Why small developers are getting squeezed out of the housing market

A guest post by Coby Lefkowitz

Fir Street Flats, a fourplex with 3 apartments in Bothell, Washington, designed and developed by Cary Westerbeck of Westerbeck Architecture. Privately financed. Completed 2019. (Westerbeck Architecture)

I’m perpetually interested in how to build more and better housing, and also how to create nicer cities. So when my friend Coby Lefkowitz, owner of a small real estate development firm, offered to write a post about why small developers are finding it difficult to operate in today’s U.S. housing market, I was naturally intrigued. Reading this post, I learned some things about how the real estate development industry operates, and I think I understand a little bit better why American cities tend to look so drab and boring.

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Over the last few decades, and increasingly in the post-Covid era, Americans have begun to question why their cities are so bad. Urbanists have provided many compelling answers, and have gone further to propose how we might make our cities more affordable, dynamic, and resilient. As a result, urbanism is winning converts across the country.

The solutions urbanists have provided run the gamut from general calls for safer streets, to specific interventions like the abolition of single family zoning. Many are tempted to believe, however, that one silver bullet policy of their choosing–whether that be repealing parking minimums, allowing for more single-stairway buildings, investing more in public transit, and so on–can solve the many problems plaguing our cities. But no single intervention can solve something so complex and politically fraught. The solutions must be as comprehensive as the scale of the challenge.

Even while recognizing the need for comprehensive solutions, too many urbanists have ignored the importance of finance in charting a different course for the future. Without credit markets that can actually finance the creation of new housing, very little can get built. Without flexible credit markets, very little good can get built.  This particularly impacts small developers, and by extension the quality of our communities overall. Small builders imbue identity, intrigue, and charm into the places they work, and confer significant quantitative benefits like providing housing typologies that larger firms might not be willing or able to build, and offering it at attainable pricing.

This piece will focus on the role that finance plays in shaping our cities, starting with an exploration of why debt is used for construction projects in the first place. After, we’ll look at how lenders deal with the risks associated with the inherently challenging process of real estate development. This risk mitigation is critical to understanding why our world looks the way it does. Finally, we’ll dive into how America’s housing finance system is leading to negative consequences, privileging large scale institutional development at the expense of more incremental, community based building, and why we should work to support more of the latter. Small developers are the backbone of our communities. If they can’t access financing, our cities and towns will materially worsen.

You can’t build buildings without debt

Let’s start with the basics. Real estate development is expensive. Whether it's an office block, apartment building, hospital, indoor ski lift, school, or strip mall, the costs can be substantial. Few individuals or institutions have enough money lying around to cover all of the expenses. Even if they do, it often makes more sense to use debt to leverage their equity proceeds further. For instance, consider the following example:

Equity Scenario

• A home costs $1,000,000 to construct

• $1,000,000 of equity is used to construct this home

• The home is sold for $1.3 million dollars after construction, netting a 1.3 multiple on investment

Debt + Equity Scenario

• A home costs $1,000,000 to construct

• $250,000 of equity, and $750,000 of debt, are used to construct this home

• The home is sold for of $1.3 million dollars after construction, netting a 2.2 multiple on investment after debt is paid down (well, not precisely, as interest and closing costs would make this number a bit lower, but you get the point)

Comparing two scenarios with identical net proceeds ($300,000), the home builder using debt enjoys significantly higher returns relative to the one who only used equity. As the scale increases, so does the divergence in returns. While the first builder can only construct one home with a $1,000,000 equity investment, the second can build four. Said another way, a $1,000,000 investment yields a $300,000 profit for the first builder, while the same initial investment nets the second home builder $1.2 million. Factors like coordinating different crews across 4 different buildings, variable construction costs, sale prices, and interest rates may complicate this simplistic math, but in theory, it underscores the power of leverage. If one can make more money from the same amount of money (or less), it makes rational sense to do so.

Understanding this power, developers and builders will use debt for nearly every project, but obtaining it is not a straightforward process. That’s because construction, in addition to being expensive, is very risky. There are a hundred things that can go wrong. A dozen usually do, and that’s only if you're lucky. That’s a problem for more reasons than one. Traditional banks, the primary lenders in the construction markets, aren't in the risk business. They're in the risk management business. If they're going to extend a loan, they want to make sure that they can take as much risk off the table as possible.

