This column pushed a lot of buttons. I've retired from a commercial architectural woodworking business that I founded and ran for forty years. I have great respect for the construction of the nineteenth century, both residential and commercial. Great effort went into the esthetics. Today's buildings are little more than boxes. In my own career I wrestled with the choice between doing larger, simpler jobs which were easier to manage, or smaller more complex jobs that I could take pride in. In the end, I did some of both.
This column is an excellent overview of the issues facing the residential construction industry. It gets at both the financial and the human issues involved. It's rare to see one column attempt to integrate the two. I live in a very old neighborhood, near a large university. You could say there is tension. Old-time residents work to preserve the nature and the history of the neighborhood, while developers work to concentrate as many students as possible into a neighborhood that was never intended to have this many residents. Generally, the American economy has become more and more favorable to larger and larger financial interests. But it leads to a subordination of the individual. We are ants in a colony.
Your idea of nonprofit loan funds is not so "novel", I'm afraid. There is a whole industry of noprofit lenders called Community Development Financial Institutions (CDFIs). These are lenders with a mission, many of whom are certified by the US Treasury Department (via a department called The CDFI Fund). There are now more than 1300 CDFIs around the country, according to the CDFI trade association (Opportunity Finance Network). The majority of these CDFIs finance affordable housing projects including ones by small developers. The industry has its challenges: 1)obtaining inexpensive capital so we can lend it out at affordable rates and 2) attracting and retaining talent. Your comment about inflating salaries at nonprofits is less of an issue than trying to retain good people when they can make more money elsewhere doing similar work. I've spent 25 years in this industry. It's not sustainable to expect people to sacrifice their earning potential over the long term.
To add another solution (that’s prone to go wrong) - I work at a state Govt agency that does a lot of project financing and the state legislature just allocated money to us to finance affordable housing projects in cities that undergo zoning reform. It’s based on a similar loan fund we’re currently operating. You can read about it in my post - https://www.complexeffects.com/p/affordable-housing-bill-could-incentivize
One problem that can occur with non-profit/public, mission-based lending is the lender can be hamstrung by policy to find projects that meet the mission-based requirements and also the DSCR. Mission-based requirements like creating a certain amount of jobs, and having proof that the project couldn’t get done with traditional bank financing. If that’s the case, the lender is a lender of last resort, and the projects often don’t meet the Debt service ratio requirements. I think the state legislature included this clause because the banks were fussy that the state would maybe compete too much with lower interest rates.
This could just be the case in my state, but mission-based lending with too many mission-driven requirements (like not wanting to compete with traditional banks) could make the fund less impactful.
I have been a developer of market rate and affordable housing in NYC for 40 years and am just completing my first development outside of NYC with the renovation of a building from 1890 located in the heart of Baltimore's largely abandoned historical downtown: www.crookhornerlofts.com. My own experience in Balt supports the basic premise of your article. Even with my extensive experience (over 7,000 units developed/$2 billion in costs) and a significant balance sheet I was forced to contribute an enormous amount of my equity in order to obtain a construction loan (from a small regional bank).
With small and regional banks now being clobbered by the mismatch between rates to attract deposits and longer term mortgage lending the financing problem is even bigger than it was. I think the best suggestion from this article is to create a more viable secondary market operation through Fannie and Freddie so that these smaller banks can off load their longer term loans. Would improve small bank profits (through origination fees and construction interest) and increase their lending. They are not going to survive investing depositor funds in Treasuries. How to get this to happen of course is a heavy lift.
Very interesting article, but I don't understand why this is framed as a financing issue.
The major roadblock to financing small developers is their relatively high risk. But most of the things the urbanist movement works on decrease that risk and the overall costs. If we are successful, this problem solves itself.
