficiency Analysis

  Is less theoretically appealing but more practical than cost-benefit analysis

  Assumes a core package of improvements essential for slum upgrading and considers various alternatives for providing these services, and determines the least-cost method to arrive at a cost/subsidy per unit

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Table: Maximum Investment Cost Per Unit/FamilyIn Selected IDB Slum Upgrading Project

Country Program Maximum Cost (US$ from 1998)

Colombia MVE 2.000Chile PMB 3.900Bolivia SMB 4.200Argentina PROMEBA 6.500Brazil PROAP 4.500 HBB 4.000 PBV 3.600Uruguay PIAI 7.000

Note: does not include social service, community development and other non-investment costs

From: J. Brakarz, 2002

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Spreading available resources over the unserved population   Takes financial sustainability into account   Typically starts by setting a goal based on need for new

and upgraded units   Then, spreads available Government resources over need

to arrive at a cost/subsidy per unit   Example: Mexico set a goal of 750,000 units/yr to cover

new household formation and spread available federal and state resources over this figure to arrive at subsidy figure of $5,000 per unit

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Cost/subsidy per unit falls within broad ranges….   Middle-income LAC countries (Brazil, Mexico,

Venezuela, Chile) spend $3,500 to $7,000 per unit   Low-income LAC countries (Nicaragua,

Guatemala, Honduras) spend $1,000 to $3,500 per unit

  Projects that spend substantially more or less than these per-unit amounts are suspect

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Second step: select among slum upgrading projects using cost/unit as a guide

  At the project level, three factors account for most cost differences among sites: share of households necessary to relocate, the sanitation solution, and the cost of on-going garbage collection

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Relocating some slum households is often necessary to re-order the community to accommodate streets and public facilities

  However, relocation is a thorny political issues with high cost as families must be placed in comparable or better circumstances and, often, reimbursed for the move

  Relocating more than 10% of a slum’s households typically makes a project financially infeasible

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Appropriate sanitation solutions

  Vary widely from pit latrines, to septic tanks, to sewers with treatment. The choice depends on population density, soils, groundwater, regulations, and other factors

  Whereas a good pit latrine can cost $300 to $500, sewers with treatment require many times this amount.

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The cost of garbage collection ...

  varies widely because of the resulting street layout and accessibility of the upgraded settlement, level of community participation, safety, and other factors

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Three other factors can help lower costs in all sites

  Use one contractor for all construction work   Involve the agencies designated to maintain

the services and infrastructure of the upgraded area from the start

  Involve local government, which has better access to land and can better coordinate investments than Central Govt, and NGOs as organizers and social service providers

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  III. RECOVERING COSTS:   CHARGING FOR SERVICES AND

LAND/TENURE, PROPERTY TAXES, AND HOUSING MICROFINANCE

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A tension exists between recovering costs and the developmental objectives of slum upgrading   Households operate in the informal sector to avoid

costs. Families connect to water and electricity lines clandestinely, and buy and sell property without registering title to avoid transfer charges and property taxes

  Hence, formalizing services and title requires a transition in the form of lifeline rates and property tax exemptions for a limited time. The benefits of formality must outweigh the costs for households to stay in the system

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Privatization increases these tensions and requires special effort if companies are to serve upgraded slum   Slum upgrading occurs in the poorest areas

least attractive for service operators   Typically, Government must pay the entire

capital cost and negotiate the terms of serving these areas with companies

  Sometimes Government provides on-going subsidies to these companies, especially for water.

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Charging for land purchase and tenancy regularization   Governments often charge low-income

households sale prices that are well below market but still substantial, thereby recouping part of the capital costs of slum upgrading

  If squatted land is private, Government usually must repay the original landowner (at rates a fraction of market) from these sale proceeds

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Housing microfinance (HMF)

  HMF refers to small loans at market interest rates at short terms to low/moderate-income households to improve, expand, or replace their unit

  HMF has started to realize its great promise to finance the progressive housing process used by the low/mod majority without subsidies

  This practice is rapidly spreading in countries where microfinance has become competitive through microfinance institutions seeking to diversify and expand their portfolio

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Eight lessons for sustainable finance of slum upgrading   Best overall strategy: expand formal-sector low/

mod land development to decrease slum formation and the huge public costs it creates. Selectively upgrade settlements starting with sites with lower costs per unit.

  Fix maximum cost per unit through a mix of cost benefit analysis, cost efficiency analysis, and spreading available resources over need

  Use one contractor and involve infrastructure service agencies from the beginning

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Lessons (continued)   Avoid sites requiring relocation of 10%+   Involve local government to help access land and

coordinate investments, and NGOs for organizing residents and social service provision

  Charge families significant sums for land purchase   Balance the ongoing costs (property taxes, service

charges) with the benefits (formal and better services, access to programs, credit) of formality to keep households in the system

  Offer microcredit through private originators to reduce subsidies and recover costs for home improvement and/or new construction