How real estate lenders limit their risk

This mitigation materializes in a few ways. First are the key ratios and metrics used to assess a project's viability. Arguably the most important metric is the Debt Service Coverage Ratio, which calculates how much net operating income (NOI) a property generates compared to the amount of stabilized debt it has. Ideally this exceeds 1.2 (where a property has 20% more NOI than debt). The Debt Yield is another important metric. It looks at NOI as a percentage of the total stabilized loan amount. Typically, lenders want this number to be more than 10%, or for a property with a $1,000,000 loan to have at least $100,000 of NOI.

Second, lenders are cautious about the size of the loans they offer as they want to avoid being overexposed to projects that might go south. Banks in the US today rarely extend credit instruments with a Loan-to-Cost (LTC) ratio greater than 75%. Depending on the macroeconomic situation, the size of the development, and the quality of the borrower, some developers may struggle to finance more than 50% of their hard and soft costs from one lender. This prompts them to either put up a larger amount of equity (reducing their returns) or seek alternative bridge financing to reach 65-70% LTC, albeit with higher interest rates.

Lastly, lenders will take collateral. If a borrower fails to live up to the terms of the contract, the bank can seize the asset. Though not a simple process, it’s rather straightforward. Through foreclosure, the lender will try to recover the balance of the debt they issued, sometimes making a small profit, sometimes losing a little bit.

This process is trickier in construction. The last thing a bank wants to do is take over a project midway through. They're not developers, after all. Collateral of a bad asset isn’t worth very much. And half-finished buildings are pretty bad assets. Half-finished structures, initially designed by a team no longer involved in the project, may have limited market appeal, especially if the plans were unconventional. This team may have cut corners as well, but that’s difficult to know unless a comprehensive diagnostic is carried out, which is expensive and time consuming. One hopes nothing will be found, but chances are that if a project went bust halfway through, things were not on the up and up. In the case where changing market conditions made the continuance of the project infeasible, whether due to rising costs or diminished demand for the final project, there may be no buyers for a stalled out construction site.

This is bad news for the bank. Taking over a project means they likely won't receive all of their principal back, and they certainly won’t be getting any interest payments, which is their core business model. If a bank issues a $6 million loan on a deal, and the sponsor walks away from it, the bank faces two choices. The first is to wait for someone to acquire the project for its debt basis, which could take a while. The second, less favorable option, would be to market the project for its land basis as some other form of development. This would be a matter of last resort, as the land may only be worth $1 million on a project of this scale. Given the headaches associated with demolishing whatever was built, it might trade for even less than this. Staring down a $5 million loss, lenders may opt to sit on the asset until the market turns around. You can imagine how precarious these things get when a couple of zeros are factored in. But the hope of salvation tomorrow is far more enticing than dealing with the reality of today.

Why small developers have trouble getting loans

This brings us to the crux of the issue. Not everyone can execute a real estate development project. It’s risky, difficult, and requires a highly specialized skill set. Banks don’t fully know who will be able to execute at the onset of a project. The best they can do is to work with developers who have a long established track record. Even this is no guarantee of success. But it erects a fairly sizable barrier to entry for smaller, younger, or unproven outfits who don’t have any track record to speak of, to say nothing of a proven one. A catch-22 materializes. The only way to get financing from a bank is to have done projects before, but the only way to have done projects before is to have gotten support from a bank previously. It’s very difficult to enter this loop without having already been in it. It’s sort of like how employers ask for a year of work experience for a job that’s only courting recent graduates. How can you have a year of experience if no one is willing to give you the year of experience you require, because you don’t have a year of experience?

A developer can enter this cycle if they possess ample financial resources to support a project. However, perhaps more important than simply having enough funds to cover unforeseen expenses is the fact that a well-capitalized sponsor provides the bank with the prospect of recovering their investment in the event of project failure.