In the meantime I guess we could try specific fiscal policy, but that's just putting the cart before the horse
This was briefly touched upon with the comment about Subway, but this seems exactly like the corporate consolidation happening all across the economy in grocery stores, airlines, agriculture, etc. Smaller companies have non-monetary benefits but get outcompeted by larger companies. Germany has their Mittelstand culture of encouraging small businesses. Meanwhile in the US, the only way we seem to be able to support small businesses is with NIMBY protests against McDonalds and real estate developers.
Apart from having more liberal zoning laws, how does Japan seem to get over the hurdles you mention in the essay? Is the industry dominated there like it is in the US and Canada by big developers? What are the cities around the world who have imitable development models?
Noah - all true. Importantly, the federal regulatory bodies removed the ability for community banks (under $1 billion in total assets) to lend to builders and small developers. These regulators, in their search for a simple explanation of loan problems, blamed contractors and small developers. Regulatory guidelines for future loans made it extremely difficult for these borrowers to obtain credit on acceptable terms. Even though most of the problem construction loans were eventually resolved with little loss, the regulators felt, as always, that punishment had to be dealt to someone.
In the market in which I live, small builders have virtually all closed up shop. Their construction activity has been replaced by large developers, who mostly build large apartment complexes and charge high rents.
So, in short, small developers and builders were forced out of business as a result of the regulators tagging them with blame for the last financial crisis. It's a shame, because they were an excellent fit for true community banks and the lending expertise for that type of loan has been replaced by criteria that requires much more equity than a small builder can muster - or than is necessary to protect the bank and its depositors.
...to promote, among other goals, in-state housing development?
States like Oregon are focused on housing production now with grants to cities for infrastructure development. So why not lend the state's resources to the financing challenge described here?
Interesting column and written by someone with obvious passion for the topic. A few observations:
1) Financing/Debt: Debt provides leverage and that is great on the way up. It is also the accelerant to demise on the way down. Part of me wants to say....be careful for what you wish. There seems to be a tradeoff between pace of development and leverage.
2) Financing/Equity: Real Estate is somewhat unique in the ability to tap banking capital for risk capital. Obviously, some of this has to do with the existence of tangible property and also implicit governmental supports (loan guarantees) . Most other industries do not have this access, yet raise very large amounts of money (note the crazy valuations around AI). The ability to do so is a function of the higher expected return. Thus, it appears that the conventional real estate product cannot provide this level of upside....or this situation has not been developed.
3) Economies of Scale and Innovation: In any market, economies of scale are real, but I am not sure it is necessarily anti innovation. There are large unique planned communities which can be built at scale (Seaside, babcock ranch, even the villages). Nearly every industry goes through this process (restaurants, farming, retail, auto, etc).
Assuming one accepts the virtues of small developers (and I do), it appears that one must figure out how to build a product where these virtues translate to tangible economic differentiation. One wonders if this means that small developers need to build a different product... perhaps one infused with services which cannot be easily scaled by a large developer. Interestingly, the US government has faced similar issues and the concepts around SBA, SBIR, and related small business support have been developed. Perhaps something similar might be useful in this circumstance from a town point-of-view. An interesting idea would be to have more relaxed rules for developers who actually live in the same town.
Overall, it appears there is a need for innovation around building a differentiated product. Building a product which fits in the preferred financial structure for large developers seems very difficult.
I whole-heartedly agree with the premise that "it's better for the health of a neighborhood if more buildings are constructed by the people who live within it, or at least in the area." I would go further in saying that it's better for the health of a neighborhood when buildings are *owned* by the people who live within it (or in the area). It's a switch from a rentier mindset to an owner mindset.
Unfortunately, it seems this ownership mindset is only accessible to the wealthy who can afford the luxuries of architecture with character, and neighborhoods with community. Of the local wealthy, who has the charity to extend these luxuries to the lower/middle class? I reckon that it's a function of where their wealth is tied up. Successful local business owners seem much more likely to extend that charity vs. successful individuals with lifetime savings tied to the stock market (not trying to disparage these folks).
Good post. As a former developer with experience across the medium to large range of buildings, I agree with the writer that more small-scale development (which, as he points out, will only be done by small-scale developers) would enrich our communities.
It would also tend to improve affordability. A point that perhaps could have been made more strongly is that lower-density building typologies are just much less expensive to build than are higher-density typologies. The building costs (per square foot of rentable area; i.e., the sum of the space inside all the apartments) of a 6-7 story building are generally 2-3 times higher than those of a two-story walkup -- a huge difference. The costs of an urban high-rise are 8-9x higher per square foot than a production ("tract") single-family home. Building cost increases directly with density (with step-changes where building typology under the building code changes), and the slope is steep.
So the kinds of infill product that small developers can build can be materially more affordable to the renter or buyer than higher-density product (assuming land can be acquired at a feasible cost; a significant challenge). That too would benefit communities.
This post hits home. We recently moved from Orlando and a large single family home on a big sub-urban lot to a new 6 story building building in Washington DC with 26 units. It sits next to a row of older town homes that were long ago modified to split single residency into multiple units each (about 3 to 5 in each town home.) It all blends in nicely and we see a lot of this happening DC with a large stock of nice apartments coming online this year. All this will make for more walk-able, beautiful neighborhoods and keep prices from shooting up. Yes, cities can still build. And DC is not doing too bad on this, for one.
This is interesting. I’m in this space more on the business side - basically micro cap M&A. The way deals typically get done at the smaller scale (<$5-8m in EV) is via SBA 7a loans. These combine a PG with a government guarantee from the SBA and can lever up to .9 LTV. It’s a fantastic program and is responsible for a ton of small business investment and innovation.
I’m pretty sure SBA 504 loans can be used for real estate construction up to $5.5m. Do you think small developers need bigger debt packages than that, or are they too risk averse for the PGs? If it’s the latter, then my sympathy levels aren’t as high.
This column pushed a lot of buttons. I've retired from a commercial architectural woodworking business that I founded and ran for forty years. I have great respect for the construction of the nineteenth century, both residential and commercial. Great effort went into the esthetics. Today's buildings are little more than boxes. In my own career I wrestled with the choice between doing larger, simpler jobs which were easier to manage, or smaller more complex jobs that I could take pride in. In the end, I did some of both.
This column is an excellent overview of the issues facing the residential construction industry. It gets at both the financial and the human issues involved. It's rare to see one column attempt to integrate the two. I live in a very old neighborhood, near a large university. You could say there is tension. Old-time residents work to preserve the nature and the history of the neighborhood, while developers work to concentrate as many students as possible into a neighborhood that was never intended to have this many residents. Generally, the American economy has become more and more favorable to larger and larger financial interests. But it leads to a subordination of the individual. We are ants in a colony.
Your idea of nonprofit loan funds is not so "novel", I'm afraid. There is a whole industry of noprofit lenders called Community Development Financial Institutions (CDFIs). These are lenders with a mission, many of whom are certified by the US Treasury Department (via a department called The CDFI Fund). There are now more than 1300 CDFIs around the country, according to the CDFI trade association (Opportunity Finance Network). The majority of these CDFIs finance affordable housing projects including ones by small developers. The industry has its challenges: 1)obtaining inexpensive capital so we can lend it out at affordable rates and 2) attracting and retaining talent. Your comment about inflating salaries at nonprofits is less of an issue than trying to retain good people when they can make more money elsewhere doing similar work. I've spent 25 years in this industry. It's not sustainable to expect people to sacrifice their earning potential over the long term.
To add another solution (that’s prone to go wrong) - I work at a state Govt agency that does a lot of project financing and the state legislature just allocated money to us to finance affordable housing projects in cities that undergo zoning reform. It’s based on a similar loan fund we’re currently operating. You can read about it in my post - https://www.complexeffects.com/p/affordable-housing-bill-could-incentivize
One problem that can occur with non-profit/public, mission-based lending is the lender can be hamstrung by policy to find projects that meet the mission-based requirements and also the DSCR. Mission-based requirements like creating a certain amount of jobs, and having proof that the project couldn’t get done with traditional bank financing. If that’s the case, the lender is a lender of last resort, and the projects often don’t meet the Debt service ratio requirements. I think the state legislature included this clause because the banks were fussy that the state would maybe compete too much with lower interest rates.