This mechanism usually comes in the form of a personal guarantee (PG) backed by one’s personal assets or a balance sheet. If the bank can’t recoup what’s owed to them through foreclosure, they can go after assets pledged as a part of the PG. This is where things can get really dangerous for less experienced developers. Depending on the terms of a PG, the bank can garnish wages, liquidate pledged assets, and pretty much make the developer’s life miserable in myriad novel and terrifying ways. Mitigating actions like shielding ownership in an LLC to protect external assets can be taken, but it adds a few layers of sophistication that new builders might not know how to navigate. Naturally, with barriers so high, and terms so onerous, many would-be developers are discouraged from even trying

These imperatives privilege a concentration of the most well-capitalized firms who have done the most projects before. In 2022, nearly 25% of all multifamily units started in the country (more than 132,000) were commenced by just 25 developers. That’s a strikingly high percentage in a country of more than 60,000 developers. Similar trends exist for new single-family homes. According to the National Association of Home Builders, in 1989 the ten largest builders “captured 8.7% of closings.  By the year 2000, the share was 18.7%; and by 2018, 31.5%, reaching above 30% for the first time.”  In 2022, that number reached 43.2%.

Multi-family units started by the top 25 developers compared to all multi-family starts in the country

The roots of this trend began in the early 90s. Following a series of tax law changes in 1993 relating to the treatment of REITs, institutions began to dip their toes into the public real estate markets. Specifically residential real estate. After getting comfortable with the asset class, they diversified into private real estate, where more than 90% of all their allocations flow today.

At the turn of the millennium, institutional investors allocated just 2–3% of their portfolios towards real estate. Two decades later, target allocations have jumped north of 10%, a ~3–5x increase. This spike tracks eerily close to both the increase in private construction spending since the mid-90s, and the balance of outstanding multifamily loans originated in the last 25 years, which have increased from $288 billion to $1.37 trillion. The total market for professionally managed real estate now stands at $5.3 trillion in the US.

That’s a lot of money flowing into this asset class. And if you're investing this money, it doesn't make sense to spread it across dozens of small projects. Too much can go wrong. Investing $100 million in one project is 20x less of a headache than investing it across 20 projects. The same is true on the debt side. It’s far more preferable to arrange debt financing on $100 million than $1 million. It takes the same amount of work to underwrite these two loans, but the financial outcomes are vastly different. If you can make more money while doing the same amount of work, you’ll choose to make more money.

Naturally, the biggest developers aren’t building duplexes, quadplexes, or rows of townhomes. They’re building projects that can absorb tens of millions of dollars—structures with hundreds of units. Those 5-over-1s you’ve seen popping up everywhere. The uptick in new multi-family buildings with 50 units or more (the Census doesn’t track the size of larger complexes), has risen commensurately with the entrance, and increased allocation into real estate, of institutions. We’ve been on a 30 year up-trend, with one Great Financial Crisis sized dip.

With more big buildings, there are fewer small buildings. The sorts of places that people just starting out typically build. As everything becomes bigger, and anonymized, and value engineered, it's nearly impossible for smaller builders to compete with larger ones capitalized with billions of dollars. So most people don't, leading to an ever larger share of institutional development. This crystalizes the notion that all developers are nameless suits (or vests, to update the stereotype). As the data shows, this is increasingly true.

Why cities still need small developers

Now, you might be asking why this is something to be concerned about. Isn’t this just what markets operating efficiently looks like? Isn’t it better to have a higher proportion of buildings carried out by the most professionalized firms to ensure higher quality homes? And with more standardization of building, shouldn’t cost efficiencies be realized? To save you the suspense of each answer—I’m not sure, I don’t think so, and construction costs have outpaced CPI over the last 30 years. I’m not suggesting that the institutionalization of real estate development is to blame for rising construction costs, but it could be related. More research on the subject is needed.

It is interesting to note, however, that much of the divergence from CPI in construction seems to be due to labor costs. This could be due to a few things. After the Great Financial Crisis, many construction workers left the industry and didn’t return, leading to a severe labor shortage. Those who remained could command much higher wages owing to their relative scarcity. Secondly, if more of the companies building housing are publicly traded home builders or institutionally backed multi-family firms, they can’t take advantage of the cheaper labor that smaller builders have access to, namely unlicensed, undocumented, or less sophisticated crews. This doesn’t mean that smaller builders are cutting corners, but that they don’t need to deal with as many headaches and costs borne of administration and bureaucracy.