This could just be the case in my state, but mission-based lending with too many mission-driven requirements (like not wanting to compete with traditional banks) could make the fund less impactful.
I have been a developer of market rate and affordable housing in NYC for 40 years and am just completing my first development outside of NYC with the renovation of a building from 1890 located in the heart of Baltimore's largely abandoned historical downtown: www.crookhornerlofts.com. My own experience in Balt supports the basic premise of your article. Even with my extensive experience (over 7,000 units developed/$2 billion in costs) and a significant balance sheet I was forced to contribute an enormous amount of my equity in order to obtain a construction loan (from a small regional bank).
With small and regional banks now being clobbered by the mismatch between rates to attract deposits and longer term mortgage lending the financing problem is even bigger than it was. I think the best suggestion from this article is to create a more viable secondary market operation through Fannie and Freddie so that these smaller banks can off load their longer term loans. Would improve small bank profits (through origination fees and construction interest) and increase their lending. They are not going to survive investing depositor funds in Treasuries. How to get this to happen of course is a heavy lift.
Very interesting article, but I don't understand why this is framed as a financing issue.
The major roadblock to financing small developers is their relatively high risk. But most of the things the urbanist movement works on decrease that risk and the overall costs. If we are successful, this problem solves itself.
In the meantime I guess we could try specific fiscal policy, but that's just putting the cart before the horse
This was briefly touched upon with the comment about Subway, but this seems exactly like the corporate consolidation happening all across the economy in grocery stores, airlines, agriculture, etc. Smaller companies have non-monetary benefits but get outcompeted by larger companies. Germany has their Mittelstand culture of encouraging small businesses. Meanwhile in the US, the only way we seem to be able to support small businesses is with NIMBY protests against McDonalds and real estate developers.
Apart from having more liberal zoning laws, how does Japan seem to get over the hurdles you mention in the essay? Is the industry dominated there like it is in the US and Canada by big developers? What are the cities around the world who have imitable development models?
Noah - all true. Importantly, the federal regulatory bodies removed the ability for community banks (under $1 billion in total assets) to lend to builders and small developers. These regulators, in their search for a simple explanation of loan problems, blamed contractors and small developers. Regulatory guidelines for future loans made it extremely difficult for these borrowers to obtain credit on acceptable terms. Even though most of the problem construction loans were eventually resolved with little loss, the regulators felt, as always, that punishment had to be dealt to someone.
In the market in which I live, small builders have virtually all closed up shop. Their construction activity has been replaced by large developers, who mostly build large apartment complexes and charge high rents.
So, in short, small developers and builders were forced out of business as a result of the regulators tagging them with blame for the last financial crisis. It's a shame, because they were an excellent fit for true community banks and the lending expertise for that type of loan has been replaced by criteria that requires much more equity than a small builder can muster - or than is necessary to protect the bank and its depositors.
Excellent analysis. You have articulated the challenges better than those of us in the industry.
In addition to non-profits as a source of funding, what about a state bank...
https://en.wikipedia.org/wiki/Bank_of_North_Dakota#:~:text=The%20Bank%20of%20North%20Dakota,bank%20in%20the%20United%20States.
...to promote, among other goals, in-state housing development?
States like Oregon are focused on housing production now with grants to cities for infrastructure development. So why not lend the state's resources to the financing challenge described here?
Interesting column and written by someone with obvious passion for the topic. A few observations:
1) Financing/Debt: Debt provides leverage and that is great on the way up. It is also the accelerant to demise on the way down. Part of me wants to say....be careful for what you wish. There seems to be a tradeoff between pace of development and leverage.
2) Financing/Equity: Real Estate is somewhat unique in the ability to tap banking capital for risk capital. Obviously, some of this has to do with the existence of tangible property and also implicit governmental supports (loan guarantees) . Most other industries do not have this access, yet raise very large amounts of money (note the crazy valuations around AI). The ability to do so is a function of the higher expected return. Thus, it appears that the conventional real estate product cannot provide this level of upside....or this situation has not been developed.
3) Economies of Scale and Innovation: In any market, economies of scale are real, but I am not sure it is necessarily anti innovation. There are large unique planned communities which can be built at scale (Seaside, babcock ranch, even the villages). Nearly every industry goes through this process (restaurants, farming, retail, auto, etc).
Assuming one accepts the virtues of small developers (and I do), it appears that one must figure out how to build a product where these virtues translate to tangible economic differentiation. One wonders if this means that small developers need to build a different product... perhaps one infused with services which cannot be easily scaled by a large developer. Interestingly, the US government has faced similar issues and the concepts around SBA, SBIR, and related small business support have been developed. Perhaps something similar might be useful in this circumstance from a town point-of-view. An interesting idea would be to have more relaxed rules for developers who actually live in the same town.
Overall, it appears there is a need for innovation around building a differentiated product. Building a product which fits in the preferred financial structure for large developers seems very difficult.
I whole-heartedly agree with the premise that "it's better for the health of a neighborhood if more buildings are constructed by the people who live within it, or at least in the area." I would go further in saying that it's better for the health of a neighborhood when buildings are *owned* by the people who live within it (or in the area). It's a switch from a rentier mindset to an owner mindset.
Unfortunately, it seems this ownership mindset is only accessible to the wealthy who can afford the luxuries of architecture with character, and neighborhoods with community. Of the local wealthy, who has the charity to extend these luxuries to the lower/middle class? I reckon that it's a function of where their wealth is tied up. Successful local business owners seem much more likely to extend that charity vs. successful individuals with lifetime savings tied to the stock market (not trying to disparage these folks).
Excellent and informative article. Pieces like this are the reason I upgraded to Paid. Keep 'em coming Noah!
Good post. As a former developer with experience across the medium to large range of buildings, I agree with the writer that more small-scale development (which, as he points out, will only be done by small-scale developers) would enrich our communities.
It would also tend to improve affordability. A point that perhaps could have been made more strongly is that lower-density building typologies are just much less expensive to build than are higher-density typologies. The building costs (per square foot of rentable area; i.e., the sum of the space inside all the apartments) of a 6-7 story building are generally 2-3 times higher than those of a two-story walkup -- a huge difference. The costs of an urban high-rise are 8-9x higher per square foot than a production ("tract") single-family home. Building cost increases directly with density (with step-changes where building typology under the building code changes), and the slope is steep.
So the kinds of infill product that small developers can build can be materially more affordable to the renter or buyer than higher-density product (assuming land can be acquired at a feasible cost; a significant challenge). That too would benefit communities.
This post hits home. We recently moved from Orlando and a large single family home on a big sub-urban lot to a new 6 story building building in Washington DC with 26 units. It sits next to a row of older town homes that were long ago modified to split single residency into multiple units each (about 3 to 5 in each town home.) It all blends in nicely and we see a lot of this happening DC with a large stock of nice apartments coming online this year. All this will make for more walk-able, beautiful neighborhoods and keep prices from shooting up. Yes, cities can still build. And DC is not doing too bad on this, for one.
This is interesting. I’m in this space more on the business side - basically micro cap M&A. The way deals typically get done at the smaller scale (<$5-8m in EV) is via SBA 7a loans. These combine a PG with a government guarantee from the SBA and can lever up to .9 LTV. It’s a fantastic program and is responsible for a ton of small business investment and innovation.
I’m pretty sure SBA 504 loans can be used for real estate construction up to $5.5m. Do you think small developers need bigger debt packages than that, or are they too risk averse for the PGs? If it’s the latter, then my sympathy levels aren’t as high.