We should care about the institutionalization of real estate for two primary reasons. One qualitative, one quantitative. First up, qualitative.

If smaller developers can’t secure traditional debt, whether because they can’t sign the personal guarantees, the deals are too small for the lenders to bother with, or byzantine rules like the restriction of lending to LLCs that plan to develop 2-4 units, our neighborhoods will materially worsen. It’s my belief 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. Fewer local developers, the corollary follows, diminishes the health and character of a neighborhood.

When you build in your own neighborhood, a pride imperative materializes. If you have to go by a project frequently, you want to feel good about the fruits of your labor. There are few things worse than spending several years creating something, only to be disappointed in the final result. Insult is added to injury if your friends, family, co-workers, or adversaries (especially your adversaries) pass your project and are likewise less than enthused with the product. Believe me, they’ll tell you, and it doesn’t exactly feel good.

On the other side of the coin, there are few feelings better than your community accepting or admiring something you created. This confers an intangible reward that can’t be calculated in any excel model. Based on the pride imperative, small builders create places they can be proud of, often imbued with the idiosyncrasies of local character. Moreover, they create places their communities need, as they have an intimate understanding of the area that cannot be divined by demographic analyses in some far off cubicle (or living room couch). 

Institutional developers rarely build in their backyards. They're based in a select few city centers (New York, Dallas, Chicago, DC, Miami, San Francisco), and are thus infrequently connected to the places they build in. This leads to a product with little personality—getting creative with design is a risk that might not pay off, after all. If you never pass the places you build, or aren't held accountable for what you create, there's little reason to care about the quality of a building beyond the bare minimum required to hit a certain return threshold unless you’re inordinately driven to create something fantastic, in which case you probably wouldn’t have found yourself in the bullpen of a large institutional developer in the first place. While it’s theoretically possible for these firms to deliver high quality interventions to the built environment, it’s preciously rare. This is painfully obvious in so much of what’s built today.

Small developers diverge from large ones when it comes to returns as well. They tend to be less motivated by squeezing every last dollar out of a project than creating somewhere they can be proud of. This isn’t to say they don’t care about making money—of course they do. But their capital structure doesn’t require them to grind down every last dollar, as they’re far more likely to be long term holders of the places they build than larger merchant builders who seek to juice returns in anticipation of a sale, driving NOI upwards to realize a sufficiently high valuation. Institutional developers have to hit a certain rate of return in order to satisfy the needs of their Limited Partners (who are pensioners, insurance recipients, scholarship students, and sophisticated high net worth individuals).

In reviewing many dozens of financial models and development schemes for small builders every year, I’m constantly surprised (and heartened) by how many of them care deeply about the quality of what they build. They defiantly underwrite rents lower than what they might be able to achieve because they don’t want to spurn the community that gave them so much. They often build strange and superfluous design features for no other reason than that they like them. They’re able to be far more flexible in rental rates, terms, and overall conditions of tenancies than corporatized property managers who can deflect blame to some nameless boss somewhere else. These narratives rarely make headlines, as small developers seek no glory and receive even less, but are nonetheless prevalent.

Small builders create the sorts of places that form the identity of communities. In one example, they often lease their retail spaces to local operators. Maybe their friend Sam, who runs a coffee shop. Sam may opt for cozy seating options like couches, and furnish the ground in rugs that make the space feel more homey. Brand standards of large chains would never permit these furnishings due to the potential maintenance nightmare they represent. It’s far easier to have polished concrete floors and uncomfortable metal chairs because they can’t so easily be stained, and are highly durable. But they’re also soulless.

These are the imperatives of institutional development. High credit, national tenants are required as banks view them more favorably. Subway will almost certainly pay higher rent than the local deli, and its cash flows are much more secure. This leads to compressed cap rates and higher valuations on top of the already increased cash flow, compounding the raw advantages of leasing to a multi-national chain over a local operator. What rational actor with obligations to their investors could turn down such a proposition? This same math bears out across salons, banks, hardware stores, burrito shops, etc., etc. We have institutionalized our communities, and drained the charm and soul out of them.

Leaving aesthetics and the warm-and-fuzzies of neighborhood composition aside, the current structure of development finance limits the amount of housing that can be built. Zoning codes, along with other land use regulations like floor area ratios (FAR), dwelling unit restrictions per acre, setback requirements, maximum lot coverage ratios, and minimum parking ratios, restrict the total number of units that can be built on any given lot. There are only so many parcels that can be acquired, or aggregated, that legally allow several hundred-unit large buildings. For example, if a 20,000 square foot (roughly half an acre) has an FAR of 0.5, only 10,000 square feet of buildable area will be permitted. Good luck getting much more than 20 units in a building this size. While rezonings and land use code revisions may increase housing allowances, achieving the necessary density for institutionally backed firms is unlikely to happen on a majority of lots.

Far more likely will be laws that permit gentle density and missing middle typologies. The sorts of deals that are just right for local developers who wish to do high quality infill work. In cities where the vast majority of land is zoned to support 4 units or less, failing to rectify the debt environment could mean leaving tens of thousands of units on the table. If we adjust the allowable density up just a little bit, that could mean hundreds of thousands of homes.

Let’s take San Francisco as an example. According to its planning department, there are 122,805 single family homes in the city, which take up roughly 38% of the land. If just 20% of these lots, or 7% of the city’s land, were redeveloped to allow 4 unit buildings, 73,683 net new homes could be realized, housing at least 155,000 people (based on the city’s current household size of 2.11 people per dwelling unit). At 10 units per building (possible with 3-5 story structures depending on the lot dimensions), more than 220,000 net new homes could be created, housing 466,000 people. Those homes would accommodate more than half of the current population of San Francisco, without compromising its generally low-rise character. The city’s housing supply would increase by 53%, and the State of California’s mandate for the city to provide 82,000 homes over the next 8 years would be exceeded nearly three times over.

To give some perspective, in New York, a city 10 times the size of San Francisco, 37% of homes are in buildings with 5 units or less. Half are in buildings with less than 20 units. It’s the densest city with over 70,000 people in the country (the 6th densest overall, the top 5 are all New Jersey suburbs of the city). 

Small buildings can also be more economical than large ones. Even in cities that adopt reforms to facilitate more intense construction, the costs can inhibit development. Economies of scale can only be leveraged so far when the cost of elevators, double loaded corridors, large parking garages, and de rigueur amenity spaces are factored in. If a certain rent threshold cannot be achieved in one of these large new buildings (which almost always must be at the top of the market, owing to the return imperatives of these firms and the high costs of construction), these buildings won’t get built, further worsening our housing crisis.

Why it’s so hard to change the financing system

So, what’s to be done? Can banks be modified to help smaller builders out? Probably not. Their fundamental nature as risk mitigation machines won't change. Metrics like DSCR, Debt Yield, and the creditworthiness of borrowers are essential to their ability to perform this mitigation. While there may be smaller customers who grow to become larger clients one day, many won’t make it there, and banks don’t exactly want to bet on the few who will survive. This isn’t to say traditional lenders aren’t willing to extend some level of risk, but it falls short of solving the challenge at a meaningful scale. As has been explored, the risk and effort associated with small loans are simply not worth it for the banks. While a lender might be comfortable underwriting a duplex, introduce complexities like a ground floor commercial unit with an ADU in the back of the lot, and it might be a better use of everyone’s time to burn the mortgage contract before it’s even signed.

Even if an enterprising lender wanted to support a developer with a more innovative building, the absence of a secondary market for these sorts of non-conforming loans is a significant structural obstacle. The majority of mortgages are sold on the secondary market, which allows banks to export their risk to someone else. That risk can only be exported, however, if there’s Federal support. But Fannie Mae and Freddie Mac don’t provide the backstopping lenders require to get comfortable with issuing these sorts of products, meaning traditional lenders must hold these loans on their balance sheets if they want to offer them. This is, you guessed it, too risky for most banks to contemplate. Better to stick with what’s proven. Currently, around 80% of federal loans and guarantees support single-family homes. This could possibly date back to the Federal Housing Administration’s original sin, Daniel Herriges argues, of defined mixed-use and smaller apartment buildings in urban areas as hazardous for the purpose of issuing loans. These vestiges continue to influence our housing finance landscape today.

It’s also unlikely that Federal and state regulations will be modified to give banks the flexibility required to support small developers navigating this process. While a large developer may easily be able to deposit $1,000,000 into a bank account to satisfy the lender’s reserve ratios, a small developer may struggle to put anything in the bank. Sorry, out of luck. Large firms increasing their share of the overall banking market is also a threat, as the sorts of smaller, local lenders who understand the merits of small developments get wiped out. And I don’t see rules that will allow small developers to build with reduced liability changing anytime soon. If anything, they may get more strict.

All of these challenges compound in high(er) interest rate environments. If projects are difficult to make work at 4%, they probably won't work at 8%. But because small developers can't get traditional financing, the rates for them aren't 8%, but 12, 15, and sometimes as high as 20% as they must go to hard money lenders who require higher returns for the perceived higher risk.

Aspirational developers must thus get creative, or grit their teeth for many years of tight times. It's hard work at the beginning, as I’ve come to know intimately. We've been developing housing for the better part of 3 years and have little to show for it. We've made even less. This period is generally known as the crawling-on-hands-and-knees-across-glass phase of one’s career. Romantically in the post-hoc, a bit less so while one’s going through it. Many days we feel as though we’re pushed several steps backwards. Other days, there are no steps at all. That's development for you. It's not easy. I’ve reconciled this (as much as one can) with the fulfillment that comes with the pursuit of creating great places. But fulfillment doesn’t put food on the table. And draining one’s savings from a small amount to a near non-existent amount promises even less. There should not have to be a glass in knees and hands phase. There has to be a better way forward.

Unfortunately, there are no great answers, or else the problem would have already been solved. But as real estate development privileges a lot of…shall we call it thinking time, here are a few ideas I’ve been meditating on.

Some ideas for how to get loans to small developers

1. Friends and Family

While it can be helpful to raise debt from friends and family to get started, it’s not really scalable, and not accessible for those who don’t come from money. It requires a lot of conviction and may strain personal relationships. For those who can access it, it’s a good step onto the property ladder, but has limited long-term potential.

2. Sympathetic Private Lenders

Hard money lenders should be a means of last resort due to potentially usurious rates. Fortunately, they’re just a subset of the broader private debt market, and philosophically aligned lenders who can offer more favorable terms are out there. On our projects, we pay rates that are very close to what a traditional bank might offer, but don’t have to sign any personal guarantees or deposit large sums of money into a bank account. The whole process gets wrapped up in a week or so over a few cups of coffee where we mostly talk about how the surf in Southern California is. Lenders like this are out there. If you can provide a compelling vision, whether through aesthetics, social responsibility, or improving communal quality of life, and are still able to achieve reasonable risk adjusted metrics (slightly less severe debt yield and DSCR thresholds), there are many who might want to support you.

Private lenders face a choice between the risk free return (or as close to it as is possible) of 4.25% through investing in the 10-year treasury note, or double that in a construction project that leads to some positive community change they support. Securing a first position on the construction loan that allows them to take over the site at 65 - 70 cents on the dollar in case the project fails may tip the decision in favor of issuing debt, especially when the lender can take upfront origination fees and reduce their equity investment at the back. This leads to a third sort of financing structure.

3. Developers as Private Lenders

While traditional lenders want to avoid taking a property back, if a developer issues the loan in the first place, they’re in a very favorable position to execute on a half-finished project should something go wrong. There are obvious conflicts of interest here, as the developer who issues the loan could use predatory tactics to wring out a lot of interest and then take over the deal at a significantly reduced basis. In circumstances like this, it’s crucial for the borrower to scrutinize operating agreements and loan documents to make sure they’re not being played for a fool. If and when this is resolved, this relationship can be mutually beneficial. The senior developer can lend not just construction proceeds, but experience and guidance on what pitfalls to avoid. The junior developer can trade long days on the job site for the equity and support of the senior partner, who also gets an opportunity to nurture a promising green talent who may shape their city in unknown but wonderful ways. This relationship may flower, with the two entering into a more formal joint venture partnership with one another. This is a pathway I’m particularly keen on.

4. Non-profit lenders

One last idea, novel, but potentially very impactful, is to establish a non-profit debt fund to offer below market construction loan terms tied to Affordable housing production goals.

In 2022, corporate philanthropy exceeded $21 billion, an extraordinary amount of money, but just a fraction of  the $500 billion donated by the American public in the same year. Redirecting even a portion of this substantial sum to housing could result in the creation of thousands of affordable homes. This isn’t an unreasonable expectation. For perspective, in 2020, Facebook alone allocated $150 million towards the creation of affordable housing. If 1% of national philanthropy were dedicated, to pick an arbitrary number, $5 billion could be unlocked.

Here are two ways this could work in practice. The first is on the debt side. A non-profit fund fueled by tax-deductible donations would be ineligible for returns, and could thus offer highly favorable construction loan terms. With administrative costs kept in check (no easy thing), the fund could be robustly managed while only charging 1 point in origination fees to borrowers, and perhaps 2% in interest rates, resulting in an annual administrative operating budget of $150 million. If the average loan size were $1 million, 5,000 projects a year could be financed. Each project would incur $30,000 in administrative costs. One internal project/loan manager could likely oversee 15, 20, or 30 projects a year, depending on the level of involvement required. If the fund needed to take over from a struggling developer, this number would of course drop, and relative administrative costs would rise.

Loans would be contingent on the developers providing housing at some designated affordable threshold of Area Median Income (AMI). Perhaps 80%. This will be more or less viable depending on the market. In more expensive metros, the fund might act as a stabilization lender, where small developers pay higher construction rates to a private lender, but refinance into a permanent loan with 2 or 3% interest rates. Not every deal will pencil under these metrics, but many more would be unlocked.

The second approach would see this money act as an equity infusion, functionally a grant. While it’s outside the scope of this article, if this money were dedicated exclusively to supply side solutions, more than 16,600 units could be built per year at a conservative cost of $300,000 per door (a healthy amount in the most expensive metros, and very very high in secondary markets and beyond).

Of course, these models work better the more money one is able to raise. While both could theoretically work at $100 million, the challenge lies in allocating $3 million for salaries across 100 projects. This equates to the same per-project administrative costs as the scenario above, but the expense of hiring a competent management team, which could cost many millions of dollars a year alone, would likely not be able to be spread across so few projects.

On this note, caution is needed to avoid non-profits inflating executive and staff salaries, a common problem in the industry. Many non-profits view themselves as beyond reproach, owing to their missions that are perceived to be noble and free from the corruption of capital. But just because a company is a non-profit does not mean there is no profit. It can simply be funneled towards salaries without employees having to cede the moral high ground. Perhaps more should demur. Executives routinely make large sums of money off of the most marginalized people. There are countless stories of non-profits raising a lot of money only for the majority of it to go towards staff compensation. Little ever finds its way to where it was intended to go. A 2007 report found that outright fraud claims more than 13% of the gross funds raised for charity. Accountability is critical.

No Substitute For Hard Work

A better built environment is possible if we’re able to solve the financing challenges faced by small developers. It won't be easy. It won't happen overnight, and it will require a great many challenges to be overcome. But what exists on the other side of that—the promise of rejecting our last century of development patterns in favor of the places of our dreams—is certainly worth it.

It will require tenacity, creativity, passion, flexibility, risk-taking and conviction on the part of developers and lenders alike. While it begins with small projects, the cumulative impact over time can lead to substantial success. With hope, the credit markets and regulatory state will recognize the importance of supporting small scale development, shifting momentum away from the institutionalized, risk-averse, beauty-averse, intrigue-averse world of contemporary development, to the magnificent idiosyncrasies of small community building.

The cities of our dreams were not built by institutions, but by industrious, proud, maverick developers who came in all shapes and sizes. Neighborhoods felt neighborhoodly because the mom and pops who built and owned the buildings lived close by. They had a vested interest in making them as good and welcoming as possible. While large builders have always played a part in the construction of our communities, and will always have some role to play, it is important that we don’t forget those who imbue the identity and spirit into the places we live. Form follows zoning. Form follows land use regulations. Form follows building codes. Form follows the developers who craft our built environment. And form follows finance. If we work hard to get the form right, who knows what magic we can create.

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